The Pursuit of Truth

Bridgewater Associates has a reputation for being something of a cult. I do not have direct experience with Bridgewater or its founder Ray Dalio other than reading some of their research and thought pieces. So I’m not really qualified to weigh in on the cult aspect. What I do appreciate about Bridgewater’s culture is that it is fanatically process-oriented, to the point of resembling a spiritual quest. Check out these snips:

Source: Website for Ray Dalio’s Principles
Source: Bridgewater Website

Now, this post is not meant as Bridgewater commercial. Bridgewater is simply a real-life example of firm that seeks to understand Truth, and has reaped the benefits of the process. If you understand the Truth of how the world operates, making money using that knowledge is trivial.

This might seem like a banal observation. I promise it is not. In my view a majority of investment organizations have it backward. They are focused on outcomes. The Truth of what caused those outcomes is irrelevant. It is easier from a business perspective to simply rationalize things in ways that appeal to clients. It is clients who pay the bills, after all.

The result is that investing becomes an endless performance chase. This is the finance equivalent of Buddhist samsara. It is an endless cycle of birth, suffering and death.

By now you might think I am off the deep end. Yet I am not the first person to connect practical issues in asset management to broader philosophical concepts. Patrick O’Shaughnessy has written an excellent post covering related subject matter, “Two Star Managers and the Wheel of Fortune.” In it he shares this Taoist story:

There is a Taoist story of an old farmer who had worked his crops for many years. One day his horse ran away. Upon hearing the news, his neighbors came to visit.

“Such bad luck,” they said sympathetically.

“We’ll see,” the farmer replied.

The next morning the horse returned, bringing with it three other wild horses.

“How wonderful,” the neighbors exclaimed.

“We’ll see,” replied the old man.

The following day, his son tried to ride one of the untamed horses, was thrown, and broke his leg. The neighbors again came to offer their sympathy on his misfortune.

“We’ll see,” answered the farmer.

The day after, military officials came to the village to draft young men into the army. Seeing that the son’s leg was broken, they passed him by. The neighbors congratulated the farmer on how well things had turned out.

“We’ll see” said the farmer.

As I was writing this I read an excellent piece by Morgan Housel discussing the impact of lived experience on investors’ views of financial markets and investment strategy. It includes this chart:

Source: Collaborative Fund Blog

Here is a bridge from the Taoist story to our lived experience as investors. It illustrates how something as simple as the year we were born can have a dramatic impact on our lived experiences, and by implication our worldview. If we only ever filter the world and the markets through the lens of our personal experiences (and biases), we will see things as we would like to see them rather than how they truly are.

This may blind us to opportunity. It may also blind us to risk. Even thinking of “opportunity” and “risk” as discrete concepts can be reductive and limiting. Typically where there is risk there is also opportunity, and vice versa. This is especially true of investments that are out of favor or misunderstood. To this day, skilled structured credit investors are making good money off toxic mortgage-backed securities originated prior to the financial crisis. Since they have deep, objective knowledge of the securities and the market, they are able to see past the label of “toxic” to the underlying value.

If you can understand the Truth, making money is trivial.

The Home Ownership Scam

We are all curmudgeons about something. Some people don’t like cats or dogs. Others don’t like children. Me? I don’t like residential real estate. In fact, I think for the average American household home ownership is something of a scam. The scam is perpetrated by a massive housing value chain, which accounts for something like 4% of US GDP.

Think for a moment about the people lined up to rip your guts out when you buy a home: the seller; the seller’s real estate agent; your real estate agent; the home inspection guy/gal; the mortgage broker; the bank/wholesale finance operation funding the mortgage; the insurance company. All of these individuals have an explicit financial incentive to promote home ownership as your path to wealth and happiness, no matter the sticker price.

To make my point another way, here are some charts from JPMorgan:


See the con?

Despite the mid-2000s housing crash, the estimated multiple of average family income needed to purchase a home has increased nearly a full turn since 2000. This despite increases in median household income:


Massive housing price inflation has been driven primarily by one thing: cheap debt. Mortgage rates have come down steadily since the 1980s. This looks a hell of a lot like a super cycle to me. In fact it’s two inter-related super cycles: one in rates and another in debt (incidentally, you see the same thing with corporate debt — companies have spent the last 30 years swapping debt for equity in their capital structures by borrowing at low rates and using the proceeds to buy back shares).

