As I’m sure you’ve heard by now, the Fed cut rates by 50 bps this week and the crypto markets erupted higher. Crypto is up double digits across the board since the announcement.

You would think that a big rate cut (50 bps is huge, for the record) would cause markets to dump. Doesn’t this mean times are tough? That we’re on the precipice of ruin?? The last 50 bp cut was during the Great Financial Crisis. I haven’t seen any notable bank failures. At least not yet.

I suppose that reasoning only applied before COVID and GME and Roaring Kitty and JPow’s money printer go brrrr.

Today we cut rates to manipulate the yield curve. We cut rates to weaken the dollar and save the Yen. We cut rates to create buckets of sloshing liquidity.

We’ve entered an easing cycle with a splash. We’ll see how it plays out, and we’ll be prepared.

Market Vibes

Crypto Reads

In Praise of Volatility: A non-intuitive explanation for why volatility can improve compound returns.

Your Quality of Life Metrics Are Just GDP: Productivity rules the world, everything else is just a proxy.

Diversification is a negative price lunch: Fairly technical blog post making that case that you don’t need to catch the 10x (or 100x) baggers to win over the long term, so long as you are adequately diversified.

Crypto is an inefficient market. And that’s good for you.

Last week, I linked to a paper written by Cliff Asness. He’s a billionaire quantitative hedge fund manager and cofounder of AQR, a $100 billion hedge fund. He’s a really nerdy, really rich guy. In that paper, he makes the case that over the past ~30 years, the markets have gotten less efficient, not more.

Today, I’m going to walk through his paper and try to tease out the really important things that I think will help us all become better investors. He mostly talks about stock markets — that’s ok. Crypto markets are like stock markets on crack. They move faster, with more volatility, and even greater information asymmetry. There’s a reason that the quant hedge funds entered crypto before the others.

Here’s what to expect:

• Efficient Markets vs Inefficient, and why it matters

• Why markets today are less efficient (his evidence and hypothesis as to why)

• What this means for markets going forward (hint: more volatility, more momentum).

This could be my confirmation bias talking, but his observations and reasoning matches up very well with what we do here at Positive Skew. These inefficiencies are our advantage, and no where is the opportunity greater than in crypto.

When he talks about social media and herd mentality — that’s crypto twitter, narratives, and meme coins.

That’s using techniques from fundamentals investing alongside quantitative/systematic tactics to run with the herd, not against it. Its using volatility and diversification to outperform.

I’ve presented the paper here as a Q&A to experiment with a different format. Reply to this email and let me know what you think.

You can download and read the full paper here.

1. What is the Efficient Market Hypothesis (EMH), and why is it important for society?

The Efficient Market Hypothesis (EMH) is the idea that asset prices fully reflect all available information. In simple terms, it means that it's impossible to consistently achieve higher returns than the overall market because prices already incorporate and reflect all relevant data.

EMH is important broadly because it suggests that financial markets are doing their job efficiently. When markets are efficient, resources are allocated effectively—meaning that capital (money) goes to the businesses that can use it best. This leads to better economic growth and productivity, benefiting everyone in the long run.

An efficient market means you can not have an edge. The best you can do is match the returns of the market as a whole. An inefficient market, on the other hand, means you can have an edge — you can beat the market with the right strategy.

2. According to Asness, how have markets changed in terms of efficiency over the past 30+ years?

Asness makes the case that markets have become less efficient, especially in how they price different stocks relative to each other.

He observes that stock prices are less accurate reflections of companies' true values, leading to larger mispricings. This means that stocks are more likely to be overvalued or undervalued compared to their actual worth than they were in the past.

In a new asset class with much less liquidity than stocks (like crypto), these mispricings are even greater. Crypto’s huge volatility is evidence enough. More on that later.

3. What evidence does Asness provide to support his claim that markets have become less efficient?

Asness points to the "value spread" as evidence. The value spread measures the difference in valuation between expensive stocks and cheap stocks. He notes that this spread has become much wider in recent years, particularly during events like the dot-com bubble in 1999-2000 and the COVID-19 pandemic. A wider value spread suggests that the market is mispricing stocks more significantly than before, indicating less efficiency.

4. What are the three hypotheses Asness offers to explain why markets have become less efficient?

Asness offers these explanations:

• Hypothesis 1: Indexing Has Ruined the Market - The rise of index investing (where investors buy a basket of stocks representing a market index) may have reduced the number of active investors who analyze and price individual stocks accurately.

