​We are all susceptible to the pull of viral ideas. Like mass hysteria. Or a tune that gets into your head that you keep on humming all day until you spread it to someone else. Jokes. Urban legends. Crackpot religions. Marxism. No matter how smart we get, there is always this deep irrational part that makes us potential hosts for self-replicating information. 
Neil Stephenson, Snow Crash, 1992, Chapter 56.
 
Markets go through phases, shifting from one regime to another. Its participants succumb to an idea about the “right” way to invest.  In the early 1970s it was go-go growth stocks.  For a while in the 1990s it was all about Buffett and value.  There are times, like the late 1990s, when it’s all about momentum.  But these are all just ideas that the market is telling itself are true at any given time, instead of viewing the markets as systems that move and evolve over time. Investors like the story of being a value investor or growth investor, because everyone needs an origin story - people like to have something to anchor them. Value versus growth versus momentum were the stories investors told themselves from about 1935 through 2009.  And then something changed.  The stories stopped being told by investors, and started being told by government entities.  Central Banks, Presidents and Prime Ministers became more important to markets than the underlying fundamentals of markets themselves, particularly in fixed income. But many investors are having a hard time adjusting to this new reality.
 
It’s uncomfortable to admit that what you do for a living can be driven for years, maybe decades, by a collective story over which you have no control.  But that may well be the only true reality we’re left with these days.  I think we’re going to look back with fondness to when the market’s origin story was told by investors arguing about growth versus value instead of central bankers and politicians. Morningstar and Lipper will be viewed with nostalgia as a quaint way of categorizing the players in a game that became unplayable.  
 
 
"Y'know, watching government regulators trying to keep up with the world is my favorite sport."
Neil Stephenson, Snow Crash, 1992.  L. Bob Rife, television interview, Chapter 14.
 
I think we’re nearing the time when regulators finally realize that their storytelling won’t save the world.  For the past seven years we have been on the receiving end of a constant stream of fairy tales from the Federal Reserve, European Central Bank, China, and Europe’s political leaders. The Fed’s “strategic communications policy” that involved “forward guidance” to “manage market expectations” about the course of future Fed policy became a self-reinforcing narrative that drove a globally connected economic system to push interest rates into negative territory and equity market valuations to levels not seen except at the market peaks in 1929 and 2000.  Merkel and Draghi continually talk about the importance of “unity” while also initiating massive ECB bond buying programs and simultaneously leaving Greece and Italy to suffer massive unemployment and stagnation without fiscal stimulus. Abe has the BOJ pegging Japan’s 10 year yield at zero.  And China just fakes its economic data while trying everything it can think of to cushion the fall in the Yuan.  And yet…everything is great! 
 
But the problem is this narrative relies on all the market participants believing it despite the fact that the narrative makes no objective sense – that at the same time “everything is fine” yet, “we need rates at zero to stimulate growth” – they both can’t be true at the same time.  And yet...the best investment decision you could have made in the past seven years was to believe them both and not fight the central banks. In policy driven markets, you need to play a “common knowledge game.” The key to exiting safely from a policy driven market, like the one we are in now, is knowing when the government regulators are no longer able to keep up with the world.
 
Hiro: "Wait a minute, Juanita. Make up your mind. This Snow Crash thing—is it a virus, a drug, or a religion?"
 
Juanita shrugs. "What's the difference?"
 
Neil Stephenson, Snow Crash, 1992.  Hiro and Juanita, Chapter 26.
 
If you’re able to play along with the new religion, and then, when it cracks, immediately liquidate and go to cash or short, then ride along. But this is tricky. It requires you to, all at once, both be acutely aware of the narrative you are being told, how it is being perceived by other market participants, and when it suddenly isn’t being heard in the way that the storytellers meant it to be. At some point, the narrative cracks, people realize they are being played, and all hell breaks loose. We may well be seeing the start of it now. You can’t tell from financial markets, but I think we’re seeing the dawning realization that the stories we’ve been told just aren’t true, that the ECB and Fed can’t magically create a world of never ending prosperity and zero volatility. Sometimes a new narrative can take over: the recent Trump Trade was one of those times. It was investor driven not CB driven. But it was built on top of the false narrative that Europe is stable and functional, so it's a temporary, albeit powerful, move. And once a critical mass realizes that the narrative is false, we’ll have a Snow Crash – a systemwide shutdown.  And that’s when you’ll want to step back in and buy. 
 
