ET Note: What You Call Love

don-draper-wide

My latest Epsilon Theory note is about the seemingly obviously nonsensical idea that “words can be violence.”

[I]n case you’re wondering, no, words are not equivalent to physical violence. That is nonsense.

What is not nonsense is the notion that if you can deftly manipulate the symbols people use to assign and create meaning in their lives, you can manipulate their thoughts and behavior. We have a name for this outside academia and the culture wars.

It’s called advertising.

Read the whole note on Epsilon Theory.

Correlation And Meaning

We’re all familiar with the old saw: “correlation is not causation.” Correlation is merely a statistical measure of the strength of the linear relationship between two variables. Correlations can change over time. The fancy stats word for this instability is “nonstationarity.”

Anyway, what I want to suggest in this post is that correlations can often be interpreted as markers of meaning.

For example, stocks and Treasury bonds have been negatively correlated since the financial crisis. The reason is that the meaning of Treasuries to investors, broadly speaking, is “safe haven asset.” A Treasury allocation is an allocation that will perform well in a deflationary environment. And deflation, broadly construed, has topped the list of investor fears for many years now.

A big mistake many investors (particularly younger investors) may make is assuming Treasuries will always be negatively correlated with stocks. This has not always been true historically and will not necessarily be the case in the future. Why? In a highly inflationary environment, both stocks and Treasuries will perform poorly. The two assets classes will become positively correlated.

Another example of this is gold. Traditionally, gold has been viewed as an inflation hedge and has been positively correlated with inflation expectations. These days, however, gold is liable to trade up on deflation fears as well as inflation fears. Why the change in correlation? The meaning of gold has changed. Gold has shifted from a pure inflation hedge to an insurance policy against economic chaos more generally. Gold is now a hedge against policy mistakes by our economic elites (our Ever Wise and Benevolent Central Bankers in particular).

What I’m driving at here is that if you want to better understand the nonstationarity of correlations, you ought to spend some time thinking about narrative.

A stable correlation is a correlation where objective meaning dominates. Objective statements can be proven true or false in a straightforward way. Unstable correlations are correlations where subjective meaning dominates. Subjective statements cannot be proven true or false in a straightforward way.  Subjective statements are reflexive.

George Soros described it this way:

Consider the statement, “it is raining.” That statement is true or false depending on whether it is, in fact, raining. Now consider the statement, “This is a revolutionary moment.” That statement is reflexive, and its truth value depends on the impact it makes.

There’s not much subjective judgement required to evaluate a Treasury bond as an investment. It’s a mostly objective process that more or less boils down to your views on the future path of inflation and interest rates.

Now, your views on inflation and interest rates may make Treasury bonds seem relatively more or less attractive to you at any given point in time. But there’s never any real question in anyone’s mind as to how Treasury bonds will perform in a deflationary environment versus an inflationary environment. This is what I’m driving at when I say the meaning of a Treasury bond for your portfolio is going to remain pretty stable over time. A Treasury bond is protection from deflation.

Credit is a bit more subjective than Treasury bonds because now you’ve got defaults and recoveries in the mix. And equity valuation is far more subjective than credit valuation because the timing and amounts of the cash flows associated with equities are highly variable.

The value of gold is an order of magnitude more subjective than even equities because there aren’t any cash flows associated with gold. Gold is a purely speculative asset. Gold has value because, for whatever reason, human beings have arrived at the collective consensus that it’s a store of value over tens of thousands of years.

At the extreme end of this spectrum you have something like Bitcoin. Bitcoin, of course, has no cash flows. On top of that, there’s no broad consensus regarding what Bitcoin means. Sometimes it’s a currency. Sometimes it’s a speculative risk asset. Sometimes it’s a store of value or even a safe haven asset.

You ought to be extremely skeptical of any MPT-style analysis of Bitcoin’s role in a portfolio at this point. You simply can’t know if, when or how its correlation with other portfolio assets is going to stabilize over time. Just because Bitcoin is uncorrelated today doesn’t mean it will continue to be uncorrelated in the future.

Another practical application of all this relates to factor investing.

Patterns of correlations are the building blocks for factor-based investment strategies (they are literally what the math going on under the hood is measuring). It’s well-known that factor strategies go through extended periods of outperformance and underperformance that are difficult, if not impossible, to time. Factor performance comes and goes in irregular regimes. Regimes are driven by a mixture of objective and subjective factors that influence one another in feedback loops.

