12: Beware of the Slippery Stairs, Investment and Speculation, Is Inflation Transitory?, Build Conviction, Blurring the Photo/Video Frontier, The Mother of MP3
I'd imagined a piano playing along behind it, like a playback for a French movie, but since I could not play the piano or knew someone who could play it, I just decided to A Capella it - Suzanne Vega
Beware of the Slippery Stairs
In last week’s issue, I commented LT3000’s article Tech, inflation, and the tyranny of the numerator, and the last few days have offered quite the testing ground for the ideas he developed:
On cryptocurrencies, volatility was through the roof over the last 7 days, with BTC spot down ~25% and Ethereum spot prices down ~42% as I write this. Many factors are at play, but I think overall what we see is a textbook illustration of reflexivity.
The cryptocurrencies space has turned to a sincere (literally) greater fool’s game, with Pump&Dump & promotion of pointless tokens making a comeback as elements of an investing strategy. But that’s not the most worrying, I think, and I’m more concerned about the true denominator effect here:
Tether, the most widespread “stablecoin” (cryptocurrency backed by tangible fiat reserves), published a report providing “full transparency” on the nature of its holdings.
Looks like the emperor was not wearing any clothes all along!
On the above chart, it states with unreal confidence that the instruments backing Tether, which people believed to be 100% comprised of USD reserves, have as little as 3% USD in it.
Here, we have the denominator effect at play: Tether, contrary to what it stated many times and to what most people believed, has been operating on a fractional reserve basis.
It’s almost like Tether thinks it is some kind of bank, isn’t it?
Well, kind of. In the 2019 affadavit, Hoegner pointed out that commercial banks operate under a similar “fractional reserve” system, and that this was “hardly a novel concept”. But 2.9 per cent is really quite the fraction isn’t it? And the difference here, of course, is that commercial banks are subject to stringent regulations and thorough independent audits, neither of which apply to Tether.
When we asked Tether about this a couple of months ago, Hoegner told us that “Tether does not purport to be a bank, call itself a bank, or carry on a banking business”, and that “Tether Limited is registered as a money services business” and was regulated as such. So it doesn’t purport to be a bank, but it points out that it operates a fractional reserve system like banks. Doesn’t that crypto-cake taste so damn good when you can have it and eat it all at the same time?
Last bit of the FTAV piece that I found interesting:
Basically, yeah, the denominator has been stretched unbelievably thin
If you’re interesting in reading Coppola’s take on this you can read Tether’s smoke and mirrors here.
But enough of crypto, I also wanted to show you a chart that illustrates perfectly the denominator effect in the SaaS (Software as a Service) and more largely tech space:
Basically, the denominator effect states that the longer the duration (valuation heavily dependent on cash flows happening in a distant future), the higher the volatility (both up and down). I think the chart illustrates the point pretty well. As you see, Jamin Ball from Clouded Judgement bucketed the SaaS businesses in different categories based on Next Twelve Months (NTM) revenue growth, and the results are:
High growth SaaS businesses benefited immensely more from the 2020 uplift in valuations, as cash flooded into corona-friendly categories, reaching almost 40.0x multiples at the top
Low growth SaaS businesses were barely affected from all these developments, because they have a much lower duration (short term cash flows represent the bulk of the total)
Beware of the slippery stairs
You could easily fall... and break your neck
Hand me that torch and I will lead the way
To the secret in the darkKing Diamond - The Family Ghost (link)
Investing & Business
Walking on the Line: Investment and Speculation
Reading time: ~10 minutes
Interesting quarterly piece by GMO on the state of the markets. There seem to be a growing number of observers trying to put words on the Denominator Effect:
The signs of speculative excess in the stock market today are obvious. Speculative booms provide both entertainment and outsized profits while they are happening, but they do generally burst painfully. This is particularly true in equity markets, where the demand growth is ordinarily met with increased supply from savvy capitalists. Maintaining excess demand in the face of growing supply becomes ever more difficult and eventually proves impossible . […] Whether the end means a fall for just the more speculative end of the market or the market as a whole is harder to predict at this point.
Remember when we were talking about Wall Street doing the work and supplying thirsty investors with evercoming new assets to invest in? Be careful about what you wish for!
Today’s stock market is seeing the largest burst of issuance we’ve seen in over a generation. Furthermore, the form of much of that issuance – SPACs – seems tailor-made to deliver additional supply of capital to exactly those areas speculators are most in love with at the time.
Insight #1 The difference between an investment and speculation
This is something that has popped up recently in conversations I had with friends and if there is a fundamental difference between investment and speculation, I was having a hard time finding the right words. I think I found them here :-)
Investment: The deployment of capital to perform an economic service for which a rational counterparty should be willing to pay.
Speculation: The deployment of capital to achieve an expected gain based on an investor’s prediction of how future prices will differ from the market’s expectations.
Investment as an activity allows for both parties to a transaction to be satisfied with the outcome, whereas speculation generally implies a winner and a loser. […] You are unlikely to get rich quick from investment activities, even if your long-term results should be satisfactory. Speculation, on the other hand, offers the potential for large and/or quick gains if you predict things well. Furthermore, it offers the prospect of the psychological reward of both “winning” the transaction and having been proven right
Insight #2 How can I protect my portfolio ?