When we can watch something on TV, and then be told right afterwards that what we saw was something else (and yes, I’m referring to the surreal press conference (is it a press conference when the press isn’t allowed to ask questions, or just a speech? But I digress…) held on Saturday by the new Trump Administration)), we’ve stepped across the line from where we knew we were being lied to by central banks and their accomplices in government but at least they pretended to be telling the truth, into a world in which the alteration of truth is upfront.  And you can choose to go along with it, or not – but it’s now hyper clear what they want you to hear.
 
When you’re having debates about facts, you’ve stepped fully into what Ben Hunt has termed the narrative machine (his writings are excellent).  Below is a chart from Hunt’s August 17, 2016 report of how news stories on Bloomberg coalesced around a common account of Brexit after it happened.  The charts show what words and phrases the stories have in common before an event (on the left) and what they share after the event.  It’s a visual way to show the self-reinforcing echo chamber in which the modern media operates. 
 

​Why are we letting this narrative happen?  Because there really isn’t anything an investor can do about it anyway. Fighting it doesn’t work. You just lose money.  And capital.  So you play along, aware that you’re in a metaverse but unable to extricate yourself.   Smart investors – and who’s to say what one really is until after the reversal – will play along too. But smart investors will also spend lots of time obsessing over alternative universes in which things do not work out so well.  They play one game while learning another.  Others…well they just barely figure out the first game before it changes.  Then they blow up.
 
When it gets down to it — talking trade balances here — once we've brain-drained all our technology into other countries, once things have evened out, they're making cars in Bolivia and microwave ovens in Tadzhikistan and selling them here — once our edge in natural resources has been made irrelevant by giant Hong Kong ships and dirigibles that can ship North Dakota all the way to New Zealand for a nickel — once the Invisible Hand has taken away all those historical inequities and smeared them out into a broad global layer of what a Pakistani brickmaker would consider to be prosperity — y'know what? There's only four things we do better than anyone else:
music
movies
microcode (software)
high-speed pizza delivery
 
Neil Stephenson, Snow Crash, 1992.  Introduction to Hiro Protagonist, Chapter 1.
 
This was written 25 years ago. And it manifested itself in our reality this past November.  The hollowing out of our middle class was not only completely forseeable, but it was written about in a popular book.  And yet, here we are, with the political establishment acting surprised it happened and not knowing what to do next.  Well, I don’t know what’s going to happen in politics, but in terms of markets, if we were just sitting here at 8 or 9 or 10 times earnings, getting a 10-12% earnings yield and a little bit of growth to boot, would I really care?  No.  Because it wouldn’t matter.  Yes, maybe the market would get worse, and stocks would go to 5 or 6 times earnings, and I’d be down 35% and wanting to puke, but then my earnings would accrete into book and I’d earn my way out of it in 3 or 4 years.  At a median S&P 500 P/E of 22.9x earnings at 12/31/16, earning your way out of it will take nearly a decade.  That’s not good.  Plan accordingly. 
 

"You don't respect those people very much, Y.T., because you're young and arrogant. But I don't respect them much either, because I'm old and wise."
 
Neil Stephenson, Snow Crash, 1992.  Uncle Enzo, Chapter 21.
 
Not respecting the markets can be a dangerous game.  But there’s a difference between not respecting their correctness, because they’ve been manipulated globally by central banks for the past 7 years, and not respecting their power.  Many smart investors have been run over in the past 2 years by not respecting the power of the markets to do irrational things for longer than they “should.”  That’s what makes this market so difficult, and I think, will make it so dangerous to the passive, indexed, long-only investor in coming years.  After the Snow Crash, we'll invent new stories and narratives to tell ourselves, and the cycle will repeat, only with new narrators and new characters. 
 
