The 18th Brumaire of Janet Yellen

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One of the more painful lessons in investing is that the prudent investor (or ‘value investor’ if you prefer) almost invariably must forego plenty of fun at the top end of markets. This market is already no exception, but speculation can hurt prudence much more and probably will. Ah, that’s life. And with a Fed like ours it’s probably what we deserve. 
– Jeremy Grantham, macro fund manager and noted Bear (Nov. 19, 2013)

I cannot look at myself in the mirror; everything I have believed in I have had to reject. This environment only makes sense through the prism of trends. 
– Hugh Hendry, macro fund manager and noted Bear (Nov. 22, 2013)

The hippies, who had never really believed they were the wave of the future anyway, saw the election results as brutal confirmation of the futility of fighting the establishment on its own terms. 
– Hunter S. Thompson, “The Hashbury is the Capital of the Hippies” (1967)

In the sunset of dissolution, everything is illuminated by the aura of nostalgia, even the guillotine. 
– Milan Kundera, “The Unbearable Lightness of Being” (1984)

The Greek word for ‘return’ is nostos. Algos means ‘suffering.’ So nostalgia is the suffering caused by an unappeased yearning to return. 
– Milan Kundera, “Ignorance” (2000)

The class which has the means of material production at its disposal, has control at the same time over the means of mental production. The ruling ideas are nothing more than the ideal expression of the dominant material relationships. 
– Karl Marx, “The German Ideology” (1846)

“Let’s go.” “We can’t.” “Why not?” “We’re waiting for Godot.” 
– Samuel Beckett, “Waiting for Godot” (1953)

Karl Marx may not have had a small-l liberal bone in his body, but he was one of the keenest observers of the human condition to ever live, and his writings are a phenomenal resource for anyone seeking to understand our lives as social animals. In 1852 Marx published an essay titled The 18th Brumaire of Louis Bonaparte, recounting the 1851 coup where Louis-Napoleon Bonaparte (nephew of THE Napoleon) seized dictatorial powers in France. The essay was, Marx wrote, intended to “demonstrate how the class struggle in France created circumstances and relationships that made it possible for a grotesque mediocrity to play a hero’s part,” and it is here that Marx describes his view of the individual’s role in history. Which is to say … not much, as individuals are almost always prisoners of the past and their class, particularly shadow or derivative individuals, as Louis-Napoleon was to his uncle and Yellen is to Bernanke. This was the essay where Marx famously said that history always repeats itself, only the second time as farce, a phenomenon I’ve written about at length as the emergency Fed policies that saved the world in 2009 have been transformed into a more or less permanent government insurance program. 

I started this note with quotes from two prominently bearish money managers – Jeremy Grantham and Hugh Hendry – both of whom are throwing in the towel on the upward trajectory of the market in the face of inexorable government bond-buying. Their change of heart reflects (finally and begrudgingly) the overwhelmingly dominant Narrative of Central Bank Omnipotence, that for better or worse it is central bank policy (particularly the Fed’s QE policy) that determines market outcomes. This Narrative is encapsulated in the following chart, a graph that we’ve all seen a million times in one form or another and has become a meme unto itself.


This is the Common Knowledge of our day … that so long as the Fed continues to buy, the market will continue to go up. Maybe they taper the rate of purchases or even stop expanding altogether, but if the market gets squirrelly they will just start buying again. The Narrative of Central Bank Omnipotence doesn’t mean that the market will only go up; it means that central bank policy is the overwhelming causal factor for market levels. It is as powerful a Common Knowledge structure as I’ve ever measured, and it’s at the heart of Grantham and Hendry’s hand-wringing. They aren’t capitulating to the market going up, but to WHY the market is going up. It’s a market dynamic that is alien to their (formidable) talents as money managers and to their (strongly held) belief structures on the meaning of an investment.

But for both Grantham and Hendry (and I suspect every investor who has been fighting the Fed in one way or another), this is a temporary capitulation. They both cling to the notion that this, too, shall pass, that we shall someday return to a market environment where real-world business fundamentals matter more than monetary policy. Maybe the return to “normal” comes with a bang … some sort of “Minsky moment” and asset price collapse where there’s a sudden realization that the Emperor has no clothes (or no more bonds to buy) … or maybe it comes with a whimper, as the Fed slowly and calmly drains the excess reserves it has built up in the financial system with the magical “tools” that are touted every time Bernanke (and now Yellen) testifies before Congress. To which I say … maybe. Or maybe that’s just wishful thinking for a market clearing Shock Ending or Happy Ending, as opposed to what seems to me to be the more likely outcome of the Entropic Ending, a long gray slog through a more or less permanently depressed world and a more or less permanently Fed-centric market.

Louis-Napoleon’s reign may have been a farcical shadow of his uncle’s Emperorship, but the truth is that Napoleon I set into motion structural changes in the world that dominate our lives still. Napoleon changed the meaning of nationalism. He changed the meaning of war. He changed what it means to live as a human animal in a mass society. I mean, the entire concept of mass society really begins with Napoleon and the levée en masse, the Napoleonic Code, the notion of Total War, and the authoritarian co-opting of revolutionary ideals. Put the political inventions of Napoleon (and his Prussian and English opponents) together with the mechanical inventions of the Industrial Revolution and you have … the modern nation-state, a massive and entrenched insurance company attached to an equally massive and entrenched standing army.

I think it’s likely that government policy initiatives of the past ten years, particularly monetary policy and particularly US monetary policy, have created a structural shift in the meaning of capital markets and the global economy that rivals what Napoleon did almost exactly 200 years ago. I think Larry Summers is right – we are mired in a world of secular stagnation and a more or less permanent liquidity trap. The degree to which ZIRP and QE and bubble-promoting monetary policy creates that secular stagnation by delaying the deleveraging, loss assignment, and creative destruction that vibrant growth requires is ludicrously underappreciated in Summers’ speech, but as a statement of economic reality it’s pretty spot-on. I think Paul Krugman is right, too – in for a penny, in for a pound. Central bankers have come this far. Do you really think they’re going to back down now? I’m not saying that Krugman’s argument is “right” in terms of being intellectually honest or even very smart. I’m saying that I believe it is an accurate representation of the world as it is.

