Painter: People think the plague is a punishment from God. Crowds wander the land lashing each other to please the Lord.
Jöns: Lashing each other?
Painter: Yes, it’s a horrible sight. You feel like hiding when they pass.
Jöns: Give me a gin. I’ve had nothing but water. I feel as thirsty as a desert camel.
Painter: Scared after all?
—The Seventh Seal
The Seventh Seal is a film about the silence of God. It’s set in medieval Europe, during the Plague and the Crusades. The protagonist, the knight Antonius Block, spends the film looking for signs of God’s existence. He stalls Death with a now-iconic game of chess.
They just don’t make ’em like this anymore, folks. We’re too clever for movies that take religion so seriously. So literally. It’s all too earnest for The Age of Snark.
Anyway, as much as it’s about Antonious Block’s existential crisis, The Seventh Seal is about medieval European society’s response to the apocalyptic destruction wrought by the plague. And boy, it ain’t pretty. Inquisitors burn witches. Charlatan theologians prey on the weak and the naive. Flagellants wander from town to town, putting on bizarre religious displays.
Observing a procession of flagellants, Block’s squire mutters:
Is this what we offer to modern men’s minds? Do they really believe we will take all of this seriously?
As investors, we too wrestle with God’s silence. It’s not war or plague that shakes our faith but changes in the structure and behavior of financial markets. How do we respond?
In many circles–particularly those of the fundamental discretionary persuasion–there has emerged a kind of millenarian cult mindset. We endure this suffering to purge our sins. To mortify the flesh. When The Great Reckoning arrives, the Algos and the Indexers and the Risk Parity Heretics shall be cast into the flames. And we, The True Investors, shall emerge from the hellfire unblemished, as did Buffett after the Dot Com Bubble.
Ricky Roma: I’m going to tell you something. Your life is your own. You have a contract with your wife? You have certain things you do jointly? Bond there. And there are other things, and those things are yours. And you needn’t feel ashamed, you needn’t feel that you’re being untrue. Or that *she* would abandon you if she knew. This is *your* life.
—Glengarry Glen Ross
Ricky Roma is the best salesman in the office. He’s at the top of the Cadillac board. And that’s no accident. Ricky Roma is a masterful storyteller. He knows all about needful things.
Ricky Roma’s stories appeal to us on an emotional level. But there are other, equally effective storytellers out there appealing to us on an intellectual level.
Much of what we think of as “financial analysis” is this second type of storytelling. Finance people tend to look down on writers and artists, but I can assure you there’s no less creativity involved in financial analysis. If you’ve ever built a discounted cash flow model, or an LBO model, you’re well aware of the enormous number of assumptions embedded in the things. Choosing a discount rate isn’t so different from a painter mixing colors on her palette.
Granted, that’s a fairly subtle example. Storytelling masquerading as analysis is much more obvious (not to mention silly) in the context of “portfolio update” and “strategy” meetings.
These are the meetings where a PM or strategist sits down with a slide deck and tells you about the state of a portfolio or the world. Make no mistake. There’s nothing analytical or scientific about this process. It’s theatre. The slide deck and the charts are just props to be used in the performance.
If the PM or strategist is a value guy, the story will be about mean reversion.
If the PM or strategist is a trend guy, the story will be about momentum.
The odds you’ll derive any decision-useful information from a performance like this are slim. To the extent there’s decision-useful information embedded in the performance, it’s in the metatext—the story of the story.
For example, there isn’t decision-useful insight embedded in a CE webinar about how floating rate securities have performed historically in rising rate environments. This is what I’d call a bagholder webinar. Same with sell-side research.
You don’t derive decision-useful insight from naively sitting through bagholder webinars and naively reading bagholder-oriented research. Do you honestly believe these firms produce research out of a deep, unwavering commitment to the Search For Truth?
No. Research groups are cost centers. They produce reports and exhibits in support of their salespeople. So always ask yourself: “why am I seeing this NOW?”
The first-order answer is usually that someone’s trying to sell you something. That firm hosting the CE webinar knows you know we’re in a rising rate environment. They know you’re worried about what it means for fixed income portfolios. Oh, look, they just happen to run a floating rate fund.
This may be a useful insight. But it’s also a trivial insight. Just because someone’s selling you something doesn’t mean it’s a bad deal.
More valuable insight comes from understanding the issuers of floating rate paper (via the sell-side) also know the firm running the floating rate strategy knows you’re worried about what rising rates mean for fixed income portfolios.
Put another way, what you need to address in your analysis isn’t how the asset class has performed historically. You need to address how the asset class might perform based on how deals are priced, structured and sold today.
Deal pricing is predominantly influenced by buy-side appetite for various types of securities. From there, it’s a matter of supply and demand.
The stories told by PMs and strategists and the sell-side and everyone else in the market ecosystem are told to influence our appetites for different cash flow profiles.
It’s storytelling that drives demand.
It’s storytelling that closes deals.
Remember this next time you’re parsing pro forma financial statements; or some chart illustrating the value/growth performance divergence; or a scatter plot showing how some asset class (*ahem* private equity) dominates everything else on a risk-adjusted basis.