One thing I try to remain conscious of as an investment professional is when people lose sight of cycles. Cycles can take a long time to play out and cyclical inflection points are difficult to forecast in advance. Hence, people tend to extrapolate naively from the present when thinking about the future. But I will tell you right here and now, households cannot continue to pay ever-increasing multiples of income for homes without access to cheap financing. Some day there will be a pointy reckoning.

One of the most pathetic things I have ever read about is people writing personalized letters to home sellers. If you are doing this intentionally as a Machiavellian value play knowing you are the low bid I have no problem with that. That’s on the seller for being a sucker. But the fact this tactic works at all demonstrates perfectly how emotionally warped our collective view of home ownership has become.

That, friends, is the home ownership scam. A cultish view of home ownership takes a straightforward asset purchase and transforms it into some bizarre emotional and cultural touchstone. So actually you end up feeling good about getting your faced ripped off in the course of the transaction.

Because when you think about it emotionally, any price seems justified. What is the American Dream worth? What is the boost to your image and self-esteem? How about a great school district for your kids and a nice, roomy yard for Flopsy? Are those things worth 4x household income? 5x? 10x?

For most people, it all depends on whether they can make the monthly payment work.

Flopsy (at left) & friends


The Hard Sell

“Mnuchin warns of equities fall without tax reforms”

One of the commenters says it best: “This is the hard sell on tax reform??”

This is just the latest example of how financial market performance has turned from output to input for policymakers in recent years. Granted, Mnuchin’s comment is more political propaganda than policy prescription. It’s worse at the Fed. At the Fed, preemptive strikes on market volatility have become standard operating procedure.

From Chris Cole’s excellent research piece, “Volatility and the Allegory of the Prisoner’s Dilemma” (linked above):

Pre-emptive central banking is a very different concept than the popular idea of the “central bank put”. The classic “central bank put” refers to policy action employed in response to, but not prior to, the onset of a crisis. Rate cuts in 1987, 1998, 2007-2008, and Quantitative Easing I and II (“QE”) programs were a response to weak economic data, elevated financial stress, and large drawdowns in credit and equity markets. To differentiate, pre-emptive central banking refers to monetary action in anticipation of future financial stress to avert a market crash before it starts,even if markets appear healthy and volatility is low. In executing a pre-emptive strike on risk, policymakers rely on changes in faster moving market data (e.g. 5yr-5yr breakeven inflation) rather than slower moving fundamental economic data (e.g. CPI and unemployment). Although well-intentioned, their actions have created dangerous self-reflexivity in markets by artificially suppressing volatility and encouraging rampant moral hazard. Central banks have exchanged ‘known unknowns’ for ‘unknown unknowns’ creating the potential for dangerous feedback loops. A central bank reaction function is now fully embedded in risk premiums. Markets are pricing the supportive policy response before action is even taken. Bad news is good news and vice versa because the intervention is more important than fundamentals. Pre-emptive strikes on risk are contributing to the massive growth and popularity of any asset or strategy with a short convexity or mean reversion return profile. The unintended consequences of this massive short convexity complex will be born from phantom liquidity, shadow gamma, and self-reflexivity.

Anyway, Mnuchin’s comments have nothing to do with tail risk. He is just beating the unwashed masses with a stick to keep pressure on Congress to deliver juicy tax cuts.

This is classic dumb money messaging. You know it’s dumb money messaging because it focuses on market prices and not valuations (traders and arbitrageurs should consider themselves exempt from my nasty sarcasm by definition). Hard selling works well with dumb money because dumb money doesn’t understand how cognitive and emotional biases impact financial decision making, or how to formulate capital market expectations. Mnuchin is basically saying to Average Joe, “if tax cuts don’t go through your 401(k) is going to crater.” That’s the true message and the true target.

See also: literally every penny stock promotion. Or the movie Boiler Room.

Something To Lose Sleep Over

Perhaps the scariest academic paper I have ever read is from a fellow named Marvin Goodfriend. Dr. Goodfriend is a professor of economics and a former Fed Research Director. His paper is titled “The Case For Unencumbering Interest Rates At The Zero Bound”. The reason this paper frightens me is that Dr. Goodfriend’s suggested methods for implementing negative interest rate policies are as follows:

1) Abolish paper currency (replace it with electronic currency)

2) Allow the value of paper currency to float (similar to the way that money market net asset values float)

3) Provide electronic currency alongside paper currency

The mechanisms may vary but the end is the same: the goal is to empower the central bank (in this case the Federal Reserve) to confiscate the cash savings of individuals to implement — at least in the Fed’s view — a more perfect form of monetary policy. Goodfriend views the zero bound on interest rates as an arbitrary constraint on Ever Wise & Enlightened Central Bankers’ policy toolbox, same as the gold standard. Of the gold standard, he writes:

The gold price of goods was determined by a variety of forces impacting the supply and demand for gold such as cost conditions in gold mining, the demand for jewelry, industrial demand, and the strength of economic growth underpinning the demand for money and its required gold backing. Fluctuations in any of the underlying determinants of the gold price of goods would feed into the price level under the gold standard.

