Global macro is dead, long live global micro

After Louis Bacon closed Moore Capital this past week, both the FT and the Economist had interesting articles on the future of global macro investing. They struck almost opposite tones, each making good points about the current and future reality. Global macro will return, but likely in an unexpected form.

Stability destabilises a generation of macro hedge fund stars

A league of their own: Do not write off the macro hedge-fund manager just yet

Stability killed the macro star

The glory days of global macro as we know it started when the Bretton Woods system collapsed in 1971, ending fixed exchange rates.    Broadly speaking, there were two different groups of investors who entered this environment and profited immensely. The first was people with long/short equity experience in global markets and included George Soros, Jim Rogers,  and Michael Steinhardt. The second group included people with a physical commodities and futures background. The Commodities Corporation trading firm trained and/or funded many macro investors including Bruce Kovner, Paul Tudo Jones, Louis Bacon, Michael Marcus, etc.  

The dramatic changes in the institutional architecture of international trade and finance created a volatile playground for these investors.  Exchanges developed new derivatives instruments for trading newly volatile currencies and increasingly global commodities markets in a high inflation environment.  Global trade started to open up dramatically, and global supply chains spidered out in response to changes in policy and technology. Many investors made or lost fortunes betting on big equity moves like the 1987 stock market crash(shortly after Greenspan became head of the Fed),  or the breaking of fixed currency regimes such as the sterling crisis of 1992, the Asia crisis of 1997, Russia in 1998, etc. There was also the emerging market debt crisis in the 1980s and the surprise interest rate hike in 1994.

After the 2009 global financial crisis, interest rates and inflation have been abnormally low.  The euro crisis notwithstanding, markets have lacked volatility. With no volatility its hard for the traditional global macro style to work.   Moore and his proteges have all closed down recently. The decline of the legacy macro investors is just one part of the broader decline of active management.  Its been a long torturous capitulation.  

Yet stability leads to instability.  Long periods of calm tend to be followed by  extreme volatility.

The future is global micro

Is there any future for global macro?  That depends on what your definition of “global macro is” Making bold systemic predictions about surface level data is unlikely to lead to profits.   Yet global macro’s main benefit is its flexibility to take long or short positions in any asset class anywhere in the world. Although trades in large liquid markets get the most attention, the analytical techniques of global macro can also uncover insights leading to lucrative opportunities less liquid frontier, emerging, and alternative markets.  

The future of global macro will involving finding bottom up industry and company specific insights that fit with top down shifts:  global micro. Steven Drobny mentioned this evolution in Inside the House of Money . Indeed most quantitative techniques of the original macro greats are commoditized. Analysts need to look beyond headline numbers numbers for less obvious global micro trends and second order impacts on tradeable assets.

Capital flows and valuations have a funny historical tendency to overshoot in both directions.  Many investors build up leveraged positions based on stale fundamental inputs, and when they wake up to a new narrative taking over the market,  they must rush to a crowded exit. What will be the next gestalt shift in which a new narrative takes over markets?

The next gestalt shifts

Don’t try to play the game better, try to figure out when the game has changed

Over coached football players do not respond well when a game takes an unexpected turn.  Investors schooled in calmer markets may similarly struggle with renewed volatility.

Many of the classic macro bets(and blowups) involved major breaks in fixed currency regimes. Sometimes the big trade(or blowup) involved direct currency exposure.  Other times it involved investments impacted by second order effects. Its possible that the big macro trades of the future will be more subtle, and play out over many years away from headlines before becoming obvious.

For the past few decades,  global trade was getting generally more open.  That is starting to reverse. The WTO dispute settlement mechanism will completely shut down next month because  the Trump administration is blocking new appointments to the appellate body. Trump’s attitude is just an extreme manifestation of a global trend towards populism and  trade conflict. At best, there will be a spaghetti bowl of bilateral agreements, instead of a large open multilateral trading system. Companies will need to dedicate more resources to supply chain strategy.  

At the same time, emerging markets are starting to trade more with each other than with the developed world.  Africa might become the world’s largest free trade area. China is attempting to facilitate more commodities trading without using the dollar.  As China develops its own bond markets, it will invest less in US dollar based debt markets. As the world shifts to cleaner energy, oil producers will have fewer dollars to recycle into US capital markets.    The relative importance of the US dollar and of major US companies is likely to decline.  

 Often policy changes  have second order impacts  on individual businesses because they alter competitive forces in their industries.     Indeed its difficult to find an example of businesses that are completely immune to change in international trade policy. 

Reality and narratives change at different paces.   Narrative changes alter capital flows ultimately impacting valuations.  

Here are some other speculations on what shocks or regime shifts might occur:  

  • I don’t have a strong view on inflation, but do find it concerning how few S&P 500 companies will do well if we encounter high inflation.  Its commonly accepted wisdom that low inflation will continue.  Yet most analysts are only considered demand driven inflation, and ignoring possible supply side shocks.  There has been little investment in new production capacity for many key over the past decade.  Note the conspicuous absence of resource companies in the top holdings of any indices. More insidiously, if certain prominent venture funded startups shifted from growth mode to harvest mode, and suddenly needed to make money, they would be forced to raise prices, impacting consumers directly (See: Cheap Stuff and Cheap Capital) .    Alternatively, if we face deflation, then debt burdens on over leveraged companies and consumers will be a much greater drag on growth. 
  • If negative interest rates continue, they’ll force banks and insurance companies to find new business models, or slowly perish.  If negative interest rates reverse, it will be a shock to a lot of overleveraged companies 
  • Pension funds are a looming disaster in many western countries. The government will overreact somehow when it becomes a social issue.
  • Many investors, including pension funds, have rushed into illiquid alternatives such as private equity in search of higher returns.  It is likely that those investments will fail to deliver the expected returns, and worse yet, they might be illiquid for longer than expected.
  • ETFs have grown from obscure backwater to the default investment option for both institutional and retail.  Many ETFS are invested in illiquid assets- creating the potential for a unique type of death spiral.  The SEC recently made some changes to its filing requirements which might make it easier to preemptively find which ETFs are most vulnerable. 

See also:

The ecological consequences of hedge fund extinction

Thinking and applying minsky

Highlights From Recent Hedge Fund Letters: 2019Q3

I love reading investment fund letters. This business requires a rare combination of variant insight and brutal intellectual honesty, which the best managers express in their writing. My highlights from the best letters I read this quarter are below, in no particular order. In this piece I mostly avoid quoting on specific stocks, and focused on broad investing and psychology themes. You can find plenty of investment ideas by following the links to the letters. This quarter several funds discussed the value/growth divide, the underappreciated risk of inflation(or deflation), business impact of negative interest rates, and mental model challenges in investing.

Thanks to the generous curators that make this possible. Mine Safety Disclosures is probably the best single source for hedge fund letters. They’ve sought out and organized many off the beaten path managers that I wasn’t reading before. The investment letter page on Reddit is another great source. I found several of these letters on twitter as well.

Vltava Fund

Vtltava Fund had one of my favorite letters this quarter. Here is their perspective on hyperbolic discounting :

I always say that one can learn a lot just by looking around oneself, seeing how the world works as well as how people perceive it. The way people perceive the world is then reflected in how investors (a subset of people) perceive the events on the capital markets (a subset of the world). The aforementioned tendency to overestimate short-term events and underestimate the importance of longterm trends is very strongly demonstrated in both cases. (Finance theory even has a name for this: hyperbolic discounting.)

On long term vs short term:

If we as investors were to profit from shortterm events, we would have to be able to recognize the truly fundamental ones in real time as they are happening. This is practically impossible, and even the effort to do so might bring very negative results, because in most cases it will transpire that one has overreacted to something that in the end will have been of no practical importance. We find it is much better to take the approach of betting on long-term expected developments in society.

One of the most cogent defenses of the valuable role that the finance sector can play in society:

For the capital market to work well and efficiently and for it to allocate capital at low costs, there must exist a sizeable number of entities of various types. Vltava Fund is one of those entities. Our role in the overall system is twofold: we act as intermediaries and analysts. We collect free capital from investors who want to invest and then analyse the individual investment opportunities to determine those into which we invest the collected capital. Even though we are just a tiny cog in the gigantic global markets machine, I am very proud of the work we do and how all of us associated with investing in Vltava Fund contribute collectively to the general progress, growth of wealth, and betterment of society.

Tollymore

Tollymore on epistemic humility and the Gell-Mann effect: 

Serious media publications invent stories to explain outcomes, without the resources or inclination to determine causality. This often manifests itself in major descriptive U-turns as the outcome changes with the wind. The matters about which financial and political journalists opine are complex. This limits the mechanism to scrutinise these stories and hold their authors to account. And there is value to their readers and listeners, who can paraphrase talking heads’ memorable soundbites at cocktail parties rather than acknowledging ignorance or retrieving the relevant facts from their addled brains. Authority bias plays a role: media appearance confers credibility, the belief in which is counter to independent thought and self-awareness. Unsubstantiated conjecture is rife. As Mr. Crichton puts it: “one problem with speculation is that it piggybacks on the Gell-Mann effect of unwarranted credibility, making the speculation look more useful than it is”.

The goal of epistemic humility is consistent with maintaining a careful distance from today’s media. To exercise good judgement, we should shield ourselves from the Gell-Mann effect. Financial markets, political and economic systems, unlike meteorology, are reflexive; participants are second guessing one another and the bases on which decisions are made are altered by the decisions themselves. Speculation thrives because it is cheap and speculators are not held to account, but forecasting is foolish when nobody knows the future.

Epistemic humility is a key concept I try to apply in my approach to life.

Greenhaven Road

Greenhaven Road discussed how they subdivide investments in high quality companies into those that are bets on the status quo continuing, vs those that are bets on the status quo changing.  

They are also SPAC curious.  They rarely do SPACs, but interesting what he goes through when he does they go to extreme lengths to compete due diligence, which they discuss in a case study. 

Also, they have decided to make an investment in South Africa, which is a bit unusual for them.  Here is some of their reasoning:

Why Bother with South Africa?   For me, there are two parts to the answer. The first is a desire to hold some non-U.S. companies. While it is true that the world catches a cold when the United States sneezes, South Africa is in the interesting position of having not meaningfully participated in the last decade’s equity market growth due to poor political leadership, poor policy choices, and corruption.  I believe that new leadership and positive reforms are likely to place South African equity markets in a position to be less correlated to developed equity markets yet produce positive returns, albeit more volatile. This is intended to be rational diversification.

The second and more important reason to venture to South Africa is the potential for returns. With a bit of continued growth, operating leverage, and anything approaching a fair multiple, I believe that the price of the shares we are acquiring could very realistically go up 5X. A hundred things can prevent that type of return from being realized, but given how absolutely beaten down South Africa is from a valuation perspective, any return to normalcy could produce abnormally positive returns.

They have some great points. We’ve also found opportunity in Africa.

Alta Fox Capital

Alta Fox on the concept of zooming in and zooming out: 

The concept of “zooming in and out” is an important one for my investment process, both from a single idea and a portfolio construction perspective.

For any individual idea, it is important to “zoom in” to understand the unit economics of a business, appreciate the finer nuances of the financial model, and to develop a sound valuation technique. However, it is equally important to “zoom out” and to understand at a higher-level what could go wrong, develop intuition for risk and uncertainties that transcend a few valuation scenarios, and know when to ride winners or when to fold losers. For a broader portfolio management perspective, it is also important to zoom in and out. It is important to track performance relative to indices over time as that is ultimately the measuring stick, and if the market is disagreeing with you, it is important to know why. However, one has to zoom out and focus on the process because too much focus on short-term performance is absolutely detrimental to day by day decision-making.

The abilities to zoom in and out are different skills. This is one of the primary distinctions between a good analyst and a good portfolio manager. They have complementary, but different, skill-sets. An analyst is most often tasked with “zooming in,” which normally involves ripping a business apart and understanding the filings at a very rigorous level. A portfolio manager, on the other hand, must have an overarching philosophy on how to allocate scarce research time to specific ideas, passing on others, how to size positions, etc. The best investors are capable of simultaneously zooming in and out.

Firebird Management

Firebird on negative interest rates:

In theory, companies trade at the present value of all future earnings. There are two key inputs to this: earnings and the discount rate. Companies that are growing earnings faster should be valued higher than companies with a slower growth rate, but how much more depends on the discount rate.