Here’s the crucial part of what Summers and Krugman are saying: this is not a temporary gig.This isn’t going to just “get better” on its own over time. This really is, as Mohamed El-Erian of PIMCO would call it, the New Normal. And if you’re Jeremy Grantham or anyone for whom a stock has meaning as a fractional ownership stake in a real-world company rather than as a casino chip that gives you “market exposure” … well, that’s really bad news.

So what’s the point of all this?

Denial ain’t just a river in Egypt, and alienation ain’t just a movie with Mandy Patinkin in heavy make-up. For my money, the smartest thing Marx ever wrote was on the concept of alienation, the separation of a worker from the meaning of his labor. Marx believed that the greatest theft that capitalism perpetrated on the working class was psychological. The Industrial Revolution and the assembly line crushed a worker’s spirit by eliminating the sense of pride, the sense of accomplishment, the sense of place and meaning that an honest day’s work previously imbued. Instead of seeing, feeling, and knowing the object of his labor, the modern worker made … a widget. He made a cog and he was a cog.

What traditional value investors like Grantham are experiencing today is alienation in the traditional Marxist sense. In today’s context it’s not the separation of a worker from the meaning of his labor, but the separation of an investor from the meaning of his investment. Sure, you can go on investing on the basis of your discounted cash-flow model or your earnings margin reversion-to-the-mean model or whatever it is that floats your boat, but it’s just going to be a continuing exercise in frustration so long as we live in a Fed-centric universe. As Hugh Hendry says, it’s hard to look at yourself in the mirror every morning when everything that you’ve held dear as your investment belief structure doesn’t seem to matter much anymore. Nostalgia, as Milan Kundera points out, is a form of suffering. Life’s way too short to wallow in those waters.

Marx has an answer to the alienation problem … end it, don’t amend it. Take your ball and go home, or at least find a different game. For the alienated proletariat, this is easier said than done. You’ve got to throw off your chains, rise up in violent class struggle, create a vanguard political party that maintains the necessary ideological discipline, watch out for counter-revolutionaries … creating a worker’s paradise is hard work! For the alienated value investor, on the other hand, the portability of capital makes the road to greener pastures quite a bit easier — just get out of public markets. Go buy a farm … or an apartment building … or a fleet of tankers … or a portfolio of bank loans … anything where your investment process has meaning again and isn’t hijacked by the game-playing and trend-following that dominates public capital markets. If you have to stay in public securities, at least move into areas of the market where you are not dominated by the game-players and where there remains a critical mass of your fellow value investors to make a community of sorts … small and mid-cap industrials, say, or maybe activist targets. Just don’t kid yourself into thinking that your deep dive into the value fundamentals of some large-cap bank has any predictive value whatsoever for the bank’s stock price, or that a return to the happy days of yesteryear is just around the corner. It doesn’t and it’s not, and even if you’re making money you’re going to be miserable and ornery while you wait nostalgically for what you do and what you’re good at to matter again. Spoiler Alert: Godot never shows up.

But maybe you’re not a dyed-in-the-wool value investor wracked by feelings of severe alienation. Maybe you’re pretty agnostic about the whole investment style box thing and you’re just looking to grow your wealth as quickly as possible with the least risk as possible. If you don’t really care WHY the markets are going up, only that they ARE going up; if you don’t feel an existential angst about Fed policy, but are actually quite happy that they’ve got your back; if you’re looking to play the investment game better, regardless of what the rule changes might be … well, Marx has some good advice for you, too. Think for yourself. 

Marx is most famous for his concept of “the means of production”, the notion that human history is best seen and understood through an economic lens, that what we have been told is a story of Great Men and Empires and Discovery is really just a byproduct of class struggle for the control of those economic means of production. But what’s less appreciated is that Marx made a distinction between material production (all the stuff that we characterize as economic activity) and what he described as “mental production” – the creation of “the ruling ideas” that do all the heavy lifting in maintaining control over the proletariat. Now Marx wrote this in the 1840’s (!), so it’s going to need some contextual updating to speak clearly to us 170 years later. To wit: in the same way that Marx’s concept of alienation is more relevant today to capitalist investors than it is to labor, so, too, is this concept of mental production and ruling ideas. We investors – big or small, retail or institutional – are the proles. A well-to-do and content proletariat, to be sure, kind of like professional athletes, but a proletariat nonetheless. We control neither the means of material production (the public capital markets in which we labor) nor, more importantly, the means of mental production – the creation of the ruling ideas that drive our behavior and are taken for granted. We are ALL suckers for a good story that has more truthiness (to use Stephen Colbert’s word) than truthfulness, and you don’t have to be a raving Marxist to believe that the institutions that do in fact control the means of material and mental production depend on this central truth about human nature to maintain their position.

What are the ruling ideas in investment theory and practice today? There are plenty, but I’ll highlight two: “stocks for the long haul” and Modern Portfolio Theory. I’m not going to go into a long critique of either ruling idea, as I’ve written on this topic here, and I have lots more planned for the future. But for now I’ll just ask this: does the Narrative of Stocks For the Long Haul or the Narrative of Modern Portfolio Theory serve your best interests and your clients’ best interests … or theirs? It’s a question that deserves to be asked and explored again and again, and that’s what I’ll keep doing with Epsilon Theory.

