Professional

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

And then I tweeted this on Feb. 26.

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

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

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

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

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

And then we had the Bear Stearns Bounce.

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

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

And so here we are in 2020.

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

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

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

So here’s my opinion.

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

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

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

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

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If our 3/23 update seemed slightly asymmetrically rosy in characterizing the near-term balance of narrative structural elements, you will probably spot a similar bent toward negative asymmetry here. Most of that is due to what we see as the emergence of a complacent narrative structure around the flattening of the curve in the US.

This is a network graph of high-circulation US financial markets-related news from April 1 through the morning of April 7. The highlighted nodes relate to articles mentioning flattening or slowing of the curve. It immediately circulated through nearly every part of the network, and was related to nearly every COVID-19 related topic within financial news.

Topic	Narrative Structure	Narrative Structure Changes Since 3/23
Current General Spread / Fear of Covid-19:	Complacent (Changed from Mixed)	Our assessment of this narrative structure has changed from “Mixed” to “Complacent” We think there continues to be both upside risk and downside risk relating to facts about the spread of COVID-19; however, in the past week we have seen the rapid emergence of a “the curve is flattening!” narrative across traditional and financial news media. We are likewise hesitant to ever attribute market action to one factor, but it is hard to ignore how this news corresponded to a meaningful shift in risk posture for many investors on 4/6 and 4/7 (the latter based on pre-open futures). We now think the risk from this factor is asymmetrically skewed toward the downside. If we were attempting to trade directionally, we would be very focused on two prospective catalysts: 1. We have long felt the major downside risk lies in changes to the reality and narrative of the length of the recession caused by the pandemic response. Flattening is wonderful news! AND it does not necessarily have very much to do with the potential for long-term knock-on effects of the shutdown. We’d be looking for unexpected stay-at-home extensions, announcements of potential delays of major events, and late summer / early fall popups of the disease as early catalysts that might cause concern for some investors. 2. We believed that investors would focus unduly on New York (for obvious reasons). That has proven true, but not in the way we anticipated. The US doesn’t have one curve. It has multiple, each at different stages. Hot spots will emerge, and if they are in economically significant locations, they could constitute meaningfully negative surprises.
Political Seriousness	Complacent (Changed from Mixed)	Our assessment of this narrative structure has changed from “Mixed” to “Complacent” What we observe in narrative structure is an expectation that some normal economic activity will resume at the end of April. We have zero insight into the accuracy of that. We also aren’t certain how the market will treat it. We think that would be greeted as good news initially, and we also think that pressure to cancel stay-at-home orders could have consequences for the length of COVID-19. This one is too complicated to be read as directionally bullish or bearish. We think you should expect meaningful volatility about how a return to normalcy takes place, and we think that volatility is probably being understated.
Depth of Economic Outcomes	Consensus (N.C.)	Minor change. We have continued to assert that an extremely deep recession was largely part of a consensus narrative structure. Big negative payrolls? Yawn. Bank comes out with new apocalyptic Q2 GDP print? Yawn. We think that’s still true, and we still think that ‘better-than-feared’ prints from individual companies are an interesting opportunity to mine. However, we also think that the “flattening narrative” is changing this somewhat. Investors may permit themselves to start dreaming a bit about Q2.
Length of Economic Outcomes	Complacent (N.C.)	No changes. The potential transition of common knowledge from “short and deep” to “long and brutal” remains our biggest concern. We think the tail of this issue is almost entirely in one direction. Given its attachment to the Unknown Unknowns, it also keeps our posture for most short-horizon investors as underweight risky assets.
Cases of Economic Ruin	Complacent (with Exceptions) (N.C.)	No changes. On 3/23 we repeated our caution against taking risk on first-order ruin trades (airlines, hotels, etc.). We repeat that caution here. Fiscal and monetary intervention remain immense risks to any go-to-zero trade. For investors in individual securities, time searching for credit-sensitive pockets in industries unlikely to meet the attention of congress could be time well spent.
Emotional / Visceral Response	Complete	We are removing this from our list of Known Unknowns, as we think the major dynamic here is no longer relevant to the narrative structure. In our last update we wrote, “We think there is probably short-run risk associated with this that doesn’t yet seem present in the narrative structure we have observed. It is very hard to quantify these effects.” We were right on the timing, right on the difficulty to quantify, but wrong on whether there would be much response. That probably adds up to a wrong. This one was a temporary narrative structure item and will be removed.
Fiscal Policy Response	Consensus (Change from Mixed)	Our assessment of this narrative structure has changed from “Mixed” to “Consensus” In our last update, we noted the following, neither of which were earth-shattering predictions. “if you are outright short risky assets over anything other than a trading horizon, your bet is at least in part a bet against coordinated, coherent government messaging about the exit strategy from distancing and lockdowns“ and “as noted above on a separate issue, know that your short run bets are probably also bets on the timing of, discussion of roadblocks for, and ultimate sticker size of the senate’s fiscal plan“ We are observing a consensus narrative structure that the “big fiscal bullets have been fired”. We have no edge on whether the newest $1 trillion proposed next step being floated is useful or high confidence. Or whether the $2 trillion Infrastructure concept Trump threw out has a chance in hell of moving forward. However, we DO think that big additional fiscal stimulus is absent from any narrative structure we can detect. We also don’t see any evidence that the actual efficacy of fiscal intervention is being treated as all that important (e.g. the PPP fiasco, which has largely been shrugged off). Big Bills with Big Headlines are still likely to be treated as Big News.
Monetary Policy Response	Consensus (Change from Mixed)	Our assessment of this narrative structure has changed from “Mixed” to “Consensus” As we have observed previously, we see common knowledge that the Fed is “out of ammo”, which we believed created some upside asymmetry in the market’s likely response to new information about fiscal intervention. We think that is more true than it was in the past weeks. We are also observing early missionary behavior (in literally the past week) that appears to be preparing the way for a “the Fed should be able to buy equities” narrative. It is early, but we think investors should be very cautious betting on the depth of drawdowns that will be permitted. Markets being treated as a utility remains a thing.

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I was an investor in one of Barry Sternlicht’s public vehicles back in the day, for a short period of time. As I recall, it was some mule-like offspring of a REIT and a SPAC. The thesis, of course, is that we were “on the same side of the table as Barry” in these transactions, which was, of course, nonsense. You’re never on the same side as guys like Sternlicht or Icahn or Barrack or Peltz or whatever robber baron you want to toss out there. Even if you win a hand tagging along on a particular deal, you know two things … a) they’re taking a huge rake from your winnings, and b) they’re just setting up for the next play, of which you are definitely not a part.