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.
This game 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.
A friend and I have been having a running conversation about the “post-truth era” and bias in the media. This post is an attempt to pull the ideas from those conversations together into a kind of mental model.
Essentially there are three issues in play here: epistemic uncertainty (the problem of induction), cognitive biases and incentive systems.
The first two help explain why otherwise intelligent and well-meaning people can come to inhabit echo chambers when they otherwise seek to reason objectively. Incentive systems then reinforce the sub-optimal behavior of well-meaning people and assist opportunists and charlatans in spreading outright falsehoods.
This post is not meant to address opportunists and charlatans as their motives are things like wealth, power and ideological fanaticism. For these individuals the truth is simply an inconvenient speed bump along the road to power. Rather, I am interested in how the uncertainty inherent in scientific reasoning leaves openings for multiple truths and seemingly contradictory bodies of evidence.
How can we know a thing is true in the first place? That seems like a good place to start.
Broadly speaking, we can reason deductively or inductively. Deductive reasoning is a process that arrives at a “logically certain conclusion.” Deductive reasoning is what you do in math class. The beauty of mathematics, which I did not properly appreciate as a kid, is that it is about the only discipline where you can know with certainty when you are right. Your conclusion must follow inevitably from your premises. It cannot be otherwise.
Inductive reasoning, on the other hand, takes specific observations and then infers general rules. Importantly, the scientific method is a form of inductive reasoning. All of the social sciences, including economics, utilize inductive reasoning. Inductive reasoning is subject to the so-called “problem of induction.” Namely: inferences are not “logically certain.”
The classic example involves swans. For a long time people believed all swans were white. This was an inference based on the fact that in every recorded observation of a swan, the swan had been white. Critically, this did not prove all swans were white. In order to prove all swans were white, you would have to observe every swan in existence, every swan that had ever existed, and every swan that ever would exist. That is of course impossible. And in fact, as soon as someone discovered a black swan (in Australia in 1697), the inference that all swans were white was immediately proven false.
That’s not to say the inference was a bad one. It was perfectly reasonable given the available data. You see how this presents issues for science, and any other truth-seeking endeavors. Even “good science” is often wrong.
If you have spent any time reading scientific research, you are familiar with the way hypotheses are formulated and tested. It is never a question of “true or false.” It is a question of “whether the null hypothesis can be rejected at such-and-such a confidence interval.”
The probabilistic nature of induction results creates epistemic uncertainty. In that sense, there is no post-truth era. There has never really been an era of truth, either. Science has never really given us truth. It’s given us inferences, some of which have withstood many years of repeated testing (evolution, Newton’s laws, etc.), and to which we’ve assigned extremely high levels of confidence. In other words: we are pretty damn sure some things are true. Sure enough we can do things like send satellites out of our solar system. But it’s still not logical certainty.
In other areas, science has given us inferences where confidence levels are much lower, or where there is significant debate over whether the inference if of any significance at all. Many scientific studies don’t replicate.
The point of this is not to argue we should junk science or inductive reasoning. It’s to show how even if two parties use scientific reasoning in good faith and with the exact same methodology, they might arrive at different conclusions. How do you resolve the conflict?
To function properly, the scientific method requires friction. Replication of results in particular is critical. However, when we layer on cognitive biases and political and economic incentives, scientific inqiuiry and other inductive reasoning processes become distorted.
Humans are funny creatures. Our brains evolved to deal with certain specific problems. It was not that long ago that the issues of the day were mainly things like: “can I eat this mushroom without dying?” and “that animal looks like it wants to eat me.”
Evolution did not optimize human brains for analyzing collateralized loan obligations.
I am not going to rehash the literature on cognitive biases here. If you are interested in a deep dive you should read Thinking, Fast and Slow, by Daniel Kahneman. Rather, I want to mention one bias in particular: confirmation bias.
Instead of looking for evidence that their inferences are false, people look for evidence that confirms them. The Wiki for confirmation bias calls it “a systematic error of inductive reasoning.” There is a saying among quants that if you torture data long enough it will say whatever you want it to. These days we have more data than ever at our fingertips, as well as new and exciting torture methods.
Importantly, confirmation bias does not represent a conscious decision to lie or deceive. People who consciously manipulate data to support a hypothesis they know ex ante to be false are opportunists and charlatans. We are not concerned with them here.
People aren’t evil or stupid for exhibiting confirmation bias. They just do. Intelligent people have to be especially careful about confirmation bias. They will be extra unconsciously clever about it.
You can probably see how combining this with inductive reasoning can be problematic. It creates a situation where everyone has “their” facts. What’s more, most people involved in research and reporting operate within incentive systems that encourage confirmation bias rather than mitigate it.
If people tend to seek out information confirming their views, it is only logical that media businesses pander to that tendency. The media business is first and foremost an attention business. Either you have people’s attention or you don’t. If you don’t, the subscribers stop paying and the advertisers don’t want to be on your platform and pretty soon you are out of business. It behooves you to serve up the kinds of stories your readers like reading, and that align with their worldviews.
