Archive for Most Recent Stories – Page 2

A Bubble is Forming in US Middle Market Leveraged Finance

by Sober Look

US middle market leveraged buyout (LBO) transactions are becoming increasingly frothy. According to the latest data from Lincoln International, risk-return fundamentals in the space are worse than they were in 2007. Here are some disturbing facts about leveraged transactions in US middle markets:

1. Leverage multiples (debt to EBITDA) are higher than at the peak of the bubble in 2007. In particular, leverage through the senior debt (dark blue) is now materially higher.


2. Yields on senior leveraged loans for middle market deals are now significantly lower than in 2007. Investors are not getting paid for taking on riskier loans.


3. Furthermore, private middle market company valuations (as a multiple of EBITDA) are at record levels.


4. Banks have all but exited leveraged loan origination, as institutions (shadow banking) have taken over. These institutions include loan funds (mutual funds and closed-end funds), BDCs, CLOs, hedge funds, insurance firms, pensions, etc. However, since the Fed is mostly looking at banks’ balance sheets, the central bank seems to be unconcerned about the froth in this market.

Source of capital

5. According to Lincoln International, there are signs that leveraged middle market firms are experiencing margin compression. That is worrisome given the amount of leverage these firms have.

Lincoln International: – While over 50% of companies are seeing revenue growth, the fact that over 50% are experiencing EBITDA declines suggests margin compression. For the sixth consecutive quarter, more middle market companies experienced EBITDA declines than gains.

The Fed has allowed for bubble to build in the US corporate sector – particularly in leveraged middle market companies. A broad hit to revenues could create a massive wave of failures, as firms become too leveraged to withstand such a shock. At the same time investors could face significant losses without being compensated for the risk they are taking. Let’s hope someone on the FOMC is paying attention.



The Worst Call of the Last 5 Years

We heard it a million times following the start of QE and the government’s stimulus package – high inflation was coming.  It was inevitable given all the “money printing” that was going on, right?  And when it didn’t come the narrative changed from “it’s coming” to “just you wait”.

Well, we’re now 5 years removed from the depths of the crisis and the Fed and the government’s extraordinary measures and the high inflation never came.  The bond vigilantes never came.  The dollar never crashed.  US Dollar denominated financial assets have beat the pants off of just about everything.  Interest rates never spiked.  The US government never turned into Greece or Zimbabwe.

5 years is a long enough time period to judge the predictions of those who called for a disastrous inflation.  And the predictions have been so far from right that you have to seriously wonder if many of these people are working from a proper operational understanding of the monetary system.  Of course, I would argue they haven’t been working with a full deck of cards.

I got to thinking about all of this as I read these two pieces in recent weeks about how bad these predictions have turned out.  It wasn’t me repeating myself again.  It was from Bloomberg and the Wall Street Journal.  They not only cite how much money was lost by traders who utilized this deficient framework, but they also cite how public policy has been directly hurt by these persistent calls for inflation.

This is huge stuff.  I think it calls entire forms of thought into question.  And it validates others.  Being right matters.  Unfortunately, in the world of economics and finance politics often trumps pragmatism.


Wednesday’s News Today: FOMC Statement Overanalysis

On Wednesday the Fed will release a very boring statement.  It will basically say:

“The economy kind of stinks still, but it’s gotten a little tiny bit better.  But we changed our statement a little tiny bit in order to communicate the fact that our views have also changed a little tiny bit.  But in reality nothing has changed all that much….”

The media and the markets will likely overreact to the FOMC statement, but just remember this picture when you consider whether the Fed will actually make any drastic moves in the near-term (via Josh Brown):



That chart shows the expectations of Fed rate hikes at various times over the course of the last 5 years.  In essence, the bond market has had this wrong all along.  Predictions about rate hikes will be headline news tomorrow and Wednesday and dozens of talking heads will fill up space debating this.  Ignore them.  Wednesday’s statement will say nothing new and any overanalysis will be largely meaningless.  We’re just not at a point in the cycle where the Fed can realistically raise rates….

How Will you Prepare for the Next Bear Market?

I wanted to revisit the question Ben Carlson answered in a recent post of his.  But I wanted to open the floor to readers.  The question:

How are you preparing for the next bear market?

