Dealing With Post Covid Debt

Countries around the world have shut down their economies in order to stop down the spread of Covid-19.  In order to prevent a humanitarian disaster they are implementing aggressive fiscal stimulus.   Prior to Covid-19 debt levels were already high.  In coming years they will reach levels never before seen in peacetime.  Average deficits in the developed world are around 11% of GDP this year, and developed world public debt could reach over 122% of GDP by the end of this year, according to The Economist.  This debt will have major consequences for the world economy in coming decades. 

Broadly speaking, there are three ways a country can deal with debt:

  1. Adjust taxes and spending
  2. Default on it.
  3. Grow/inflate out of it.  

Each scenario has very different implications for financial markets.

Adjust taxes and spending

Governments couldeither raise taxes or cut spending.   However this is the least likely scenario.  Raising taxes is politically extremely difficult.  And in a globalized world, companies nad rich people can leave if taxes are too high.  Cutting spending is also difficult.   Bureaucracy is an entrenched interest in most countries. Populism is on the rise globally.  In a coronavirus world, more spending on healthcare is likely necessary.  IF growth is weak, government austerity will only worsen the problem. 


Sovereign debt defaults are usually an emerging market issue.   If a country defaults on debt they will likely be  cut off from financial markets for at least a few years.   Sovereign countries rarely default on debt unless it is denominated in a foreign currency.   

Growth /inflation

If real  growth inflation is higher than the interest rate on debt, the debt will shrink as a percentage of the economy.   The US had a lot of debt coming out of World War II.  However, the economy grew rapidly in the following year,s and the relative size of the debt shrunk.  Its possible that economists and policymakers learned the wrong lesson from this.   Current US demographics, and Covid-19  make such a growth spurt unlikely. 

High inflation also shrinks the relative size of the debt burden. In the old days, sovereigns would literally debase coins by reducing the percentage of gold and silver. In modern times the process is more subtle.   Printing money drives inflation.   If the treasury issues debt in order to give money to consumers or businesses, and the central bank buys that debt, the impact is like printing money.  The central bank can buy financial assets from the private sector, driving asset price inflation.  The Federal Reserve is doing all of these things right now.    This could potentially stoke higher nominal GDP growth, due to higher prices.   Over time this would cause the amount of debt to become a smaller percentage of the economy.

 The practical consequences of high inflation for the wealth of lenders are very similar to a default.  If the inflation rate exceeds the interest rate, the real return is negative.  At the end, the principal amount returned buys less stuff.   Throughout history every systemically important country that borrowed a lot of money has printed money in order to effectively restructure debt.  The Dutch and the British Empires are two examples.


The Long Now

What happens fast is illusion, what happens slow is reality. The job of the long view is to penetrate illusion.

Stewart Brand’s Clock of the Long Now is about an ambitious project to reframe human endeavor to focus on the long term. Not next week, next month, next year, or even next decade. Really long term. The Long Now Foundation is building a 10,000 year clock and a library to go with it. Their purpose is to take care of information deemed especially useful over long periods of time. For example, by promoting long term scientific studies, they can keep track of decisions with long term consequences. No other institution is set up to do this.

The main problem might be stated, How do we make long-term thinking automatic and common instead of difficult and rare? How do we make the taking of long-term responsibility inevitable?

Rigorous long-view thinking makes responsibility taking inevitable because it response to the slower, deeper feedback loops of the whole society and the natural world.

The style of the book is unusual- its written as a mosaic- each chapter a separate essay in different situational voice Its exploratory, rather than convergent. Its a collection of essays that teach the practical use of the long time perspective.

The ultimate reason for initiating something ambitious is not to fulfill certain notions but to find out what surprises might emerge. The most remarkable results almost certainly cannot be anticipated.

The product of even the most imaginative and prudent forethought is not certainty but surprise.

Reframing Human Endeavor

The truly long term perspective requires a major perspective shift.

Clock/library aims for the mythic depth to become, as Brian Eno puts it, “one of those system-level ideas which sets in motion all sorts of behaviour without ever having to be referred to directly again. This is what dominant mythos do: they make some sorts of behaviour ring with recognition and familiarity and value and a sense of goodness, and thus lay deep templates for social cohesion about what would otherwise be very hard-to-discuss topics.”
In this respect it might be like a species genotype, which contains much more hidden diversity (in recessive genes, mutations, etc.) than what is expressed in current bodily phenotypes. By its very inefficiency the genotype preserves tremendous adaptivity in the species.

One simple heuristic they propose is to expand the concept of present to two hundred years, personally experienced, generations- based period of time.

The trick is learning how to treat the last ten thousand years as if it were last week, and the next ten thousand as if it were next week. Such tricks confer advantage.

The book introduces two concepts (1) Kairos- opportunity of a propitious moment and (2)Chronos- Eternal or ongoing time. While the first offers hope, the second extends a warning. Kairos is the time of cleverness, chronos the time of wisdom.

There are so many varieties of short-term opportunity, and the pace of events buffets our attention with so many surprises, it is as if the old dialogue between opportunistic kairos and durational chronos has become a monologue, just a shriek of joy into the gale of freefall.

In praise of slow learning and long science

The incentive structure of science is not set up to study important questions. In the domain of atmosphere and climate, the delay between cause and effect can be 30 years. We are changing the world faster than we are understanding it.

Since it is the long, slow fluctuations and cycles that most influence everything in ecology, we still don’t have the most important information on how natural systems actually work over t ime.
Enormous inexorable power is in the long trends, but we cannot measure them or even notice them without doing extremely patient science.

Closely related to this, our society overemphasizes fast learning. But quick answers aren’t always right.

As history accelerates, people become fast learners, and thats good, but its also a problem. “Fast learners tend to track noisy signals to closely and confuse themselves by making changes before the effects of previous actions are clear, says decision analyst James March. Quiz shows and classroom reward the quick answers. This is not helpful in domains where the quick answer is the wrong answer.

Making use of accumulated wisdom

The accumulated past is life’s best resource for innovation.

Brand emphasizes the importance of making use of accumulated wisdom. This contrasts sharply with the utopian ideal of a hard restart, or the arrogance of a conquering civilization. Utopias eventually become dystopias. The Spaniards destroyed valuable scientific knowledge that the Mayans had developed, setting civilization back centuries.

Starting anew with a clean slate has been mone of the most harmful ideas in history. It treate previous knowledge as an impediment, and imagines that only present knowledge deployed in theoretical purity can make real the wondrous new vision. Thus the French revolution of 1789, the Russian Revolution of 1917, and the Chinese Communist Revolution of 1949 each made brave new worlds but catastrophically failed. By cutting off continuity with the slower parts of their cultures they had no fallback. The American Revolution of 1776, by contrast, was highly conservative. Its instigators studied Roman, Venetian, and even Iroquois history for precedents. There was little of the brutal rhetoric of making a total break with the past. As a result , all the leaders who started the revolution lived to see through to completion, and its innovations in governance aged relatively well. The Americans severed the political bonds with the Old World, but not the cultural bonds. They burned their bridges, not their libraries.

This is why it’s so important to carefully maintain historical records.

If raw data can be kept accessible as well as stored, history will become a different discipline, closer to a science, because it can use marketers data-mining techniques to detect patterns hidden in the data.

Digital archivists thus join and ancient lineage of copyists and translators reaching back through European monastic scribes to the Hellenistic scholars at the Library of Alexandria. The process, now as then, can introduce copying errors and spurious “improvements” and can lose the equivalent of volumes of Aristotle; yet the practice also builds the bridge between language eras, from Greek ot Latin to English to whatever follows. I think that to become comfortable about digital continuity- to feel assured that our future will stay connected to our past, that the digital dark age is ending- we will need the framework for a universal translation system.

Reverence for past can still be over-done. Brand emphasizes a balance between the two. Comparing Europe and the US is a useful framework.

While Europe specializes in deep continuity with occasional equally deep discontinuity, America specializes in perpetual petty turmoil. America provides the stimulation in the arrangement., Europe makes the wisdom. America is comic, Europe tragic. Together they make great theater. The kairos- chronos dialogue can be between different parts of the world; it can be between different parts of the mind. The one contrives, the other warns..

Different parts of civilization have different paces

The Long Now isn’t about making everything slow. Its merely about fixing the balance between fast and slow. Ecological systems typically find a natural balance.

The combination of fast and slow components makes the system resilient, along with the way differently paced parts affect each other. Fast learns, slow remembers. Fast proposes, slow disposes. Fast is discontinuous, slow is continuous. Fast and small instructs slow and big by accrued innovation and occasional revolution. Slow and big controls small and fast by constraint and constancy. Fast gets our attention, slow has all the power. All durable dynamic systems have this sort of structure it is what makes them adaptable and robust.

Why reality is stranger than fiction

The book shifted my perspective, not just on time, but on reality itself:

At any time the several “probably” things that might occur in the future are vastly outnumbered by countless near-impossible eventualities, which are so many and individually so unlikely that it is not worth the effort of futurists or futurists to examine and prepare for even a fraction of them. Yet one of those innumerable near-impossibilities is what is most likely to occur. Reality is thus statistically forced to always be extraordinary. Fiction is not allowed that freedom. Fiction has to be plausible; reality doesn’t.

