No man is an Iland, intire of it selfe; Every man is a peece of the Continent, a part of the maine; If a Clod bee washed away by the Sea, Europe is the lesse, as well as if a Promontorie were, as well as if a Mannor of thy friends or of thine owne were; Any man’s death diminishes me, because I am involved in Mankinde; And therefore never send to know for whom the bell tolls; It tolls for thee. – John Donne (1572 – 1631), “Devotions upon Emergent Occasions”
I’m often asked what I read for Epsilon Theory, and the answer is that my daily fodder is the same as everyone else’s – the NYT, the WSJ, the FT, Bloomberg, etc. But I think that I read media differently from most people, and that’s the key for an Epsilon Theory perspective. I’m not reading these articles for facts, but for the effort to lead opinion…to communicate an opinion as if it were fact. It’s not hard to read this way. Every time you see a word like “because” or anytime you read a “reason” why something happened the way it did, you just need to detach yourself from the article and consider how you are being played.
I don’t mean that in a malevolent sense. It’s what social animals DO. It’s what it means to be a social animal. Ants, bees, termites, and humans – the most successful species on the planet – are constantly signaling each other so that we can make sense of our world together. That’s the secret of our success as social animals – E Pluribus Unum, as it says on the dollar bill – and we can no more separate ourselves from playing and being played than we can from our individual consciousness. We swim in a sea of communication and signaling. It is our media in the same sense the word is used for the agar in a Petrie dish, and that’s how I think of media in the sense of newspapers and television and the like.
My favorite example? On November 24, 2008, President-elect Obama announced that he would nominate Tim Geithner as his Treasury Secretary. The S&P 500 was up about 6% that day, and Geithner’s nomination was widely credited as the “reason”. All of the talking heads on the Sunday talk shows that weekend referenced the amazing impact that Geithner had on US markets, and this “fact” was prominently discussed in his confirmation hearings. Clearly this was a man beloved by Wall Street, whose mere presence at the economic policy helm would soothe and support global markets. Yeah, right.
Was Geithner’s nomination good news? Sure. I mean…I suppose. So long as Obama didn’t nominate a raving Marxist I think it would have been a (small) positive development in the context of the collapsing world of November 2008. Was the specific nomination of specifically Tim Geithner WHY markets were up so much on November 24th? Of course not.
The inherent problem is that any market movement is over-determined. There are far more reasons that might account for a market move than actually account for the move, and that’s without any consideration of stochastic factors or game-playing behaviors. But the questions of “Why is the market up?” or “Why is the market down?” are the only questions that matter in the heat of a big move up or a big move down, and no one who is in the business of answering such questions is ever going to say “I don’t know” or “no reason”. You MUST provide an acceptable answer, or whoever is asking the question is quickly going to find someone else to replace you. Fortunately, you can’t be proved wrong if you ascribe market causality to a contemporaneous event, so it’s the totally safe play to say that the November 24th 2008 market was up “because” of Geithner. And once a prominent opinion-leader like the WSJ says it’s true, it’s not only a safe answer…it’s the only answer that’s safe.
The ability to convince someone that you know WHY a security is up or a security is down is at the heart of the entire financial advisory industry, maybe the entire financial services sector. It is the Power of Why, and it has no inherent connection to any true causal connection or the way the world truly works. Maybe it’s all true. Probably it’s partially true. But it really doesn’t matter one way or another.
Once you start thinking of everything communicated by humans as a signal, as an intentional effort to make you see the world differently than you saw it before, your world will change. This is the great insight of Information Theory – that information is measured by how much it changes your mind, that the strength of any communication has nothing to do with truth or accuracy, but only with the subjective impact it has on your perceptions – and it’s an enormously useful insight for making sense of markets.
Two days ago the WSJ ran the online headline “China Intervenes to Lower Yuan” together with a series of articles to support the thesis that recent declines in the yuan’s value versus the dollar were the result of Chinese central bank intervention and some sort of master plan to achieve some set of policy goals. I want to include and comment on a selection from one of those accompanying articles – “Why the Yuan’s Decline Matters” – not to criticize the author (I could just as easily chosen any number of other authors from any number of other media outlets), but as an example of what I mean by the Power of Why.
Here’s what happened:
China’s yuan has fallen steadily against the U.S. dollar in the past week. On Wednesday, The Wall Street Journal reported that it wasn’t market forces or traders behind the move, but that the Chinese central bank was deliberately pushing the currency lower. That a central bank would do this on purpose has caught some off-guard, especially since the yuan was long seen by investors as a currency that was only going up.
Why does this matter now? Why are they doing it?
Currently, the yuan trades within a tight range set by the central bank every day. But, short-term traders and increasing demand is almost constantly pushing the currency higher within that range. By denting the currency’s value on purpose, the central bank is trying to spook away these traders who will now have to worry about the possibility China does this again. With fewer “speculators” trading the yuan, China hopes to have an easier path to widen the yuan’s trading range further and, in the much longer term, make the yuan a free-floating currency that’s driven only by economic and market forces.
Why does China want to free its currency in the long term?
Having a freely traded currency opens up a wide door for the yuan to become much more prominent in trade and payments across the globe. Perhaps most importantly to China, a freely convertible currency also makes the yuan a more attractive option for other central banks’ stockpiles of cash, also known as their foreign exchange reserves. Currently the U.S. dollar dominates as the number-one reserve currency in the world—that’s why so many central banks hold U.S. government bonds even when the U.S. economy doesn’t look to rosy. China wants the yuan to challenge the dollar’s long-established role, and gradually freeing its currency is a critical step to get there.
China is also trying to push its economy away from relying so much on exports and investment. It, instead, wants more of its growth to come from domestic demand. Making the yuan behave more like a market-driven currency fits into this broader plan.
Okay. So the party line (no pun intended) is that the Chinese government is massively intervening in their currency market to make the yuan “more like a market-driven currency”. The party line is that the Chinese government is forcing its currency lower in order “to push its economy away from relying so much on exports and investment”.
Two reactions. First, I consider myself to be something of a connoisseur of opinion-leading writing, and from an artistic or aesthetic point of view I am quite simply blown away by the creativity and execution of this Orwellian masterpiece. It’s the same reaction I have when I see a politician oh-so-naturally jab at the air or flash a wry grin during a particularly moving speech. It’s a beautiful thing to see a professional excelling at his or her craft, and never so much than at moments like this when the craft becomes art.
