When Does the Story Break?


Until an hour before the Devil fell, God thought him beautiful in Heaven.
– Arthur Miller, “The Crucible”

It’s always about timing. If it’s too soon, no one understands. If it’s too late, everyone’s forgotten.

– Anna Wintour

Saint Laurent has excellent taste. The more he copies me, the better taste he displays.

 – Coco Chanel

Beauty, to me, is about being comfortable in your own skin. That, or a kick-ass red lipstick.

– Gwyneth Paltrow


For, dear me, why abandon a belief Merely because it ceases to be true? Cling to it long enough, and not a doubt It will turn true again, for so it goes. Most of the change we think we see in life Is due to truths being in and out of favor.

– Robert Frost, “The Black Cottage”

Lord I am so tired How long can this go on?

– Devo, “Working in a Coal Mine”

He can’t think without his hat.

– Samuel Beckett, “Waiting for Godot”

Perhaps the most irrational fashion act of all was the male habit for 150 years of wearing wigs. Samuel Pepys, as with so many things, was in the vanguard, noting with some apprehension the purchase of a wig in 1663 when wigs were not yet common. It was such a novelty that he feared people would laugh at him in church; he was greatly relieved, and a little proud, to find that they did not. He also worried, not unreasonably, that the hair of wigs might come from plague victims. Perhaps nothing says more about the power of fashion than that Pepys continued wearing wigs even while wondering if they might kill him.

– Bill Bryson, “At Home: A Short History of Private Life


The most common question I get from Epsilon Theory readers is when. When does the market break? When will the Narrative of Central Bank Omnipotence fail? To quote the immortal words of Devo, how long can this go on? Implicit (and sometimes explicit) in these questions is the belief that this – whatever this is – simply can’t go on much longer, that there is some natural law being violated in today’s markets that in the not-so-distant future will visit some terrible retribution on those who continue to flout it. There has never been a more unloved bull market or a more mistrusted stock market high.

It’s a lack of love and a lack of trust that I share. I believe that public markets today are essentially hollow, as what passes for volume and liquidity is primarily machines talking to other machines for portfolio “positioning” or ephemeral arbitrage rather than the human expression of a desire to own a fractional ownership share of a real-world company. I believe that today’s public market price levels primarily reflect the greatest monetary policy accommodation in human history rather than the real-world prospects of real-world companies. I believe that the political risks to both capital market structure and international trade (which are the twin engines of global growth, period, end of story) have not been this great since the 1930’s. Simply put, I believe we are being played like fiddles. That does NOT mean, however, that I think anything has to change next week … or next month … or next year … or next decade. The human animal is a social animal in the biological sense, and as such we are cognitively evolved to maintain our beliefs and behaviors far beyond what is “true” in an objective sense. This is, in fact, the core argument of Epsilon Theory, that there is no such thing as Truth with a capital T when it comes to the institutions and the social organizations that we create. There’s nothing more “natural” about our market behaviors than there is around, say, our fashion behaviors … the way we wear our clothes or the way we cut our hair. For 150 years everyone knew that everyone knew that gentlemen wore wigs. This was the dominant common knowledge of its day in the fashion world, absolutely no different in any way, shape or form than the dominant common knowledge of today in the investing world … everyone knows that everyone knows that it’s central bank policy that determines market outcomes. And this market common knowledge could last for 150 years, too.

I’m not saying that a precipitous change in market beliefs and behaviors is impossible. I’m saying that it’s not inevitable. I’m saying that it’s NOT just a matter of when. I’m saying that understanding the timing of change in market behaviors is very similar to understanding the timing of change in fashion behaviors, because both are social constructions based on the Common Knowledge Game. It’s no accident that the most popular way to relate that game is the story of the Emperor’s New Clothes.