On tragic optimism

The book builds towards a conclusion of tragic optimism.

Everything has been going to hell as long as anyone can remember. Empires are always dying. Your friends are always dying. But in the long sweep of history, life has been getting steadily better for as long as you care to look. Does anyone really want to live in medieval times..
So short term worse, long term better. Maybe the way to resolve them is tragic optimism. I would settle for a world of tragic optimists.

Get the full book here.

Genghis Khan Was a Progressive Humanitarian Who Sparked the Western Enlightenment

Genghis Khan(born as Temujin) is remembered for conquering most of the known world. Many people remember Mongols as barbarians. Yet in reality Mongols were a civilizing force, according to Jack Weatherford’s Genghis Khan and the Making of the Modern World. Mongols conquered because they were pragmatic learning machines that improved the societies they entered. He was ahead of his time in promoting religious freedom and tolerance, along with the modern ideas of free speech, free trade, and meritocracy. Genghis Khan didn’t bother to build elaborate statues or buildings, but he built more bridges, both literally and metaphorically than any leader in history.

As he smashed the feudal system of aristocratic privilege and birth, he built a unique system based on individual merit, loyalty and achievement. He took the disjointed and languorous trading towns along the Silk Route and organized them into history’s largest free- trade zone. He lowered taxes for everyone, and abolished them altogether for doctors, teachers, priests and educational institutions. He established a regular census and created the first international postal system. His was not an empire that hoarded wealth and treasure; instead, he widely distributed the goods in combat so they could make their way back into commercial circulation. He created international law and recognized the ultimate supreme law of the Eternal Blue Sky over all people. At a time when most rulers considered themselves to be above the law, Genghis Khan insisted on laws holding rulers as equally accountable as the lowest herder. He granted religious freedom within his realms, though he demanded total loyalty from conquered subjects of all religions. He insisted on the rule of law and aoboloshed torture, but he mounted major campaigns to seek out and kill raiding bandits and terrorist assasins. He refused to hold hostages and, instead, instituted the novel practice of granting diplomatic immunity for all ambassadors and envoys, including those from hostile nations with whom he was at war.

Indeed, we can credit Genghis Khan for inspiring the European Renaissance. German cleric Nicolaus of Cusa in 1440 wrote an essay called “On Learned Ignorance” which made heavy use of Mongol ideas, and sparked the trends gave rise cultural, artistic, political and economic rebirth during the Renaissance. Genghis Khan grew up in a tribal society, but he was the first to show the modern world was possible:

The ideas of the Mongol Empire awakened new possibilities in the European mind.  New knowledge from the travel writing of Marco Polo to the detailed star charts of Ulugh Beg proved that much of their received classical knowledge was simply wrong, and at the same time it opened up new paths of intellectual discovery.  Because much of the Mongol Empire had been based on novel ideas and ways of organizing public life rather than on mere technology, these ideas provoked new thoughts and experiments in Europe. The common principles of the Mongol Empire- such as paper money, primacy of the state over the church, freedom of religion, diplomatic immunity and international  law were ideas that gained new importance.  

My notes below are organized around a few themes:

  • Pragmatism and Constant Learning
  • Loyalty
  • Religious Freedom and Tolerance
  • Free Speech
  • Free Movement of People
  • Rule By Law
  • Mongol Economics
  • Mongols as a Civilizing Force
  • Civility and Nonviolence
  • Meritocracy

Pragmatism and Constant Learning

The Mongols were rigorously pragmatic. They learned what worked, and took it from anywhere they could find it. They promoted knowledge diffusion and Mongol society had higher literacy than Western societies of the time. Everytime they conquered new land they passed skills on from other lands they had conquered. Their ability to pay close attention to their environment combined with extreme resourcefulness proved a lethal advantage compared to other civilizations. Robert Bacon noted that “…they have succeeded by means of science. Although the Mongols are eager for war they have advanced so far because they “devote their leisure to the principles of philosophy.”

Genghis Khan had a “penchant for finding a use for everything he encountered” His ability to learn was actually his greatest advantage:

Genghis Khan’s ability to manipulate people and technology represented the experienced knowledge of more than four decades of nearly constant warfare. At no single crucial moment in his life did he suddenly acquire the genius at warfare, his ability to inspire loyalty of his followers, or his unprecedented skill for organizing on a global scale. These derived not from epiphanic enlightenment of formal schooling but from a persistent cycle of pragmatic learnings, experimental adaptation, and constant revision driven from his uniquely disciplined mind and focused will. His fighting career began long before most of his warriors at Bukhara had been born, and in every battle he learned something new. In every skirmish, he acquired more followers and additional fighting techniques. In each struggle he combined the new ideas into a constantly changing set of military tactics, strategies, and weapons. He never fought the same war twice.

When Mongols conquered new lands, they would gladly adopt local customs where appropriate. Rather than forcing their way of life on their subjects, they worked to constantly improve on the best in each society.

While the Mongols consistently rejected some parts of Chinese culture such as Confucianism and footbinding, the refinement of the monetary system shows their great appreciation for other aspects of Chinese culture. Khubilai proved willlingness to reach far back into Chinese history for ideas and institutions that showed practical value.

They would also take what they learned from one culture that they conquered, and use it to conquer another society. It was the compound knowledge principal applied to world domination.

For the Mongols, written history also became an important tool in learning about other nations in order to conquer and rule them more effectively.

Prior to launching an invasion, they did thorough research and intel gathering not just about the natural environment, but also about local political relations. Genghis Khan was a master of due diligence (describing invasion of what is modern day Georgia):

Systematically, but persistently, the Mongols probed the area. With the usual emphasis on reconnaissance and information gathering, they determined the number of people, the location of cities, the political divisions and rivalries among them.  

Mongols were masters of preparation. Referring to the invasion of Europe:

Preparation for the campaign toward Europe required two years. Messengers went out in all directions to deliver the decision and distribute assignments…Before the actual invasion, the Mongols sent in small squads to probe enemy defense and to locate appropriate pasturelands and water sources for the Mongol animals. They identified valleys and plains that would best feed sheep or goats and those that would support cattle and horses. Where the natural grassland seemed inadequate, the Mongols opened up farmland for pasture by sending in small detachments of soldiers to burn villages and farm settlements in their future path. Without farmers to plow and plant the land, it reverted to grassland before the Main

They willing to experiment with unconventional methods and were highly adaptable to different situations. Again, referring to the invasion of Europe:

In 1236, the Year of the Monkey, the main army set out.  They moved with a party of about two hundred scouts in front and with a rear guard of another two hundred warriors. Once they reached the Volga, the real invasion began.  At this point, the Mongols enacted their unusual, but for them, tried and true strategy of dividing their army and invading on at least two fronts at once. In this way, the enemy could not tell which city or prince would be the main target. If any prince took his army from his home city to help another prince, then the other Mongol army could attack the undefended one.  With such uncertainty and danger to his home base, every prince kept his army at home to guard his own territory, and none came to the aid of the others.  

Their pragmatism allowed them to travel lite, which was a huge advantage in warfare:

In contrast to almost every major army in history, the Mongols traveled lightly, without a supply train.  By waiting until the coldest months to make the desert crossing, men and horses required less water. Dew also formed during this season, thereby stimulating the growth of some grass that provided grazing for horses and attracted the  game that the men eagerly hunted for their own sustenance. Instead of transporting slow-moving siege engines and heavy equipment with them, the Mongols carried a faster-moving engineer corps that could build whatever was needed on the spot from available materials.  When the Mongols came to the fist trees after crossing the vast desert, they cut them down and made them into ladders, siege engines and other instruments for their attack.  


Genghis Khan inspired loyalty in his people:

Though the steppe tribes of his changed  sides at the least provocation and soldiers might desert their s leaders, none of Temujin’sgenerals deserted him throughout his six decades as a warrior.  In turn, Temujin never punished or harmed one of his generals. Among the great kings and conquerors of history, this record of fidelity is unique.  

Loyalty was an important part of  his innovation in social policy.

In another innovation, he ordered that a soldier’s share be allocated to each widow and to each orphan of every soldier killed in the raid.  Whether he did this because of the memory of his own mother’s predicament when the Tatars killed his father, or for more political purposes, it had a profound effect.  This policy not only ensured him the support of the poorest people in the tribe, but it also inspired loyalty among his soldiers who knew that even if they died, he would take care of their surviving families.

Religious Freedom and Tolerance

The steppe people included people from just about every religion in the world(Buddhism, Christianity, Manicheanism, Islam, etc) , each of which claimed it was the true religion, and the only one. Genghis Khan welcomed them all.

In probably the first law of its kind anywhere in the world, Genghis Khan decreed complete and total religious freedom for everyone. Although he continued to worship the spirits of homeland, he did not permit them to be used as a national cult.

To promote all religions, Genghis Khan exempted religious leaders and their property from taxation and from all types of public service. 

At a time when the Western world was rife with sectarian violence, Mongol society was an expanding oasis of open minds. Indeed there are some records of refugees from European religious violence being accepted into mongol society. There was actually a thirty year old Englishman who had somehow been recruited as an officer in the Mongol military. Historians speculate that he had been involved in the effort to force King John to sign the Magna Carta in 1215, and had been forced to flee England, ended up being excommunicated from Catholic church. He found employment with the Mongols, who were much more tolerant.