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When E.F. Hutton Talks



If you like your health plan, you can keep your health plan.
– Barack Obama

Of course, one objective of both traditional and nontraditional policy during recoveries is to promote a return to productive risk-taking.
– Ben Bernanke

Most people are other people. Their thoughts are someone else’s opinion, their lives a mimicry, their passions a quotation.
– Oscar Wilde (“De Profundis”)

Don’t piss down my back and tell me it’s raining.
– Fletcher (“The Outlaw Josey Wales”)

EU = Max(E(1+r)α/α)
– Paul Samuelson, Nobel Prize winner, author of all-time best-selling economics textbook

Through his research, teaching, and writing Paul Samuelson had more impact on the economic life of this country and the world than any government economic official and many presidents.
– Larry Summers, former Treasury Secretary (and Paul Samuelson’s nephew)

EU = Max(E log(1+r)2)
– Edward Thorp, hedge fund manager, author of all-time best-selling gambling textbook

Edward O. Thorp and the Kelly criterion have been a lighthouse for risk management for me and PIMCO for over 45 years. First at the blackjack tables, and then in portfolio management, the Kelly system has helped to minimize risk and maximize return for thousands of PIMCO clients.
– Bill Gross, Co-CIO PIMCO

The concept of utility is the most fundamental concept in economics. It gets wrapped up in impressive sounding terms like “exogenous preference functions”, and written in all sorts of arcane runes and formulas, but all utility means is that you like something more than something else. The assumptions that economic theory makes about utility are really pretty simple and mostly about consistency – if you like vanilla ice cream more than chocolate ice cream, and chocolate more than strawberry, then economic theory assumes you also like vanilla more than strawberry – and continuity – if you like one scoop of vanilla ice cream, then you like two scoops even more. But as far as what you like, what your tastes or preferences are in ice cream or music … or health insurance plans … economic theory is intentionally silent. Economics is all about making rational decisions given some set of likes and dislikes. It doesn’t presume to tell you what you should like or dislike, and it assumes that you do in fact know what you like or dislike.

Or at least that’s what economic theory used to proclaim. Today economic theory is used as the intellectual foundation for a political stratagem that goes something like this: you do not know what you truly like, and in particular you do not know your economic self-interest, but luckily for you we are here to fix that. This is the common strand between QE and Obamacare. The former says that you are wrong to prefer safety to risk in your investments, and so we will fix that misconception of yours by making it extremely painful for you not to take greater investment risks than you would otherwise prefer. The latter says that you are wrong to prefer no health insurance or a certain type of health insurance to another type of health insurance, and so we will make it illegal for you to do anything but purchase a policy that we are certain you would prefer if only you were thinking more clearly about all this.

Anyone who believes that this political maneuver is inherently a phenomenon of the Left is kidding himself. The Right – in the form of sectarian or secular authoritarianism that imposes behavioral politics on the justification that this is how to get into heaven or demonstrate true patriotism – is no stranger to exactly this sort of political aggrandizement. Nor am I arguing that it’s smart to put your money under a mattress or that it’s wise to use the local emergency clinic as your primary care provider. What I’m saying is that the notion that we know your interests better than you know your interests is inherently an anti-liberal position, whether it comes from the Left or the Right. That’s liberalism with a small-l, the liberalism of Adam Smith and John Stuart Mill, not Walter Mondale … a political philosophy that argues for your right to be as stupid as you want to be in your personal economic decisions.

While there are hundreds of examples of anti-liberal policies in the annals of Western history, QE and Obamacare stand out in two important respects.

First, they’re big. Really big. Either policy on its own would be the largest instantiation in human history of what the French call dirigisme, at least on an absolute scale. I suppose you could argue that the US Social Security system has evolved into something even larger, but that took 70+ years to match what QE and Obamacare have accomplished in a few dozen months. I’ve written at length about the manner in which emergency policy responses to national traumas like wars and depressions are transformed into permanent government programs, so I won’t repeat that here. Suffice it to say that it’s not a coincidence that Social Security is a child of the Great Depression in the same way that both QE and Obamacare are children of the Great Recession. The institutionalization and expansion of centralized economic policy is what always happens after an economic crisis, but the scale and scope of QE and Obamacare, particularly when considered together as two sides of the same illiberal coin, are unprecedented in US history.

Second, and this is what really distinguishes the dirigiste policies of today from those of the past, the political and bureaucratic advocates of QE and Obamacare have co-opted the Narrative of Science to promote these policies to the public. If you look at the financial media’s representation of monetary policy during, say, the Volcker years, you see a curious thing. These articles almost never mention academic papers or Fed research. Today you can’t go a week without tripping over a prominent WSJ or FT article trumpeting this Fed publication or that IMF working paper as the reason behind a monetary policy rhyme. The authority vested in the Volcker Fed was based on a Narrative of Experience, an argument for trust based on a representation of personal leadership and experiential wisdom. Today, the argument for trusting the Fed places zero weight on the real-world experience or personal wisdom of the Fed Chair. Instead, both Bernanke and Yellen are presented as Wizards who channel the transcendent magic of economic theory. For better or worse, a popular faith in Economic Science is the source of their authority.

As for healthcare policy … the entire edifice of Obamacare has been presented as a self-consciously scientific, enlightened economic argument. This allows its political adversaries to be painted as bizarrely opposed to an objectively correct scientific position, as either know-nothing rubes who probably don’t even believe in evolution or as greedy stooges of the criminally rapacious insurance industry. Contrast this to the media presentation of healthcare policy initiatives in the 1960’s, particularly the establishment of Medicare as part of Johnson’s Great Society. As the phrase “Great Society” implies, arguments for Medicare had nothing to do with macroeconomic theories of efficiency and everything to do with political theories of justice. All of Johnson’s political initiatives, from Medicare to the Civil Rights Act, were based on a Narrative of Social Justice, an explicitly political argument that made little pretense of marshaling social science to prove the point. Seems like a more honest mode of politics to me, one that recognizes and embraces the hot-blooded nature of politics for what it is rather than hiding it within a cool armor of Science, and maybe that’s why Johnson’s policies have stood the test of time.