We all know it’s coming eventually.  And no one really knows when.  And while we know that bear markets only occur about 20% of the time we also know that they can be extremely devastating events as they can set us back by years in trying to achieve our financial goals.  It’s times like these when you really should be preparing a plan because stability inevitably leads to instability.  At a time when everyone is getting more bullish you should be thinking about how to benefit when the bear market really comes.

So, how are you prepared for this inevitable event?  Are you just mentally preparing?  Diversify, hold and hope?  Are you more active?  Are you more likely to move into “actively” managed funds given the uniqueness of this environment? Are you just putting together a “passive” portfolio assuming that the future will look something like the past?  Let me know what you think….

Calpers Takes a Major Swipe at the Hedge Fund Industry

The California Public Employees’ Retirement System just took a major swipe at hedge funds as they decided to eliminate all hedge funds and fund of fund strategies from their allocations.  They don’t cite performance as the concern despite a poor run in recent years by the vast majority of hedge funds.  Instead, they cite costs and complexity (via Businessweek):

“We concluded that we would eliminate the hedge fund program in order to reduce the complexity, reduce the costs in the program, particularly in relation to our view that given the scale of Calpers, we would not be able to scale a hedge fund program to a size that would really move the needle,”

It’s probably a good move.  The opaqueness of many funds and the high fees make them poor additions to public employment programs where fund administrators need to be much more cognizant of any potential conflicts.

More interestingly, this is another big blow to high fee fund managers.  The days of being able to charge 2 & 20 are dying out.  My general guidance on any form of active management is to avoid any fund with a fee structure over 0.5%.  I make an exception on rare occasion for higher fee funds, but that’s a pretty good rule of thumb in most cases.  And that’s on the high side….

The Economics of Digital Currencies

Just passing along this nice piece from the Bank of England on Bitcoin and its role in the monetary system.  A lot of this stuff jibes nicely with Monetary Realism.  Here’s a short summary:

  • The article discusses the reality that the monetary system is essentially already an endogenous system in which we all can issue money, but banks dominate the system with their issuance of the primary form of money, bank deposits.
  • The banking system is constructed around the Central Bank as the bank where interbank payment clearing occurs.
  • The Bank of England is skeptical about the ability of Bitcoin to serve as a competing form of money without the same components that have been addressed by modern banks.

If you’ve read most of my thoughts on Bitcoin I don’t think that much of this will be new to you, but it’s an interesting read for the uninitiated. Read it here.

How to Preserve Capital During a Bear Market

By Ben Carlson, A Wealth of Common Sense

A few weeks ago I took part in a webcast with MarketWatch on long-term investing that was partly spurred on by a post I wrote about my idea for a TV show about investing. MarketsWatch’s Victor Reklaitis ran the show while I was joined by Tim Strauts from Morningstar and Chuck Jaffe of MarketWatch to answer viewer questions.

Here’s one of the questions that I thought deserved a deeper dive:

What’s your advice for handling an awful year for stocks like 2008?

This may seem like a silly thing to think about now, but you don’t start planning for a bear market after it occurs. If you prepare yourself psychologically for any investment environment ahead of time it decreases the chances of blowing up your portfolio by making unforced errors at the wrong time.

Courtesy of Eric Nelson from Servo Wealth Management, here are the five most severe bear markets since the 1920s broken out by losses, recovery and total return from peak to peak:


A few observations on Nelson’s data:

  • You don’t need to get fancy with black swan disaster hedges. High quality intermediate-term bonds have been your best option for preserving capital during an economic disaster. They do their job as the portfolio anchor during periods of stress to give investors dry powder for rebalancing purposes to buy stocks on sale or for spending purposes so stocks don’t get sold after a crash has occurred.
  • Stocks can fall far and fast but also tend to recover very quickly. That’s why bailing out of stocks after they crash just compounds your problems if you held them through the crash in the first place.
  • Balance is the key to surviving these periodic crashes. The Balanced Asset Class Index which included large caps, small caps, value stocks and bonds fared much better than the all-stock options and outperformed the other options over the full cycle 4 out of 5 times.
  • Value and small cap stocks are great diversifiers and return enhancers as you can see from the All Stock Asset Class, but be prepared for large losses as well.

The biggest thing is to have a plan and stick with it (everyone says this but it’s true). You won’t know the exact reasons ahead of time as to why the market will fall, but understand that you will see a handful of market crashes over your lifetime.