Free Speech

Rather than kill each other over different interpretations of ancient texts, Mongols encouraged their citizens to debate. They would organize civil debates between scholars of different religions Some priests, etc found this difficult when it first started. Mongols suggested that different scholars take time to write out their thoughts more clearly and return for fuller debate.

The debates between religious scholars became kind of like a sport for the open minded Mongols.

The Mongols loved competitions of all sorts, and they organized debates among rival religious the same way the organized wrestling matches. IT began on a specific date with a panel of judges to oversee it.

The panel consisted of members of each religion. The Mongols had one strict rule. On pain of death, no one was allowed to speak words of contention against each other. With Ad Hominen attacks strictly forbidden:

The religious scholars had to compete on the basis of their beliefs and ideas, using no weapons or the authority of any ruler or army behind them. They could use only words and logic to test the ability of their ideas to persuade.

The debates usually own with everyone from all religions getting incredibly drunk and singing. In Europe, different people from different religious factions were killing and torturing each other, But in the mongol empire, they held a party together.

Genghis Khan had his own personal beliefs, but didn’t force them on people. At the same time, he couldn’t resist pointing out the hypocrisy of the societies he conquered.

We Mongols believe in one God by Whom we live and Whom we die and toward Him we have an upright heart… Just as God gave different fingers to the Hand so He has given different ways to men. To you God has given Scriptures and you Christians do not observe them.

Genghis Khan didn’t leave behind much written record, however the author describes a letter that he sent to a Taoist monk in China that reveals his true thoughts:

His voice comes through as simple, clear, and informed by common sense. He ascribed the fall of his enemies more to their own lack of ability than to his superior prowess:  “I have not myself distinguished qualities. He said that he Eternal Blue Sky had condemned the civilizations around him because of their “haughtiness and their extravagant luxury.”  Despite the tremendous wealth and power he had accumulated he continued to live a simple life. “I wear the same clothing and eat the same food as the cowherds and cowherders. We make the same sacrifices, and we share the riches.  He offered a simple assessment of his ideals: “ I hate luxury,” and I exercise moderation/.” He strove to treat his subjects like his children, and he treated talented men like his brothers no matter what their origin was. He described his relations with his officials as being close and based on respect: “We always agree in our principles and we are always united in mutual affection.  “

Free Movement of People

Mongol society was more cosmopolitan and progressive than Western civilization of their time.

The Mongols made culture portable. It was not enough to merely exchange goods, because the whole system of knowledge had to be transported in order to use many of the new products. Drugs for example, were not profitable items of trade unless there was adequate knowledge of how to use them. Toward this objective, the Mongol court imported Persian and Arab doctors in to China, and they exported Chinese doctors to the Middle East. Every form of knowledge carried new possibilities for merchandising. It became apparent that the Chinse operated with a superior knowledge of pharmacology and of unusual forms of treatment such as acupuncture,… Muslim doctors, however, possesssed a much more sophisticated knowledge of surgery, but , based on their dissection of executed criminals, the Chinese had a detailed knowledge of internal organs and the circulatory system. To encourage a fuller exchange of medical knowledge, the Mongols created hospitals and training centers in China using doctors from India and Middle East as well as Chinese healers. Khublai Khan founded a department for the study of Western medicine under the direction of a Christian scholar.

The plague ultimately devastated Mongol empire, because it led to isolation, and cut off the flow of people and ideas temporarily.

Rule of Law

The Western enlightenment concept of rule by law not men actually originated with the Mongols.

Enforcement of the law and responsibility to abide by it began at the highest level, with the khan himself. In this manner, Genghis Khan had proclaimed the supremacy of the rule of law over any individual, even the sovereign. By subjugating the ruler to law, he achieved something that no other civilization had yet accomplished. Unlike many civilizations, most particularly western Europe, where monarchs ruled by the will of God and reigned above the law, Genghis Khan made it clear that his Great law applied as strictly to the rulers as to everyone else.

Genghis Khan, Applied Economist

When they conquered new territory they made sure to stabilize the local economy. They would even pay off the old rulers debts to merchants and foreigners. The Mongols were also pioneers in paper currency, which they were careful to manage and standardize so as not to cause debasement and inflation. Genghis Khan authorized the use of paper money backed by precious metals and silk shortly before his death. The practice grew erratically, but had important implications for the long run success of Mongols empire.

… standardization of currency allowed Mongke Khan to monetize taxes, rather than accepting payment in local goods.  In turn, the monetization allowed for standardized budgeting procedures for his imperial administration, since instead of accepting taxes in goods, the Mongols increasingly accepted them in money.  Rather than relying on government officials to collect and reallocate tribute of grain, arrows, silk, fur, oil and other commodities, the government increasingly moved money rather than goods. For the first time, a standardized unit of account could be used from China to Persia.  So long as Mongols maintained control of money, they could let merchants assume responsibility form the movement of goods without the loss of government power.  

Mongols are most known for their use of strength and propaganda, but they also understood good policy and administration. When Khublai Khan invaded China, he was able to achieve national unification. Chinese elite had dreamed of this for centuries, but struggled with constant wars between factions. It took took a horde of Steppe barbarians to achieve unification of the most advanced civilization of the ancient world.

Mongols grasped the concept of free trade centuries before Adam Smith and David Ricardo.

The Mongol elite’s intimate involvement with trade represented a marked break with tradition. From China to Europe, traditional aristocrats generally disdained commercial enterprise as undignified, dirty, and often, immoral; it ranked with the manual trades bbeneath the interest of either the powerful of the pious. Furthermore, the economic ideal in feudal Europe of this time was not merely that each country should be self–sufficient, but that each manor estate should strive to be a self-supporting a spractical. Any goods that left the estate should not be going to trade for other goods for the peasants on the land but to buy jewelry, religious relics, and other luxury goods for the aristocratic family or church. The feudal rulers sought to have their peasants supply all their own needs- to produce their food, grow their timber, make their tools, and weave their cloth- and to trade for as little as possible. In a feudal system, reliance on imported goods represented a failure at time.

…The traditional Chinese kingdoms operated under centuries of constraints on commerce. The building of walls on their borders had been a way of limiting such trade and literally keeping the wealth of the nation intact inside the walls. oFor such administrators, giving up trade goods was the same as paying tribute to their neighbors, and they sought to avoid it as much as they could. The Mongols directly attacked the Chinese cultural prejudice that ranked merchants as merely a step above robbers by officially elevating their status ahead of all religions and professions, second only to government officials.

Mongols as a Civilizing Force

Mongols invaded countries in a manner that was frighteningly efficient. Yet they they were never uneccesarily cruel, and they never tortured anyone, even though torture was common practice in Europe at the time. They were ruthless towards elites, but gentle and kind towards common civilians.

Although the army of Genghis Khan killed at an unprecedented rate and used death almost as a matter of policy and certainly as a calculated means of creating terror, they deviated from standard practices of the time in an important and surprising way. The Mongols did not torture, mutilate or maim. War during that time was often a a form of combat in terror, and other contemporary rulers used the simple and barbaric tactic of instilling terror and horror into people through torture or gruesome mutilation…

…By comparison with the terrifying acts of civilized armies of the era, the Mongols did not inspire fear by the ferocity or cruelty of their acts so much as by the speed and efficiency with which they conquered and their seemingly total disdain for the lives of the rich and powerful.

Their kindness was of course, never weakness.

Those cities that surrendered to the Mongols at first found their treatment so mild and benign, in comparison with the horrific stories that circulated, that they naively doubted the abilities of the Mongols in other areas as well. 

Overall Mongol ruthlessness was probably exaggerated in history. Some of this was partly the result of Genhis Khan’s humility, partly the result of his strategy.

He showed no interest in having his accomplishments recorded or in panegyrics to his prowess; instead, he allowed people to freely circulate the worst and most incredible stories about him and the Mongols 

Civility and Nonviolence

Its a common myth that the Mongols were violent for the sake of violence. Yet Mongol culture was actually less violent than western culture at the time.

In their patronage of popular culture to entertain themselves and the masses, the Mongols adhered to their cultural abhorrence of bloodshed.  Although they enjoyed wrestling and archery, they developed no counterpart to the gladiatorial games and public slaughter that fascinated the Romans nor any of the traditional European sports of pitting animals against each other, as in bear baiting and dogfights, or animals against humans as in bullfighting.  Mongols did not permit the execution of criminals to become public sport, as in the beheadings and hangings common in European cities. The Mongols offered no counterpart to the common public entertainment of burning people alive that occur so frequently in western Europe wherever the Christian church had the power to do so.  

