How Fireworks are Made (Not Always in China)

Markets this past week were rattled by some outsized internal moves, particularly across sectors that had posted momentous gains from the March lows.  Let’s look at the micro-tech wreck of late last week from a broader context.

The outperformance of growth vs value factors (yellow) has reached extreme levels. This is happening right as the trade-weighted USD (green) tests long-term (10 year) support levels.

A DXY level under 94 for a meaningful period (weeks) could confirm a break in the trend going back to 2011. But a bounce from long-term support likely sets up more mayhem in equity return factors.

Below is the S&P Value Index ratioed to the NASDAQ. For years now tech and growth-weighted indices have dramatically outperformed value. The period leading up to the tech bubble peak in 1999 was explosive – and then as the TMT bubble popped, value out-performed wildly ‘right of bang’.

Portfolios mostly purely representing these factors (from Russell 3000 constituents) are posting returns that are – something else. It’s quite unbelievable actually (look at YTD returns below).

The other week I wrote about TIPS, gold, inflation expectations, and rates. The case I made was that using long-term monetary base terms, gold is not historically overvalued. But over the shorter term, deviations in the relationship come from changes in real interest rates.

Bill Gross wrote an “Investment Outlook’ letter recently that made the case for lower real interest rates (“r”) significantly influencing the price (“P”) of growth (“g”) stocks more than for value stocks based on the Gordon dividend discount model (DDM). He’s trying to explain the outperformance in growth in the context of the DDM.

If you remember this formula from finance 101, it means that price equals current dividends dividend by “required rate of return” minus “expected growth rate of future dividends”. Of course, this is just one of a myriad of old school equity valuation methods.

He argues that if you use real rates for r, and they go down, but growth isn’t adjusted lower because we’re talking about a ‘secular grower’ (Amazon), the discounting of future dividends will lead to dramatically higher valuations. Further, he notes that the price of MSFT carries a -.85 R-squared to TIPS yields. I can’t actually get to these correlations (but below I show what I think he is getting at). Focusing entirely on growth/value equity style spreads blowing out as a result of simply the Gordon DDM seems a little spurious to me.

But here’s what we do know:

1)    Of late, real rates and the outperformance of the growth factor have been very correlated. But it’s much muddier on a longer-term basis.

The thick orange line represents real 10-year rates, and the lighter orange line is Value factor performance / Growth factor performance. I think this is what the former Bond King was getting at.

But, if you zoom out a bit further, real rates bounce around while value continues to get beat up.

2)    The largest holdings of growth factor proxies (indices, ETFs) are over-represented by companies that either benefitted from Covid (e-commerce) or at least were highly insulated from shutdowns.

The $55 Billion market cap IWF (iShares Russell 1000 Growth) top 5 holdings are AAPL, MSFT, AMZN, FB, and GOOG. Those 5 represent almost 40% of the fund’s holdings. Other growth proxies carry similar weightings.

Now we have crowding among growth index constituents, and then further crowding into the growth factor (and products) by institutions, and more recently, retail.

The pendulum has been pushed to extremes by crowding squared – both in the sense of what growth proxies are concentrated into and by how investors have concentrated into growth factors. This of course had started long before Covid emerged.

The emergence of a global pandemic created an exogenous catalyst to push the pendulum even further. At some point, the pendulum falls or breaks. Are we there? Signs are indicating we could be close.

3)    Bond yields have also been pushed to extreme levels, but not necessarily by direct CB intervention 

30-year Treasuries yielding 1.23% is a shocking level in absolute terms. But the rate of change in yields since February has been unprecedented.

In absolute terms, the early-mid ‘80’s experience demonstrated more extreme moves in 30-year yields as Volcker set about on his inflation crushing policies.

But on a lognormal basis, the 2020 experience in rate of change terms takes the cake.

The implications for long-term liability matching and income are obvious. Pensions and endowments are pushed into other asset classes to generate returns. Gone are the days of sterilizing long-term liabilities at a 3-5% notional return.

The S&P has traditionally been one of many recipients of massive global carry trades. With dividend yields on most index components exceeding that of Treasuries, this carry trade has exploded in notional terms.

Meanwhile, the S&P earnings yield sits at just 4.25%, well below its 10-year average of 5.7% and at its lowest level since 2009.

This is a trailing yield measure. On a forward basis, the S&P earnings yield is just 3.93%. After parsing SPX forward earnings estimates, it’s fair to say that the street is pricing in some genuinely optimistic scenarios.

Last week I highlighted the runup in TIPS implied inflation, despite bond yields grinding lower. Significantly negative real rates have led to substantial moves in gold and silver.

Below is a bar graph from a recent JP Morgan slide deck:

Equity indices certainly aren’t pricing a recession, are they? Aren’t we already in a recession? Do models like this have any value anymore if CBs maintain their narratives of omnipotency?

There has been no shortage of Treasury demand, though supply has skyrocketed. In fact, the Fed has bought almost zero Treasury Bills, though the government has issued about $2.2 trillion in bills to raise cash for economic stimulus amid the pandemic. Remember that massive TGA balance I discussed a couple of weeks ago?

Bond strategist extraordinaire Jeffrey Snider wrote a fantastic piece; So Long As The Bucket Is Full of Holes, Treasury Demand Comes First that convincingly challenges the concept that the Fed is directly responsible for the current yield environment.

His main point is that debt monetization isn’t usually inflationary on its own. And that there currently is an unquenchable demand for the safest, most liquid assets in the world (USTs). The majority of Treasury purchases are predicated on real demand. He makes a strong case that recent pickup in inflation is not a result of CB purchases, though they would have you believe that.

If Snider is right, then we should be thinking hard about the alternate stories being told by equities compared to bond markets. The admirable track record of the bond market should make you question expectations embedded in growth stocks from these levels.

This is another sign that the bungee cords tying together equity style factors may be near their elasticity threshold.

4)    The derivatives market has turbocharged spread widening across equity factors.

 Last week Goldman Sachs noted that single stock volumes have reached 114% of share volumes. The options market is now larger than the shares market. What used to be the tail that sometimes wagged the dog has morphed into the wolf that shakes the dog.

They also note that single stock option volumes with less than 2 weeks to maturity now comprise 75% of total options volume. And this is particularly weighted towards calls.

What stocks are fueling the historic surge in options volumes?

Growth and tech. And retail-driven orders (<50 contracts) are the major driver.

Option upside skew is also inverted on a large number of popular growth stocks: AMZN, NFLX, TWTR, AMD (quite the recent move on that one).

This type of speculative positioning is so far responsible for significant intraday volatility in popular growth names like TSLA and AAPL.

Dollar King Now a Paper Bag Princess? 

Since the Dollar was the first major macro component discussed in this note, let’s address the de-dollarization narrative. These types of stories find boosted transmission power post hoc periods of dollar weakness. “The Chinese are done with the Dollar (via USTs) for good this time!”

Is it all happening right now, with the USD on long-term trend support?

Recall that the China de-dollarization story was predominant in 2014, right as PBoC holdings of UST’s stopped growing.

In late 2016, China sold an enormous number of USTs (much of them through Belgium). In the 2015-2018 period, the world went through 2 offshore Dollar shortage (Eurodollar) events. Central banks scrambled, and in the case of the PBoC, they widened the Yuan trading band and sold Treasuries.

Here’s Snider on the topic:

“In between (2015 – Feb 2016), as Reflation #3 took hold, suddenly the Chinese weren’t interested in de-dollarizing any longer? The level of external debt, almost all of which denominated in the dollar, rose like CNY under globally synchronized growth; not because of the PBOC’s dollar activities one way or the other, but because of that reflationary substance centered on 2017…

So, going back to 2011 and Euro$ #2, every time there’s a renewed dollar shortage the media gets filled with stories about China de-dollarizing. Back in 2011 it was all about bilateral currency and trade deals which were sure to finish off King Dollar’s remarkable if too lengthy reign.

Once you take the central banks out of the equation, you have no such trouble understanding these ups and downs. Not purposefully de-dollarizing only occasionally, being forcefully, painfully, involuntarily de-dollared if intermittently.” 

(His full piece on this is here)

The prevalence of these ideas can inflect sharply when it seems like a U.S.-China Cold War Train is picking up steam. And it probably is. But the same argument has been made for almost a decade and has proven secular dollar bears wrong time and again.

Here’s the point: whether or not the trade-weighted Dollar holds long-term support levels here likely has nothing to do with a de-dollarization narrative. In fact, the USD is grossly oversold, and history suggests that this is likely not “the big one” – the singular event of global (primarily Chinese) de-dollarization. De-dollarization is a process, not an event.   

Consensus remains firmly Dollar bearish. CFTC USD non-commercial positioning is at extreme levels, equalling lows from 2014 and 2018, periods from which the Dollar rallied sharply. The one-year CFTC positioning Z score is just shy of 2.0.

1+2+3+4 = ?