There’s no way you can avoid risk in the financial markets if you hope to beat inflation over the long-term and earn a respectable return on your portfolio. Stocks outperform bonds over longer cycles, but bonds provide stability when you need it the most. Stocks wouldn’t offer a risk premium over bonds if they didn’t have these periodic large selloffs.

It’s also important to understand your ability and willingness to take risk. Allocate more money to less volatile investments if you can’t handle losses, but understand that you will likely have to save more to reach your financial goals if you carry a more risk averse portfolio.

And for those investors that are in or approaching retirement, don’t have money tied up in stocks that you’ll need to use for spending purposes within 5 years or so. It’s too much of a risk that stocks could take a hit right when you need to sell if you have an all-stock portfolio.

For most average investors, a good rule of thumb would be to never own more stocks in a bull market than you’re comfortable holding during a bear market.

There really are no easy answers to this question as every investor’s tolerance for risk and investment strategy is different. Investing really is a balancing act that’s full of trade-offs. There is a constant tug of war going on inside our brains between fear and greed depending on the market environment. We want to be able to sidestep losses in the markets and only participate in the gains but it’s impossible to to invest in stocks and not experience periodic losses.

Pick your poison and understand your emotional swings.

Watch the entire MarketWatch webcast here: How to make money in the long run

“The Stupidest Article Ever Published”

I got a good chuckle from this comment over at Mark Thoma’s website:

Via email, I was asked if this is the “stupidest article ever published?”:

The Inflation-Debt Scam

If not, it’s certainly in the running.

The articles promotes the Shadow Stats views and the idea that the USA is on the verge of catastrophe.  In essence, they argue that inflation has been massively understated, the US government is on the verge of financial insolvency and that GDP is actually lower than it was in 2002.

I’ve touched on the Shadow Stats and hyperinflation views enough in the last 5 years that I don’t think I need to repeat myself.  Besides, Mark Thoma’s comment pretty much covered all the necessary bases there.  People who still buy into the views of the hyperinflationists and Shadow Stats are working from what has been a seriously discredited framework….



Commodity ETFs are Dying and that’s a Good Thing

One of the points I stress in my book is how commodities are not really a wise asset class to allocate assets to for long periods of time.  History has shown us that commodities generate poor real, real returns over the long-term.  But we don’t have only history on our side.  It makes perfect sense that commodities aren’t good long-term performers because they’re huge cost inputs in the capital structure.  So they tend to have a very high correlation with inflation.

It’s interesting to look at commodity trading exchanges where these financial products were created primarily as hedging products and slowly became trading vehicles.  As a hedging vehicle commodities often make a lot of sense.  But as a long-term allocation they make no sense.

It’s my opinion that commodity investing has become somewhat of a fad.  As some people have tried to add forms of diversification to portfolios to add some non-correlation they’ve tilted towards commodities.  This became a hot selling idea for Wall Street firms who could create products that invested in commodities.  And in my opinion, the foundation of this thinking was never very sound as it made no sense to allocate assets towards commodities in the first place.

Anyhow, we’re now seeing a massive supply glut in commodity ETFs and so the death of the commodity ETF has begun.  That’s a good thing.  Commodities in a portfolio are often diworsification.  That is, there’s a level where adding too many assets and trying to get too fancy can be detrimental.  I hope retail investors begin to shun commodity ETFs en masse.  That way hey’ll be transferring a lot less of their money into the pockets of financial engineers.

The Savings Portfolio Perspective

I really liked this piece by Ben Carlson.  Particularly the conclusion:

“There will always be a handful of standout market performers that earn seemingly easy profits, but that’s really a pipe dream for 99% of investors. For the rest of us, getting rich at a painstakingly slow pace is still the best option.”

It’s funny how “investors” abuse the term “investing”.  What we’re really doing when we buy shares on a secondary exchange is not really “investing” at all.  It’s just an allocation of savings.  Investing, in a very technical sense, is spending for future production.  So, if you build a factory and spend money to do so then you’re investing.  But when companies issue shares to raise money they’re simply issuing those shares so they can invest.  And once those shares trade on the secondary exchange the company really doesn’t care who buys/sells them because their funds have been raised and they’ve likely already invested in future production.  You just allocate your savings by exchanging shares with other people when you buy and sell financial assets.