Likewise academics face their own pressures to conform with peers. Academic departments are subject to the same power games and politics as corporate boardrooms. Reputation matters. Particularly given the importance of tenure to young faculty. Also, if you are an academic star who has built a 40-year reputation on the back of a particular theory, how much incentive do you have to want to try and poke holes in that? If you think these dynamics don’t impact behavior, you don’t know very much about human behavior.
Closer to home for this blog, at hedge funds and mutual funds analysts often receive bonuses based on how their ideas perform once they are in a portfolio. But what if you are the analyst covering a weak opportunity set? The right thing to do is throw up your hands and say, “everything I am looking at sucks.” But if you go that route you can look forward to no bonus and possibly being fired. So instead you will sugar coat the least bad ideas and try to get them into the book.
Putting It All Together
So here we have it, from start to finish:
Many forms of “knowing,” including the scientific method, are forms of inductive reasoning. Inductive inferences are subject to uncertainty and potential falsification. This means there is always an opening for doubt or contradictory evidence. We accept certain scientific principles as true, but they are not actually logical certainties. Truth in the sense of logical certainty is not as common as many people think.
Due to cognitive biases, especially confirmation bias, people distort the process of scientific inquiry. Rather than seek information that could falsify their existing beliefs (the correct approach), they seek out information that confirms them. People have “their facts,” which they can back up with evidence, which in turn creates multiple, plausible versions of “the truth.”
Economically, media companies are incentivized to appeal to peoples’ cognitive biases. The economics of media incentivize a continuous feedback loop between content producers and consumers. Academics and other researchers are also incentivized to confirm their beliefs due to issues of reputation, professional advancement and compensation.
In craps the best bet on the table (other than Odds) is Don’t Pass. The house edge is just a teensy bit narrower there than on the Pass Line. But no one really bets that way. And when people do, they are quiet about it, because they are betting for everyone else at the table to lose. That’s not the way you endear yourself to a bunch of degenerates at the casino. Betting Don’t Pass is also called betting “dark side.”
Personally, I have no interest in betting dark side in craps. The edge is pretty small to have to endure swarthy drunks shooting you sideways glances all night. But when it comes to investing I am plenty interested in opportunities to bet dark side.
In fact, sometimes I play a mental little game with myself called: What’s A Seemingly Obvious Trend Or Theme I Can Get On The Other Side Of?
For example right now everyone in the US is whining about how there are no cheap stocks. You know where stocks are cheap?
In Russia you’ve got stuff on single digit earnings multiples paying 6% dividend yields. And it’s not even distressed stuff for the most part. Research Affiliates has got a phenomenal little asset allocation tool you can use for free. See those two red dots on the upper right in the double-digit return zone? That’s Russian and Turkish equities. (In case you are wondering, US large cap equity plots at about 40 bps of annualized real return)
Yeah. I know. Everyone hates Russia. You can probably rattle off at least five reasons why Russia is an absolute no-go off the top of your head. But I will happily bet dark side on Russian equity. I won’t bet the farm, but I’ll take meaningful exposure. The reason is I am getting paid pretty well to take Russian equity risk.
Risk assets are a pretty crappy deal here in the US. (40 bps real per year over the next decade, remember?) Here everyone’s convinced themselves stocks don’t go down anymore so they are willing to pay up. I guess some day that will be put to the test. We’ll see.
In the meantime, what other trends can we get on the other side of?
ESG might create opportunities. If you haven’t heard of ESG it stands for Environmental, Social and Governance. Big asset managers have become obsessed with ESG because it’s an opportunity to gather assets from millennials and women at a time when index funds and quants are hoovering up all the flows.
This is literally what the big asset managers tell allocators in presentations now: “millenials and women are going to inherit all the assets and they want to be invested in line with their values. Here are all our ESG products. Also here is marketing collateral to help you have ‘the ESG talk’ with your clients.”
So where do we go from here?
Well, for starters I am thinking a trillion dollars rotates into stuff that screens well on ESG. If this persists long enough and to a significant enough degree the stuff that doesn’t screen well on ESG is going to get hammered. With any luck it will get kicked out of indices and analysts will drop coverage and the bid-offer spreads will blow out.
Like Russian equities, the oil companies and the natural gas companies and the miners and the basic chemical companies and the capital intensive heavy manufacturers will trade on single digit earnings multiples with 6% dividend yields. All because they don’t score well on the asset gatherers’ screens.
So yeah, I think I’ll bet dark side when it comes to ESG, too.
For the record, I don’t have anything against ESG in principle. I am actually a big fan of an extreme form of ESG, called impact investing, where you allocate capital with low return hurdles (like 0% real) to achieve a specific social objective. Maybe to fund development in a low income community in your city. Micro-lending is an example of this, and I think it’s a better model than philanthropy in many cases. But that’s a topic for another day.
This post is about how people’s emotional reactions to the securities they own create bargains. Here betting dark side is betting on something kind of icky. “Ick” is an emotional reaction. When people react emotionally to stuff, it has the potential to get mispriced. “Ick” is a feeling that encourages indiscriminate selling.
That’s where the Don’t Pass bet comes back into play. It’s one of the better bets in the casino, and it’s massively underutilized. Why?