Just Like Jon Snow, Alpha Is Not Dead

Is Jon Snow Really Dead?


I am big fan of the show Game of Thrones and the big topic this summer is whether Jon Snow died in the season finale? I will use the power of logical reasoning to come to a somewhat definitive answer to that question. Fans of the show know that Jon Snow is Eddard Stark’s bastard. This raises the first question – Is it possible that a man like Ned Stark, the epitome of honor, would cheat in the first year of his marriage to the woman bearing his first child? Not likely. So Jon Snow for sure isn’t his own son. He is somebody else’s son that Ned is trying to raise and protect as his own. As fans of the show might be vaguely aware, the Seven Kingdoms are currently in a big mess because of the monumental conflict between House Baratheon and House Targaryen. The conflict is Trojan in nature as it arises from the battle of two powerful men for the love of a beautiful woman. The woman in question is Ned Stark’s sister Lyanna. Lyanna was betrothed to Robert Baratheon, but during the tournament at Harrenhal, Rhaegar Targaryen, the crown prince and winner of the tournament gives the honorary rose to her instead of his own wife. At some point, Lyanna, a strong independent minded woman, leaves Robert and joins Rhaeger in King’s Landing. Not much else is known, but that at some point Robert Baratheon leads a revolt against the Targaryens to “free” Lyanna from Rheager. And soon after Rheager is killed in the battle of the Trident by Robert, she dies while giving birth.


The child supposedly also died at birth. Or did it? Right around that time Ned Stark shows up in Winterfell with a bastard. A descendant with Targaryen (dragon) blood and Stark (First Men) blood is the perfect candidate to become the Azor Ahai – the mythical one who can bring light to the world of the Seven Kingdoms from the darkness that the Others are about to plunge it in.

So while the producers of the show swear that he is dead, an observer who uses the power of reasoning should know better.

Just Like Jon Snow, Alpha Is Not Dead

A couple of days ago Robert Shiller published a great article called “The Mirage of the Financial Singularity” in which he discusses the fascinating topic of whether Alpha will eventually go to zero for every imaginable investment strategy?

Before I delve into the topic, I want to say that I am a great fan of Mr. Shiller. He is the creator of a lot of indexes by which we measure value today and the incredible thing about his models, indexes and research is the astounding simplicity and intellectual purity of his models. His CAPE model/spreadsheet takes exactly 1 minute to comprehend and can be understood by a 3rd grader. While I am sure the math to get to it is pretty complicated, the end result is far from complicated. A lot of laws in nature and finance have similar properties. They are hard to come up but once discovered their rules are amazingly simple. The gravitation formula is not for the faint of heart, but its final outcome is remarkably simple – an apple left on its own will fall down. Same with finance, a lot goes into calculating enterprise value and fundamental asset valuation, but at the end of the day the asset is either cheap or expensive.

In my view, Shiller’s view of asset pricing can be boiled down to the following simple formula:

Asset Market Price = Fundamental Valuation + Sentiment Premium

Fundamental Valuation is what the asset price should be based on cash flows, underlying asset valuations, etc.

Sentiment Premium is simply the difference between the current Market Price and the Fundamental Valuation.

The Market Price and Fundamental Valuation are almost always different numbers simply because the asset trades on a market and the price paid is subject to negotiation. In other words, market price has nothing to do with the laws of cash flow analysis and everything to do with the perception and positioning of the two market participants who have to agree on a price. The reason can be many:

  • A buyer can be overly optimistic/pessimistic about the value of a stock based on his personal experience.
  • A seller may be in urgent need for a capital and is willing to part at a cheaper price.
  • Central bank floods the market with liquidity leading to institutional buyers having more cash to spend on an asset than is fundamentally reasonable.
  • High taxation removes capital from buyers and they end up bidding lower.

The reasons are many, I will not cover them all. I will let a guy with a PhD do that. The point I want to make is very simple. The Sentiment Premium is almost never zero.

Warren Buffet approach to investing can be summarized very simply with the following simple formula:

When Sentiment Premium < 0, Buy Asset

It can totally be replicated by a modern day computer. The software program can be built in a few minutes, right?