Now, this might all sound like a bunch of semantics, but it’s really important in my opinion.  After all, when you understand the precise definitions of saving and investing you realize that our portfolios actually look more like saving accounts than investment accounts.  That is, they’re not really these sexy get rich quick vehicles.  Yes, the allure of becoming the next Warren Buffett by trading stocks is powerful.  But the reality is that you’re much more likely to get rich by making real investments, ie, spending to improve your future production.  Flipping stocks isn’t going to do that for you.

This leads you to realize your portfolio is a place where you are simply trying to grow your savings at a reasonable rate without exposing it to excessive permanent loss risk or excessive purchasing power loss.  It’s not a place for gambling or getting rich quick.  In fact, it’s much the opposite.   It’s a nuanced view, but one I feel is tremendously important to financial success.

The First Mover Advantage

By Ben Carlson, A Wealth of Common Sense

“Diversifying is easy; doing so early is difficult.” – William Bernstein

John Burr Williams wrote The Theory of Investment Value in 1938. It was based on his Ph.D. thesis that stated prices in the financial markets were a reflection of an asset’s intrinsic value.

He was among the first people to ever use Discounted Cash Flow analysis (DCF) to value stocks, which states that any investment is simply the present value of its net future cash flows. Before this theory was more broadly accepted, most investors were purely speculating on past prices.

One of the early benficiaries of the fact that valuation was such a new phenomenon was Benjamin Graham. He bought value stocks throughout the 1930s, 40s and 50s while the playing field was wide open. It was easy pickings because there wasn’t much competition.

Shortly before his death, Graham discussed how the changing investment landscape altered his views on discovering value:

I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity say, forty years ago when our textbook Graham and Dodd (Security Analysis, 1935) was first published. But the situation has changed a good deal since then. In the old days any well-trained analyst could do a good professional job of selecting undervalued issues through detailed studies. But in light of the enormous amount of research now being carried on, I doubt that in most cases such extensive efforts will generate sufficiently superior returns to justify their costs.

Fast forward to the early-1970s for another early adopter of market analysis, Michael Steinhardt.  Steinhardt’s hedge fund was one of the most successful funds of all-time, racking up annual returns of nearly 25% over a dozen years. The majority of this success can be traced to a three year period from 1973 to 1975.

Here’s one of the main reasons Steinhardt’s fund was so successful from the book More Money Than God about one of the researchers on his team:

Cilluffo had begun tracking monetary data, hoping it might anticipate shifts in the stock market. A decade or so later, this sort of exercise was common on Wall Street. […] But during the 1960s, Wall Street’s equity investors could not be bothered with this sort of analysis. Monetary conditions and the Federal Reserve’s response were marginal to their thinking.

This different line of thinking helped the firm anticipate and profit from both the 1973-74 stock market collapse as well as the eventual recovery that followed. The fund was up 43% in the 73-74 bear market when the S&P 500 was down almost 37% and up 54% in 1975 when the market recovered 37%.

Both of these instances show the first mover advantage that can be gleaned from non-traditional analysis. Stating the obvious, this is not an easy task, especially in today’s day and age where knowledgable investors are constantly seeking out mis-priced securities.

Something I’ve noticed since the financial crisis is a steady stream of investors touting back-tested models they’ve created in the past few years that make some variation on this claim:

The model we created would have gotten out right before the market peaks of 1929, 1973, 2000 and 2007 and got back in at the bottom so you’d miss the downside but participate in the upside.

Unfortunately, it would have been extremely difficult to pull this off in those earlier periods. You have to ask yourself: Could I have made these same decisions with the information that was available to me at that time?

While I don’t question the fact that you can create systems based on historical information to show just about anything you want, I am skeptical of any model or investor that thinks they can guess the future of investor emotions. Because that’s really what you’re saying when you make the claim that a model can call tops and bottoms.

Although market analysis will continue to evolve, the aspect of investing that will never change is our human nature. Emotions will always play a role in causing some investors to make the wrong move at the wrong time.

Regardless of the fire hose of information we try to digest it will still take second level thinking to truly separate yourself from the crowd. Emotional intelligence, discipline and patience will never go out of style. They will be tested, but that’s nothing new.

I guess the point here is that it’s never going to be easy. The low hanging fruit is gone. Unless you can be truly innovative in your approach, you’re never going to completely outsmart the market at all times. And the innovation life cycles are getting shorter and shorter, so one of the only ways to really differentiate yourself these days as an investor is to extend your time horizon.

