Good management teams are first and foremost good storytellers. They’re shapers of reality. I don’t care whether you’re Warren Buffett, Elon Musk or Reed Hastings. If you are the Big Guy (or Big Gal) most of your job is storytelling. You spend most of your time telling stories to your stakeholders. Employees. Customers. Investors.
What’s truly amazing about Reed Hastings’s ability as a CEO/storyteller is how he’s managed to make Netflix’s free cash flow burn irrelevant. Here’s a screenshot directly from the company website:
This is a company burning billions in cash a year, that is utterly dependent on the amity and goodwill of the capital markets (specifically, the high yield debt market) to support its continued existence.
And no one cares.
The reason no one cares is Reed Hastings is a great CEO/storyteller. He’s convinced the market it’s subscriber growth and not free cash flow that matters.
Well, yesterday NFLX (badly) missed expectations for subscriber growth. The result?
Live by the sword, die by the sword, as the saying goes. This is the kind of reaction you get when you train the market on a certain narrative, and then that narrative is called into question. The market freaks out.
This is something short sellers understand deeply and intuitively. If you are a short seller who doesn’t understand this deeply and intuitively, you’re not going to last very long.
A short needs to understand the narrative driving a stock. The time to short a stock is when the narrative breaks. When a narrative breaks, investors start casting around, looking for a new narrative. If the CEO can’t get control of the narrative again, they might start to fixate on things like profitability and cash flows and leverage.
Of course, a good management team will have a new narrative ready to go to replace the old one. In NFLX’s case, they are talking about the limitations of their internal forecasting methods. Short selling is a hard life.
I literally have no opinion on NFLX’s subscriber growth numbers. But I do understand the narrative around them, and the purpose it serves.
Once you start looking for this stuff, you see it everywhere. Tesla is the best example, but it’s a more controversial stock than NFLX. The reason Elon Musk is coming apart at the seams is he’s losing control of TSLA’s narrative. That’s bad for TSLA, which is going to have to pay down or refi about $7 billion worth of debt in the next couple of years.
For these large cap cash incinerators, narrative is a matter of life and death.
The world is a complicated place. A good way of attacking that complexity is to view the world as a nested series of games and meta-games.
Ben Hunt at Epsilon Theory wrote an excellent post about meta-games in financial markets a while back, specifically in the context of financial innovation. While I’m going to take a slightly different angle here, his illustration of how a meta-game works is useful as a jumping off point.
It involves the coyotes that “skirmish” with the residents of his town:
What’s the meta-game? It’s the game of games. It’s the larger social game where this little game of aggression and dominance with my wife played out. The meta-game for coyotes is how to stay alive in pockets of dense woods while surrounded by increasingly domesticated humans who are increasingly fearful of anything and everything that is actually untamed and natural. A strategy of Skirmish and scheming feints and counter-feints is something that coyotes are really good at. They will “win” every time they play this individual mini-game with domesticated dogs and domesticated humans shaking coffee cans half-filled with coins. But it is a suicidal strategy for the meta-game. As in literally suicidal. As in you will be killed by the animal control officer who HATES the idea of taking you out but is REQUIRED to do it because there’s an angry posse of families who just moved into town from the city and are AGHAST at the notion that they share these woods with creatures that actually have fangs and claws.
For simplicity’s sake, I’m going to write about four interrelated layers of “games” that influence financial markets. Imagine we are looking at a set of Russian nesting dolls, like the ones in the image at top, and we are working from the innermost layer out. Each successive layer is more expansive and subsumes all the preceding layers.
The layers/ games are:
1. The Security Selection Game
2. The Asset Allocation Game
3. The Economic Policy Game
4. The Socio-Political Power Game
Each of these games is connected to the others through various linkages and feedback loops.
This is the most straightforward, and, in many ways, the most banal of the games we play involving financial markets. It’s the game stock pickers play, and really the game anyone who is buying and selling assets based on price fluctuations or deviations from estimates of intrinsic value is playing. This is ultimately just an exercise in buying low and selling high, though you can dress it up any way you like.
While it often looks a lot like speculation and gambling, there is a real purpose to all this: price discovery and liquidity provision. The Security Selection Game greases the wheels of the market machine. However, it’s the least consequential of the games we will discuss in this post.