Why has the Narrative of Science been co-opted in this way? Because it works. Because Science is the dominant religion, i.e. belief system in transcendent forces, in the West today. Because politicians have always sought to direct or tap into these belief systems for their own ends. In exactly the same way that French kings in the 13th century used ecclesiastical arguments and Papal bulls to justify their conquest of what we now know as southern France in the Albigensian Crusades, so do American Presidents in the 21st century use macroeconomic arguments and Nobel prize winner op-eds to justify their expansionist aims. Economists play the same role in the court of George W. Bush or Barack Obama as clerics played in the court of Louis VIII or Louis IX. They intentionally write and speak in a “higher” language that lay people do not understand, they are assigned to senior positions in every bureaucratic institution of importance, and they are treated as the conduits of a received Truth that is – at least in terms of its relationship to politics – purely a social construction. I’m not trying to be flippant about this, but when you read the history of the Middle Ages I find it impossible not to be struck by the similarity in social meaning between clerics then and economists today.

So why does this bug me so much? What’s the big deal about wrapping a political argument in the mantle of Economics in the same way that it used to be wrapped in the mantle of Catholicism? Isn’t this what powerful political and commercial interests have done since the dawn of time, drawing on some outside source of social authority to support their cause?

Part of the answer is that as a limited government, small-l liberal I’m on the losing side of this particular political argument. I believe that it’s crucial to allow everyone to be as stupid as they want to be in their personal economic decisions because a) economic vitality and growth in the aggregate requires plenty of individual mistakes and losers along the way (sorry, but it does), and b) the alternative – allowing or requiring government to make these decisions on our behalf – inevitably creates a terribly fragile system where a single poor decision can lead to permanent ruin. Is it difficult and at times inefficient to maintain limited government in a mass society? Absolutely. Should we make small exceptions to these liberal principles to grease the wheels of effective governance in ordinary times, and big exceptions to these principles in a national emergency? Without a doubt. I think Lincoln saved the United States in 1861 when he suspended habeas corpus and imposed martial law in wide swaths of the country. I think Bernanke saved the world in 2009 when he implemented QE 1. But like the Roman dictator Cincinnatus, a great leader goes back to the farm after he saves the Republic. It’s the hardest thing to do in politics … to voluntarily relinquish emergency powers used wisely for the common good, to maintain a personal humility and trust in the system in the aftermath of great success. George Washington did it, and that’s why he’s the greatest President this country ever had. I understand that it’s not terribly likely we’ll ever see Washington’s like again … different times, different world, etc., etc. … but hope springs eternal.

The other part of the answer is that using Science for political ends subverts its usefulness (as does using Religion for political ends … just ask Martin Luther). We lose something very important when we associate a particular social scientific hypothesis with a winning policy outcome or a losing policy outcome, and that’s the recognition that social science – particularly economic science – is never True or False, but only more or less useful depending on whatever it is in life that you value … your utility function. Both as individuals and as collectives, we can achieve much greater levels of utility – we can be happier – if we maintain this agnostic view of Truth when it comes to social science. Politicians want to sell us on the notion that they have The Answer, that they can deliver the good life if only we keep them in power. Social scientists – or at least honest ones – recognize that there are no Answers in the patterns and relationships they identify, even if those patterns can be written in the highly precise language of mathematics. There is More Useful and Less Useful in social science … that’s all … and claims to the contrary detract from the very real benefits and advances that social science can provide.

Here’s a concrete example of what I mean …

Let’s say that you’re interested in wealth maximization, that this is the utility function you are most concerned with as an investor, and you want to know what percentage of your wealth you should allocate to the different investment opportunities you can choose from. Paul Samuelson, the most influential economist of the post-World War II era and the first American winner of the Nobel prize in Economics has an answer for you: EU = Max(E(1+r)α/α) . Translation: the more confident you are in the expected return of the investment choice, the more you should allocate to that choice, but in a more or less linearly proportional manner. On the other hand, Edward Thorp, author of “Beat the Dealer” and evangelist of the Kelly Criterion – an algorithm designed by mathematician John Kelly at Bell Labs in the 1950’s and used by investors like Warren Buffett, Bill Gross, and Jim Simons (if you’ve never read “Fortune’s Formula”, by William Poundstone, you should) – has a different answer for you: EU = Max(E log(1+r)2). Translation, the more confident you are in the expected return of the investment choice, the more you should allocate to that choice, but in a logarithmically proportional manner.

The difference between investing on the basis of linear proportionality and logarithmic proportionality is vast and incommensurable. With the Kelly criterion, even a small expected advantage in the investment odds – say a 52% chance of doubling your investment and a 48% chance of losing it all – requires you to invest a significant portion of your overall wealth, in this case about 2%. With a larger expected advantage in the investment odds, the recommended allocation gets very large, very fast. If the odds are 60/40 on doubling up/losing the entire investment, Kelly says invest 20% of your total wealth; if the odds are 80/20, Kelly says invest 60% of your total wealth in this single bet! Definitely not for the faint of heart, and definitely a far riskier strategy at any given point in time than the straightforward Samuelson expected utility approach. But you never lose ALL of your money with the Kelly criterion, and over a long enough period of time (maybe a very long period of time) with infinitely divisible bet amounts and correct assessment of the investment odds, the Kelly criterion will, by definition, maximize the growth rate of your wealth.

These are two VERY different answers to the wealth maximization question by two world-class geniuses, each with a legion of world-class genius supporters. Samuelson is a lot more famous and received far more public accolades; Thorp made a lot more money from investing (Kelly died of a stroke at age 41 in 1965 and never made a dime from his theory). But they can’t BOTH be right, the politician would say. What’s The Answer to the wealth maximization question so we can institute the right policy? Well … they ARE both right, there is no Answer, and the correct choice between the two depends entirely on your individual utility function. In fact, choosing either wealth maximization algorithm and imposing it on everyone is guaranteed to make everyone worse off in the aggregate.