The 4 points taken together paint a picture for extremely crowded exposures and the potential for future fireworks. Not necessarily for a market crash, a bond rout, or a financial crisis. But instead, the potential for huge factor reversals and drawdowns in crowded risk assets. This would have implications for overall equities, growth/value, and even gold (on which I continue to take a bullish view, though caution is warranted here from overbought levels). 5-year real rates reverting back to just -1% (from 1.36% currently) would imply mid $1,700 gold – down about $200 from Friday’s close (which would probably be a buying opportunity). We were just there a month ago. Probably time to at least partially ring the register.

Interestingly, a compressed set of events – stimulus rollovers, the forbearance cliff, and the final push to the November election – are all right in front of us. If we get fireworks, the talking heads will ascribe them to various real-world events, ignoring the path that got us here and current overextended positioning. The elastic bands holding together the machinery are stretched precipitously, and something will have to give.

The powder keg is primed. What we saw starting on Thursday’s massive reversal of growth (tech, NASDAQ) and into value (staples, energy, utes) is getting a fair bit of attention, though has been minor in the context of the YTD factor returns.

It’s certainly not encouraging for the broader economy that decreases in U.S. Weekly Initial Claims has stalled out around 1.4 mm, particularly when combined with the U.S. and the world still make record daily number of Covid cases.

Going forward, no one knows what happens in real-world terms: jobs, the virus, the election. In market terms, very small reversions from extreme levels of asset positioning are creating some minor doses of mayhem (ahem, TSLA and AAPL longs).

These kinds of reversions normally take longer to play out than expected. In many ways they already have. The short-term pain trade could be dollar down, and growth equities to new highs before the fun begins, twisting the knife in the remaining dollar bulls and value-weighted investors.  But this is 2020 after all. We may not be there, but a lot of signs indicate we are close.

'Trader's Market'? Careful What you Wish For.

Reader note: I’m going to start posting some notes that I write (usually weekly) on markets. Feedback has been strong, but admittedly to a fairly tight group. I’d love to hear your comments.

Originally from a note published May 29, 2020

Be careful what you wish for.  Traders have for years hankered for a market offering more opportunities in single stocks, sectors, and factors. It’s here, just not necessarily in the version of itself that some envisioned.

It’s difficult to understate the amount of volatility that is gyrating under the market surface. Spasmic reversions in factor returns this past week had many scratching their heads. Some of this has been anecdotally explained as a ‘COVID basket rotation trade’ - the discounting of how long certain companies benefit from pandemic induced behaviour. As a return to normalcy is discounted, the thesis is that the high-flying beneficiaries of CV-19 return to earth.  It’s easy to pin that narrative to days when stocks like Shopify, Zoom or Teladoc are down 20% in 3 days.

A handful of days with strong returns in cyclicals and value had some proclaiming that ‘the recovery is upon us, and industrials are back!’. How well did cyclicals do through recent periods of > 2.5% Real U.S. GDP Growth in early 2018 – end 2019? (answer: underperformed the S&P by about 10% over two years).

Given there is no historical data for anything resembling a basket of stocks that have idiosyncratic exposures to global pandemics, there isn’t any way to quantify this. I’m not saying some investors aren’t discounting an expedited recovery through buying cyclicals, I’m saying that the rotation has been short-lived, and we have insufficient data to expound ‘pandemic stocks’. Plus, most of the drivers of a ‘pandemic basket’ are captured by more traditional factors.

Periods with substantial economic distress and uncertainty have typically exhibited wild swings in factor returns. Here’s a chart I compiled of factor returns since 2007. Take a look at 2008-9 vs. today in terms of weekly factor returns. In short, the reverberations affecting relative factor returns took some time to settle down.

To date here are the quintile returns of the actual stocks with those factor exposures.

To conceptualize the extent of the factor rotations in stocks, focus on the 1w return versus the YTD. These are huge weekly moves, but in the context of the yearly underperformance in value, cyclicals, and leverage, it’s fairly minor.

On top of what may or may not be the beginning of a real rotation (it’s way too early to call), the impact of retail flows is substantial. We’ve all seen the Robinhood charts. It’s interesting that the rate of change on new positions is declining (will nice weather and re-openings crush the retail bid in the market?).

There’s also a strong case suggesting that equities with the largest intraday moves are highly correlated to changes in the number of Robinhood holders.

Short-term rotation events are going to present gut-check moments, just as they did through the GFC.  Events related to insolvencies, weak labour markets, a potential second wave of CV-19, and the growing China conflict are risks to a pro-cyclical/value rotation. (Which is a bit of a misnomer in itself. Google, as an example of a stock that falls into the ‘not cyclical, not value’ category, generates about 85% of revenues from advertising revenue. The concept behind ‘secular grower’ ignores the fact that many of these stocks haven’t even seen a full cycle. And their customers are primarily other business also exposed to the cycle.)

Here’s a zoomed in look at the volatility of pure weekly factor returns since the beginning of the year:

View fullsize

Given that the leverage factor and the value factor are substantially inclusive, it makes sense that value is indicating high correlations across highly shorted and highly levered companies. In turn, these factors are highly correlated to increases user activity in Robin Hood account data!

Institutions are also carrying very crowded trades on their books. The below charts from Morgan Stanley indicate the record levels of concentrations among positions at hedge funds:

All of this tells me that we’re in for a continued period of volatility in factors, sectors and individual equities. This means don’t chase your favourite stocks and calculate your exposures to various factors driving a substantial part of this volatility.

Factor volatility that started in 2007 pre-GFC took over two years to settle down to ‘normal’ levels. Even in periods with the VIX at lower levels than today. Look again at the first chart I posted of factor returns: from mid-2009 to early 2010, the VIX compressed from 25 to 16. At the same time factor returns continued to be wild. 

At only 3 months in, we can probably expect more volatility across sectors and factor returns. This can happen even if implied volatility grinds lower, as it did through the GFC.

In terms of overall market sentiment, Nordea makes a strong case that V-shaped economic survey shenanigans lead to FOMO markets. The IMF also commented that the coronavirus has "disrupted the production of many key statistics, which is in turn likely to cause problems with policy-making and assessing”.

My view is that the optimistic outlook being discounted in U.S. markets has a higher susceptibility to disappointment than at any point in recent weeks (months?). How this exactly plays out entirely unknown. The case for sector, stock, and factor volatility to remain at some heightened level (say over 20) for a meaningful period of time is strong. Maybe this is the traders’ market that many have pined for.

On the other hand remember the Jim Rogers mantra: “when there is nothing to do, do nothing”. For large full-cycle allocators and average investors, this may be the case. If you’re willing to stomach the cost of single stock and sector volatility, maybe this is some version of the market you’ve been wishing for.

P-Delta and the Force Continuum

We’re taught to respond to exogenous events using a set of balanced, progressively more acute responses. Police officers are trained in the use of “Force Continuum”, progressing from presence and verbal warnings all the way to deadly use of force. One of the major problems facing peacekeepers in past decades has been an obscure set of Rules of Engagement, often cooked up in political backrooms by men that have never done 20 consecutive pushups. Even in a fully declared war, political gerrymandering around the rules of combat cost lives and nations. 

It’s easy to understand why politicians are compelled to act incrementally to emerging events. Winning the popularity contest and the spin game of politics requires a careful read of your audience. Perception is reality. Often at the detriment of outcomes. Imagine some set of Use of Force Continuums for any imaginable event that a leader has to face. They will all look different. Each step comes with a cost. In the policing example, the cost of making an arrest is higher than the cost of presence and lower than the cost of drawing and firing a pistol.

Many times, if you choose the appropriate level of force on the continuum, you will be accused of overplaying your hand. The incremental cost can become the straw man your opponents decide to burn. This sort of post hoc analysis is often understood to be disingenuous in politics. Just part of the game in a full-contact sport. Now scale this down to the coach who decides to bench his player that passed the concussion protocol, but looked ‘off’ in warmups. If the team loses without the star cornerback, fingers are pointed (at least in this case). This outcomes-based analysis only serves to reinforce the faulty process. What happens the next time there is a borderline injury situation? 

And then you have the problem of first and second-order analysis. Engineers talk about the perils of first-order analysis that doesn’t consider the deformed shape of a structure. This has to do with understanding the network effects applied by first-order effects. Engineers talk about something called P-Delta analysis, where P represents the force acting on the body (say a support beam) and delta refers to lateral displacement. P-Delta destabilizes the beam through non-linear, non-first order sets of cascading mechanisms.

A load on the deflected shape will catalyze second-order effects like shearing and volatile moments of inertia. This generates positive reflexivity reinforcing weakening in the structure. Metallurgical effects from shearing over time will reinforce the deflected shape and increase the lateral deflection, and so on.

Let’s think about the combination of the two concepts above. Combining a poorly calibrated Use of Force Continuum with ignorance of second-order effects only amplifies the potential for positive reflexivity and system collapse.

