7 Quick Points on Europe

#1) Here are the most relevant recent notes for an Epsilon Theory perspective on the underlying political and market risks in Europe: “The Red King” (July 14, 2014) and “Now There’s Something You Don’t See Every Day, Chauncey” (Dec. 16, 2014).

#2) Markets reacted positively to last Thursday’s announcement because Draghi doubled the amount of QE that he leaked to the press on Wednesday. Financial media pegged QE at 600 billion euros on Wednesday and 1.2 trillion euros on Thursday. Once again, Draghi played the Narrative game like a maestro.

#3) This is NOT open-ended QE. Sorry, but the Narrative game doesn’t work like this. If you mention a target date (September 2016), then that becomes the Schelling focal point, no matter how much you try to walk that back by saying it’s open-ended.

#4) Risk-sharing, or the lack thereof, matters. Draghi won approval of a doubled QE target by minimizing the mutualization of QE risk among EU countries. 80% of the bond-buying will be done by national central banks, and Germany will only buy German government bonds, France will only buy French bonds, etc. That’s important for two reasons. First, if Italy or Spain goes off the rails, then the Bundesbank’s balance sheet isn’t immediately crippled. Second, this is why German bonds are rallying just as hard (harder, really) than periphery bonds. It’s also why US bonds are rallying so hard, because you can’t maintain a huge spread between the only risk-free rates left in the world.

#5) Market complacency on Greece is a mistake. Not because Greece itself is a huge systemic threat, but because the same political dynamics in Greece are coming soon to Italy. Greece is Bear Stearns. Italy is Lehman.

#6) In tail-risk trades as in comedy, timing is everything. Even if you think that it’s an attractively asymmetric risk/reward profile to bet on a Euro crisis (and I do), this is a heavily negative carry trade. If you don’t know what the phrase “negative carry trade” means, then please don’t make this bet. If you do know what it means, then you know that you either have to play a lot of hands to make the odds work out for you (and the nature of systemic crises makes that impossible) or you have to be spot-on with your timing.

#7) In a fundamentals-driven market you need to look at fund flows; in a Narrative-driven market you need to look at Narrative flows. With Draghi’s announcement last Thursday, there is no longer a marginal provider of market-supportive monetary policy Narrative. Or to put this in game theoretic terms, the 2nd derivative of the Narrative of Central Bank Omnipotence just flipped negative. We’ve shifted from an accelerating Narrative flow to a decelerating Narrative flow, and that inflection point in profoundly important in game-playing. The long grey slide of the Entropic Ending begins.

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Ghost in the Machine, Part 1

  The way out is through the door. Why is it that no one will use this method?
― Confucius (551 – 479 BC)

Tanzan and Ekido were once traveling together down a muddy road. A heavy rain was still falling. Coming around a bend, they met a lovely girl in a silk kimono and sash, unable to cross the intersection.
“Come on, girl,” said Tanzan at once. Lifting her in his arms, he carried her over the mud.
Ekido did not speak again until that night when they reached a lodging temple. Then he could no longer restrain himself. “We monks don’t go near females,” he told Tanzan, “especially not young and lovely ones. It is dangerous. Why did you do that?”
“I left the girl there,” said Tanzan. “Are you still carrying her?”
― Nyogen Senzaki, “Zen Flesh, Zen Bones: A Collection of Zen and Pre-Zen Writings” (1957)

In 1995, David Justice had a superior batting average to Derek Jeter (.253 to .250)
In 1996, David Justice had a superior batting average to Derek Jeter (.321 to .314)
In 1997, David Justice had a superior batting average to Derek Jeter (.329 to .291)
Yet from 1995 – 1997, Derek Jeter had a superior batting average to David Justice (.300 to .298)
― example of Simpson’s Paradox, aka The Yule-Simpson Effect (1951)

A student says, “Master, please hand me the knife,” and he hands the student the knife, blade first. “Please give me the other end,” the student says. And the master replies, “What would you do with the other end?”
― Alan W. Watts, “What Is Zen?” (2000)

Such in outline is the official theory. I shall often speak of it, with deliberate abusiveness, as “the dogma of the Ghost in the Machine.” I hope to prove that it is entirely false, and false not in detail but in principle. It is not merely an assemblage of particular mistakes. It is one big mistake and a mistake of a special kind. It is, namely, a category mistake.
― Gilbert Ryle (1900 – 1976) 

The trouble with Oakland is that when you get there, there isn’t any there there.
― Gertrude Stein (1874 – 1946) 