When the Mongols invaded China, they reduced violence in the society, and also improved the criminal justice system. Mongols instituted a parole system, which required fingerprinting, and having all family members signing documents. Also, family members were given opportunity to register complaints about sentencing. Although they had the death penalty, the number of criminals executed was few, far less than modern China, or the modern United States

The so called barbarians actually made the most advanced civilization of the time more civil(On Khublai Khan, after he invaded China) :

Overall, he installed a more consistent system of laws and punishments as well as one that was substantially milder and more humanitarian then the Sung’s .  Where practical, he substituted fines for physical punishment, and he installed procedures to grant amnesty to criminals who repented of their wrongdoings. In a similar way, Mongol authorities sought to eradicate torture, or at least, to severely curtail its use.  Mongol law specified that before torture could be applied to elicit a confession, the officials had to already have substantial evidence, not mere suspicion that the person had committed the particular crime. The Mongol legal code of 1291 specified that officials must “first use reason to analyze and surmise, and shall not impose abruptly any torture.”  By comparison, at the same time that the Mongols were moving to limit the use of torture, both church and state in Europe passed laws to expand its usage to an ever greater variety of cries for which there need be no evidence. Unlike the variety of bloody forms f torture, such as stretching on the rack, being crushed by a great wheel, being impaled on spikes, or various forms of burning, on other countries, Mongols limited it to beating with a cane.

Their civility and nonviolence not only led to better law enforcement, and fit with the broader principles of freedom, pragmatism, and meritocracy.

The Mongol procedures not only improved the quality of law enforcement, but corresponded with the overarching Mongol policy that all people, not just an educated elite should know and be able to act through the law.

At a time when only priests were allowed to read in Western Literacy the Mongols promoted widespread literacy:

… the Mongols promoted general literacy as a way of improving the quality of life for everyone.  Khubilai Khan created public schools to provide education to all children, including those of peasants.  Until this point, only the rich had the time and income to educate their children and thereby maintain power over the illiterate peasantry for generation after generation. The Mongols recognized that in the winter, peasant children had time to learn, and rather than teaching them in classical Chinese, the teachers used the colloquial language for more practical lessons.


When Mongols took over a new country, they would kill the aristocrats, but avoid harming any of the common people unless necessary for self defense. Indeed he was extremely generous to the common people.

The Mongols captors slaughtered the rich and powerful.  Under the chivalrous rules of warfare as practiced in Europe and the Middle East during the Crusades, enemy aristocrats displayed superficial and often pompous respect for on another while freely slaughtering common soldiers.  Rather than kill their aristocratic enemy on the battlefield, they preferred to capture him as a hostage who they could ransom back to his family or country. The Mongols sought to kill all the aristocrats as quickly as possible in order to prevent future wars against them, and Genghis Khan never accepted enemy aristocrats into his army, anr rarely into his service in any capacity.

Genghis Khan’s emphasis on meritocracy continued with his successors, including Khubilai Khan.

Just as Genghis Khan promoted men from the lowest levels of society to the highest ranks of leadership based on their skills and achievements rather than birth,  Khubilai’s administration constantly promoted men from the lowest jobs such as cooks, gatekeepers, scribes and translators.

He distrusted higher ranking people, but willing to trust people outside clan if deserved. 

… he would judges others primarily by their actions toward him and not according to their kinship bonds, a revolutionary concept in a steppe society. 

Genghis Khan was the intellectual pioneer of the modern world.

Get the full book here.

How History Gets Things Wrong

How History Gets Thing Wrong shatters many of the most pervasive and seductive illusions about reality. It examines the theory of mind, that is the ability to guess others people thoughts and motivations and how it leads to people’s use of narratives to understand the world. Although this ability is innate to humans, and has been highly adaptive throughout human evolution, it has overshot and turned us into “hyperactive agency detectors who suspect conspiracies and motives behind everything that happens. Narrative history often leads to inaccurate interpretation of events. Evolutionary game theory is probably a better theory for understanding societal developments. The conclusions are shocking, yet compelling and intuitive once the argument is laid out.

In fact, much of the conventional narrative history, written by conventional narrative historians since they started writing down stories 3000 years ago, demonstrates that the driving force of history is this Darwinian process operating through human culture.

Our minds are hardwired to impose the theory of mind on chronologies — to make them into narrative histories — and to find pleasure in doing so … We humans are very much the products of a natural selection process that has made us seek out such histories and conduct our affairs by employing them.

The Theory of Mind is Adaptive

The theory of mind is a highly adaptive trait when we deal with people who are close in space and time.

…As an adaptive trait , the theory of mind is right up there with binocular vision, opposable thumbs, and bipedalism. Together with language , it’s what moved us to the top of the food chain. Like other hardwired traits, its still with us, still shaping our culture, manifesting itself in everything we do. Its still the way we explain ourselves to ourselves and to one another. And because it comes to us before we even learn to walk let alone talk, we aren’t just used to it; we can’t stop using it, without even thinking about it— automatically, persistently, and unrestrainedly.

The theory of mind causes our addiction to stories

There is an interesting nature nurture dilemma in its development:

The almost innate theory of mind is probably the cumulative product of the iteration of an evolutionary process called the “Baldwin effect,” first identified by the psychologist James Mark Baldwin in 1896. In any organism capable of at least some environmental learning, behaviors that are repeatedly rewarded by food or warmth or safety, a bit of prey caught, a mate found, or a predator avoided are reinforced and become more frequent, and behaviors that are repeatedly punished by pain, injury, hunger or other privation are inhibited and become less frequent; deploying the rearded behaviors and avoiding the punished ones as a matter of course become learned traits for the organism. Through its life, there will be other traits, most of them hardwired, that can help the organism learn more quickly, deploy the rewarded behaviors for longer and fine-tune them further and avoid the punished behaviors more often and sooner. All of the traits that help the organism learn will be selected for, over and over again, in the course of evolution. Eventually, selection for traits that accelerate learning will make the organism’s ability to learn so early , so fast, and so accurate that it might as well be innate. There’s hardly any difference between hardwired species-specific behavior and behavior that is learned ealy and quickly, needing only slight reinforcement, and that is strongly maintained and operates with great discrimination.
This process of moving originally learned behaviors “inside” to become innate abilities by small steps over countless generations that makes the behaviors easier to learn, earlier learned further fine-tuned, and more automatically deployed, operates not only for individual behaviors, but also for suites of related behaviors that go together in an organism’s life.

All animals are “means-ends” systems. Their behaviors appear to track sources of food, shelter, reproductive opportunities, predators and prey. Since almost all animals are eaten by other animals, it is highly adaptive for all animals to be able to track the means-ends behavior of predators and prey. There will thus be selection for any new capacity that improves on this ability. Tracking the ends-means behaviors of prey or predators requires the ability to track the environmental resources and opportunities those behaviors are responses to – to see what they prey or predators are seeing, smelling and so on — as well as their ends at any given moment. Then there must be a capacity to combine these two into trajectories that can result in successful predation or escape. In the long-term struggle for survival between predators and prey, anything that facilitates the earliest acquisition of the most accurate version of this ability to predict other animals’ ends and means behavior will be selected for. Natural selection driven by Baldwin-effect mechanisms will continue until the suite of related abilities to do this predicting gets as close to being hardwired into cognitive development as biologically possible.

..Its the building of such suites of abilities, first in mammals, then in primates, and finally in hominins, that probably produced might as well be innate theory of mind in Homo Sapiens. Hers roughly how this may have happened. Natural selection started with operant conditioning, then used Baldwin-effect process on learning to produce what the youngest babies and most predatory mammals can do instinctively- predict behavior with a certain reliability: in what directions prey will move next, where edible insects will build their colonies, or birds lay eggs that predators can steal, how predators hunt and what their own pups or cubs might do that endangers them . By the time the great apes appeared this process had already produced primates who were very good at predicting and acting on a range of behaviors, of their predators, their prey, and their fellow primates.

Narratives Help Us Learn

As a matter of fact, acquiring the ability to teach and to learn is arguably more complicated than acquiring the technology of building compound axes. If teaching and learning that technology also requires learning teaching the more complex theory of mind, iits not surprise hominins were around for a million years before inventing the compound ax. Accomplishing the simpler task– building a compound ax– required learning how to imitate and figuring out how to teach. And because teaching required both parties to apply the theory of mind repeatedly, over and over again, each party would have had to frame beliefs about the beliefs of the other party, beliefs about the desires of the other party, desires about that party’s beliefs as well as desires, and sometimes each of these, over and over again.
If everything we ever learn from other requires that we already have the ability to learn, there is only about one solution to the problem of how we ever accomplished the original feat, acquiring the theory of mind, or at least as much of it as is needed for learning by imitation— the theory had to have been either innate, or once learned, faithfully preserved from generation to generation by teaching. Because without it, the evolutionary path to us humans could never have gotten started.

Narratives are a key part of human evolution

The theory of mind allowed humans to rise out of the African Savannah to dominate the planet. Yet we also extend and misapply the theory.

The progression from a (nearly ) innate theory of mind to a fixation on stories- narrative– was made in only a few short steps. We went from explaining how and why we did things in the present, to explaining how and why we did things in the past, to explaining how and why others did things in the present, then in the past, and finally to explaining how others did things with, to against, and for still others.
In its response to particular environments, natural selection often appears to overshoot and then sometimes fine-tune. But what looks like overshooting may really be adapatation to a different “design problem” or even to a new problem created by the solution to an earlier one. Our theory of mind is probably embroiled in one such tangle of “problems” and “solutions” . To encourage our use of the theory of mind, natural selection has selected for those of us who are rewarded with a feeling of satisfaction, an “aha” experience when we do (Gopnik, 2000). Neuroscientists have shown that hearing a story, especially a tension filled one in the protagonists’ emotions are invoked, is followed by the release of pleasure-producing hormones such as oxytocin, which is also released during orgasm and is important for sustaining cooperation as well(Zak, 2015) . The pleasurable sensation reinforces our subsequent use of the theory of mind and is another source of our love of history and biography.