On the other hand – from a risk management point of view – these articles made me throw up in my mouth a little bit.
Governments don’t make their currency cheaper to reduce their reliance on exports and investment. They make their currency cheaper to spur export-led growth. The problem that the world has with China as a currency manipulator is not that the yuan has been going up. The problem is that it hasn’t been going up fast enough. And now it’s being forced down.
Look, I understand why the Chinese government wants the yuan lower. The political imperative in China is still growth. Period, end of story. Net exports are the swing factor in every country’s GDP growth rates, and China is not an exception, it is the foremost exemplar. Do you think China is happy about the yen going down, down, down? Do you think China is happy about competing in export markets for advanced industrial products – because that’s what China manufactures today – with an inexorably appreciating currency? Do you really think they’re going to sit there and just take it?
I also understand why the Chinese government would prefer to characterize their actions as part of some grand domestic reform agenda, where they just need a wee bit more anti-market, export-supporting currency manipulation in order to move forward towards a glorious future of pro-market, domestic-focused life in the brotherhood of liberal nations. Pardon me if I am skeptical.
And finally, I understand why the financial media reports the Chinese government’s party line (including some after-the-fact “we really didn’t intervene that much” stories in the FT yesterday) as a True Fact rather than as a Narrative. When a market event like a plummeting yuan occurs the only thing that matters is presenting a plausible WHY, and China provided just that. Whether that story is the whole truth, some partial truth, or the equivalent of crediting Tim Geithner’s nomination for a 6% move up in the market…well, that’s really beside the point if you’re a financial media publisher. But it’s certainly not beside the point if you’re an investor or an allocator.
Buck Finemann, seventy two years old. Cantankerous old geezer. No-one liked him much, but they allowed him to play poker with them once a week because he was a terrible card player and had been known to lose as much as seventy five cents in a single evening.
– Carl Kolchak, “Kolchak: The Nightstalker – Horror in the Heights”
Rakshasa: Known first in India, these evil spirits encased in flesh are spreading.
– E. Gary Gygax, “Advanced Dungeons & Dragons, 1st Edition, Monster Manual”
So may the outward shows be least themselves. The world is still deceived with ornament. … Thus ornament is but the guiled shore To a most dangerous sea, the beauteous scarf Veiling an Indian beauty—in a word, The seeming truth which cunning times put on To entrap the wisest.
– Shakespeare, “The Merchant of Venice”
I would guess that not more than 1 in 100 Epsilon Theory readers remembers Darren McGavin in Kolchak: The Nightstalker. It’s a television series that only ran one year in the mid-1970’s, plus a couple of made-for-TV movies, but for whatever reason it made a big impression on me. A perpetually down-on-his-luck news wire stringer, Kolchak was a truth-seeker and a puzzle-solver, even if his truths and puzzles were found in the hidden corners and supernatural mysteries of 1970’s Chicago. Kolchak was Mulder before The X-Files was a gleam in Chris Carter’s eye.
My favorite Nightstalker episode involved a Rakshasa, an evil Indian spirit that could take the form of whatever human its victim trusted the most. For the unfortunate Buck Finemann it was his rabbi; for Kolchak (who thought himself immune because he trusted no one) it was his elderly neighbor. For weeks afterwards I enjoyed scaring myself by imagining that my family and friends were actually Rakshasas, just waiting for the most psychologically crushing moment to pounce. A few years later, when the first AD&D Monster Manual was released, I can’t tell you how delighted I was to see my old friend the Rakshasa playing a prominent role, captured perfectly by Dave Trampier’s drawing of a pipe-smoking tiger.
Almost all cultures have their mythological version of an evil shape-shifter who replaces a loved one. Sometimes it’s a child switched at birth; sometimes it’s an adult doppelgänger. The human animal has a primal fear of the counterfeit human…an alien consciousness possessing a perfectly “normal” human body…and it remains one of the foremost tropes for horror media, from “Invasion of the Body Snatchers” to “The Thing” to “The Omen”. We love to scare ourselves by imagining Rakshasas and their ilk.
In Indian mythology, however, the Rakshasa is less inherently malevolent than it is simply foreign or alien. It is an Outsider, with an entirely non-human conception of social organization and purpose, and it is this differentness, particularly when coupled with an intimately familiar external appearance, that frightens us. When the Other looks like us, we take it as a betrayal and we assume it must be a threat. External appearance is a signal, as powerful to us as a pheromone is to an ant, and as a eusocial animal we are biologically evolved and culturally trained to respond to these signals…positively to a familiar appearance and negatively to the unfamiliar. But the human animal makes immediate assumptions based on external appearance that go far beyond simple positive and negative affect. Virtually all of our communications – including the meaning we ascribe to language – are part and parcel of the cognitive models we form based on external appearance. There are plenty of good evolutionary reasons why the human animal places such an inordinate reliance on external appearances to drive our Bayesian decision-making processes, plenty of reasons why we are so suspicious of differentness, so trusting of sameness. But all of these good reasons were developed for small group subsistence on the African savanna 100,000 years ago, not modern mass society.
In 1952 John Steinbeck published East of Eden, the book he considered to be his masterpiece. There’s a passage in this book – a startling conversation between the wealthy farmer Samuel and his Cantonese cook, Lee – which reveals beautifully the chasm of meaning and understanding in our communications perniciously created by our group-oriented, external appearance-focused, social animal nature. It’s a genius observation of the human condition, and I hope it prompts you to read the book.
“Lee,” he said at last, “I mean no disrespect, but I’ve never been able to figure out why you people still talk pidgin when an illiterate baboon from the black bogs of Ireland, with a head full of Gaelic and a tongue like a potato, learns to talk a poor grade of English in ten years.”
Lee grinned. “Me talkee Chinese talk,” he said.
“Well, I guess you have your response. And it’s not my affair. I hope you’ll forgive me if I don’t believe it, Lee.”
Lee looked at him and the brown eyes under their rounded upper lids seemed to deepen until they weren’t foreign any more, but man’s eyes, warm and understanding. Lee chuckled. “It’s more than a convenience,” he said. “It’s even more than self-protection. Mostly we have to use it to be understood at all.”
Samuel showed no sign of having observed any change. “I can understand the first two,” he said thoughtfully, “but the third escapes me.”