There will always be a handful of standout market performers that earn seemingly easy profits, but that’s really a pipe dream for 99% of investors. For the rest of us, getting rich at a painstakingly slow pace is still the best option.

More Money Than God

And here’s the best stuff I’ve been reading this week:

  • 28 secrets of exceptionally productive people (Inc.)
  • Failure is not predictive of your future success in life (Reformed Broker)
  • A dozen lessons learned from Josh Brown (25iq)
  • Never delegate your understanding (Research Puzzle)
  • When’s the best time to invest? (Boomer & Echo)
  • The secret to investing success: Amnesia (Daily Finance)
  • Avoid extreme stances and give up on the either/or line of thinking when building a portfolio (Derek Hernquist)
  • Rick Ferri’s solution for the mutual fund industry (WSJ)
  • Things you should know the difference between (Morgan Housel)
  • Why we watch certain movies over and over again (Atlantic)
  • Watching the market all day is a bad idea (Abnormal Returns)
  • How to invest in active funds (Monevator)

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Goldman Sachs: The Economy Grew at 4.7% in Q2

Although it doesn’t feel like a recovery for everyone (see here) the economy does appear to be moving in the right direction.  Goldman Sachs is now reporting that Q2 GDP was much stronger than expected at 4.7% (via Business Insider):

Goldman Sachs revised its estimate of second-quarter GDP growth to 4.7% on Thursday, based on new data from the Census Bureau’s Quarterly Services Survey (QSS). 

Stronger-than-expected healthcare spending growth led to the revised Goldman estimate of 4.7%, which was up 0.5% from the Bureau of Economic Analysis’ second advance estimate of 4.2%.

That’s well above the consensus of 4.2%.  Q3 is still estimated to come in at 3.1% as growth moderates after the big seasonal snapback.  Steady as she goes….

Thinking about the Cost of College

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

The beginning of the new school year heightens the anxiety over the rising cost of higher education. The cost of a college education is increasingly beyond the means of average American family. Tuition has risen faster than inflation, student debt has soared and jobs are difficult to secure.

At the same time, it seems that more people are questioning the value of a college degree. The New York Federal Reserve’s Current Issues newsletter recently took a look these issues. The authors, Jaison R. Abel and Richard Peitz, also posted an article “The Value of a College Degree” on the NY Fed’s blog Liberty Street that looks at the cost of an associate and bachelor’s degree. They conclude that the benefits still outweigh the costs. While the cost have risen, the wages to workers without a two or four-year degree have fallen.

NPV College

These two Great Graphics come from their work and illustrates their conclusion. This first chart shows their calculation of the net present value of a bachelor’s degree between 1970 and 2013. It is expressed in constant 2103 dollars.

They estimate that the value of a four-year college degree fell from about $120,000 in the early 1970s to about $80,000 in the early 1980s. It then proceeded to more than triple in the next decade and a half to nearly $300,000 by the late 1990s. It has been surprising stable since. It has eased a bit in in the post-crisis period, but it remains near the all-time high.

Recoup College

The second chart shows how long one needs to work to recoup the cost of college. The authors use the discounted cash flows that were used to calculate the net present value to determine how many years it take to turn the cash flow positive. To say the same thing, after earning a four-year degree how many years does it take to recover the cost of the degree.

It shows that the time required to recoup the costs of a bachelor’s degree has fell significantly in the 1980s and then leveled off. In the late 1970s, it took nearly two decades to coup the cost of college. Now it takes about half as long.

The authors conclude that the value of a college degree remains near its historic highs, while the time to recoup the cost is near historic lows. This study is part of a larger work. In an essay earlier this year, the authors calculated the return on investment for the average colleges student was about 15%. In a subsequent report, the authors look at the distribution of the wages earned by college graduates and find that for a sizable fraction, a college degree has not paid off. College may be a negative investment for one in four who attend.