Consider a simple thought experiment at different interest rates: Company A is growing earnings at 2% per annum while Company B is growing at 15%. At a 7% blended discount rate, Company A is worth 17x this year’s earnings, while company B is worth 107x! Company B is value higher but has a much higher sensitivity to interest rates. A mere 1% change in the blended discount rate leads to 35% drop in value of Company B, while Company A valuation drops by only 15%

Note we also wrote up an extensive Negative Interest Rates Thought Experiment here. The implications across the economy are startling.

Of course, so are the implications of reversing negative interest rates, as Firebird points out:

In the U.S. market, growth companies have been outperforming value dramatically since the beginning of 2015, when we first started seeing corporate debt trading in negative territory. We believe that this outperformance is in large part due to repricing the cost of capital in light of the likelihood that low rates could persist for longer than originally anticipated. With the negative impact of low rates becoming more apparent every day, it is not surprising that the market reacted to the possibility that the policy of low negative interest rates may be in question.

Third Point

According to Third Point, the markets aggregate results have masked a “tumultuous factor rotation” taking place underneath the surface.

In August, equity portfolios tied to momentum or the near inverse – “laggards” – outperformed, as markets inflated assets reflecting economic weakening in a low inflation/low growth world. These momentum asset biases – favoring large cap over small cap stocks, growth versus value, or “min vol” strategies – became increasingly correlated, crowded, and sometimes expensive. The equation extended itself more acutely in secular growth names and similarly punished unloved shorts.

Third Point has increased its emphasis on activism.  Currently activist names account for 40% of their assets, the highest percentage in history. 

Askeladden Capital

Askeladden Capital’s letter this quarter reflected a maturing process. They discuss the limitations of primary research, and how their approach to risk has changed:

In certain circumstances (such as levered companies), we have become far more conservative, and less willing to underwrite certain outcomes with any confidence whatsoever. In other circumstances (such as recurring revenue businesses), we have become far less conservative, and far more willing to underwrite certain outcomes with a high degree of confidence. We have become more aggressive in underwriting knowable factors which we can understand better through thorough research and become far more conservative in underwriting unknowable factors which we generally believe cannot be elucidated by research to a degree helpful for the investing process. When we aren’t sure if something is knowable or unknowable, we like to default to ´unknowable for conservatism -overconfidence is killer in our business.

Nuances like these are what drive outperformance …

The letter was also full of links to articles on mental models.  Separate letter for clients that includes specific positions. I won’t disclose any specific positions , but I will say as a client that performance has been solid, and there are several intriguing investments currently in the portfolio. 

Comus Investments

Comus Investment’s letter had some intriguing criticism of dividend investing:

Firstly the term dividend- investor makes no sense at all to me, and it makes even less sense than the fabricated demarcation between supposed growth and value investors. Dividend- investing often implies that one is investing with the goal to receive a currently yield at the expense of long term capital appreciation as if the two sources of returns are distinct(they aren’t)

Also, notable discussion on absurdities in the valuation in SAAS companies

Any tech investors reading this will likely roll their eyes given how often they are mentioned but I have to bring up the SAAS basket of stocks. I believe it is lower now, but last I saw the entire group of public SAAS-related stocks was valued above 10x sales. This is similar to 100 fishermen at a single lake estimating they can each catch a fish a day with only 10 fish in the lake- for the fishermen to be right the fish will have to reproduce extremely quickly. The entire industry is valued as if every investor will do extraordinarily well and each business is valued as if it will experience organic ROE’s of 20%+ for decades.

Theye also had an interesting point about how accounting changes (ASU 2014- 09B) will influence SAAS accounting

Punch & Associates

In their latest letter, Punch & Associates frames a fascinating discussion around the parallels between the Screwtape Letters (great book) and the emotional and psychological challenges investors face. Screwtape Letters are fictional letters from Screwtape, to his nephew Wormwood, part of an underworld organization charged with taking souls from people trying to live a righteous life.

parallels exist between the forces (temptations, distractions, habits) acting on the Patient and the forces impacting the hearts and minds of individual investors. While these forces may not be described as demonic (some may be), and while the fate of one’s soul may not hang in the balance, the fact that these forces exist and that we are all vulnerable at times does indeed matter. The world is not perfectly architected so that you can get rich, beat the S&P 500, or even reach your financial goals. Quite the opposite. 

People’s lives go through peaks and troughs, and this impacts thaeir ability to live a good life.  Similarly, peaks and troughs in the market impact people’s ability to make rational decisions.  

Closely related, there are great lessons for dealing with temptation of noise:

Noise is something that we all deal with in investing and in our lives. Like Wormwood’s whisperings, it’s constant. Noise can enter into your life and cloud both your judgement and priorities. People are subject to it one moment, and then they are not. The effect of noise, therefore, undulates. It’s not enough, however, to occasionally ignore noise, because mistakes are made in moments. Wormwood’s efforts are like the noise we encounter today, constantly whispering in our ears.

Pangolin Investment Management

Pangolin Investment Management is focused on Asia, and their August letter made some interesting points about tax policy in Southeast Asian countries . Also they have some commentary on a challenging history/geopolitics situation in Indonesia. In their October letter Pangolin discussed car racing in Malaysia, and the broader meaning implications for emerging markets.

Lifestyles are changing quickly in Asia. Motor racing with all its glamour is a million miles away from Lombok’s subsistence padi farming of 20 years ago. Here, income growth lifts people from being poor farmers to basic consumers, and then on to becoming middle class discretionary spenders.

It’s not just about a GDP growth, but the massive change in people’s lifestyles that accompanies it.

Ensemble Capital

Ensemble Capital on the three types of traps they avoid: 

We’ve identified three traps we want to avoid. First, the commoditization trap. This is when there’s strong management in place and an easy-to-understand business, but either a non-existent or narrowing moat. Much of a company’s intrinsic value is driven by its so-called “terminal value” – the value the business will create over the very, very long term. As such, if we’re not confident that a company can maintain or widen its economic moat beyond 5 or 10 years, estimating terminal value becomes increasingly difficult. In this circumstance, long-term returns on invested capital and growth – the two pillars of our valuation model – can decline faster than might otherwise be expected. Some investors are comfortable making a bet on a company decline being slower than market expectations – and that’s another way to make money – but we think that’s a dangerous game and one we intentionally avoid.

The second trap is a stewardship trap. This is when there’s evidence of a durable moat and an easy-to-understand business, but we lack confidence in management. We live in a hyper-competitive economy where cheap and abundant capital and new advertising platforms have made it easier than ever for challengers – whether that’s a startup or Amazon – to take on lazy incumbents and chip away at their business. Because of this, we require our companies to be managed by what we consider to be good business stewards. Our management teams need to understand how to create sustainable value and thoughtfully allocate capital.

The final trap is the complexity trap. This is when we like management and think there’s a durable moat, but we just can’t get comfortable understanding the business. Sometimes the reason is that we lack requisite domain knowledge in a specialized field. Other times, the financials are opaque, or the business operates in multiple competitive arenas and we struggle to grasp unit economics. Before investing in any company, we want to appreciate the known risks and the so-called “known unknowns” about the business, and a lack of understanding prevents us from achieving this.

Artko Capital

Artko Capital’s latest letter included discussion on investment business challenges of focusing on microcaps.  Although returns in the space are lucrative, structural reasons that opportunities are left for smaller funds. Also includes a great case study on handling portfolio responsibilities as a portfolio manager when investing in turn around type situations. 

Andaz Private Investment

Andaz Private Investment’s latest letter includes some provocative commentary on the real meaning of inflation statistics:

There is a prevailing argument out there that inflation is nowhere to be seen, and that deflationary forces are at play e.g. technology replacing workers, offsetting the effects of money printing. In our view, this is naive. The metric used to measure inflation (CPI) is misleading and we would argue, deceptive. In fairness, the Australian Bureau of Statistics makes no attempt to hide this and has the following disclaimer: 
“In practice, no statistical agencies compile true cost of living or purchasing power measures as it is too difficult to do.” 

Other bodies are not so forthcoming. Central banks have decided that this garbage-in, garbage-out statistical measure is their sacred metric, that 2.0% is their precise target, and will print money until that figure is very close to 2.0% but not over it.

….

The most crucial criteria for investment over the foreseeable future will be to hold assets and securities which can outrun inflation (e.g. businesses which can raise prices or use levers to increase profits/earnings on a per share – again undiluted – basis). 

East 72

The East 72 Quarterly letter had some interesting macro discussion on company earnings trends.

Additionally, they also discussed a bunch of super cheap, esoteric investment/asset holding company investments. Listed investment companies in Australia seem like an especially interesting hunting ground these days.

It has been noteworthy that the mania surrounding Australian LIC’s, rather than subsiding, has turned to near derision in some cases. This is leading to a number of corporate actions and activist behaviour designed to close up value gaps or force liquidation against hefty fee imposts for “me-too” investment strategies. …

We have always held the belief that having permanent capital available means that a far more esoteric/illiquid investment strategy can be pursued (in essence, that’s the basis of East 72 itself). However, in these situations, care needs to be taken to retain liquidity to ensure discounts to NAV do not blow out.

Saber Capital

Great discussion on the different types of edge in the Saber Capital letter. This comment on time horizon edge is key for long term investors:

….the deterioration of the info edge has actually increased the size of the “time horizon” edge.

GMO

GMO recently released a letter called Shades of 2000:

..many investors made the case in 2000 that long-term averages were not meaningful anymore and the future would be far different from the past.  From the standpoint of the world from 200-2010, those investors proved to be wrong as asset prices

Value investing is way out of favor these days, but GMO believes the current environment that value investors have had in 20 years.

Horizon Kinetics

Horizon Kinetics 2019Q3 letter summarizes their current investment positining this way:

The composition of our equity portfolios is intended to avoid making their performance dependent on the continuation of the status quo. 

They discuss what type of companies might do well under different scenarios, and include this handy diagram:

Horizon Kinetics’ points out that most investors are all invested in the same group of stocks, and are not prepared for any inflation.  Enroute they point out some of the absurdities of ETF land, such as the fact that the same stocks are classified as both growth, value, low vol, high dividend in different indexes.

A couple of interesting statistics, since this discussion is all about diversification. This year through September, the daily price correlation of the following indexes with the S&P 500 were all between 0.86 and 0.98, meaning that their price behavior varied almost identically with the S&P 500: S&P 500 Growth ETF, the S&P 500 Value ETF, the Russell 2000 ETF of small-cap stocks, and the All Country World Index Ex-U.S. The greatest variance, among the major equity classifications was from the Emerging Markets ETF, and that fund mirrored the S&P 500 77% of the time.

People think they are diversified, but they aren’t. 

Focused Compounding

Focused Compounding discusses different types of price risks in their investments.  They explains why they look for a combination of low share turnover , and low beta in order to identify underfollowed stocks.     It contained this gem of a quote :

In investing: beta is like syphilis. If art, cash, gold, or bonds are inherently lousy, low returning assets (barren islands) – then, institutions and individual investors can simply switch into inherently more productive assets like stocks, farmland, timberland, real estate, etc. (fertile islands) and collectively lower the risk they won’t achieve their long-term financial goals.

They use a couple case studies to discuss why their experience has led them to personally prefer “compounders” to asset plays as well.

Silver Ring Value Partners

Silver Ring Value Partners mostly follows a bottom up stock picking strategy.  However, they have decided to put on a Minsky style tail hedge, which they discuss in detail in the letter.   They looked for for companies that have high debt levels and will need to refinance soon. These companies are most likely to decline severely in a panic.     Its a great example of combining micro and macro- of a bottom up investor, productively worrying from the top down.

