The Party's Over

The Republican Party is facing an existential crisis. It is at a point where it must decide as an organization if it is going to continue to be a personality cult devoid of ideas and completely unable and unwilling to provide potential solutions to problems. 

The Democratic Party is facing an existential crisis of its own. It must decide as an organization if it is going to continue to be an elitist cabal that refuses to engage in anything but gesture politics. Interestingly the Democratic Party just emerged from or narrowly avoided becoming its own personality cult during the years of Obama. But the next iteration of the party was a substantial backward step rather than a major mistake averted. 

The Republicans basically do not have ideas. The Democrats basically have only bad ideas. I’m not sure which is worse, and I am equally unsure about which one can right its listing ship both of which are at risk of completely capsizing.

If there is any salience to my Five Tribes of Politics theory, then perhaps that can shine some light on where things go next. 

To recall, I think there are five key factions that in order to be electorally successful the major parties must appeal to. They are:

• Crony Capitalists
• Labor
• Patriots
• Evangelicals
• Woke Champions

Balance is important as too much appeal to any one group can alienate the others making a strong coalition of resistance. 

The Republicans are about to get what they supposedly were asking for with abortion pleasing evangelicals. While this enrages woke champions, that is not a group the Republicans have any interest in appealing to. However, like the dog that caught the car, evangelicals might be done with the strategy of "using Trump to get the courts". At the same time the extent of strictness of some state's abortion laws might turn away others who find the developments a bridge too far.

More problematic for the personality cult would be the shifting ground on geopolitical tensions. Praise for Putin doesn't look so hot to patriots these days, and both labor and crony capitalists have reasons to see a strong, engaged American military as a benefit. 

But for Democrats the footing isn't any better. So many parts of the woke agenda eventually conflict with the real-world aims of labor and crony capitalists. Patriots too tend to lean toward an America-first policy world. At some point you cannot keep convincing these factions that what you "really, really mean to say is [thing that benefits them most truly]". 

A very big part of what the parties are grappling with is the same phenomenon that is reshaping so much of society and institutions--namely, disintermediation in all its gory and wonderful forms. America's two-party system has been remarkably enduring. Perhaps this was a function of America spending over 100 years fighting obvious enemies with the parties arguing about whose ideas were best suited to bring a better world. 

These enemies included economic collapse just as the industrial revolution hit its stride (i.e., the Great Depression), tyrannical kingdoms hell bent on world domination (i.e., the axis powers of WWII followed by the USSR; the hottest of wars and the Cold War), domestic unrest as people no longer tolerated various inequalities (i.e., the civil rights and women's liberation movements; note these virtuous developments were "enemies" in that they threatened the order of things--they were enemies of the regime), and threats to American hegemony (i.e., economic globalization and terrorism). 

All of these were ironically existential threats to the United States. All of them called for solutions ranging from combat to embracement. Big parties were an efficient means of fighting these battles. That era may have ended. Economies of scale have limits and one of the virtues of specialization is that bespoke eventually outcompetes commodification. 

What I'm Worried About as a Crypto Investor

Much like throwing a pass in football, there are three general outcomes from crypto investing, and two of them are bad. Namely, aside from maintaining or increasing in value, crypto assets like Bitcoin and Ethereum could become nearly valueless to an investor in two distinct ways. They could go bust or they could fail to reward investors even though they prove valuable to society in general. 

I consider these two bad outcomes distinct since they are so different in every manner except for the ultimate experience for investors. In the one case we have the conjecture that cryptocurrencies are vaporware that are just riding a greater-fool wave that will ultimately come crashing down. Label this one the "worthless" scenario.

In the other case we have the concern that even though crypto and its inseparable blockchain technology are godsends, there is no way to actually profit from their benefits directly. Label this one the "unable-to-capture-worth" scenario. 

Which one you subscribe to or concern yourself with says a lot about your crypto demeanor. For me the second concern is what keeps me up at night. I am a modest investor and a big, enthusiastic supporter. I want it to win and for me to win with it. 

Others are rooting for it to lose because they don't believe or don't want to believe in it or maybe some of both. For these doubters there is often a FOMO element that partially drives the want for crypto's demise. But in many cases these are thoughtful people making intelligent arguments against.

While the case against crypto isn't completely empty, I believe the clock is running out on that perspective. As crypto assets continue to establish themselves now more than a decade into their existence, this view looks more and more like a trivial dismissal similar to thinking the Internet would not amount to much beyond a step up from a fax machine.

Much more likely is that if crypto investors are left holding the bag the value has melted away from investors flowing to the benefit of all of society in general. Tyler Cowen made this case recently in his Bloomberg column:

So you can be bullish on crypto’s future without being bullish on current crypto prices. For a simple analogy, Spotify and YouTube have greatly expanded music’s reach, but overall the price of recorded music has fallen, and many performers earn much less than did their peers in the LP era. Or consider the agriculture sector, defined broadly: It has done very well over the last few centuries, but food prices have fallen rather than risen, due to higher output and greater competition.

I consider the unable-to-capture-worth scenario the serious, thoughtful worry. There are many ways this almost certainly will be true if crypto pans out for the long haul. You can make a great living as a bathroom remodeler or a plumber, but you aren't coming anywhere close to capturing all the value to consumers of indoor plumbing. 