Beguiled by Narrative

By Robert Seawright, Above the Market


The photograph above, taken at the Brooklyn waterfront on the afternoon of September 11, 2001 by German photographer Thomas Hoepker, is now one of the iconic images of that horrible day. In fact, the Observer New Review (London) republished it in 2011 as the 9/11 photograph. In Hoepker’s words, he saw “an almost idyllic scene near a restaurant — flowers, cypress trees, a group of young people sitting in the bright sunshine of this splendid late summer day while the dark, thick plume of smoke was rising in the background.” By his reckoning, even though he had paused but for a moment and didn’t speak to anyone in the picture, Hoepker was concerned that the people in the photo “were not stirred” by the events at the World Trade Center — they “didn’t seem to care.” Hoepker published many images from that day, but he withheld this picture for over four years because, in his view, it “did not reflect at all what had transpired on that day.”

In 2006, the image was finally published in David Friend’s book, Watching the World ChangeFrank Rich wrote a 9.11 fifth anniversary column in The New York Times, framed by the photo, which he called “shocking.” Rich claimed that the five New Yorkers were “relaxing” and were already “mov[ing] on” from the attacks. Rich described those in the photo as being on “what seems to be a lunch or bike-riding break, enjoying the radiant late-summer sun and chatting away as cascades of smoke engulf Lower Manhattan in the background.” Indeed, Rich’s explanatory narrative is hardly complimentary.

Mr. Hoepker’s photo is prescient as well as important — a snapshot of history soon to come. What he caught was this: Traumatic as the attack on America was, 9/11 would recede quickly for many. This is a country that likes to move on, and fast. The young people in Mr. Hoepker’s photo aren’t necessarily callous. They’re just American.

It was a plausible — if utterly speculative — interpretation based upon the photograph alone. More importantly, it framed Rich’s desired narrative perfectly. But even though a picture may well be worth a thousand words (1,506 in this case, to be exact), those words aren’t necessarily all that accurate.

Daniel Plotz quickly came forward with an alternative interpretation that disputed Rich, calling Rich’s reading of the image a “cheap shot.” In Plotz’s view the five had not ignored or moved beyond 9.11 but had “turned toward each other for solace and for debate.” To his credit, Plotz emphasized that he didn’t “really know” what the pictured people were doing and feeling and called upon them to contact him so as to set the record straight. Two did, and they repudiated Rich’s narrative in the strongest of terms.

The first to respond was Walter Sipser, a Brooklyn artist and the man on the far right in the shot. “A snapshot can make mourners attending a funeral look like they’re having a party,” he wrote. “Had Hoepker walked fifty feet over to introduce himself he would have discovered a bunch of New Yorkers in the middle of an animated discussion about what had just happened.”

Chris Schiavo, a professional photographer, Sipser’s then-girlfriend and second from the right above, also responded. She criticized both Rich and Hoepker for their “cynical expression of an assumed reality.” As a “third-generation native New Yorker, who knows and loves every square inch of this city,” whose “mother even worked for Minoru Yamasaki, the World Trade Center architect,” she stated that “it was genetically impossible for [her] to be unaffected by this event.”

So much for the accuracy of Rich’s story.

We love stories, true or not, almost from the cradle. Stories are crucial to how we make sense of reality. They help us to explain, understand and interpret the world around us. They also give us a frame of reference we can use to remember the concepts we take them to represent. Whether measured by my grandchildren begging for one (or “just” one more), the book industry, data visualization, television, journalism (which reports “stories”),the movies, the parables of Jesus, video games, or even country music (“every song tells a story”), story is perhaps the overarching human experience. It’s how we think and respond. We always want to know what happens next.

Stories are culture’s way of teaching us what is important. They are what allow us to imagine what might happen next – and beyond – so as to prepare for it. We are hardwiredto respond to story. A good story doesn’t feel like a story – it feels exactly like real life, but most decidedly is not like real life. It is simplified and otherwise altered. We prefer rhetorical grace and an emotional charge to the work of hard thought. Because we are inveterate simplifiers, we prefer clean and clear narrative to messy reality. A famous book by Karl Popper, The Poverty of Historicism, pretty well demolished the popular notion that history was a narrative, that it had a shape, a progression, and followed laws of development. But we believe that it does (or devoutly wish to believe that it does) anyway.

Still, because it feels so true (“It can’t be wrong when it feels so right”), it isn’t hyperbole to say you’ve been lost in a story. Story turns us into willing students, eager to learn the story’s message. It’s how we sift through the raw data of our lives to ascertain what matters. Our brains are designed to analyze the environment, pick out the important parts, and use those bits to extrapolate linearly and simplistically about and into the future.