Here’s a photograph Margaret Bourke-White took of the Garment District in 1930. Every single person on the street is wearing a hat. How did THAT behavior change over time? How did the common knowledge that All Men Wear Hats, or wigs or whatever, change? Does it happen all at once? Smoothly over time? In fits and starts? Who or what sparks this sort of change and how do we know? To use a five dollar phrase, what is the dynamic process that underpins the timing of change in socially-constructed behaviors, whether that behavior is in the investing world or the fashion world?

Fortunately for us, game theory provides exactly the right tool kit to unpack socially driven dynamic processes. To start this exploration, we need to return to the classic thought experiment of the Common Knowledge Game – 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 the next morning. But there are no mirrors or reflective surfaces on the island, so you don’t know the color of your own eyes. It is also taboo to talk or otherwise communicate with each other about blue eyes, so when you see a fellow tribesman with blue eyes, you say nothing. As a result, even though everyone knows there are blue-eyed tribesmen, no one has ever left the island for this taboo. A Missionary comes to the island and announces to everyone, “At least one of you has blue eyes.” What happens?

Let’s take the trivial case of only one tribesman 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 tribesmen having blue eyes. The two blue-eyed tribesmen 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 tribesmen 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.

Before the Missionary arrives, the Island is a pristine example of perfect private information. Everyone knows the eye color of everyone else, but that knowledge is locked up inside each tribesman’s own head, never to be made public. The Missionary does NOT turn private information into public information. He does not say, for example, that Tribesman Jones and Tribesman Smith have blue eyes. But he nonetheless transforms everyone’s private information into common knowledge. Common knowledge is not the same thing as public information. Common knowledge is simply information, public or private, that everyone believes is shared by everyone else. It’s the crowd of tribesmen looking around and seeing that the entire crowd heard the Missionary that unlocks the private information in their heads and turns it into common knowledge. This is the power of the crowd watching the crowd, and for my money it’s the most potent behavioral force in human society.

Prior Epsilon Theory notes have focused on the role of the Missionary, and I’ll return to that aspect of the game in a moment. But today my primary focus is on the role of time in this game, and here’s the key: no one thinks he’s on the wrong side of common knowledge at the outset of the game. It takes time for individual tribesmen to observe other tribesmen and process the fact that the other tribesmen have not changed their behavior. I know this sounds really weird, that it’s the LACK of behavioral change in other tribesmen who you believe should be changing their behavior that eventually gets you to realize that they are wondering the same thing about you and your lack of behavioral change, which ultimately gets ALL of you blue-eyed tribesmen to change your behavior in a sudden flurry of activity. But that’s exactly the dynamic here. Even though there is zero behavioral change by any individual tribesman for perhaps a long period of time, such that an external observer might think that the Missionary’s statement had no impact at all, the truth is that an enormous amount of mentalcalculations and changes are taking place within each and every tribesman’s head as soon as the common knowledge is created.

I’ve written at length about the portfolio construction corollary to phenotype, or the physical expression of a genetic code, and genotype, or the genetic code itself. The former gets all of the attention because it’s visible, even though the latter is where all the action really is, and that’s a problem. In modern society it means that we place an enormous emphasis on skin color as a signifier of otherness or differentiation, when really it deserves almost no attention at all. In portfolio management it means that we place an enormous emphasis on style boxes and asset classes as a signifier of diversification, when really there are far more telling manifestations. The dynamic of the Common Knowledge Game is another variation on this theme. For almost the entire duration of the game, the activity is internal and invisible, not external and visible, but it’s there all the same, bubbling beneath the behavioral surface until it finally erupts. The more tribesmen with blue eyes, the longer the game simmers. And the longer the game simmers the more everyone – blue-eyed or not – questions whether or not he has blue eyes. It’s a horribly draining game to play from a mental or emotional perspective, even if nothing much is happening externally and regardless of which side of the common knowledge you are “truly” on.