Except that it can’t. What should also be obvious is that Warren Buffet’s success is not just the simple application of that rule. It is what he is actively doing to the asset once it is purchased:

  • Changes to management
  • Creation of new markets and products
  • Optimization of an inefficient business process
  • Expansion of a regional business to national level

There is a lot that Warren Buffet does in the realm of asset management that is the prime reason for his success. If he didn’t manage his assets well, the fact that he bought the assets at discount does not mean much. The price of a mismanaged asset can always go down to zero (see Kodak).

Warren Buffet is not the only one who practices this investing style. The management of every good company in the S&P 500 practices that investing style. There are many examples. America is littered with successful investors.

The fact that in a free market the Sentiment Premium is almost always not zero does not mean that markets are inefficient. Markets are extremely efficient; now more than ever. It just means that market participants don’t evaluate stocks efficiently. Market participants are human beings; or computer algorithms written by human beings. Markets are a conglomerate of millions of inefficient human decision makers with limited memory capacity driven by the biochemical reactions that happen in their brains that day. God forbid they end up being happy at the same time based on serotonin releases from their brains because it’s a holiday weekend. You can hardly find a down holiday week for decades if ever.

So long as there are free markets, there will be a Sentiment Premium for each individual asset and thus there will be Alpha to be made. Just like John Snow, Alpha is not dead and it simply can’t die. It’s the nature of the markets.

Don’t Fight The Fed

While financial markets are most certainly efficient and represent the most efficient structures ever designed by human beings, they are also very, very manipulated. The market participants can be broken down into the following 4 major categories:

  1. Governments/Central Banks
  2. Institutional Investors (Public/Private Pension Funds, College Endowments, Corporate Treasury)
  3. Market Makers/Banks
  4. Retail Investors

This is roughly the Commitments of Traders report except the “Large Speculators” is broken down a little further, because there is a distinct difference in the size of these groups. While Banks/Market Makers deal with billions to tens of billions, Institutional Investors deal with ten to hundreds of billions and Governments/Central Banks deal with hundreds of billions to trillions. Each one of these is an order of magnitude bigger and the weight of its Sentiment Premium dwarfs that of the remaining market participants. As a result, what Central Banks assign as a Sentiment Premium for an asset class is about the only thing that matters. Ok, it is not 100%, it is roughly 90%, but one thing should be crystal clear is that 10% doesn’t move the needle much except on a short term basis.

This is a profound realization. What the Harvard Endowment thinks doesn’t matter.  What Goldman Sachs thinks doesn’t matter. What Black Rock thinks doesn’t matter.  What the FED thinks is the only thing that matters.

So how do we make this realization work for us as retail investors? Retail investors are a speck on the whale that is the financial market. We have to utilize alternative asymmetric thinking in order to survive.

Military Lessons from Eastern Europe

I am somewhat of a fan of military history. While I am certainly not a military expert, I do have favorite battles. The 300 Spartans is one of them, as their 80 to 1 kill ratio over 3 days is probably unmatched in military history based on the weaponry available. However, my favorite battle is the virtually unknown Battle of the Shipka Pass in 1877 between the Ottoman Turks and Russia.


In that battle, 5,000 strategically placed Russians and Bulgarians on St. Nicholas Peak withstood frontal assault by 30,000 Turks for 3 days. The Turks who were militarily superior at the time and better organized suffered a 3-to-1 kill ratio. It is said that even the dead fought for the defenders as the living would throw the dead bodies down the slope. After losing that battle, the Turks were unable to combine their two main battalions while the Russians were able to and General Gourko then routed the Turks all the way to Constantinople resulting the formation of the present day Eastern European countries of Romania, Serbia, and Bulgaria with the peace Treaty of San Stefano.

The military philosophy in Eastern Europe emphasizes asymmetric thinking and the value of positioning, selectivity and misdirection. Eastern Europe is a conglomerate of small countries each of which has had to fight much bigger and well-funded opponents to gain its independence. You cannot throw numbers at an opponent and your technology is vastly inferior. You have to protect every single military asset at all costs whether it’s a soldier or a weapon. You have to minimize your losses and maximize your gains. You have to hide and misdirect. You have to selectively hack your way at the corners and intersections of the enemy’s military organization at just the right times and decapitate and turn against them what makes them strong – their communication, organization and technological superiority. Break down the communications, disrupt the supply chain, blow up the provisions and pretty soon, it doesn’t make sense for them to continue their campaign. Guerilla warfare at its finest. That’s why when you go to Eastern Europe, in a week you can go to 10 countries whose total territory is the state of Ohio. But if they want their independence, who can say no? The military costs are simply prohibitive and Ukraine is about to find that out nowadays in their conflict with the Donetsk Republic.