This is how things fall apart. Consider the response of the Singapore government to CV-19 compared to that of the U.S. Yikes. Want to take this a step further? Look at what the U.K. is doing with their most likely disastrous policy based on the dubious concept of ‘herd immunity’. I’m Canadian and am disgusted by the lack of leadership from Ottawa so far. Far too slow a progression through the Force Continuum. We’re still allowing flights from Europe. Screening at airports from inbound international flights is not happening. Canadian PM Trudeau’s wife has contracted CV-19. This still hasn’t been enough to wake up legislators. The most pertinent second-order effect of this failure of policy escalation could be the structural collapse of the support beams, in this case, the health care network. If the lateral deflection weakens the support beams enough, the whole building falls down. Once the health care system falls, everyone is on their own. This also describes the U.S. situation. However, we’re seeing steps in the right direction recently from the White House, and hopefully, mobilization is hard and fast.

There is a high cost to social distancing, travel bans, event and school closures. Those most at risk to the economic ramifications are wage earners that are employed at hair salons, restaurants, stores, bars, and entertainment venues. Many are already in precarious economic straits. Addressing this is another component of the Continuum. Providing these people with some sort of economic assurance, be it through debt repayment holidays, helicopter money or accelerated unemployment benefits (I’m not going to analyze what’s best here as it’s over my pay grade) needs to happen immediately. 

The same poorly calibrated Continuum and ignorance of second-order effects is being mirrored by the financial community for the most part. The traditional investment advisor and their big bank employer still don’t get it. Their Continuum doesn’t include an option that says “sell everything and go to cash”. This is an asset-gathering business after all, and it’s impossible to charge 1% on a fee-based account when clients are 40% or 80% in cash. The ignorance of second-order effects at the client-advisor level is glaring. What will happen to their business if most clients lose 50% of their capital over a 12-month period? Won’t happen they say. Why? Because our bank economists and strategists say stocks are cheap and GDP will only go down for a quarter or two. (LOL). I just read CIBC’s economist Avery Shenfeld’s Sunday afternoon blast. Check out this gem:

“Overall, we see 2020 global growth at 2.7%, versus a prior forecast of 2.9%. Owing to recent disappointments, we knocked down 2020 eurozone growth to 0.7% (from 0.9%), and also set our sights slight lower for the UK (to 0.6%). “

Are you out of your mind? But par for the course. We’re not just dealing with the ignorance of second-order effects here of course. We’ve got conflicts of interest and shitty-to-the-point-of-dangerous linear econometric models that have never been able to call growth and cycle inflections. All this exists within the larger zeitgeist which Eric Weinstein calls the EGO – the Embedded Growth Obligation – that permeates every major corporation, central bank, and economy in the world.  

Direct response failures directly to CV-19 entirely ignore the asymmetry between Type 1 and Type 2 errors.

Read this from Josh Wolfe’s recent letter to Lux L.P.s:  

“Make no mistake: those who calmly waited and reflected while others panicked in our ancestral environment were eaten by tigers.”

The cost of one of our ancestors standing up and looking around when they hear what might be a tiger in the savannah is minuscule compared to the potential cost of not standing up and potentially being eaten. We’re talking a handful of calories. Just another notch down the Continuum. A pure asymmetry of potential outcomes.

We’re going to beat this thing. Hopefully, policymakers get their respective acts together and we come out the other end of this in decent shape. As a society.

But I believe the second-order effects in both global economies and social behaviours are being nearly entirely ignored.

These comments from excellent Natixis economist Trinh Nguyen resonate loudly with me:

Of course, economists are out to lunch on their 2020 forecasts for a multitude of reasons. Ignorance of path dependency, second order effects, and the institutional embrace of EGO, just to name a few.

But what if the experience of CV-19 changes the way that society at large thinks about the things that are important to them? If your health fails, it really doesn’t matter how many nice restaurants you visited in the last year.  Do I need 2 gym memberships when I have a Peloton and some dumb-bells in the basement? Do I even need the Peloton since I barely use it and that monthly fee can be chopped?

I am talking about the potential for a recalibration of the relationship people have with their preconceived notions of value. Do you value having an 18-month cash reserve more or less than before CV-19? Will the perceived value proposition of going on a cruise revert to pre-virus levels? Yes then No. This is entirely at odds with the EGO. We’re nudged daily into participating in an ecosystem that perpetuates unnecessary consumption and untethered complacency.

Some market commentators have written on the pulling forward of demand through monetary measures since the GFC. Sure. But what about the nascent extrapolation of social behaviours and the implications on broader society (which includes markets)?

Path dependency and all that.

Gaming the Dope Wars

First I'd like to start by acknowledging the lack of activity on this blog the last six months. I'll put it down to some big changes in my professional and personal life. My plan is to change a few things up around here.

The other day I listened to the No Laying Up (NLU) podcast's interview with long time (and now former) CBS golf commentator Peter Kostis. It's excellent for a lot of reasons that are much bigger than golf. For those unfamiliar, Peter had worked at CBS since 1992, working as a key booth commentator with Gary McCord for many of those years. He also teaches and had a cool cameo in the legendary movie Tin Cup. He was recently canned by CBS (contract not extended) along with McCord in what was a five minute telephone conversation from his CBS overlord. Ice cold.

NLU is probably the most successful independently run golf podcasts around. It's a great startup story. Beginning with some hardcore golf nuts recording in their basement during their free time, later quitting their day jobs, and now touring the world while interviewing the likes of Rory McIlroy, Tiger Woods and recently Peter Kostis.

NLU is the Joe Rogan Experience of the bland and starchy golf media world. These guys have built a huge platform (200k Twitter followers, hundreds of podcasts), and pull no punches. This has gotten them into minor trouble in the past. Which is a common thread for many successful, disruptive media models. 

In many ways, the criticisms that Kostis levied at the PGA Tour and network affiliates regarding the strategic direction of televised golf can be applied to almost everything happening right now in finance, media and business. Kostis' scathing criticisms can be boiled down to one over-arching goal:

Unfettered Growth at All Costs (GAAC)

Sound familiar?

This is happening in nearly all major pro sports leagues. And in asset management. The NFL is more concerned about how its image reflects on revenue potential more than the actual well being of players' brains, player's families (looking at you Ray Rice, AP and Tyreek) or common sense. Networks are forced to play by league rules to maintain the 'privilege' of broadcasting events. Step out of line and you're gone. And like the mob's rackets, the price of admission (broadcast deals) inflates at insane rates. To do otherwise would incense the Krafts and the Joneses. After all, you can’t have a down mark on franchise value. Eh, private equity?

In the case of Viacom owned CBS, the bean counters at HQ still need CBS Sports to generate profits and capture market share. Meanwhile, technology advances in broadcasting (shot trackers, drones, ultra high speed cameras, 4K) are also being pushed on the networks by leagues. Eventually this breaks. Kostis talks about the fact that CBS cut down on camera crews and technology to stay in the black. Platforms like NLU have skewered the networks and the Tour for the way this badly impacted the product.

Tow the Line

This is Jerry Maguire's Mission Statement or Voldemort's Curse of the Taboo. The Tour requires the networks to act as Sheriffs to police anything that could deviate from the Tour's misguided concept of Brand. Kostis was chastised by his bosses for not asking a rookie tournament winner if he was happy about winning 500 FedEX Cup points. Meanwhile the kid just won a two year job, an invitation to Augusta, and a fat wad that will at least allow him to fly coach to tournaments. Rich stuff. Applications open to Yes men and women.

The overlords want full control.

Confusion

On one hand the bosses want sterilized C-suite dictated content. On the other, they are chasing growthy business models to engage new revenue streams that are rich in 'young audience' demographics. Kostis claims that the vision of the Tour is to turn broadcasts into a cross between video poker and daily fantasy sports.  Imagine watching the U.S. Open on your streaming device, and a pop-up prompts you to bet if whether or not Rory hits the fairway. It sounds fun I guess, I know I’d try it. But what does that mean for the actual product?

Sports gambling is a hot space right now, and when GAAC is your Mission Statement (though it’s Mission Impossible) of course you're going to chase it hard. And hey, there are lots of short term indications it works. Penn Gaming shares have added well over $1B in market cap after paying $163mm for 36% of Barstool Sports in January. We live in strange times.

The Tour is trying to monetize the same demographic that it has repelled through bland product and a Minitrue approach to corralling talented commentators. The content has to match the demo to effectively monetize. NLU gets this. Rogan gets this. The PGA is perfectly aware that golf is a declining sport in a post peak Tiger era. They are desperate, and failing.

Dope on a Rope

Smart devices have become Dopamine Delivery Devices (DDDs). Developers hire psychologist consultants to maximize 'engagement' and more effectively hijack neurotransmitter pathways. This is the 'better' version of the ugly carpets and flashing lights of the Vegas strip.

The stalking horse narratives of new(ish) zero commission trading models include schticky Mission Statements like:

"We're on a mission to democratize our financial system." (Robinhood). Vomit.

Schwab, Robinhood and E-trade are chasing the same demo as Penn Gaming and the PGA Tour. But there is another angle here, and it relates to GAAC. WSJ'S Jason Zweig hits the points here:

https://www.wsj.com/articles/what-the-e-trade-deal-tells-you-about-the-new-investing-game-

You probably knew most of this already. It's all about size. And keeping you in their eco-system through yogababble bullshit, and better Rube Goldberg type dopamine delivery systems.

