The Haunter of the Dark

581px-the_black_man
Source: Jens Heimdahl via Wikipedia

I had never heard the name NYARLATHOTEP before, but seemed to understand the allusion. Nyarlathotep was a kind of itinerant showman or lecturer who held forth in public halls and aroused widespread fear and discussion with his exhibitions. These exhibitions consisted of two parts—first, a horrible—possibly prophetic—cinema reel; and later some extraordinary experiments with scientific and electrical apparatus. As I received the letter, I seemed to recall that Nyarlathotep was already in Providence…. I seemed to remember that persons had whispered to me in awe of his horrors, and warned me not to go near him. But Loveman’s dream letter decided me…. As I left the house I saw throngs of men plodding through the night, all whispering affrightedly and bound in one direction. I fell in with them, afraid yet eager to see and hear the great, the obscure, the unutterable Nyarlathotep.

–H.P. Lovecraft

Nyarlathotep (try saying that 10 times fast!) was inspired by a dream. Lovecraft dreamed his friend Samuel Loveman wrote a letter encouraging him to see the “itinerant showman”:

Don’t fail to see Nyarlathotep if he comes to Providence. He is horrible—horrible beyond anything you can imagine—but wonderful. He haunts one for hours afterwards. I am still shuddering at what he showed.

Nyarlathotep is a perversion of the Wizard! archetype: a twisted incarnation of the mad scientist futurist.

In the Cthulhu Mythos, Nyarlathotep serves the Great Old Ones. He’s a kind of messenger. The guys over at Epsilon Theory would call him a Missionary. In fact, Nyarlathotep is the archetypical Evil Missionary. He most definitely does not respect our autonomy of mind. The notion of pathetic, insignificant humans exercising autonomy of mind and spirit would be utterly incomprehensible to him. To Nyarlathotep, we’re no more worthy of autonomy of thought and feeling than cockroaches. Typically, whenever one of Lovecraft’s unfortunate protagonists encounters him, the result is either insanity or death.

Nyarlathotep’s nature is never entirely clarified in Lovecraft’s fiction. Some commentators think of him as a lesser god, subordinate to the Great Old Ones. My preferred interpretation is that Nyarlathotep isn’t a discrete being with his own conscious will, but rather the manifestation of the Elder Gods’ power and influence in our world. He’s a vessel for the Old Magic. For Dark Magic. He channels the Elder Gods’ power for their cults here on Earth.

But Nyarlathotep isn’t simply a purveyor of cosmic horror. No, he’s also a purveyor of science. Scientism, to be precise. Nyarlathotep’s special blend of scientism is occult magic, gussied up in the trappings of science and technology, with some religiosity thrown in for good measure. It’s occult scientism.

So what the hell does any of this have to do with economics, geopolitics, or investing?

Well, once you start looking for Nyarlathotep, and his particular brand of occult scientism, you’ll see him everywhere. I made a snarky nerd joke about Nyarlathotep at Davos on Twitter the other day, and received a rather evocative reply:

nyarlathotep_tweet

Indeed. And we see his handiwork everywhere.

It’s the Gaussian Copula.

It’s eugenics and racial pseudioscience.

It’s Soviet collectivized agriculture.

It’s esoteric securitizations of risky assets and byzantine structured products.

It animates the Chinese social credit system; the Intellectually Superior Davos Man; the Cult of MMT-Enabled Economic Management; the Cult of Supply-Side Economics; the Divine Order of the Ever-Wise and Benevolent Central Banker; the erstwhile Caliphate of the Islamic State; the Malthusian Society of Self-Loathing Climate Warriors.

Occult scientism is powerful stuff. It combines the memetic power of symbolic abstraction with a veneer of scientific (“rational”) credibility, then underscores it all with religious fervor. Occult scientism topples governments. It launches revolutions, wars and genocides. It shapes our perception of our world and ourselves in a way that scientism and religion, taken in isolation, cannot. When we encounter it, we’re transfixed.