Find your Beta and Live Happily Ever After

The position of the small Eastern European nation is the where the Retail Investor finds himself today. The retail crowd is vastly outteched by the computer and automation capability at the institutional players. They don’t have the man power to do exhaustive research on thousands of assets. They are a unorganized crowd against a very well organized opponent (institutions coordinate every day). And their capital is relatively insignificant. It is very difficult for retail investors to succeed at the traditional game of stock picking. Yes some will, but 90% of them won’t.

While Alpha is a tough find for the retail investor, Beta sure isn’t! There are plenty of markets and ETFs to pick from.

A retail investor has to think alternatively and asymmetrically. How so? Let’s apply some Eastern European military strategy here:

  1. Carefully select your strikes

Limit your coverage – trade ETFs not stocks. If you can’t cover and follow 5000 issues in the broad US stock market, focus on what you can cover and follow. There are about 60+ ETFs that cover all asset classes, industries and major countries. A lot less work to deal with.

It is scientifically proven that a portfolio of 15+ stocks generally matches the benchmark. In other words, if your portfolio is too diversified, you’re fooling yourself that you are beating your benchmark. Even if you beat it, you can do pretty much the same with a lot less work. Might as well buy the NASDAQ and not worry if the CEO if the company you follow resigns tomorrow plunging your stock 25% before you can even place a trade (see Twitter for the latest example).

  1. Position yourself well

Invest only in ETFs that are trending up. The slope of the 50 day moving average is an excellent pointer to the general trend in an ETF. If the slope is positive, it is good idea to buy the dips.

Use the media to your advantage. The FED, Bank of Japan, ECB are well covered. If they print money, just invest where money is being printed. Use currency-hedge ETFs. You literally follow the money with the risk factored out. It’s a no brainer and it only takes the 10 minutes to read the Wall Street Journal headline every day, which you do anyways.

  1. Minimize your losses

Utilize stop losses and buy on drawdowns. Asset classes fluctuate, but unlike stocks it is rare that they go down 50% hard quickly. ETFs go down but not nearly as fast as individual stocks. You have time to react. In general, if you buy an ETF at 50% discount from its high, it is unlikely you will suffer 50% in losses. If the general trend of the ETF is down (the slope of the 50dma is negative) stay away until the trend turns positive. Once the ETF trend starts going up, it is hard to stop the advance.

  1. Maximize your gains

Use moderate leverage. If an ETF is trending up and goes up 30% in a year, you can goose your returns safely by using the leveraged version of that ETF. Such a 3x ETF will give you 90% that year which the same as buying Facebook at 38 and holding to 70 for a year; with a fraction of the risk to boot as you’re not buying an individual stock!

  1. You don’t have to win the battle to win the war

Eastern Europe is littered with countries whose armies lost every single battle they fought. However, each loss was so expensive for the winner that it rendered them ineffective in governing the territory. Hence, you get to see 20 different Eastern European countries the size of Brooklyn waving flags at the Olympics.

Similarly in investing you have to always remember that you’re in it to build wealth not to beat the stock market. Your goal is to accumulate wealth, whether you are doing this at a rate faster or slower than the S&P 500 is immaterial. You are not a hedge fund manager, you don’t charge 2 and 20 and you don’t need to prove anything to anybody. Your only goals are to not lose money and have more money each year than the prior year. Keep making 10% a year and pretty soon you won’t know your wealth even though you rarely beat the market. All you need to do is make 10%, when the market loses 50% like in 2008 and you’ll be far ahead in terms of total performance for a long, long time.

  1. Use the strength of the opponent against him

So now that you have picked 4-5 ETFs that are trending up and have leveraged them moderately, you need to find an asymmetrical investment vehicle that can smoothen up your portfolio performance.

I can think of one such vehicle – XIV, the short volatility ETF. The FED is in an ongoing war with deflation and they seek to cheapen government debts overtime by devaluing the currency; in the process of doing that, they seek to neuter asset price fluctuations or as otherwise known – volatility. The FED actively seeks to suppress volatility. You can invest along with the FED by shorting volatility or investing in XIV. XIV has had quite a few years of 100%+ returns or 100%+ intra-year streaks. Learn how to invest in XIV and your portfolio couldn’t be happier.