If crypto investing fails, I think it will fail despite succeeding as a technology rather than because of it failing to ever deliver.

 

P.S. I take it as a very positive sign for crypto assets that the serious ones (Bitcoin, Ethereum, etc.) are becoming more and more correlated with the performance of "real" financial assets like stocks and bonds. It is an unfortunate economic fact that assets tend to become more highly correlated together as they mature making investing more difficult as some of the benefits of diversification erode.

WWCF: War of the Future

Which will come first?

Intentional detonation of a nuclear weapon as an act of war

or

A battle with robots fighting robots as the dominant form of combat

Terms:

The basic terms are fairly straightforward in the first case--a nuke blows up on purpose designed to hurt targeted victims. But I guess there could be some ambiguity like if a bomb detonation is attempted but somehow fails or is thwarted or if it melts down rather than properly explodes. In the interest of specificity I will stipulate that the device must be truly an intentional nuclear explosion. 

In the second case there would seem to be a lot of room for interpretation. Let us stipulate that it would need to be a significant engagement with at least a potentially meaningful affect on a larger conflict if not be the entire war by itself. This must be a major conflict in terms of world events. It must involve at least one nation state with the opponent being at least a major aggressor (significant terrorist group, etc. if not a state-level actor itself). To be robot-on-robot it must mean that humans cannot be directly targeted in the robot versus robot fighting--collateral damage notwithstanding as well as other human involvement/risk as a secondary part of the combat. I will allow that the devices doing the fighting can be "dumb" devices like drones fully controlled by humans remotely, but extra credit to the degree these are autonomous entities.

Discussion:

Tyler Cowen has been thinking a lot about nuclear war and nuclear device detonation recently including before the Russian invasion of Ukraine. His latest Bloomberg piece discusses just how thinkable the "unthinkable" has become. This is a bigger part of a much needed rethinking of MAD. 

Tyler's partner at Marginal Revolution, Alex Tabarrok, is in the game contributing this overview of the related probabilities. 

Thankfully, Max Roser has done the math for us. Relatedly, he argues that "reducing the risk of nuclear war should be a key concern of our generation". Before we get too excited about a white-flash end to civilization, consider as gentle pushback this piece arguing that nuclear weapons are likely not as destructive as we commonly believe--make no mistake, they are still really bad.*

If Roser is roughly correct, then within a decade we are at a 10% chance of nuclear war. I am not sure if his "nuclear war" would be a equal to or a different level of what would qualify in this WWCF. Suppose it is a higher threshold. Let's make the probability of nuclear weapon use as defined here slightly higher each year such that there is a 20% chance within 10 years (basically equal to his 2% annual risk curve). This gives us a baseline for comparison.

Turning to Rock 'Em Sock 'Em Robots it is not as farfetched as I think most people believe. In fact we may be quite close to it as defensive weapons like Israel's Iron Dome prepare to confront adversaries like drones and Saudi Arabia battles against drone counter attacks from Yemen. As Noah Smith writes, "the future of war is bizarre and terrifying".

It does sound terrifying in one reading, but in another there is a glimmer of hope. A proxy war using robots to settle disputes could be vastly better than any conflict humanity as known before. Imagine a world where the idea that a human would be actually physically harmed from combat was unthinkable. This is not too many steps away from professional armies, rules of engagement, and norms, laws, and treaties against harming civilians, et al.**

Back to the issue at hand, once we consider that dumb, remotely driven/released weapons might soon be battling smart, sophisticated devices with either of these being on defense from the other, we quickly relax how hard it is to foresee it all happening. The hardest hurdle might only be if the conflict big enough to qualify.

My Prediction:

I think nuclear risk is a lumpy, non-normal risk that follows a random walk (i.e., it can all of a sudden get a lot more likely but that likelihood can get absorbed away if conditions improve). It is not as linear and cumulative as Roser suggests. At the same time play the game long enough and anything will happen.

Robot battles seem more like a cumulative progression, an inevitability. We almost cannot escape it eventually happening and probably soon. So, this comes down to how likely a nuclear pop is in the very near term as it tries to out race the tortoise of robot warfare. Just like in the fable, the turtle is going to win.***

I'll put it at 75% confidence that we see this one resolved robot fights robot.

*Of course other future potential weapons that are not nuclear can be extremely scary too--"Rods from God" doesn't just sound very ominous; it truly is. 

**Then again, maybe not:

As a result, conflicts involving AI complements are likely to unfold very differently than visions of AI substitution would suggest. Rather than rapid robotic wars and decisive shifts in military power, AI-enabled conflict will likely involve significant uncertainty, organizational friction, and chronic controversy. Greater military reliance on AI will therefore make the human element in war even more important, not less.

***I know they aren't the same thing! 

P.S. When I first conceived of this WWCF, I thought I'd be comparing robot wars to lasers as prolific, dominant weapons. I changed it as laser weaponry seemed to be consistently failing to launch. However, great strides have been made recently in this realm. Perhaps I was too hasty. However, thinking about it more I would guess that robot war will go hand in hand with laser weaponry. The development of one spurs the development of the other such that there isn't much room for a WWCF.

P.P.S. The ultimate tie would be an AI launches a preemptive nuclear strike on a rival nation's AI or other robot weaponry. Let's hope if they do this the battle is on Mars.