He is horrible—horrible beyond anything you can imagine—but wonderful. He haunts one for hours afterwards. I am still shuddering at what he showed.

Wherever our most powerful missionaries congregate, look carefully for Nyarlathotep and his miracles. He may not be preaching front-and-center, but he’s almost certainly there, lurking in the shadows, whispering in the dark.

Are Structured Products Trash?

oscar_the_grouch

I am not a fan of structured products.

For those of you who haven’t wasted hours of your life ruminating on the pros and cons of financial engineering, structured products are sold to investors as a custom package of risk exposures.

For example, you might buy a note that promises a guaranteed minimum value and potential upside participation in an equity index’s return. This is equivalent to being long a zero coupon bond and a call option on the underlying index.

Or, you might buy a reverse convertible that pays a fat yield in exchange for exposing you to downside equity risk. In this case you are long a bond and short a put (you are shorting volatility).

Here’s my beef with structured products:

  • They’re expensive.
  • Most banks are better than you and me at pricing options. The deck is stacked against us (this is not to be confused with the common misconception that the bank is on the other side of the trade when you buy a structured product–issuers hedge out their exposures).
  • Because structured products are such profitable products for banks, they have fat commissions attached to them and are often foisted on unsuspecting retail investors who have no idea what they own. For example, it’s easy to sell Yield! to unsophisticated clients (and some sophisticated ones, too).
  • Oh, by the way you’re an unsecured creditor of the bank, which is one of those things that doesn’t matter until suddenly it matters, and then it’s the only thing that matters.

Before I wrote this post, I solicited some feedback from folks on Twitter. I wanted to know: do you see any legitimate uses for these products? The responses I received boiled down to the following:

  • It can be difficult for individuals and institutions to replicate their desired exposures directly in the options market for structural reasons or due to governance constraints.
  • At times, banks screw up on pricing, or there’s an opportunity to put a trade on that’s so attractive it justifies getting your face ripped off on pricing (as one individual put it: “an obviously suboptimal implementation [may be] the best available implementation”).

Taking this all into consideration I’ll modify my stance on structured products somewhat. If you are good with options, and are able to decompose these structures to judge whether the embedded options are cheap or expensive, it may make sense to dabble in structured products. I certainly don’t begrudge anyone a clever way to make a buck. In fact, it warms the heart to know clever people have made a few bucks beating Wall Street at its own game.

Likewise, if the design of your portfolio absolutely, positively requires options exposure, and structured products are the only way to access that exposure, perhaps it makes sense.

But I suspect most of us are better off without them.

The Maginot Mentality

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A military commander may approach decision with either of two philosophies. He may select his course of action on the basis of his estimate of what the enemy is able to do to oppose him. Or, he may make his selection on the basis of what his enemy is going to do. The former is a doctrine of decision based on enemy capabilities; the latter, on enemy intentions. The doctrine of decision of the armed forces of the United States is a doctrine based on enemy capabilities. A commander is enjoined to select the course of action which offers the greatest promise of success in view of the enemy capabilities.

–R. Duncan Luce and Howard Raiffa, Games And Decisions: Introduction & Critical Survey

A recent Epsilon Theory note has me thinking on how we play the various games and meta-games that touch our lives. Specifically, how often we dismiss our opponents and competitors as stupid, ignorant, or subject to behavioral biases and constraints we’ve miraculously managed to transcend.

Our opponents and competitors may indeed be stupid, ignorant, and subject to behavioral biases and constraints we’ve miraculously managed to transcend. But basing business and investment decisions on this characterization is bad strategy.

History is rich with examples. In the first world war, for example, Britain badly underestimated Ottoman resources and fighting spirit, at the Dardanelles and again at Gallipoli.

A common variation on this mistake is refusing to adapt to changes in our opponents’ capabilities, or changes in the payoffs and estimations shaping the game. This may arise out of hubris and ignorance. More often it’s a result of institutional inertia and constraints. We sometimes call this the “man with a hammer” problem.” When the only tool we’ve got is a hammer, every problem is either a nail, or analogous to a nail.