Lee said. “I know it’s hard to believe, but it has happened so often to me and to my friends that we take it for granted. If I should go up to a lady or gentleman, for instance, and speak as I am doing now, I wouldn’t be understood.”
“Pidgin they expect, and pidgin they’ll listen to. But English from me they don’t listen to, and so they don’t understand it.”
“Can that be possible? How do I understand you?”
“That’s why I’m talking to you. You are one of the rare people who can separate your observation from your preconception.”…“I’m wondering whether I can explain,” said Lee. “Where there is no likeness of experience it’s very difficult. I understand you were not born in America.”
“No, in Ireland.”
“And in a few years you can almost disappear; while I, who was born in Grass Valley, went to school and several years to the University of California, have no chance of mixing.”
“If you cut your queue, dressed and talked like other people?”
“No. I tried it. To the so-called whites I was still a Chinese, but an untrustworthy one; and at the same time my Chinese friends steered clear of me. I had to give it up.”
– John Steinbeck, “East of Eden”
Steinbeck didn’t know it, but his observation of the false differentness generated by race is exactly what evolutionary science reveals. In fact, from a human evolutionary perspective, the external characteristics that we associate with race have almost nothing to do with fundamental differentness or genetic diversity.
This is a Wikimedia Commons map of the human migration out of Africa (upper left of diagram, North Pole in the center), showing our inexorable advancement to every corner of the globe. By testing the persistent mutations of mitochondrial DNA of modern humans (passed from mothers to their children, so tracing the matrilineal line), we can identify which genetic populations (called haplo-groups) precede others, and by how long. The earliest splits of the mtDNA haplogroup occurred within Africa itself (L1, L2, and L3) between 130,000 and 170,000 years ago. Once out of Africa the human animal migrated first to South and Southeast Asia (60 – 70,000 years ago), then to Europe (40 – 50,000 years ago), and from there to East Asia, North America, and South America.
Nature. 2010 February 18; 463(7283): 943-947 (National Institutes of Health Public Access)
It’s not that the Khoisan are somehow more primitive or “less evolved” than Europeans or Asians. They are just as evolved as any other group of humans. It simply means that because their respective tribes separated from each other about 150,000 years ago, their genetic codes have mutated independently for a lot longer than the Chinese and American tribes. Mao and Reagan share a common matrilineal ancestor from maybe 40,000 years ago. !Gubi and G/aq’o, on the other hand, have to go back 150,000 years to find their common mother. There is enormous genotype differentiation between the various sub-linguistic groups of the Khoisan despite very little phenotype differentiation…from a human perspective the Khoisan are a veritable Amazon rainforest of genetic diversity. They don’t look different, but genetically speaking they are VERY different. On the other hand, the genetic diversity found within a modern, cosmopolitan city – no matter how much of an ethnic and racial melting pot it might be – is quite low by comparison. It’s a hard concept to grasp because it goes against the “evidence” of our own eyes, but the distinction between genotype and phenotype (and the primacy of the former for explanatory usefulness) is about as important a concept as there is in evolutionary theory.
Fair enough, Ben…thanks for the science lesson. But what in the world does all this have to do with investing?
The notion of the Other – the concept of differentness – is at the heart of portfolio theory, modern or otherwise. Portfolio theory works because of the Other, because of non-correlated and independent investment choices with differentiated return profiles. If the human animal has a hard time perceiving the Other correctly, if we are poor judges of what does and does not make for fundamental diversity, then we have a big problem with portfolio theory…a problem that will never be perceived, much less addressed, if we do not focus on our evolutionary baggage to become better judges of what generates substantive portfolio diversification. There is no bigger issue in portfolio risk management than the accurate identification of diversifying exposures, no more important topic for an Epsilon Theory perspective.
Here’s my point: we place waaaay too much emphasis on a security’s external appearance – its asset class or sector – in making our portfolio decisions. We place waaaay too much emphasis on a manager’s external appearance – his style box – in making our portfolio decisions. Do we need this sort of simplifying classification or modeling as part of our investment evaluation process? Sure. But to define the diversification qualities of an investment in terms of its phenotype rather than its genotype…well, that’s a mistake. I think that there is enormous room for improvement in constructing smart portfolios if we can stop staring at surface appearances and start focusing on the investment DNA of securities and strategies.
Of course, there’s no such thing as a genetic sequencing assay for an investment or a strategy, so what does this mean in practice, that we should focus on the investment DNA of a security or strategy? If we’re not going to measure the diversification of a portfolio by externally visible characteristics such as asset class or style box, then what are we supposed to do? I think the answer is to look at the externally visible attribute that is most closely linked to the diversity of the human haplogroup: language. I’ve written about this at length, so won’t repeat all that here. The basic idea, though, is that just as linguistic evolution maps almost perfectly to human adaptive radiation and the way our species spread into new environments out of Southern Africa, so, too, are there investment languages and grammars that map to the underlying “DNA” of a security or strategy. The ancient investment languages are Value (together with its grammar, Reversion to the Mean) and Growth (together with its grammar, Extrapolation), and the relative mix of these languages in the description and practice of securities and strategies reveals an enormous amount about their hidden “genotype”.
From this Epsilon Theory perspective, a portfolio comprised of various large-cap US industrial and banking stocks (almost all of which speak a strong Value dialect) would receive much less diversification benefit than a traditional perspective would suggest from an allocation to a macro hedge fund that used various reversion-to-the-mean strategies for currency trades. Conversely, I suspect that a portfolio holding Microsoft (Value-speaking) could receive a significant diversification benefit from adding Salesforce.com (Growth-speaking), even though they are both large-cap tech stocks. I think that there are dozens of ways to put this focus on investment language, investment grammar, and by extension – investment genotype – into practical use for the construction of better-diversified portfolios, and I’ll be spending a lot of time in the coming months testing these applications.
To be sure, this isn’t the first time in the history of the world that someone has suggested looking through surface characteristics such as asset class to find more useful dimensions of portfolio diversification.