Regime_Graphic

If you’re trying to figure out when the relative underperformance of value stocks will end, you need to be thinking about what in the zeitgeist and market regime needs to change so that investors will want to buy stocks with “value” characteristics (how you choose to define “value” is important here). For example, in late 2016 the election of Donald Trump triggered a massive rally in cyclical industrial and financial services stocks. If you’re a long-suffering, old-school value investor who owns a lot of these stocks, what you want at a high level is higher growth, (modestly) higher inflation and (modestly) higher long-term interest rates.

If you’re a growth-oriented investor, such as a VC, who owns unprofitable, high-growth businesses that will not generate free cash flows for many years, what you want is a regime with solid growth but even more importantly with low inflation. More specifically, low interest rates. The value of your equity ownership is extremely sensitive to the cost of capital because your investments are very long duration. Much like a zero coupon bond, their cash flows lie far out in the future.

So anyway, when you’re considering factors such as value and growth what you want to be thinking about when evaluating their potential persistence over time are the drivers of the underlying patterns of correlation. And if you go through this exercise enough, I think you’ll find you keep coming back to investor preferences for different cash flow profiles.

As my friend Rusty Guinn once wrote:

Investment returns are always and everywhere a behavioral phenomenon.

Because, in the words of Marty Whitman, we’re pretty much always looking for a “cash bailout” when it comes to our investments. And our ability to exit an investment almost always ends up depending on a sale to another party. Marty wrote a wonderful explanation of this in an old investor letter (I’ll end on this note because I think it’s a fitting conclusion for this post):

From the point of view of any security holder, that holder is seeking a “cash bailout,” not a “cash flow.” One really cannot understand securities’ values unless one is also aware of the three sources of cash bailouts.

A security (with the minor exception of hybrids such as convertibles) has to represent either a promise by the issuer to pay a holder cash, sooner or later; or ownership. A legally enforceable promise to pay is a credit instrument. Ownership is mostly represented by common stock.

There are three sources from which a security holder can get a cash bailout. The first mostly involves holding performing loans. The second and third mostly involve owners as well as holders of distressed credits. They are:

Payments by the company in the form of interest or dividends, repayment of principal (or share repurchases), or payment of a premium. Insofar as TAVF seeks income exclusively, it restricts its investments to corporate AAA’s, or U.S. Treasuries and other U.S. government guaranteed debt issues.

Sale to a market. There are myriad markets, not just the New York Stock Exchange or NASDAQ. There are take-over markets, Merger and Acquisition (M&A) markets, Leveraged Buyout (LBO) markets and reorganization of distressed companies markets. Historically, most of TAVF’s exits from investments have been to these other markets, especially LBO, takeover and M&A markets.

Control. TAVF is an outside passive minority investor that does not seek control of companies, even though we try to be highly influential in the reorganization process when dealing with the credit instruments of troubled companies. It is likely that a majority of funds involved in value investing are in the hands of control investors such as Warren Buffett at Berkshire Hathaway, the various LBO firms and many venture capitalists. Unlike TAVF, many control investors do not need a market out because they obtain cash bailouts, at least in part, from home office charges, tax treaties, salaries, fees and perks.

I am continually amazed by how little appreciation there is by government authorities in both the U.S. and Japan that non-control ownership of securities which do not pay cash dividends is of little or no value to an owner unless that owner obtains opportunities to sell to a market

ET Note: The Life Aquatic

life_aquatic_group

My latest for Epsilon Theory is about surviving and thriving in a highly financialized world. What’s financialization?

Financialization is all about using financial engineering techniques, either securitization or borrowing, to transfer risk. More specifically, financialization is about the systematic engineering of Heads I Win, Tails You Lose (HIWTYL) payoff structures.

In business, and especially in finance, we see this playing out everywhere.

Debt-financed share buybacks? HIWTYL.

Highly-leveraged, dropdown yieldcos? HIWTYL.

Options strategies that systematically sell tail risk for (shudder) “income”? HIWTYL.

Management fee plus carry fee structures? HIWTYL.

Literally every legal doc ever written for a fund? HIWTYL.

There are two ways to effectively handle a counterparty that has engineered a HIWTYL game: 1) refuse to play the game at all, 2) play the game only if you have some ability to retaliate if your counterpaty screws you. Legal action doesn’t count. The docs and disclosures are written to be HIWTYL, remember?

(aside: corporate borrowing can be viewed as management selling put options on a company’s assets. I’ll leave it to you to consider what that might imply about government borrowing)

You need to be in a position to hurt your counterparty for real.

You need to be in a position to hurt your counterparty economically.