How’s that? Let’s say I’m investing my life savings, and I’ve only got one shot to get this right. Not one investment, but one shot at implementing a coherent investment strategy for this, the only life’s savings I will ever have. If that’s my personal situation, then I would be nuts to choose the Kelly criterion to drive that strategy. It’s just too risky, and if I’m unlucky I’ll be down so much that I’ll hate myself. Maybe in the long run it maximizes my wealth growth rate, but in the long run I’m also dead. On the other hand, let’s say I’m investing a small bonus. It’s not the only bonus I’ll ever receive, and in and of itself it’s not life changing money. If that’s my personal situation, then I would be nuts NOT to choose the Kelly criterion because it has the very real possibility of transforming the small bonus into life changing money.

No one’s utility function for money is linear – $20 has more than 20 times the utility to me than $1 – and no two people have the same utility function for money – I’m sure there are people out there who care as little about $20 as I do about $1. Everyone’s utility function for money changes over time, and most are contextually dependent. It is impossible to design a one-size-fits-all wealth maximization formula, which is why human financial advisors have such an important job. It’s also why government efforts to force us to converge on a utility function for investment choices, healthcare choices, or any other sort of personal economic choice result in such a widespread gnashing of teeth and popular dissatisfaction. At best, it’s a myopic conception of how to generate more economic utility. At worst, it’s an intentional subversion of useful social science to cloak politics as usual. In either event, it’s something that deserves to be called out, and that’s what I’ll keep doing with Epsilon Theory.

Two quick points on portfolio management, utility functions, and the Kelly criterion that I’ll present without elaboration and will probably only be of interest to professional investors who are immersed in this sort of thing.

  1. In several important respects, risk parity investment allocations are to 60/40 stock/bond allocations what the Kelly criterion is to Samuelson expected utility.
  2. The allocation of capital by an investment manager who wants to establish multiple independent Kelly criterion strategies across traders or sub-investment managers, each of whose individual utility functions favors a fractional Kelly or Samuelson expected utility function, is a solvable game.

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The Wages of Fear



You don’t know what fear is. But you’ll see. It’s catching, it’s catching like small pox! And once you get it, it’s for life! So long, boys, and good luck. 
– Henri-Georges Clouzot, “The Wages of Fear”

I must not fear. Fear is the mind-killer. Fear is the little-death that brings total obliteration. I will face my fear. I will permit it to pass over me and through me.
– Frank Herbert, “Dune”

In “The Wages of Fear”, Yves Montand and three other down-on-their-luck French expats agree to drive two truckloads of unstable nitroglycerin hundreds of miles across an impossibly difficult South American terrain. Driving 30 minutes apart so that the destruction of one truck won’t blow up the other, the two teams wind their way across one obstacle after another, facing the constant danger that an unanticipated bump will mean their deaths. One truck blows up in just such an unexpected way, killing two of the drivers in a giant fireball. A third driver is killed in the effort to traverse a final obstacle, a huge pit of oil and muck, but the lone truck and single surviving driver make it to their destination with the deadly cargo intact. Paid double wages … enough to live comfortably for years … and recovered from his exhaustion, the surviving driver must only drive the unloaded truck back to the origination point, where his girlfriend has already started putting together a celebratory party. But living with constant and overwhelming fear has changed the surviving driver’s psyche. He starts taking crazy chances driving the perfectly safe truck home, ultimately taking a turn way too fast and careening to his death in the chasm below. The End.

This is what living with fear does to an individual, a tribe, or a nation … it warps their view of the world and creates massive behavioral change even after the source of that fear is removed. These are the wages of fear, and this is the hidden and awful cost of 9/11 and Lehman’s collapse. 

In the immediate aftermath of 9/11, we created a massive NSA eavesdropping and spying apparatus to combat the very real and immediate threat posed by a decentralized terrorist organization that we suspected had significant sovereign sponsors. Today al Qaeda is a pale shadow of its former self, and its sovereign sponsors are in retreat or eliminated. We won this war. Yet we have not scaled back or reduced our spying apparatus. On the contrary, we have created a bureaucratic and judicial structure to support the program, and we are expanding its technical and operational scope to identify and combat potential threats to national security. Why? Because our collective fear of another 9/11 has created a social and political sanction for such a bureaucratic capture. And because these potential threats to national security will always be present, this emergency NSA eavesdropping policy has become a permanent government program with enormous social and economic costs.

In the immediate aftermath of Lehman’s collapse, we created a massive monetary policy program called Quantitative Easing to combat the very real and immediate threat posed by a deflationary spiral as markets seized up. Today there is zero chance of a deflationary freefall with a US epicenter, and we have returned to our regularly scheduled entertainment of a lackluster business cycle. We won this war. Yet we have not scaled back or reduced our QE apparatus. On the contrary, we have created a bureaucratic and judicial structure to support the program, and we are expanding its technical and operational scope to identify and combat potential threats to economic security. Why? Because our collective fear of another Great Recession has created a social and political sanction for such a bureaucratic capture.  And because these potential threats to economic security will always be present, this emergency QE policy has become a permanent government program with enormous social and economic costs.

In the parlance of strategic military doctrine, we have transformed our goals from fighting a responsive war against a specific threat that has injured us to fighting a preventive war against a potential threat that might injure us in the future. There’s nothing inherently wrong or stupid with fighting a preventive war, but it has a very different set of goals and effective social modalities than a responsive war. If this is our choice … fine, but let’s make it an honest choice as opposed to a fait accompli imposed on us by powerful interests. It’s always important to call things by their proper names, but never more so than when you’re fighting a war.

The classic example of a preventive war is the Japanese attack on Pearl Harbor in 1941. Squeezed mercilessly by the coal, oil, and steel embargo imposed by the US, the Japanese leadership concluded that although they would probably lose a war with the US, they would definitely lose the peace. Rather than accept the slow decline of the status quo and the economic constraints imposed by US policy, Japan decided to accelerate an outcome by launching the Pearl Harbor attack.