It's about "democratization" as much as Google buying Fitbit is about "making everyone in the world healthier". Remember, When the Product is Free, You're the Product.

Nauseating stuff.

Someone Gonna Get Hurt Real Bad

What do you do when you realize you're trapped in a rigged game? Game the game. Take advantage of stupid TAM GAAC business models that subsidize 'user adds'. Zero commission trading, use it. Understand HFTs are buying your data and adjust your process accordingly. Use the free promo to PGA Tour Live that will surely come once they bundle in their video casino (but have the TV on too to avoid all the popups). Use that UberEats $5 off plus free delivery promo. There are some online apparel companies losing money on promotions to drive new customers. Some of them actually make decent clothes. Try them. That's the right arb.

But maintain your intellectual honesty about the 'deal'. Don't get Stockholm Syndrome. Realize that the Achilles heel of all of these models is customer retention failure. Customer acquisition costs for low fee models are huge relative to per account fees generated. They will try to trap you in their ecosystem with subscription promotions, contracts and stranded funds. Don't play that game.

But realize people will get hurt here. Yes, the 14 year old girl trading TSLA on Robinhood will blow up. Maybe the online apparel retailer goes tits up and you can’t get the same jeans. Dealing with the second one is no big deal. The first is awful, avoid that.

No one likes when their favourite broadcaster gets canned. Or when their league of choice takes their advertising game to European hockey standards.

Find alternative sources for your consumption. Buy NFL Red Zone to remove ads if the cost to value ratio looks right. Rogan can have a more honest conversation with a politician or executive that CNN ever will. Ignore CNBC. NLU will call out the latest cheating scandal that puckers the sphincters at the Tour. That economic narrative that comes with your Ameritrade account? Burn, and do not read. There have never been more free and/or inexpensive sources of engagement. Golf, NFL, economics, science? Check. Better content, much more honesty.

A final thought that came to me listening to Kostis discuss the warts within CBS centred around the fact this was CBS. And golf. The golf events, stories, and narratives they try to shape and bury do not impact elections or economies. Networks have never been as ‘levelled up’ in the fiat mindset as they are now. If you can’t even discuss an off color remark by a Tour Pro, what the hell are you doing listening to their other ‘content’? Gell-Mann Amnesia and all that.

Sandbagging and how not to be Yamada

There are lots of expletives thrown around the course during the (sometimes) gentlemanly sport of golf. But there is one word in particular that when said in earnest about another player isn't simply an insult, but an accusation. It's often mumbled quietly over beers after thousands of amateur tournaments each year. The word is Sandbagger.

If you're unfamiliar with golf gambling parlance, it refers to a competitor that systematically overstates his or her handicap. Over enough games an inflated handicap, even by a couple strokes, will mathematically ensure an edge, and the profits that come with it (if you’re properly gaming).

The Sandbagger may not always win, but just like an astute card counter at the blackjack table, tipping the odds in one's favour to a minor but meaningful amount over enough iterations, (other variables aside) can mathematically ensure a positive expected gambling outcome. So how do cheating golfers pull this off? The most unsophisticated method is to simply not post low scores into the handicapping system, or to fabricate higher scores. More savvy hustlers employ more advanced techniques. For instance, when a match doesn't matter part way through, or during a match that has minimal financial implications, the Sandbagger might decide to not line up a putt and maybe, just maybe miss it. Or hit a terrible bunker shot on purpose. Or pull the wrong club from 150 yards out. Even delaying entering a good score from the day before for today's big money match is common practice among this despised breed.

Tour pros don't worry much about this, they all play a gross (not net) game at their events. But if you think that Sandbagging is reserved simply for cash games at your local club, think again. In 1995 at the AT&T Pro-Am at Pebble Beach, the winners of the Pro-Am better ball component of the tournament were announced as Bruce Vaughan (being the pro) and Masashi Yamada. Vaughan played terribly, shooting 71, 75 and 79 through 54 holes. But in the world's most prestigious Pro-Am, the team score was enough to put them into the final round on Sunday, where they posted a team net score of 59. They were awarded their hardware and went their separate ways. A month or so later, while reading a golf magazine, USGA Rules expert Dean Knuth came across the tournament outcome. After making some calls, he determined that Yamada had been playing off a 15 handicap during the tournament. Some simple probability calculations had Knuth scratching his head. Yamada, off a 15 handicap, had shot or broken 79 on four consecutive days. This is statistically next to impossible for a 15. After a flurry of phone calls and faxes, it was determined that Yamada was in fact a mid-single digit handicapper (5) in Japan, and he and Vaughan were stripped of their title by Pebble Beach chairman Clint Eastwood. It turned out that the 72 year old Yamada was one of the better known amateurs in Japan (it didn't hurt he was a wealthy and connected real estate tycoon). David Duval and his agent/playing partner, Hughes Norton, were awarded the Pro-Am title over a month after the tournament finished.

"This comes pretty close to being a desecration," said Sandy Tatum, the former USGA president who won the event in 1961. "I'm only glad Bing didn't have to deal with it." (Bing Crosby used to be the tournament organizer).

Needless to say, Yamada was never invited back to the event.

Now and then you run across the opposite, a reverse sandbagger. This is the guy who claims he is a 5 handicap and proceeds to shoot a 93, claiming a "bad day". They are often referred to as having a 'vanity handicap'. The surface motives behind each of these behaviours is pretty clear: in the case of the Sandbagger it's to win more bets, for the reverse Sandbagger it's to maintain an unrealistic narrative about themselves as a golfer. The motivation to maintain a positive self narrative, to stoke an ego that cannot hold up to the smallest amount of pressure or critique comes at the cost of actually improving (not to mention being a human ATM). Having said that, among gamblers, no one really worries about the second type of golfer, after all, they are throwing away money (if they will actually lay a bet). But the implications of this type of thinking off the golf course can be very different.

From a psychological perspective, Sandbagging has been explained as "A self-presentational strategy involving the false prediction or feigned demonstration of inability." But what successful Sandbaggers know, and has been shown in studies (Baumeister, 1984), is that largely speaking, public expectations of success inhibit performance, while private expectations of success facilitate performance. The successful hustler is able to compartmentalize the two, and is able to feed off the subsequent self- presentation benefit by improving the perception of his recent performance. During the match, external observers had lowered expectations for the performance. The ‘bagger’ still thinks he is going to win, he is merely acting the part. The Sandbagger's wallet is not only made fatter, but in many cases his confidence swells as well, with the positive feedback coming from the social dynamics of the victory and apparent excellent play. This works until it doesn’t…

In sports we like to talk about 'clutch players', those that rise up in the biggest moments in the biggest events. Research shows that for the vast majority of professional athletes at the highest levels, increasing performance pressure (mainly through high observer expectations) leads to more instances of choking under pressure. Of course there are outliers that consistently thrive in these situations, and many of these figures are enshrined forever in Cooperstown, Canton, Springfield, St. Augustine, and Toronto.

The successful hustler has a method to his madness, and is typically pretty astute on knowing when to leave it all out there, and when to back off. They are audience and opponent manipulators. This is very different than what are known as 'self-handicappers' - the much more typical guys you come across that practice negative self-presentation before a match. He wants to avoid negative ability attributions that will come from a poor performance. Call it a very expensive ego hedge. Unlike the Sandbagger, the self-handicapper does not feel confident about the outcome of the match to such a degree that ego maintenance is more important than the actual game. The Sandbagger and the self-handicappers are very different animals.

Gambling aside, the strategy of sandbagging with the goal of (perceived or real) lowered public expectations are legendary in sports. Former Notre Dame football coach Lou Holtz used this technique to great effect. In 1993, before a stretch of games against tough opponents, he said "We're not a good enough football team to play the people we have to play". They were 5-0 at the time, ranked 4th in the country. They won the next 5 games handily, and nearly made it to the national championship after a last minute field goal by Boston College.

Playing the (meta) game

The problem comes from using this technique too often. For starters, if you're a billiards shark, golf Sandbagger or darts hustler, you start losing the ability to control your audience over time - which often is comprised of your potential future opponents (marks). No one wants a game with the Sandbagger, but everyone wants one against the guy with the vanity handicap. The negative self-presentation (the act) has the potential to bleed through into your actual confidence that you need to compete. If Holtz pulled this move every season or every week, no doubt its efficacy would wane. In gambling, only highly functioning sociopaths can indefinitely maintain this level of compartmentalization, assuming they can still get a game. Another cost is the potential reputation, perception or cartoon that one is trying to maintain in the long run. We've written previously about the value of multi-play games. The famous saying "Listen, if you can't spot the sucker in your first half hour at the table then you ARE the sucker" only has half the story right. Once you identify the sucker, you do everything you can to keep that person in the game. Insulting him, belittling him, laughing at his hands - that is a bad financial planning. You don't kill the golden goose.

Much has been said about corporate short term-ism. That is the propensity of public companies, investors and the oft vapid financial media to fixate on 'making the quarter' and 'beating the whisper'.