Ultimately, the key to a good story isn’t just what happens or to whom it happens. AsRoger Ebert so eloquently put it, broadened ever so slightly, a story “is not about what it’s about; it’s about how it’s about it.” Stories are about how the protagonist changes and how we react to those changes and ourselves change. We can “see” the world as it isn’t.(yet) and as it might become.

The best stories are simple, easily communicated, easily grasped and easily remembered. Perhaps most significantly, we inherently prefer narrative to data — often to the detriment of our understanding. To do math, neither maturity nor knowledge of human nature and experience are required. All that is required is the ability to perceive patterns, logical rules and linkages. But because of the enormous sets of random variables involved in real life, patterns, logical rules and linkages alone do not solve any actual puzzles. Correlation does not imply causation. Information may be cheap but meaning is both expensive and elusive.

As Nassim Taleb explains in The Black Swan, the narrative fallacy addresses our limited ability to look at sequences of facts without weaving an (often erroneous)explanation into them or, equivalently, forcing a logical link, an arrow of relationship upon them. Explanations bind facts together. They make them all the more easily remembered; they help them make more sense. Where this propensity often goes wrong is when it increases our impression of understanding.

Frank Rich — I’m looking at you.

Five years after the towers came down, Frank Rich had a story to tell. It was a story of a “divided and dispirited” America that had lost touch with the horror of 9.11, of a forgetful nation desperate to move on, a divided nation insufficiently stirred. It was also the story of a callow, fear-mongering President with a selfish and secret partisan agenda far removed from committed sacrifice for the common good. It was a story of a once-great country that had moved on but not ahead. And he thought he had found the perfect picture to illustrate that story.

As a journalist, Rich had an obligation to check the facts of his story. By all appearances, he did not. Perhaps he thought it was “too good to check.” If so, he was dreadfully and blatantly wrong. Perhaps he tried and was unsuccessful or that Hoepker’s description was enough to go on. If so, he didn’t try hard enough and also had an obligation to be forthright about what he knew and what was mere speculation. That he did not was an egregious error, an error that would make him look silly when the truth came out, as it so often does.

Many of our foibles (narrative and otherwise) are the result of our laziness. Sometimes the laziness is overt. Other times it is simply a function of the various shortcuts we take, sometimes reasonably, to make life more manageable. Rich took a variety of shortcuts in writing his story, shortcuts that perverted the truth of what the Hoepker photograph actually portrayed. His facts were wrong, plain and simple.

We like to think that we are like judges, that we carefully gather and evaluate facts and data before coming to an objective and well-founded conclusion. Instead, we cut straight to the chase. We are much more like lawyers, grasping for any scrap of purported evidence we can exploit to support our preconceived notions and allegiances. Doing so is a common cognitive shortcut such that “truthiness” — “truth that comes from the gut” per the comedian Stephen Colbert — seems more useful than actual, verifiable fact. Whatreally matters is that which “seems like truth – the truth we want to exist.” That’s because “the facts can change, but my opinion will never change, no matter what the facts are.”

The concept even “became a lexical prize jewel” for Rich himself (see here, for example), allowing him (of course) to criticize his political opponents for offering only “a thick fog of truthiness” such that they presented “a bogus alternative reality so relentless it can overwhelm any haphazard journalistic stabs at puncturing it.” Rich has expounded on the idea a number of times in print and even on The Oprah Winfrey Show. Of course, he always directs the analysis outward rather than inward. Oh the delicious irony.

This concept of “truthiness” captures how, as cognitive psychologist Eryn Newman puts it, “smart, sophisticated people” can go astray on matters of fact. Newman’s research has shown that the less effort it takes to process a factual claim, the more accurate it seems. In one classic study, for example, people were more likely to think a statement was true when it was written in high color contrast as opposed to low contrast. Easy-to-pronounce ticker symbols (such as KAR) perform better in the markets than their difficult-to-pronounce counterparts (such as RDO) — even after just one day of trading. And, astonishingly, claims attributed to people with easy-to-pronounce names were deemed more credible than those attributed to people with difficult-to-pronounce names. Assummarized by Slate recently: “When we fluidly and frictionlessly absorb a piece of information, one that perhaps snaps neatly onto our existing belief structures, we are filled with a sense of comfort, familiarity, and trust. The information strikes us as credible, and we are more likely to affirm it — whether or not we should.”