While there are quite a few historical examples of insurgent or up-and-coming countries like Japan challenging dominant or status quo countries with a preventive war, it’s actually rather hard to find examples of a dominant country starting a preventive war. That’s probably because dominant countries have other policy levers they can pull – like a coal, oil, and steel embargo – to keep the insurgent countries in their place without resorting to war. But we have a very good example of the considerationof preventive war by a dominant country in the internal US debate over how to deal with the growing power of the Soviet Union and China in the 1950’s and 1960’s. By examining the arguments in favor of preventive war (or its close cousin, pre-emptive war) made by some US strategists during this period, and why those arguments were ultimately rejected in favor of a less aggressive policy of containment, we can gain some insights into the risks and rewards of the preventive wars we are currently fighting and why we might prefer a less aggressive approach.

Here’s a snapshot and a few indicative quotes from probably the most effective and outspoken proponent of a preventive/pre-emptive stance regarding US nuclear policy – Curtis LeMay.


Gen. Curtis LeMay, Air Force Strategic Air Command (SAC), youngest 4-star general since Ulysses Grant, 
1968 Vice-Presidential candidate with George Wallace

Killing Japanese didn’t bother me very much at the time. I suppose if I had lost the war I would have been tried as a war criminal. …

I think there are many times when it would be most efficient to use nuclear weapons. However, the public opinion in this country and throughout the world throw up their hands in horror when you mention nuclear weapons, just because of the propaganda that’s been fed to them. …

That’s the reason some schools of thinking don’t rule out a destruction of the Chinese military potential before the situation grows worse than it is today. It’s bad enough now.

It’s easy from our modern perspective to poke fun at how LeMay presented himself with a giant cigar, and it’s very hard to get comfortable with a man who directed the low-altitude firebombing campaign of Japanese civilian populations and who ran on a national ticket with noted segregationist George Wallace. But LeMay was also a brilliant contributor to the US victory in the Cold War. He almost singlehandedly transformed SAC into the most powerful warfighting force in human history (my favorite story is the mock bombing run he ordered on Dayton, Ohio to figure out which of his pilots could hit a target), and it would be a mistake to underestimate his arguments just because we don’t like his politics.

LeMay’s advocacy of preventive/pre-emptive war is based on a very specific utility function – nothing is worse than US military defeat. If that’s your view, that it’s better to be dead than Red, then a preventive attack on a relatively growing Soviet Union or China is an easy call. Far better to strike today, when the correlation of forces (to use a phrase favored by Soviet strategists of the day) were still tilted to the US, than tomorrow when we might not be so fortunate. Because the avoidance of US military defeat was LeMay’s end all and be all goal, he was prepared to “do whatever it takes” including “the killing of a nation” (his words) in the furtherance of that goal.

Anyone who says that he or she is prepared to “do whatever it takes”, whether it’s Mario Draghi and Angela Merkel talking about support of the euro, Ben Bernanke talking about preventing deflation, George W. Bush talking about pursuit of terrorism, or Barack Obama talking about growing the economy … is making a preventive war argument just like Curtis LeMay. Not a preventive war against a particular nation, but a preventive war against some conceptual social ill. Of course, you can’t defeat a conceptual social ill like you can defeat a nation. You can’t accept the surrender of General Deflation. These social ills will always be with us in one form or another, which means that a preventive war in the modern context is a permanent and constant war.

It may not seem like we are on a war footing when it comes to NSA eavesdropping or QE, because the trappings of war … mobilizations, set battles, etc. … may not be present. But the language associated with a war footing is definitely present, and this is what creates the social space that allows these policies to exist and thrive. I am struck almost every day by how the language of extremism and war pervades our domestic political and social institutions, on both the left and the right. I hear the voice of Curtis LeMay everywhere! Unfortunately, I think it’s a voice that tends to promote the wages of fear, and I’m certain it’s a voice that drives game-playing in markets. But it’s also a voice that diminishes as it is identified for what it is, and that’s a pretty worthy goal for Epsilon Theory.

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Poindexter Über Alles


Recent papers written by Fed functionaries and the attendant media attention serve as a reminder of the academic and bureaucratic capture of the Fed. More interesting is whether this same capture has occurred in other policy areas, such as national security and healthcare, such that QE, Obamacare, and NSA eavesdropping are all best understood as a transformation of emergency policy actions against immediate threats into permanent insurance programs against future and potential threats.

epsilon-theory-poindexter-uber-alles-november-7-2013.pdf (473KB)


A Game of Sentiment



I know. You know I know. I know you know I know. We know Henry knows, and Henry knows we know it. We’re a knowledgeable family.
– Prince Geoffrey, “The Lion In Winter”

We do not sow.
– House Greyjoy motto, “A Game of Thrones”

It would be ideal if we could have an uncontrolled flow of information.
– Poindexter, former Director of DARPA Information Awareness Office

It’s SCIENCE, Mr. Felix! 
– Poindexter, cartoon boy genius

Sentiment is affect. Sentiment is emotion. Sentiment is fickle and transitory. In the context of investing, Sentiment is how you feel about a stock. Sentiment is NOT how you feel about a company, and sometimes it can be difficult to separate our feelings about a company from our feelings about a stock. Difficult, but necessary.

Your feelings about a stock, as opposed to your feelings about a company, should be completely determined by your beliefs about other investors and their feelings about the stock. In the lingo … your preference functions for stocks qua stocks are entirely exogenously derived and epiphenomenal. There is no rational internally-developed preference for one stock versus another stock, any more than I prefer a $5 chip from Harrah’s to a $5 chip from Caesar’s Palace. The only thing I care about is whether other investors, for whatever reason, will value the Harrah’s chip at $6 tomorrow.

But each of these other investors is thinking about his or her feelings about stocks in the same way that you are. And you all know it. And you all know that you all know it. The strategic interaction of all investors trying to figure out how all other investors feel about a stock, each of whom knows that everyone else is going through the same decision process, is Sentiment.

Any strategic interaction is a game, in the formal sense of the word. Every game has rules, and every game has a smart way to play and less smart way to play.

What are the rules for the Game of Sentiment? And how can we play the game smartly? 