A friend (who is not in finance) recently asked me about the relationship between the sell-side and the buy-side. His question was basically this: is the purpose of investment banking just to rip fee revenue out of people by whatever means necessary even if it involves deliberately misleading them to screw them over?

My answer is that the sell-side’s purpose is simply to facilitate transactions. For investment bankers, that means raising capital or advising on M&A deals or whatever. For sell-side research groups it means driving buy and sell transactions.

The sell-side does not exist to make you money.

You can do business with the sell-side. You can even respect the sell-side. But you should never trust the sell-side. The same goes for pretty much all business relationships. Especially transactional relationships.

We poke fun at the sell-side around here, but what we’re poking fun at is just the sell-side’s Buddha nature. The zen master Shunryu Suzuki described Buddha nature thusly:

“If something exists, it has its own true nature, its Buddha nature. In the Parinirvana Sutra Buddha says, “Everything has a Buddha nature,” but Dogen reads it in this way: “Everything is Buddha nature.” There is a difference. If you say, “Everything has Buddha nature,” it means Buddha nature is in each existence, so Buddha nature and each existence are different. But when you say, “Everything is Buddha nature,” it means everything is Buddha nature itself.”

If that’s a bit too inscrutable for your taste, consider the fable of the scorpion and the frog:

A scorpion asks a frog to carry it across a river. The frog hesitates, afraid of being stung by the scorpion, but the scorpion argues that if it did that, they would both drown. The frog considers this argument sensible and agrees to transport the scorpion. The scorpion climbs onto the frog’s back and the frog begins to swim, but midway across the river, the scorpion stings the frog, dooming them both. The dying frog asks the scorpion why it stung the frog, to which the scorpion replies “I couldn’t help it. It’s in my nature.”

The Psychic Prison

AlcatrazIsland_TheRock

The first self-archetype is merely the subset of James’ blooming, buzzing confusion that we classify into our mind’s “I.” It is extraordinarily hard to redraw this boundary later in life. Hallucinogenic drugs, intense stress, sensory deprivation chambers, or the rigors of meditative practice are usually required.

Venkatesh Rao, Tempo

Freedom’s just another word for nothin’ left to lose.

Kris Kristofferson, “Me And Bobby McGee”

John Patrick Mason: Your “best?!” Losers always whine about [doing their] best. Winners go home and f*** the prom queen.

The Rock (1996)

This is going to be one of those abstract, philosophical posts. Consider yourself warned. However, portions will tie in rather neatly with investing. So you may want to stick around. I’m also going to try to write with as much clarity as possible here, because the concepts I want to explore in this post are fundamentally weird. In order, they are:

  1. Identity functions as a psychic prison.
  2. To have any chance of escaping the psychic prison of identity, we must to cultivate the ability to redraw the boundaries of the self.
  3. Therefore, freedom is, at a fundamental level, the ability to participate as a principal in the process of creative destruction.

Let’s start at the beginning.

The Psychic Prison

There’s a well-known quote from the book (and movie) Fight Club: “the things you own, end up owning you.” The idea is that over time you settle into a pattern of consumption. You stagnate within this pattern. After a while, it is impossible to determine whether you define your pattern of consumption or whether your pattern of consumption defines you.

I’ll take this a step further and suggest the following: the thoughts you think, end up thinking you. That is to say, you think your “self” into existence.

We’ve all met someone who’s chronically negative. That person who’s always put upon, who’s always sick, who’s always short on cash or the victim of sinister forces outside her control. That person who spends her life lurching from one crisis to the next. At times it seems as though she’s the physical manifestation of negativity and misfortune in the world.

It seems that way because it’s true. That person truly is a physical manifestation of negativity and misfortune. While plenty of her misfortunes may well be beyond her control, she’s also co-creator of the misery in her life. She has chosen to define her life with negativity. Now, she may not see this as a choice. (In fact, she almost certainly does not) Stuff just happens to her. But allowing yourself to fall into the posture of a chronic victim is itself a kind of choice.

The thoughts you think, end up thinking you.

You are the co-creator of your lived experience.

If you find yourself attracted to value investing, and you come to identify strongly as a “value investor,” in addition to whatever financial returns you generate that identity probably gives you a sense of meaning and maybe even a sense of community or belonging (if you don’t see Berkshire Hathaway’s annual meeting as a form of religious pilgrimage I’m really not sure what to tell you). Your value investor identity also frames your worldview a certain way. It limits your worldview in certain ways. This can be a liability, if your value worldview is fundamentally misaligned with the prevailing market regime. In this case your identity may well turn out to be a form of maladaptation.