So it always amazes me when ordinarily sensible people take what guys like Sternlicht say on CNBC or Bloomberg at face value, as if their statements are anything other than a purely self-serving collection of words. That when Sternlicht goes on the tube to say that we need to suspend mark-to-market on CMBS, or Barrack says we need to suspend margin calls on levered CMBS portfolios, they are not lying through their teeth when they also say they have no dog in the fight. These guys don’t get out of bed if there’s not something in it for them. Or as my favorite market saying of old goes, they’d sell their mother for an eighth. That’s at least three mixed metaphors, but you get my drift.

Rusty wrote a great little note on this the other week: The Miracle Max of MBS.

But it did get me to thinking … what the hell is happening in MBS-world that both Tom Barrack and Barry Sternlicht feel compelled to slick back their hair, put on their best TV make-up, and go do their song and dance routine on CNBC? How bad does it have to be wake these two krakens? Well, pretty damn bad, as it turns out, both in market-world and real-world.

I’m sure that Barrack and Sternlicht are primarily concerned with market-world, and the problem here is familiar to anyone who survived 2008. If your business as a lender makes you naturally long mortgages (either commercial or residential), and so you maintain a hedge by shorting mortgage-backed securities (MBS) … that hedge has killed you recently and your long position hasn’t really caught up. On the other hand, if your business as an investor involves you being levered long MBS (either commercial or residential) … well, you’ve been killed on that position, too. Basically, whatever your business model is in the MBS world these days, you’re getting killed, and whatever cleverness you were employing not to get killed has been too clever by half, as the Brits would say.

I say that this problem is familiar to anyone who survived 2008, because hedges similarly failed throughout that market crisis, for both naturals and speculators. It’s tempting, right? You’re a Master of the Universe, so why should you draw down your book, why should you take down your gross exposure and your leverage here in an era of free money, when you can just lever up a little bit more and put on some clever hedges to your core positions? It’s what too clever by half coyotes always do … they reduce their net exposure and maintain their leverage rather than reduce their gross exposure and reduce their leverage. I can’t tell you how many people I saw blow themselves up in 2008 doing this, because hedges go perverse when tectonic plates shift in real-world.

And that IS what’s happening in real-world. It’s not just the tectonic plate of globalization that has now reversed course … it’s the tectonic plate of lease obligations that now seems like it could be rent asunder. What do I mean? I mean that companies with massive lease obligations like Cheesecake Factory (CAKE) have told their landlords that they’re not going to pay any more rent on their VERY long-term lease obligations. Not because they can’t pay. But because they’ve decided they won’t pay. I mean … wow.

And I get it. There’s a non-trivial chance that the physical world of commerce … the world that gives meaning to Commercial. Real. Estate. … will be permanently scarred and structurally altered by the COVID-19 pandemic. Will we EVER go back to cramming ourselves into little booths at Cheesecake Factory and ordering something from page 23 of the menu? It’s hard to believe I’m saying this, because no one loves a starter of loaded potatoes followed by a main of spicy tuna wrapped in lettuce leaves more than me, but maybe not.

I honestly have no idea what the world is going to look like in six months! I’m sure I’m not alone. And if you honestly have no idea what the world is going to look like in six months, are you going to live up to your commercial obligations (like a lease) over the next six months as if the world is still spinning as always on its axis? I am. I know that Rusty is. Cheesecake Factory, though … not so much. And there are a lot Cheesecake Factorys out there.

There’s a war of all against all brewing today. Or at least a war of the dealbreakers against the dealbreakers. It’s as important in business as it is in our personal lives. Find your partner. Find your pack.

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This is a running set of observations of changes in the structures of narratives relative to our initial document published on March 17th. You can read it here for context.

We don’t see any material change in the Known Knowns or Unknown Unknowns as described in the prior document, and have not updated them here. That means that we continue to believe the right broad playbook relies on reduced use of leverage, reduced reliance on correlation and diversification assumptions, reduced position-level and risk-level concentration.

However, with the week’s news and unprecedented action by the Federal Reserve, we update our assessment of the narrative structure of what we previously coined the Known Unknowns: risks that it may be possible to model probabilistically. The two with material changes? Both in policy response land: the narratives surrounding Fiscal and Monetary Policy response.

Topic	Narrative Structure	Narrative Structure Changes Since 3/17
Current General Spread / Fear of Covid-19:	Mixed (N.C.)	No material changes. We continue to think that means there is risk in both directions on bets on the speed / expansion of spread.  That said, we do think, despite the fact that #DontTestDontTell is still rampant in many areas, the ramp this week in testing is real and probably underdiscounted. Numbers in the US are becoming less fictional and the reality of the situation is becoming more widely acknowledged. As we communicated in an early Pro note, testing steadily removes one source of uncertainty from the system. Similarly, as argued here, we think it is entirely possible to change course from the overwhelmingly bearish transition from “short and deep” to a “long and brutal” narrative. Testing and screening is a fundamental part of how that would take place. If you are outright short risky assets over anything other than a trading horizon, your bet is at least in part a bet against coordinated, coherent government messaging about the exit strategy from distancing and lockdowns. Not saying that’s a bad bet, but now more than ever, know what edge you are counting on to make you right.
Political Seriousness	Consensus (N.C.)	No material changes. Separating this from the slowness of fiscal response (covered below), the general sense of seriousness conveyed in media reports, especially about local and state governments, remains high. We are somewhat concerned about emerging language relating to agitation for a “date certain” that could change the narrative structure. (As one subscriber pointed out to us, this appeared to accelerate over the weekend, with more commentators expressing concern about the looming economic impact of distancing. We agree.) Either way, we think this remains mostly a one-way risk to the downside for the near term.
Depth of Economic Outcomes	Consensus (N.C.)	No material changes. The common knowledge about GPS / Earnings / Unemployment outcomes for Q1 and Q2 continued to deepen – each of the banks came out with progressively more aggressive drops for these periods. Consistent with our expectations, this didn’t seem to cause much concern or consternation. We continue to think this strong common knowledge structure will create idiosyncratic opportunities (to the upside) in the coming weeks/months for companies who buck that common knowledge.
Length of Economic Outcomes	Complacent (N.C.)	No material changes. The potential transition of common knowledge from “short and deep” to “long and brutal” remains our biggest concern. We think the tail of this issue is almost entirely in one direction. Given its attachment to the Unknown Unknowns, it also keeps our posture for most short-horizon investors as underweight risky assets.
Cases of Economic Ruin	Complacent (with Exceptions) (N.C.)	No material changes. We still think markets remain focused on the obvious first-order ruin risks (airlines, hotels, etc.).
Emotional / Visceral Response	Complacent (N.C.)	No material changes. This week through, say, April 10th will be the ones with the first images coming from crowded NYC hospitals with empty NYC streets. We think there is probably short-run risk associated with this that doesn’t yet seem present in the narrative structure we have observed. It is very hard to quantify these effects.
Fiscal Policy Response	Mixed (N.C.)	Some change. We still see this structure as mixed, with risk of creating volatility in both directions. But with bickering in the Senate, the focus of the narrative seems to be shifting from how large to how long is it going to take. We think this makes it a likely (and increasing) source of volatility this week if unresolved. As noted above on a separate issue, know that your short run bets are probably also bets on the timing of, discussion of roadblocks for, and ultimate sticker size of the senate’s fiscal plan.
Monetary Policy Response	Mixed (N.C.)	Some change. We observed in our initial assessment that the common knowledge that the Fed was “out of ammo” created some upside asymmetry in the market’s likely response to new information. This morning proved that to be the case, although truth be told, the perking up from limit down futures was still pretty limited given the remarkable expansiveness of the steps taken. We STILL think this narrative structure exists, and that the common knowledge that the Fed is out of bullets continues to support asymmetrically positive market response to rabbits they may pull out of hats from time to time. But probably less, barring a relaxing of restrictions on buying equity securities outright.