Choose: Stocks and Bonds or Bitcoin and Cash

Over lunch this past week an interesting hypothetical was posed. Suppose you were offered one of the following, which would you choose: 

• One million dollars in some initial combination of your choosing between stocks and bonds (fully-indexed, total market coverage), or
• One million dollars in some initial combination of your choosing between Bitcoin and cash (U.S. dollars).

You will be forced to lock it in for 10 years with no changes to it or any ability to borrow against it. After the 10-year period is up, it is yours free and clear (no taxes either at that point).

Without too much thinking or much hesitation, I chose Bitcoin and cash in a 50/50 combination. My wiser colleagues said with as much or more conviction stocks and bonds--I don't recall their combinations if they stated them. Since I am the investment guy, this raised eyebrows. Maybe I'm just also the gambler. To be sure I caveated my decision with the disclaimer that I might change my mind (my guess was low conviction). To be fair the others did similarly but with perhaps a bit less hesitation (somewhat higher conviction).

In general I would assume that all four of us in this conversation are of very similar financial standing adjusted for our ages (there is about a 30-year spread from youngest to oldest). There is not a right or wrong answer on this question--at least not without a lot more information about each chooser including several underlying assumptions (risk tolerance, liquidity needs, expectations about each person's future goals and paths of life, etc.). I don't wish to get into speculation about that here nor try to evaluate the soundness of any starting position. 

What I am interested in is exploring further how we might frame such a tradeoff. One additional outcome from this exercise is thinking about what assumptions one would make about critical variables and the implications of those assumptions. 

Some people would very appropriately, for themselves, choose an allocation of 100% cash. We could argue about that, but again only by digging deeper into their goals and risk tolerance among other things. "Hey, I'll take free money and I want to know it will be basically there for me at the end of the rainbow (inflation be dammed!)." That is potentially a sensible position, but we could write a book (many books have been written) about what extreme conditions must be in place for that to be rational. Geez, I better stop now or that will be this post . . .

So let's just assume we are debating only the question of which outcome has the best highest expected value after 10 years. I strike "best" because that implies more than just the math problem I want to explore.

We need just a few inputs: 

• expected returns of stocks, bonds, Bitcoin, and cash (I am assuming we can get some yield on cash rather than thinking of it as money under the mattress.)
• expected inflation (We are going to look at values in real terms so we don't let the cash option appear better than it actually is--a likely net loser to inflation.)
• probability of various outcomes (Using a range of expected returns we need to know how likely we think those are. The range is really only important for Bitcoin given its unknown future.)

I am going to use Vanguard's capital market assumptions (CMA) for expected returns of stocks, bonds, and cash as well as inflation. To make these always updating predictions evergreen in this post and because these are publicly available information as linked above, I will also post a picture of these below. Please do see Vanguard's website for more information including appropriate disclaimers. 

I am going to totally make up the expected returns for Bitcoin because 1) my guess is as good as yours and 2) the devil is in the probability and the relative outcome versus the others--my accuracy is nearly immaterial if I am in the ballpark. 

Before you dismiss any of this upon glancing at the inflation prediction (range 1.6% - 2.6%), understand that these are 10-year predictions. I hope they are right given what this implies going forward given currently very high inflation rates, but it can easily be the case even with some persistence of current inflation (8% for a year (not that bad yet) plus 5% for a year plus 8 years at 1.6% would land us at the high range).

Note that I am looking at true total market coverage in stocks (U.S. and all international), thus I will combine the growth rates below in the proportion 55/45 U.S./Int'l. Note also that I am only using U.S. bonds in the model. I generally like some international bonds, but I will make this limiting assumption. Regardless, U.S. versus Int'l bond returns are pretty close as you can see in the details below and at the link.

Enough of that already, let's model this thing.

Here is version 1:

I am putting my thumb on the scale to be optimistic about traditional asset returns (stocks and bonds)  making the low case 25% likely and the high case 75% likely, which serves to put my initial Bitcoin/cash choice at a disadvantage. For Bitcoin I am assuming total collapse in the low-end prediction versus only 25% annual growth in the high-end version. I say only as this isn't "to the moon" although it is very strong growth indeed. Keep in mind that Bitcoin has averaged about 94% annual growth over the past 5 years through to today's price of about $38,300. While being conservative? on the high-end growth rate, perhaps I am not appropriately discounting the likelihood of the high side putting it at a 20% chance. I will change that assumption in the next model. 

But just before that, let me explain why I don't think we need to worry about the mixing and matching between individual high and low estimates (e.g., stocks grow at 6.1% while bonds only grow at 1.9% or stocks and bonds are high but Bitcoin and cash are low, etc.). Assets tend to be positively correlated over longer and longer timeframes. Even though stocks and bonds enjoy some degree of poor correlation, these fade away over time as what is good for stocks (a productive, growing economy) is also good for bonds. Likewise, a world that has Bitcoin doing well probably has stocks doing well, and a world where inflation is low, stock and bond returns are also probably low. Regardless, the heart of the debate isn't going to be impacted by these details. 

Here is version 2:

Ouch! Even though I made the low-high range for stocks and bonds 50/50, the move to make low to high outcomes 95/5 for Bitcoin destroys that option. But if that is really more like the future likelihood of the outcome range for Bitcoin, perhaps stronger return possibilities on the high end are as well. So . . .