A recent study claims that "the amount of value destroyed by companies striving to hit earnings targets exceeds the value lost in high profile fraud cases". The core belief is that hitting earnings estimates builds credibility with the investing community and CFO's are willing to sacrifice long-term economic value to deliver increases in the company's stock price in the short run. "A surprisingly high 78 percent of the surveyed executives responded they would destroy economic value in exchange for smooth earnings. The executives believe that unpredictable earnings—as reflected in a missed earnings target or volatile earnings—command a higher risk premium. In short, CFOs argued that the system (that is, financial market pressures and overreactions) encourages decisions that at times destroys long-term value to meet earnings targets"

Various prescriptions to re-calibrate short-term-ism of corporate behaviour are very in vogue now. They are part of the G in ESG. Tweaking incentive structures and accounting allowances under the guise of corporate governance is #trending. Maybe that's the right place to start, maybe it's not. But it's kind of like fiddling with minute scoring rules in golf in an attempt to abolish sandbagging. Dean Knuth came up with system to mitigate the effects of sandbagging in golf tournaments. It works to some extent, but it leaves many other areas unaddressed. In Yamada's case, this was a post-hoc analysis by Knuth initiated only by his tournament win (and Knuth browsing through a golf magazine). Yamada had played the AT&T Pro-Am the year before his win using the same 15 handicap. He hadn't won in 1994, and no one ever brought up his sandbagging until the following year's victory. But his victory put an audit into motion. The problem is that these concepts of self narrative development (which related to corporate identity) are hard-wired into us. If a hustler wants an angle, regardless of the short-term consequences, he will find it. Or go down in flames trying.

Much here can be applied to investing. In the universe of equities I follow, my peers and I all know many of the companies that often take the short game of presentational strategies too far. A little bit of sandbagging the quarter is the norm. Mark it up to putting your best foot forward. "These guys always beat their quarter" is a nice little narrative that helps the sell side execute the rotation trade. Reverse sandbagging perpetually just comes off as being promotional and well, missing the financials consistently doesn’t look great. That's not to say it doesn’t happen (it does) and then attempts to rationalize it away look just like the guy with the vanity handicap making excuses. Many of the more extreme examples lead down a more dangerous path. Taking ‘normal’ things like securitization and leverage and redlining them to levels that can undermine the well being of the company/industry/economy. This is where Fast Eddie Felson has his thumbs broken. Epsilon Theory would call this poor meta-game management.

Doesn’t make the double bank shot any easier

Some of us have seen firsthand the intense amount of effort many management teams put into 'presentational strategies'. I've had CEOs ask me how they can best stay in a sub-index, or how they can manage their financials to 'get on the quant screens'(!). I've even heard "what sort of quarterly numbers or guidance would get the shorts scrambling to cover my stock?" My response is typically something like "Well, what are the tools at your disposal and how would you use them?" I am basically asking how far they are willing to go. From this, we can maybe, possibly, deduce if they are in fact likely to destroy long-term value for short-term gain. Then again, sometimes not. In any case, it pulls the curtain back a little bit on how they are thinking about their corporate self narrative.

The long-term costs of being the Sandbagger or the hustler are real. Want a gambling game with your pals at the club? Good luck if your cartoon is that of Fast Eddie Felson. Want to be invited to net play tournaments? Sorry. How much energy are you wasting trying to hustle a few people, and what are those opportunity costs? How will others extrapolate your golf/gambling cartoon to other walks of life? And the reverse sandbagger just looks like...well a loser that lacks self confidence. And that costs you too. It is much easier to spot the reverse Sandbagger than the Sandbagger. Don't be like Yamada, don't be like Fast Eddie, and don’t be the CFO explaining that the weather screwed up ANOTHER quarter. Play the meta-game correctly. Understand that in real life, when the long game is botched, the end looks more like that of Yamada's or Lehmann Brothers and less like Fast Eddie Felson's. Fast Eddie got a sequel in ‘The Color of Money’, but Yamada never got another invite to the AT&T Pro-Am.

The Great Pebble Filter

The Great Filter is one possible solution to the famous Fermi Paradox, also known as the "Where Are They" problem. If you don't recall what that is, the famous physicist Enrico Fermi purportedly posed the question "Where are all the aliens?" on the way to lunch with his colleagues in 1950. Michael Hart formalized the Paradox further in 1975, and it goes something like this.

1. There are hundreds of billions of stars in the Milky Way. Many of them are much older than our sun.

2. Earth isn't unique - mathematically there must be many earth like planets in the galaxy, some of which have spawned intelligent life.

3. Some of those advanced enough to develop interstellar travel.

4. Several millions of years should be enough time to traverse the entire galaxy, yet we find no artifacts or evidence of 'them'.

Like any proposed scientific model, the Paradox raises more questions than it puts to rest. The Paradox asks both "why is there no evidence of extraterrestrials on earth", and "why are there no artifacts of extraterrestrials that we can observe" relying on a probability model given the massive scale of the Milky Way. Among the artifacts that scientists are looking for include stars with odd spectral signatures as clues to civilizations that have invented Dyson Spheres (apparatus for large scale harnessing of the main star's energy). The likely forms of advanced space travel have been contemplated since von Neumann riffed his idea that self replicating probes are plausible.

But the question is not belief, it’s evidence, Mulder

“Any sufficiently advanced technology is indistinguishable from magic“ - Arthur C. Clarke

The idea of the Great Filter was hatched by economist Robin Hanson in the mid 1990s as a response to the Fermi Paradox. The Great Filter is a probability barrier. It states that the reason we observe no evidence of interstellar visitors is because there are a number of existential tipping points that must be passed through successfully to achieve interstellar capabilities. It's our only concrete data point on existential risk. Hanson lists nine conditions:

1. The right star system (including organics)

2. Reproductive something (e.g. RNA)

3. Simple (prokaryotic) single-cell life

4. Complex (archaeatic & eukaryotic) single-cell life

5. Sexual reproduction

6. Multi-cell life

7. Tool-using animals with big brains

8. Where we are now

9. Colonization explosion

He makes clear that this list is incomplete. The claim is that the Great Silence has happened because one or many of these conditions is very difficult to satisfy. Other scientists have identified more specific sub-filters at length. For instance, between numbers 7 and 8, one could talk about splitting the atom as a filter for a civilization that has a high amount of improbability of passing through. It has been 74 odd years after developing the first fission bomb, has it been long enough to mean we are through that specific filter? Or should we be grouping all nuclear technology development into one larger category that would include past achievements, current applications and future new technologies and development?

Philosopher and futurist Nick Bostrom makes the case that the worst thing that could happen to mankind is that we find evidence in our backyard of past intelligent life. If we found evidence of life on say, Mars, it would suggest that the emergence of life is not very improbable, that lots of star systems would have gotten to this point, and yet we still have the Great Silence. It implies that the weight of the Great Filter is ahead of us. However, even finding a Great Filter behind us does not rule out another ahead of us. If the artifacts we discover indicate an advanced level of biological and technological development, even worse for us. If humankind did make such a Martian discovery, it would be heralded by the press and state as a positive event, yet it would be completely the opposite.

The Great Filter is a nice heuristic - very much like the models and explanations humans like to throw around to explain incredibly complex phenomena where the complex causal loops and variables are not properly understood. To go from Hanson's #8 to #9 is the most crucial step, if only because it would be the step necessary to allow us to see the evidence of extraterrestrial life. And as complexity increases, the dependent variable relationships increase superlinearly. Complex systems often result in 2nd and nth order effects that are very hard to see. This would mean that passing through this stage of the filter is not a single-key problem. It is not a dual key problem. It is more complex that we can imagine.

An unlikely solution to an unlikely Great Filter. But fracking tech has improved dramatically since 1998!

Hanson has written a long piece entitled "Beware General Visible Prey" which aside from being a fun (and long) read, he postulates an idea about how a late stage Great Filter plays out. He coins the term "General Non Diminishing Prey"

So, bottom line, the future great filter scenario that most concerns me is one where our solar-system-bound descendants have killed most of nature, can’t yet colonize other stars, are general predators and prey of each other, and have fallen into a short-term-predatory-focus equilibrium where predators can easily see and travel to most all prey.

He explains why that scenario could be plausible in his piece. To me, this sounds more like "Everything Goes Wrong at Once" as a filter. "Killed most of nature" implies resource scarcity, predator/prey equilibrium becomes impossible.

Volterra Lotka Dynamics

The more different are the methods that prey use to create and store value, the smaller the fraction of that value a predator can obtain via a simple hostile takeover.

Typically predators face a diminishing return in a particular predator/prey scenario. At some point in the equilibrium game it gets harder and harder for the Arctic wolf pack to pursue the local hare population. That doesn't mean that they won't sometimes spend an non-rational amount of calories on a kill, it just means in aggregate the returns are diminishing, and the pack must pursue a different prey or one in a different geography. In nature, the more ways or interfaces available to prey for protecting themselves and their resources, the more prevalent the diminishing returns to the predator.