A static identity locks you into particular patterns of thought and behavior. These patterns are relatively straightforward for others to identify and exploit, whether in business, politics or investing.

This lock-in is what I mean by psychic prison.

Escaping The Psychic Prison

Escaping the psychic prison of identity is straightforward but not easy. All you have to do is redraw the boundaries of your identity.

This lies at the heart of zen practice, adjacent to the idea of non-attachment. After years of practice, a zen master might be able to completely erase his attachment to self–a process that might trigger a complete mental breakdown for someone unprepared for the experience. What might this feel like? Having not experienced the feeling of complete dissolution of self, I’m hardly qualified to describe it.

Fortunately, complete dissolution of the self isn’t required to break out of the psychic prison of identity. All that’s needed is the ability to consciously rewrite the boundaries of identity.

Meditation is one way to practice this. Another is acting.

Our value investor might begin working on his escape from the limiting aspects of that identity by play-acting at growth or momentum investing. This doesn’t mean completely abandoning the tenets of value investing. It merely means cultivating the ability to view the world through someone else’s eyes. It’s merely about wearing the mask of a growth investor. At least to start, anyway.

The things you own, end up owning you.

The thoughts you think, end up thinking you.

The masks you wear, end up wearing you.

Ultimately, there’s no difference between you and the masks you wear. You are the masks you choose to wear. For some this is a frightening possibility to consider. Particularly from a metaphysical perspective. However, it’s also empowering.

Remember, you get to choose the masks you wear. That’s the point of this post.

The Nature Of Freedom

True freedom is freedom from an arbitrary or externally defined definition of self. It’s engaging in the process of creative destruction.

Personal freedom is engaging in creative destruction at the level of the self. Economic freedom is engaging in the process of creative destruction in the external world. When I say engage in I mean engage in as a principal, as a force acting on the world around you. Like it or not, we’re all subject to the process of creative destruction. The difference between freedom and slavery is agency.

This is the reason I included that quote from The Rock at the start of this post. It cuts to the very heart of what it means to be free. Free people manifest their will in the world around them. Losers whine about doing their best.

The archetype of the chronically negative loser described at the beginning of this post is especially grim. Here is a person who cannot even rise to the level of whining about doing her best. All she can do is whine about being a victim.

By contrast, by this definition, Frederick Douglass was probably freer as a slave than most nominally “free” people are today. It’s not an accident that one of Douglass’s most famous sayings is the statement that “knowledge is the pathway from slavery to freedom.” There is a reason slave owners did not want their slaves to learn to read.

In this spirit I’ll close with an excerpt from Douglass’s speech, “Self-Made Men,” which I recommend you read in its entirety.

I am certain that there is nothing good, great or desirable which man can possess in this world, that does not come by some kind of labor of physical or mental, moral or spiritual. A man, at times, gets something for nothing, but it will, in his hands, amount to nothing. What is true in the world of matter, is equally true in the world of the mind. Without culture there can be no growth; without exertion, no acquisition; without friction, no polish; without labor, no knowledge; without action, no progress and without conflict, no victory. A man that lies down a fool at night, hoping that he will waken wise in the morning, will rise up in the morning as he laid down in the evening.

Faith, in the absence of work, seems to be worth little, if anything. The preacher who finds it easier to pray for knowledge than to tax his brain with study and application will find his congregation growing beautifully less and his flock looking elsewhere for their spiritual and mental food. In the old slave times colored ministers were somewhat remarkable for the fervor with which they prayed for knowledge, but it did not appear that they were remarkable for any wonderful success. In fact, they who prayed loudest seemed to get least. They thought if they opened their mouths they would be filled. The result was an abundance of sound with a great destitution of sense.

334px-Frederick_Douglass_(circa_1879)

ET Note: The Grand Inquisition

Below is the teaser for my latest Epsilon Theory note. The piece is a meditation on freedom, through the lens of Dostoyevsky’s parable, “The Grand Inquisitor”:

The Nudging State and Nudging Oligarchy believe they are giving us a gift: Freedom from Choice.

Except that it is neither a gift nor freedom in any sense. Rejecting it isn’t always easy and it isn’t always costless. But it’s the only choice for anyone who would be free.

Click through to Epsilon Theory to read the whole thing.