In 1935, John Maynard Keynes bemoaned the Sentiment game as dominating markets to such a degree that “genuine long-term expectation is so difficult today as to be scarcely practicable.” Sound familiar? Keynes described the Sentiment game as a “Newspaper Beauty Contest”, a media promotion that was familiar to his readers (this was, after all, the heyday of the Miss America contest and “bathing beauty” pageants everywhere), less so to us. Here’s how it works.

A newspaper would run a page of photographs of pretty girls, and readers were invited to mail in a ballot with their choice of the prettiest. If you picked the girl who got the most votes, you were entered into a drawing for some sort of prize. Voting for the girl you think is the prettiest is what Keynes would call the first degree of decision-making.


Now it doesn’t take a lot of thought before you realize that choosing the girl who you truly believe is the prettiest is probably not a winning strategy. To win, you need to choose the girl who gets the most votes as the prettiest, and your personal preferences aren’t nearly as useful in that task as figuring out who everyone else is going to vote for as the prettiest. Voting for the girl you anticipate more people will consider to be the prettiest is what Keynes would call the second degree of decision-making.

But there’s a big problem with the second degree. It assumes that everyone else is making a first degree decision, that everyone else is making a choice “on the merits” of the photographs and you’re the only one smart enough to think about the average preference of the group. As a result, you quickly realize that everyone will be thinking exactly like you are, so you need to make a third-degree decision – who will get the most votes when all the voters are basing their votes on who they think will get the most votes? This is the Sentiment game!

Note that this third-level decision probably has nothing to do with the relative or objective prettiness of the girls. If “everyone knows” that the brunette with the biggest smile tends to win, then that’s where you should place your vote regardless of your personal preference or your knowledge of everyone else’s personal preferences. It’s the “everyone knows” component of the contest – regardless of what the contest is fundamentally supposed to be about – that determines voting behavior and contest winners. To get beyond the third degree of decision-making requires a superior identification of whatever it is that “everyone knows”. As Keynes wrote, “We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”

So … how do we practice the fourth, fifth and higher degrees of decision-making? How do we identify the context and strength of what “everyone knows”? How do we win the Sentiment game?

What Keynes called the Newspaper Beauty Contest is known to modern game theory as a variant of the Common Knowledge (CK) game. To illustrate how this game is played on a fundamental level, I’ll use another classic example: The Island of the Green-Eyed Tribe.

On the Island of the Green-Eyed Tribe, blue eyes are taboo. If you have blue eyes you must get in your canoe and leave the island at dawn the morning after you learn the awful truth. But there are no mirrors or reflective surfaces on the island, so no one has actually ever seen the color of his or her own eyes. It is also taboo to talk or otherwise communicate with each other about eye color, so if anyone saw that you had blue eyes he wouldn’t tell you. Similarly, when you see a fellow tribe member with blue eyes, you are not allowed to tell him the true state of his eye color. It’s a small island, so every tribe member knows the eye color of everyone else, but not his or her own eye color.

A Missionary comes to the island one day and announces to everyone, “At least one of you has blue eyes.” What happens?

Let’s take the trivial case of only one tribe member having blue eyes. He has seen everyone else’s eyes, and he knows that everyone else has green eyes. Immediately after the Missionary’s statement this poor fellow realizes, “Oh, no! I must be the one with blue eyes.” So the next morning he gets in his canoe and leaves the island.

But now let’s take the case of two tribe members having blue eyes. The two blue-eyed tribe members have seen each other, so each thinks, “Whew! That guy has blue eyes, so he must be the one that the Missionary is talking about.” But because neither blue-eyed tribesman believes that he has blue eyes himself, neither gets in his canoe the next morning and leaves the island. The next day, then, each is very surprised to see the other fellow still on the island, at which point each thinks, “Wait a second … if he didn’t leave the island, it must mean that he saw someone else with blue eyes. And since I know that everyone else has green eyes, that means … oh, no! I must have blue eyes, too.” So on the morning of the second day, both blue-eyed tribesmen get in their canoes and leave the island.

The generalized answer to the question of “what happens?” is that for any n tribe members with blue eyes, they all leave simultaneously on the nth morning after the Missionary’s statement. Note that no one forces the blue-eyed tribesmen to leave the island. They leave voluntarily once public knowledge is inserted into the informational structure of the tribal taboo system, which is the hallmark of an equilibrium shift in any game. Given the tribal taboo system (the rules of the game) and its pre-Missionary informational structure, new information from the Missionary causes the players to update their assessments of where they stand within the informational structure and choose to move to a new equilibrium outcome.

Note also the role of time in this example. It takes time for strategic observations to take place (the other blue-eyed tribesmen didn’t leave right away) and time for strategic calculations to occur. The more ambiguity associated with the Missionary’s message or the more tribesmen who have blue-eyes, the more time required for behavior to move the system to a new equilibrium position. Both of these concepts – message ambiguity and prevalence of non-conforming players – play a crucial role in the operationalization of CK game theory into practical investment applications.

But the most interesting aspect of the CK game played on the Island of the Green-Eyed Tribe is the role of the Missionary. It is the public statement of information, not the prevalence of private information or beliefs, that forces movement in the CK game. The public statement is what creates Common Knowledge, even if all of that knowledge was already there privately. Everyone must see that everyone else sees the same thing in order to unlock that privately held information and drive individual decisions and behavior.

The context of what “everyone knows” is whatever the Missionary says it is.

The strength of what “everyone knows” is a function of the Missionary’s credibility and the loudness of his voice.

For better or worse, as investors we love Missionaries. Our reaction is almost never this:


But almost always this:


Who are our Missionaries? Well, there are the obvious choices:


But the more precise answer is that the role of the Missionary is served by any signal that is propagated widely enough and publicly enough so that everyone thinks that everyone has heard the signal. The important thing is NOT that lots of people actually hear the signal. The important thing is that lots of people believe that lots of people heard the signal. The power source of Common Knowledge is not the crowd seeing an announcement or a press conference. The power source of Common Knowledge is the crowd seeing the crowd seeing an announcement or a press conference. This is why sitcom laugh tracks exist. This is why American Idol is filmed in front of an audience. This is why the Chinese government still bans any media mention of the Tiananmen Square protests more than 20 years after they occurred. The power of a crowd seeing a crowd is one of the most awesome forces in human society. It topples governments. It launches Crusades. It builds cathedrals. And it darn sure moves markets.