Future interstellar technology, if created, would mean big problems for the two mechanisms that create diminishing returns on prey: distance and diversity of hiding places. Any civilization that has the technology to colonize on an interstellar scale would most certainly have solutions to these two problems as they are fundamental to the decision to embark on the pursuit of travel in the first place. This reduces the predator/prey dynamic to fewer dimensions - less types of predator and prey, less places to hide, distance is less meaningful (technology) - leads to reduced diminishing returns to predation. This doesn't just destroy equilibrium, it increases the chance of prey population extinction.

The Great Filter concept is appealing, partly through its simplistic framework, but I suspect that focusing on descriptions of 'progress' based on science alone (multi-celled organisms, splitting the atom) becomes progressively less useful in describing how a civilization gets filtered as it progresses. Maybe the exception is some terminal theoretical physics experiment that all advanced civilizations are destined to attempt, but it's hard to optimize to prevent that type of disaster, particularly when this research might actually provide a solution to our future

If we focus on Hanson's #8 - 'Where we are Now', I suspect the likely Great Filter we are up against now is closer to "Everything Goes Wrong at the Same Time". If there was a single key problem that was responsible for the Great Filter, it would be relatively easy to think up solutions and patches, even if we could only narrow it down to say ten key problems.

The two concepts that are key here are emergence and intention.

We clearly cannot claim we are over the filter of self imposed nuclear destruction, even though Fermi created the first nuclear reaction in 1942. Emergence of technology having occurred at some point in the past has no indication as to when or if it will (if it can) be used in a way that would give it a starring role in the Great Filter. That's where intention comes into play.

Climate change, nuclear war, resource depletion - these are all legitimate problems for our brightest and best to work on. But sometimes problems build up faster than you can solve them, and so far we've been very lucky in our ability to do so. The hardest problems to solve are ones that will affect large proportions of the population and also have severe consequences for those people. Those tasked with solving these problems as well as the tools that allow them to do so are also dependent on a working economic and scientific apparatus. Task automating AI (forget about AGI for now) creates some emergent problems that society seems woefully unprepared to tackle. As it moves from the realm of unskilled labour to skilled, the problem of health of the apparatus is a real concern.

Mathematician/economist Eric Weinstein has a nice framework for describing this

Computer programs, like life itself, can be decomposed into two types of components:

1. Loops which repeat with small variations.

2. Rube Goldberg like processes which happen once.

Our skilled and unskilled labour professions look remarkably like A.

In short, what today’s flexible software is threatening is to “free” us from the drudgery of all repetitive tasks rather than those of lowest value, pushing us away from expertise (A) which we know how to impart, toward ingenious Rube Goldberg like opportunities (B) unsupported by any proven educational model. This shift in emphasis from jobs to opportunities is great news for a tiny number of creatives of today, but deeply troubling for a majority who depend on stable and cyclical work to feed families. The opportunities of the future should be many and lavishly rewarded, but it is unlikely that they will ever return in the form of stable jobs.

If you pause a piece of software while it is functioning, you probably interrupt some sort of function A loop. As foreign as the idea of ride sharing was to most people 8 years ago, in another 10 it will probably seem amazing that we had not let software entirely manage the 'Loops with small variations'. And then as software and digital products continue to replace physical economic output (MP3's) they start to resemble public goods which are both inexhaustible, fungible and easy to duplicate.

The velocity of these dynamics creates new challenges for economic stability. Machines optimize to the types of highly repetitive work the gig economy has given us. Wealth inequality partially expressed through modern culture wars have exhumed the concept of things like UBI and MMT, even as the modern version of automation has only just begun to displace the skilled labour force. How do governments replace tax revenue from skilled workers being replaced by software?

The human problems of having machines to do much of our bidding are real. With nothing that ties together the need to consume with the need to contribute, the human soul loses meaning, purpose and dignity.

Recent appeals to socialism are a result of these dynamics, and also because capitalism has become Capitalism! - the move toward corporatism, the melding of the oppressive state with the oppressive oligarchy. Modern Capitalism! doesn't currently have a real solution for the inability of a worker in an automated, financialized society to maintain dignity. This sets up political opportunists as predators with low diminishing returns to predation.

Consider the "Everything Goes Wrong at Once" scenario, specifically the balance of technology, resources and organization that allows for the maintenance of 7.5 billion people, and how quickly economic collapse could lead to a cascade of terminal events for humanity. The radical uncertainty exists that our brainiacs could have us all sucked into another dimension through some ill fated physics experiment, or a planet ending asteroid strike is obliterates all life. (Remember when scientists thought the first nuclear test could burn the entire atmosphere?) Better science and responsible science can assist there. But the potential cascade effects resulting from socio-economic collapse could unlock the tools to our own undoing that we already possess.

The emergence of potential man made Great Filter mechanisms is not new. The conditions that allow for their use have appeared here and there throughout history. It appears we are on the doorstep of another one of these periods, ushered in by both the failure of economic systems to harmonize the consumption/contribution formula, and by the emergence of software that has the potential to redefine billions of individual's roles in our Pebble in the Sky.

Killers From The Egg

The pike is nature's optimized predator. He sits silently in his ambush, dorsal and pectoral fins moving ever so slightly to maintain his orientation. When prey enters range, the pike relies on a rapid burst attack to maneuver his razor sharp teeth to a position to tear and consume his prey. Not unlike other aggressive species like piranha, pike are cannibalistic, territorial and very space conscious.

English poet Ted Hughes wrote a popular poem titled "Pike", his interest for the species established during childhood and pursued through his life as a recreational angler. I highly recommend you check it out here. The poem is wonderful. Here's a favourite part:

The jaws’ hooked clamp and fangs

Not to be changed at this date:

A life subdued to its instrument;

The gills kneading quietly, and the pectorals.

Three we kept behind glass,

Jungled in weed: three inches, four,

And four and a half: fed fry to them-

Suddenly there were two. Finally one

With a sag belly and the grin it was born with.

And indeed they spare nobody.

Two, six pounds each, over two feet long

High and dry and dead in the willow-herb-

One jammed past its gills down the other’s gullet:

The outside eye stared: as a vice locks-

The same iron in this eye

Though its film shrank in death.

“A life subdued to its instrument” is a rich account of the biological killing apparatus - the jaw and teeth - ‘determining’ the function of the organism. But also as nature has made the pike a brutally efficient killer, evolution and natural selection have left the pike with traits such as cannibalism and over-aggressiveness that guaranteed the demise of other ancient species. Yet some of the world's oldest creatures such as crocodiles and lizards share these traits. The genes allowing for both the success at killing and 'anti-social behaviour' in piranhas, crocodiles and pike are remnants of millions to hundreds of millions of years of mutation, selection and evolution. A pike is wired to be what a Pike is after all, remember the fable of the Scorpion and the Frog? https://en.wikipedia.org/wiki/The_Scorpion_and_the_Frog

The steampunk (cybernetic?) version of the Scorpion and the Frog

Or is it? Years ago a study (here) was done where minnows and a pike were placed in an aquarium. The results were as expected. The unheard screams of the minnows were offset by the silent delight of the pike. Ok not really, nature just did as nature does. New minnows were placed in the tank inside another glass vessel. Now the pike attempted to eat the minnows but the invisible glass of the vessel left the smaller fish unharmed. After some indeterminate period of time, the vessel was removed exposing the minnows again to the now famished pike. The pike did nothing, even as minnows brushed against his sharp weapons of death. Allegedly, the pike died of starvation.

So how do we explain that millions to hundreds of millions of years of genetic optimization of a species (to killing things in lakes) was 'undone' in the matter of days? Subsequent experiments with rats and other animals have shown similar outcomes. Narratives about consistency of being and character are among the most powerful in most cultures and for good reason. After all, reputation matters in a tribe or a clan. The tale of the scorpion and frog among a number of other stories we tell each other remind of us that fact. Psychologists posit that core personality traits among humans are incredibly stable throughout life. So how can this idea of learned helplessness be so pervasive to subdue the ancient killing instincts that Ted Hughes so beautifully described in 'Pike'?

Psychologist Marty Seligman coined the term learned helplessness. Repeated negative stimuli beyond the control of the subject often results in acceptance of the situation as new default programming, even when mechanisms for control are reintroduced. He tested this idea using a set of experiments involving dogs and electric shocks. The first group of dogs learned they could stop an electric shock via pushing a lever, and did so. Another group was trained that the lever did nothing to help their suffering by stopping the electric charge. Subsequently, when placed on an electrified pad with no barriers, the 2nd group did not even attempt to step off the shock pad, instead submitting entirely to what they internalized as the new normal state (random shocks).

Later experiments with humans led to similar results. Other animal studies showed that mammals that knew they had the ability to end negative stimuli experienced a better cognitive and emotional state, even if they did not end the stimuli, compared to those that had been trained into helplessness.

This means a lot to us humans. It shows that the most resourceful, prepared and competent of us all can be trained into a state of learned helplessness with relative ease. Leaders throughout history used this to their advantage. Under the weight of an oppressive medieval lord, effective domination of his subjects was best done when it had been 'demonstrated' that they were helpless louts that had no alternative than the lord's bidding. And whether that meant military conscription or taxation, that too would be normalized into helplessness.