Asset Allocation is the game individuals, institutions and their financial advisors play as they endeavor to preserve and grow wealth over time. People often confuse the Security Selection Game with the Asset Allocation Game. Index funds and ETFs haven’t helped this confusion, since they are more or less securitizations of broad asset classes.
At its core, the Asset Allocation Game is about matching assets and liabilities. This is true whether you are an individual investor or a pension plan or an endowment. Personally, I think individual investors would be better served if they were taught to understand how saving and investing converts their human capital to financial capital, and how financial capital is then allocated to fund future liabilities (retirement, charitable bequests, etc). Unfortunately, no one has the patience for this.
The Asset Allocation Game is incredibly influential because it drives relative valuations across asset classes. As in Ben Hunt’s coyote example, you can simultaneously win at Security Selection and lose at Asset Allocation. For example, you can be overly concentrated in the “best” stock in a sector that crashes, blowing up the asset side of your balance sheet and leaving you with a large underfunded liability.
I sometimes meet people who claim they don’t think about asset allocation at all. They just pick stocks or invest in a couple of private businesses or rental properties or whatever. To which I say: show me a portfolio, or a breakout of your net worth, and I’ll show you an asset allocation.
Like it or not, we’re all playing the Asset Allocation Game.
The Economic Policy Game is played by politicians, bureaucrats, business leaders and anyone else with sociopolitical power. The goal of the Economic Policy Game is to engineer what they deem to be favorable economic outcomes. Importantly, these may or may not be “optimal” outcomes for a society as a whole.
If you are lucky, the people in power will do their best to think about optimal outcomes for society as a whole. Plenty of people would disagree with me, but I think generally the United States has been run this way. If you are unlucky, however, you’ll get people in power who are preoccupied with unproductive (yet lucrative) pursuits like looting the economy (see China, Russia, Venezuela).
The Economic Policy Game shapes the starting conditions for the Asset Allocation Game. For example, if central banks hold short-term interest rates near or below zero, that impacts everyone’s risk preferences. What we saw all over the world post-financial crisis was a “reach for yield.” Everyone with liabilities to fund had to invest in progressively riskier assets to earn any kind of return. Cash moved to corporate bonds; corporate bonds moved to high yield; high yield moved to public equity; public equity moved to private equity and venture capital. Turtles all the way down.
A more extreme example would be a country like Zimbabwe. Under Robert Mugabe the folks playing the Economic Policy Game triggered hyperinflation. In a highly inflationary environment, Asset Allocators favor real assets (preferably ones difficult for the state to confiscate). Think gold, Bitcoins and hard commodities.
This is no different than Darwin’s finches evolving in response to their environment.
Do you suppose massive, cash-incinerating companies like Uber and Tesla can somehow exist independent of their environment? No. In fact, they are products of their environment. Where would Tesla and Uber be without all kinds of long duration capital sloshing around in the retirement accounts and pension funds and sovereign wealth funds and Softbank Vision Funds of the world, desperate to eke out a couple hundred basis points of alpha?
Insolvent is where Uber and Tesla would be.
In general, western Economic Policy players want to promote asset price inflation while limiting other forms of inflation. There are both good and selfish reasons for this. The best and simultaneously most selfish reason is that, to a point, these conditions support social, political and economic stability.
However, the compound interest math also means this strategy favors capital over labor. This can create friction in society over real or perceived inequality (it doesn’t really matter which–perception is reality in the end). We’re seeing this now with the rise of populism in the developed world.
The Sociopolitical Power Game
Only the winners of the Sociopolitical Power Game get to play the Economic Policy Game. In that sense it is the most important game of all. If you are American, and naïve, you might think this is about winning elections. Sure, that is part of the game. But it’s only the tip of the proverbial iceberg.
Winning this game is really hinges on creating and controlling the narratives that shape individuals’ opinions and identities. If you are lucky as a society, the winners will create narratives that resemble empirical reality, which will lead to “progress.” But narratives aren’t required to even faintly resemble reality to be effective (it took me a long time to understand and come to grips with this).
You could not find a more perfect example of this than President Donald Trump. People who insist on “fact checking” him entirely miss the point. Donald Trump and his political base are impervious to facts, precisely because Trump is a master of creating and controlling narratives.