If the bubble bursting takes the form of the speculative end of growth falling, the easy protection is not to own the speculative end of growth […] You can protect your equity portfolios by choosing to bias them toward value and away from the most expensive end of growth. Doing so has the nice feature of being both risk-reducing and return-enhancing in today’s environment. If, as it did in 2000, the overall market is going to follow the expensive growth end down, a value bias will help but not necessarily make you money.
Is Inflation Transitory?
Reading time: ~10 minutes
Short and concise take on the debate about inflation in the US, the FED policy and whether or not CPI price increases we are seeing are “transitory” or not:
Maybe what they mean is that “these price changes we are seeing are all the results of supply and demand imbalances in nominal space, so they’ll all reach equilibrium and inflation will go away.” If that’s so, then (a) they’re probably wrong, (b) that’s what inflation looks like anyway; it doesn’t manifest as smooth price changes across all goods at the same time, and (c) you still haven’t told me over what period it will take for this equilibrium to occur. Suppose it takes 5 years, and the average price change over that time is 5%. Does that mean it was transitory? Absolutely. Does that mean we should ignore it in that case? Absolutely not! A 25% change in the price level over five years would mean significant adjustments in product, service, and asset markets.
The core debate is to understand whether price will normalize in the short term or if we’re really at the beginning of period of elevated inflation. In the short term, there is too much noise to have confidence, but as Ramp Capital put it in a mail on monday:
Just go out and try to buy anything without feeling like you got taken advantage of. I purchased my first flight in 18 months and paid nearly $500/ticket for a flight that should have been less than $300. The rental car was over $1000 for 5 days. A 2x4x8 piece of lumber from Home Depot is $8, which used to be about $2.50 a year ago. National gas prices are at the highest levels since 2014, hitting a national average of $3. Used cars are now an appreciating asset. The list goes on.
I was also amused at the metaphor he uses about his positioning, some summer vibes in here!
So, lumber futures are falling now, after spiking higher. Resin prices have come down after spiking higher. Does that mean these were ‘transitory’ effects? If we were at the beach, we would describe each wave as transitory. But we would also want to know if the tide was coming in, or going out, when we set up our beach chairs. If it’s me? Right now I am setting my chairs a good distance away from the water.
Thought-provoking stuff…
Building Conviction Is Your #1 Priority
Reading time: ~10 minutes
Along with discipline, I think conviction is one of the most important traits that you need to be successful in your personal endeavors.
While discipline helps you achieve seemingly unachievable outcomes by breaking it down into smaller steps that you complete consistently, conviction helps you cut the procrastinating phase that is induced by the lack of confidence (is this the right approach? but what if that goes wrong?).
I would venture out and say that this can be a defining attribute of success: being able to cut the corners and pull the trigger when a satisfying conviction threshold is reached.
In fact, making bad decisions is part of the game, there is no way around it. The key thing is to get going:
When you’re implementing a bad plan yourself, instead of having a mentor bail you out by fixing it, a few really useful things happen:
You learn many more details about why it was a bad idea. If someone else tells you your plan is bad, they’ll probably list the top two or three reasons. By actually following through, you’ll also get to learn reasons 4–1,217.
You spend about 100x more time thinking about how you’ll avoid ever making that type of mistake again, i.e., digesting what you’ve learned and integrating it into your overall decision-making.
Experimenting with high stakes decisions taken in the fog of war is what prepares you to be able to operate a company, and helps you build your own mental models:
By far the most important part of the CEO’s job is the high-conviction decisions. What product should we build? What strategy should we pursue? Who should we hire? And so on.
If you join a company where someone else is already making those decisions well, you’ll never get the type of practice that you need in order to build your own models and heuristics. You’ll end up with a good, but not perfect, model of “what would my boss do?"—a model that can make the 95% of easy decisions, but not the 5% of hard ones that add the most value.
Arts & History
Blurring the Photo/Video Frontier
Interesting video on the Canon R3, and why this might be a defining moment in the history of professional photography.
Very quickly the differences between photo and video capture are converging and it is resulting in a camera landscape that might end up making both features virtually the same. It’s a situation that photographers don’t like to think about as it removes a lot of what makes photography a skill: preparing and being able to capture a decisive moment. The idea of a camera that can just record and not need a photographer to tell it when exactly to hit the shutter creates an uncomfortable situation for many photographers: what are we needed for?
Treat for the Ears
Highlights from the comments:
This was the first song converted to MP3. "Karlheinz Brandenburg used a CD recording of Suzanne Vega's song "Tom's Diner" to assess and refine the MP3 compression algorithm. This song was chosen because of its nearly monophonic nature and wide spectral content, making it easier to hear imperfections in the compression format during playbacks. Some refer to Suzanne Vega as "The mother of MP3" - Source
Tom’s Diner is actually a real restaurant on Broadway, where Suzanne Vega used to have breakfast before heading to work:
The song was actually reinterpreted by Giogio Moroder & Britney Spears (with a great music video) - listen here
Other Interesting Links
Okay, last crypto bit but with the volatility we had some interesting comments. See Taleb’s take:
On Wednesday, 775,000 traders had their accounts liquidated in a debacle involving $8.6 billion of crypto. Adding leverage upon leverage with an underlying asset exhibiting tremendous volatility was always a recipe for failure. Taleb is right in suggesting that neophyte traders should learn from the experience and, above all, learn that to win, you must first survive.
(Rational Reflections Weekend Links, 05/21)
Until next week!
Antoine