• Hypothesis 2: Very Low Interest Rates for a Very Long Period - Prolonged periods of low interest rates might encourage investors to take on more risk and inflate asset prices, leading to market inefficiencies.

• Hypothesis 3: The Effect of Technology Is Backwards - Technological advancements, especially social media and high-speed trading, have not made markets more efficient as expected. Instead, they may have led to herd behavior and the spread of misinformation, causing prices to deviate from true values.

5. How do wider value spreads indicate less efficient markets, and what happened during the dot-com bubble and COVID-19 in terms of value spreads?

Wider value spreads mean that the difference in valuation between expensive and cheap stocks is larger than usual. In an efficient market, this spread should be smaller because prices reflect true values.

During the dot-com bubble (1999-2000) and the COVID-19 pandemic (2019-2020), the value spread reached unprecedented levels. This means that expensive stocks became extremely overpriced compared to cheap stocks. Such extreme differences suggest that the market was mispricing stocks significantly, indicating less efficiency.

I hope I don’t need to say how insane crypto prices can get. Just listen to Michael Saylor in this clip:

6. What are the implications of less efficient markets for investors who follow disciplined, value-based strategies?

For disciplined, value-based investors—those like Ben Graham or Warren Buffett who buy undervalued stocks and sell overvalued ones—less efficient markets present both risks and opportunities.

On one hand, greater inefficiencies mean there are more chances to find mispriced stocks and potentially earn higher returns in the long run. On the other hand, these investors may face longer and more severe periods of underperformance because the market can stay irrational for extended times.

In crypto, where the notion of a “value token” is still undefined, these periods of irrationality are pure opportunity. Systematic approaches ensure discipline, proper risk management, and profit taking. Understanding market dynamics like momentum, trend, and narrative lead you to the profitable bets.

7. Why might investors find it harder to stick with rational investing strategies in less efficient markets, according to Asness?

Investors might find it harder because periods of underperformance can be more intense and last longer in less efficient markets. When their strategies aren't working for extended periods, it can be psychologically challenging to stay committed.

Additionally, social pressures and the fear of missing out on popular trends can make it tempting to abandon disciplined approaches.

We talk about this almost every week — you have to have a system to succeed in crypto. The emotions are just too strong when things go vertical, up or down. Crypto bear markets are called “crypto winter” for a reason. It’s brutal and tests even the strongest conviction.

8. What are some of the ways investors are responding to less efficient markets, and what does Asness think about these responses?

Many investors are turning to index investing or moving their money into private investments (like private equity and private credit) to avoid the volatility of public markets.

Asness is critical of these responses. He believes that while indexing is acceptable for those who can't commit to long-term strategies, hiding in private investments can be risky. Private investments may appear less volatile because they aren't frequently priced, but they can carry hidden risks and may offer lower returns in the long run.

You can probably guess how I feel about this: I think you should seek the volatility. That’s our opportunity. We don’t hide. We embrace the challenge.

9. What advice does Asness give to investors for dealing with less efficient markets?

Asness advises investors to:

• Stay Committed to Rational Strategies: Focus on long-term value-based investing, even when it's challenging (keyword: rational).

• Have a Long-Term Perspective: Understand that markets can be irrational in the short term but tend to correct over time.

• Diversify: Build a well-rounded portfolio to spread risk across different assets.

• Avoid Herd Mentality: Don't be swayed by market fads or short-term trends promoted through social media or other platforms. (IMO this doesn’t mean avoid the herd — it just means avoid the herd mentality).

• Focus on the Whole Portfolio: Instead of fixating on individual investments, look at how all assets work together to achieve financial goals. Crypto should not be 100% of your investments. Crypto is a high vol diversifier.

10. What is Asness's overall conclusion about the shift towards less efficient markets and its impact on investing?

Asness concludes that while markets have become less efficient, making it harder to stick with disciplined investing strategies, this shift also creates greater opportunities for those who can remain committed.

He believes that investors who maintain a rational, long-term approach will ultimately be rewarded.

However, you need to be prepared for increased volatility and the psychological challenges that come with it.

The full paper is worth a read.

I’m already at almost 2,000 words in the newsletter this week, and that’s a shame because there’s so much more gold in this paper.

The discussion of EMH is nuanced and deeper, he talks about market bubbles, critiques alternative investments further, discusses the concept of "statistical time" versus "real-life time" in investing, and offers more detailed recommendations for portfolio management.

I strongly encourage you to find the time for a deeper read of the full paper.

Portfolio Update

No trades this week, but I’ve got an itchy trigger finger circling that buy button.