See also: Thinking and Applying Minsky

Templeton & Phillips Capital Management

Tempelton & Phillips latest letter has interesting commentary on how the value and growth divide is blurring when you look carefully.   (see also: Why All Great Investors Are Intellectual Cross Dressers)

Excellent analysis of how intangible assets influence modern balance sheet analysis:

…the assets driving economic gains today are more closely related to Mickey Mouse in nature, than they are to the tangible assets that statistical measures, accounting methods, and valuation methods were designed around in the last century. This reality has created significant challenges for today’s economists and accountants, who still struggle to account for intangible assets that defy being touched, seen, measured, valued, and in some cases even fully understood. Rather than tackle the anomalous values of Mickey Mouse, or the formula for Coke,

economists and accountants today are tasked with collecting, interpreting and recording data representing a widely expanded realm of intangible assets including: in-house proprietary software, customer databases, customer network effects, business processes, and organizational structures. So, while the assets listed above are very real to shareholders, and tend to be more durable than not, the business activities used to create them flow through the income statement as expenses, rather than get recorded on the balance sheet as an investment. In sum, the financial parties that collect and report data to the markets are failing to capture an increasing amount of economic activity tied to today’s growth in intangible assets.

….

One final note here is that we believe in order for a Ben Graham style asset-based valuation approach to be successful today—such as the widely used price to book ratio—the analysis would need to make an estimate regarding the value of intangible assets (not fully reported in financials) in order to calculate a reasonably accurate ratio. Since many intangible assets are not counted in traditional book value, the price to book value without any adjustment appears inflated (and expensive). Similarly, a low price to book ratio without any adjustments implies to us the possible need for asset write-downs or a firm’s reliance on underperforming tangible assets. Since low price to book ratios are a key focus for the “value” indices, we believe
these measures have a bias towards selecting firms with less productive assets. To the extent this is true, this collection of assets are very likely to underperform the overall market, much less the growth stocks where earnings estimates are growing even faster (but may not be sustainable).

White Crane

White Crane discusses the bifurcation of the credit markets between companies that can raise tons of easy money on easy terms, and those unable to raise any at all.

Such bifurcation of credit markets is often witnessed in the latter stages of credit cycles, as the availability of capital erodes. With credit availability becoming finite, lenders allocate only towardsselect borrowers, while others are either forced to pay exorbitant rates or seek other forms of Capital.

In order to take advantage of this market bifurcation, and a potential transition into a broader credit downturn, the Fund has built short positions in a basket of corporate credit securities.

These short positions can be grouped into two categories:

1) Investment grade credits that currently have access to unlimited amounts of low-costcredit; and

2) High yield credits that, in our opinion, do not have access to capital markets – yet are being priced as if they are investment grade credits with unlimited access to inexpensive


The common theme between all the credits in our short basket is that the all-in negative carry is low and they each have specific catalysts that we believe will result in a re-rating of the securities. Through this basket, we have created inexpensive capital structure put options where our downside is limited (i.e. essentially the negative carry) and our potential upside is substantial should our identified catalysts unfold. We expect to continue adding to this basket of credit shortsas the credit cycle becomes increasingly elongated and additional opportunities emerge.

Saga Partners

Saga Partners latest letter on investing in a time of heightened uncertainty

… when is there not a heightened sense of uncertainty in the markets? And when markets do inevitably panic again, as they did in the fourth quarter of last year, will investors then overcome their fears and say now is the right time to invest? Or will they wait until things calm down and become less uncertain?

We are certain that another recession will happen sometime in the future, but we do not know when it will happen, how long it will last, or how extreme it will be. We do not even know how the market will react going into and coming out of it. We do know during 2008 following the Lehman Brothers bankruptcy and subsequent financial meltdown, the outlook at the market lows was far from certain. We prefer to keep our heads down, ignore the noise, and simply look for the best opportunities we can find given the information we have today. As we’ve noted before, more money has been lost waiting for corrections or trying to anticipate them than has been lost in the corrections themselves.

On value vs growth:

A company is neither cheap nor expensive because of where it sells relative to recent fundamentals. These classifications of value or growth are just a convenient box ticking, quantitative oriented practice used by consultants which can distort the investing process. While different styles, genres, or investing factors may go in and out of favor at times, at the end of the day, the value of a stock is all the cash that can be taken out of a company going forward.

They also had a detailed discussion on how fee structure impacts ultimate returns to investors.

Forager Funds

In contrast with Horizon Kinetics, Forager Funds argues that it might actually be deflation for which investors are most egregiously underprepared.

Many investors assume that “what goes down must go up”. Many of our clients lived through the inflation of the 70s and 80s and seee its return around every corner. But what if that period was the anomoly rather than the rule. We all thought that the stimulus andgrowth in money supply after the financial crisis was certain to kick start an inflationary spiral. It hasn’t. In fact, inflation has been worryingly low. Best prepare, I would suggest, for a sustained period of zero rates.

More importantly, what do these zero rates imply about the future of the economy? What if, rather than rates going up, we are headed for a long period of low growth and deflation?

Low nominal rates are not necessarily a panacea for borrowers. It feels like it because the interest payments today are so low. But if we are headed for a deflationary world, its repayments later in life that you need to worry about.

The world might be “turning Japanese. Forager’s research into ASX listed Japanese property trusts leads to some startling conclusion of what that might be like. They were initially intrigued by how the companies were, but then realized that with wages, and rents falling in 18 out of 20 years, they might think they were earning a good return only to one day find the property was worth less than the debt.

Today’s low rates are sending a very important signal. The world is turning more and more Japanese.

If that is the world we are headed for, be very wary of debt.


In addition to this macro commentary, the letter includes a lot of intriguing off the beaten stock ideas in Asia.

What great managers did I leave out? Send me your favorite hedge fund letters.

Test counter-intuitive things because no one else ever does

Alchemy one of a small set of books that helped fill out important gaps in my understanding of how the world works. Its essential reading for people who think they are logical, and valuable for everyone else. I’ve organized my (copious) notes and highlights around key themes below. But seriously you should just get the book.

  • Not everything that makes sense works, and not everything that works makes sense.
  • Test counterintuitive things and ask dumb questions .
  • Never denigrate something as irrational until you have considered what purpose it really serves.
  • Try to understand the real reason for things(not the surface reason)
  • Cooperation has major evolutionary value, but most deductive logical thinking ignores it.
  • If you optimise incentive systems(or anything else) in one direction, you may be creating a weakness somewhere else.
  • People are way too confident in traditional technocratic approaches and big data solutions relative to how well they actually work
  • Hacking personal improvement: Many important features of the human brain are not under our direct control but are instead the product of instinctive and automatic emotions.
  • Embrace uncertainty.

Not everything that makes sense works, and not everything that works makes sense.

We used to have a shortage of conventional deductive logic. Now we have too much. Conventional deductive logic is often a good thing. However we have venerated this manner of thinking so much that we have become blind to the situations in which it doesn’t work. Complex and evolved systems are not consciously designed, and often second order consequences that aren’t readily apparent are more important than what can be analyzed on the surface. Evolution doesn’t care if things make sense- it only cares if things work. Therefore, trial and error usually works better than reasoning everything out before acting.

Often when a phenomenon or group behavior doesn’t seem logical/rational, it is because the observer has an incomplete model of reality.

Not everything that makes sense works, and not everything that works makes sense. The top-right section of this graph is populated with the very real and significant advances made in pure science, where achievements can be made by improving on human perception and psychology. In the other quadrants, ‘wonky’ human perception and emotionality are integral to any workable solution. The bicycle may seem a strange inclusion here: however, although humans can learn how to ride bicycles quite easily, physicists still cannot fully understand how bicycles work. Seriously. The bicycle evolved by trial and error more than by intentional design.

There are two separate forms of scientific enquiry – the discovery of what works and the explanation and understanding of why it works. These are two entirely different things, and can happen in either order. Scientific progress is not a one-way street. Aspirin, for instance, was known to work as an analgesic for decades before anyone knew how it worked. It was a discovery made by experience and only much later was it explained. If science did not allow for such lucky accidents,* its record would be much poorer – imagine if we forbade the use of penicillin, because its discovery was not predicted in advance? Yet policy and business decisions are overwhelmingly based on a ‘reason first, discovery later’ methodology, which seems wasteful in the extreme. Remember the bicycle. Evolution, too, is a haphazard process that discovers what can survive in a world where some things are predictable but others aren’t. It works because each gene reaps the rewards and costs from its lucky or unlucky mistakes, but it doesn’t care a damn about reasons. It isn’t necessary for anything to make sense: if it works it survives and proliferates; if it doesn’t, it diminishes and dies. It doesn’t need to know why it works – it just needs to work.

Perhaps a plausible ‘why’ should not be a pre-requisite in deciding a ‘what’, and the things we try should not be confined to those things whose future success we can most easily explain in retrospect. The record of science in some ways casts doubt on a scientific approach to problem solving.

Like thinking fast and slow, Alchemy makes an intellectual reader see the value of humility:

Once you accept that there may be a value or purpose to things that are hard to justify, you will naturally come to another conclusion: that it is perfectly possible to be both rational and wrong. Logical ideas often fail because logic demands universally applicable laws but humans, unlike atoms, are not consistent enough in their behaviour for such laws to hold very broadly.

It’s true that logic is usually the best way to succeed in an argument, but if you want to succeed in life it is not necessarily all that useful; entrepreneurs are disproportionately valuable precisely because they are not confined to doing only those things that make sense to a committee

… if we allow the world to be run by logical people, we will only discover logical things. But in real life, most things aren’t logical – they are psycho-logical. There are often two reasons behind people’s behaviour: the ostensibly logical reason, and the real reason

Test counterintuitive things, ask dumb questions

Alchemy provides the blueprint for a type of inversion one can do in approaching problems.

Test counterintuitive things, because no one else ever does.

Here’s a simple (if expensive) lifestyle hack. If you would like everything in your kitchen to be dishwasher-proof, simply treat everything in your kitchen as though it was; after a year or so, anything that isn’t dishwasher-proof will have been either destroyed or rendered unusable. Bingo – everything you have left will now be dishwasher-proof! Think of it as a kind of kitchen-utensil Darwinism. Similarly, if you expose every one of the world’s problems to ostensibly logical solutions, those that can easily be solved by logic will rapidly disappear, and all that will be left are the ones that are logic-proof – those where, for whatever reason, the logical answer does not work.

Most political, business, foreign policy and, I strongly suspect, marital problems seem to be of this type.
Similarly, if you expose every one of the world’s problems to ostensibly logical solutions, those that can easily be solved by logic will rapidly disappear, and all that will be left are the ones that are logic-proof – those where, for whatever reason, the logical answer does not work. Most political, business, foreign policy and, I strongly suspect, marital problems seem to be of this type.

The mental model at work here is like a broader application of the case in World War II , where Navy analysts had to figure out how to build stronger planes not by thinking about the missing bulletholes.

Closely related is how great insight comes from asking dumb questions. Leaders must allow and encourage their team to ask dumb questions:

This freedom is much more valuable than we realise, because to reach intelligent answers, you often need to ask really dumb questions.

Never denigrate something as irrational until you have considered what purpose it really serves. 

There are a lot of social psychology lessons in Alchemy Many of them are more fun(and easier to process) examples of the phenomonen revealed through evolutionary case studies in Secrets of Our Success.

There is an important lesson in evaluating human behaviour: never denigrate a behaviour as irrational until you have considered what purpose it really serves

Try to understand the real reason for things(not the surface reason)

Sometimes behavior that seems illogical has a hidden evolutionary value. People make mistakes when they judge others by surface actions, without considering things working below the surface.

there is an ostensible, rational, self-declared reason why we do things, and there is also a cryptic or hidden purpose. Learning how to disentangle the literal from the lateral meaning is essential to solving cryptic crosswords, and it is also essential to understanding human behaviour.

….Sometimes human behaviour that seems nonsensical is really non-sensical – it only appears nonsensical because we are judging people’s motivations, aims and intentions the wrong way. And sometimes behaviour is non-sensical because evolution is just smarter than we are. Evolution is like a brilliant uneducated craftsman: what it lacks in intellect it makes up for in experience.

….One problem (of many) with Soviet-style command economies is that they can only work if people know what they want and need, and can define and express their wants adequately. But this is impossible, because not only do people not know what they want, they don’t even know why they like the things they buy. The only way you can discover what people really want (their ‘revealed preferences’, in economic parlance) is through seeing what they actually pay for under a variety of different conditions, in a variety of contexts. This requires trial and error – which requires competitive markets and marketing.

There are no universal laws of human behaviour:

Our very perception of the world is affected by context, which is why the rational attempt to contrive universal, context-free laws for human behaviour may be largely doomed.