In the case of France in the run-up to the second world war, economic and political constraints mired the country in a defensive posture. In fact, geopolitical reality demanded a decisive, proactive strategy. As Kissinger writes in Diplomacy:

French policy grew increasingly reactive and defensive. Symbolic of this state of mind was that France began to construct the Maginot Line within two years of Locarno–at a time when Germany was still disarmed and the independence of the new states of Eastern Europe depended on France’s ability to come to their aid. In the event of German aggression Eastern Europe could only be saved if France adopted an offensive strategy centered on its using the demilitarized Rhineland as a hostage. Yet the Maginot Line indicated that France intended to stay on the defensive inside its own borders, thereby liberating Germany to work its will in the East.

In the investing game, we build Maginot Lines all the time. We’re building and extending Maginot Lines whenever we embrace and promote appealing narratives in a way that reinforces rigid and inflexible thinking.

Discretionary active managers build Maginot Lines with narratives about index funds distorting valuations and ETFs as weapons of mass destruction.

Bogleheads build Maginot Lines with narratives about the greedy asset managers and efficient markets.

Financial advisors build Maginot Lines defending various fee structures with endless sniping and virtue signaling around what compensation structure makes someone “a true fiduciary.”

The Maginot Mentality is a kind of strategic solipsism. It assumes our opponents and competitors will play to our strengths and weaknesses. Or, perhaps, they’ll play according to some caricature we’ve drawn of their own strengths and weaknesses. It’s bad strategy, all around.

Mostly, the Maginot Lines we build for ourselves are symbols. Sure, they can be real enough. All those forts and gun emplacements along the Franco-German border were certainly real enough. They even impacted strategic decision making. But our opponents aren’t obligated to act according to the caricature we’ve drawn. They can choose another axis and mode of advance–one that plays to their true strengths and weaknesses.

Sound strategic thinking assumes they will.

Mental Model: Market Regimes

Markets and economies go through cycles. We’re used to hearing about bull markets and bear markets. We’re used to hearing about economic booms and recessions. But we don’t talk quite as much about market regimes.

A regime is a particular iteration of a particular phase (or phases) of a market cycle. Understanding regimes is important because markets are adaptive systems. Investors respond dynamically to changes in the economic environment, since changes in the economic environment influence their preferences for different cash flow profiles. As I wrote here, these changing preferences are key drivers for asset prices.

What characteristics define a regime? Things like:

  • Economic growth
  • Inflation
  • Interest rates (cost of capital)
  • Credit expansion/contraction
  • Market volatility

Every market regime is a bit different, but regimes tend to influence investor behavior in relatively predictable ways (partly the intuition behind the old saw: “history doesn’t repeat, but it rhymes”). In a deflationary regime, investors sell stocks and buy long-dated Treasury bonds. In an an inflationary regime, investors sell long-dated bonds, while bidding up real assets. In a growth regime, investors will bid up stocks at the expense of long-dated bonds.

Of course, this is a massive oversimplification. Identifying and profiting from market regimes is no easy feat. That’s the goal of the top-down global macro investor, and it’s an extraordinarily complex and difficult task.

So what do us mere mortals take away from this?

We want to ensure our financial plans and investment portfolios remain robust to different market regimes. This doesn’t mean we have to become market timers or macro forecasters. It means we should be thoughtful about the bets we’re embedding in our portfolios.

Unintended Bets

Today, the consensus view is that we’re in a “lower for longer” regime. Low growth. Low inflation. Low interest rates. There are big secular drivers behind this. In developed countries, older populations need to save a lot of money to fund future liabilities. Lots of investment capital in need of a home pushes down the cost of capital. Technological advances have kept a lid on inflation in many areas of daily life.

If the regime is “lower for longer,” what you want to bet on is duration.