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Epsilon Theory PDF Download (paid subscription required): The Pandemic Playbook – 3/17

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Beyond what we have published about Covid-19 itself since early February, we have also published a range of more explicit observations about Covid-19 from the perspective of a risk manager or asset owner over the past several weeks.

On February 27th we argued that the narrative of Covid-19 continued to be complacent. We argued that most investors should pursue the universal shrinking of active risk and gross exposure. We argued for a circumstances-based analysis to consider risk asset exposure reduction (i.e. net exposure). We also wrote what we thought would trigger a reevaluation of circumstances:

It means we’d be doing all of the above until the cargo cult of Covid-19 analysis turns back into science. In short, we’d be doing the above until we felt that the measurements being provided about the state of Covid-19 infections reflected some underlying reality.

Covid-19 Cargo Cults

Following the speech given by Donald Trump yesterday (3/16) and the change in strategy adopted by the United Kingdom that same day, we believe this is now the case. The two components of this change are the capacity and willingness/recognition to make testing the single highest priority. The former quality is identifiable. Covid-19 testing across (most of) the United States ramped up substantially over the weekend. Individual states like New York are now performing more than 1,000 tests per day. The latter is subjective. Watch both speeches for yourself.

What do we think that means?

It means we think that the narrative of market complacency about Covid-19 is officially over.

It means that data demonstrating the importance of asymptomatic transmission in earlier infected countries has supported a rapid sea-change in the seriousness with which countries have embraced social distancing measures that explicitly reduce tail outcomes (for the disease).

It means we think the uncertainty overhang related to non-testing and the lack of institutional inertia within business and government to act on testing and mitigation has been relaxed.

This is NOT an all clear, folks. But it does mean a change in the game being played and in our ability to play that game. We’d like to walk through our updated framework for thinking about the governing narratives and events we see for the Covid-19 pandemic (a term which you should understand we always mean in context of the medical, economic AND quarantine effects unless otherwise stated).

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We recommend that institutions and asset owners construct their response framework from what we have referred to previously as the Koan of Donald Rumsfeld.

Decision-making under certainty – the known knowns. This is the sure thing, like betting on the sun coming up tomorrow, and it is a trivial sub-set of decision-making under risk where probabilities collapse to zero or 1.

Decision-making under risk – the known unknowns, where we are reasonably confident that we know the potential future states of the world and the rough probability distributions associated with those outcomes. This is the logical foundation of Expected Utility, the formal language of microeconomic behavior, and mainstream economic theory is predicated on the prevalence of decision-making under risk in our everyday lives.

Decision-making under uncertainty – the unknown unknowns, where we have little sense of either the potential future states of the world or, obviously, the probability distributions associated with those unknown outcomes. This is the decision-making environment faced by a Stranger in a Strange Land, where traditional cause-and-effect is topsy-turvy and personal or institutional experience counts for little, where good news is really bad news and vice versa. Sound familiar?

The Koan of Donald Rumsfeld

To that end, below we outline for each of the three categories the facts, narratives and events which we think will frame how information that matters to markets is conveyed. To the extent we can, we will identify the type of narrative structure which we believe exists and how we think new information will be processed.

Importantly, you should know that this will necessarily evolve. We will not always be in a position to update the state of each item. What we are recommending is incorporating aspects of this into your own framework in ways that suit your objectives, process and ability to take in rapidly evolving new information.

The Known Knowns

Other than “the sky is not falling” and “the sun will rise”, practically nothing falls into this category today.

I don’t mean this flippantly. It matters that this set is empty for all practical purposes, because it would usually include things like “markets will be open” and “you’ll be able to short” and “daily variation margin on centrally cleared derivatives is de facto riskless.”

That means that your framework must assume a non-zero probability that your hedges will not work. That means that your framework must assume that series of small trades structured to exploit asymmetry / volatility have a non-zero chance of not paying out.

We think that continues to argue for a smaller gross exposure or (for long-oriented investors) smaller active risk position than your perceived edge would otherwise lead you to establish.

We think that furthermore argues for some caution in thinking that options-based view expressions are a “workaround” for gross exposure aversion. If this were part of our strategy and we weren’t explicit about this in our risk management to begin with, we’d explicitly cap our negative carry from premium.

The Known Unknowns

We refer to the below as known unknowns because we think they are appropriately thought of as decisions that can be made under risk rather than uncertainty. But make no mistake: the level of risk attached to any predictions you might make on any of these categories is substantial.