For years, Ray Dalio and Bridgewater have been advocating something very similar to this notion with their argument concerning the weakness of asset class correlations in determining optimal portfolio allocations. Dalio’s point – which is the theoretical foundation of Bridgewater’s All-Weather risk parity strategy – is that the correlation of returns between asset classes like stocks and bonds is neither constant nor random. The correlation waxes and wanes over time, with long periods of negative correlation and long periods of positive correlation that must reflect some underlying force. Dalio calls this underlying force the macroeconomic “machine”, which at any given point in time reflects what other people call a “regime”…some combination of inflation and growth characteristics within a context of debt cyclicality to which stocks and bonds respond in predictable ways. Depending on the current regime (which tends to change slowly), stocks and bonds will have either a strong or weak, positive or negative correlation to each other, but there’s nothing meaningful about that correlation. What’s meaningful is the relationship or correlation between stocks and bonds to the macro regime. If you can measure the inflation/growth regime accurately and you know the performance relationship of asset classes to this underlying force, then voilà…you can construct a portfolio of stocks and bonds (and other assets, like commodities) that should perform as well as it is possible to perform within the given regime, where good performance is defined as the most reward for the least volatility. Or so the argument goes.
I think it’s a good argument. Dalio’s theory of why a risk-balanced portfolio works is not the skin-deep perspective embedded in most portfolio construction efforts. Dalio is saying that there’s nothing special about this asset class or that asset class in determining a risk-balanced portfolio, no magical ratio, 60/40 or otherwise, of stocks to bonds. The Bridgewater approach isn’t focused on “balancing” asset classes at all, because there’s really nothing of importance to balance here, no meaning in asset classes per se. Securities are simply instruments that reflect an underlying economic regime with their performance characteristics, and a portfolio should be constructed on the basis of combining these securities in the best possible risk/reward configuration given the underlying regime, period. Sometimes this will mean a lot of stocks and a few bonds; more typically this will mean a lot of bonds and a few stocks. Either way, the Bridgewater approach looks beneath the asset class skin of a security, and that’s a good start.
But it’s only a start. I want to suggest an alternative conceptual basis for risk-balanced portfolio construction, one that doesn’t rely on a deterministic model of the economy.
Moving from an asset class conception of correlation and risk to an inflation/growth regime conception of correlation and risk is not really a fundamental change in perspective. We’re still talking about external characteristics, only now we’re talking about the economy as a whole rather than asset classes or individual securities. It’s like a Hindu mystic saying that it’s wrong to conceive of the world being supported by four elephants, but that what you really need to look for is the turtle that supports the elephants.
The problem, of course, is that once you accept this concept, you have to ask what the turtle is standing on. The Bridgewater answer is that the macroeconomic turtle-machine is the first mover, the Aristotelian primum mobile, the bedrock on which everything else rests. The only acceptable complement to the beta portfolio in Bridgewater’s turtle-machine framework has to be confined to the realm of “alpha” or skill-based returns that cannot be modeled as a systematic or identifiable phenomenon. The relationships between assets and the macroeconomic machine are “timeless and universal” to quote Bridgewater co-CIO Bob Prince, which means that it’s difficult for their model to account for a regime of regimes, a long and unpredictable game by which political and social forces shape and transform the investment meaning and return correlation of a security to the macroeconomic characteristics of inflation and growth. We believe that these political and social forces are both detectable and actionable and would be more appropriately identified as components of epsilon rather than alpha.
Why is this a problem? Because as the story goes, it’s not nothing beneath that first turtle, but rather more and more turtles…all the way down in an infinite expanse of turtle-dom. In this Epsilon Theory scenario, below the economic turtle-machine is a political turtle-machine, and below that is a social turtle-machine, and below that is a human animal turtle-machine, etc. etc. The lower the turtle, the more slow-moving it is, and the more likely you can ignore its existence for the sake of expedient model prediction at any given point in time. But if you are unfortunate enough to be investing on the basis of your economic turtle-machine when one of the lower turtles lurches forward…you’re in for a nasty surprise. What might this look like? Consider that for most of the past 2,000 years it has been illegal to accept interest payments for a loan to a company, much less to securitize that sort of loan into a bond. Read The Merchant Of Venice again if you need a refresher course in the scope and power of usury laws. Or for a more recent example, consider that private residential mortgage-backed securities hardly existed prior to 2001, were a $4 trillion asset class by the end of 2007, and are now totally moribund, simply running off into oblivion. I just don’t think it’s crazy to imagine large and unpredictable shifts in the economic machine borne out of political and social change. In fact, I think it’s crazy not to expect these shifts, even if the timing and focus of the lurch is impossible to predict.
There are two ways out of the infinite turtles problem. The first, which is what I imagine the Bridgewater Elect are doing, is to expand the macroeconomic machine to include political and social sub-machines. If you’ve ever read Isaac Asimov’s Foundation Trilogy, you can easily imagine Ray Dalio as Hari Seldon, with a legion of psychohistorians figuring out more and more equations to incorporate into a massive econometric model of human society and mass behavior.
The second way out (which I favor for precisely the reasons that Seldon’s model failed) is to reject the notion of ANY mechanistic model of how the world works in favor of a profound agnosticism about what the future holds. The only constants I’m willing to accept, particularly in a period of global deleveraging and ferocious political fragmentation within and between countries, are the constants of human nature. My predictions for the markets in 2014 are that fear and greed will still reign supreme, that investors will still speak ancient languages of Value and Growth, and that emergent behaviors like the Common Knowledge Game will drive short to medium-term price levels in many securities.
I believe that a risk-balanced portfolio – if it explicitly includes both the grammar of Reversion-to-the-Mean and the grammar of Extrapolation – can be as responsive and adaptive to changing patterns and market-moving forces as you want it to be, whether or not you have the right model to explain why those patterns are shifting. As recently as 10 years ago a simplifying macroeconomic model was an absolute necessity for making sense of all the signals that the world throws at us minute after minute. A model, by definition, will ignore certain signals. It’s what models DO. They simplify the world and occasionally miss important signals so that we are not drowned by the sheer flood of less important signals. It’s a trade-off that used to be necessary…but it’s not anymore.
We are in the midst of an information processing revolution – a quantum leap forward in inductive reasoning and inference colloquially named Big Data – that is every bit as important for portfolio management as the economic theory developed by Markowitz et al in the 1950’s.Today we can measure the market world – all of it – and infer the likelihood function of any given pattern or outcome. We know what the past patterns have been and we have the tools to sound an alarm if those patterns start to change, for whatever reason. We no longer have to model the economic world and intentionally cut ourselves off from potentially useful signals because they don’t fit our preconceptions. We no longer have to be the ladies and gentlemen that Steinbeck described, unable to understand Lee if he spoke anything other than pidgin English, because otherwise he would not fit their model of who Lee was. We can be like Samuel, one of the rare people able to separate our observations from our preconceptions. You cannot do that if you approach the world constrained by a model. Sorry, but you can’t.