Right now I’m market neutral, with fairly large bets via options on a SPX decline. I am still short international sovereign debt, along with small shorts on the Italian and Chinese stock markets.  I’m leaning long in some tech companies, consumer discretionary stocks, and defense in the U.S., with a number of shorts in other sectors offsetting that. And I’m still waiting for the time when market participants realize they’re part of a story that doesn’t end well.
 
I was quoted in Barron’s The Trader column, written by Ben Levisohn a few weeks ago. You can find a link to the PDF here if you don’t get Barron’s (but you should).    
 
If you would like more specific ideas on how to navigate these markets, just reply and let me know and I will sign you up for a free trial of my newsletter.  By the way, we changed the name to Miller’s Market Matrix.  Stockpicker was too similar to some others out there.
_______________________________________________________________________
This week’s Trading Rules: (all from Neil Stephenson’s Snow Crash, 1992)

• The world is full of power and energy and a person can go far by just skimming off a tiny bit of it.
• When you are wrestling for possession of a sword, the man with the handle always wins.

 
SPY Trading Levels: Our levels have been about spot on.  The S&P 500 has gone 99 days without a decline of more than 1%.  That's very rare.  It can lead to higher VAR positions than normal.  Be prepared.  
This week’s levels: 

Resistance: Same as before, there is a lot between 226 and 228.  Not a lot above that.
Support: A little at 221/222, then 218/219, then a lot at 213/215.  After that it’s a little at 209.

Positions: Net neutral stocks (both long and short stocks). Short FXI, SPY, and BWX. Long put options on SPY, KRE, HYG and FXI.

Miller’s Market Musings is a free bi-weekly market commentary written by Jeffrey Miller, who has been managing money through various market environments for over 20 years. You can subscribe here. If you no longer wish to receive this letter, simply hit reply and put “Remove” in the subject line.  Prior posts can be found at www.millersmusings.com. 
​
Mr. Miller has been quoted in financial publications including the Wall Street Journal, Barron’s, American Banker, and New York Times, and he has appeared on Fox Business News, PBS and CNBC.  More information and past articles can be found at www.StockResearch.net.  Sharing and quoting from this letter is permitted with attribution and a link to www.millersmusings.com.

Mike McDermott: Listen, here's the thing. If you can't spot the sucker in your first half hour at the table, then you ARE the sucker. – Rounders, 1998
 
In any zero-sum endeavor, it pays to know who you’re playing against.  In a 9 person poker game, who the sucker is becomes clear fairly fast. But in financial markets, figuring out who the sucker is can take quite a bit longer, particularly when the markets all start moving in the same direction. This herding mentality can lead to crowding into trades, whether its Nifty Fifty stocks in the 1970s, internet stocks in 1999, AAA-rated senior CDO notes in 2007, or…passive investing today. 
 
There is lots of data about the saturation of passive today, but being superficial, I like to look at the obvious things that are right in front of me.  Earlier this week the Wall Street Journal ran an article on Jeremy Grantham and his firm, GMO. The short version: investors are doing it again.  $40 billion has been pulled from the firm, just as stocks are at all-time highs.  This is the same guy who warned about the internet bubble in 2000 and the stock market in 2008, and was right. And yet…since he’s been wrong for a little while, out goes the money.  So who’s right?  Grantham, or this guy who just pulled $211 million from him: “GMO is a deep-value investor that takes a really long-term view,” said Dan Gallagher, chief investment officer of the Ventura County Employees’ Retirement Association. “But the board felt it was time for a change.”  Ok.  We’ll see how that works out for them.  Anyone want to place a bet?
 
But it’s not just Grantham.  If it was, then I’d be looking at other factors.  Is the game he’s playing oversaturated with better players now?  Did he lose his edge? Or is it just a bad run of the cards?  Here’s where the other players at the table matter.  Let’s look at who’s down a bit in chips.  Paul Tudor Jones is having a bad run.  David Einhorn at Greenlight can’t catch a break.  Even John Burbank at Passport had a rough year.  What’s really interesting to me is that all 4 of these investors utilize different investment strategies or focus on different markets, but all have excellent long-term records that suddenly went bad.  Did they all get dumb, all at once?  Or is something else going on? 
 