Cooperation has major evolutionary value, but most deductive logical thinking ignores it

Humans are a social species. This is not exactly a big insight, yet much of standard applied psychology and economics actually ignores this in practice. Indeed many ostensibly logical people ignore this in attempting to understand the world. This is made worse by the contrived nature of a lot of academic research.

Robert Zion, the social psychologist, once described cognitive psychology as ‘social psychology with all the interesting variables set to zero’. The point he was making is that humans are a deeply social species (which may mean that research into human behaviour or choices in artificial experiments where there is no social context isn’t really all that useful).

Humans are willing to forgoe short term expediency in order to cooperate and sacrifice for other people.

This is not irrationality – it is second-order social intelligence applied to an uncertain world.

There is an important biological reason:

Unlike short-term expediency, long-term self-interest, as the evolutionary biologist Robert Trivers has shown, often leads to behaviours that are indistinguishable from mutually beneficial cooperation. The reason the large fish does not eat its cleaner….

If fish (and even some symbiotic plants) have evolved to spot this sort of distinction, it seems perfectly plausible that humans instinctively can do the same, and prefer to do business with brands with whom they have longer-term relationships. This theory,

As a result, like any social species, we need to engage in ostensibly ‘nonsensical’ behaviour if we wish to reliably convey meaning to other members of our species.

One of the most important ideas in this book is that it is only by deviating from a narrow, short-term self-interest that we can generate anything more than cheap talk. It is therefore impossible to generate trust, affection, respect, reputation, status, loyalty, generosity or sexual opportunity by simply pursuing the dictates

There is a parallel in the behaviour of bees, which do not make the most of the system they have evolved to collect nectar and pollen. Although they have an efficient way of communicating about the direction of reliable food sources, the waggle dance, a significant proportion of the hive seems to ignore it altogether and journeys off at random. In the short term, the hive would be better off if all bees slavishly followed the waggle dance, and for a time this random behaviour baffled scientists, who wondered why 20 million years of bee evolution had not enforced a greater level of behavioural compliance. However, what they discovered was fascinating: without these rogue bees, the hive would get stuck in what complexity theorists call ‘a local maximum’; they would be so efficient at collecting food from known sources that, once these existing sources of food dried up, they wouldn’t know where to go next and the hive would starve to death. So the rogue bees are, in a sense, the hive’s research and development function, and their inefficiency pays off handsomely when they discover a fresh source of food. It is precisely because they do not concentrate exclusively on short-term efficiency that bees have survived so many million years.

If you optimise incentive systems(or anything else) in one direction, you may be creating a weakness somewhere else.

Incentives, incentives incentives.

In institutional settings, we need to be alert to the wide divergence between what is good for the company and what is good for the individual. Ironically, the kind of incentives we put in place to encourage people to perform may lead to them to be unwilling to take any risks that have a potential personal downside – even when this would be the best approach for the company overall. For example, preferring a definite 5 per cent gain in sales to a 50 per cent chance of a 20 per cent gain.

If you optimise something in one direction, you may be creating a weakness somewhere else.

In any complex system, an overemphasis on the importance of some metrics will lead to weaknesses developing in other overlooked ones. I prefer Simon’s second type of satisficing; it’s surely better to find satisfactory solutions for a realistic world, than perfect solutions for an unrealistic one. It is all too easy,

See Also: Goodhart’s Law and the Fall of Nick Schorsch , Department of Unintended Consequences, The Value of Improvisation and Informal Processes

People are way too confident in traditional technocratic approaches and big data solutions relative to how well they actually work

We don’t need to throw out economic models- but we need to spend time considering what htey ignore.

By using a simple economic model with a narrow view of human motivation, the neo-liberal project has become a threat to the human imagination.

…The alchemy of this book’s title is the science of knowing what economists are wrong about. The trick to being an alchemist lies not in understanding universal laws, but in spotting the many instances where those laws do not apply. It lies not in narrow logic, but in the equally important skill of knowing when and how to abandon it. This is why alchemy is more valuable today than ever.

…The technocratic mind models the economy as though it were a machine: if the machine is left idle for a greater amount of time, then it must be less valuable. But the economy is not a machine – it is a highly complex system. Machines don’t allow for magic, but complex systems do. …

…We should absolutely consider what economic models might reveal. However, it’s clear to me that we need to acknowledge that such models can be hopelessly creatively limiting. To put it another way, the problem with logic is that it kills off magic. Or, as Niels Bohr* apparently once told Einstein, ‘You are not thinking; you are merely being logical.’ A strictly logical approach to problem-solving gives the reassuring impression that you are solving a problem, even when no such process is possible; consequently the only potential solutions considered are those which have been reached through ‘approved’ conventional reasoning – often at the expense of better (and cheaper) solutions…

The advent of big data doesn’t change this:

We should also remember that all big data comes from the same place: the past. Yet a single change in context can change human behaviour significantly. For instance, all the behavioural data in 1993 would have predicted a great future for the fax machine.

Tangentially related, Alchemy connects economics with psychology and evolutionary biology in a better way than just about anything else I’ve read(some other examples see: Ecological Consequences of Hedge Fund Extinction)

Because they offer competing choices, consumer markets provide a guide to our unconscious in a way that theories don’t. For this reason, I have called consumer capitalism ‘the Galapagos Islands for understanding human motivation’; like the beaks of finches, the anomalies are small-but-revealing.

Hacking personal improvement: Many important features of the human brain are not under our direct control but are instead the product of instinctive and automatic emotions.

Alchemy has many insights for how one can approach personal improvement, and “hacking oneself.” Many important features of the human brain are not under our direct control but are instead the product of instinctive and automatic emotions:

There is a good evolutionary reason why we are imbued with these strong, involuntary feelings: feelings can be inherited, whereas reasons have to be taught, which means that evolution can select for emotions much more reliably than for reasons. To ensure your survival, it is much more reliable for evolution to give you an instinctive fear of snakes at birth than relying on each generation to teach its offspring to avoid them. Things like this aren’t in our software – they are in our hardware.

Useful to have a machine metaphor. I think of it like a computer. He uses a car:

…The truth is that you can control the gearbox of an automatic car, but you just have to do it obliquely. The same applies to human free will: we can control our actions and emotions to some extent, but we cannot do so directly, so we have to learn to do it indirectly – by foot rather than by hand.

Closely related, he had some insights into the placebo effect:

The placebo effect, like many other forms of alchemy, is an attempt to influence the mind or body’s automatic processes. Our unconscious, specifically our ‘adaptive unconscious’ as psychologist Timothy Wilson calls it in Strangers to Ourselves (2002), does not notice or process information in the same way we do consciously, and does not speak the same language that our consciousness does, but it holds the reins when it comes to much of our behaviour. This means that we often cannot alter subconscious processes through a direct logical act of will – we instead have to tinker with those things we can control to influence those things we can’t or manipulate our environment to create conditions conducive to an emotional state which we cannot will into being.

The actions required to create such conditions may involve a certain degree of what appears to be bullshit – but it is only bullshit when you don’t know what its reason is. It is this oblique hacking of unconscious emotional and physiological mechanisms that often causes suspicion of the placebo effect, and of related forms of alchemy. Essentially we like to imagine we have more free will than we really do, which means we favour direct interventions that preserve our inner delusion of personal autonomy, over oblique interventions that seem less logical.

Embrace uncertainty

Many problems come from seeking out false certainty.  Avoiding uncertainty can have social benefits within certain institutions, and it can abodi discomfort.  But ultimately certainty is an illusion, and pretending it is reality is a disaster. Embracing uncertainty is a prerequisite to major breakthroughs.  See also: Thinking in Bets

The modern education system spends most of its time teaching us how to make decisions under conditions of perfect certainty. However, as soon as we leave school or university, the vast majority of decisions we all have to take are not of that kind at all. Most of the decisions we face have something missing – a vital fact or statistic that is unavailable, or else unknowable at the time we make the decision. The types of intelligence prized by education and by evolution seem to be very different. Moreover, the kind of skill that we tend to prize in many academic settings is precisely the kind that is easiest to automate.

If you want to look like a scientist, it pays to cultivate an air of certainty, but the problem with attachment to certainty is that it causes people completely to misrepresent the nature of the problem being examined, as if it were a simple physics problem rather than a psychological one. 

Related Ockham’s Notebook Posts

Other Books/Papers:

A Negative Interest Rates Thought Experiment

Toto, I have a feeling we’re not in Kansas anymore

Dorothy in Wizard of Oz

With a negative yielding investment, the price you pay exceeds the sum that you will get back at maturity plus the income you receive in the interim. If you buy a negative yielding bond you are guaranteed to lose money. If the rate you receive on bank deposits is negative, you are guaranteed to lose money.

Negative interest rates are becoming kind of a big deal:

Most negative yielding debt is government debt, which is ironically considered “safe”, at least in first world countries. With government debt, you know what cash flows you will receive during the holding period, and what face value amount of principal you will receive upon maturity. With everything else, cash flow is uncertain and principal is always at risk. Indeed the yield on government debt functions as a proxy for the “risk free rate” , which is a critical input in financial models investors use to make strategic decisions throughout financial markets.

Conservative investors generally prefer to hold a lot of government debt in order to meet future needs. Pensions, banks, and insurance companies are required to hold a minimum percentage of their assets in government debt so they can safely meet obligations to their stakeholders.

Negative interest rates cause a lot of surprising second order impacts throughout the world impacting how people do business.

Options Pricing

The Black Scholes model is one of the pillars of modern finance. It uses the risk free rate as an input but it cannot compute when the risk free rate is negative. It requires users to calculate a logarithm. Yet the logarithm of a negative number is undefined/meaningless. Here is a paper that explored the implications in more detail. Maybe people can use the old Brownian motion models, but there isn’t going to be universal agreement right away on what to use.

Any switchover will create unintended consequences throughout the investment world . Lots of funds hold over the counter options or swaps which must be valued using models in the time between their initiation and expiration or exercise. This valuation impacts the number that appears on the statement of investors. To the extent that investors have asset allocation targets around what percent of the entity’s assets can be invested in what, this will have secondary impacts in other markets. A lot of large firms have to totally change their valuation policies which is never easy to do because valuation departments are plenty busy with their jobs as it is. Markets aren’t going to close just so they can rewrite their valuation policies.

Also, in cases where a swap or OTC option contract requires collateral to be posted as the pricing changes throughout the life of a contract, both sides of the contract need to agree on valuation methods. When interest rates are positive, Black Scholes is a noncontroversial options I doubt contractual language was written in a way that accommodate for a world where Black Scholes would completely stop working.

Currently, more banks are trading a wide number of options without a reliable price. Each bank could handle this problem by performing its own solution, but the lack of a shared approach could lead to serious legal issues.

Source

This stuff is all theoretical but it has real cash impact throughout the world. What types of risks can be hedged will impact how capital can be allocated. How capital is allocated directly impacts what ideas get funded.

Now lets consider the real world impact on different groups of investors.

Stimulating TINA

In theory, negative rates should stimulate the economy. If investors only invest in safe assets, nothing else will get funded. Retirees need income from investments to live, foundations need to earn enough to safely withdraw funds, etc etc. If the bank charges them to hold their cash, they will invest more in real estate, high yield debt, and venture capital etc. They will have to take no more risk because “there is no alternative”(TINA).

However, when you look at how negative rates will impact pensions, banks and insurance companies, its hard to escape the conclusion that they might have a destructive, rather than stimulative impact on financial markets.

Pensions

People live longer than they can work.  To prevent a social catastrophe, countries have different ways of providing for old people.  Pensions are a big part of the financial markets According to CFA society:   Willis Towers Watson’s 2017 Global Pension Assets Study covers 22 major pension markets, which total USD 36.4 trillion in pension assets and account for 62.0% of the GDP of these economies.

 In the US people pay into Social Security, which provides a bare minimum standard of living to old people. The Social Security Fund is only allowed to invest in US Treasury Securities. If Treasuries yielded negative, the Social Security Fund will erode over time, meaning it won’t be able to meet its bare minimum obligations to retirees.  

Social Security by itself barely provides enough to live on. A lot of people in the US and around the world also have pensions through their jobs as well.  The impacts of negative rates get more nuanced and even weirder when you consider how these work.  