Ben Hunt, who writes extensively about narrative on Epsilon Theory, calls this “controlling his cartoon.” As long as there are people who find Trump’s narratives attractive, he will have their support. Facts are irrelevant. They bought the cartoon. (“I just like him,” people say)
It’s the same with Anti-Vaxxers. Scientific evidence doesn’t mean a thing to Anti-Vaxxers. If they cared even the slightest bit about scientific evidence, they wouldn’t exist in the first place!
I’m picking on Trump here because he is a particularly prominent example. The same can be said of any politician or influential figure. Barack Obama. Angela Merkel. JFK. MLK. I think MLK in particular is one of the more underrated strategists of the modern era.
Here is Sean McElwee, creator of #AbolishICE, commenting to the FT on effectively crafting and propagating narratives:
“You make maximalist demands that are rooted in a clear moral vision and you continue to make those demands until those demands are met,” said Mr McElwee. “This is an issue where activists have done a very good job of moving the discussion of what has to be done on immigration to the left very quickly.”
If you want to get very good at the Sociopolitical Power Game, you have to be willing to manipulate others at the expense of the Truth. It comes with the territory. Very often the Truth is not politically expedient, because our world is full of unpleasant tradeoffs, and people would prefer not to think about them.
I have been picking on the left a lot lately so I’ll pick on free market fundamentalists here instead. In general it is not a good idea to highlight certain features of the capitalist system to the voting public. Creative destruction, for example. In Truth, creative destruction is vital to economic growth. It ensures capital and labor are reallocated from dying enterprises to flourishing enterprises. Creative destruction performs the same function wildfires perform in nature. Good luck explaining that to the voters whose changing industries and obsolete jobs have been destroyed.
Because of all this, many people who are very good at the Sociopolitical Power Game are not actually “the face” of political movements. These are political operatives like Roger Stone and Lee Atwater, and they are more influential than you might think.
The Most Important Thing
There is a popular movement these days to get back to Enlightenment principles and the pursuit of philosophical Truth. I’m sympathetic to that movement. But I’m not sure it really helps you understand the world as it is.
In the world as it is, people don’t make decisions based on Truth with a capital T. In general, people make decisions based on: 1) how they self-identify; and 2) what will benefit them personally. Rationalization takes care of the rest.
When have you heard an unemployed manufacturing worker say, “yeah, it’s a bummer to be out of a job but in the long run the aggregate gains from trade will outweigh losses like my job”?
In the world as it is, people operate much more like players on competing “teams.” They want their team (a.k.a tribe) to win. They are not particularly concerned with reaching stable equilibria across a number of games.
And that tribal competition game is probably the most important meta-game of all.
This is a pretty amazing image, courtesy of J.P. Morgan Asset Management:
People are really starting to worry the Fed is going to invert the curve. Historically, an inverted curve (short rates above long rates) has been a pretty good recession indicator. I don’t have a particularly strong opinion about the direction of interest rates, especially now that we are above 2% on the 2-Year. But I do think this chart is telling us something.
If the curve is basically flat from 7 years on out to 30 years, that is not exactly a ringing endorsement of long-term growth and inflation prospects. I’ve heard from some fixed income people that it’s demand for long-dated paper from overseas buyers holding the 30-year yield down. I’ll buy that. But it’s still telling us something about supply and demand for capital along various time horizons.
Namely: we’ve got an awful lot of long duration capital out there looking for a home, and not enough opportunities to absorb it all.
I predict we are going to hear a lot more about Modern Monetary Theory (MMT) in the next few years. I am not particularly happy about it, but I think it is the way the cookie will crumble.
To the extent the hard left wing of the American political spectrum has coherent economic principles they are grounded in MMT. And it is the hard left and right wings of the political spectrum that have the momentum these days.
Here’s the gist of MMT:
Governments that issue their own currencies are not budget constrained. In other words, government spending is not constrained by tax revenues. As long as a government issues its own currency, it can run perpetual budget deficits of any size. A sovereign currency issuer can’t go bankrupt. The MMT people are actually right about this, and in my view this is what lends MMT a superficial degree of credibility. Because the MMT people can point to deficit hawks and say, “The Rich are lying to you!” which is a message that sells.