Here is version 3: 

I greatly increased the growth rate for Bitcoin using 38.6% annual growth. This isn't a randomly chosen number. This would correspond to a Bitcoin price of approximately $1,000,000, which some roughly project as a possible destination (who knows?). Regardless, stocks and bonds still look better. So let's do just two more for the sake of good order . . .

Here is version 4:

The only change here is to make the Bitcoin high possibility a little more likely moving it from 5% to 10%. And wow! Look how sensitive the difference result is to this change. Obviously this should come as no surprise as this whole thing is about Bitcoin's high end. I guess we could run just one more taking a look at a more moderate Bitcoin but also a less than total bust low-end for it.

Finally, here is version 5:

So, allowing for a Bitcoin future in any future (low end is 10% annual decline in value) gives us a fairly strong case for my gamble on some combination of Bitcoin and cash. 

Having gone through this process would I now change my mind? I will stick with 50/50 Bitcoin and cash. But that strongly suggests a question: how can I justify that choice given that I don't have an existing portfolio that looks anything like that. I am personally overwhelmingly "boring" with an almost all-stock portfolio with just a bit of crypto sprinkled in. 

At the risk of a slight digression into the post I keep promising this will not be, allow me to defend my rationality. This hypothetical is a forced gamble. My retirement investments are different in that regard. Those I can and do change periodically including both allocation as well as contribution. I get to guide those and adjust them. The hypothetical gift invested is a Ron Popeil "set it and forget it". Part of why I cannot invest more in Bitcoin (aside from it wisely not being a 401(k) option (looking right at you, Fidelity)) is that I likely cannot tolerate the variance. If I can get in and get out of it, I am as more likely to make the wrong in/out moves as the right ones. And that is before the tax-drag effect. 

Besides that, my investment reality is the retirement assets I actually do have. This hypothetical is a lottery ticket idea. If I win the lottery, my reality materially would change. I could afford more and different risk. In this sense and surprisingly, if the hypothetical was $10,000 in stocks and bonds versus Bitcoin and cash, the rational decision for me might have been stocks and bonds! Whereas the typical person would say, "that is too little to worry about the risk, let it ride!", I would counter, "I can't afford to take the the riskiness of Bitcoin at that magnitude ($10,000)." Along this one dimension, I would be right. 

I want exposure to big upsides. Unfortunately, these are difficult to find and doubly difficult to stick with. In a sense this thought experiment has revealed some of my own limitations on putting my money where my mind and heart and mouth are. 

-----

What All The Pundits Are Getting Wrong About CFB Playoff Expansion

In the subculture that is major college football, big news broke earlier this month that the championship playoff at the sport's highest level, FBS, would not be expanding from the current 4-team format for the duration of the current contract.

from CBS Sports:

College Football Playoff expansion on hold, current four-team format will remain until 2026

A 12-team proposal was proposed, but the CFP won't be expanding until after the current contract expires in 2025

Many of us who follow the sport found this disappointing. In fact almost everyone weighing in on it including the people who decided the matter by voting against expansion expressed disappointment. So what's going on here?

Most pundits write it off as simply a group of people too petty and short-sighted to get past themselves and grasp the bigger picture. To be sure, that might actually be true. However, I think there may be something else at play. 

College football is in incredible flux. From the rise/revolt of the student athlete finally demanding and getting a fairer seat at the table to competitive pressures to realign into better and better deals, there is much uncertain about its future. 

I think it is fairly obvious that the current arrangement in college football is not sustainable. There are currently 130 teams in the division with four more planning to make the upgrade from the lower-division FCS. This is a league that ranges from Alabama to Kansas (winningest to losingest over the past 10 seasons). That is a big range.* The bottom of the league would typically be an extreme underdog to any opponent from the top of the league--perhaps on average a matchup between a top 20 team and a bottom 20 team would imply a +90% likelihood the favorite would prevail.

This is not a league with any sense of balance. Frankly, somebody has gotta go. Most of the members of the major conferences, the so-called Power Five, know this. As a group their teams are much better than the rest of the league, the so-called Group of Five. While some of the weakest teams are found in the Power Five (e.g., Kansas and Vanderbilt) and some of the strongest teams are found outside the Power Five (e.g., Central Florida, Boise State, and independent Notre Dame), these are exceptions. 

It is my contention that the major stumbling block to expansion of the CFP before 2026 is what kind of deal the Group of Five would get in the arrangement. If those conferences were granted slots in the playoff, they would hold a lot of bargaining power going forward. The teams within those conferences, especially the very good teams, would have much less incentive to move into a power conference. If nothing else, the buyout of those rights would grow astronomically. 

It has been at least rumored that the Power Five have offered to buy out the Group of Five from the CFP. This would line up with my hypothesis nicely. The elite teams and conferences see the writing on the wall. They know, I believe, that the highest division of college football should have perhaps 64 or so teams in it. 

They also know, I believe, that even if a field of ~130 teams continues, it very well might be one with a de facto two divisions (upper and lower). The lower teams would be there as sort of a relegation à la soccer. By no means in this arrangement should a lower-division team have anything but the slimmest of chances at a playoff berth. 

Any concession made today to a lower-tier team/conference, is very risky. As talent accumulates into the better teams/conferences, those entities have the luxury of wanting a bigger share of the spoils. Negotiations while the future of the league is still sorting itself out means deals can't come together--the lower-level teams/conferences want more than they can offer and the upper-level teams/conferences need more than they can get. 