We can define duration in different ways. Usually we’re talking bond math. In this context, duration is the sensitivity of a bond’s price to changes in interest rates. The longer a bond’s future cash flows extend out into the future, the higher its duration. The higher the duration, the more sensitive the bond will be to changes in interest rates. The archetypical high duration asset is the zero coupon bond.

If the market regime is “lower for longer,” you have an incentive to bet on large cash flows further out into the future. Low rates and low growth mean the opportunity cost for making these bets is also low.

Duration isn’t just a bond thing. Every asset with cash flows also has duration. It’s just harder to quantify for equities and real estate because of the other variables influencing their cash flow profiles.

Your venture capital investments? They’re a duration bet.

Your small cap biotechs? They’re a duration bet.

Your cash burning large cap growth equities? They’re a duration bet.

All these things are attractive in a “lower for longer” world because they offer Growth! But they’re also sensitive to the cost of capital. In a world of cheap capital, it’s easy to convince investors to subsidize losses for the sake of Growth! If and when the regime changes, that may no longer be the case.

As much as we hate to admit it, our portfolios are products of our environment. It’s what people are talking about when they say “don’t fight the market” and “don’t fight the Fed.” They might as well be saying, “don’t fight the market regime.”

As I’ve written many times before, I’m not a fan of “all-in,” “all-out” calls. That doesn’t just go for market timing. It goes for all the unintended bets that seep into our portfolios over time.

Especially those driven by market regimes.

Wunderwaffen, Part II

My last post was about tradeoffs we must weigh when building investment portfolios. There’s no such thing as a magical asset. Most of the time we spend looking for superweapons (Wunderwaffen) is wasted. In this post I want to riff on Wunderwaffen from another angle: our fascination with things that are exciting conceptually but prove ineffective or even dangerous in practice.

This is a Messerschmitt Me-163 “Komet”.

Messerschmitt Me 163B
Source: USAF

The Komet was a rocket-powered interceptor designed to combat Allied bombers over Germany. Its distinguishing feature was its incredible speed–it could climb to combat altitude in just three minutes. One test pilot hit a speed of 700 mph in 1944. This set an unofficial world record that wasn’t broken until 1947, when Chuck Yeager set another unofficial record during a secret test flight. Officially, the flight airspeed record remained below 700 mph until 1953.

Unfortunately, the Komet’s incredible engine power was also the source of its greatest weakness. The volatile fuel mixture that fed the engine made it the rough equivalent of a flying bomb. The wiki on the Komet provides these details:

The fuel system was particularly troublesome, as leaks incurred during hard landings easily caused fires and explosions. Metal fuel lines and fittings, which failed in unpredictable ways, were used as this was the best technology available. Both fuel and oxidizer were toxic and required extreme care when loading in the aircraft, yet there were occasions when Komets exploded on the tarmac from the propellants’ hypergolic nature. […]

The corrosive nature of the liquids, especially for the T-Stoff oxidizer, required special protective gear for the pilots. To help prevent explosions, the engine and the propellant storage and delivery systems were frequently and thoroughly hosed down and flushed with water run through the propellant tanks and the rocket engine’s propellant systems before and after flights, to clean out any remnants. The relative “closeness” to the pilot of some 120 litres (31.7 US gal) of the chemically active T-Stoff oxidizer, split between two auxiliary oxidizer tanks of equal volume to either side within the lower flanks of the cockpit area—besides the main oxidizer tank of some 1,040 litre (275 US gal) volume just behind the cockpit’s rear wall, could present a serious or even fatal hazard to a pilot in a fuel-caused mishap.

Ultimately, the Komet had no impact on the European air war. It made very few kills and to the extent it did, its kill ratio was low. This disappointing operational performance hardly justified the many pilot deaths that occurred in development, testing and training.

There are lots of Komet-like investment products out there, including:

  • Levered and inverse levered ETFs
  • VIX Futures ETPs
  • Naked option writing strategies

Most of us shouldn’t get anywhere near these products and strategies. I’ll make an allowance for my trader friends who have a deep and intuitive grasp of the market forces that shape changes in both realized and implied volatility. For us tourists, the leverage and short gamma exposure embedded in many of these products are every bit as dangerous as the Komet’s rocket fuel.