Topic	Narrative Structure	Narrative Observations
Current General Spread / Fear of Covid-19:	Mixed	As noted above, we would no longer classify this as an Unknown Unknown, or as complacent. This may be too clever by half, as there is a non-zero chance that we allowed ourselves to get far enough out on the exponential curve that the downside risk of reality revealing itself exceeds any feasible prediction. But in general, we think the pandemic’s spread in this cycle is being transformed by effective policy back into a risk. However, we don’t see a single narrative here, but multiple narratives in competition. We think that means there is bi-directional risk on bets on the speed / expansion of spread.
Political Seriousness	Consensus	We think that there is now common knowledge that there is political awareness, willingness and capacity to act on Covid-19-related policies. Everybody knows that everybody knows that policies proposed in one state are quickly manifested across the country. We think that means there is short-run one-way risk owing to any events giving the impression of politicization, lack of focus or excessive focus on short-term financial market responses.
Depth of Economic Outcomes	Consensus	The potential economic effects of Covid-19 are both vast and vastly variable. Difficult to predict as they will be, we think they generally qualify as risks rather than uncertainties at this time, however. We think that there IS an expectation of very bad GDP and EPS prints. We aren’t saying they won’t have negative effects on asset prices when reported as news, but we do think in GENERAL that bad Q1 / Q2 prints will be tuned and framed and generally excused within that existing narrative. Not unreasonable to expect the odd less-nightmarish than expected Q1 prints to produce an asymmetrically positive response.
Length of Economic Outcomes	Complacent	We saw flashes of this in what appeared to be the market’s response to”July or August” comments from the president on March 16th; however, in our judgment, the narrative of economic effects is that they will be short-lived. “One to two quarters” is common shared language among nearly ALL reports and research pieces. Given this complacency, we think there is mostly one-way risk (i.e. negative) on information relating to the length of EPS / GDP effects at this time. We would be very concerned about the emergence of the narrative – and obviously about the actual existence of – an extended global depression. We think this is a really significant long-term risk to markets that is being almost completely ignored in current narratives. We would take it very seriously.
Cases of Economic Ruin	Complacent (with Exceptions)	Related somewhat to the “Bailout” unknown unknown in the following table, the narratives of industries at risk remains confined to first-degree effects: hospitality, leisure and transportation. There we think the narrative is consensus, subject to the binary risk of bailout policy posture. Outside of that and dalliances in feature coverage considering small restaurant businesses, there appears to be zero narrative about knock-on effects in adjacent / dependent / broader industries and sectors. We think there is significant, targeted one-way (i.e. negative) risk for some of these non-hospitality, leisure and transportation industries for contrarians.
Emotional / Visceral Response	Complacent	Even though it has been predicted and seems almost statistically inevitable, there is practically no recognition or discussion of a prospective news cycle of overwhelmed New York City hospitals and ICUs. We think there remains complacency about the unique short-horizon impact of two weeks of news focused exclusively on the region where so much of the financial industry AND Covid-19 outbreaks are located: New York, Westchester County and Fairfield County, CT. We think this is largely a one-way risk, but over a short horizon that probably has potential to manifest in the last two weeks of March.
Fiscal Policy Response	Mixed	There are enough policy proposal drafts and stalking horses in the wild at this point to treat this usually binary kind of event as a Known Unknown. It is difficult to pin down a narrative here, as there are clusters of commentary and missionary behaviors around multiple suggested strategies. There isn’t a global expectation of what the policy package will look like that has become common knowledge. If anything, we think the narrative tilts toward cynicism that households, families and small businesses will be helped quickly enough relative to industry backstops/bailouts. Accordingly, we mostly view this as two-way risk based on the size of the package, but our opinion (not really present in the data – purely subjective) is that there is some asymmetric upside sensitivity to a quicker or larger-than-expected package.
Monetary Policy Response	Mixed	While the data set is limited in scope, since Sunday (3/15) we think that a strong narrative with two dimensions – “out of ammunition” and “focused on liquidity and orderliness” – has emerged about central banks, and the Fed in particular. We think the former is a consensus narrative with more upside asymmetry in certain extreme cases (ie – everybody believes that everybody believes the Fed can’t take actions that will support asset price). We think the latter is supportive of framing most illiquidity-related news, data or research in a positive way, but also creates downside asymmetry if they aren’t as rapid dealing with issues in CP markets or other sources of market illiquidity.

The Unknown Unknowns

Part of the concept of unknown unknowns is, of course, that they are unknown, so the first allowance here that must be made is a general one: there are paths here that are not identifiable in advance. They all yield the same answers: Avoid leverage. Avoid reliance on ex-post measurements of cross-asset correlations. Avoid position-level and risk-level concentration. We’d add our previously communicated “avoid illiquidity” but it’s probably too late for that at this point.

But the Koan of Rumsfeld as we have it slots in the idea of unknown unknowns as uncertainty. In addition to the many paths which cannot be identified in advance, we think there are three other major categories of uncertainty which investors must take into account.

Topic	Narrative Structure	Narrative Observations
Seasonality Effects and Resurgence	?	We have some data now about the R0 influences of heat and humidity, and that data is positive. Positive but not enough for prediction. The parameters are still insufficient to tell us what life with an endemic Covid-19 looks like. Will its resurgence mirror 1918? How effective will vaccinations be from making Covid-20 just as bad? We think investors should expect that information which rapidly shifts this critical topic’s substance and importance into the Known Unknown range could still emerge at ANY time and in either direction. This alone should keep gross exposures and active risk budgets at very subdued levels.
Industry Bailout Response	?	While we think there is a general focus on risks to certain obvious industries (as described in the known unknowns above) that should govern some forms of risk-taking, specific company outcomes are subject to a veil of binary uncertainty. This is obvious counsel, but still must be part of the framework: go-to-zero bets on airlines, cruise companies, aerospace companies and hospitality companies are not risky but uncertain. We would warn investors away from spending active risk on such positions based on a fundamental thesis unless they are explicitly cordoned and risk-managed behavioral bets on other investors (e.g. in vol markets).
Election and Unrest	?	We are witnesses to what we think will probably be the single biggest sociopolitical event of our lives (so far, anyway). We are shutting off entire economies. For months. Soldiers are being deployed in free, democratic countries. A base rate of a return to normalcy is probably still correct! It’s our mean case, too. But these kinds of events create branching paths with no visibility beyond them. Unrest and political upheaval in many markets throughout the world are absolutely unquantifiable possibilities. We would continue to be apply deep skepticism to the diversifying properties of sovereign debt both against risky assets and against other debt assets in our portfolio construction.