First of all, extremely low interest rates worsen pension deficits.  Future obligations must be discounted backwards. Lower discount rate leads to higher obligations in the present day.   On the other side of their balance sheet, they must make an actuarial assumption about future returns on their investments.    From what I’ve seen they often make aggressive return assumptions. To try to justify higher return assumptions, they put what they can into riskier investments.  To this extent pension funds are partially in the TINA Crowd.

Pensions are generally also obligated to put a certain amount of assets into “safe assets”  which are the first thing to start yielding a negative rate. As a result, this negative rate will create a destructive feedback loop.

Gavekal had this story of a Dutch Pension as an example: 

One day he was called by a pension regulator at the central bank and reminded of a rule that says funds should not hold too much cash because it’s risky; they should instead buy more long-dated bonds. His retort was that most eurozone long bonds had negative yields and so he was sure to lose money. “It doesn’t matter,” came the regulator’s reply: “A rule is a rule, and you must apply it.”

Thus, to “reduce” risk the manager had to buy assets that were 100% sure to lose the pensioners money.

Pension funds get caught in a feedback loop that will erode their capital base. For example say they buy a 5 year zero coupon bond at €103:

The €3 loss will reduce the market value of assets by €3. Holland also has a rule that pension funds must buy more government bonds the closer they get to being underfunded. Yet buying such negative-yielding bonds and keeping them to maturity ensures losses, making it more likely the fund will be underfunded, and so forced to buy more loss-making bonds (spot the feedback loop). Soon the fund will be distributing returns from capital, rather than returns on capital. Hence,it is not inflation that will destroy pension funds, but the mix of negative rates and rules that stop managers from deploying capital as they see fit. These protect governments, not pensioners who are forced to buy bad paper.

So negative rates will exacerbate the global retirement crisis. Oops.

Banks

What about banks?  Negative rates also destroy their capital base, and leave them with less money to actually lend out in the economy.  This hits at the heart of how fractional reserve banking works.

According to Jim Bianco at Bloomberg:

For every dollar that goes into a bank, some set amount (usually about 10%) must go into a reserve account to be overseen by the central bank. The rest is either lent out or used to buy securities.

In other words, the fractional reserve banking system is leveraged to interest rates. This works when rates are positive. Loans are made and securities bought because they will generate income for the bank. In a negative rate environment, the bank must pay to hold loans and securities. In other words, banks would be punished for providing credit, which is the lifeblood of an economy.

Gavekal explains how this leads to an eroding capital base (using the same 5 year zero coupon bond as the pension example above):

As a leveraged player, let’s assume it lends a fairly standard 12 times its capital. This capital has to be invested in “riskless” assets that are always liquid. In the old days, this would have been gold or central bank paper exchangeable into gold. Today, the government bond market plays the role of “riskless” (you have to laugh) asset, which has no reserve requirement. As a result, banks are loaded up with bonds issued by the local state. Now let us assume that a bank has just lost €3 on the zerocoupon bond mentioned above. The bank’s capital base will be reduced by €3. Based on the 12x banking multiplier, the bank will have to reduce its loans by a whopping €36 to keep its leverage ratio at 12. Hence, the effect of managing negative rates while also respecting bank capital adequacy rules means that the capital base can only shrink.

Insurance Companies

One of the main ways that insurance companies make money is by collecting premiums in advance of paying out any claims.  Hey are able to invest these premiums, collecting a float premium. Of course they are limited in how much risk they can take with the money they are holding to pay out any possible claims.  Regulators generally require them to put a certain amount in a “risk free “ asset like government debt, and the rest in riskier assets. If government debt is negative yielding, we again get to a destructive feedback loop that has major second order impacts.

From the Gavekal note:  

The insurance company could raise its premium by the amount of the expected loss from holding the bond (not very commercial), or it could just underwrite less business. Either way, it will have less money to invest in equities and real estate. Simply put, either the insurance company’s clients will pay the negative rates, or the company itself will do so by increasing its risks without raising returns. This means that either the client pays more for insurance, and so becomes less profitable, or the insurance company takes a hit to its bottom line.

People will have to pay more premiums for less insurance coverage.

Long term, negative rates will exacerbate the retirement crisis and basically destroy the business models of banks and insurance companies as we know them. This doesn’t automatically mean negative interest rates can’t persist. Perhaps there are other ways to provide for old people (ie higher taxes on a shrinking economy?) Banks and insurance companies can find other ways to make money. Regulators might respond, by changing rules or creating various incentive programs.

In this post I only covered only a few of the second order impacts of negative interest rates. Negative interest rates make the capital asset pricing model give nonsensical infinite results. I think CAPM is mostly bullshit anyways, but enough people use it that it has a reflexive impact on asset pricing. Unwinding it won’t be easy. I didn’t even touch on how negative rates can screw up the plumbing of financial markets: repo markets, securities settlement , escrow etc. Not enough people have really thought this all through. Many of the assumptions that have historically driven investor behavior will no longer hold if negative rates persist.

Maybe interest rates will normalize again. It will wipe out a few of the most overleveraged players, but the financial system will recover quickly. On the other hand, if negative rate do persist, get ready for a slew of unintended consequences in places you didn’t expect.

See also:

Mysterious by Howard Marks at Oaktree

Empty Spaces on Maps

Prior to the 15th century,  maps generally contained no empty spaces.  Mapmakers simply left out unfamiliar areas, or filled them with imaginary monsters and wonders.  This practice changed in Europe as the great age of exploration began. In Sapiens, Yuval Harari argues that leaving empty spaces on maps reflected a more scientific mindset, and was a key reason that Europeans were able to conquer and colonize other continents, in spite of starting with a technological and military disadvantage.   Conquerors were curious, but the conquered were uninterested in the unknown. Amerigo Vespucci, after whom our home continent was named, was a strong advocate of leaving unknown spaces on maps blank. Explorers used these maps to move beyond the known,  sailing into those empty spaces so they did not stay unmapped for long.

The same phenomenon occurs in business. In the Innovator’s Dilemma, Clayton Christensen shows why large established ostensibly well-run companies so frequently miss out on major waves of innovation.   A key principle in the book is the difference between sustaining technologies, which merely improve the status quo, and disruptive technologies, which offer a new and unique value proposition.  Large companies will frequently focus on sustaining technologies, and ignore disruptive technologies that serve fringe markets initially. Ultimately its disruptive technologies that define business history. Yet complacent companies don’t figure that out until its too late.

Companies whose investment processes demand quantification of market sizes and financial returns before they can enter a market get paralyzed or make serious mistakes when faced with disruptive technologies.

There are two parts to overcoming the innovator’s dilemma:

  • Acknowledging that the market sizes and potential financial returns of a nascent market are unknowable and cannot be quantified  (drawing the blank spaces on the maps) and;
  • Entering the nascent market in the absence of quantifiable data- (travelling into the empty space) 

Analogous ideas also apply to investing.  In Investing in the Unknown and Unknowable, Richard Zeckhauser distinguishes between situations where the probability of future states is known, and when it is not.     The former is the realm of academic finance and decision theory. The latter is the real world.  

The real world of investing often ratchets the level of non-knowledge into still another dimension, where even the identity and nature of possible future states are not known. This is the world of ignorance. In it, there is no way that one can sensibly assign probabilities to the unknown states of the world. Just as traditional finance theory hits the wall when it encounters uncertainty, modern decision theory hits the wall when addressing the world of ignorance.

Human bias leads us into classic decision traps when confronted with the unknown and unknowable. Overconfidence and recollection bias are especially pernicious. Yet just because we are ignorant doesn’t mean we need to be nihilists.    The essay has some key optimistic conclusions:

The first positive conclusion is that unknowable situations have been and will be associated with remarkably powerful investment returns. The second positive conclusion is that there are systematic ways to think about unknowable situations. If these ways are followed, they can provide a path to extraordinary expected investment returns. To be sure, some substantial losses are inevitable, and some will be blameworthy after the fact. But the net expected results, even after allowing for risk aversion, will be strongly positive.

Examples in the essay include David Ricardo buying British Sovereign bonds on the eve Battle of Waterloo, venture capital, frontier markets with high political risk, and some of Warren Buffet’s more non-standard insurance deals.  Yet since even the industries that seem simple and steady can be disrupted, its critical to keep these ideas in mind at all times in order to avoid value traps. 

The best returns are available to those willing to acknowledge ignorance, then systematically venture into blank spaces on maps and in markets.

Investing in the Unknown and Unknowable

See also:

When is the crowd right?

Humans have flawed brains that cause them to act crazy sometimes. And in groups, people get even more crazy. Many smart people believe dumb things. Sometimes a group of otherwise completely sane people come together and do something insane. History is full of examples of the “ Extraordinary Popular Delusions and the Madness of Crowds, or Manias, Panics and Financial crisis. Humans sometimes join suicide cults. Human literally burned witches not that long ago. Groupthink is a helluva drug.

Financial markets provide an arena in which the biggest gains can be made betting against consensus. Yet statistically speaking, the consensus is usually right. The times when the crowd goes crazy are notable because they are exceptions. One must carefully decide when to be a contrarian.

Under what conditions is the consensus likely to be wrong? Lets invert the question: under what conditions is the crowd likely to be right?

Most of the time, a large group of people actually comes to a more accurate conclusion than any one individual. The success of Estimize, which crowdsources earnings estimates is one useful empirical example. “Wisdom of Crowds” is a well documented phenomenon, and well summarized in the book by the same title.

Why is the crowd so often right? What must happen for the crowd to be right ? Researchers have identified four interrelated conditions that encourage the wisdom of the crowds:Diversity, Information Availability, Decentralization, and existence of an Aggregation Mechanism.

Understanding these conditions can help one know when to follow the zeitgeist, and when to make a contrarian bet against it. A firm grasp of the facts on both sides of a controversy is necessary, but possibly not sufficient. One can never be sure of all the facts. Its also useful to understand the broader social forces, and how they influence the likelihood of the consensus being right or wrong. Searching for these conditions(or their absence), can be a useful method of avoiding cults and identifying opportunity, beyond just the facts of the individual situations.

The biggest gains are available by being a contrarian who understands the crowd.

The key is understanding when the wisdom of crowds flips to the madness of crowds. And the essential insight is that it has to do with a violation of one or more of the core conditions for a wise crowd.

Michael Mauboussin: Who is on the other side?

Diversity

Diversity implies that each person has their own point of view and some private information, even if only their unique interpretation of the available public information. Diversity is important because it adds different perspectives and increases the amount of available information.

The Value of Crowdsourcing: Evidence from Earnings Forecasts

Crowded trades have a tendency to crash- leading to no bid markets all the way down. Academics have noted that in a run up to a market crash diversity of population declines. The market becomes fragile, and eventually there is no one to buy from (or sell to).

One reason Estimize’ earnings estimates have tended to be better than Wall Street Sell side is that Estimize analysts are a diverse group of independent thinkers from around the world, holding a variety of different jobs. A lot of Wall Street analysts go to the same conferences, went to the same schools, etc.

When people come to the same conclusion from different backgrounds, logical methods, etc , their collective wisdom refines understanding of reality. The opposite occurs when people feel pressure to conform. Its important to note this is a genuine deep diversity of thought and perspective, not a superficial check the box diversity.

If multiple people with different viewpoints all come to similar conclusions, the odds of the opposite being true decrease substantially. On the other hand, if there is an obivous archetype of the thinker on the other side, then maybe a contrarian opportunity is available.

As Michael Maubossin has noted- conformity is a nonlinear process:

Scientists even have a sense of the neurobiological basis for conformity.Informational cascades occur when individuals follow the decisions of those who precede them without regard to their personal information.

Epidemiological models are useful here.

Information

The wisdom of crowds does not emerge in groups of idiots. It only applies when there is widespread access to information necessary to reach a conclusion. The extreme opposite occurs in totalitarian societies (or large corporations), where information is tightly restricted. Prior to the internet, information sometimes diffused slowly through a market, leading to massive price discrepancies obvious at even a quick quantitative glance.

Quality of input is critical to the success of crowdsource analysis:

Alternatively, it is possible that the inclusion of forecasts from certain individuals, such as Non-Professionals, may provide no value, or worse, cause the Estimize consensus to deviate further from actuals. Surowiecki (2004) states that although diversity matters, assembling a group of diverse but thoroughly uninformed people is not likely to lead to wise outcomes.