The tyranny of models is rampant in almost every aspect of our investment lives, from every central bank in the world to every giant asset manager in the world to the largest hedge funds in the world. There are very good reasons why we live in a model-driven world, and there are very good reasons why model-driven institutions tend to dominate their non-modeling competitors. The use of models is wonderfully comforting to the human animal because it’s what we do in our own minds and our own groups and tribes all the time. We can’t help ourselves from applying simplifying models in our lives because we are evolved and trained to do just that. But models are most useful in normal times, where the inherent informational trade-off between modeling power and modeling comprehensiveness isn’t a big concern and where historical patterns don’t break. Unfortunately we are living in decidedly abnormal times, a time where simplifications can blind us to structural change and where models create a risk that cannot be resolved by more or better modeling! It’s not a matter of using a different model or improving the model that we have. It’s the risk that ALL economic models pose when a bedrock assumption about politics or society shifts. If you’re not prepared to look past your model…if you’re not prepared, as Steinbeck wrote, to separate your observations from your preconceptions…then you have a big invisible risk in your portfolio.
I know it’s hard to embrace what I’m describing as a profound agnosticism about the mechanics of how the world works. I know it goes against our biological grain to reject the comfort and succor of a deterministic model and an Answer. In many respects, deep agnosticism is the ultimate Other. It is a non-human perspective on how to think about the world – a Rakshasa – and I’m not expecting it to receive a warm or trusting welcome, particularly when it has the skin of some familiar investment product. But I think it’s the right way to look at a world wracked by political fragmentation, saddled with enormous debts, and engaged in the greatest monetary policy experiments ever devised by man. I think it’s the right way to look at a world of massive uncertainty, as opposed to a world of merely substantial risk, and it’s the perspective I’ll continue to take with Epsilon Theory.
Is there any other point to which you would wish to draw my attention?
To the curious incident of the dog in the night-time.
The dog did nothing in the night-time.
That was the curious incident.
– Arthur Conan Doyle, “Silver Blaze”
The market was down more than 2% last Monday. Why? According to the WSJ, CNBC, and all the other media outlets it was “because” investors were freaked out (to use the technical term) by poor US growth data. Disappointing ISM number, car sales, yada, yada, yada. But then the market was up more than 2% last Thursday and Friday (and another 1% this Tuesday), despite a Friday jobs report that was more negative in its own right than the ISM number by a mile. Why? According to those same media arbiters, investors were now “looking through” the weak data.
Please. This is nonsense. Or rather, it’s an explanation that predicts nothing, which means that it’s not an explanation at all. It’s a tautology. What we want to understand is what makes investors either react badly to bad news like on Monday or rejoice and “look through” bad news like on Friday. To understand this, I sing the Epsilon Theory song, once more with feeling … it’s not the data! It’s how the data is molded or interpreted in the context of the dominant market Narratives.
We have two dominant market Narratives – the same ones we’ve had for almost 4 years now – Self-Sustaining US Growth and Central Bank Omnipotence.
The former is pretty self-explanatory. It’s what every politician, every asset manager, and every media outlet wants to sell you. Is it true? I have no idea. Probably yes (technological innovation, shale-based energy resources) and probably no (global trade/currency conflict, growth-diminishing policy decisions). Regardless of what I believe or what you believe, though, it IS, and it’s not going away so long as all of our status quo institutions have such a vested interest in its “truth”.
The latter – Central Bank Omnipotence – is something I’ve written a lot about, so I won’t repeat all that here. Just remember that this Narrative does NOT mean that the Fed always makes the market go up. It means that all market outcomes – up and down – are determined by Fed policy. If the Fed is not decelerating an easy money policy (what we’ve taken to calling the Taper), the market tends to go up. If the Fed is decelerating its easy money policy, the market tends to go down. But make no mistake, the Common Knowledge information structure of this market is that Fed policy is responsible for everything. It was Barzini all along!
How do Narratives of growth and monetary policy come together? Well, there’s one combination that the stock market truly and dearly loves – the Goldilocks scenario. That’s when growth is strong enough so that there’s no fear of recession (terrible for stocks), but not so strong as to whip the flames of inflation (not necessarily terrible for stocks, but sure to provoke Fed tightening which is terrible for stocks).
Over the past few years the Goldilocks scenario has changed. Inflation is … well, let’s be straight here … inflation is dead. I know, I know … our official measures of inflation are all messed up and intentionally constructed to keep the concept of “inflation” and the Inflation Narrative in check. I get that. But it’s the Narratives that I care about for trying to predict market behaviors, not the Truth with a capital T about inflation. If you want to buy your inflation hedge and protect yourself from the ultimate wealth-destroyer, go right ahead. At some point I’m sure you’ll be right. But I’m in a business where the path matters, and I can’t afford to make a guess about where the world may be in 5 to 10 years and just close my eyes. The Inflation Narrative is, for the foreseeable future, dead because there is zero wage inflation, which is the sine qua non for an Inflation Narrative. It’s a zombie, as all powerful Narratives are, so it will return one day. But today Goldilocks has nothing to do with inflation.
The Goldilocks scenario today is macro data that’s strong enough to keep the Self-Sustaining US Growth Narrative from collapsing (ISM >50 and positive monthly job growth) but weak enough to keep the market-positive side of the Central Bank Omnipotence Narrative in play.That’s the scenario we’ve enjoyed for the past few years, particularly last year, and it’s the scenario that our political, economic, and media “leaders” are desperate to preserve. So they will.
On Monday we had bad macro data on the heels of the Fed establishing a focal point of $10 billion in additional Taper cuts per FOMC meeting, a clear signal that monetary easing is decelerating on a predictable path. This is the market-negative side of the Central Bank Omnipotence coin, which turns bad macro news into bad market news. And so we were down 2%. And so the Powers That Be started to freak out. Did you see Liesman on CNBC after the Monday debacle? He was adamant that the Fed needed to reconsider the path and pace of the Taper.
