Opus 15: Some Recent Thoughts
Reflexivity, NOPE, Valuations, & Inequality
I have several long-form Opus Letters in the hopper that aren’t quite ready to see the limelight. In the meantime, I wanted to share a few recent thoughts that have been bouncing around my head from things I have read, discussed, or heard in passing.
The George Soros General Theory of Reflexitiy series is the most under-appreciated video series on the internet. Soros gave the three lectures in 2010, just after the financial crisis had bottomed out. Soros attributes most of his career’s notable successes to the Theory of Reflexivity.
The basic idea behind reflexivity is as follows: subjective beliefs regarding objective reality can, to a certain extent, change objective reality because of the actions participants take as a result of those subjective beliefs. Reflexivity shows itself most often in financial markets since markets simply quantify our beliefs about reality. Our market decisions are the currency through which we manifest those beliefs.
An example might be helpful: Tesla is the most valuable carmaker in the world right now. The reality is Tesla does not produce that many cars, does not generate that much revenue, doesn’t generate any cash flows, and is not the largest car company by any other measure but its market cap. That is reality. But, the subjective belief held by many allows Tesla to fund their growth through secondary equity offerings and debt offerings - both of which would not be possible if they were valued similarly to other carmakers - which could allow them to become the largest carmaker in the world by those fundamental measures. Tesla can use this decoupling of the two realities to, hopefully, converge them onto one another. This is reflexivity. Soros provides a few other examples:
Consider the statement, “it is raining.” That statement is true or false depending on whether it is, in fact, raining. Now consider the statement, “This is a revolutionary moment.” That statement is reflexive, and its truth value depends on the impact it makes.
The other is that these distorted views can influence the situation to which they relate because false views lead to inappropriate actions. That is the principle of reflexivity. For instance, treating drug addicts as criminals creates criminal behavior. It misconstrues the problem and interferes with the proper treatment of addicts. As another example, declaring that government is bad tends to make for bad government.
We are currently living through the largest exposé of Reflexivity in history within the financial markets, especially the private markets around technology and venture equity. Investors’ beliefs are changing reality more than ever, rather than the classical causal relationship where capital follows growth. Now, growth follows capital. Reflexivity often shows itself most in change times, when participants believe the future will look very different from the present. As Alex Danco says,
“Startups are a bet that the future will be radically different from the present, and they are valuable on the way up because they are, effectively, a call option on that future coming true.”
Deploy enough capital into the future you want, and the future may come true. Reflexivity.
There is far more to unpack here - when and how reflexivity breaks, deterministic futures, etc. - and I am working on a more fleshed out post diving into the historical examples of reflexivity at work in financial markets, policy, and beyond.
NOPE - Net Options Pricing Effect
I recently read Lily Francus’s post on the reversed relationship of options in financial markets. In theory, derivatives react to their underlying assets. But, throughout the Covid era, derivative volume exploded, and this forced market makers to move the underlying assets as a function of the derivative markets; this is analogous to the tail wagging the dog. Here, the technical term is delta hedging, which is done by market makers to derisk their options inventory by purchasing the underlying asset to enter a neutral position with their derivative inventory. Lilly provides a more eloquent walkthrough:
This intuitively contradicts the idea of a memoryless process, because the buying and selling of derivatives due to delta hedging at previous times substantially impacts the movement of the underlying (as well as makes it non-linear except in the simplest examples, due to gamma hedging).
To put it even more simply, the net delta represented by the open derivatives on X represents an additive force to random changes in the underlying spot price. As we can see stepping from time t to t+e, given open call delta we can anticipate even in a random walk scenario that the spot should move in a path dependent manner given derivative positions previously opened on the asset. More interestingly, this is a generalizable effect that should exist independent of equities, for example, but in any market or market-like environment where hedged derivatives can exist.
Valuations & Time
While I generally try to shy away from discussions about my day job as an investor in the Opus Letter, I do want to discuss valuations - the only thing people are talking about today in the investment world. Assets are inflated. Never before have we seen equity prices where they are today. This inflation is caused by 1) the amount of money in the world, and 2) the cost of that money. That is fairly well known. But, what does value actually mean? The finance 101 definition would be, “value is the summation of all discounted, future cash flows.” That is also well known. The tongue-in-cheek definition is, “value is whatever someone is willing to pay.” When discount rates (interest rates combined with risk premiums, more on those later) go down, valuations go up. Simple. When people get more money from the money supply exploding, they will be willing to pay more for the same asset because the opportunity cost of that capital has gone down with its supply going up. Also simple.
A more abstract angle to approach this question includes the idea of time. Interest rates all include a time axis - more often known as the yield curve. Time is money. Again, simple. But, now time is free. Ignoring the biological and philosophical constraints - i.e. we only have so much time on this earth, etc. - right now, a gain of 20% over one year is just as good as a gain of 20% over 10 years when the time value of capital is zero, or negative in real terms.
In my little world of venture capital, we generally operate on a time horizon of 5-7 years. Our funds are structured in that way and our investors expect some type of realized returns in that time. Save for family office structures, this is one of the longest time horizons of any investable capital. Public markets demand quarterly results and many trading firms report success daily.
When interest rates are zero, capital becomes more patient because it has very few other options, otherwise known as the opportunity cost. Packy McCormick touched on this idea of the time constraint, or lack thereof, in his recent Not Boring post:
As Will Fang put it when we were discussing this idea, “When the discount rate is near-zero, time value isn’t really a thing anymore, so it's not a matter of when company x can win, but if it will eventually.”