Independence

Independence is related to diversity. People need to be able to freely analyze reality and discuss opinions. Conventional wisdom is more likely to be accurate when it is freely subjected to challenge. When there are institutional or social factors that make people extremely afraid to speak truth, what everybody says to be true, may be wrong.

Children learn of this phenomenon early through the Emperor Wears No Clothes. For grown ups, see Death of Stalin for an example of lack of independence leading to morbidly hilarious results.

Independence requires relative freedom from opinions and actions of others, not complete isolation. Independence enables people to actually express their diverse information and reduces potential bias in the group decision.

Decentralization

Decentralization allows people to specialize and draw on local knowledge, without any individual or small group dictating the process.

Diversity and independence all fit in nicely with decentralization. Through specialization, decentralization encourages independence and increases the scope and diversity of information. Decentralization reduces the risk that independence and diversity will go away. Similarly having capital flows from all around the world, not just from a small group of schools or similarly thinking firms, increases the likelihood that markets become more efficient.

Existence of an Aggregation Mechanism

Finally, an aggregation mechanism is necessary to collect the individual opinions and harness the ‘wisdom-of-crowds’ effect.

This is basically why capitalism has succeeded. The price mechanism aggregates facts about supply and demand better than any bureaucracy could. At the same time, this why often the best opportunities to earn an investment profit are in illiquid asset classes where the market does not function as an aggregation mechanism to make the price close to right.

Of course, just because the market consensus is wrong, doesn’t mean that is necessarily wise to bet against it today. Must also consider reflexivity, narratives, and capital flows etc, and maintain a balance sheet that allows one to survive long periods of mass delusion.

Postscript: This is all indirectly related earlier post on finding underfollowed opportunities: The hard thing about finding easy things . This linked the ideas of both Sun Tzu and Warren Buffett. Some of the specific opportunity sets mentioned in this post have since been too widely known and we’ve moved further into more esoteric off the beaten path ideas. Nonetheless the basic principal still holds: there are more likely to be opportunities where the crowd isn’t looking.

Infinite Detail: With Zero Bandwith, Things Get Weird

What would happen if the internet crashed everywhere- completely died, and didn’t come back? Tim Maughan’s Infinite Detail is a dystopian sci fi novel that hits close to home.

The book alternates between Before and After chapters, slowly revealing details on the great crash that destroyed the global internet infrastructure. There is also an ongoing long distance love story interrupted by the great crash.

The Before chapters are a slightly more advanced version of our current reality. Everything is connected and everything is tracked. People accept lack of privacy in exchange for extreme convenience. Almost everyone uses “Spex” which are glasses that allow people to access information just by moving your eyes- a step more convenient than a smartphone . Cities are all “smart” with services such as trash collection automated.

The book explores how the underclass is impacted by smart cities. Relying on RFID tags for recycling means people who collect cans to survive(canners) are subject to problems caused by technology. The city is full of canners:

There’s hundreds of us. Thousands, maybe. City is full of ’em. Used to be a lot of people did it as a part-time thing, but more and more are going full-time, it seems. Especially since there’s no work for cabbies now, y’know? I used to know a lot of cabbies that would just do a little canning on the side when work was slow and all, but now they gotta go full-time, they says. Say nobody wants anyone to drive a cab anymore. I ain’t worried, though.

The attitude of one superstar canner is eerily reminiscent of people who fail to keep up with changes in the digital economy:

“Hell yeah! Canning is a growth industry. I been doing this fifteen years, and every year I seen more cans than before. There’s always going to be canning, as long as there’s people that want to drink. They’ll never stop that. Never take that away from me. They might not need cab drivers anymore, but they’ll always need canners.” He smiles, for the first time. Rush isn’t sure what to say to him. He sighs and looks at the cart, and the hundreds of floating tags reappear. His heart sinks.

A group of disillusioned techno optimists are they key characters in the Before scenes. Their views are basically a more extreme version of current critics driving the anti Silicon Valley backlash. Many of them started out as idealists who believed in the internet, but became cynical as corporations and governments started using it for control.

We used to think that we could own it, that we were fighting to build communities for ourselves. That it was ours for the taking. To stake a claim for a place we could control and belong, a fight to make “safe spaces” for ourselves.It was a noble thing to think, that we were fighting for our own spaces, but we were kidding ourselves. We never owned these spaces, we never could. They were never ours to own, never ours to control. Instead we watch our battles turn into spectator sports, our revolutions turn to infighting. We watched our new communities dissolve into civil wars. We watched our political activist and community leaders become celebrity brands, our tech-utopian visionaries bow to capital and shareholders

A group of them builds an experimental community completely cut off from global networks. A terrorist group combines hacking with real life terrorism. Their motto is “With zero bandwidth there is no calling for backup.”

Rumors spread that someone is developing a virus that can impact all internet connected devices. When its released, people experience:

a very real sense that something had ended, had gone, something huge and fundamental. The feeling that a structure — a way of life, something nobody could really imagine changing — had collapsed. The end of being watched. The end of being tracked. The end of being indentured to it all. The end of capital. The end of security. The end of knowing. The end of safety. The end of being reassured. The end of being connected. The end of friendships. It was all there, in that crowd, sprayed across faces that had been denied sleep and electricity and communication for days — the fear, the uncertainty, the excitement, the thrill. The relief.

The After chapters describe a post apocalyptic hellscape where people struggle for survival. Chaos breaks out across the world as every city simultaneously goes dark. The descriptions are fantastic

…video games industry conference in Los Angeles that had to be abandoned and had quickly dissolved into spoiled man-children rioting; an automated container terminal in Shanghai that shut itself down for nearly a week and caused the collapse of at least two shipping companies; and countless other blackouts and disruptive infrastructure failures. He’d also seen it connected to protests—the Times Square blackout being just the latest, after an uprising of migrant workers in Singapore, and the takeover of a brand-new, built-from-scratch, concept-art-perfect smart city by an army of protesters from the slums of Mumbai.

As is often the case, utopian revolutionaries are dismayed at what happens in real life, once they actually “win”. Civil wars occur around the globe. The former unconnected haven ends up turning into a scene of bloody conflict between the old guard government, and a group of outlaws. Basically everything is worse than it was before.

As one character puts it:

Your self-determination is a fucking power vacuum, that’s all it is. Your revolution, with no idea of what would happen next, just created a massive hole full of people fucking each other over to stay alive.

The impact on people’s material well being is most stark.  

She finds herself heading down the steps of a long-motionless escalator to the floor below, eager to explore, drawn to join in, wanting to experience what appears to be the decentralized, community-driven anarchic economy they’d spent so many late, stoned, enthusiasm-soaked nights dreaming of…

Instead, standing in the silence of the first shop she passes, she finds inevitable disappointment. For a start, the nameless store has barely any stock, and what is here is a disorganized mess of broken, discarded junk piled up in boxes or spread randomly around the half-bare shelving—at first glance she thinks it could even be the ramshackle debris left over from the original store’s ransacking, but soon she realizes the truth is even more depressing. For that to be true there’d have to be some shred of purpose, form. Between embarrassed glances she starts to think that maybe it’s just her own deep-rooted, bred-in consumer expectations clouding her assessment, so she tries to throw them aside and embrace the nonconforming landfill-mined chaos of scuffed plasticwear, broken crockery, torn clothing, dead electronics, and crumbling paperbacks—but it’s impossible. There’s not just a lack of organization here, it’s a total absence of function, value.

People who had acquired a cargo ship ahead of the crash go on a tour of the world, and observe collapsed cities, and silent ports. Its an interesting commentary on global supply chains. They make everything so convenient, but are really quite fragile.

This was why the supply chains existed, in order to make transactions that logic dictated were most efficient on local scales work on global ones, through sheer size, brute force, cheap labor, and global inequality.

…pinnacle of human effort had been to create a largely hidden, superefficient, globe-spanning infrastructure of vast ships and city-size container ports—and all to do nothing more than keep feeding capitalism’s hunger for the disposable. To move plastic trash made by the global poor into the hands of hapless, clueless consumers. A seemingly unstoppable beast built from parasitic tentacles, clenching the planet with an iron grip.

The crash has an irreversible impact on relationships, especially those that are long distance:

He sits there for a minute, in silence. It’s the first time they’ve been forcibly disconnected like this, and it’s jarring. Like they’ve been ripped apart, like he’s lost control. Suddenly the frailty of their relationship feels exposed, like it’s utterly reliant on this vast global infrastructure that he doesn’t own or control, that’s too complex for any one person to understand, that could break or disappear without even a second’s notice. He could lose him completely, just at the flick of a switch, at the typing of a command.

The Strange Case Of Benin Rice Imports

Benin rice imports more than doubled between 2015 and 2017. Its a tiny country, slightly smaller than Pennsylvania, with a population of 11 million. Yet it is now the world’s largest importer of Thai rice. Why?

Turns out the answer has little to do with cuisine, and a lot to do with incentives. Benin shares a border with Nigeria, a much larger country that put strict tariffs on rice in 2014. Smuggling rice from Benin into Nigeria became big business. (see here, here, and here)

Unintended consequences of trade policy permeate Nigerian life. One of the richest people is a cement manufacturer. It just so happens that cement has a 60% tariff. Oh, and Nigeria doesn’t exactly have great infrastructure. Basically the only businesses of any size that can survive depend on some sort of favorable policy. The textile industry can’t really compete with cheap foreign imports, for example.

Favored importers get access to USD at a favorable rate. Petroleum importers, and the politically connected get an even better rate. Everyone else has to pay nearly twice as much of the local currency (naira) to access USD on the black market. I’m not sure if there is a secondary market in whatever documents importers can use to access cheaper USD, but if there is, these documents could be quite valuable.

Department of Unintended Consequences

Tariffs and exchange controls are not necessarily bad. One can hardly blame Nigerian policy makers. Powerful political constituencies depend on favorable policy. Nigeria has had a rough few decades, and opening up to foreign competition can create disruption. But trying to understand an economy requires looking beyond immediate impact, and finding second order impacts that are the unintended consequences of intervention. Even in neighboring countries. Never underestimate the power of incentives.

Perhaps Nigeria also needs a Department of Unintended Consequences.

See also:

The value of improvisation and informal processes

Recent Deep Reads: June 2019

Investing/Business

Assessing Vincent Bollore

Bollore is one of the greatest capitalists most Americans have never heard of. There aren’t many examples of other French corporate raiders. He built up a massive business empire consisting of 457 companies over four decades. In the three decades its main holding company has been public, investors are up 40x, compared to an 8x return to France’s index. Its a story horribly neglected by English language media(most of the time). Some argue that the various holding companies are full of hidden value, others that they are on the brink of collapse. At the very least, as Muddy Waters has pointed out, you can’t model it in a spreadsheet. Here is what it looks like:

Accounting reality and economic reality are often divergent. You get interesting feedback loops from all the cross shareholdings. The Economist article takes a bit of a bearish slant

Analysts attribute over a third of Bollore SA’s Market value to shareholding in its parents; these parents are also worth around 12 billion in total. That does odd things to Bollore SA accounts. When its value falls (like last year when its shares lost 24%), that of the holding companies above it dips too. Because Bollore SA in turn owns them, its balance-sheet and income must be adjusted downwards. This then effects metrics used to calculate the value of its shares, whose fall prompts a further adjustment. Share-price rises cause upward revisions.

Have Regulators Created a New Type of Financial Monster?

I would place clearing houses in the category, of important risk that not a lot of people are thinking about. Everyone knows central clearing is better(which it generally is), but ignores how clearing houses actually work. Clearing houses have offsetting positions, so they never have directional risk. However if one side of a transaction goes bust, and the clearing houses funds are exhausted, then members need to pay in.

Nasdaq Clearing’s recent Norwegian problems have put this issue on more people’s agenda. Clearing houses have outright failed in the past (Paris 1974, Kuala Lumpur 1983, Hong Kong 1987) . Post financial crisis global clearing has become increasingly centralized. If it fails the need for members to pay in could be a systemic problem. Who will clear the clearing houses when they get too big?