And then we had Friday. Honest to God, I thought Liesman was going to collapse of apoplexy, what my grandmother from Scottsboro, Alabama would have called a conniption fit, right there on the CNBC set. The Fed MUST reconsider its Taper path. The Fed MUST do everything in its power to avoid even a whiff of deflationary pressures. Heady stuff. By 10 am ET that morning the WSJ was running an online lead story titled “U.S Stocks Rise as Focus Returns to Fed”, acknowledging and promulgating the dynamic behind bad macro news driving good market news.
It’s not necessary (and is in fact counter-productive from a Narrative construction viewpoint) to switch the Fed trajectory 180 degrees from Taper to no-Taper. What’s necessary is to inject ambiguity into Fed communication policy, particularly after the non-ambiguous FOMC signal of two weeks ago that led directly to Monday’s horror show. The need for ambiguity is also something I’ve written a lot about so won’t repeat here. But this is why Hilsenrath and Zandi and all the rest of the in-crowd are writing that the Taper is still on track … probably. Unless, you know, the data continues to be weak. What you’re NOT seeing are the articles and statements by the Powers That Be placing a final number on QE3, extrapolating from the last FOMC meeting to a projected QE conclusion. And that’s the dog that didn’t bark. It’s the projection that Yellen won’t be asked about in her testimony; it’s the article that won’t be written in the WSJ or the FT. Is the Taper still on? Two weeks ago the common knowledge was “Yes, and how.” Today, after a stellar bout of Narrative construction, the answer is back to “Yes, but.” That’s the ambiguous, “data dependent” script that Yellen and all the other Fed Governors now have the freedom to re-assert. Fed support for the market is back in play.
If I’m right, what does this mean for markets? It means that our default is a Goldilocks scenario between now and the next FOMC meeting in mid-March. It means that bad macro news is good market news, and vice versa. If the next ISM manufacturing number is a big jump upwards, the market goes down. Ditto for the February jobs number. If they’re weak, though, that’s more pressure on the Fed and another leg up for markets.
Place your bets, ladies and gentlemen, the croupier is about to spin the roulette wheel. Pardon me if I sit this one out, though. My crystal ball is broken.
If I’m right, what does this mean for the real world? It means an Entropic Ending to the story … disappointing, slow and uneven growth as far as the eye can see, but never negative growth, never an honest assignment of losses to clear the field or cull the herd (two qualities that, not coincidentally, are clearly present in the growth sectors of technology and energy). That’s not my vision of a good investment world, but who cares? We’ve got to live in the world as it is, even if it’s a long gray slog.
Instead of a long-form note this Sunday, I thought I’d write a briefer note in advance of this Friday’s jobs report. I’ll be back next Sunday, Feb. 16, with a long note taking an Epsilon Theory view on portfolio diversification. Please feel free to forward this email to whomever you think might be interested, and all prior notes are available on the Epsilon Theory website. If you’re receiving this note via forwarded email and you’re not yet on the direct distribution list (and you find it a worthwhile read), I’d appreciate the opportunity to add you to the list. I’m building the Adaptive Investing framework in plain sight and in real time through these notes, and I’d welcome the widest possible participation, as well as your thoughts and comments.
Oh, Stewardess, I speak jive. — Barbara Billingsley, “Airplane”
This is an important jobs report. Not because it matters in the least whether the US economy added 170,000 new jobs or 185,000 new jobs. Not because it matters a whit whether the unemployment rate goes up or down 1/10th of 1 percent. No, the importance of this jobs report rests is two related linguistic games. Here’s how to translate the lingo …
First, do the Hilsenrath’s and Liesman’s and Cramer’s of the world proclaim from their pulpits that this is a positive report or a negative report?
If by this time next week the Common Knowledge surrounding the jobs report is that it was a dud, then there will be a COLOSSAL effort by Famous Journalists, Famous Economists, and Famous Investors to pressure the Fed into reducing the Taper. If by this time next week the Common Knowledge is that this was a positive jobs report, then you will merely see a continuation of the current assertion by the opinion-leading Powers That Be that the Emerging Markets carnage we are witnessing is a tempest in a teapot so long as the US remains on a self-sustaining growth trajectory. Nothing to see here, folks. Stay calm and carry on.
Of course, the jobs report could miss expectations and still generate a positive Narrative, as “bad weather” or some other devil is identified as the one-off cause (funny how good weather is never credited with macro data results that surprise to the upside). Conversely, a jobs report that beats expectations may still be recast in a horrible light. If there’s one lesson that I hope even a cursory reading of Epsilon Theory delivers, it’s that the reality of macro data is only indicative of its ultimate media communication, not dispositive! The public perception of macro data is incredibly mutable, politicians and media prey on our weakness for a good story, and so we won’t know for another week what the final Common Knowledge or Narrative construction looks like here.
Second, what does Yellen communicate in reaction to this jobs report Narrative?
There will be no reaction to the jobs report itself, because it really doesn’t matter to anyone, including the FOMC. What matters is the Narrative or Common Knowledge structure around the jobs report, and that’s what the Fed will both shape and be shaped by. We will start to receive these signals from Yellen directly as early as next week with her Congressional testimony, and you should expect a media feeding frenzy over her every word, culminating in her first press conference as Fed Chair on March 19th. If you were a wee bit tired of the markets racing up and racing down in response to breathless Bloomberg headlines parsing everything that every Fed Governor does (or doesn’t) say … well, sorry, but the circus is back in town.
There’s not as much pressure on Yellen if the Common Knowledge around the jobs report is positive, because it won’t be an overt “reason” for her to change the current policy course of the Fed. But if it’s negative … oh, boy. Then Janet Yellen is going to be tested. Whoever said that hell hath no fury like a woman scorned apparently never met a levered long equity manager who sees the easy money punchbowl starting to drain without another obvious punchbowl (like the Narrative of Global Growth) there to take its place. And by levered long equity manager I mean almost everyone. I mean every politician, every financial media outlet, every CEO, (almost) every asset manager. Everyone is levered to either massive liquidity or global growth, and if both of those pillars of the current economic world are now in doubt you will hear a howl of pain and anger that will make the Earth shake. Oh, the protestations will be dressed up in their Sunday best clothes, full of phrases like “monetary policy transmission mechanisms”, but there’s no mistaking the animal under those clothes. The markets have had almost 5 years of central banks suspending the rules of business cycles. That’s fun. It’s like a magic pinball machine where your ball never drains. Of course no one wants to go back to the old days of actually having to suffer through temporary economic weakness, much less (gasp!) a garden-variety recession. We want our magic pinball machine! And we just might get it.