Revisiting the above section of reflexivity, if capital is free and therefore patient, then deploying massive amounts of it into binary strategies makes sense. You can shift reality in the direction you want because of the decisions people will make in reaction to the capital deployment. This is what we have seen happen with the migration of mega, multi strat hedge funds into venture land — Coatue, Tiger, D1. Their public portfolios have kicked off so much cash that they are now creating the future they believe in with reflexive capital. This behavior is taken to the extreme when markets are derisked by the third body, the monetary policymakers.
For now, the monetary bodies only directly interact with the public markets, but their effect flows throughout the entire financial system like a flooding riverbed. The monetary policymakers inject infinite liquidity into the debt markets (originally just the government debt but also corporate debt), creating a stable credit environment and pushing down rates. This compression in rates, both short and long term, makes equity markets more attractive. The effect is double-dipped as credit markets become less attractive from a yield perspective, and leverage becomes cheaper, leading to more buying power provided to equity holders. This has a stronger relative effect on growth companies as much of their equity value is driven by cash flows far into the future as their growth continues, and today they are not cash flowing. The future cash flows have a negative, convex relationship to current yields (Future revenue / change in yield), especially when current yields are at the lower bound near zero. This drives growth company multiples through the roof, providing the comparable company dataset to private market growth investors. They see comparable companies trading at 20,30,50+ times revenue and will happily fund anything in, or even far above, that range understanding the company's short and medium-term growth prospects and its “revolutionary” product.
In times like these, I always come back to this quote given by the Sun Microsystems CEO in 2002, shortly after his company’s stock was down over 90%:
Two years ago we were selling at 10 times revenues when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don't need any transparency. You don't need any footnotes. What were you thinking?
I was thinking it was at $64, what do I do? I'm here to represent the shareholders. Do I stand up and say, "Sell"? I'd get sued if I said that. Do I stand up and say, "Buy"? Then they say you're [Enron Chairman] Ken Lay. So you just sit there and go, "I'm going to be a bum for the next two years. I'm just going to keep my mouth shut, and I'm not going to predict anything." And that's what I did.
Certainly, a fun read in the context of today.
Inequality is Natural
Martin Gurri’s recent piece on inequality is a must-read. The “inequality discussion” has been permanent throughout our society over the last decade, or at least certain forms of inequality that we assign importance to. Gurri presents a different take,
Should every instance of inequality be labeled an injustice? That is a strange question to ask in an age that considers “one of our country’s greatest strengths” to be its “diversity”—a concept typically defined as recognizing and respecting our “individual differences.” Such differences are evidently the cause, or at least the expression, of inequality, but the ideal of diversity is to make us complementary rather than identical. To advance in the path of progress, every nation, community and company requires an enormous range of human attributes. Since none of us are big enough to do it all, the attributes must be distributed, unevenly, among the population.
In its most literal sense, inequality is the most natural thing about us. Inequality amongst mother nature has persisted for all of time and it has driven the evolutionary process. Why should a societal structure strive to undo this natural state? Humans are the only animals that have developed any serious form of empathy. This trait is the sole reason we even have these discussions about the injustices of inequality. But are they legitimate discussions to be had? If all inequality - both the inequality we label as bad and the inequality we ignore - is eliminated, we become a stagnant body of water with nowhere to flow. As a society, we have just cherry-picked which inequality is “bad,” and that is the only inequality we target to undo.
One of the strangest things about the myths of technological neutrality and inevitability is that, even though they directly contradict one another, they’re often articulated together.
The truth is simple but uncomfortable. If interest rates are low and expected growth is held constant, higher valuations imply lower long-term returns. If interest rates are low because expected future growth is also low, higher valuations are not required. Long-term returns will be lower anyway. A valuation premium just makes future returns even worse.
Either way, Americans have come to believe, rightly so, that their absolute rights to “life, liberty, and the pursuit of happiness” are not to be afforded to them by the government. Government’s role is to protect those rights, not to grant them.
My solution is quite different. The meritocracy is hardening into an aristocracy—so let it. Every society in history has had an elite, and what is an aristocracy but an elite that has put some care into making itself presentable? Allow the social forces that created this aristocracy to continue their work, and embrace the label. By all means this caste should admit as many worthy newcomers as is compatible with their sense of continuity. New brains, like new money, have been necessary to every ruling class, meritocratic or not.
When an author caps two hundred pages of rhetorical fire with fifteen pages of platitudes or utopian fantasy, that is called “the last chapter problem.” When every author who takes up a question finds himself equally at a loss, that is something else. In this case, our authors fail as critics of meritocracy because they cannot get their heads outside of it. They are incapable of imagining what it would be like not to believe in it. They assume the validity of the very thing they should be questioning.
Their ideas might be argued against, but their genius and their influence was undeniable. Is there anyone who died in the last decade you could make that sort of claim for? How about for the last two decades? The last three? Or is there anyone at all who is still living today that might be described this way? In the realm of science, perhaps. But in the world of social, historical, ethical, and political thought, no one comes to mind. Most "great books" curricula stop right around World War II and its immediate aftermath. St. John's recently added Wittgenstein and de Beauvoir to their curricula, but their works are almost 70 years old. Michel Foucault is the next obvious candidate, and he died 37 years ago.
For no matter how power originates, the crucial interest is in how power is exercised. What determines the quality of a civilization is the use made of power. And that use cannot be controlled at the source.
But if, instead of hanging human dignity on the one assumption about self-government, you insist that man’s dignity requires a standard of living, in which his capacities are properly exercised, the whole problem changes. The criteria that you then apply to government are whether it is producing a certain minimum of health, of decent housing, of material necessities, of education, of freedom, of pleasures, of beauty, not simply whether at the sacrifice of all these things, it vibrates to the self-centered opinions that happen to be floating around in men’s minds.