Due to our affinity for like-minded people, we seek out the people like us to provide echo chambers for our own claims, claims that perpetuate themselves every time we hear them reverberated back to us. We are neuro-chemically confirmation bias addicts. As such, we tend to reach our conclusions first. Only thereafter do we gather purported facts and, even then, see those facts in such a way as to support our pre-conceived conclusions. When it fits with our desired narrative, so much the better. Writing op-eds forThe New York Times provided Rich with a heady and exclusive echo chamber, but an echo chamber nonetheless. Keeping one’s analysis and interpretation of the facts of a story reasonably objective — since analysis and interpretation are required for data to be actionable — is really, really hard in the best of circumstances, even when one has gotten the facts close to right.

Megan McArdle summed things up nicely earlier this week.

We like studies and facts that confirm what we already believe, especially when what we believe is that we are nicer, smarter and more rational than other people. We especially like to hear that when we are engaged in some sort of bruising contest with those wicked troglodytes — say, for political and cultural control of the country we both inhabit. When we are presented with what seems to be evidence for these propositions, we don’t tend to investigate it too closely. The temptation is common to all political persuasions, and it requires a constant mustering of will to resist it.

Frank Rich — I’m looking at you.

Once we have bought-in to a particular narrative, it becomes increasingly more difficult to falsify, even (especially!) when presented with contradicting fact. Take the example of parents who choose not to vaccinate their children and the pediatricians who try to convince them otherwise. When presented with unequivocal information that autism diagnosis and vaccinations were not linked, the strategy backfired and parent became more set in their ignorance. In other words, the disconfirming facts offered actually (in effect) turned up the volume inside the echo chamber such that the truth could not be heard.

The more we repeat and reiterate our explanatory narratives, the harder it is to recognize evidence that ought to cause us to re-evaluate our prior conclusions. By making it a careful habit skeptically to re-think our prior interpretations and conclusions, we at leastgive ourselves a fighting chance to correct the mistakes that we will inevitably make. As with everything in science, each conclusion we draw must be tentative and subject to revision when the facts so demand. As John Maynard Keynes famously stated, “When the facts change, I change my mind. What do you do, sir?” Indeed, what do you do?


Note: This post is a much-expanded version of one that appeared here.

Who Determines Interest Rates?

I get this question a ton – who determines interest rates in the economy, the markets or the Fed?  The answer is actually neither.  The state of the economy determines how interest rates will be set.

It shouldn’t be controversial that the Federal Reserve could, in theory, control the nominal rate of interest on US government issued debt.  As the monopoly supplier of reserves to the banking system they can effectively set a ceiling on interest rates by making a market in bonds.  Bond traders don’t fight the Fed because they know the Fed is the monopoly reserve supplier.  You can’t beat the Fed’s printing press.  Therefore, “bond vigilantes” in the USA are an overstated risk in general.

Now, this gives the appearance that the Fed determines interest rates.  But there are many more interest rates in the economy than the overnight rate or the rates on US government bonds.  Yes, these are important benchmark rates, but they are just benchmark rates.

Most importantly, it’s crucial to understand the context in which interest rates are set at a certain level.  For instance, in an environment of high inflation the Fed is likely to respond to the state of the economy by raising interest rates.  The Fed can’t control the economy and generally reacts to the state of the economy. In addition, the market rates on other interest rate products are likely to rise in a high inflationary environment even if the Fed were to keep overnight rates low.  If a bank can charge you a higher real rate on bank loans because the economy is stronger then the difference between the benchmark rate and the lending rate just makes it more profitable for the banks to issue loans.  This could also become inflationary and so the Fed is very likely to respond to a high rate of inflation by raising interest rates.  Therefore, the Fed responds to the state of the economy.

Anyhow, the point here is that neither the Fed nor the markets determine interest rates.  The state of the economy will lead the markets and the Fed to respond in certain ways which may or may not lead to interest rate changes.  But make no mistake, while bond vigilantes aren’t going to push the rate of interest on US government bonds higher if the Fed doesn’t want them higher, the Fed also can’t control the rate of interest on all credit instruments.  In other words, the Fed can control the nominal rate of interest on US government bonds, but it can’t control the entire economy.  So, as is generally the case, the answer to this question isn’t quite as black and white as many assume.