We evolved not to see what is true, but to survive.

How can the theory of mind be so adaptive if it is wrong? Its because there is no evolutionary reason for us to always see what is true.

The process of natural selection does not as a rule produce true beliefs, just ones that foster survival. Nor does it “track” truths about the world or about us so much as produce “quick and dirty” solutions to problems of survival and reproduction

Yet the Theory of Mind Is wrong

The trouble is, the theory of mind is not a very good theory, not at least by the standards we set for theories everywhere else. This should come as no surprise. If the neory was, in effect, conferred by natural selection, and not the result of careful scientific investigation, it wasn’t likely to be anything more than a relatively recent quick and dirty solution to an evolutionary “design problem” or perhaps a quick and dirty response to a “competitive opportunity “, like most of our other inherited traits.

The theory of mind overshot and led to an addiction to narratives. Its not enough to understand anything. its not even indispensable or necessary. In fact its not even in a good way, let alone the best or only way to understand anything. Most of the book is detailing how the theory of mind is wrong, and constant application of narratives leads us astray.

But the theory of mind was the first, indeed the only, cognitive tool available for coping with other people when human life became more complex and it was already wired in, hard to give up, and hard not to think things through with. Which meant that all of subsequent theorizing about human affairs has been built on its rickety foundations.

The theory of mind has been debunked by modern science

Neuroscientists tried to find evidence for the theory of mind, but what they found was the opposite.

Neuroscientists were supposed to show us how our pairings of beliefs and desires caused us to act: how the beliefs and desires in our minds were expressed with content in the neural circuits of our brains, and how the firing of these neural circuits brought about our movements and actions.

But when neuroscientists instead found that the neural circuits neither content nor needed it to perform their functions, it became clear that there was no room either for beliefs and desires or for purpose in those circuits or in the brain itself, even when almost all of us persisted in attaching purpose to beliefs and desires, both ours and other people’s. Most neuroscientists were not surprised by this outcome. The behaviorists anticipated it two or three generations before them but just didn’t have the tools that neuroscientists had to achieve it.

The implications are startling :

To see the theory of mind reconciled with, vindicated by what neuro scientists have discovered about the brain and how it works- we’d need to show (1) how the neural circuits in the brain have content are about things, represent the world; and (2) how they run the rest of the body in at least roughly the way the theory of mind says beliefs and desires do.

If we can’t do this, the two theories will compete with each other. The theory of mind’s explanations of how the mind works will rule out neuroscience’s explanations of how the brain works as being just wrong. And vice versa. We’ll have to choose which theory to accept. There’s only one way the theory of mind and neuroscience could both be right, or even at least roughly right, on track to being right about how our brains work. That way would be f neuroscience were able to find content, aboutness, representation somewhere in the neural circuits of the brain.

Theory of mind works in small groups, not in big groups:

We’ve noted several times that the core application of the theory of mind, the one we use it for most and in which it works best is in coping with the immediate behaviour of other people in immediate contact with us over relatively short periods of time. The more people are hidden from our direct observation, and the longer into the future we attempt to use the theory, the more ambiguous and unreliable its predictions become. Within the domain of its optimal application the theory works well because it treats its subjects- people and other animals as ends-means systems and combines this assumption with information about their immediate circumstances.

The theory of mind works best when it doesn’t stray very far from the mind-reading ability we share with other mammals. Since mind readers share their target animals’ environments, they have some sensory access to what the target animals see, hear, smell, taste and so on. Mind readers also have sensory access to their target animals’ current behaviour and perhaps memory access (somewhere in the hippocampus or neocortex) to the past behavior of those and similar animals in the local environment. Mind reading, whether in predators, prey, or cooperators is just a matter of how the brain makes a means-end calculation from a target’ animal’s current behavior in its environment to its behavior in the near future. Think of a lion tracking a gazelle. The lion factors the gazelle’s speed and endurance and the terrain to close in and make the kill. Think of the gazelle trying to escape the lion. The gazelle factors the lion’s speed and endurance and the terrain to take evasive action, which it adjusted to match the lion’s pursuit. The behaviors of booth lion and gazelle reflect the means-ends calculation that mind reading consists in.

The theory of mind doesn’t work when we apply it beyond immediate circumstances.

Thus the development of language creates a theory of mind out of the means-ends calculation that the human brain’s mind-reading ability consists in. then that theory provides languages use with a ready-made easily understood explanation of how language comes by the meanings of its words. Meanwhile the theory also helps Homo sapiens climb to the top of the African food chain and continues to work well enough in interactions both between cooperating people and between them and their predators and prey (human and nonhuman). Eventually this adaptation overshoots and humans start to use the theory of mind beyond their immediate circumstances that selected for its adaptive improvements on their mind-reading ability. Until, finally, we begin to speculate, invent conspiracies, to narrate, tell stories and write histories.

This overshooting is impossible to turn off:

By this point, natural selection is no longer able to do much about such overshooting and our use of mind reading outside its effective range of application. Having selected for the theory of mind’s placement in the mind-reading module of our brains and the reward system for using it, it can’t easily fine-tune the theory further. Nor can natural selection select for turning the theory off unless and until it becomes clearly harmful for our survival and reproduction.

Addiction to stories can lead us badly astray. It causes us to assume the worst about strangers:

But mind reading becomes malevolent when the theory of mind enables it to unleash our hostile emotions against people we don’t even know, people who may even be long dead or far away.    

See also: Talking to Strangers

On a broader scale, narratives become extremely destructive:

… Most people , especially those who drag narrative history into politics didn’t get the message. National narratives especially move people by giving meaning to the chronicle of their history. People mistake the emotions such narratives foster for understanding. When the broad sweep of narrative history comes packaged in a story – Manifest Destiny, The White Man’s Burden, “the civilizing mission【la mission civilatrice]” “blood and soil [blud und Boden]”- its hard for anyone to shake it off just because of the way its packages.
Not only has historical storytelling led us astray in our expectations about the future. It is more often than not led those who believe it into moral catastrophes. No one can seriously suggest , on balance, narrative history has been a force for good since it began to be written down some 5,000 years ago. There are, of course, exceptions to this woeful track record, onese we honor even as we try to overlook the atrocities sincerely perpetrated in the name of history.

The author believes we need to move beyond narratives, in order to avoid continued suffering.

Its not just that “collective historical memory” is neither factual n or proportional nor stable. The same problems arise in the best, most disinterested archibally scrupulous, primary source- driven historical scholarship. If the historical record is anything more than a chronology, its not verifiable. Its wrong. And wrong in the most dangerous way, the way pretty much guaranteed to ensure the mayhem of the last 5,000 years of recorded history will continue into the future.

OK Computer

… the appearance of design by some all-powerful intelligence is produced mindlessly by purely mechanical processes(Dennett, 1995) And they make manifest that the next stage in the research program that began with Newton ins the banishment of the theory of mind from its last bastion- the domain of human psychology.

Hardwarde-software models are probably a better model for understanding reality. Note that the Jeapordy! winning computer doesn’t operate according to theory of mind.

But now we’ve seen that programs, even programs powerful enough to win at Jeopardy! don’t have, indeed can’t have the features that the theory of mind requires. They don’t operate on the content of their inputs to shape the content of their outputs.  All programs do is take the form, structure, and syntax of each input and produce an output with the same or different form, structure and syntax. If their inputs represent anything, mean anything, are about anything, that fact about them doesn’t matter to how programs work.  Content doesn’t matter to programs because all they can do is change 0s to 1s, low voltage to high voltage and so on, or vice versa.  

..If the computer hardware-software model is a good model of how our brains and minds work- how we think- then the theory of mind is critically, completely and hopelessly wrong. 

This has huge implications for the future, as artificial intelligence takes on a bigger role in society.

Unpredictable Factors

The author also had some interesting insights into the role technological progress has made the future more unpredictable. Unfortunately our narrative toolkit isn’t auto updating.

.. But the users of history have increasingly underestimated the role of entirely new factors in shifting the trajectory of events away from its past directions. The effect of entirely new and unarguably unpredictable factors on history has grown rapidly in the last two centuries. Ironically, its safe to predict the role of these factors will soon completely undermine confidence in any predictive role for history. This prediction is not itself based on history, though the history of the four German thrusts through Ardennes illustrates it plainly enough. Technological change from 1870 through 1944 was clearly unpredictable and had a decisive impact when added to other factors that remained the same over the period. The machine gun, the Maginot Line , the tank, Ultra decryption all made a difference in what happened in each of the thrusts- and all made any extrapolation from previous history pretty pointless. It’s interesting to note that the military planners were later criticized by historians for not having learned this obvious fact from history. If technological change is driven by scientific discovery and invention– the quintessentially unpredictable results of human creativity— then it seems obvious that the events technology affects will be just as unpredictable. And, as the role played by technology in humans affairs grows ever greater, the study of history will have fewer and fewer lessons for the future.