A Hong Kong Doctor’s Nefarious Network Sparks Market Inquiry – Epic

The collapse of Cho’s network would lead to one of Hong Kong’s most spectacular stock implosions and is now part of the biggest investigation of market malfeasance in the city’s history, an effort to expose and shut down what the regulator has called “nefarious networks.” These are groups of public companies, licensed dealers and other financial firms that “enrich themselves at the expense of unsuspecting investors,” Securities and Futures Commission enforcement head Thomas Atkinson said in an October speech revealing plans for criminal and civil action against about 60 companies and individuals. Their activities, Atkinson said, are “having a deleterious effect on our markets.”

Investors Beware: Today’s $100m + Late-stage Private Rounds Are Very Different from an IPO– From 2015, this perspective is even more true today.

Over the last few years, the late-stage (pre-IPO) market has become the most competitive, the most crowded, and the frothiest of these financing stages. Investors from all walks of life have decided that “late stage private” is where they want to play. As a result, a “late-stage” financing is no longer reserved for high-revenue, pre-profitability companies getting ready for an IPO; it is simply any large round of financing done at a high price. An unprecedented 80 private companies have raised financings at valuations over $1B in the last few years. These large, high-priced private financings are the defining characteristic of this particular technology cycle.


Some have argued that each of these companies would already be public in a prior era. Buying into such a notion is dangerous – dangerous for the entrepreneur and dangerous for the investor. Actually, very few of these companies are at a point where they could or should consider being public. Lost in this conversation are the dramatic differences between a high priced private round and an IPO. Understanding these differences is crucial to understanding the true risks in this large private-round phenomenon.

The Problem With Ben Thompson’s Aggregation Theory, and Ben Thompson’s response are essential reading for understanding modern business reality and narratives driving markets.

Is the paradigm that has defined investment returns for a decade coming to an end? An important question anyone with capital at risk should be asking.

Graham and Doddsville interview with Harvey Sawikin of Firebird – one of the all time greats of frontier market investing.

In the early stages, we’re looking for a few things. First, is the political environment: you want a country that ha been through political change that has made things more stable. For example, Russia had come out of a period of chaos, and Yeltsin finally established more personal control and installed a prime minister who could make things happen. We’ve seen this many times, in Georgia in 2004, and Mongolia. Second is macroeconomic stabilization. If you have a government that is determined to stabilize the economy, it’s often after a period of high inflation or when they’ve lost a war and everything is in chaos.
Someone comes in and manages to get control of the economy, and bring the inflation rate down. Third, we look for a functioning capital market that should have a few investible stocks. It doesn’t have to have a lot. You can make a lot of money on just one stock, which is what we
did in Georgia where we made 10x our money on Bank of Georgia.

In general, ETFs have proven to be a poor way to invest in emerging markets. Institutional investors who want low fees and that have played emerging markets through ETFs are starting to realize that it may not be suitable, and there’s a reason why: ETFs are market cap-weighted. Market caps tend to be the largest in state owned or state-influenced companies, which generally tend not to be managed for the benefit of minority shareholders. The top five stocks in the MSCI Russia constitute 60% of the index. You’re missing out on all these amazing companies that have smaller market caps.

(See also: Riches among the Ruins)

The Non-Interchangeable, Non-Mechanical Elements of Value Creation

A lot of investors – including us – were influenced by William Thorndike’s excellent book, The Outsiders, which profiled eight CEOs with some common traits that work wonderfully at certain types of businesses. Outsiders improve operational efficiency, make opportunistic buybacks, bold M&A decisions, and so on. They work great when a business generates a lot of cash and has room to generate more. There’s a clear blueprint for success.
On the other hand, there are situations in which there is no blueprint for success – new and emerging industries or business models, for example, or trying to revive a company in steady decline. In these situations, an Outsider CEO will do more damage than good. Here, you’d rather have a Visionary/Creative CEO at the helm who inspires his or her staff, is mission-driven, and is willing to experiment with new products or services.
Limiting your concept of a “good” CEO to the Outsider archetype can lead to you missing out on opportunities in companies on their way to establishing or dramatically widening their moats.

Data is not the new oil and most of the debate around it makes no sense

…we are now faced with a series of peculiar ideas that draw heavily on misleading uses of the term data. They call for the monetisation of data, stating that it is valuable, and customers should be compensated for providing it. These ideas presuppose that data is some kind of commodity, and even the refutations of these positions engage with inherent differences between, say, data, which can be reused, and oil, which can’t. But the conversation doesn’t even need to reach this point.

The Radical Lucrative and Controversial Company Hiding in Steve Schwarzman’s Pocket Good profile of Blackstone’s massive GSO group. Huge force in the distressed credit space lately.

GSO was a dominant force in the massive restructuring of credit that started a decade ago, becoming a major lender to non-investment-grade companies that the banks could no longer finance with cheap money after 2008. Banks retreated to their traditional role as advisers to corporations, underwriting bonds for highly rated companies and riskless deals. That left an enticing vacuum, and many firms eagerly and profitably stepped in, including Apollo Global Management, Ares Management, TPG Capital, KKR & Co., Bain Capital Credit, and scores of smaller credit shops. GSO capitalized on being early and being part of Blackstone, yet still independent. Now firms like Apollo and Ares have become formidable competitors in huge sectors like business development companies.

Geopolitics

The Trump Dump: War Gaming The Next China Move Makes a very important and scary point of where escalation of the trade war may go

When each side has exhausted the potential for trade-damage by tariffs (and the US has inflicted all the self-harm it can bear), if not sooner, we would not be surprised to see Mr Trump apply capital sanctions and force US Persons to dump their holdings of Chinese equities and bonds. They have potentially wide scope to do this, using the US Treasury’s Office of Foreign Assets Control (OFAC)

Side note: since sanctions are such a handy tool, trigger happy Trump has used sanctions a lot. This has created a bull market in financial compliance services, in spite of the general trend towards deregulation.

A Look at the Future of Sino-US Relations from the Historic Lens of Human Civilization One of the better pieces on this important bilateral relationship.

In the United States there are four schools of thought on China policy. Till recently, the mainstream school of thought was that of engagement. Its proponents argued that China’s market reforms were good for the United States and the international community as a whole, since they believed that economic liberalization would spill over into politics and lead to political democratization, and that China would gradually become more and more like the US. They put their faith in American soft power, believing that the US would exert a subtle influence on China. On the opposite side were the China hawks that supported the school of containment, who argued that the ideologies of the two would never be compatible as long as China remained under the totalitarian rule of the Communist Party. They believed that, as her economic power grew, China’s threat level would go from mere adversary to potential enemy. One can see that people from both camps carry a certain amount of missionary zeal that is the hallmark of American tradition. The third school was the school of pragmatism, particularly popular in the business community. The rationale behind this approach was that China’s rise has created many business opportunities for American companies. In addition, both were big nuclear states, and should stay friendly. Furthermore, closer economic ties could win China’s cooperation and support in addressing global challenges such as global financial crises, nuclear nonproliferation, climate change and counterterrorism. The fourth group was the populists, who came mostly from the lower and middle classes and helped elect Trump. Supporters of populist policy viewed themselves as primarily victims of globalization and the rise of China, citing the ills of unemployment and the hollowing-out of American manufacturing.

Psychology/Philosophy/Sports/etc.

The Best Ideas Are the Ones That Make the Least Sense Perhaps the problem is we overrate our rational capabilities- there are simply factors our models don’t take into account.

My contention is that nearly all really successful businesses — like Dyson, Apple, Starbucks, and Red Bull — owe most of their success to having stumbled onto a psychological magic trick, even if unwittingly. But you don’t have to stumble onto it. To find that magic, you must embrace the idea that anything — from consumer behavior to people’s perception of a product — can be transformed, so long as you’re willing to think like an alchemist.

The models that dominate all human decision-making today are heavy on logic and light on magic. A spreadsheet leaves no room for miracles. But while logic may be right in the narrow sphere of physics, it is hopelessly wrong when it comes to the very different business of psychology.


We don’t value things; we value their meaning. What they are is determined by the laws of physics, but what they mean is determined by the laws of psychology. The reason the alchemists gave up in the Middle Ages was because they were looking at the problem the wrong way. They had set themselves the impossible task of trying to turn lead into gold but had got it into their heads that the value of something lies solely in what it is. This was a false assumption, because you don’t need to tinker with atomic structure to make lead as valuable as gold. All you need to do is to tinker with human psychology so that it feels as valuable as gold, at which point, who cares that it isn’t actually gold? If you think that’s impossible, look at the paper money in your wallet; the value is exclusively psychological.


All these disproportionate successes were entirely illogical. And all of them worked. In the modern world, oversupplied as it is with economists, technocrats, managers, analysts, spreadsheet tweakers, and algorithm designers, it is becoming a more and more difficult place to practice magic — or even to experiment with it. I hope to remind everyone that magic should have a place in our lives. It is never too late to discover your inner alchemist.

Standing Against Psychiatry’s Crazes

Dr. McHugh believes psychiatrists’ first order of business ought to be to determine whether a mental disorder is generated by something the patient has (a disease of the brain), something the patient is (“overly extroverted” or “cognitively subnormal”), something a patient is doing (behavior such as self-starvation), or something a patient has encountered (a traumatic or otherwise disorienting experience). Practitioners too often practice what he calls “DSM checklist psychiatry” — matching up symptoms from the Diagnostic and Statistical Manual of Mental Disorders with the goal of achieving diagnosis — rather than inquiring deeply into the sources and nature of an affliction

Israelis “know that you can get a terrible psychological reaction out of a traumatic battle. And they do take the soldiers out, and they tell them the following: ‘This is perfectly normal; you need to be out of battle for a while. Don’t think that this is a disease that’s going to hurt you, this is like grief. You’re going to get over it, it’s normal. And within a few weeks, after a little rest, we’re going to put you back with your comrades and you’re going to go back to work.’ And they all do.” By contrast, American psychiatrists say: “‘You’ve had a permanent wound. You’re going to be on disability forever. And this country has mistreated you by putting you in a false war.’ They make chronic invalids of them. That’s the difference.”

The Age of Diffraction


The Great Weirding and associated narrative collapse is, in a sense, the narratives of the industrial age reaching some sort of diffraction limit. Even the best historians of our age will not be able to handle the narrative collapse we’re living through with traditional history-writing techniques. So what are our options?

We could go grander. Bigger telescopes! This is what a lot of big history theorizing of the Sapiens variety appears to attempt. The results are kinda janky and feel like unsatisfying just-so myth-making. It is just hard to make and hold up really big mirrors to the human condition.
We could work with shorter and shorter wavelengths. I think this is roughly what intersectional identity politics is trying, and failing, to do.
Or finally, we could learn to work with our own wave-like nature, embracing diffracted identities and multitemporality

I like to think of it in terms of that old stoic line: the only way out is through. I’ve preferred the slight variant the only way through is through, because with time, there is no “out”, even though sometimes it is helpful to pretend like there is. The quantum-tunneling update to that is: the only way through is to diffract through.

That’s why we are in the Age of Diffraction. You have to interfere with yourself to get anywhere at all.

When Men Lose To Women

What we are seeing is that, in ultramarathons, more and more of the fatigue comes from central fatigue, which means that the brain is not able to drive the muscle, even though the muscle is capable,” says Shawn Bearden, a professor of exercise physiology at Idaho State University. Researchers in France have hooked runners up to electrodes to stimulate muscles, demonstrating they still have the ability to produce movement. “There’s something about a person’s brain that just isn’t driving the muscle as well late in these very long-distance races,” Bearden says. “It turns out women have a slightly, it seems, better resistance to that kind of fatigue.” While some studies show no real difference—women are on par with men—others show women with an ever-so-slight advantage. “Running economy and fatigue resistance are places where women seem to have a bit of an edge,” says Bearden. “And, with those two factors, the longer the distance of the race, the more important those two factors are.”

A marathon is run on a relatively flat, paved road designed to remove variables. But because there are so many hazards along the course of an ultramarathon—from tree roots and loose rocks to bee stings and hallucinations—few runners have perfected their craft. No one factor in an ultramarathon will propel a winner to the podium, but a single mistake can remove any runner from the race. An ultramarathon, therefore, may be the competition where gender matters the least.

We Are Nowhere Close to the Limits of Athletic Performance Gene editing will have a far bigger impact than doping. Although performance has increased a lot in the past century in basically all sports, we are still far from our true potential. Interesting to think of the search problem inherent in getting the best talent into the right sports.