Dr. Malcolm:     Yeah, yeah, but your scientists were so preoccupied with whether or not they could that they didn’t stop to think if they should.
― “Jurassic Park” (1993) 

It’s a big enough umbrella
But it’s always me that ends up getting wet.
― The Police, “Every Little Thing She Does is Magic” (1981)  

Everyone who lost money on the SNB’s decision to reverse course on their three and a half year policy to cap the exchange rate between the CHF and the Euro made a category error. And by everyone I mean everyone from Mrs. Watanabe trading forex from her living room in Tokyo to a CTA portfolio manager sitting in front of 6 Bloomberg monitors to a financial advisor answering a call from an angry client. It will take me a bit of verbiage to explain what I mean by a category error and why it’s such a powerful concept in logic and portfolio construction. But I think you’ll find it useful, not just for understanding what happened, but also (and more importantly) to protect yourself from it happening again. Because this won’t be the last time the markets will be buffeted by a forex storm here in the Golden Age of the Central Banker.

A year and a half ago, when I was just starting Epsilon Theory, I wrote a note called “The Tao of Portfolio Management.” It’s one of my less-downloaded notes, I think largely because its subject matter – problems of misunderstood logic and causality in portfolio construction – doesn’t exactly have the sexiness of a rant against Central Bank Narrative dominance, but it’s one of my personal favorites. That note was all about the ecological fallacy – a pervasive (but wrong-headed) human tendency to infer qualities about the individual from qualities of the group, and vice versa. Today I’ve got the chance to write once again about the logic of portfolio construction AND work in some of my favorite Zen quotes AND manage something of a Central Bank screed … a banner day!

I’ve titled this note “The Ghost in the Machine” because it starts with another pervasive (but wrong-headed) human tendency – the creation of a false dualism between mind and body. I know, I know … that sounds both really daunting and really boring, but bear with me. What I’m talking about is maybe the most important question of modern philosophy – is there a separate thing called “mind” or “consciousness” that humans possess, or is all of that just the artefact of a critical mass of neurons firing within our magnificent, but entirely physical, brains? I’m definitely in the “everything is explained by neurobiology” camp, which I’d say is probably the more widely accepted view (certainly the louder view) in academic philosophy today, but for most of the 19th and 20th centuries the dualist or Cartesian view was clearly dominant, and it was responsible for a vast edifice of thought, a beautiful cathedral of philosophical constructs that was … ultimately really disappointing and empty. It wasn’t until philosophers like Gilbert Ryle and Van Quine started questioning what Ryle called “the ghost in the machine” – this totally non-empirical but totally accepted belief that humans possessed some ghostly quality of mind that couldn’t be measured or observed but was responsible for driving the human machine – that the entire field of philosophy could be reconfigured and take a quantum leap forward by incorporating the insights of evolutionary biology, neurobiology, and linguistics.

Unfortunately, most economists and investors still believe in ghosts, and we are a long way from taking that same quantum leap. There is an edifice of mind that dominates modern economic practice… a beautiful cathedral where everything can be symbolized, where everything can be securitized, and where everything can be traded. We have come to treat these constructed symbols as the driver of the economic machine rather than as an incomplete reflection of the real world things and real world activities and real world humans that actually comprise the economy. We treat our investment symbols and thoughts as a reified end in themselves, and ultimately this beautiful edifice of symbols becomes a maze that traps us as investors, just as mid-20th century philosophers found themselves trapped within their gorgeous constructs of mind. We are like Ekido in the Zen koan of the muddy road, unable to stop carrying the pretty girl in our thoughts and trapped by that mental structure, long after the far more sensible monk Tanzan has carried the girl safely over the real world mud without consequence, symbolic or otherwise.

The answer to our overwrought edifice of mind is not complex. As Confucius wrote in The Analects, the door is right there in front of us. Exiting the maze and reducing uncompensated risk in our portfolios does not require an advanced degree in symbolic logic or some pretzel-like mathematical process. It requires only a ferocious commitment to call things by their proper names. That’s often not an easy task, of course, as the Missionaries of the Common Knowledge Game – politicians, central bankers, famous investors, famous economists, and famous journalists – are dead-set on giving things false names, knowing full well that we are hard-wired as social animals to respond in ant-like fashion to these communication pheromones. We are both evolved and trained to think in terms of symbols that often serve the purposes of others more than ourselves, to think of the handle rather than the blade when we ask for a knife. The meaning of a knife is the blade. The handle is not “the other end” of a knife; it is a separate thing with its own name and usefulness. The human animal conflates separate things constantly … maybe not a big deal in the kitchen, but a huge deal in our portfolios. Replace the word “knife” with “diversification” and you’ll get a sense of where I’m going with this.