I didn't see this clearly at first and expected an expansion to happen before the current contract's expiration in 2025. Now I understand it better if for no other reason than having to look hard to understand why a deal fell through. 

*If you don't agree that Kansas isn't a serious team (Texas Longhorns probably don't), then consider the other doormats over the past decade: UMass, New Mexico State, Connecticut. 

Biden - One Year In

About a year ago I posted on the Biden administration looking at what I saw as the reasons to be optimistic and pessimistic. Let's check in on those predictions and see otherwise how Trump's second term is proceeding.

I considered four areas for potential optimism: Trade, Immigration, Drug Policy, and Presidential Prestige. For these I felt like there was both a relative and absolute way to evaluate them--relative to Trump and absolute as in a general case.

Trade - I was quite hopeful on this front from a relative position believing that Biden would embrace a change from Trump. Well . . . no. Peruse the Cato Institute trade team's 2022 wish list to see how many times they identify a problem that is a continuation of Trump's policies. Trade suffered by being a non-meaningful issue beyond anti-Trump symbolism.

Prediction grade = FAIL

Immigration - I was quite hopeful that here Biden would be absolutely good. Instead he has literally continued Trump-era policies that he and his base strongly criticized during Trump's term while during this first year largely ignoring the issue otherwise. His modest improvements are vastly overshadowed by failures which shows cowardly indifference to people in dire need.

Prediction grade = FAIL

Drug Policy - I had slight optimism of an absolute variety. Alas, we elected an architect of the drug war with an uncaring bad cop as VP and expected change. Shame on us.

Prediction grade = FAIL

Presidential Prestige - This prediction was all relative, which made it a quite low bar. But hurdles aren't Uncle Joe's strong suit. As elucidated by Jonah Goldberg, Biden has very much not taken the high road. And his lying is about as common and as obvious as was Trump's. Gene Healy's recent presentation on Partisanship, Polarization, and Political Hatred was a good summary of how Biden's presidency started (was promised) and how it's going.

Prediction grade = FAIL 

Zero for four so far; let's turn to pessimism.

Here I was only considering each area on an absolute scale, and it was here I had the most confidence.

Judicial Appointments - My hope was for impartial, well-reasoning judges who apply the law and not politics. Without any high-profile appointments or me having enough inside baseball knowledge of federal court appointees, it is too soon to tell here.

Prediction grade = INCONCLUSIVE

Regulation - I expected Biden to reverse the gains made in the regulatory administrative state under Trump. In many small ways this has been true just as it was many small advances Trump accomplished, but it is in pandemic policy where my prediction really shines. Biden committed what I believe is a clear impeachable (and removable) act by extending the CDC's eviction moratorium despite knowing and admitting that the Supreme Court found it/would find it unconstitutional. He then in hateful fashion (see presidential prestige above) instituted a vaccine mandate for all private employers under OSHA's supposed authority.

Prediction grade = PASS

Taxes - Despite repeated attempts at worsening our tax code like a huge giveaway to the wealthy, the Democrat's inability to control their own crazies lead all of Biden's policy goals to failure. Even though the administration did not get its desired tax policy accomplished, I still believe my pessimism was confirmed regarding what tax policy would look like if they had their druthers.

Prediction grade = PASS

War - This one will get messy as war always does. I am still astonished and happy that Biden followed through on Trump's initial actions to end our involvement in Afghanistan. It wasn't pretty and Biden deserves criticism for those details. But it was a very good and difficult decision he made. Much remains to be seen regarding Russia/Ukraine and China/Taiwan among other areas. The latest looks a lot like his pullout in Afghanistan--the right move executed very sloppily.

Prediction grade = FAIL (thankfully)

Woke Politics and Policies - From "othering" those who disagree with the narrative to sic'ing the FBI on parents who dare to exercise free speech in regards to their children's education, my fears were realized.

Prediction grade = PASS

Spending - As I put it to a friend recently who said that I criticized Trump for being a big spender, Biden clearly had a "hold-my-beer" moment in his first year. We are now officially playing chicken with the gods of inflation. Let's see how this goes for President Ford take two.

Prediction grade = PASS

Presidential Power & Authority - When the NYTimes is telling a Democratic president to ease up on the executive orders, you know it is out of control. The ratchet turns another big notch yet again.

Prediction grade = PASS

Overall my predictions were 5-5-1. In the sense of what I would wish had happened I was a dreadful 1-10-1.

P.S. In that prior post I also stated some predictions about COVID-19 that have proven wrong. Some were wrong in my hope for saner policy responses. Others were wrong in terms of missing the negative magnitude of a potential variant (the Delta variant as it turns out) as well as my implicit hope that vaccine uptake would be greater than it was. The latter part contributing to why the former part was a bad prediction. Unfortunately I was dead-on correct about government failure regarding the FDA, et al. 

A Crowding Theory to Explain the Trade of the Decade

Bold title, I know. Yet while there may be some hyperbole in it, we do face a situation in equity markets quite unlike anything we've seen since the dot-com tech bubble era. 

[Disclaimer: This is not investment advice because I don't know you. I am not analyzing your situation, your appropriateness or suitability for equity or any other investment idea, your goals, or your risk tolerance. This is an attempt to explain what I believe to be the valuation existent in the market today. Read at your own risk.]