There is no purpose in nature, only the illusion of purpose

This conclusion manages to be shocking, yet intuitive:

But the whole history of science from Newton onward tells us there is no purpose in nature, only the appearance of purpose, overlay our minds spread across the domains of nature, whether physical, biological, or psychological. Neurosciences just completed project of banishing purpose from nature, showing that its appearance is an illusion, although once a highly adaptive illusion and perhaps still indispensable in everyday life , but, for all that, not real, so not available to explain anything.
Recall that Darwin revealed the causal mechanism, the “machine behind the curtain” that produced in us the illusion in nature – blind variation and natural selection. Perhaps he should have called natural selection “environmental filtration” instead to emphasize the passivity of the proces, its complete freedom from even the suggestion of purposeful “selection.” But its too late to change the name of the theory even though calling it something like the :theory of environmental filtration” would have made Diamond’s reliance on it to drive the process Guns, Germs and Steel describes much easier.
It needs to be re emphasized how science first banished purpose from the physical domain, and then revealed the detailed mechanisms that produced the illusion of purpose wherever that illusion appeared. That purpose has no explanatory role and indeed no place at all in the physical domain is abundantly clear from the most fundamental facts of physics. Until Darwin, there was no way to banish purpose from the biological domain as well. Toward the end of the eighteenth century, the German Philosopher Immanuel Kant wrote, “There will never be a Newton for the blade of grass, “ meaning that purpose could never be surrendered in the life sciences , since without it, the evident means-ends economy of nature couldn’t b explained. But 25 years later, in 1809, the Newton of the blade of grass” was in fact born in Shropshire, England. Darwin would advance the Newtonian project, banishing purpose from the biological domain while leaving the appearance of purpose, even as he explained it way. Contemporary molecular biology would fill in the details of Darwin’s theory, showing how both the heredity and development of organic systems were simply the result of the interaction of macromolecules, and how these systems interact with their environment through the same physical and chemical processes to produce adaptations that we still take for the fulfillment of purpose.

The Go Go Years: Forgotten 1960s Hold Lessons For Investors

I’ve seen a lot of commentary comparing the current era to the last tech boom in the late 1990s. Yet perhaps we can learn more from studying a forgotten market era- the Go Go Years of the 1960s. It was a period of intense social strife, yet the market climbed a wall of worry to record highs. Just like today, there was extreme overvaluation of a small subset of stocks fitting a certain theme. There was also the rise of weird alternative investment products, a precursor to “ESG” investing, and whole slew of shady characters. As always retail entered last, and the crash was brutal. Many corporate governance techniques that are commonplace now were pioneered during the 1960s conglomerate craze.

The Go Go Years by John Brooks is “a comedy farce to end them all, the show that had everything, deal-makers, fund managers, gambling stocks purchased respectively , offshore operations.” The author has a pretentious writing style, that almost seems like a parody at places. In spite of this (or maybe because of this), it’s an incredibly entertaining tale full of lessons for modern investors.

My notes/highlights below are organized around themes, all of which seem to have ominous parallels with the modern market environment.

  • Intense social strife
  • Old establishment losing credibility
  • Market rising a wall of worry
  • Extreme valuation of a small subset of stocks fitting a certain theme
  • Rise of weird alternative investments
  • Rise of scammers
  • Fragile plumbing
  • Violent shifts in narrative
  • Retail always last
  • Aftermath

Each crisis is unique, but there are also patterns. 

Before the crash in 1929 the financial sages had insisted repeatedly that there couldn’t be another panic like that of 1907 because of the protective role of the Federal Reserve System;  before the crash of 1969-1970 a later generation observed repeatedly that there couldn’t be another panic like that of 1929 because of the protective role of the Federal Reserve System and the Securities and Exchange Commision. In each case a severe market break had taken place about eight years earlier (1921 and 1962 respectively, followed by a period of progressively more unfettered speculation.  In each case huge, shaky financial pyramids built on minimum of cash base, had been erected by financiers eager to take advantage of the public’s insatiable appetite for common stocks. Before 1929 they had been called investment trusts and holding companies; now they were called conglomerates. In each case there had been a single market operator whom the public assigned the star role of official seer.  In the 1920s the man to whom the public ascribed almost supernatural power to divine the future prices had been Jesse L. Livermore. In the middle 1960s it was Gerald Tsai.

Social Strife

A lot of people feel like modern American society is breaking down due to political divisions. Yet the 1960s were probably worse:

By Wednesday , May 6 1970 a week after Cambodia announcement and two days after the Kent State incident, eighty colleges across the country were closed as a result of student and faculty strikes and students were boycotting classes at 300 more.
… suddenly, simultaneously from all four approaches to the intersection, like a well trained raiding force, the hardhats came. They were construction workers, many employed in the huge nearby World Trade Center project, and their brown overalls and orange and yellow helmets seemed to be a sort of uniform. Many of them carried American flags; others, it soon became clear, carried construction tools and wore heavy boots that were intended as weapons. Later it was said that their movements appeared to be directed by means of hand signals, by two unidentified men in gray hats and gray suits. There were perhaps two hundred of them.

There was even a violent riot started by war protestors at the heart of Wall Street

Most of Wall Street’s elite working population watched the carnage from high, safe windows.
Indeed there was little else they little else they sensibly could have done; no purpose would have been served by their rushing down and joining the fray. Nevertheless, there is an all too symbolic aspect to professional Wall Street’s role that day as a bystander, sympathizing, unmistakably, with the underdogs, the unarmed the peace-lovers but keeping its hans clean– watching with fascination and horror from its windows that looked out over the lovely (at that perspective ) Upper Bay with its still-green islands and its proud passing liners, and down into the canyon from which there now rose, inconveniently the cries of hurt or frightened children.

More striking parallels

There was in the middle sixties an underground current of thought in the country that said the West had failed, that its rational liberalism was only a hypocritical cover for privilege and violence, that salvation if possible at all, lay in the more intuitive approach of the East.

It has become commonplace for social commentators to say that 1968 was the year when the fabric of American life unravelled- when the moral ground shifted and quaked under American feet; when the political far left turned violent and took on ominous landmarks of the far right; when the democratic idealism and optimism of the mass of Americans seemed to become a delusion.

New York was a rough place in the 1960s:

Not by chance, cultural and social revolution hit Wall Street, New York, at the same time that it hit Wall Street, USA. It was in 1968 that New York City first came to seem ungovernable, out of hand , to large numbers of formerly optimistic citizens. Those who loved the city had clung to the belief that for all its passing anarchies- soot, noise, clogged streets, racial tensions, the deadly cycle of drugs and crime, the unconscionable strikes against the public, corruption in office- some deep, underlying civic principle of order and good will ruled it with an invisible hand, so that things would come out all right in the end. But in 1968- perhaps chiefly because of the infamous teachers strike, as shocking for the shrugging public acceptance of closed schools as for the cynical political maneuvering that caused and perpetuated it- the sinking feeling overtook many citizens that the invisible hand had disappeared, if it had ever existed and there was no longer any foundation of order.

Old establishment fading

The 1960s experienced a rapid loss of faith in the old Wall Street establishment. This parallels the rise of fintech entrepreneurs and bitcoin in the modern world.

The loss of power and influence of the Old Establishment was partly its own fault.  Morally and intellectually, it seemed to be in decline. 

Some people still believed in aura of respectability resulted in falling for major scams. 

The Old Establishment of US investing had fallen for its own fading mystique.  Believing, with tribal faith that can only be called touching, that no member of the club could make a serious mistake, the members had followed each other blindly into the crudest of traps and had paid the price for their folly.  

Wall Street provided a climate that permitted a trend to feed on itself; the quite traditional levers of Wall Street success , personal contacts and the possession of privileged information now worked in favor of the young money manager or brokerage deal-maker and against the old one.   

But the revolution in Wall Street faiths and values that the youth binge briefly produced was a necessary corrective to some venerable shibboleths, an antithesis that might later lead to a synthesis.  It taught Wall Street that old men make mistakes too.

Market Rising on a Wall of Worry

The 1960s wall of worry seems more dramatic than the Trump administration

And all through the stormy course of 1967 and 1968, when things had been coming apart and it had seemed that the center really couldn’t hold- the rising national economic crisis culminating in a day when the dollar was unredeemable in Paris, the Martin Luther King and Robert Kennedy Assassinations, the shame of the Chicago Democratic convention, the rising tempo of student riots– the silly market had gone its merry way, heedlessly soaring upward as if everything were O.K. or would surely come out O.K. as mindlessly, maniacally euphoric as a Japanese beetle in July. Or as a doomed man enjoying his last meal. One could only ask: Did Wall Street, for all its gutter shrewdness, have the slightest idea what was really going on?

After Kennedy Inaugural:

By mid-February the stock averages were up some 15 percent from their October lows, and there began to be talk of a “Kennedy Boom”.  Not even the Cuban Bay of Pigs disaster in mid-April could stem the tide; a kweek after Castro’s men drove out the CIA backed invaders, the market was up almost 25 percent, the fastest recovery since the end of World War II

Its interesting how a wall of worry can lead to a bubble.  Investors turned from blue chips to more speculative issues.

Yet in another perhaps more important perspective, the stock market was not more closely related to American life in 1970 than in 1929; in fac t the contrary was true. In 1929, America -the America of history , the one described in books and newspapers and popular magazines and even in the intellectual journals- had been essentially still a small country consisting of people possessing either land or money.  Everybody else had been simply considered beneath notice. As the stories consisting of slaves is ignored in the idyllic histories of democracy in ancient Greece, so the majority of the poor was ignored in the social histories of America circa 1929.