There’s an idea embedded in this note, related to the specific mechanism through which the Nudging State engages in social engineering, which is worth making more explicit. I’ve written around the edges of it before on this blog, in The Tyranny of Optimization, when I wrote:

Here you’re not staring down the barrel of a gun but rather at a smartphone screen. Here, the trick is not only convincing people to buy into your optimization, but that buying in was their idea in the first place. This is tyranny updated for the 21st century. Much cleaner than putting people up against a wall.

What I’m describing here is what my friends at Epsilon Theory call “fiat thought.” These are thoughts and behaviors you believe are your own, though in reality they’ve been engineered by the Nudging State and the Nudging Oligarchy to promote some policy or behavior.

How do you test for fiat thought?

Ask why.

“Why do I believe [whatever]?”

For fiat thought, the answer is always some permutation of “because someone told me so.” Maybe that’s a politician. Maybe it’s a business leader. Maybe it’s a public intellectual or “thought leader.” Maybe it’s a go-to media outlet (or several). Bottom line is you won’t have a principles-based reason for believing whatever is at issue.

Having your thoughts replaced with fiat thought is perhaps the purest form of slavery I can imagine. It’s like being transformed into a pod person, except you don’t even realize the transformation is taking place. In fact, to the extent you notice the transformation at all, you’ll believe it was your own idea. This is the nature of “choice architecture.” It’s a kind of rigged game–a simulation of free will.

In reading some of the responses to my note, there are a couple common threads:

  1. Aren’t constraints on our behavior necessary to some extent to have a functional society?
  2. Most of the folks who serve the State do not have malicious intentions and are sincerely doing the best they can to balance tradeoffs when making policy.

These are both excellent points. I totally agree with both of them.

Constraints on our behavior and incentive systems are terms we negotiate as part of the social contract. The negotiation process is ongoing and dynamic. It never ends. An important aspect of freedom is the ability to participate in the negotiation process as a principal. “Nudgers” do not treat us as principals. Nudgers treat us as biological systems to be engineered.

ET Note: The Alchemy of Narrative

I revisited some of George Soros’s writing on reflexivity over the weekend (thanks Ben Hunt!). In doing so, I realized my initial reading, years ago, had been extremely superficial. Back then, I focused on feedback loops as amplifying the usual cognitive and emotional biases we point to in investment writing. Things like confirmation bias and loss aversion and overconfidence. This reading of Soros wasn’t necessarily wrong. But it was narrow and incomplete.

When Soros writes about reflexivity, he isn’t just arguing cognitive errors made by market participants cause prices to diverge from the objective reality of the fundamentals in self-reinforcing feedback loops. He’s arguing the fundamentals are often, if not always, themselves subjective realities.

Click through to Epsilon Theory to read the whole thing.

But since you got here through the blog, you also get some bonus content. Note that if you continue reading, things will get conceptual, abstract, philosophical, and maybe a little weird. Consider yourself warned. If you’re not interested in that kind of thing you can safely skip the rest of this post.

My ET note is about subjective reality in the context of financial markets. At the very end, it alludes to the fact that reflexivity and subjective realities influence all social systems. Politics. Geopolitics. Economics. It’s all reflexive. The Big Idea is this: reflexivity is what drives the cyclicality we observe throughout history. Reflexivity is why we appear to learn from history and yet are doomed to repeat it.

Back in 2013, Venkatesh Rao of Ribbonfarm wrote what turns out to be a pretty compelling explanation of how Missionaries come to an intuitive understanding of both reflexivity and subjective reality, in the context of the TV show, The Office. Rao uses “Sociopath” in place of “Missionary” in his piece, but for our purposes here the terms are interchangeable.

It’s important to understand that when Rao writes about Sociopaths, he’s not writing narrowly about serial killer wannabes. He’s writing about people who want to know The Truth. Specifically, Sociopaths want unmediated access to the Truth, because they (rightly) suspect other people have a vested interested in obscuring or distorting it for their own ends. The Beginner Sociopath is vaguely aware of Narrative. In pursuit of Truth she begins unmasking reality–ripping away Narrative abstractions.

Over to Rao:

As the journey proceeds, Sociopaths progressively rip away layer after layer of social reality. The Sociopath’s journey can be understood as progressive unmasking of a sequence of increasingly ancient and fearsome gods, each reigning over a harsher social order, governing fewer humans. If morality falls by the wayside when the first layer is ripped away, other reassuring certainties, such as the idea of a benevolent universe, and predictable relationships between efforts and rewards, fall away in deeper layers.

With each new layer decoded, Sociopaths find transient meaning, but not enduring satisfaction.