If you haven’t observed exactly this sort of dynamic taking place in markets over the past five years, with nothing, nothing, nothing despite what seems like lots of relevant news, and then – boom! – a big move up or down as if out of nowhere – I just don’t know what to say. And I don’t know a single market participant, no matter how successful, who’s not bone-tired from all the mental anguish involved with trying to navigate these unfamiliar waters. These punctuated moves don’t come out of nowhere. They are part and parcel of the Common Knowledge Game, no more and no less, and understandable as such.

What starts the clock ticking on the “simmering stage” of the Common Knowledge Game? The Missionary’s public statement that everyone hears, creating the new common knowledge that everyone believes that everyone believes. How long does the simmering stage last? That depends on a couple of factors. First, as described above, the more game players who are on the wrong side of the new common knowledge, the longer the game simmers. Second, the dynamic depends critically on the fame or public acclaim of the Missionary, as well as the power of his or her microphone. A system with a few dominant Missionaries and only a few big microphones will create a clearer common knowledge more quickly, reducing the simmering time. Whether it’s Anna Wintour and Vogue or Janet Yellen and the Wall Street Journal, the scope and pace of game-playing depends directly on who is creating the common knowledge and how that message is amplified by mass media. Fashion changes much more quickly today than in, say, the 1930’s, because the “arbiters of taste” – what I’m calling Missionaries – are fewer, more famous, and have stronger media microphones at their disposal. Ditto with the investment world.

But has the clock started ticking on new common knowledge to change the dominant investment game? Has there been a perception-changing public statement from a powerful Missionary to make us question Central Bank Omnipotence, to make us question the color of our eyes? No, there hasn’t. There are clearly new CK games being played in subsidiary common knowledge structures – what I call Narratives – but not in this core Narrative of the Fed’s control over market outcomes. So for example, the market can go down, and more than a little, as the common knowledge around the subsidiary Narrative of The Fed Has Got Your Back comes undone with a second derivative shift from easing to tightening. The Fed itself is the Missionary on this new common knowledge. But the market can’t break so long as the common knowledge of Central Bank Omnipotence remains intact. So long as everyone knows that everyone knows that market outcomes ultimately depend on Fed policy, then the Yellen put is firmly in place. If things get really bad, then the Fed can save us. We might argue about timing and reaction functions and the like, but everyone believes that everyone believes that the Fed has this ability. And because it’s such strong common knowledge, this ability will never be tested and the market will never break. A nice trick if you can pull it off, and until a Missionary with the clout of the Fed comes out and challenges this core common knowledge it’s a fait accompli within the structure of the game. Who has this sort of clout? Only two people – Mario Draghi and Angela Merkel. That’s who I watch and who I listen to for any signs of a crack in the Omnipotence Narrative, and so far … nothing. On the contrary, Draghi and Merkel have been totally on board with the program. We’re all going to be wearing hats for a long time so long as all the investment arbiters of taste stick with their story.

There is, of course, a fly in this glorious ointment, and it’s the single most important difference between the dynamic of fashion markets and financial markets: political shocks and political dislocations can trump common knowledge and precipitate an economic and market dislocation. Wars and coups and revolutions certainly influence fashion, but obviously in a far less immediate and pervasive manner than they influence financial markets. The fashion world is an almost purely self-contained Common Knowledge Game, and the investment world is not. Where am I looking for a political shock that would be big enough to challenge the common knowledge that Central Banks are large and in charge, capable of bailing us out no matter what? It’s not the Ukraine. On the contrary, events there are public enough to give Draghi an excuse to move forward with negative deposit rates or however he intends to implement greater monetary policy accommodation, but peripheral enough to any real economic impact so that the ECB’s competence to manufacture an outcome is not questioned. It’s China. If you don’t think that the territorial tussles with Vietnam and Japan matter, if you don’t think that the mutual accusations and arrests of American and Chinese citizens matter, if you don’t think that the HUGE natural gas deal between Russia and China matters, if you don’t think that the sea change in Chinese monetary policy matters … well, you’re just not paying attention. A political shock here is absolutely large enough to challenge the dominant market game, and that’s what I’ll be exploring in the next few Epsilon Theory notes.