So how does all this game-playing and Narrative construction connect to market outcomes? If Yellen stays the course with the current Taper path then regardless of whether the jobs report Narrative is negative or positive I think there’s a negatively biased informational surface to this market. It’s easier for the market to go down than to go up when Common Knowledge says that the Fed is tightening. That’s particularly so if the struts are kicked out from under the US Growth Narrative with a negatively portrayed jobs report, but even if the US Growth Narrative is intact, a Taper-as-she-goes Fed puts enormous pressure on Emerging Markets and the short-Yen trade. That means that big levered positions in risk assets will continue to unwind, at times violently. This is a very ugly risk environment.
But if Yellen succumbs to the addicts’ plea, either because she wants to appease or because she actually believes the Narrative tripe that the plea will be gussied-up in … well, the market will get its fix. The Fed still has your back, Mr. Levered Long Equity Investor. Or rather, the Fed is now even more a monkey on your back. And as addicts have learned since time immemorial, shaking that monkey gets harder over time. And harder. And harder. I’ve written at length (here and here) about how I believe QE has been transformed from an emergency government policy that saved the world in 2009 into a permanent government program that stifles growth and well-functioning markets, and I think that’s true regardless of what happens over the next few weeks or months. You can’t unring the QE bell, and this will be a go-to monetary policy in the aftermath of any negative economic news, no matter how mild. But if this is all it takes to shift the second derivative of US monetary policy, if mildly disappointing macro data is all it takes to return to an “emergency” acceleration of the Fed balance sheet … that’s just sad.
There was a clear short-term narrative developed in the financial media last week creating a focal point at 102 in the Yen/USD exchange rate. The short-Yen trade is perhaps the most crowded trade in the world right now, so a strengthening of the Yen to break below the focal point is a big deal for market game-playing behavior. The Yen broke below 102 today, which will put plenty of game-playing pressure on levered short-Yen positions in particular, and the entire equity market in general. Be careful out there.
If you want to read more about focal points, check out the Jan. 28 “Flatland” email on the Epsilon Theory website, as well as some of the longer-form notes.
We did get something – a gift – after the election. … It was a little cocker spaniel dog in a crate. … And our little girl – Tricia, the 6-year old – named it Checkers. And you know, the kids, like all kids, love the dog and I just want to say this right now, that regardless of what they say about it, we’re gonna keep it. – Richard Nixon, “Checkers” speech after accepting illegal campaign contributions
Cory is here tonight. And like the Army he loves, like the America he serves, Sergeant First Class Cory Remsburg never gives up, and he does not quit. My fellow Americans, men and women like Cory remind us that America has never come easy.
–Barack Obama, 2014 State of the Union address
You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold. – William Jennings Bryan, the Boy Orator of the Platte, 1896 Democratic nomination speech
Every man a king, but no one wears a crown. – Huey Long, the Kingfish, slogan from 1928 Louisiana gubernatorial campaign
You didn’t build that. – Elizabeth Warren, slogan from 2012 Massachusetts campaign for US Senate
The play’s the thing. Wherein I’ll capture the conscience of the king. – Shakespeare, “Hamlet”
As usual, I was struck by the pageantry and sheer theatricality of this Tuesday’s State of the Union address. As usual, you had the props – human and otherwise – on full display. As usual, you had the rhetorical flourishes, the ritualized audience behavior, the talking head performances before and after. Unusual for me, though, was the professionally scripted and rehearsed television broadcast production, such that the cameras were trained on the human props before the President referred to them in his speech. A bravura technical performance, to be sure.
Last week’s note focused on the primal human behavior of dance. This week it’s the primal human behavior of theatre, of the representation of stories, particularly the play-within-a-play…a fundamental trope of human story-telling from Hamlet to The Simpsons.
Daniel Maclise, “The Play Scene” (1842)
Matt Groening, “The Simpsons”
There’s the ostensible meaning of the spoken words and the performance, and there’s the ostensible audience to whom the words and performance are addressed. But then there’s the real meaning of the words, and the real audience to whom the words are addressed. And then maybe there’s a meaning and an audience beyond that. This is the recursive, strategic nature of public communications. These multi-level games are the beating hearts of both politics and economics, and looking at these behaviors through the lens of game theory can help us both see the social world more clearly and call more things by their proper names.
We expect this sort of linguistic game-playing in politics. It’s what politicians DO, whether it’s Elizabeth Warren’s “You didn’t build that” speeches putting a modern slant on the same language and imagery of populism and class warfare used by William Jennings Bryan in the 1890’s and Huey “Kingfish” Long in the 1920’s, or whether it’s the entire Republican Party’s “Southern Strategy” of coded language to maintain racist voting blocs post the Civil Rights Act of 1964. If you’ve never read political operative extraordinaire Lee Atwater’s infamous interview on the subject, you really should. And yes, I know that Atwater’s point was that overt racist appeals were diminishing in the South as the language changed, but does anyone doubt that Atwater would use language straight from the KKK handbook if he thought it were still an effective campaign tool? It’s not that he thinks racism is wrong or even distasteful in the context of a political campaign, any more than Elizabeth Warren would be opposed to burning Jamie Dimon in effigy (or maybe in person) at her next campaign rally … it’s just an unpopular tactic today, at least in its unvarnished form. But if it works tomorrow? Sure, why not? In the immortal words of Al Davis, “Just win, baby.”
This sort of linguistic game-playing is not a modern phenomenon. It is a quintessential human phenomenon, played just as effectively by Pericles 2,500 years ago as it is by politicians today. My favorite example of a linguistic play-within-a-play was staged 150 years ago by an undisputed American political genius: Abraham Lincoln. We’re all familiar with the Lincoln-Douglas debates as some sort of shining example of civic participation and civil discourse, but few know the politics behind those debates. Lincoln lost that 1858 election to Stephen Douglas for the US Senate (well, he won the aggregate popular vote by a slim margin, but US Senators were still chosen by state legislatures back then, and the allocation of votes within the Illinois legislature gave Douglas a clear victory). But the way he lost that Senate race … the way Lincoln played the game … won him the Presidency in 1860.