Conglomerate Craze (thematic investing)

The rise of business schools made business into profession.  Business schools taught that management ability was an absolute quality- not determined by business.  Federal anti trust laws forbade most mergers between companies in same line of business- forced companies to be exogamous if they wanted to merge at all (ie empire building). 

Investors became obsessed with the “conglomerate” theme.  Conglomerates earned high valuations compared to the rest of the stock market. 

On the managers:

Each of them felt  that his company was a mesh of corporate and managerial genius in which diverse lines of endeavor- producing, say, ice cream, cement and flagpoles- were subtly welded together by some abstruse metaphysical principle so refined as to be invisible to the vulgar eye.  Other diversified companies, each such genius acknowledged , were conglomerates; but not his own.

(note this happened before in the 1920s, where it became common for companies to buy others – it happens when companies have spare money, its discussed there is the pyramiding chapter of Securities Analysis.)

New Metrics and Goodharts Law

Never before had a company’s reported earnings per share meant so much in terms of its stock-market price. 

Narratives about metrics matter as much as the metrics themselves. For the first time in US market history Earnings Per Share became a significant factor in the 1960s. During the 1920s, investors obsessed with dividends more than earnings, but after World War II, high taxes on ordinary income, and favored tax treatment of capital gains, shifted attention from dividends to earnings. The average novice investor would only focus on market price and net profit per share- the famous bottom line of the quarterly earnings report’s financial summary. This obsession with earnings per share fueled the conglomerate boom. Under the accounting rules at the time, merging allowed companies to capitalize on stock market value and boost EPS.

Earnings per share of the new, merged company in the first year of its life come out higher than those of the acquiring company in the previous year, even though neither company does any more business than before.  There is an apparent growth in earnings that is entirely an optical illusion. Moreover, under accounting procedures of the late nineteen sixties, a merger could generally be recorded in either of two ways- as a purchase of one company by another, or as a simple pooling of the combined resources.  In many cases , the current earnings of the combined company came out quite differently under the two methods, and it was understandable that the company’s accountants were inclined to choose arbitrarily the method that gave the more cheerful result.

Goodharts law definitely applies.  Once companies focused on boosting EPS, it ceased to be a good metric of actual company performance. 

As the boom continued, companies would find more aggressive ways to make acquisitions.  For example, companies could buy others with debentures, transfering cost to books of taken over company.  Additionally, they could throw in other goodies, like warrants.

Sometimes, debentures alone were not thought to be sufficient inducement to the stockholders of companies being sought for acquisition, and in such cases conglomerates augmented the tender offer with a variety of extras, of which the principal ones were warrants and convertibility What Professor Warren Law of Harvard called “the underwear of corporate securities.”

Acquirers deliberately made acquisition terms complex:

Often it was plainly intended to throw dust in the eyes of the average investor with his tunnel vision trained on the bottom line. 

This era gave rise to modern corporate governance techniques- takeover defense,  poison pills, buying other companies, changing charter, staggered terms of directors.   public proxy campaigns, etc. Additionally the roots of modern rust belt economic problems probably started during the conglomerate era:

Conglomerates’ headquarters were mostly on the two coasts , and often enough their corporate victims resided in the cities in between. The result was the repeated reduction of mid-American cities oldest established industries from independent ventures to subsidiaries of conglomerate spiderwebs based in New York or Los Angeles. Pittsburgh for one, lost about a dozen important corporations through conglomerate mergers. To Andrew Carnegie’s city, cradle of the steel industry, the conglomerate phenomenon was like a tornado that left it battered and shaken; it is unlikely to think of itself in quite the old way ever again.

Alternative Investments

There was also an alternative investments boom in the 1960s.

The funds had queer excrescences, exotic offshoot plants deriving from the same root, and the oddest of these was the hedge fund.

Some of the shadiest funds were those that nominally focused on economic development. These funds were marketed the same way modern ESG funds are marketed. In particular, there was the Mates Fund, run by Fred Mates. They employed various valuation shenanigans with unlisted stock, the same way some of the venture fund space is doing these days.

A tiny conglomerate called Omega Equities privately sold the Mates Fund 300,000 shares of common stock at $3.25 a share. Omega was then selling on the over-the counter-market at around 24, so the price was apparently an almost unbelievable bargain. But only apparently. The Omega shares that Mates bought were not registered with the SEC , and therfore could not legally be resold until they had been through such registration; for practical purposes, they were unmarketable.

This was known as letter value. Mates Fund carried these shares using the marking down the OTC price by ⅓ to $16 per share- a huge profit showed on the Mates Fund books. This was common practice in 1968, only much later in 1969 did SEC crack down…
In December 1968, SEC suspended Omega stock:

The immediate result was as disastrous for Mates as it was predictable. Many Mates Fund shareholders demanded redemption of their shares in cash, and this demand, because of the unmarketability of all Omega shares was one that the fund could not possibly meet. Technically, it had failed. But the SEC was in no mood to force it out of business and thus damage its 3,300 stockholders. Mates hastily applied to the SEC for permission to suspend redemptions for an indefinite period and the SEC hastily and meekly complied.
The fund industry shuttered. This was purest heresy; the fundamental right of share redemption without question at any time was the cornerstone of the whole $50 billion business, analogous to the right of a bank depositor to draw from his checking account; now the cornerstone was cracked, the letter stock deception suddenly exposed, and dozens of other funds came under suspicion of having similar concealed weaknesses.

Omega was later marked down to 50 cents a share by summer of 1969. By 1972, there were still on the Mates funds books- at a nickel a share. Letter stock was a faustian bargain.
A character named Bernie Cornfield also managed shady offshore funds that were marketed for their social justice value.

Its investment record was mediocre, in part because of the lavish overcompensation of its salesmen- at the expense of course , of the customers…. By early 1969, the “offshore” fund arena included about seventy firms, some of them quietly run by outwardly respectable WAll Street houses, with well over $3 billion in the American stock market, all, presumably, for the benefit of underprivileged foreing investors but more palpably for that of a ravenous rat pack of newly overprivileged American entrepreneurs

Fund Liquidity Mismatches

The founder of Gramco had interned at Whitehouse  during Kennedy years. He hired many former Kennedy administration people including ambassadors, etc. this helped with marketing.  It didn’t help with delivering results to investors.

…. A mutual fund that would invest chiefly in American real estate , rather than American stocks. Thus he would bring to his investors the benefits of the apparently endless upward trend in land and property values.  The SEC frowned on such funds because of real estate inherent lack of liquidity, but no matter; Barish planned to “invent” a new thing called “liquid real estate” ; and besides he proposed to escape the disapproving surveillance of the SEC entirely by setting up his fund in the Bahamas and selling its shares only outside the United STates, presumably to non-Americans.   

Running a real-estate fund gave the managers a golden opportunity to do what the managers of a stock fund legally could not, that is to serve as their own brokers in their transactions and collect commissions accordingly.  Moreover the fact that real estate could be bought largely on credit, as stocks could not make it possible for them to take in remarkably high commissions in relation to the amount of money invested.  

Rise of Scammers

Bull markets give rise to fraud. Scammers always make interesting characters. The author’s writing style is hilarious in places. He should have written a screenplay:

Guterma was in the mold of the traditional international cheat of spy stories- an elusive man of uncertain national origin whose speech accent sometimes suggested Old Russia, sometimes the Lower East Side of New York, sometimes the American Deep South. On occasion he presented himself as a Russian from Irkutsk, at other times as an American named McSande. Whoever he was and wherever he came from, he apparently made his first fortune in the Phillipines during World War II, running a gambling casino that catered to occupying Japanese serviceman. After that he married an American woman, survived a charge of having collaborated with the enemy, and in 1950, moved to the United States. During the succeeding decade he controlled, and systematically looted, more than a dozen substantial American companies, including listed on the New York Stock Exchange and a leading radio network, the Mutual Broadcasting Company. After some sour dealis in 1957 and 1958 left him short of cash, he was reduced to taking money from General Rafael Trujillo of the Domincan Republic in return for promises (never fulfilled to boost the Trujillo regime on Mutual. The law caught up with him, in September, 1959, he was indicted for fraud, stock manipulation, violation of federal banking laws and failure to register as the agne of a foreign government; a few months later he went to prison and vanished unmourned from the business scene.

Another (different) character fitting with the classic repeating narrative 

A smooth operator with a streak of the gambler; a company more interested in attracting investors than in making real profits; the resort to tricky accounting; the eager complicity of long-established supposedly conservative investing institutions, the desperation plunge in a gambling casino at the last minute; the need for massive central bank action to localize the disaster; and finally, reform measures instituted too late – we will see all of these elements reproduced with uncanny faithfulness in United States financial scandals and mishaps in the nineteen sixties.

In the sixties, as Wall Street moved rapidly through the revolution that made it the first genuinely public securities market in the world’s history, the crucial new element of stock trading was the financial and accounting naivete of the millions of new investors. Naivete led to a search for simplicity and simplicity as we have seen, was found in focusing attention on the bottom line. And this simplified view of business performance soon led accountants, including some of the best to descend almost unawares from their pedestals of disinterestedness to become at times the willing accomplices of ruthless corporate managements and essentially dishonest promoters.