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Equity Volatility-of-Volatility Falls to All-Time Low


1M implied volatility on the VIX fell to an all-time low last week. Generally speaking, this means that options on short-term market volatility increasing have never been cheaper. How is this possible, you ask, with outright war simmering in Eastern Ukraine and China flexing its muscles in the South China Sea? Because Mario Draghi is “signaling” that he’s going to launch a European version of QE. Because the Narrative of Central Bank Omnipotence has never been stronger, and for markets this is the only thing that matters. Because we continue to live in the new Goldilocks environment, where mediocre growth is not so weak as to plunge us into recession but not so strong as to take central banks out of play. If the news gets a lot better the market will go down, and if the news gets a lot worse the market will go down. But what I call the Entropic Ending, a market-positive gray slog where global growth is more-or-less permanently crippled by the very monetary policies that prevent global growth from collapsing, can go on for a looooooong time.

epsilon-theory-equity-volatility-of-volatility-falls-to-all-time-low-may-12-2014.pdf (63KB)


All that Glitters



I’ve received a lot of questions over the past few weeks about Russia and the Ukraine, and why I don’t include this flashpoint in my list of greatest market risks. Sorry, but I just don’t think it’s that big of a deal from a markets perspective. Russia is going to control Sevastapol, and everyone – including Obama and Merkel and whoever is calling the shots in Kiev – knows it. Period. End of story. Owning a warm water port on the Black Sea has been a cornerstone of Russian political identity since Catherine the Great in the 18th century, and there’s nothing that anyone can do (or really wants to do) to stop it. Does effective control of Sevastapol and the Crimea require annexation of Eastern Ukraine? Maybe. Southern Ukraine and Moldova? Seems like a stretch to me, but I hear that the Danube is beautiful this time of year, and if that’s what Putin wants that’s what he’ll get. I’m sure we’ll get the usual tsk-tsk’ing from the usual suspects, and maybe even the 2014 equivalent of Jimmy Carter’s Moscow Olympics boycott, but that’s as far as it goes.

In fact, as far as markets are concerned, the more Sturm und Drang over Ukraine, the better. Draghi needs an excuse to launch some form of European QE, and an ECB staff projection of the dire consequences of Gazprom shutting off the pipelines is just what the doctor ordered. A few days of media hand-wringing over Putin’s intentions, perhaps accompanied by – gasp! – a 1% decline in markets, and even Janet Yellen can get into the act, promising to do “whatever it takes” to support our European brethren and overcome this horrific threat to global growth.

Ultimately this all further strengthens the Narrative of Central Bank Omnipotence – the market-controlling common knowledge that market outcomes are the result of central bank policy rather than anything that happens in the real economy. How can you know if this Narrative starts to waver or shift? If and when gold starts to work. This is what gold means in the modern age … not a store of value or some sort of protection against geopolitical instability … but an insurance policy against massive central bank error and loss of control. So long as the dominant narrative remains that central banks are large and in charge, so long as global investors hang on every throwaway line that Draghi utters … gold doesn’t stand a chance.

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The Risk Trilogy


A trilogy is a pretty abstract notion. You can apply it to almost any three things. 

– Jonathan Demme


Mozart: So then you like it? You really like it, Your Majesty?
Emperor Joseph II: Of course I do. It’s very good. Of course now and then – just now and then – it gets a touch elaborate.
Mozart: What do you mean, Sire?
Emperor Joseph II: Well, I mean occasionally it seems to have, how shall one say? How shall one say, Director?
Orsini-Rosenberg: Too many notes, Your Majesty?
Emperor Joseph II: Exactly. Very well put. Too many notes.
Mozart: I don’t understand. There are just as many notes, Majesty, as are required. Neither more nor less.
Emperor Joseph II: My dear fellow, there are in fact only so many notes the ear can hear in the course of an evening. I think I’m right in saying that, aren’t I, Court Composer?
Salieri: Yes! Yes! Er, on the whole, yes, Majesty.
Mozart: But this is absurd!
Emperor Joseph II: My dear young man, don’t take it too hard. Your work is ingenious. It’s quality work. And there are simply too many notes, that’s all. Just cut a few and it will be perfect.
Mozart: Which few did you have in mind, Majesty?