I. The Trade of The Decade

Typically with tolerable variation equities are "cheap" or "expensive" at the same time. The Great Recession was a period where equities went on sale, so to speak, for those willing and able to bear the risk. You didn't have to be brilliant; you just had to be brave. Buying and holding throughout the deepest points of the downturn (roughly Oct 2008 - Mar 2009) was a rewarding investment. Make no mistake it was not easy to do this as for years after the market bottomed it still never felt quite safe, but that is what investors generally and equity investors specifically get rewarded for--buying when no one wants to. 

At least they should be rewarded for that. And the expected reward is the "risk premium"--the expected return over and above the return for a risk-free investment. Think of it simply as the premium you should expect to earn for bearing the risk. Every investment has one. Sometimes it is relatively high like for stocks in the early 2010s. Sometimes it is relatively low like for stocks in the late 1990s. That "relative" measure could be in relation to its own history alone, the position of that asset class compared to other asset classes, or both. Current market risk premiums are the foundation behind my hypothesis that a big opportunity/challenge is in front of equity investors today.

The "trade of the decade" I allude to is a relative trade. Unlike so many highly-touted trades in history, this one is fairly simple. I wish to briefly outline it without effectively proving it so as to get to the true purpose of this post: a hypothesized reason for the opportunity to exist in the first place. After all, I am a strong supporter of semi-strong efficient markets theory (EMH).

First, some assumptions:

1. Markets are generally efficiently priced. This means all important known information is thoroughly and quickly incorporated into market prices. Therefore, an investor should not expect to be able to outperform the market. 
2. Risk tolerance (degree of risk aversion) among investors and risk outlook (the economic picture going forward) determine risk premia. The world looked very scary in March 2020 and investors' general appetites for risk were substantially lower than usual. 
3. Risk premiums today are generally low across all asset classes. A couple of ways to say this in everyday language are: equity returns going forward (next ten years) will be lower than what we have enjoyed historically especially in the last 11 years and interest rates look to be lower for longer (lower than historically and for longer than typically has been the case). Caveat: risk premiums can be low and returns look high and vice versa. I am being a bit casual with how I equate risk premiums and future returns as compared to history, but I believe the underlying point holds.

Here is the problem, opportunity, and challenge all rolled up into one. Today certain portions of the stock market look fairly expensive (high valuation) while other parts look fairly attractive (low valuation). To be more concrete about it the high/low valuations are in comparison to those specific equity subclasses' own history. However, adding to the puzzle the risk premia for those asset classes look typical for the expensive group while they likely are desirable for the attractive group. 

Even a sloppy reader at this point is growing quite frustrated by the fact that I haven't identified which groups of stocks I put into the expensive and attractive categories. That is intentional as I don't want that to be the takeaway from this post, but I will now relieve that frustration as long as you know I am NOT effectively proving my case. Take this too as assumption. 

From the perspective of valuation, large-cap stocks in the U.S. (especially growth-style stocks) are expensive compared to their own history. Small-cap stocks in the U.S. (especially value-style stocks) are cheap compared to their own history. International stocks (especially value-style stocks) are also cheap compared to their own history. One way to measure valuation is to look at the current market price compared to the earnings, the P/E ratio. The higher the ratio all else equal the more expensive the stock.

One of the best ways to see this is to look at long-term analyses of real (inflation-adjusted) price/earnings ratios. The most famous of these is Shiller's CAPE (cyclically-adjusted PE) for the S&P 500 index. 

We can then do very similar analysis on various other indices considering important subclasses to see how they compare to the S&P 500 (large-cap U.S. stocks). This analysis [summarized in the table below] is where we see these key differences. Namely, that the riskier areas of the stock market (value-style companies, smaller sized companies, international companies, et al.) look relatively inexpensive.

Risk premiums* [analysis and results not shown] both echo some of the valuation analysis as well as tell a bit of a different story. The risk premium for large U.S. stocks is near the median of where it has been over the last 15 or so years meaning that adjusted for risk these stocks look appropriately priced. The risk premium for small U.S. stocks is far above its own historical median meaning adjusted for risk these stocks look very low priced. To a lesser degree the same low price depiction can be ascribed to international value stocks. The risk premium for international growth stocks is more similar to large U.S. stocks (i.e., it is around its historic median). So we have a general range of stocks from those that look appropriately priced (safer stocks like large companies and growth-style companies) to those that still look attractively priced (riskier categories mentioned before).

The risk premium story is not as sanguine for large U.S. stocks as it may appear. Despite my assumption above that interest rates will remain low for a long time, they don't have to. And they can rise meaningfully above current levels and still be historically low. If they do rise, that will have a big impact on stock valuations. Large growth stocks in particular look very sensitive to this risk as their cash flows come far into the future. A rising interest rate means a rising discount rate applied to those cash flows, which reduces the current value of the stock.

The trade of the decade is to fade away from large U.S. stocks and increase exposure to small U.S. stocks (especially value) and international stocks (especially value). The most acute version of this is for large growth versus small value stocks in the U.S. Specifically we could identify indices like the Russell Top 200® Growth Index and compare it to indices like the Russell 2000® Value Index. The reason I call it the trade of the decade is because my more in-depth analysis focuses on 10-year expected returns and risk pricing as well as the fact that it might take a decade to fully play out. The reason you should heed caution before engaging in this trade is (1) this risk might not be for you (it indeed comes with risk not specified in this post) and (2) this is not an endorsement of reducing diversification (I still advocate exposure to large-growth stocks, etc.).