Mike McDermott: [Narrating] In "Confessions of a Winning Poker Player," Jack King said, "Few players recall big pots they have won, strange as it seems, but every player can remember with remarkable accuracy the outstanding tough beats of his career." It seems true to me, ‘cause walking in here, I can hardly remember how I built my bankroll, but I can't stop thinking of how I lost it. – Rounders, 1998
 
So why have the cards suddenly gone so cold for so many of the best investors?  What changed?  Just like in past bubbles, dumb money is on a hot streak, which is running over the better players – in the short term.  But just like you always see the same faces at the final tables of professional poker games, I think we’re about to see a turn in the game of investing, where the sheep start getting sheared again and the dumb money gets flushed out.  I don’t know what the trigger will be, just like no one knew that Yahoo actually reporting a profit in March 2000 would trigger the bursting of the internet bubble, but it will happen.  Probably sooner than later. 
 
I think we are at or near “peak passive” as it’s being called. When everyone knows something to be true, it’s probably not. And right now the one thing that “everyone” knows is “true” is that passive always beats active investing. Instead of folding in the face of that, I think it’s about time to call that bet.  Don’t believe me?  Let’s review some numbers.  According to ICI, since the end of 2006 investors have taken about $1.2 trillion from actively managed mutual funds and given $1.4 trillion to equity index funds and ETFs in the U.S. alone.  That’s a lot of money.  How much is it?  Well, when you consider that the U.S. equity mutual fund industry has grown from just $284 billion in AUM in 1989 to around $6.7 trillion today, it’s a lot.  And look at the growth in Index funds – they were just $3 billion in AUM in 1989 and are about $2 trillion today, or nearly 30% of total assets under management, according to Credit Suisse. 
 
The issue is timing. While it’s usually fairly clear when a bubble is forming, it’s a lot harder to time when it’s going to pop. These processes usually become self-reinforcing, as successful relative performance leads more investors to invest in the same strategies, driving up their assets, with which they buy the same securities they already own, and on and on.  This is the “Madness of Crowds” Charles Mackay wrote about in 1841 that infects markets periodically. (You can see it at the craps table in a casino as well.  They’re always the ones having fun. Until they bust.)  But it’s this same crowding into a narrow asset class that creates future problems, as there are fewer assets on the other side of the trade to buffer the eventual reversal.  See the $211 million that Ventura County took out.  Or the other $1.4 trillion in actively managed assets that were shifted to passive.  Who’s going to be the buyer, when that money turns and runs?  Yeah, I don’t know either.  
​

​I hesitated a few days before sending this note, since just after writing it I was sent Michael Mauboussin of Credit Suisse’s latest piece, titled “Looking for Easy Games.”  Not wanting to look like I mirrored his work, I had to take the time to read it and be sure our ideas weren’t too similar or that I would just be repeating what he said.  They aren’t and I’m not, despite the similarity of theme (using a poker analogy to point investors towards games they can win).  That said, he had some great data. His conclusion: if you’re going to be an active investor, be REALLY active and long-term. Don’t closet index. But that doesn’t really answer the question of what games active investors can win.  And that’s where I want to dig in.    
 
Mike McDermott: [Narrating a quote from a gambling maxim] You can shear a sheep many times, but skin him only once. – Rounders, 1998
 
When markets change, you need to find a way to either change with it, or be able to just fold your cards a lot. Poker pros fold many more hands than they play. Amateurs are in every hand and re-raising pre-flop with Queen-Ten. (No, this is not a good starting hand.)  But professional investors face a problem: if they fold for too long, their investors may leave them, like Ventura leaving GMO.  But many pros aren’t really able to get up from the table and find another game. If you’re known as a deep value investor, and you think most stocks are overvalued, do you change your investing philosophy and become a growth investor, or a GARP aficionado, or something else?  That’s called style drift. Asset allocators don’t like it. I know – I used to be accused of it all the time in my mutual fund days.  (In my defense, my team and I were just buying whatever was cheap, regardless of what bucket Morningstar put the stock in.  Still, it made for some interesting sales meetings.) 
 