Here’s what an engine fire looks like for these strategies:

201812_SVXY_Chart
Source: Morningstar
201812_HFXAX_Chart
Source: Morningstar

So why are we drawn to this stuff?

Mostly because it’s cool. It’s got Sophistication! It gives us an excuse to talk about things like the volatility risk premium. It makes us feel as if we’re part of some elite fraternity of financial markets people. We “get it.” “Have fun with your index funds, you buy-and-hold simpletons.” 

Except really, the joke is on us.

We should never underestimate our deep-rooted weakness for Sophistication! Most of us got into this business at least partly because we’re smart and competitive. We’re captivated by that powerful rocket engine as a feat of human ingenuity. Deep down, we want a shot at that airspeed record.

But it’s not necessarily the most powerful, most sophisticated engine that’s going to win us the war. It might not even make a difference.

And if we’re not careful, it’ll blow up on us.

 

01/08/19 Addendum: Got into a Twitter discussion on this topic and Corey Hoffstein of Newfound Research was kind enough to educate me on how inverse and leveraged ETFs can be used in a DIY risk parity implementation for small investors. Here is the link to his article. So as always, it seems, #notall applies.

Wunderwaffen

One theme I harp on relentlessly is that there’s no such thing as a magical investment strategy. By “magical strategy” I mean some asset class or system that’s inherently superior to all others. Hedge funds were once sold this way, and we’ve spent the last 10 years or so watching the ridiculous mythology built up around hedge funds die a slow and miserable death.

The unpleasant truth is that all investment strategies involve tradeoffs. In this way, investment strategies are a bit like weapons systems.

Tank design, for example, must balance three fundamental factors:

  • Firepower
  • Protection
  • Mobility

This is a Tiger tank:

Bundesarchiv_Bild_101I-299-1805-16,_Nordfrankreich,_Panzer_VI_(Tiger_I).2
Source: Bundesarchiv via Wikipedia

You might recognize it from any number of WWII movies and video games. The Tiger is often presented as a kind of superweapon (German: Wunderwaffe)–an awe inspiring feat of German engineering. In many respects, the Tiger was indeed a fearsome weapons system. Its heavy frontal armor rendered it nearly invulnerable to threats approaching head-on. Its gun could knock out an American M4 at distance of over a mile, and a Soviet T-34 at a little under a mile.

The Tiger had its weaknesses, however, and they were almost laughably mundane. It was over-engineered, expensive to produce and difficult to recover when damaged. Early models in particular struggled mightily with reliability. The Tiger was also a gas guzzler–problematic for a German panzer corps chronically short on fuel.

Viewed holistically, the Tiger was hardly a magical weapon. The balance of its strengths and weaknesses favored localized, defensive operations. Not the worst thing in the world for an army largely on the defensive when the Tiger arrived on the battlefield. But it was hardly going to alter the strategic calculus for Germany. In fact, there’s an argument to be made that German industry should have abandoned Tiger production to concentrate on churning out Panzer IV tanks and StuG III assault guns. (Thankfully, for all our sakes, it did not)

Likewise with investment strategies, the tradeoffs between certain fundamental factors must be weighed in determining which strategies to pursue:

  • Alpha Generation
  • Liquidity
  • Capacity

Alpha generation is typically inversely related to liquidity and capacity. The more liquid and higher capacity a strategy, the less likely it is to consistently deliver significant alpha. Smaller, less liquid strategies may be able to generate more alpha, but can’t support large asset bases. Investment allocations, like military doctrine, should be designed to suit the resources and capabilities at hand.

If I’m allocating capital, one of the first things I should do is evaluate my strategy in the context of these three factors.

First, do I even need to pursue alpha?

If so, am I willing and able to accept the liquidity constraints that may be necessary to generate that alpha?