Again, we will continue to update the general framework based on events that warrant it, but the rapidity of changes in narrative structure will likely exceed that frequency. We think any of these would be additive to whatever framework your institution or team is using to monitor and manage through this situation, and will benefit from your incorporation of monitoring and judgment of news flow and research relating to each narrative and event. If you have specific questions, of course, please feel free to reach out to either Ben or Rusty via email.

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Epsilon Theory PDF Download (paid subscription required):  The Pandemic Playbook – 3/17

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PDF Download (paid subscription required): First-Level Foolishness

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“I’d like to first repeat what I said last week, and that is that over 90% of the value of a stock is due to its profits more than one year into the future. So as bad as this year can be…we could really have a short quick recession, the long-term value is not significantly impaired…let’s face it, this is mostly going to be a demand-induced slowdown.”

Dr. Jeremy Siegel to CNBC (March 2, 2020)

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In a severe pandemic, infrastructure can be disrupted at a national level, such as healthcare, transportation, commerce, and utilities. This is due partly to risk mitigation measures but also potentially higher rates of patients on sick leave, employees taking care of children or other family members, or general population anxiety about gathering in public places.

The direct and indirect U.S. healthcare costs of a moderate pandemic, like those in the 1950s and 1960s, were estimated at roughly $180 billion in 2005 by the U.S. Department of Health and Human Services, assuming no intervention, but this does not include potential for commerce disruption. According to the Congressional Budget Office, a pandemic could cost the U.S. more than 4% of GDP in a severe situation (similar to the Spanish flu of 1918) or 1% of GDP (if the pandemic is more mild, similar to 1957 and 1968 pandemics).

Overall, we think the costs of coronavirus will mirror those of a milder pandemic. As we assume a lower death rate that primarily focuses on patients over the age of 65, we think there could be a significant short-term hit (1.5% of 2020 GDP) but minimal hits beyond, as the economy should be in position to rebound quickly.

Morningstar’s View: The Impact of Coronavirus on the Economy (March 10, 2020)

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It is an uncertain time, but I’m willing to bet on a couple things: I know what your personal email inbox looks like. I know what your professional email inbox looks like.

And I bet yesterday – March 11th – felt like a dam breaking for both.

There wasn’t any real change in the facts on the ground about Covid-19 in that time. Nothing fundamental. China continued to report few new cases. Korea continued to report improvement, with a little new concern in Seoul, perhaps. Italy continued to be grim. Germany and France had pockets of growing concern. America looked to be somewhat closer to the path of southern Europe than East Asia. The fact pattern on the morning of March 11th was consistent with the day before and the week before.

What changed was common knowledge. What changed was what everybody knew everybody knew.

It changed because powerful missionaries who had been in the grip of “just the flu” and “panic would be worse than the disease” memes – memes promoted in financial media beginning in January, as we highlighted previously here – threw in the towel. The WHO, which for weeks pretended it could be agnostic about the “p” word, relented. Harvard sent students home, and a raft of schools followed within hours.

That change in common knowledge is why yesterday you received a dozen or two “Here’s what we’re doing” emails from your kids’ schools, your local fast food chain, the airline you have frequent flier miles with, and the hotel flag you used to be loyal to until they merged and made your points worth half as much. A long-time friend and reader informed us of a Covid-19 CYA Communication from a…<checks notes>…food truck. Apparently they got his email through Square.

It’s also why (along with a little bit of feisty market action) your professional inbox filled up with new sell side reports, buy side update letters and – unless you were lucky – one or two “can we talk after the close?” emails from a fund manager or two this morning.

Will you permit me one more wager? I will also bet more than a few of THOSE emails probably looked like the lukewarm garbage that produced the two quotes above.

Both the Siegel appearances and the pseudo-scientific “scenario analyses” Morningstar and others are pumping into your inboxes are emblematic of the same thing: first level thinking, the mistaken assumption that markets function by assessing the first order effects of events. But it is far worse than that. They are also emblematic of ergodic thinking, which is a ten dollar way of saying that someone is using their estimate of the potential range of current outcomes as a proxy for the potential range of how outcomes may unfold in sequence over time.

Just one problem with that:

The path that events follow matters.

Path-dependence is why a disease that is only moderately more deadly than the seasonal flu becomes a Big Deal when its characteristics give it the potential to overwhelm hospital capacity. Path-dependence is why every college, school, sports team and corporation made their decisions in unison once missionaries finally created common knowledge. Path-dependence is why uncertainty in markets should inform your portfolio risk management.

The first-level thinkers miss this, and they miss it in three big ways.

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1. They treat the market as if it were a clockwork machine, constantly repricing everything about issuers and securities. In reality, the market is a bonfire, unevenly assessing investors’ expectations of other investors’ responses to information at the margin.

The Siegel style of analysis is perhaps the most emblematic of this idiotic framework. That shouldn’t be surprising – the notion that market participants wake up every day and reassess everything in their portfolio and what it ought to be worth is a foundational abstraction of academics in finance, even today. To be true, it IS useful for teaching DCF-based thinking on a bottom-up basis. But it is utterly nonsensical for explaining asset prices changes at a top-down level.

At any given time, millions of people setting prices at the margin treat the prior day’s price as a Thing In-Itself. In other words, the prior day’s price becomes the thing that matters, completely independent of whatever information was being considered by the participants who participated in the prior day’s price setting activities. Take that back a week or a month and you start to realize something very important about markets: at any given time, simple inertia is a very important part of why people believe the price of a thing is correct.

When prices move after an event, first-level thinkers say, “Well, only X has changed, so the price should only change by the effects of X.” The problem, of course, is that when prices change by a sufficient amount, investors who AREN’T first level thinkers don’t just question how much Event X ought to have changed the price; they begin to question the inertia that led to YESTERDAY’S price.

One financial markets commentator observed the following today (March 12th):

All the permabears are coming out now and saying, “I told you so.” It’s just too bad that not a single one of their theories is the reason why we are in the current sell off. But don’t worry, they will congratulate themselves anyways.

No!