The tools of the over-reaching state are the same tools of the over-reaching oligarchy. And by oligarchy today I mean Goldman Sachs, Facebook, Google, the IMF, Carlyle Group, and LOTS more.

Modern learned helplessness to small business was the feeling mom and pop stores had in a small town when Walmart first moved in.

Modern learned helplessness to voters is the feeling that no matter who you vote for the the outcomes and the beneficiaries are the same.

Modern learned helplessness to investors is the feeling that meritocracy is dead, the old notions of liberalism have no place in capital markets, and that the game is in fact rigged.

It's not to say that these are insurmountable things. They are big, daunting challenges that resemble a David vs. Goliath battle. But the most insidious part of learned helplessness it that it blinds you to the potential solutions to the maze. It's why the pike couldn't figure out that he could eat the minnows again, and the dogs that had been conditioned that they could not stop electric shocks would not even walk away from the electrified floor.

The widely (and often justifiably) mocked emergence of 'victim culture', particularly among young people is easier to understand in this context. Consolidating and wielding the power to control narrative has been made a larger prize and also scales easier with current technology and the reliance on social media for interaction and ‘news’, especially among younger people. At the same time, there are also real reasons why it is harder now to succeed in new paradigms - it is more difficult for the Mom and Pop main street business to succeed when the box store moves into town - but you aren't helpless. Same with voters, investors and students.

Seligman identifies three dimensions people use to explain events:

1. Permanence – Is the event a temporary event? People that give up easily typically perceive negative events as being permanent, and as such feel helpless. Optimists typically see negative events as temporary.

2. Pervasiveness – Pessimists catastrophize. “When one thread of their lives snaps, the whole fabric unravels” (Seligman, 1990). This is the opposite of compartmentalization.

3. Personalization – Those that have learned helplessness internalize all failure. People with optimistic outlooks often blame failure on the external environment.

Personalization controls what we feel, while permanence and pervasiveness control what we do. Personalization is the only dimension easy to fake. This is why an ‘excessive optimist’ (also a sociopath) can blame all his personal mistakes on external events or other people, taking no responsibility whatsoever. We don’t want to go far in either direction. Skepticism, and if not taken too far pessimism can provide some very useful survival instincts.

Some psychologists posit the idea that being too closely tethered to reality can result in depression. Intuitively this makes sense. Understanding the odds against success from a mathematical perspective of any venture can dissuade someone from even starting. But it also assumes that perfect, or near perfect knowledge of probabilities of outcomes is readily available about long term, incredibly complex relationships. It’s a tough case to make when most people couldn’t tell you the odds on 3 card monte.

A scarcity mindset is one associated with learned helplessness. It is the idea that there are never enough resources, be it money, food or emotional support. One feels it impossible to find new sources of resources (helplessness). Scarcity mindset traits include pettiness, selfishness, envy, short-sightedness, tunnel vision, fearfulness, and withholding information. The exact opposite of these describes the abundance mindset.

Scarcity mindset players in game theory are typically opting for non-co-operative gameplay. This is infectious as co-operative-type players are trained that many of the other participants ARE playing a competitive game and attempt to adjust their own strategy. This leads to only or predominantly single play games, because reputation does not matter (or matters less) in single play games.

Definitely not the outcome of a co-operative game

With an abundance mindset, and with multiple iterations of the game an equilibrium can be reached where both players mutually benefit, but also the knowledge about the fact an equilibrium exists in a stable co-operative setting has a number of other benefits. There is certainty regarding future resource expenditure and return. Cognitive demands on the players is lower, allowing for the opportunity of refocusing bandwidth on other ventures. With a single play mindset, players become reactionary as opposed to having a framework about how things are supposed to work. They focus on 'the information' coming at them instead of a larger set of understandings based on a cooperative framework. This means the outlandish pandering of politicians to what polls and strategists tell them they think the electorate wants RIGHT NOW, whether or not this is right. This means reinterpreting economic statistics like GDP and inflation as a means to an end. This means that these 'facts' or 'information'' guiding these types of decisions are valuable, powerful and almost certain to be manipulated.

And from Seligman’s work, the real tragedy here is how this impacts the personalization dimension - how does this affect what matters – people. Both Seligman’s work as well as anecdotal evidence suggest that competent, typically well anchored people are personalizing the events of the (mostly) last ten years into a condition of learned helplessness. And increasingly of learned anti-coordination because we can’t see a better way. Seligman’s permanence dimension feels particularly potent right now because things are still accelerating the wrong way. Killers from the egg are dangerous, but as pike can be trained into ignoring their instincts (to fatal consequence), I fear many of the best of us can be trained into reactive, short sighted competitive game playing with potentially fatal consequences.

Institutional Memory and the Neuralyzer

‘Institutional memory’ is typically thought of as an organization’s collected knowledge of facts, experiences and concepts.  Knowledge is often forgotten, shaped, interpreted and reinterpreted over time. Sometimes institutional memory is enshrined in icons like logos, buildings, or mythologies, which serve as mechanisms to ensconce institutional knowledge into a an identity, or even an ideology.

Most of us acknowledge that storytelling has always been the key to culture – from passing down stored knowledge like tribal history, specific technical knowledge (how to build something) or cultural customs. We are predominantly evolved to learn and communicate through narrative. Even one of the oldest stories we know, “The Epic of Gilgamesh” has the same literary themes you’ll see in your favourite Netflix show: A king and a rival fight, become allies, set out on a hero quest, one of them dies, a reprisal second quest begins, and the true nature of reality presents itself.

“Nothing ages faster than yesterday’s vision of the future”

— RIchard Corliss

There are natural reasons for institutional memory to change and fade over time. As resource optimizing mammals, we are wired to focus brain cycles and calories on whatever seems the most pressing to survival and well being. Employees with knowledge leave organizations, records aren’t read or disappear and memories fade. Managers focus on beating last quarter’s sales figures and hiring employees that bring in revenue come hell or high water.                             

One narrative common in economic history is that the German Bundesbank had a stored set of memories directly linked to the economic experience of the hyper-inflationary Weimar Republic. This is tethered to the narrative that the German people had also developed a national psyche that orbited around the perils of hyperinflation, even post WWII. Google ‘Weimar Republic’ and take a look at the images associated with the topic. They look the image below.

German newspapers and national narrative post WWII and pre-ECB were very sympathetic to the Bundesbank’s hawkish execution of its price stability mandate.

There were A LOT of terrible consequences for the German people that were compounding as reparations went unpaid. The French occupied the Ruhr, limiting access to coal and signalling that the Versailles Treaty would be enforced. The Republic used extensive propaganda in an effort to conceal the rate of price inflation from the public, closing stock exchanges, instating price controls, and blaming both the WWI defeat and the horrific economic condition on deserting soldiers (who weren’t being paid regularly during the rebuilding of Germany). After numerous coups and assassinations, the 1932 Reichstag elections established the NSDAP as the largest party in parliament and set the stage for a series of events that would eventually set Europe on fire.

So did institutional memory influence the policies of the Bundesbank in the ’57 to ’90 period? Probably. Popular pictures like the one below, of people using bank notes to wallpaper their houses and for use as coffee tables had become a part of the German collective memory of pre-WW2.  

Germany didn’t finish paying their WWI reparations until 2010! Trying to decipher the status of WWII reparations is even more complex, with multiple amendments since the 40’s, and as recent as 5 years ago Greece and Israel both claimed that Germany owed further payments. Decades of Soviet occupancy was the cherry on top of a multi decade tragedy for the German people.

Most historical narrative from academia does link the national political instability exacerbated by 1920’s hyperinflation to the rise of the Nazi party. And has linear narrative preferring apes, it makes sense, after all it came right before. Digging deeper on the topic is PhD thesis material, and way over my pay grade, but it’s safe to say that the printing presses were at a minimum a destabilizing force, what Soros would call positive reflexivity.

The below chart illustrates the success of the Bundesbank in capping 1970’s inflation.

Image credit: Figure 2 in "How the U.S. and Other Countries Experience Inflation" by OpenStaxCollege, CC BY 4.0

By the time the ECB was established in 1998 and the next phase of the European project was firmly underway, effectively moving monetary policy decisions to the single mandate ECB, the developed world had not seen anything that had resembled 70’s, or even ‘80s inflation. If the lessons of the 1920’s and 1970’s had left some remnant of institutional memory within German central banking by the late 1990’s, surely this at least the beginning of the end.