If so, does my strategy for capturing alpha have enough capacity for an allocation to meaningfully impact my overall portfolio?

In many cases, the answer to all three of those questions should be a resounding “no.”

And that’s okay! Not everyone should be concerned with capturing alpha. For many of us, simply harvesting beta(s) through liquid, high-capacity strategies should get the job done over time. Identifying strategies and investment organizations capable of sustainable alpha generation ex ante is extremely difficult. And even if we can correctly identify those strategies and investment organizations, we must have enough faith to stick with them through the inevitable rough patches. These are not trivial challenges.

But even more importantly, in a diversified portfolio it’s unlikely you’ll deploy a single strategy so powerful and reliable, and in such size, that it completely alters your strategic calculus. In general, we ought to spend more time reflecting on the strategic tradeoffs facing our portfolios, and less time scouring the earth for Wunderwaffen.

You Can’t Borrow Conviction

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Source: David Palumbo

“Nowhere left to go,” Barlow murmured sadly. His dark eyes bubbled with infernal mirth. “Sad to see a man’s faith fail. Ah, well…”

The cross trembled in Callahan’s hands and suddenly the last of its light vanished. It was only a piece of plaster that his mother had bought in a Dublin souvenir shop, probably at a scalper’s price. The power it had sent ramming up his arm, enough power to smash down walls and shatter stone, was gone. The muscles remembered the thrumming but could not duplicate it.

[…] And the next sound would haunt him for the rest of his life: two dry snaps as Barlow broke the arms of the cross, and a meaningless thump as he threw it on the floor.

[…] “It’s too late for such melodrama,” Barlow said from the darkness. His voice was almost sorrowful. “There is no need of it. You have forgotten the doctrine of your own church, is it not so? The cross… the bread and wine… the confessional… only symbols. Without faith, the cross is only wood, the bread baked wheat, the wine sour grapes.”

–Stephen King, ‘Salem’s Lot

Whenever the market falls, you start to see symbol-waving. This famous Charlie Munger quote about equity drawdowns, for example:

If you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder, and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.

This is core doctrine for the Church of Value Investing. It works for Charlie because Charlie has Faith. Unfortunately, many of us who wave the symbols of Buffett and Munger in the face of Scary Things do not, in fact, have Faith. We fancy ourselves members of the Church of Long-Term, Buy & Hold Investing when times are good. But when things go bump in the night, we find ourselves waving cheap plaster crosses at the drawdown monster.

barlow

And it works about as well for us as it did for Father Callahan.

So we make arbitrary changes to what are meant to be long-term asset allocations designed to capture structural risk premia. We fiddle with exotic alternative strategies we don’t properly understand. We sell to cash without any idea how we’ll convince ourselves to buy back in. We seriously damage our chances of achieving our long-term objectives.

This chart?

CRSP_2018_big_picture
Source: CRSP

This chart is a plaster cross. I show it specifically because it’s the most common exhibit financial advisors use to harp on “a long-term view” in client presentations.

But if you don’t believe equities should earn a structural premium over gold or T-bills or credit over very long periods of time, this chart will do nothing whatsoever to help you when your equity holdings halve. Same if don’t believe your portfolio has enough of a liquidity buffer to withstand a lengthy drawdown. You will waver. The drawdown vampire will snap your plaster cross and eat you.*

How do you build Faith?

Honestly, I had only the vaguest idea how to answer that question, so I punched it into Google and found this article (no idea what The Living Church of God might be–link isn’t an endorsement). Suggestions include:

Prove what you believe (or try to, anyway).

Study what you believe.

Endure the trials that arise as you go.

Because ultimately, there are no shortcuts to Faith.

Faith is a Process, not an Answer.

You can’t borrow conviction.

 

 

*Yeah, I know Barlow doesn’t actually kill Father Callahan in ‘Salem’s Lot. ‘Salem’s Lot purists can extend the metaphor and imagine the drawdown vampire turning them into unclean market-timers, doomed to wander the earth for all eternity with low returns and even less credibility.