– Peter Shaffer, “Amadeus” (1984)

The most dangerous thing about an academic education is that it enables my tendency to over-intellectualize stuff, to get lost in abstract thinking instead of simply paying attention to what’s going on in front of me.   

– David Foster Wallace, “This is Water: Some Thoughts, Delivered on a Significant Occasion, about Living a Compassionate Life” (2009)

TLDR (Too Long Didn’t Read) 

– most common acronym I see on Zerohedge to describe an Epsilon Theory note


Gregg Greenberg at TheStreet.com was kind enough the other week to give me a few minutes (2:30 to be exact) in a video interview to enumerate the three biggest risks I saw facing markets today. At first I rolled my eyes at the request and the format. 150 seconds? Really? I mean, have you heard my Alabama drawl? It can take me 150 seconds just to order a cup of coffee. Then this past week Alex Coppola of the Wall Street Journal was similarly kind enough to give me a platform to talk about the Epsilon Theory perspective on markets for a forthcoming Voices column, again with a focus on the three biggest risks facing markets, again with a pretty strict format to prevent verbosity. How could I possibly communicate what I wanted to say in 400 words?

But you know what? I did. And my message was the better for it. Like David Foster Wallace, I have a tendency to over-intellectualize my work, and this was a healthy corrective. Is there an element of Short Attention Span Theatre in what Gregg and Alex do? Is there still a place in the world for a 25,000 word article in The New Yorker on the history of grain? Yes and yes. But there’s also a place for busy people to get a Classics comic book version of a long-form saga. Not a dumbing down, but rather a condensation to essential elements and an invitation to dig deeper if desired.


And yes, I realize that I’ve spent the better part of a page describing how I intend to write a pithy note. So here’s the drill. Three downside risks for markets, each summarized in a single page and linked to Epsilon Theory notes if you want to read more.

1) China has shifted from a monetary policy of choice to a monetary policy of necessity.

Just to be clear, I’m not one of those guys who sees China as on the brink of some enormous economic collapse. But I do believe that Chinese political legitimacy depends on the government delivering real economic growth … not the pleasant veneer of asset price inflation as in the US or the simple avoidance of abject deflation as in Europe.  As that real economic growth becomes more difficult to achieve (three reasons: cheaper yen and greater Japanese competition in advanced export markets, more or less permanently depressed demand in primary European export markets, disappointingly slow growth in domestic consumer-led demand), the Chinese government increasingly faces the existential threat of a hard landing. Because it’s an existential threat, it ain’t happening. The Chinese government will seek to reverse economic growth uncertainty by any means necessary, including massive shifts in decades-long trends in monetary policy.

What is the primary instrument of Chinese monetary policy? It’s not control over short rates or QE balance sheet expansion as in the West, both of which are powerful but indirect economic levers. It’s direct control over credit availability and direct control over currency exchange rates. I’m particularly concerned about the latter. Recent forced declines in the value of the yuan are not simply efforts to “increase volatility” or “punish speculators”, as the Party line and Western apologists would have you believe. No, the goal is to invigorate growth by making exports cheaper, and when that goal is a political necessity it will be pursued regardless of the tensions it creates with both Japan and the US. My concern is that this is what a modern-day trade war looks like … conflict over exchange rates, not tariffs and quotas.


If you want a deeper analysis, the core Epsilon Theory note here is “Rosebud”. Relevant shorter notes include “The Power of Why” and “Two Shifting Narratives”.

2) The Narrative of Fed Omnipotence continues to reign supreme, but now in a tightening monetary policy environment.

A narrative is a set of widely held beliefs about what everyone thinks that everyone thinks (in game theoretic terms, “common knowledge”) created by very public statements by very public people … Janet Yellen, Mario Draghi, even the WSJ’s own Jon Hilsenrath. Over the past five years an extremely powerful narrative has been created, what I call the Narrative of Fed Omnipotence – whatever happens in the market, for good or for bad, happened because of what the Fed did, not because of what happened in the “real” economy. And for the past five years that’s been great for the market (US market, anyway, EM’s not so much) as the Fed did very market-supportive things. But now the Fed is starting to tighten, which is definitely not market-supportive. If the Narrative holds true, then the market will go down even if the real economy picks up. In fact, so long as the Narrative holds true, bad real world news is good market news because it keeps the Fed in play, and vice versa.

Is a declining market a foregone conclusion as the Fed continues to tighten? No, but for the market to go up from here will require the development of an alternative narrative that supplants the dominant Narrative of Fed Omnipotence. This is what I’m watching for, and movement on this front (or lack thereof) is what I’ll try to alert you to through Epsilon Theory. The leading challenger? Same as it ever was – American exceptionalism and self-sustaining growth. The two variants on this theme? Technology-led growth (mightily damaged over past few months) and Energy-led growth (still going strong). But for now, at least, the Fed narrative still trumps all.


If you’ve read anything from Epsilon Theory, you’re familiar with my arguments around Narrative and Common Knowledge. This is the heart of a game theoretic perspective on markets, and it’s by far the most prevalent subject of Epsilon Theory notes.  I’ll highlight three: “It Was Barzini All Along”, “How Gold Lost Its Luster”, and “A World of Guarantees”. Relevant shorter notes of late include:  “The King is Dead. Long Live the King.”, “Goldilocks and the Dog That Didn’t Bark”, and “Oh Stewardess, I Speak Jive”.

3) The Hollow Market is cracked open by well-intentioned but destructive regulators.

The Hollow Market is my phrase for a market structure where humans trading to express an interest in the fractional ownership of a real world company account for less than 30% of market activity. Whether it’s “liquidity provision” or algorithm-driven arbitrage, machine-to-machine trading dominates modern markets against a backdrop of increasingly concentrated holdings of securities, and that’s a very unstable recipe. My concern with the Hollow Market is not only that it exists in such a Flash Crash-prone fashion, but that it’s terribly misunderstood. The Big Data technology that created the Hollow Market cannot be un-invented, but government regulators are apt to really screw things up as they try to do just that. As always, market infrastructure is created in the intersection of human greed, technology, and regulation. As always, technological breakthroughs upend the market structure apple cart, allowing upstart players to bypass regulatory barriers and steal rents from incumbents. As always, the incumbents muster the support of their political allies to recapture their rents, absorbing or crushing the upstarts in the process.

What’s different this time is that this brewing regulatory crusade is part and parcel of a larger regime effort to turn markets into social utilities, where private information is criminalized and broad market price inflation is effectively enshrined as a permanent government policy objective. As Clemenceau famously said about World War I, “War is too important to be left to the generals.” Political leaders today, across the globe and regardless of political stripe, are saying of the Great Recession, “Markets are too important to be left to private investors.” I have to admit, it’s an ingenious political response to maintain social order in the face of a global deleveraging cycle, even as the small-l liberal in me weeps. Bottom line: I have no idea what market structure will look like in 5 to 10 years, but my strong suspicion is that alpha will be an even rarer commodity than it is today.


The core Epsilon Theory notes on this score include: “The Adaptive Genius of Rigged Markets”, “Hollow Men, Hollow Markets, Hollow World”, “The Levelers”, and “A World of Guarantees”. See also: “When E.F. Hutton Talks”, “The Wages of Fear”, and “Uttin’ on the Itz”.

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