How do we “see” a crowd in financial markets? Through the financial media outlets that are ubiquitous throughout every professional investment operation in the world – the Wall Street Journal, the Financial Times, CNBC, and Bloomberg. That’s it. These are the only four signal transmission and mediation channels that matter from a financial market CK game perspective because “everyone knows” that we all subscribe to these four channels. If a signal appears prominently in any one of these media outlets (and if it appears prominently in one, it becomes “news” and will appear in all), then every professional investor in the world automatically assumes that every other professional investor in the world heard the signal. So if Famous Investor X appears on CNBC and says that the latest FOMC announcement is a great and wonderful thing for equity markets, then the market will go up. It won’t go up because investors agree with Famous Investor X’s assessment of the merits of the FOMC announcement. The market will go up because every investor will believe that every other investor heard what Famous Investor X said, and every investor will be forced to update his or her estimation of what every other investor estimates the market will do. The greater the signal strength (from an Information Theory perspective) of Famous Investor X’s words, the greater the change in each investor’s estimation of every other investor’s estimation, and the more the market goes up. That’s how the Sentiment game works.

The key to winning the Sentiment game, then, is to listen to all of the signals emanating from all the Missionaries in the world, human and otherwise, as they are mediated through the Big Four channels, and calculate the impact of these signals on investor estimations of all other investor estimations before the actual decision-making process occurs. That may sound like an impossible task, but it’s really not.


Just putting together the listening system would have been a logistical challenge even a few years ago, both in terms of data access and computer processing power. Today this part of the solution is almost trivially easy and cheap. And while I’d like to claim that the underlying estimation updating algorithms are ferociously complex, the truth is that we’re talking about a pretty simple Bayesian approach.

Fortunately for me, what remains less than trivial is to operationalize Information Theory appropriately in order to gauge the relative strength of this signal versus that signal, this Missionary versus that Missionary, in order to process quickly the market’s Bayesian update within the CK game structure. I’ve written extensively about what I think is the appropriate framework for just such an application of Information Theory, so I won’t repeat that here. But you don’t have to take my word for how to win the Sentiment game … that a keen ear and a quick Bayesian update can carry the day … because we all know people who are already using this strategy successfully today. We call them good traders.

What I’m proposing to do systematically is exactly what effective, alpha-generating traders do non-systematically every day. They have internalized an ability to gauge whether a piece of news hitting the market has legs or should be faded. Maybe it’s an earnings announcement; maybe it’s a jobs report; maybe it’s an FOMC announcement. Maybe they trade e-mini’s; maybe they trade currency futures; maybe they trade stocks. Regardless of the signal context or the security implementation, what all effective traders have in common is the ability to, as Keynes wrote, “guess better than the crowd how the crowd will behave.” Keynes would call these traders effective players of the Newspaper Beauty Contest. I would call them effective players of the Common Knowledge game. We can all call them effective players of the Game of Sentiment, and they are one of the last sources of pure alpha in this world.

There’s an obvious business opportunity for Epsilon Theory in the full-blown systematization of the alpha-capture process described above … an externalization of the internalized abilities of effective traders across their various niche-y specialties. But one thing I’ve learned in 25 years of operationalizing content analysis on a massive scale is that an experienced human is still far and away the most accurate and quickest interpreter of meaning in these public signals that are at the heart of any CK game. Computerized systems, particularly learning or adaptive systems, are wonderful for solving various pieces of this puzzle, and they can provide extremely useful tools and guidelines for the entire puzzle. But an experienced human has a knack for contextual pattern recognition of content meaning and salience that cannot be duplicated by either a computer or a roomful of less-experienced humans.

All this suggests an alternative model for applying Epsilon Theory to alpha mining, one where the Epsilon Theory tools and algorithms support effective traders to make them better at what they have already intuited – that they are playing a complex game with thousands of other market participants, some human and some not, where the decision-making processes of those participants in response to some new signal are somewhat predictable. This is what traders have always done, well before there was even a concept of a stock market or securitization.

Traders are all about buying something, anything, for two copper coins and selling it for three. They are doing this in an environment where lots of other traders are trying to do the same thing, where everyone is playing the same game, and where your “edge” is your ability to assimilate informational signals of all sorts and translate that into an anticipation of everyone else’s behavior. This is the game that has been played for thousands of years, and the basic rules are the same whether you’re sitting in Hong Kong in 2013, New York in 1935, or Tyre in 800 BC.


But traders today are like those Phoenician captains in 800 BC roaming the Levantine coast in their little wooden ships looking for their next score … they have a good ear for news, a good nose for the weather, and a good eye for a bargain, but they’re doing all this by the seat of their pants and with rudimentary tools based on naïve empiricism and personal experience. Can you imagine what a Phoenician trader could have done with a decent astrolabe, much less a weather forecasting service? Just thinking about trading activities within the right theoretical framework – recognizing that what traders do in their everyday life is to play a game with a certain set of Information Theory rules and a certain set of Game Theory behaviors – will pay dividends in ways that it’s impossible to predict in advance. This is why theory matters. Once you put a smart person on the right theoretical path … once you show him or her how to see the world in a new light, one that illuminates and makes clear behaviors and decisions that were formerly shrouded in myth or custom … well, there’s just no end to what’s possible.

I’m not sure of the best way to implement this sort of hybrid system, where both human traders and Big Data systems work together under a common theory of how the Game of Sentiment is played. There are many variations on this theme that could be composed, from selling astrolabes as a tool to predicting the weather as a service to forming a network of a few skilled traders and arming them with tools that no one else has. But whatever the final composition, it’s a melody that rings true to my ears, and one that I hope you’ll follow with me at Epsilon Theory.

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