II. The Crowding Theory

IF I am correct about the different relative risk-adjusted valuations for various equity subclasses such as large growth stocks versus small value stocks, interesting questions emerge. How did this come to be? What explains it consistent with EMH?

I believe two crowding effects have brought this about. Flight to safety is the first crowding effect. Sophisticated money avoiding public equities is second. 

Recall my assumption that risk premia are determined by the general level of risk aversion among investors and the market's risk outlook. The tidal wave of the pandemic that unfolded gradually then suddenly from mid-January 2020 through to the market bottom of late March 2020 was a massive reevaluation of risk that triggered an extreme flight to safety. Note that it was not the entirety of the valuation dispersion between various groups of stocks. For some time now growth has been outperforming value, large has been outperforming small, and U.S. has been outperforming international. For U.S. equities the market's reaction to the pandemic was in fact the dominant portion of the differences we see today. 

From Vanguard: 

Difference in annualized total returns over rolling five-year periods

Source: https://advisors.vanguard.com/insights/article/growthvsvaluewillthetideschange

As the risks and worry of the pandemic grew, investors sought refuge in the safest of assets, U.S. Treasury securities. This lowered interest rates to nearly zero across the yield curve. They also derisked in other ways. For those who wanted continued equity exposer, they flocked to the safest equities in the world, large U.S. growth companies. The now much lower interest rate conditions worked in tandem to make these equities more and more attractive. The riskier aspects of the market suffered as investors tended to rotate away from them and into safety. 

So that is how risk premiums for various stocks got so extremely different, but why didn't sophisticated investors step in to absorb the difference? After all, they are supposed to have extremely long (infinite?) time horizons and not be subject to wild swings in risk. 

Sophisticated investors is a bit pejorative on my part. Here I am talking about the so-called "smart money" of institutional investors like endowments and pension funds. They like to think of themselves as cunning lions, but they bunch together like scared, vulnerable sheep. Theoretically, they should be a counterbalance to short-horizon investors who are theoretically much more sensitive to changes in risk appetite and risk conditions. 

For example, a person close to or recently entering retirement should be invested positionally to withstand the risk of market volatility. The same can be said of any investor--they should be so positioned. Yet often times they are not. And even more often they are liable to overreact to bad news leading them to drastically alter their investment positioning as an attempt to predict the future. However, I do not think this is a big effect. It is a behavioral story that isn't necessarily as irrational as it seems--extreme events like the Great Recession and COVID pandemic give us insights into our attitudes on risk tolerance not apparent before. 

At the same time the sophisticated investors themselves are subject to the same types of risk tolerance reevaluation. Rather, to be a counter-balance they need to be in the market. The reason why the “smart money” hasn’t absorbed all the excess risk premium in riskier aspects of the market already is because endowments and pensions have trended far from traditional public markets. Endowments have on average reduced their public market equity exposures by 50% in the past 50 years going from about 60% to less than 30%. They are crowding away from public equities making them unavailable to provide a counterweight. 

To be sure riskier assets have done well in the past few months--small-cap U.S. stocks were up 35% for the three months ending in January 2021. The primary catalyst were vaccine developments in November. Add to that improvement in our understanding of the true risks of the pandemic as well as rapidly improving economic fundamentals. Even still, risk premiums in risky assets (value, small cap, international stocks) are at elevated levels compared to their own history as well as their safer equity counterparts. 

As risk aversion gradually (and perhaps in sudden bursts) returns to normal levels and as the risk outlook continues to improve, my hypothesis is that those assets with outsized risk premiums will perform relatively well (high confidence) and absolutely well (moderate confidence). 

Incidentally while this bodes well for public risk assets, it likely portends poorly for alternatives (private equity, venture capital, hedge funds, et al.). That is a crowded space with not much low-hanging fruit, and what is there is very expensive to be had. 

*The reason I deliberately gloss over the risk premium results is the model I am referring to is proprietary, but more importantly the calculation of risk premia is art and science. Laden with assumptions, it can be very much argued over in fine detail. However, I believe the depiction above is well grounded and firmly supported by a wide range of reasonable underlying assumptions. For more on this topic see Research Affiliates work among many others. 

Biden O/U Performance Predictions

Admittedly I’m being too vague to be falsifiable, but set some agreeable terms, and I’m willing to bet (#MoneyWhereMyMouthIs #TaxOnBullshit). 

Here is a partial list of what I predict the Biden Administration's performance will be in a number of important areas. Specifically where will it outperform (Over) and where will it underperform (Under) the conventional wisdom’s current estimation. To be clear this is where it will be better/worse from my desired perspective than the conventional wisdom’s current estimation. 

For example, I think the conventional wisdom is that Biden will greatly raise personal and corporate income tax rates, increase capital gains tax rates, and restore the SALT deduction. Mostly all bad items from my perspective. I think it won't be as bad as assumed. Likewise, it is presumed that he will user in a much better world of trade and immigration policy. I think it meaningfully won't be that good. 