The BIS did a study in 2003 entitled “The institutional memory hypothesis and the procyclicality of bank lending behavior” with the goal of determining (a) is bank credit creation procyclical? (hint: yes), and (b) does this occur because of institutional memory, in particular how it changes throughout the business cycle (hint: yes, partly). The study considers the idea that during a cycle boom, overly optimistic lending officers ease credit standards and get caught up in some classic behavioral finance traps. Secondly, few officers or executives from the previous cycle were still in the organization – they had lost institutional memory. The net effect is that bank lending in this manner exacerbates business cycles, increases systemic risks, and makes regulators jobs harder. https://www.bis.org/publ/work125.pdf

This describes the natural decay of institutional memory. This can happen at different rates with different consequences depending on the type of organization and exogenous environment. With each passing year since the GFC, less PMs, risk managers and even CIOs have experienced risk management in a non-centrally planned environment. Talk about modelling errors being institutionalized! As with each passing generation of Germans, the power of the cautionary tale of the destructive nature of hyperinflation is gradually diluted and slowly fades away. It is not ‘deleted’ from history, instead is subject to the human phenomenon of rationalizing resources to a threat that hasn’t materialized in generations.

I recall working on an institutional trading desk in 2008, and some of the more well read senior guys on the desk cited ‘moral hazard’ as a major determinant of how the crisis would play out. They were wrong. Few in the mainstream narrative talk about moral hazard much anymore. It’s embarrassing for many to acknowledge they thought the Fed would actually a number of banks fail on the basis of reputational integrity (ha!). So we ignore that we thought that, we slowly change our assumptions about the way they will behave, and we drive on.

No one cares or talks about this anymore. Nothing to see here. A perfect example of a narrative losing Attention, even though ‘price stability’ is one of the Fed’s dual mandates’

“Who controls the past controls the future. Who controls the present controls the past”

— Orwell

“The past was erased, the erasure was forgotten, the lie became the truth”

— Orwell

What we are facing now is much more dangerous than the seemingly natural Alzheimers that institutions go through. Forgetting the lessons of history slowly is like a trench-warfare. What we are facing now is the nuke dropped on the trenches that happens in an instant and no one sees it coming until it’s too late.

As with Orwell’s Newspeak, controlling language is the thoroughfare to control of ideas. Consider how many of Alinsky’s ‘Rules for Radicals’ concern narrative dominance. The SJW’s know this. The politicians and the corporate oligarchy know this, and technology has allowed them the means to scale their efforts in ways that would have made Oceania’s Inner Party jealous. We can rename old ideas into acronyms like MMT, rebranded and repackaged for the nudging-turned-shoving state and elite to use. It’s a function of the modern zeitgeist, not a flaw, that we can barely agree on basic facts.  Orwell’s memory hole exists in institutions all around us. Cue the Neuralyzer.

Reformat and Rewrite

So what happens next? More of the same - more rewriting of institutional memories, more financialization, less subtle and more overt nudging by the state and oligarchy toward what they want you to think. More cognitive dissonance between the ideas that we have about institutions and what they are actually going to be doing. That in itself is a powerful weapon for the state and the elite - it at least gives them cover for a while, until people figure it out, and then it’s too late for them. And then inflation, which with its consequences, has components of both computational irreducibility (a model or formula cannot solve for) and radical uncertainty - we can’t even imagine what we should be worried about. But we won’t, because we can’t.

Fighting (and Modelling) the Last War

“History must be lived forwards, but can only be understood backwards”

In military parlance, the concept of ‘fighting the last war’ is understood as leadership applying the tactics and lessons from the last major conflict to the current situation. The costs can be catastrophic. German cavalry in 1914 appeared on the battlefield in the spiked Pickelhaube helmet, spears, and beautiful mounts. While they may have looked dashing, their ineffectiveness by 1915 led to the Cavalry Corps effectively being redesignated to infantry units given the emergence of machine gun and trench warfare.

German Cavalry, 1914

Otto von Bismarck in the Pickelhaube, circa 1880

France’s famous Maginot Line was reminiscent of fortified trench systems from World War I, even as the Germans had developed a new method of combat, “Blitzkrieg”, that effectively rendered the Line nearly useless. Korea, Vietnam, and more recent conflicts have shown that this phenomenon is not something that modernity has inherently ‘figured out’, instead for thousands of years, kings, generals and officers have lost battles, wars, nations and empires by fighting the ‘last war’.

 Any given Sunday, you will probably see some NFL coach fighting the ‘last war’ – an outmoded and predictable set of plays that will likely lead to a few wins and his job. In the trenches of WWI, the consequences were catastrophic. Millions of lives were thrown into the meat grinders of the trenches due to inept leaders not adapting to the new rules of battle.

 Central banks are the modern ‘omniscient’ force fighting the last war. By 2008, three letter acronyms (TLAs) unrecognizable to ‘even’ an equity salesman on Wall Street just a year or two prior were commonly overheard in gyms, taxis and coffee shops. Since then we’ve had TARP, multiple rounds of QE, operation twist, ZIRP, and if you’re ‘lucky’ enough to live in Europe, NIRP. The beginning of the reversal of these policies had the bond and equity markets screaming bloody murder by December 2018, enough so that the Fed is about to reverse course. Now the market waits with bated breath for a new round of Fed rate cuts, cessation of QT, and the contemplation of other ‘tools’ (cowbell) to push asset prices higher. Why do they think they can get away with this? Why do they think this will ‘solve’ for any problem? Specifically, because the specter of inflation hasn’t been spotted for decades. But more generally, because markets have been formed into political utilities. I highly recommend Epsilon Theory’s work on this topic.

But why do they think it will work? Central bankers only know how to fight the last battle, while pontificating not only that newly invented gadgets will work, but we know better than you, so back off. The GFC led to all sorts of models to explain, monitor and prevent new crises from emerging. And these are typically calibrated to solve for the types of specific problems that came about in the GFC that 11 years ago lead to massive asset price deflation. It’s amusing (but mostly terrifying) that the Fed thinks that right now their return to loose monetary policy is being proactive to the extent it will protect against a new crisis as opposed to being reactive, reactive in the sense the Germans ditched the horses and spiky helmets for trenches and machine guns after being mowed down. But the Central Bank plan is sadly misguided. How do a bunch of super Team Elite braniacs with massive resources and nearly unlimited power make such modelling errors?

In his excellent book “The End of Theory” Richard Bookstaber identifies 4 phenomena that lead to potentially catastrophic modelling errors:

 1) Emergent phenomena

o   Any number of independent actions cause catastrophic, unforseeable and novel events. Unintended consequences also create previously unseen crises. Think of people who act in a personally rationally manner in their frame of reference, but the sum of all the group actions results in chaos (people rushing to leave a burning theater).

2) Non-ergodicity

o   Probabilities and distributions of certain events are non-static over time. This is fundamental of both physics and picking up a gun and playing Russian roulette. Casinos would have a hard time doing business not only if the odds only changed every game, but if no one knew what they would be in advance (including the house). But much of our natural and social world is non-ergodic, yet we apply ergodic models to them.

3) Radical Uncertainty

o   This is what Rumsfeld famously characterized as “unknown unknowns”. Effectively, you have no way of knowing that you don’t know about the existence of certain phenomena. Newton didn’t know he didn’t know about the ‘existence’ of particle physics.

4) Computational Irreducibility

o   Economists (among others) assume that all phenomenon can be reduced to formulas and models that will predict future outcomes. We know this to be false across many natural and unnatural phenomenon, for instance the Three Body Problem.

Even simple systems involving a small number of interactions (human or otherwise) are typically irreducible. Consider the calculative permutations among hundreds of nations, thousands of companies or billions of people in a non-reducible subset!

We do understand that the above modelling errors ARE going to happen. We cannot erase non ergodicity in non-ergodic things for instance. We CAN acknowledge the nature of the model being applied versus the data set.

Decentralized Command

 In his legendary book “About Face” U.S. Army Col. David Hackworth at length describes the mechanisms of compounding errors due to centralized command during his time in the US Army in Vietnam.

“As a rule, the judgment of those on the ground was respected less and less in the post Korea years. Centralization of command, which had characterized the trench war of  ’52-’53, was alive and growing stronger every day. And it wasn’t just know-nothing commanders making the decisions (which would have been bad enough); now it was a combination of computers and peacetime procedures that ignored the human variables: initiative, potential and personal growth of an individual soldier” (Hackworth, 323)

The concept of decentralized command was his prescription (I am simplifying) for many of the policy and execution errors he saw the US military (and D.C.) making in Vietnam. The centralization of capital allocation through central bank policy is NOT the answer to winning the ‘war’ against deflation and anemic growth that so terrify central banks. The financialization of markets and zombification of corporations sounds a lot like the things identified by Hack (ignorance of initiative, potential and personal growth) within the U.S. military. Model errors will be present as long as we have data and models. Correct application of models, skepticism of ‘Big Data Solving’ and agent based models is the first step to avoiding these mistakes. What’s harder is we can only hope to attenuate the consequences of these errors by limiting the power and scope of those misusing models to form policy. But for now that (Prussian) horse has left the stable.

Of course all this makes the assumption that the Central Bankers are acting as independent and in good faith. A topic for later…

What is this blog?

This is a blog about financial markets, economics, people, history, politics and whatever else seems to make sense at the time.

I’m an asset manager, musician, father, husband and good at being well rounded. I am incredibly humbled by some of the thought leaders out there in so many different fields. My content won’t be as good as theirs. I’m okay with that as long as I can come out with something coherent and interesting.

Thanks for stopping by, feel free to provide any feedback.

Wraith