With the proliferation of cheap computing power and widely available data, it has become a lot harder to find games you can win. For example, when I started at Keefe, Bruyette & Woods as a bank analyst in 1994, just having the data on the banking industry gave us a huge edge. Every quarter we dutifully collected it from regulatory filings and company releases, entered it into a big database, then printed the “Bank Book.”  It was the bible for bank investors.  With that bank book alone and some time digging around, you could make good money.  Then others starting collecting the same data (damn you SNL), and computers got cheaper, and just having the data wasn’t enough. When I started my hedge fund in 1997, we had an edge – we knew small-cap banks better than 95% of the investors out there.  There were others who did what we did – but there was room for more than one shark at the table.  The market was so inefficient that there were plenty of sheep.   And then our returns sealed our fates.  We compounded at 25% per year net of all fees for 10 years.  Assets swelled.  We closed our fund to new investors, but others who were similar to us, and just as smart, kept getting assets, and suddenly our market got crowded. We killed the sheep. 
 
Worm: [Pretending to be a sore loser at the college fraternity game] Like my uncle Les used to say "When the money is gone, it's time to move on."  – Rounders, 1998
 
We were left playing against other professionals. The game got hard, and returns suffered, so we started looking for other games. Some we were good at, and some we weren’t. It was a painful adjustment, but over time we found more sheep.  That’s the nature of markets – they move in cycles.  I think the professionals, the Einhorns and Burbank’s of the world, will adjust, and active managers will have their due. 
 
So what are the games that can be won today?  Where are there still sheep?  I’m not going to give away all my secrets, but look for where sheep are doing things that they really shouldn’t be doing. Trading weekly options.  Buying yield stocks at any price.  Buying very high-yielding BDCs. Chasing performance in the “Trump Trades.”  If you can, just keep folding, and wait till investors panic and dump something that “everyone knows is a disaster”, like energy and bank stocks a year ago.  Then push in your chips.  In markets that are dominated by passive flows into ETFs, and especially sector ETFs, your edge may well be your ability to do nothing for awhile.
 
Look at these charts from Credit Suisse and tell me if you can spot the bubble.  I’ll wait. 
​

Jo: Mike, I learned it from you. You always told me this was the rule. Rule number one: Throw away your cards the moment you know they can't win. Fold the hand. – Rounders, 1998
 
Right now I’m market neutral, with fairly large bets via options on a SPX decline. I increased these bets in the past few days. I am still short international sovereign debt, along with small shorts on the Italian and Chinese stock markets.  I’m leaning long in some tech companies, consumer discretionary stocks, and defense in the U.S., with a number of shorts in other sectors offsetting that. And I waiting for the moment when passive panics, and we can push in our chips again.
 
I was quoted in Barron’s The Trader column, written by Ben Levisohn last weekend. We discussed the trend from big to small and global to local that I wrote about in my last Musings. You can find a link to the PDF here if you don’t get Barron’s (but you should).    
_______________________________________________________________________
This week’s Trading Rules:

• Throw away your cards the moment you know they can't win.
• Only play games you know you can win.
• Sometimes you need to learn a new game.

 
SPY Trading Levels: Our levels have been about spot on.  Maybe time to play smaller.

This week’s levels: 

Resistance: Same as before, there is a lot between 226 and 228.  Not a lot above that.

Support: A little at 221, then 218/219, then a lot at 213/215.  After that it’s a little at 209.

Positions: Net neutral stocks (both long and short stocks). Short XLU, SPY, and BWX. Long options on SPY, KRE, XLF, HYG.

Miller’s Market Musings is a free bi-weekly market commentary written by Jeffrey Miller, who has been managing money through various market environments for over 20 years. You can subscribe here. If you no longer wish to receive this letter, simply hit reply and put “Remove” in the subject line.  Prior posts can be found at www.millersmusings.com. 

Mr. Miller has been quoted in financial publications including the Wall Street Journal, Barron’s, American Banker, and New York Times, and he has appeared on Fox Business News, PBS and CNBC.  More information and past articles can be found at www.StockResearch.net.  Sharing and quoting from this letter is permitted with attribution and a link to www.millersmusings.com.