Over:
Taxes
Environmental regulation

Other general business regulation

Minimum wage

Under:
Trade
Immigration
Drug policy

Health regulation
COVID

Foreign policy (not including hot wars)

Police reform

On Target (bettingwise = no action):
War (actual hostilities)
Education

Demagoguery and divisive politics

The Time of Biden

Now that all the attempts at election stealing are over I feel compelled to put down in writing some predictions about Biden's presidency. Call it political fatigue from the 400 years of the Trump Presidency, but it is hard for me to muster much energy to do this. Still, here goes . . .

Optimism:

There are two kinds of optimism in the case of Biden--relative and absolute. The relative is in regard to the Trump alternative and perhaps the Biden of politics past. The absolute is more genuine if not also more wishful. 

Trade - This one is quite positive even though it is strongly of the relative variety. Biden was never great on trade and many times poor. Still this has changed as he shifts in the political winds. He both wants/needs to be not Trump and the political base is different for Democrats today than it was when he first ran for president over three decades ago. See my Five Tribes theory for background, but Labor is not the Democratic lock that it was in the past. Just a reset to pre-2018 (actual policy) and pre-2016 (rhetoric) would be a great improvement. 

Immigration - There is a strong chance that Biden will be very good on immigration. The development of Democrats getting better on immigration has been building for some time having only accelerated under Trump. So in this case we have relative and absolute improvement opportunities. 

Drug Policy - My optimism is tempered here, but it is present in an absolute sense. At the very least we should get a more hands-off, non-escalating war on drugs policy. This is a BIG improvement from what we would have expected from a 1990s Biden. My baseline expectation is eventual of decriminalization/legalization of marijuana within the next few years.  

Presidential Prestige - I am optimistic that the tone and style of the office will now be back to a civilized place--very much a relative optimism. The office of the U.S. President should be occupied by a person easily described as a gentleman or lady. Trump never fit this description, and his final days were the icing on the top. Yes, I want that same office to be greatly diminished in terms of power and worship. My hope was Trump would deliver the diminishment without going Game of Thrones. Largely my fear of getting the reverse was realized. 

Pessimism:

Unlike the optimism analysis, the pessimism comes basically only in the absolute variety. It is also the areas I tend to be most confident, unfortunately. 

Judicial Appointments - This one is not as pessimistic as one might assume. I don't want judges from the right or the left--that is a silly concept. I want judges that think critically and consistently demonstrating good application of the Law. Certainly I expect Biden's typical nominee will be less desirable than was the typical Trump nominee from my perspective. However, the best judges are impartial and well reasoned, and those include very many Biden will nominate. 

Regulation - The Trump administration was flat out good on regulation compared to any recent president (probably including Reagan!). He didn't as much shrink, though, as he reduced or stopped the growth of the regulatory state. Biden will reverse this trend. There is one area where Trump was certainly bad and Biden will likely continue this just in a different flavor--industrial policy/meddling with individual firms and industries. 

Taxes - Many people are rightfully worried about this for mostly wrong reasons. They don't want their own tax rates to go up. Ignoring the fiscal hypocrisy of this given the spending policies these same people typically demand, it is not a major problem that individual income tax rates (especially at the high end) are likely to increase. What people should be worried about is corporate tax rates increasing and to a lesser degree capital gains rates increasing. These are both much more destructive forms of taxes as they are taxing the creation of resources rather than the use of resources. Additionally, the restoration of the SALT deduction and the reduction in the standard deduction are also bad potential outcomes of coming tax policy.

War - I am hopeful that this ends up being an area like others mentioned where Biden today is different than he has been over the last 40 years. Despite this hope, you'll notice in which category I have placed it. 

Woke Politics and Policies - Think of this item as the inverse of Trump's nationalism. The risks are similar including divisive policies and rhetoric as well as censorship and ostracization. 

Spending - Your first thought should be, "Pessimistic on spending? Have you seen 2020?" True, but in only that limited and aberrational case is the relative comparison optimistic for Biden. The ratchet works in one direction generally, and even the possibility of a republican midterm sweep doesn't leave me optimistic.

Presidential Power & Authority - Here is the other side of presidential prestige from above. Every president in the last 20+ years has looked at the prior administrations' advancement of executive orders and general authority and said simply, "Hold my beer". If we only had another branch of government designed to be the strongest branch and willing to hold presidents accountable and within the bounds of their legal authority . . . 

Overall: 

The Biden years will hopefully be a time of surprise at how good some things are, not so bad other things are, and tolerably bad the balance is. This is how I now view the Clinton presidency. All of it is quite relative of course. Hope aside, I am more optimistic than I would have expected being faced with a Biden administration. Still the pessimistic angles are acute and meaningful. 

P.S. What about COVID-19 and the pandemic? While I expect a lot of theater to emerge and a rewriting of some history in favor of the current winners, the substantive part of this large issue is basically settled. In this way it doesn't matter much who won this election. Most of the decisions to be made are in the same incapable hands of FDA and other government officials along with the capable hands of private firms, organizations, and individuals. And in many ways the die is cast. The trajectory of the virus is set--declining regardless of what comes next but with a trajectory that very much can change depending on policy and actions taken. This is true and basically the same under Biden or Trump and even without vaccines. Vaccines are just a wonderful accelerator of the progress against the virus, which very much means fewer people suffering and dying.