Since they are not budget constrained, governments can spend whatever is necessary to ensure maximum employment and an arbitrarily high standard of living for the population.To the extent tax revenues fall short of the required spending, the government will simply run a deficit. Under MMT, you really can have your cake and eat it. The government need only decide everyone is entitled to as many cakes as he wants. In fact, the only reason we don’t have MMT today is nasty, greedy Elites perpetuate the myth of balanced budgets the keep the huddled mass of The 99% in check. That’s the MMT view, anyway.
Sure, you can get down into the weeds on any number of operational details. But the above is all you really need to know to get to grips with MMT.
Why MMT Is A Bad Idea
The MMT people are absolutely correct that a sovereign government that issues its own currency cannot go bankrupt. That doesn’t mean MMT “works,” or is a particularly good idea.
Two reasons spring readily to mind:
Even with fiat money, inflation remains a constraint on government spending.A government can spend as much as it wants, as long as someone is willing to hold its liabilities (a government liability is always an asset to someone else). Yes, in theory this amount is still unlimited. The Bank of Japan, for example, has printed an extraordinary amount of money with hardly a whiff of inflation. Ultimately, the amount of money a government can print is limited by its credibility. Fiat money is a faith-based system.
When people lose faith in government liabilities (a.k.a money), they abandon them for stores of value like land, gold, bitcoin, whatever. Hyperinflation results as people try to unload their monopoly money as quickly as possible while it still has some purchasing power. I remember reading stories about Zimbabwe’s hyperinflation in the mid-2000s. Prices would rise so fast people would take the bus to work in the morning but wouldn’t be able to afford a ticket on the way home.
Now, the MMT people will argue the government can use taxation to “mop up” excess liquidity and maintain price stability. Maybe it can. Maybe it can’t. Personally I am skeptical. Regardless…
…MMT would require a massive government apparatus to administer. Let’s call this apparatus Gosplan. Under MMT, Gosplan does the following:
Decides on the appropriate standard of living for all citizens
Calibrates government spending and money creation to meet that standard of living
Allocates labor between the private and public sectors via a job guarantee program
Sets tax policy in such a way as to maintain price stability without upsetting the rest of the apple cart
Simple, right? What could possibly go wrong?
I suspect things would ultimately go about as well as they have with every other centrally planned economy in history. (spoiler: not very well)
The Enduring Appeal Of MMT
Sadly, I fear MMT will continue to get traction. It is an easy sell. Under MMT, there needn’t be any scarcity. Gosplan will ensure full employment, price stability and a fantastic standard of living. If you dare to dream, you can make it real. It’s the perfect economic platform for the populist left. If I were a hard left politician, I would be out flogging MMT at every opportunity. “Cake for everyone!” I would tell the euphoric crowds. “One for having and one for eating!”
Like socialism more broadly, MMT appears to offer a convenient “out” from some of the nastiness and brutishness of the human condition. As Will and Ariel Durant wrote in The Lessons of History:
[T]he first biological lesson of history is that life is competition. Competition is not only the life of trade, it is the trade of life–peaceful when food abounds, violent when the mouths outrun the food. Animals eat one another without qualm; civilized men consume one another by due process of law.
In theory, MMT is attractive because it eliminates certain economic risks that individuals face, allowing them to live more dignified lives. That’s an admirable goal. But here’s the thing. Risk can never be destroyed. The best you can do is lay it off on someone else. And that’s exactly what MMT would do.
Sure, MMT might nominally eliminate unpleasantness like unemployment and poverty. But the underlying risk of economic imbalances wouldn’t be reduced. Imbalances would just shift around. Most likely they would reappear in the form of supply/demand mismatches, like shortages and surpluses of certain goods, and, eventually, serious inflationary pressure.
Below are my latest factor return charts. I update these on quarterly intervals but the underlying data, from Ken French’s Data Library, lags by a month.
Not much to write home about this quarter. The divergence over the past few years between the Momentum and Market factors and the remaining, more value-oriented factors (Value (Price/Book), Operating Profitability, Conservative Investment) remains striking.
The Size factor has also performed well year-to-date. May was a particularly good month for Size (+4.78%) and Momentum (+4.02%). In traditional “style box” terms, this corresponds to small cap growth stocks.