Much to their surprise, however, they find that in the unsatisfying meanings they uncover, lie the keys to power over others. In seeking to penetrate mediated experiences of reality, they unexpectedly find themselves mediating those very realities for others. They acquire agency in the broadest sense of the word. Losers and the Clueless delegate to them not mere specialist matters like heart surgery or car repair, but control over the meanings of their very lives.

So in seeking to unmask the gods, they find themselves turning into the gods.

When they speak, they find that their words become imbued with divine authority. When they are spoken to, they hear prayerful tones of awe. The Clueless want to be them, Losers want to defer to them.

[…]

Once the Sociopath overcomes reality shock and frames his life condition as one defined by an absence of ultimate parental authority, and the fictitious nature of all social realities, he experiences a great sense of unlimited possibilities and power.

Daddy and Mommy are not hereAnything is possible, and I can get away with anything. I can make up any sort of bullshit and my younger siblings will buy it. 

The sense of freedom is one I like to describe as free as in speech, and as in lunch

Free as in speech describes the Sociopath’s complete creative freedom in scripting social realities for others.  Cherished human values are merely his crayon box.

Free as in lunch describes the Sociopath’s complete freedom from accountability, in his exercise of the agency ceded to him by the Losers and Clueless, via their belief in the reality of social orders.

Non-Sociopaths dimly recognize the nature of the free Sociopath world through their own categories: “moral hazard” and “principal-agent problem.”  They vaguely sense that the realities being presented to them are bullshit: things said by people who are not lying so much as indifferent to whether or not they are telling the truth. Sociopath freedom of speech is the freedom to bullshit: they are bullshit artists in the truest sense of the phrase.

What non-Sociopaths don’t recognize is that these aren’t just strange and unusual environmental conditions that can be found in small pockets at the tops of pyramids of power, such as Lance Armstrong’s racing team, within a social order that otherwise makes some sort of sense.

It is the default condition of the universe. The universe is a morally hazardous place. The small pockets of unusual environmental conditions are in fact the fictional realities non-Sociopaths inhabit. This figure-ground inversion of non-Sociopath world-views gives us the default perspective of the Sociopath.

Non-Sociopaths, as Jack Nicholson correctly argued, really cannot handle the truth. The truth of an absent god. The truth of social realities as canvases for fiction for those who choose to create them. The truth of values as crayons in the pockets of unsupervised Sociopaths. The truth of the non-centrality of humans in the larger scheme of things.

When these truths are recognized, internalized and turned into default ways of seeing the world, creative-destruction becomes merely the act of living free, not a divinely ordained imperative or a primal urge. Creative destruction is not a script, but the absence of scripts. The freedom of Sociopaths is the same as the freedom of non-human animals. Those who view it as base merely provide yet another opportunity for Sociopaths to create non-base fictions for them to inhabit.

Regardless of how I qualify it in advance, the word Sociopath carries with it decidedly negative connotations. But again, Sociopaths as described here are not inherently evil. Rao only tangentially touches on the difference between Good Sociopaths and Evil Sociopaths. Here it is: Good Sociopaths choose to adhere to some kind of moral code. Evil Sociopaths choose to live in a state of amorality.*

I’ll expand on this slightly.

The Evil Sociopath embraces nihilism as a license to treat others as playthings. Most often Evil Sociopaths do this through legal means, for example under the cover of business and financial dealings. Others do it through criminal activity, or by playing manipulative games within their personal relationships. And yes, a very small minority of Evil Sociopaths go the serial killer route.

The Good Sociopath, on the other hand, rejects nihilism as a license to treat others as playthings. Critically, this is not because there is some fundamental, verifiable Truth out there affirming an underlying moral order. Instead it’s because, for whatever reason, Good Sociopaths find the thought of embracing nihilism repulsive. The Good Sociopath chooses to believe other people are worthy of some level of dignity.

I have been annoyingly consistent in highlighting the word choose here just to emphasize that we’re dealing with subjective reality. Social systems are reflexive. Facts and small-t truth do exist, but to Sociopaths they’re negotiable.

In the immortal words of Don Draper: “if you don’t like what’s being said, change the conversation.”

And the Sociopath/Missionary is free to do so.

Free as in speech.

Free as in lunch.

 

* For another pop culture reference that may make this more concrete, the first season of HBO’s True Detective is pretty explicitly about Rust Cohle’s Sociopath journey, and how he and various and sundry other Sociopaths cope with “reality shock.”

Storytime

GLENGARRY GLEN ROSS, Al Pacino, Jonathan Pryce, 1992, (c) New Line/courtesy Everett Collection

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.

It’s storytime.