Thinking that the sell-off we are observing can be completely divorced from all of the assumptions that led to the prices yesterday that are being subjected to closer scrutiny TODAY is first-level thinking. All those things the “perma-bears” straw men theorized cannot be ignored. The expectations of undue central bank asset price support and profligacy that led to those prices is going to be questioned. The appropriateness of multiples that led to previous prices is going to be questioned. The behavioral expectations investors had for other investors that led to previous prices is going to be questioned.

In short, any event of sufficient size is capable of influencing asset prices BEYOND the scale of the event itself, and that influence must NOT be considered an inherent overreaction. It is a fundamental part of the long-cycle process whereby markets periodically reevaluate endemic assumptions that exist on the basis of inertia alone!

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2. They treat market events as if they were isolated from the non-market events they influence, especially in political and regulatory spheres.

Ben is going to be write about this in a great deal more detail for a note next week, so I won’t belabor it too much here. But analyzing purely market fundamental events through probabilistic analyses to estimate market outcomes is worse than useless if it abstracts from the range of potential non-market responses.

Some of those events under a cloud of uncertainty are bullish! A massive landmark fiscal package coupled with aggressive state government aid would be a seminal such event, and could dramatically change the complexion of the market event.

Some of them are not so bullish. Some of those bearish outcomes manifest in major structural changes, such as changes to the narrative of globalization Ben and I have both hinted at observing as an emerging narrative. This is a potential multi-year outcome that could become part of core market narratives much sooner than most investors expect. The effects of a forced return of manufacturing and supply chains to North American shores would go far beyond the Siegel Cartoon of a 1-year share of a stock’s present value.

Some of the more bearish potential outcomes are almost impossible to bake into prices in ANY way prior to them taking shape. Your septuagenarian president hung out for a good bit with a Covid-19 exposed (and potentially infected) Jair Bolsonaro a week ago. How much of today’s price decline would you estimate accounts for the probability that our >10% CFR bucketed administration will announce infection next week? Some? None? Lots? A little?

You have no idea. I have no idea. There are a hundred events exactly like this – both bullish and bearish (but probably more bearish, if we’re being honest) – lurking in the fog of uncertainty, of unknowable incidence and severity. The idea that some sell side guy on CNBC thinks he can tell you what S&P earnings level for 2H 2020 the market is discounting should offend your spirit. The idea that there’s a clockwork machine pricing a risk premium on this basis should produce pain deep within your capitalist soul.

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3. They miss that nearly all financial assets exist in and cannot be divorced from their portfolios. When events change the interaction of those financial assets, those events can have reflexive responses in asset prices that we cannot assume are temporary or irrational!

Ben and I have both written frequently about how critical the narrative of stocks and bonds as mutual diversifiers is for the plumbing of the asset management industry, much of which has formed around that assumption during the last 35 years. If an event like the Covid-19 response produces compression of rates on US sovereign debt toward zero and an extended period of zero to positive correlations between rates and risk assets, modeling the event itself without accounting for how these assumptions would dramatically change the behaviors of institutions from pensions to insurance companies to family offices to yield-sensitive high net worth individuals is incomplete to the point of irrelevance!

And a reminder, since this is Epsilon Theory after all: to be IMPORTANT, these things don’t have to be long-term true in fundamental space so long as they are true in narrative space. If everybody knows that everybody knows that bonds don’t diversify stocks, or if everybody knows that everybody knows that you don’t buy bonds for yield but for duration bets alone, the game has changed on dimensions that go far beyond what one might model for the event.

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What does all this mean?

It means that the appreciation for uncertainty that we have counseled throughout this process should remain. There are single events ahead of us which will completely change the complexion of this situation. They will shift the incidence and severity of outcomes on their head. Some may even bring probabilistically modeling outcomes back into the realm of the reasonable.

We should manage risks for an uncertain market, and monitor the signs investors’ are transitioning back to a risky market.

What do we do?

The same thing you did the last two weeks. By far the most important play in this playbook, because it responds to EACH of these three problems, is this:

Shrink your book.

Keep your use of leverage at a minimum.

Keep your reduced reliance on covariance estimates.

Keep your trimmed down gross exposure.

If you’re deciding between a selling and hedging, sell.

The most important place that path-dependence rears its head to create unexpected risks is in the breakdown in relationships among assets. A limited gross and skepticism about covariance estimates is how you reduce your exposure to THAT. And keep it down.

What do we look for?

We counsel looking for signs of an emerging narrative that uncertainty is changing back to risk.

I’ll be more explicit. I think bearish behavior subsides for some period if and when everybody knows that everybody knows that US testing is happening and is representative. There are enough analogs in Korea and Italy to frame the problem. Once this data exists, missionaries of “quantifiable risk” narratives will be more successful.

But let’s be clear on another point. We think that is a tradeable phenomenon in the short run. We also think that it doesn’t necessarily change the real, fundamental uncertainty of some long-term outcomes precipitated by Covid-19.

More on that to come next week.

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This email is the foundation of a much longer ET note that I hope to publish next week, but wanted to share the basic idea with you and get your feedback.

The title of the note is going to be Minimax Regret, which is a game-playing strategy referring to minimizing your maximum regret. It’s a very different approach to playing any game, whether it’s investing or voting or living with our families, than the approach we almost always take in life, which is straightforward Utility Maximization. I don’t think I need to spend a lot of time describing what Utility Maximization is, except that it’s so embedded in our social psychology that sometimes people have a hard time imagining that there is any other way to think about their choices in a game … or in life. Certainly it’s embedded in everything we do as professional investors, from the very definition of an “efficient frontier” in economics and portfolio construction to the monomaniacal focus we have on evaluating “performance”.

One aspect of Utility Maximization that usually goes unnoticed, however, until it bites us in the ass when something like the coronavirus comes around, is that it’s based on a “normally distributed underlying stochastic process”. Now there’s a mouthful! In English, that means that when we engage in Utility Maximization (which we are always doing, whether we recognize it or not) we assume that there is some sort of a probabilistic bell curve that sits behind our guesses about the answer to a question we’re pondering. Like I say, this is so embedded in our human psychology that we don’t even recognize that we’re doing it.  

But you can see this phenomenon clearly in surveys about things which people have NO IDEA about.

This is a “snap survey” from one of those independent market research firms that you may subscribe to, and I want to call your attention to the first question: when do you believe the maximum impact from the coronavirus will be felt?

Now what I will tell you, from years and years of constructing surveys like this in a prior lifetime, is that if you give humans three dates as possible answers to a question like this, the middle date will ALWAYS get the most votes. If you give them seven dates, the middle date will get the most votes, and the dates just before and after will get the second-most votes. If you give them 15 dates (yes, you always give an odd number of possible responses in survey questions like this, for this reason), you’ll see the same pattern take shape. Doesn’t matter what the dates are (I mean, within reason) … the votes will take the form of a bell curve, aka a normal distribution.

Again, this is for questions where the respondents have no freakin’ idea what the right answer is … like asking investors when the maximum impact of the coronavirus will be felt.

The problem, of course, is that we assume there is some information to be taken from surveys like this, some sort of “wisdom of the crowd” to be gleaned from this exercise. There’s not. There’s zero information here. What we’re seeing is nothing more than the bell curve probability distribution that we human utility maximizers apply when we have no idea what the future holds.

The larger problem, of course, is that SO MUCH of market price setting and market behavior is based on “surveys” like this. For example, all of CNBC’s coverage of CV-19 has been a form of a survey like this … asking professional investors what they think about the “impact” of coronavirus on these Markets in Turmoil ™. There’s zero information here. Zero. All you are receiving is different votes for an underlying bell curve of possible outcomes. That’s it. There is literally nothing more to the entire exercise than that.

To be fair, usually this isn’t a problem at all. Usually this is nothing more than harmless entertainment, because usually the reality of something like corporate earnings or a jobs report (technically, the difference in our guesses about things like corporate earnings and the reality of things like corporate earnings) truly does fit some sort of bell curve distribution. There’s a reason we’ve been so well trained to be utility maximizers in our social lives … it usually works!

But when reality doesn’t fit a “normally distributed underlying stochastic process”, then all hell breaks loose. Like happened in 2008 with mortgage-backed securities. Like is happening now with CV-19.

All of our thinking about CV-19 is wrong and all of our decision-making about CV-19 is wrong because we believe we’re getting “information”, when actually all we’re getting is an irrelevant error distribution.

Investing (or just living for that matter) under the shadow of CV-19 is not decision-making under risk. It is decision-making under uncertainty, and for that you need Minimax Regret.

Here are four older ET notes that talk about Minimax Regret (there are others, too):

The Koan of Donald Rumsfeld

It’s Not About the Nail

Why Take a Chance

Things Fall Apart (Part 3) – Markets

My goal is to take some elements from these older notes and write a couple of notes on how I think we have to change our thinking about investing in an age of CV-19. Because I believe that CV-19 is bringing forth permanent and secular changes to our world, changes that will not show their “maximum impact” by … [[checks survey]] … April.

CV-19 is the catalyst that not only slows down globalization, but reverses it.

I’m trying to figure out the first, second and third order consequences of THAT. And I’d love your help. If you have any thoughts or ideas, I’m all ears.

Not gonna lie … the more I dig into the statistical analysis of the Wuhan coronavirus outbreak (I used to call it nCov2019, but going forward I’ll call it COVID-19 to follow the latest World Health Organization naming convention), the more I believe that the virus has not been contained in China and that we are far more likely than not to have a major outbreak of the disease outside of China.

This statistical analysis is principally based on two research papers (both attached here as PDFs), one written by WHO-sponsored doctors based in Hong Kong and published in The Lancet, and the other written by DARPA-sponsored researchers based at Los Alamos National Labs. The skinny from these notes is that COVID-19 is ridiculously infectious. Yes, it’s airborne. Yes, it’s waterborne. If it’s anywhere near you, odds are you’re going to catch it. I mean, when China is sterilizing and quarantining paper money from Hubei province, that should give you an idea that no one has any idea whatsoever how to contain the disease once it’s in a population center.

So when I read that there were more new cases of COVID-19 infection identified yesterday on that cruise ship in Yokohama than were identified in all of Africa and the Southeast Asian sub-continent, you can forgive me for believing that we *already* have a cluster of COVID-19 cases in cities like Djakarta … it’s just not being measured. How long will it take for this cluster to reach a noticeable mass given COVID-19’s high reproduction baseline? Using Wuhan as an example, I figure three or four weeks.

We also have a front-line doctor’s report coming in from Wuhan, also published in The Lancet, and real-time feedback from doctors in Singapore and Beijing on what they are observing in patients-under-investigation (PUI). The skinny here is that Wuhan fell because the healthcare system in that city collapsed. Doctors and nurses themselves contracted the virus in vast numbers, and once hospitals became a source of infection rather than treatment, the Chinese authorities made the decision to shut off the city and effectively let the disease run its course.

This is what we must avoid when/if there is an outbreak outside of China.

I believe we must stop playing the “Confirmed Cases” game, which is just that … a public relations game … and start doing three things:

1. PROTECT healthcare professionals with pre-positioned gear NOW (esp. in cities like Jakarta);
2. INFORM healthcare professionals with better diagnostic criteria NOW (Singapore is doing strong work here);
3. INSULATE healthcare professionals with (much) bigger isolation wards that should be built NOW (esp. in cities like Jakarta).

Unfortunately, I don’t believe any of this is going to happen, in large part because senior leadership of the World Health Organization is primarily concerned with maintaining the favor of their Chinese patrons and toeing the (literal) party line. The way that WHO leadership has handled COVID-19 thus far is not just a disgrace, not just a humiliation for the thousands of people doing good and important work under WHO auspices … it’s a betrayal of the entire world.

Yep, strong words. And here’s my latest note to back it up – The Industrially Necessary Doctor Tedros.

The Industrially Necessary Doctor Tedros

When WHO Director General Tedros recommended on Feb. 4 that there should be NO systematic limitation on air travel and visa issuance in and out China, he KNEW that the CCP-provided “evidence” for that recommendation was a crock. How did he know? Because independent WHO-sponsored doctors had published their paper on Jan. 31 showing that the CCP-provided evidence was a crock.

Barf.

Is there good news? Yes. If you’re young and female, you have an excellent chance of surviving an infection, and perhaps being asymptomatic entirely. On the other hand, if you’re an older male with a pre-existing cardiovascular condition or high cortisol levels … well, that’s a problem.

The critical thing is that we can’t let another city fall like Wuhan did.

Not gonna lie … they got us in the first half. But I think if we prepare and strengthen our healthcare systems NOW, we can still win the game.

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I published this note today on the website, and it’s making a bi of a splash. We’ll publicize it more actively tomorrow, but wanted to give you a headstart, including a copy of the PDF.

Body Count

From a narrative perspective, China is fighting this war against nCov2019 exactly like the US fought its war against North Vietnam.

It’s what the Best and the Brightest always do … they convince themselves that the people can’t handle the truth, particularly if the truth ain’t such good news. They convince themselves that they can buy enough time to win the real-world war by designing and employing a carefully constructed “communication strategy” to win the narrative-world war.

That strategy proved to be a social and political disaster for the United States, as the cartoon tail (gotta get more NV casualties for Cronkite to report) ended up wagging the policy dog (send out more counterproductive search-and-destroy missions).

I think exactly the same thing is happening in China, and I think the social and political repercussions will be exactly as disastrous.

I believe that the Chinese government is massively under-reporting infection data in the pandemic regions of Hubei and Zhejiang provinces. Worse, I also believe that Chinese epidemic-fighting policy – just like American war-fighting policy in the Vietnam War – is now being driven by the narrative requirement to find and count the “right number” of coronavirus casualties. And I think I’ve got pretty strong evidence this is the case.

It’s a good note. I think you’ll like it (and I’m all ears to how anyone thinks this plays out in markets).

Also …

I’ll have more from our narrative Monitors in next week’s email, but I think we’ve got a really important finding in regards to the Inflation narrative. Last month I highlighted an inflection point in the structural Attention measure for Inflation (how much financial media drumbeating exists for Inflation relative to other big macro narratives).

So here’s the Attention data for Inflation this month.

Wow! Now to be clear, the narrative *substance* of all this narrative attention is NOT “oh, my god, inflation is starting to get out of hand.” On the contrary, the biggest cluster in the inflation narrative (and the source of a lot of the attention increase) is the equivalent of a prayer to the Fed in the wake of the coronavirus outbreak in China. It’s a wail about global growth and a hope that the Fed will ease in response (and with “inflation being so low”, why not?). So I don’t want to get too worked up about the spike here. In the absence of the coronavirus growth scare, I think the narrative attention score would be up this month – and “for the right reasons” – but not at these highly elevated levels. Which is a good thing. If narrative attention were this high because of an “inflation out of control” cluster, then it would be too late to position yourself effectively for a trade. As it stands, I think you’ve got time.

Also of note (and also supportive of the gradual development of this trade), it’s very notable that for the first time in a loooong time, the gold / precious metals cluster is now near the center of the overall narrative map (it’s usually way off to itself on the periphery of the map) and is directly connected to the other central clusters. This is quite bullish for gold.

First things first, we published what I think is an important note last Friday, “A New Road to Serfdom,” which I’ve included as a PDF attachment, as well.  

A New Road to Serfdom

Here’s the skinny: Today there is a global political effort to convey vast new powers to central banks in order to “fight” climate change. In truth, however, this effort is not about climate change, any more than it could be about any number of significant dangers. This effort is about narrative. This effort is about power. It is an effort that must be resisted, especially if you believe (as I do) in the reality of anthropogenic climate change and the severe threat it poses to human society.

Second, and relatedly, I think that the use of central banks to monetize vast new fiscal spending programs in every developed nation on Earth – under the guise of CB-financed Green Bonds for left-leaning governments and CB-financed Infrastructure Bonds for right-leaning governments – is the biggest economic story of, not just the next year, but the next decade. This is how the Fourth Horseman of the Investment Apocalypse – inflation – rides into town, and it will challenge everything we think we know about investing and asset allocation.

Things Fall Apart (Part 3) – Markets

We still have time. Deflationary shocks like the Wuhan coronavirus will rear their deadly head from time to time, pushing us temporarily back into the slowing global growth narrative (and reality). More importantly, there is still no narrative missionary, no political entrepreneur, yet willing to turn the world on its head and say that inflation is here … and that it’s a good thing. But in an MMT world we’re getting close to that. Most importantly for the question of time, shifting to an inflationary regime isn’t going to feel so bad for months at a time. As the old country song goes, falling feels like flying … for a little while.

But ultimately this is the source of the next great reset, both politically and economically. It won’t take the form of a “crash” or a “great recession” … that’s the last war. This is the next war, and we’re going to need a new strategy – a new playbook – to get through it intact.

To that end, we’re revamping the ET Pro subscription service (or at least my contribution in these emails and analysis) to focus directly on that challenge. I think you’ll find ET Pro more focused as a result, more instrumental and direct in its efforts. I really intend this to be the construction of an investment playbook, with offensive and defensive plays – some general purpose, some situational – built around a coherent minimax regret asset allocation strategy for a deflationary regime in transition to an inflationary regime.

We’ll wrap up the construction of this playbook at the Epsilon Theory Forum this October in San Antonio, where we will have a full day dedicated exclusively to ET Pro subscribers. Stay tuned for details!

We published our macro narrative Monitors last week (attached here), and something really jumped out at me.

Media attention to an inflation narrative turned dramatically in December, and I will tell you that I see signs of it continuing to accelerate to the upside here in January, particularly in sell-side analysis and reports (which are typically NOT picked up in our Monitor analysis, which pulls from publicly available media).

Does this mean that real-world inflation is off and running? No idea. I mean … my personal opinion is that real-world inflation is much more prevalent and entrenched than we are led to believe by the mandarins, but that’s just my personal opinion. I do not have a professional opinion on real-world inflation. I DO have a professional opinion on narrative-world inflation, however, and that is YES, this a classic “Emerging Narrative” set-up. We are a couple of CNBC missionary statements away from everyone knowing that everyone knows that inflation is off and running. We are one “hot” employment report from everyone knowing that everyone knows that inflation is off and running.

And that’s going to be a very squirrely day for markets.

Why? Because it’s going to bring the politicization of the Fed into sharper focus than any amount of overnight and short-term repo financing will ever achieve.

The Fed is playing a weak hand. If we get an inflation narrative now, just as the “global recession is nigh” narrative kicks the bucket, then the chatter immediately becomes whether or not the Fed has to HIKE. Not “stand pat”. Hike.

There is zero market anticipation for this, which makes this a dinner bell for the trader types reading this note, and a warning bell for the buy-and-hold types. Political risk starts to get real after the Iowa caucuses in a few weeks. Put that together with an incipient inflation narrative and you’ve got the makings of a volatility party. Be careful out there.