Golf is a weird game. Playing well is actually fairly demanding physically (assuming you are walking). It requires core strength and good hand-eye coordination. But what makes golf truly weird is the mental dimension. Sure, all sports have a mental dimension. But golf is especially mental. If your head is not right, you will play terribly.
Every Shot Must Have A Purpose, by Pia Nilsson and Lynn Marriott, is described early on as “a life philosophy, not merely a golf instruction book.” It is therefore relevant for anyone engaged in any complex and mentally demanding endeavor (read: investing). Given the nature of this blog, I’m going to focus on the broader relevance of the ideas in the book.
There are a handful of Big Ideas in this book:
Focus on process, not outcome
Learn to bring yourself from heightened emotional states back to neutral
Trust your swing. It is your signature.
All of this is relevant for investors. Even the part about trusting your swing. I’ll take them in reverse order.
Trust Your Swing
On trusting your swing, Nilsson and Marriott write:
If you can hit the shots you want under pressure, your swing is working. What is important is to make up your mind what swing you believe in, and to have the discipline not to abandon that belief because of a bad round or two. To be in “search-and-scan” mode never works over time. Find your swing, trust it, and stay committed to it.
For the investor, your “swing” is your investing discipline. It is the value creation mechanism(s) that will compound the value of your capital over time.
Classical Ben Graham value investing is a swing form. Munger and Buffett-style value investing is a swing form. Momentum investing is a swing form. All of these swing forms “work” because they are fundamentally sound in terms of economic principles and investor behavior. Just like the golf swing “works” because it is grounded in the laws of physics.
What does not work very well is trying to time different styles to chase “what’s working” at a given point in time. This is the equivalent of trying to rebuild your golf swing from scratch after every round where you score poorly. Both are a recipe for poor future performance.
Bring Yourself Back To Neutral
It is fun to take a pitching wedge from 90 yards out and land a perfect strike six feet from the pin. When you hit a shot like that, you literally get high. But when you chunk a five iron thirty-five yards from a perfect lie in the middle of the fairway, you crash.
Experiencing wild emotional swings is not a recipe for consistent golf.
Likewise in investing, you get high when a stock doubles in three months. You crash when a name halves on some seemingly random exogenous event.
How many times have you hit your tee shot into the trees and then, in a fit of anger, tried to do too much with your second shot and ended up making a triple bogey? The disappointment with the drive leads you to attempt to erase the poor shot with one swing. And we all know how that works out. More often than not, a gamble is greeted with a ball clunking off a tree or remaining in the rough.
The frustrating thing is that on many of those occasions, when you looked back at the round you wondered why you didn’t just pitch back to the fairway and settle for a bogey–or maybe a one-putt par. Anger opens the door to a variety of mistakes: bad decisions, hesitant swings, rushed tempo, and even not seeing the line to the target clearly.
Consistent performance starts internally, with how you regulate your emotions. The goal isn’t to become a robot impervious to emotion. I don’t think such a thing is possible. And even if it is, it’s certainly not healthy. The goal is that whether you hit a good shot or a bad shot (whether an investment is a winner or a loser) you are able to bring yourself back to a neutral state of focus, where your attention is on executing the shot in front of you.
Focus On Process, Not Outcome
One of the reasons golfers–professionals as well as recreational players–can’t take their games from the range to the course is that, in the current practice culture, they are two different experiences. Just as we try to unify the mental with the mechanical aspects of the game, we also must try to erase the line between practice and playing. We want to teach you to play when you practice and practice when you play. In the end, it all has to be about executing golf shots with total commitment when it matters most. To do this you have to learn that playing needs to be a process focus and not score focus.
It’s not that different in investing. Particularly in situations where you have to make a buy/sell/hold decision under pressure. Thinking about the score (returns) doesn’t do any good here. If anything, you’ll fall victim to the disposition effect.
Who Should Read This Book
Anyone trying to improve her golf game should read this book. Investors and other professionals who golf (regardless of skill level–I think I am a 25 handicap) can also benefit from applying these concepts to areas outside the game. I would not recommend the book to non-golfers, as it’s hard to relate if you haven’t struggled through learning the game or fought through some difficult rounds.