Now we are entering an era in which it will not be chance that configures DNA, but rather the human intellect via tools of its own creation. As our understanding of complex traits improves, genetic engineers will be able to modify strength, size, explosiveness, endurance, quickness, speed, and even the determination and drive required for extensive athletic training. Estimates of the number of variants controlling height and cognitive ability, two of the most complex traits, yield results in the range of 10,000.5 If, as a simplification, we assume that in each of the 10,000 cases the favorable variant is present in roughly half the population, then the probability of random mating producing a “maximal” outlier is roughly two raised to the power of negative 10,000, or about one part in a googol (10 to the power 100) multiplied by itself 30 times. Of course it may not be possible to simultaneously have all 10,000 favorable variants, due to debilitating higher-order effects like being too large, or too muscular, or having a heart that is too powerful. Nevertheless, it is almost certain that viable individuals will exist with higher ability level than any person has ever had.

In other words, it is highly unlikely that we have come anywhere close to maximum performance among all the 100 billion humans who have ever lived. (A completely random search process might require the production of something like a googol different individuals!

But we should be able to accelerate this search greatly through engineering. After all, the agricultural breeding of animals like chickens and cows, which is a kind of directed selection, has easily produced animals that would have been one in a billion among the wild population. Selective breeding of corn plants for oil content of kernels has moved the population by 30 standard deviations in roughly just 100 generations.6 That feat is comparable to finding a maximal human type for a specific athletic event. But direct editing techniques like CRISPR could get us there even faster, producing Bolts beyond Bolt and Shaqs beyond Shaq.

The Gospel According to X-22 Classic article profiling one of the greatest backgammon players of all time(and the author of classic books). Interesting how he was decades before the “moneyball” movement in sports.

“The dice”, Magriel contends, don’t change the game intellectually, but only psychologically. Theres still a move for every roll in every position. But the dice make the game a gamble. They make a game perverse. It can be unbelievably vexing The dice can mock you, tease you, lead you on. It requires a certain amount of masochism to subject yourself repeatedly to their brutality. But intellectually, the challenge is to react neutrally to the dice, to make the right move on a bad roll on as a good one.

Peculiar looking plays of course are relative to one’s expectations.  There is no such thing as an inevitable arrangement of checkers in backgammon, any more then there is such thing as an inevitable musical scale.  Its purely a matter of convention. But conventions come to seem inevitable ,and it takes a special species of genius to see beyond them.

See also: Backgammon and Life Philosophy

A Different Kind of Death Spiral: ETFS, Mutual Funds and Systemic Risk

The rapid growth of ETFs is one of the most significant changes to financial markets in the last decade. Total ETF AUM grew from $0.5 trillion in 2008 to over $3 trillion by the end of 2017. More remarkably, AUM of ETFs invested in illiquid sectors such as global bank loan , emerging market bonds, and global high yield bonds increased 14 fold from $10 billion 2007 to $140 billion at the end of 2017. Prior to the last financial crisis, ETFs were a relatively small niche, but these past few years it seems like every asset manager has launched an ETF. Most investors have a large portion of their retirement assets in ETFs, and many investors exclusively invest in ETFs.

This is a major systemic change from what was in place prior to the last financial crisis. Since markets go through cycles its worth asking: how will the ETF ecosystem hold up next time there is market turmoil?

ETFs have overall been a massive benefit to investors because they lowered costs. Yet as more and investors put more and more money into ETFs, there are growing signs of distortions. Some investors have pointed out how ETFs are creating bizarre valuations that are unlikely to be sustainable. Additionally, there are growing signs that the ETF structure is far more fragile than most market participants realize. These aren’t just doom and gloom conspiracies from Zero Hedge. Organizations such as the IMF, DTCC, G20 Financial Stability Board, and the Congressional Research Service have all pointed out possible risks from the unintended consequences of ETF growth.

How the ETF ecosystem works

The structure and mechanics of ETFs are unique and different from mutual funds.  Unlike mutual funds, ETFs generally don’t have to meet redemptions in cash.  The key difference is the role of Authorized Participants (APs), and the arbitrage mechanism.  The Congressional Research Service provides a handy diagram explaining the structure (Most fund sponsors have similar diagrams in their whitepapers)  :

ETF Liquidity Leveraged Loan ETFs

From the same CRS paper:

In a typical ETF creation process, the ETF sponsor would first publish a list of securities in an ETF share basket. The APs have the option to assemble and deliver the securities basket to the ETF sponsor. Once the sponsor receives the basket of securities, it would deliver new ETF shares to the AP. The AP could then sell the ETF shares on a stock exchange to all investors. The redemption process is in reverse, with the APs transferring ETF shares to sponsors and receiving securities.

ETF shares are created and redeemed by authorized participants in the primary market. The fund sponsors do not sell their ETF shares directly to investors; instead, they issue the shares to APs in large blocks called “creation units” that usually consist of 50,000 or more shares. The APs’ creation and redemption process often involves the purchase of the created units “in-kind” rather than in cash. This means that the shares are exchanged for a basket of securities instead of cash settlements.
The supply of ETF shares is flexible, meaning that the shares can be created or redeemed to offset changes in demand; however, only authorized participants can create or redeem ETF shares from the sponsors. A large ETF may have dozens of APs, whereas smaller ETFs could use fewer of them.

The “arbitrage mechanism” is a key feature of the ETF ecoystem. The market incentivizes APs to correct supply demand imbalances for ETFs because they can always exchange underlying shares for the securities in the portfolio and vice versa. So theoretically ETFs should not end up with discounts or premiums to NAVs like closed end funds.

Additionally, since the ETF Sponsor can redeem in kind, rather than in cash, they don’t need to sell underlying securities to meet redemption requests, like with mutual funds. Additionally, unlike with mutual funds, you get some intraday price transparency. Sometimes media commentary on “illiquid assets in liquid wrappers” mixes these up, but the nuance is important to how the respective ecosystems will react to market turmoil.

The arbitrage mechanism is a huge benefit for ETFs, and it works pretty well for deep liquid markets, like large cap stocks. Yet with less liquid assets such as leveraged loans or high yield bonds, there is reason to worry. ETFs haven’t really solved the liquidity mismatch problem. Closely related, any understanding of market history leads us to conclude that APs are unlikely to function in a falling market.

Liquidity mismatch in ETFs

Theoretically if there is a flood of selling at ETF level, APs can buy from portfolio managers, then exchange for underlying securities. However what happens if there is no bid/ask for some or all of the underlying securities?

There are several large ETFs that consist of leveraged loans and high yield bonds. A retail investor can have instant liquidity in the ETF market, and theoretically if there is an imbalance in the secondary market APs will step in and exchange ETF shares for the underlying bonds and loans. Yet these underlying assets can go days without actually trading(they are “trade by appointment”) . ETFs may be a small percentage of all outstanding bonds/loans, yet there is very little turnover of these assets, and often its difficult to get pricing. Its not clear how the market would respond if there was a macro event that caused loan prices to gap down, and investors to seek redemptions from ETFs en masse. Prior to the last financial crisis, few ETFs held high yield bonds, and no ETFs held leveraged loans.

According to the DTCC:

Some analysts assert that ETFs have become so large in certain markets that the underlying securities may no longer be sufficiently liquid to facilitate ETF creation/redemption activity during periods of stress and could result in price dislocations.

From Duke Law’s FinReg Blog:

Consider a crisis scenario where selling pressure causes underlying assets (like fixed income securities) to become illiquid and rapidly lose value prompting ETF holders to quickly sell their shares. Here market makers and APs would likely widen their bid-ask spreads to “compensate for market volatility and pricing errors.” Increased fund redemptions in the primary market could also detrimentally change the composition of the underlying portfolio basket causing APs – who no longer want to redeem ETF shares and receive, in-kind, the plummeting and illiquid securities – to withdraw from the market altogether.

Also notable, post financial crisis regulatory changes caused bond dealers to hold less inventory. This can mean less liquidity in a crisis, as this recent academic paper notes:

When an extreme crisis hits, historically, OTC market liquidity disappears. That is, no one is available to take the other side of the trade. There are simply no bids, no offers, and no trading activity in OTC markets. The recent reduction in dealer inventories means that markets will be even more volatile in the next crisis.

This is unlikely to be a problem for deep liquid markets such as large cap stocks. So any problem with popular stock index funds is likely to be resolve itself quickly But it could take a long time to unwind problems in leveraged loan and high yield bond ETFs.

Won’t the APs fix this?

Its important to emphasize that the APs have no fiduciary duty to provide liquidity. The AP will have an agreement with the fund sponsor, but the fund sponsor does not compensate the AP directly. APs can profit by acting as dealers in the secondary market, or clearing brokers, thus collecting payment for processing and creation/redemption of ETF shares from a wide variety of market participants. APs can stop providing liquidity anytime they want. In the event of a crisis it may be prudent to do so. From Duke Law:

As such, a reliance on discretionary liquidity, in the context of a crisis is inherently “fragile” since dealers and market makers will stop providing it once they start incurring losses, or their balance sheets are negatively impacted from other exposures and they can no longer bear the additional risk from providing the liquidity support

In 2013 some ETFs traded at a steep discount when Citigroup hit its internal risk limits.   That was in the middle of a great bull market.  What will happen if there is a serious macro problem? As a historical precedent, during the financial crisis the auction rate security market collapsed when discretionary liquidity providers exited due to turmoil.

A different kind of death spiral

There are risks for both ETFs and Mutual Funds that hold illiquid assets. However the  reasons are different, and the nuances of a blow up will be different. 

A mutual fund can get exemptive relief from the SEC to suspend cash redemptions in extreme circumstances. Mutual fund investors, who thought they had a daily liquidity vehicle, are left holding an illiquid asset. This happened to the Third Avenue Focused Credit fund a couple years back. This caused a short lived mini-panic in the high yield debt market. When the fund suspended cash redemptions, they paid redemptions in shares of a liquidating trust. An outside party offered to buy the shares at a 61% discount to the NAV, which had already declined sharply.

In the case of an ETF it’s a bit more complicated.  The death spiral could simply take the form of a self reinforcing feedback loop.   Retail investors would be able to exit, albeit at a steep discount.  APs would sell underlying securities that they can sell, causing prices to plummet, causing further retail panic.   Some assets are more illiquid than others, and once once the dust settles, the ETF will be left holding the most illiquid and opaque assets.  

During the past few years we’ve seen a few tremors. There was the short incident in 2013 mentioned above. In May 2010 and August 2015 there were large one day price swings in more liquid parts of the ETF market probably caused by algorithms. In February 2018 there was the great VIX blowup/ “volmageddon”. The VIX example was a bit different because it involved very unique derivatives, but I think the bigger more interesting problems could be in the credit space.    In 2018Q4 there was some volatility in the credit space, and MSCI noted ETFs appeared to have a mild impact on bid/ask spreads. Yet by historical standards what happened in 2018Q4 was very minor.

These examples all occurred during a long bull market. What will happen in the next 2008 type scenario? I Still need to look more into how they might actually unwind.

So what can an investor do?

Most ETFs(and mutual funds) will probably be fine. During a crisis there might be temporary NAV discounts even for large cap index funds and lots of panic selling all around. Mutual fund investors will redeem at the worst possible time, and funds will sell shares into a falling market to meet these requests. Headlines will be full of doom and gloom. The prudent thing for most investors will be to ignore it all. Continue dollar cost averaging across the decades to retirement and beyond.

Nonetheless, investors holding some of the more esoteric, illiquid ETFs and mutual funds could be in for an unpleasant surprise and possible permanent capital impairment. Even though these potentially problematic funds are a small portion of the overall market, there is likely to be systemic contagion, as the IMF noted.

I’ve purchased some cheap puts on more fragile ETFs(mainly high yield bond and leveraged loan) although the lack of an imminent catalyst means that the position size needs to be small. I’ll be looking more closely at the way these different types of structures are unwound, since there are likely to be some major time sensitive opportunities next time it occurs.

Other possible case studies of the unwinding of illiquid assets in liquid wrappers:

  • UK open end commercial property funds during Brexit vote
  • Auction rate securities during financial crisis
  • Interval Funds during the financial crisis.
  • Other mutual fund redemption suspensions and ETF tremors?

See also:

Is Credit Really the Smart Money?