Central banks worked increasingly during the 20th century to offset the influence of gold flows on their respective price levels. Central banks forced to buy gold at the pegged money price of gold sterilized the goal inflows, effectively raising their gold reserve ratios against currency and deposits, rather than allowing the gold inflows to generate inflationary growth of the money supply. Such behavior raised the world demand for gold, depressed the gold price of goods, and created global deflation pressure. Those countries losing gold, and thereby under pressure to deflate their domestic money supplies and price levels, chose instead to reduce minimum required gold reserves against currency and deposits, to impose direct controls of one sort or another, or to devalue their currencies in terms of gold. The gold standard was finally abandoned in the early 1970s so that fluctuations in the gold price of goods could be reflected in the money price of gold without destabilizing the general price level.

Similarly, the zero bound for interest rates impedes central banks’ ability to exercise complete control over monetary policy. The paper explains this through the use of a model (I am not much of a macro guy so I will not delve into the derivation of the model here). The plain language translation is that in making consumption choices households weigh whether it is better to spend to consume goods and services now or to save to consume goods and services later. In a deflationary environment households will hoard cash in hopes of spending later at lower prices. This creates a vicious, self-reinforcing cycle that sends prices, wages and economic output on a downward spiral.

To counteract this negative feedback loop the Ever Wise & Enlightened Central banker would impose a negative interest rate. That is, there would be an explicit cost attached to saving and an explicit payment attached to borrowing. Rather than earn interest on your savings account, you would pay interest on it. Rather than pay interest on your mortgage, the bank would pay you for borrowing.

Up is down. Black is white. If you are an academic economist I suppose this is all well and good. You swap some terms around in a model, develop a policy position and then implement it. If you are a real person — you know, the kind who has to make “real” decisions about saving versus spending — this sounds completely insane.

People may be dumb but they are not stupid. No one is going to say “gee, interest rates are negative, I should spend all of my money to avoid this tax on my savings, The Ever Wise & Enlightened Central Bankers will make sure everything works out in the end.” It is self-evident that if a negative interest rate policy ends up being effective, inflation will eventually return and interest rates will shift back into positive territory.

So what people will end up doing is hoarding assets anyway. Now they may not hoard actual cash (if Dr. Goodfriend has anything to say about it central banks will be able to delete units of currency at will). They will find some other asset to hoard though. Gold, silver, Bitcoins. Another thing people might end up saying is, “gee, interest rates are negative and appointed central bank officials with no direct accountability are confiscating my wealth. Maybe it is time for a change in political system.” A friend of mine calls this “villagers with pitchforks risk.”

Central bankers suffer from a collective delusion of control. It is evident when you hear Janet Yellen saying that we are unlikely to experience another financial crisis in our lifetimes, or when Mario Draghi brags about the ECB having neutralized tail risks (something that is by definition impossible). This is no different than tech stock investors claiming earnings no longer mattered in the late 1990s, or structured credit salespeople claiming home prices would never fall all at the same time circa 2005.

Be afraid.

How To Destroy An Economy

FT Alphaville has up a transcript of a fascinating interview with Venezuelan economist Ricardo Hausmann. If you don’t keep up to date on the latest happenings in Venezuela, the below video of a gang of bikers attacking a cargo truck with Molotov cocktails illustrates the post-apocalyptic state of the Venezuelan economy.

And if you have ever wondered how best to blow apart an economy, the interview pretty much walks you through the process. Here is an illustrative passage:

Let me just give you a sense of the magnitude of the mismanagement of the oil industry. In 1998, the year before Chávez got elected, or the year in which in December of that year Chávez got elected and he took power in February 1999. In 1998, Venezuela produced 3.7 million barrels of oil [per day]. Today it’s producing about two. If Venezuela had maintained its market share in the world oil industry — which it could have because it had infinite reserves, it had the largest reserves in the world — it would be producing two million barrels more than it is currently producing. With the same market share. So the collapse is immense relative to history, and it’s immense relative to this opportunity cost of where it should have gone had it just kept its market share the way it was.