Fiduciary duty?

Most financial services employees aren’t fraudsters. But all face conflicts of interest. These conflicts of interest are especially acute in the brokerage business. Francis C Huntington was a clergyman working as a curate at Wall Street’s Trinity Church- it was a challenging ministry that gave him inside perspective on conflicts faced in the business.

Put bluntly, Huntintgton found that many brokers felt they were under pressure to dis-serve their customers in order to increase their own and their firms’ profits. No amount of formal management caveats against speculation or investment without investigation could paper over the essential conflict of interest: it seemed to be built into the business as practiced. IF you really want to know what bugs me, “ a broker told Huntington. “Its’ the fact that I take a client out of General Motors and put him in Chrysler- when in my heart I feel that he probably shouldn’t be in any motors at all.

Back office was really screwed up:

Its shocking how fragile the plumbing of the financial system has always been. 

The rule of thumb in Wall Street in 1968 held that an acceptable level of fails on New York Stock Exchange transactions at any given time (“acceptable” the bemused observer must conclude, in relative terms) amounted to one billion dollar’s worth. 

Epic number of fails one year:

As the autumn continued and the public reached maniacally for easy money while Wall Street raked in the commision , the downtown situation took on the quality of a play by Pinter on Beckett.  One Wall Streeter told about stock certificates turning up “stuffed behind pipes in ladies’ rooms , at the bottom of trash baskets, in the backs of filing cabinets with old letters. 

This all sounds horrible,  but consider the modern system of old software cap tables on old spreadsheets,  rehypothecation, etc… are we really not closer to an epic disaster these days?  

Investors who bought one hundred shares of a stock might receive in the mail one shares, or a thousand shares, or a hundred shares of some other stock, or , frequently, an empty envelope. Sixty-dollar-a-week backroom employees, tempted by the presence of negotiable securities piled at random on every level surface round them, stole millions of dollars’ worth.

Eliminating stock certificates proved difficult because people were attached to the old ways of doing things:

Called for something more than planning or expense and something that perhaps no amount of wisdom could have accomplished- finding a way of persuading the cautious and possession-proud American stockholder that a monthly statement from his broker showing his holdings was an adequate substitute for the embossed stock certificates that he kept locked so lovingly in his bank safe-deposit box.

… Rites of passage and symbols of possession are not readily given up, even in times like 1968 when the rites and symbols themselves stand in danger of destroying what they symbolize. Some states made certificates mandatory by law.

Too much drug use probably made things worse in the 1960s:

It is that a moment arrived in Wall Street in 1968 when the necessary minions of industrial life found their work, or their lives, or both so unfulfilling as to drive them to chemical escape, that in its turn, made them incapable of performing the necessary work. The life sustaining cycle of commerce had been broken.

Fragile Financial Engineering

There were Minsky style problems in the commercial paper market, and the collapse of Penn Central Railroad was reminiscent of the problems faced by GE during the 2009 Financial Crisis.

…. the supposedly unshakable Penn Central Railroad Company, suffering from management that in retrospect would appear to have been inept beyond belief, suddenly collapsed into bankruptcy. This time, something more economically palpable was at stake than the general loss of confidence in the nation’s policies. What was at stake was the survival of the “commercial paper market,” a revolving credit system among corporations in which they borrow money short-term and unsecured, usually from each other, and in which in June 1970 there was the vast sum of $40 billion. With the Penn Central’s paper in default , the danger was that the unfortunate companies that had lent tens of millions to the Penn Central might themselves be unable to meet their obligations, and that other commercial papers might suddenly renew their loans, leading to a chain reaction ending in a classic national money panic, and of course, a stock-market collapse.

Violent Shift in Narrative

The 1960s also illustrated how violent shifts in narratives can alter stock valuations within the stock market:

For a while it was standard narrative that war was good for wall street- occaisional “peace scares” when rumors of an end to Vietnam came about, but always passed, blue chips defense contractors continued march upwards.

But sometime in late 1967 Wall Street had come to decide that the Vietnam war was bad business , and had broken the all precedent by turning decisively on war and bullish on peace. The defense contractors were no longer blue chips; one of the biggest Lockheed, would soon be in danger of bankruptcy. The peace initiatives of early 1968 had caused or contributed to a huge bull market on record volume. An unheard of phenomenon ; an old shame of Wall Street ended, to sighs of relief from financiers with consciences.

See Narrative Economics: How Stories Go Viral and Drive Major Economic Events

The shift in Wall Street sentiment coincided with the shift in public anti war sentiment.  

Hippies and the efficient market theory:

Wall Street was actually kind of ignored by leftists at the time- it was a political non issues. Most stopped caring or paying attention to in. However there was a a protest where protesters threw a bunch of dollar bills of from the visitors gallery . The stock exchange responded by putting up bullet proof glass to protect it.

Retail Always Last

The mutual fund industry had a meteoric rise:

As recently as the end of World War II, the funds had been a trivial element in securities trading, with just over $1 billion under management; now the figure was $35 billion and rising fast….

Retail investors are always the last to get in before a crash.

If one fact is glaringly clear in stock-market history, it is that a new issues craze is always the last stage of a dangerous boom – a warning of impending disaster almost as infallible as Cheyne-Stokes breathing is a warning of impending death. But not so inexorable; fif heads could be cooler nad memories longer, investors both large and small, professional and amateur , might ward off danger by reading the signs, eschewing the new issues and lightening their commitments generally. But investors like other human beings, tragically repeat their mistakes; when the danger signs are plain, the lure of easy money blanks their memories and dissipates their calm. In 1929 shooters were jerrybuilt investment trusts like Alleghany, Shenandoah, and United Corporation. In 1961 they were tiny scientific companies put together by little clutches of glittery -eyed young PH.D.’s, wheir company names ending in “——-onics”. In 1968-1969, what a promoter needed to launch a new stock, apart from a persuasive tongue and a resourceful accountant was to have a “story”- an easily grasped concept, preferably related to some current national fad or preoccupation, that sounded as if it would lead to profits. Such stories , like most stories are best told quickly and concisely, and best of all within the name of the company itself. Were the new government Medicare and Medicaid programs pouring millions into the care of elderly person? A cunning investor could presumably get a piece of that action by buying stocks called Four Season Nursing Centers or United Convalescent Homes. Were people’s recreational expenditures soaring? Hardly coincidentally, there turned out to be a stock called International Leisure. Was concern about the environment a popular passion of the moment, why look – a stock called Responsive Environments! ……

Most retail investors invested in the last years of the boom. So they experienced the worst drawdowns when the crash occurred.

After the Bust

The inevitable bust was brutal, especially because inflation made it impossible to apply the usual policy prescriptions.

The Federal Reserve, worried about accelerating inflation, kept constricting the money supply , driving interest rates through the roof without apparently accomplishing its purpose , and there came to be a specter- confounding to classical economists- of a recession accompanied by runaway inflation, the worst of two apparently opposing worlds. The failure of the blue-chip Dow to reflect the true situation was becoming more pronounced all the time; the advanced guard of former high flyerses were already crashing not 20 percent like the Dow but 50 to 75 percent, and even more….
The Stock Exchange, which for some years had used the motto- “Own your share in American business, “suddenly dropped it in 1969, without explanation.

Having graduated during the recession, this sounds familiar: 

Most large industrial companies began cutting their campus recruiting visits sharply, some cutting them in half. The advanced-degree job market became a small disaster area, with new Ph.D holders taking jobs , when they could find them, at half the going rates of the years before.

Fragile Brokerage Industry

The way Wall Street financed itself became exposed after trend of bull market. Simultaneous drop in stock prices in stock prices and trading volume 1969-1970 :

History, in its economic aspect, seemed to have become a recurring nightmare from which the United States could not awake. But for Wall Street, the nightmare this time had a new dimension. In the second half of 1970, Wall Street itself, as distinguished from its hapless customers, came within a hair of plunging into irretrievable bankruptcy, and the American securities market into full-fledged socialism.

The brokerage industry was incredibly fragile. Brokerages weren’t allowed to do standard IPOs they were all heavy leveraged with very little net capital. Policy changes ultimately fixed some of the problems, but only after the entire edifice came within inches of collapse.

Yet in the latter nineteen sixties the capital structure of Wall Street itself became unsafe and unsound to a degree that, when hard times struck, it was revealed as nothing less than a scandal. It was more than a case of a physician being unable to heal itself; it was a case of a physician habitually and systematically flouting everything he had learned at medical school, including the simplest rules of personal daily hygiene.

Carnage was serious:

One hundred firms vanished through merger or liquidation in a year. 40,000 customer accounts tied up in firms under liquidation, unable to get cash or securities. Firms forced to pay into rudimentary trust fund.Finally led to legislation to create SIPC.

Much later, the elimination of fixed commissions, leading to competition on price. Elimination of private club atmosphere, and turning it into actual competitive business. This of course led to its own craziness. (see serpent on the rock). Additionally, there was also the breakdown of the gold standard, which gave rise to a great era of macro investing.

Get the Full Book Here

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 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 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

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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.


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.


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.


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: