An Ice Bucket Dilemma


Something on the lighter side from Epsilon Theory today, as summer winds downs here in the last week of August. Most of us have seen videos galore of the ALS “ice bucket challenge,” and I thought it might be interesting to recast a classic game theory construct – The Prisoner’s Dilemma – in ice bucket terms. So I enlisted my four daughters to be prisoners and wardens with the following scenario.

If both prisoners choose a green card, I’ll donate $100 in each prisoner’s name to ALS research. If one prisoner chooses green but the other prisoner chooses red, I’ll donate $250 in the name of the red-choosing prisoner but $0 for the green-choosing prisoner, and a warden will dump an ice bucket on the head of the green-choosing prisoner. If both prisoners choose a red card, I’ll donate $50 in each prisoner’s name, and both wardens will dump an ice bucket on her prisoner.

Both prisoners know the payoffs, but they can’t see each other and can’t communicate with each other. In 2×2 matrix form (see “Through the Looking Glass” for another example), the game looks like this:


As with all PD games, joint cooperation (2 green cards) is a much better outcome for both players than joint defection (2 red cards), but the stable equilibrium as marked by the blue oval is joint defection, with half as much money donated to ALS research and a bucket of ice water on your head to boot.

The results? Well, see for yourself in the video below!


epsilon-theory-an-ice-bucket-dilemma-august-25-2014 (97KB)





One Little Old Russian Convoy



You know what I’ve noticed? Nobody panics when things go “according to plan”. Even if the plan is horrifying. If, tomorrow, I tell the press that, like, a gang banger will get shot, or a truckload of soldiers will be blown up, nobody panics, because it’s all “part of the plan” But when I say that one little old mayor will die, well then everyone loses their minds!
– The Joker, “The Dark Knight” (2008)

Dick Grayson: Gosh, Economics is sure a dull subject.
Bruce Wayne: Oh, you must be jesting, Dick. Economics dull? The glamour, the romance of commerce…Hmm. It’s the very lifeblood of our country’s society.”

– Batman: TV Series” (1967)

It’s a funny world when stocks can soar on a -6.8% Japanese GDP print but stumble when a Russian armored personnel carrier finds itself on the wrong end of a Ukrainian howitzer shell. That’s what you get, though, in the Golden Age of the Central Banker, as all events are filtered through the narrative of central bank control. Weak Japanese GDP was “part of the plan”, to quote both The Joker and Prime Minister Abe, or at least the revised plan after the new sales tax pulled economic activity forward in Q1, and besides, this weakness just means that “help from the BOJ may be on the way”, to quote the WSJ.  Direct artillery fire on a Russian APC column in Ukrainian territory, on the other hand … well, that’s not part of anyone’s plan. It’s a significant escalation in both Russian provocation and Ukrainian response, an escalation that for the first time illuminates a warpath that no amount of central bank jawboning can derail or recast in a market-positive light.

Is this the path we’re headed down? I doubt it. There’s enough plausible deniability in the construction of this “humanitarian aid convoy” (which may or may not have some serious armament underneath those green canvas truck covers), such that both Russia and Ukraine can return to the regularly scheduled entertainment of indirect warfare through the Donetsk proxies. And so long as the fighting simmers through proxies the sanctions won’t be life-threatening to either the Russian or German economies. The economic pain is annoying, for sure, but not so overwhelming as to be catastrophic or impervious to Draghi’s tender ministrations.

But three months ago I really thought Putin would call it a day with a Crimean annexation and just enough low-level insurgency in the rest of Russian-speaking Ukraine to keep the latest cohort of kleptomaniacs in Kiev on their toes. Instead, we’re seeing Russian-supported advanced surface-to-air missile capabilities and uniformed Russian “escorts” for supply convoys, and there’s nothing low-level about that.

And as recently as two weeks ago I would have sooner challenged Tony Stewart to a dirt-track race than challenge Draghi’s determination to push forward more and more market-pleasing monetary easing policies. Instead, we got last week’s ECB press conference, where just as he did in the spring of 2012 Draghi threatened to withhold monetary easing beyond the already announced TLTRO program unless Italy and France moved forward with structural economic reforms and commensurate fiscal consolidation.

It all just goes to show how futile any sort of crystal-ball reading effort is in the politically fractured world of 1914 … ummm, sorry, I meant to write 2014. My bad. But regardless of what century you’re in, when political stability breaks down, market stability is never far behind. We’re not there yet, as the Golden Age of the Central Banker provides a wonderful political tranquilizer in the West. But the East, whether it’s China or Russia, isn’t taking the same medicine, and that’s where we should be looking for sources of political instability large enough to wake the Red King from its long sleep.

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Here We Go Again


From an Epsilon Theory perspective, the scariest, most market risk-creating event of the past 48 hours had nothing to do with Iraq, nothing to do with Israel, nothing to do Russia. It was Mario Draghi’s press conference. 

Yesterday Draghi re-launched the Great Fiscal Consolidation War of 2012, a multi-level game where the ECB attempts to force spendthrift sovereigns to undertake structural reforms while ostensibly going about their business of maintaining their single mandate of price stability. It’s a neat trick if you can pull it off, as Draghi kinda sorta did with the PIIGS two summers ago, but … geez, do we really have to go through this all over again?

Multi-level games live at the intersection of politics and economics. I wrote about them earlier this year in the Epsilon Theory note “The Play’s the Thing”, and the basic idea is that public communication policy has a recursive, strategic nature. That is, while there’s an ostensible meaning and an ostensible audience for any performance, there are almost always one or more deeper levels of real meaning and real audience for any political performance. And Mario Draghi is one heck of a political performer.

The press conference delivered two ostensible messages yesterday.

First, Draghi called out Italy and France. Why is Italian GDP back in the red? Why is France threatened by deflation, the Great Satan of modern monetary policy dogma? “It’s mostly the lack of structural reforms”, something “that has nothing to do with monetary policy.”

Second, Draghi put the kibosh on monetary easing beyond what was announced months ago. Why not do more to force credit into the European economy? “If one can’t open a new business [because of structural impediments], there’s no point in giving more credit. You won’t know what to do with this.”

The linkage of the messages is the real communication here. Memo to France and Italy: you want more easy money? Then stop spending so much and pass meaningful labor and tax reform legislation. It’s a giant game of Chicken, just like in 2012, and the big question now is who will blink first, ECB/Germany or Italy/France.

What do I think is going on? Why do I think that Draghi felt compelled to pull this stunt now?

I think that the looming conflict with Russia is a big problem for the German economy, which means that Germany’s degrees of freedom to accommodate bad actors in the EU club are dramatically reduced, which means that Germany’s overwhelming macroeconomic focus – a weaker euro and fiscal consolidation in the periphery (and France) – is now Draghi’s overwhelming macroeconomic focus.

I think that the ECB’s asset quality review and stress test of major EU banks has revealed just what a bitter pill it’s going to be to assume regulatory control (see “The Red King” for more). Does anyone else find it odd that Espirito Santo, which has been under troika supervision for years, is only now revealed as a basket case, right before the ECB becomes its primary regulator? Sorry, but it seems like a kitchen-sink quarterly earnings announcement to me, where new management comes in and blames everything on the prior gang of incompetents. The last thing in the world these undercapitalized, overlevered, and stuffed-to-the-gills-with-sovereign-debt banks need is more pressure to finance their sovereigns, but that’s exactly what they will face without structural reform and fiscal consolidation.

I also think that Draghi believes he’s mastered the Common Knowledge Game, that he is confident he can always save the day if markets get too squirrelly by invoking the magic spell of the OMT or some other phantom policy. The difference between 2014 and 2012 is that Draghi believes he has established a safety net of sorts, at least to prevent a sovereign-level liquidity crisis as in 2012, with his command and control of the Narrative.

And trust me, the Narrative of Central Bank Omnipotence is alive and well. Want to read a really terrifying article? Take a look at this August 6th Op-Ed piece in the FT by Draghi’s former colleague, Lorenzo Bini Smaghi: “The ECB Must Move to Counteract Market Turbulence”. Are you kidding me? This is what we have come to … that the proper role of a central bank is to counteract “market turbulence” before it happens? I’d laugh, but then I remember that Yellen means exactly the same thing when she refers to “macroprudential policy”, and I want to cry.

Draghi is playing a variation on this theme. He’s intentionally injecting “market turbulence” in order to achieve larger political goals, but only because he is of one mind with Bini Smaghi and Yellen and the rest of the Central Banking nomenklatura – central banks can control market outcomes. Period, end of story. And so far he’s been absolutely right. Will the winning streak continue? I have no idea.

What I am certain of, however, is that this is a very dangerous game. It’s obviously a disaster if the game spirals out of Draghi’s control, if he’s unable to put the inevitable market freak-out genie back in the bottle as he was in the summer of 2012. But it’s a different kind of disaster, at least to my way of thinking, if Draghi succeeds, because then the Narrative of Central Bank Omnipotence will just be stronger than ever. If you like the notion of capital markets transformed into public utilities, then this is great news. For everyone else, not so much.

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Fear and Loathing on the Marketing Trail, 2014



I shared a dark suspicion that the life we were leading was a lost cause, that we were all actors, kidding ourselves along on a senseless journey. It was the tension between these two poles – a restless idealism on one hand and a sense of impending doom on the other – that kept me going.
– Hunter S. Thompson, “The Rum Diary”


There lives more faith in honest doubt, believe me, than in half the creeds. 

– Alfred, Lord Tennyson


Preach the Gospel at all times, and when necessary, use words. 

– St. Francis of Assisi


Faith is the bird that feels the light and sings when the dawn is still dark.

– Rabindranath Tagore, 1913 Literature Nobel Prize winner


Hold faithfulness and sincerity as first principles.
– Confucius, “The Analects”

I’ve spent the past few weeks meeting Salient clients and partners all across the country: New York, California, Illinois, Texas, Minnesota, Massachusetts, etc. With four teenage or tweenage daughters at home I don’t mind the travel, talking about Epsilon Theory topics with smart, engaged people takes me back to what I loved about academia, and I find tremendous value in listening to what investment professionals have to say about markets today. Of particular note to me is how investment professionals are experiencing markets. What does it mean to be a professional investor or investment advisor in the Golden Age of the Central Banker? Two observations surprised me, and I believe they’re connected.

First, when I had these conversations six months ago I would get a fair amount of resistance to the notion that narratives dominate markets and that we’re in an Emperor’s New Clothes world. Today, everyone believes that market price levels are largely driven by monetary policy and that we are all being played by politicians and central bankers using their words for effect rather than direct communication. No one requires convincing that market price levels are unsupported by real world economic activity. Everyone believes that this will all end badly, and the only real question is when.

Second, trading volumes are abysmal. I know it’s summer, but this is more than just seasonality. Here’s a chart using data from my friends at Barclays showing the 10-year trend in US cash equity volumes.


 Source: Barclays Capital (July 2014)

I love charts that require absolutely no explanation. Since the outbreak of the Great Recession, with a few exceptional months marked by panic selling, trading activity in US equity markets has done nothing but go down. And when you take into account the growth of algorithmic trading and other machine-to-machine activity, which now accounts for as much as 70% of daily trading volume, the decline in actual human beings buying or selling stock in order to acquire a fractional ownership share in an actual real-world company is much more dramatic than this chart shows.

But wait, there’s more. Here’s a 50-year chart (!) from my friends at Deutsche Bank showing the steady growth rate of trading volume in the S&P 500. With an r-squared trend line fit of 96%, this growth rate of 9.3% is an incredibly strong and stable pattern. Until late 2008 or early 2009, that is, at which point the pattern breaks like a thin, dead twig.


Source: Deutsche Bank (July 2014)

How unusual is this 5-year break in the 50-year pattern of equity trading volume growth? Is this perhaps a transitory or random blip? Or maybe just a more pronounced version of a cyclical trough in trading activity.  Ummm … no.

Take a look at the chart below showing the degree of deviation from the trend line. Back in the 1973-74 recession trading volumes dropped slightly more than two standard deviations from the trend line. Today we are more than four standard deviations below the trend line, and the separation is steadily getting worse. The 50-year boom in US equity trading activity has not just stopped. It has reversed. 


   Source: Deutsche Bank (July 2014)

Is this just an equity story? Nope. Here’s a 20-year growth trend and deviation chart for US bonds.


Source: Deutsche Bank (July 2014)


Source: Deutsche Bank (July 2014)

This summer’s anemic trading volumes in both stocks and bonds are neither seasonal nor temporary. As you might expect, the Powers That Be at the bulge-bracket market makers are pretty freaked out and are pushing hard to generate some activity (not that we’d want any account churning, mind you). But all of these efforts announced from on high … all of the reorg’s and all of the revised compensation programs and all of the new investment platforms … it’s all just pushing on a string if there’s been a fundamental change in the behavior of advisors and investors. Unfortunately, that’s exactly what I’ve been seeing and hearing over the past year, and particularly the past few weeks. It’s a buyers’ strike, a massive “meh” about public capital markets, and it’s growing.

These two observations about the state of mind of advisors and investors today – a prevailing belief that market outcomes are driven by monetary policy (what I call the Narrative of Central Bank Omnipotence) and a lack of appetite to do much buying of anything – are two sides of the same coin.

The overwhelming perception I had of the advisors and investors I met over the past few weeks is that they feel as if they’re going along with some big charade. There’s a profound disillusionment with political and economic leaders … not that these leaders are necessarily incompetent, but that they are completely insincere. The advisors and investors I met – no matter how successful they had been over the past five years – were weary of the game and wary of being told what to think. They’re not suckers. They know they’re being played by Authority, whether it’s a Famous Investor talking up his book on CNBC or a Central Banker jawboning the entire market for the umpteenth time or a Chief Economist pushing his latest prediction from some macroeconomic crystal ball, and they’re playing the game right back, usually pretty well. But OMG are they sick and tired of the lack of authenticity in the investment world today!

There’s still plenty of “confidence” in markets, per se, because these advisors and investors are justifiably confident in their knowledge of how the game is played. No one is running for the hills or hiding under a rock. On the contrary, everyone is pretty much fully invested because they feel like they have to be. But there’s no faith in markets, which is a totally different thing than knowledge or intellectual confidence. No one is excited or bulled-up about anything in a visceral or emotional way, so there’s neither a powerful push nor pull to buy anything. I saw lots of faces like this guy in the classic WWI propaganda poster, sort of a wistful far-away gaze, wishing that they had enough faith in something – anything! – that would trigger their animal spirits and get them up out of their comfortable chairs and back into the trenches of actively buying and selling to make a real difference in their portfolios. But alas, no.


I don’t think you have to be an ace salesman or marketing guru to appreciate the crucial difference between knowledge and faith when it comes to driving action, the actual buying behavior that creates markets. My favorite quote on the subject comes from a perhaps unlikely source, St. Francis of Assisi, when he wrote, “Preach the Gospel at all times, and when necessary, use words.” Brilliant! Faith, regardless of its venue or form, is only faintly reflected in words and speeches and Fed employment models. But it shines like the sun from what we DO. Without a faith or belief system to drive us, we human animals tend to DO very little, or at least very little with passion, energy, and growth. Faith, to quote Indian Nobel Prize winner Rabindranath Tagore, is the little bird that feels the dawn of a new day well before the first light of the sun. Where is that little bird today? It’s sure not flitting around in the financial advisor offices that I visited recently.

The animal spirits of greed and fear have been crushed, not so much by zero interest rates or any other specific policy, but more by the non-stop game-playing of our political and economic leaders as they seek to maintain a political status quo within a deleveraging and fragmented world of overwhelming public debt. In macroeconomics we talk all the time about “the crowding-out effect”, where public sector borrowing sops up available private capital and diverts it from more productive uses in the overall economy. What we are experiencing today is a Narrative crowding-out effect, where public stories and words in the service of political goals dominate market expectations and prevent private narratives in the service of greed and fear from taking root in the hearts of investors. When every real-world event is interpreted for us by Voices of Authority within seconds, when Bernanke’s farewell speech is all about social control through communication policy … well, that’s a world designed to tell you what to think, which among thinking people inevitably becomes a world where you are hesitant to act. That’s a world where public insincerity reigns and private authenticity is painted as either quaint or dangerous. That’s a world of “macroprudential policy”, to use our current Fed Chair’s favorite phrase, and you better believe there’s no room at that inn for good old-fashioned greed and fear.

Are there exceptions to this general rule, small pockets of faith in real-world economic activity that retain their power to compel action? Sure. The “US Energy Independence” story, for example, remains strong and motivating among its devotees (of which I am one). In general today, the farther away an investment narrative is from public market game-playing and the closer it is to private market opportunities, the more it inspires belief and action. Everyone I know still believes with their heart of hearts in private market opportunities. It’s the public markets where faith has been lost, and that’s why the Golden Age of the Central Banker poses existential risks for firms and business strategies based on trading activity within those public markets.

For all of us that rely directly or indirectly on healthy, growing public markets for our livelihood, it’s high time to recognize that these markets are neither healthy nor growing. They are hollow and declining. A 50-year bull market in the market itself ended with policy responses to the Great Recession, and we are now in the 5th year of a bear market in the market itself, a bear market that shows no sign of abating but rather of accelerating. I’m calling this an existential risk, because it is, but it’s also a phenomenal opportunity for any investment firm that can make an emotional, animal-spirited connection with public market investors. The capacity for faith is there. Investors will absolutely come back to public markets if they’re given a rationale that works not only for the head but also for the gut, if they’re given a philosophy that is not only smart but also something they can believe in.

What is that investment philosophy that can inspire as well as inform? I don’t know where it ends, but I know where it starts. It starts with what Tennyson called honest doubt. It starts with what Confucius described as his first principles – faithfulness and sincerity. There’s absolutely nothing sincere about the public sphere today, in its politics or its economics, and as a result we have lost faith in our public institutions, including public markets. It’s not the first time in the history of the Western world this has happened … the last time was in the 1930’s … and over time, perhaps a very long period of time, a modicum of faith will return. This, too, shall pass. But in the meantime, investment firms immersed in the public markets had better start adapting to these new political realities.

How? By embracing honest doubt and rejecting the didactic, crystal ball-driven approach to asset allocation and broad portfolio construction that is so rampant in our industry. By embracing sincerity and rejecting the hard sell of “alpha”, as if market-beating returns in this politically-driven investment environment were just a matter of listening to this analyst’s opinion rather than that analyst’s opinion. Adaptation to difficult times is never easy, and the implications of embracing honest doubt and sincerity within an investment philosophy will start to seem rather uncomfortable and weird to most investment firms pretty quickly. But as Hunter S. Thompson said in his most famous line, when the going gets weird, the weird turn pro.

Without adaptation and on its current trajectory of trading volume declines, vast swaths of the professional investment community will have a hard time surviving another 5 years just like the last 5 years. It’s time for reform, not in the sense of adding regulations or government oversight, but in the sense of re-forming our investment beliefs based on first principles of honest doubt and sincerity and, yes, greed and fear. Only then will our actions speak more loudly than the politicians’ and central bankers’ words. And won’t that be a sight?

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Watching the Narratives


You think you’re alone until you realize you’re in it.

Now fear is here to stay. Love is here for a visit.

– Elvis Costello, “Watching the Detectives”

A quick email to follow up on yesterday’s market debacle. The question, of course, is whether this was simply a blip – yet another one-day BTFD opportunity – or the start of something bigger and worse. The answer, I think, depends on how the media Narrative surrounding yesterday takes shape over the next several days. That’s what I’m watching closely, and I think you should, too.

Right now the media Narrative about yesterday is in complete disarray, because there was no obvious “reason” for the sell-off. Or rather, there were too many possible reasons, from bad earnings reports to the Argentina default to worries about a strong jobs number to Espirito Santo cracking up to new Russian sanctions to just a generic “we were overdue for this”. From a game theory perspective, this sort of seemingly out-of-the-blue sharp move had very little to do with anything that happened yesterday, but is a natural by-product of the Common Knowledge Game in action. The game was put into motion by Yellen’s recent version of Greenspan’s “irrational exuberance” words, together with continued Fed-speak about tightening sooner and faster rather than slower and later. As described in the Epsilon Theory note “When Does the Story Break”, the Common Knowledge Game plays out in investors’ heads, not in their behaviors, until a predictable tipping point is reached and a large group of investors simultaneously heads for the exit. Yesterday’s sell-off really began a couple of weeks ago. We’re just seeing the market manifestation of it now.

Were yesterday’s events important? Sure, particularly the Espirito Santo news, which puts a big crimp in the market-positive story that the ECB will take over the Fed’s role as the global punchbowl provider (see “The Red King” for more). These events were each catalysts, providing a wrapper of sorts for the decisions to sell. But they were neither necessary nor sufficient for the market sell-off. They just happened to be the subway train that stopped in front of us when we walked into the station. If it hadn’t been this train, another would have been right behind it.

So what now? Everything hinges on how the “Missionaries” like Yellen and Draghi and their mouthpieces respond. Like clockwork, Jon Hilsenrath is already out with his first remain-calm-all-is-well piece, and I expect several more before markets open on Monday. But we haven’t heard yet from the really big voices, and we have yet to see how the media microphones either amplify or mute the second-tier Missionaries like Hilsenrath. I’ll be watching closely and posting occasional updates on Twitter @EpsilonTheory, but in general you want to see more articles like Hilsenrath wrote today (jobs data not strong enough to make Fed accelerate tightening) and fewer about failed loans and cracks in the monetary policy dam that the Fed and ECB have built. On this latter point, an Argentine default has extremely little impact on the Narrative of Central Bank Omnipotence. European bank defaults and forced capital raises, on the other hand … well, that’s the sort of thing that can make the Red King wake up. And that will not be a pretty sight.

epsilon-theory-watching-the-narratives-august-1-2014.pdf (87 KB)