That collapse of the oil industry happened in two steps. First, all the know-how of that industry, centuries of man-years of experience was lost in the firing of these people. They were not only fired but persecuted, so most of them left the country. Many of them left the country. And they caused, for example, an oil boom in Colombia [where many of them moved to]. Colombia went from producing 200,000 barrels of oil [per day] to a million barrels of oil thanks to the fact that Venezuelans knew how to extract much more oil from the fields that Colombia was already exploiting.

So there was a massive loss of human capital. They also wanted to create a politically conscious oil company, so they started to put an enormous amount of social programmes and other things on the books of PDVSA, the oil company. And as a consequence they starved the company from investment and they ran the company in an amazingly corrupt way, and this is really not just talk about corruption but evidence of corruption in massive ways. There were these foreign oil companies… These foreign oil companies have been complaining to the government that they want to wrest control of the procurement of oil projects because they know that this procurement is being done at multiples of what things should cost. There’s people that have been found in the US owning hundreds of millions of dollars of money that has been laundered out of PDVSA and so on.

So they really destroyed the hen that laid the golden eggs, at the time when their own plans and their own announced plans was to move Venezuela to produce six million barrels of oil. And instead of increased production they have never been able to stop a very rapid decline in production.

The (understandable) gut reaction of many people to what is happening in Venezuela is to kind of chuckle and shake their heads and say, “that’s socialism for you — good luck with that Bernie Sanders.” However, I’m not so sure the late Hugo Chavez even made a proper go at running a socialist economy. When you read Hausmann’s description of asset expropriations under Chavez it all sounds rather whimsical and Qaddafi-esque:

Chávez won re-election in 2006. And in early 2007 he announced that he was now going to move towards socialism, and he started with a spree of nationalisations. In those days the price of oil was very high, so he could afford to just buy everything that moved or that he fancied.

So for example he nationalised the telephone company that was owned by Verizon. He nationalised the three cement companies that were owned by the Mexicans, Cemex, Holcim and Lafarge. He nationalised one of the largest banks, which was owned at the time by Banco Santander. He nationalised the supermarket chain. He nationalised 3.7 million hectares of land.

So he went on an expropriation spree. At the beginning, when he had money, he would pay for things, and then if these were things owned by people he didn’t like, he would just expropriate and not pay for them. So he changed the contracts of the oil companies in a way that essentially extracted part of the expected cash flows out of them, and many of them accepted but a few of them, Exxon, Conoco Phillips and so on sued. And these suits are now being adjudicated by the International Court for the Settlement of Investment Disputes, and these investment disputes in Washington now add up to $16 billion of claims. Of expropriations that he didn’t pay for. And these are only the foreigners.

He expropriated the service companies that provided services to the oil company, because they started to protest that they were not being paid so instead of paying he just expropriated them.

So he took over significant chunks of the Venezuelan economy, and the typical thing is that the moment they took over a company, they ran it to the ground. Production collapsed. They nationalised the steel company. The steel company at the time of nationalisation was producing 4.5 million tons of steel with 5,000 workers. It now has 22,000 workers but it’s producing something like 200,000 tons of steel. So they ran those companies to the ground. Aluminium is almost not done any more, when Venezuela was producing about a million tons of aluminium back when…

So essentially they expropriated the economy and collapsed it on the public sector. And in the private sector they created all these constraints and this enormous uncertainty over property rights because everybody else was being expropriated and you never knew when it would be your turn. Owens-Illinois was a company making bottles. They were expropriated. Why bottles? Another company making detergents was expropriated. Why detergents?

So everybody else would not know when would his turn come up.

To me that reads more like a dictator and his cronies stripping assets. Which isn’t to defend the merits of socialism so much as argue socialism provided a convenient platform for Chavez to justify the systematic looting of the Venezuelan economy. In fact, dictators in general seem fond of socialist posturing as a means of bamboozling the masses. So-called Arab socialism is littered with examples of strongmen spouting vaguely socialist pronouncements while consolidating political and economic power within single party authoritarian states.

In a serendipitous convergence of themes, the Wikipedia entry for Nasserism contains the following reference to Chavez:

Hugo Chávez, late President of Venezuela, and leader of the self-styled ‘Bolivarian Revolution’, cited Nasserism as a direct influence on his own political thinking, stating: “Someone talked to me about his pessimism regarding the future of Arab nationalism. I told him that I was optimistic, because the ideas of Nasser are still alive. Nasser was one of the greatest people of Arab history. To say the least, I am a Nasserist, ever since I was a young soldier.”