Here was the central question of those debates, the way in which Lincoln framed the language of the debate to give himself the best chance of winning the larger political game: should the citizens of a Territory have the right to decide whether or not to allow slavery in that Territory? Every time Douglas tried to move the debate to some other topic (and seeing as how Illinois was, of course, a state rather than a Territory, you can understand why other topics might be of interest), Lincoln moved it right back. Every time the crowd’s attention seemed to wane in the subject, Lincoln would say something certain to inflame his opponents in the crowd, drawing Douglas back into the fight. Lincoln’s position on this question may surprise you. He was adamantly opposed to popular sovereignty in the Territories, even when the majority opposed slavery (like Kansas). Lincoln’s position was not only anti-slavery, but also (and perhaps more importantly to Lincoln from a political game perspective) anti-states’ rights and local sovereignty.
Why? Lincoln’s question was not really directed at Douglas, the immediate audience. Nor was it really directed at the crowds of voters in the various Illinois towns where they debated. Nor was it really directed at the Illinois newspaper reporters who carried the debates across the entire state of Illinois. It was really directed at a national audience of Republican voters, because Lincoln knew that the Illinois Senate race in 1858 was just a warm-up for the Presidential election of 1860. If Douglas agreed with Lincoln on the Territorial sovereignty question, then he would lose the only issue where he was more popular than Lincoln within Illinois … Douglas would lose the Senate race and fatally damage his chances in the national Democratic primary. If Douglas disagreed with Lincoln, then he would probably win the Illinois Senate race and put himself in a reasonable position to win the national Democratic primary, but not without splitting his own party (Southern Democrats wanted slavery legalized in Territories even if the majority voted it down). Lincoln was playing a game four layers deep! He didn’t care about “winning” the debate. He didn’t care about winning the crowd. He didn’t really care about winning the Illinois Senate election. All of those things would be nice, but it was the fourth level – winning the national Republican primary and the national Presidential election of 1860 – where Lincoln was focused.
Lincoln’s multi-level game strategy worked perfectly. The Democratic party split into Northern and Southern factions (really into three factions if you count the Constitutional Union, which drew principally from former Southern Whigs), giving the Republicans a clean sweep of the Northern states and Electoral College domination even though Lincoln received less than 40% of the popular vote nation-wide. Douglas – the candidate of the (Northern) Democratic Party – finished second in the popular vote with 30% of the vote, but carried only one state (Missouri) and ended up with a mere 12 Electoral College votes, compared to Lincoln’s 180. Not bad for a former Congressman from a frontier state who couldn’t even win a Senate seat.
I’m always surprised when people who are quite aware of the linguistic game-playing that creates the fabric of politics are somehow blind to the same linguistic shaping of the fabric of economics and market behavior. I shouldn’t be surprised – as Upton Sinclair said, “it is difficult to get a man to understand something when his salary depends upon his not understanding it” – but still. We don’t expect our politics to be “scientific” or our politicians to be anything less than fallible humans, but somehow we expect Truth with a capital T when it comes to economics. There’s a tendency to treat economic communications and signals – whether it’s from a Famous CEO, a Famous Investor, a Famous Economist, a Famous TV Personality, or a Central Banker – as somehow less theatrical or less staged for a larger purpose than political speech. But this is a mistake. When Ben Bernanke said that the Fed would increasingly use its communications as a policy tool, he was declaring his intention to start playing a linguistic game. Or rather, his intention to play the game even harder than it had been played in the past. When Jean-Claude Juncker, former Luxembourg Prime Minister and head of the Eurogroup Council, said of European monetary policy “when it becomes serious you have to lie,” he was simply saying what every successful game-player knows: sometimes you have to bluff. Some Central Bankers are pretty good poker players (Draghi, for example); others … not so much. But they are all playing the Common Knowledge Game as hard as they can, they’re getting better at it, and they’re not going to stop. If you don’t understand the rules of this game, if you don’t listen to what is being said in the context of game-playing, then you are placed at a disadvantage versus those who do. You will not understand the WHY that exists behind the public statements.
There’s a slightly different linguistic game going on in the financial media, but no less important for understanding market outcomes. I’ll take CNBC as an example, but it’s just an example…you could make the same observations about any other media outlet. Within CNBC, Jim Cramer is everyone’s favorite whipping boy when it comes to complaints about media theatrics, but this is missing the forest for the trees. At least Cramer lets us in on the play-within-a-play conceit without constantly pretending that a daily price chart or a market “heat map” is anything other than a theatrical prop. If anything, Cramer’s performance is a paragon of honesty compared to the performances of the “news” hosts or the interchangeable “traders” on shows like “Fast Money.” XKCD published this cartoon in reference to ESPN and the like, but it’s even more applicable to CNBC and its ilk. Just to be clear, I’m not slamming these hosts and traders. I’m sure that they are overwhelmingly smart, honest people who believe that what they say are useful truths from their own perspectives. They are not hypocrites. But they are performers. And like any performer, there is a larger game being played with their words.
The larger meaning of the statements made on CNBC has absolutely nothing to do with specific investment advice or news. CNBC really could not care less about the actual content of what is being said. The purpose of CNBC’s game is not to tell you WHAT to think, but HOW to think, that thinking about investing in terms of some sell-side analyst’s anodyne story about fundamentals or some trader’s breathless story about open option interest is smart or wise or what all the cool kids are doing. Why? Because CNBC can create inexpensive content essentially at will to fill this demand, allowing them to sell advertisements and take cable carriage fees. Nothing evil or wrong about this. It’s what for-profit media companies DO. But the content they are producing is no less of a theatrical production than the State of the Union address, no less of a multi-level game, and it needs to be understood as such.
Jacob Jordaens, “Diogenes Searching for an Honest Man” (c. 1642)
So what’s to be done if all of our leaders and all of our institutions are speaking past us, playing a larger game for power or money or whatever? Do we rage against the machine? Do we wander around like Diogenes, the founder of Cynic philosophy, holding to some absolutist standards of Honesty with a capital H and Truth with a capital T, living in rags and sleeping in a large clay jar? If that’s the price of being a Cynic and constantly fighting the innate fallibility of Man and his works…no thanks. There has to be a middle ground between being a Cynic and a Fool, some way of playing the game without losing one’s soul. Recognizing that all of us human animals, including me and including you, are playing multiple multi-level games … well, that seems like a good start to me. The Truths in life are still death and taxes (and maybe compounding returns). Everything else is theatre, where honesty (with a small h) and truth (with a small t) are probably the best we can achieve. And that’s not so bad.