Here’s what I mean by calling things by their proper names. The stock ticker “AAPL” or the currency ticker “CHF” are obviously symbols. Less obviously but more importantly, so are the shares of Apple stock and the quantities of Swiss francs that AAPL and CHF represent. Stocks and bonds and commodity futures and currencies are symbols, not real things at all, and we should never forget that. The most common category error that investors make (and “category error” is just a $10 phrase for calling something by the wrong name) is confusing the symbol for what it represents, and as a result we forget the meaning of the real world thing that’s been symbolized.

A share of stock in, say, Apple is a symbol. Of what? A limited liability fractional ownership position in the economic interests of Apple, particularly its free cash flows.

A futures contract in, say, copper is a symbol. Of what? A commitment to receive or deliver some amount of real-world copper at some price at some point in the future.

A bond issued by, say, Argentina is a symbol. Of what? A commitment by the Argentine government to repay some borrowed money over an agreed-upon period of time, plus interest.

A currency issued by, say, Switzerland is a symbol. Of what? Well, that’s an interesting question. There’s no real world commitment or ownership that a currency symbolizes, at least not in the same way that stocks, bonds, and commodity contracts symbolize an economic commitment or ownership stake. A currency symbolizes government permission. It is a license. It is an exclusive license (which makes it a requirement!) to use that currency as a medium for facilitating economic transactions within the borders of the issuing government, with terms that the government can impose or revoke at will for any reason at all. That’s it. There’s no economic claim or right inherent in a piece of money. As Gertrude Stein famously said of Oakland, there’s no there there.

Why is this examination of underlying real world meaning so important? It’s important because there is no positive long-term expected return from trading one country’s economic license for another country’s economic license. There is a positive long-term expected return from trading money for stock. There is a positive long-term expected return from trading money for bonds. There is a positive long-term expected return from trading money for commodities and other real assets. But there is no positive long-term expected return from trading money for money.

Unfortunately, we’ve been trained and encouraged – often under the linguistic rubric of “science” – to think of ANY new trading vehicle or security, particularly one that taps into as huge a market as foreign exchange, as a good thing for our portfolios. We are deluged with the usual narratives that alternatively seek to tempt us and embarrass us into participation. On an individual level we are told stories of savvy investors who look and act like we want to look and act, taking bold advantage of the technological wizardry (look! it’s a heat map! that changes color while I’m watching it!) and insanely great trade financing now at our fingertips in this, the best of all possible worlds. On an institutional level we are told stories of liquidity and non-correlation (what? you don’t understand what an efficient portfolio frontier is? and you call yourself a professional?), both good and necessary things, to be sure. But not sufficient things, at least not to cast the powerful magic that is diversification.

There are only a few sure things in investing. First, taxes and fees are bad. Second, compound growth is a beautiful thing. Third, portfolio diversification works. At Salient we spend a lot of time thinking about what makes diversification work more or less well for different types of investors, and if you’re interested in questions like “what’s the difference between de-risking and diversification?” I heartily recommend our latest white paper (“The Free Lunch Effect”) to you. One thing we don’t do at Salient is include currency trading within our systematic asset allocation or trend-following strategies. Why not? Because Rule #1 for tapping into the power of portfolio diversification is that you don’t include things that lack a long-term positive expected return. Just because we can trade currency pairs easily and efficiently doesn’t mean that we should trade currency pairs easily and efficiently, any more than cloning dinosaurs because they could was a good idea for the Jurassic Park guys. The point of adding things to your portfolio for diversification should be to create a more effective umbrella, not just a bigger umbrella. I like a big umbrella just as much as the next guy, but not if I’m going to get wet every time a forex storm whips up.

So if not for diversification, why do smart people engage in currency trading? There’s a good answer and a not-as-good answer to that question.

The good answer is that you have an alpha-driven (i.e. private information-driven) divergent view on the terms of the government license embedded within any modern currency. This is why Stanley Druckenmiller is an investing god, and it’s why anyone who put money with him before, during, and after he and George Soros “broke the Bank of England” in 1992 has been rewarded many times over.

The not-as-good answer is that you have identified a predictive pattern in the symbols themselves. I say that it’s not as good of an answer, but I’m not denying that there is meaning in the pattern of market symbols. On the contrary, I think there is real information regarding internal market behaviors to be found in the inductive study of symbolic patterns. This information is alpha, maybe the only consistent source of alpha left in the world today, and acting on these patterns is what good traders DO. But because it’s inductively derived, anyone else can find your special pattern, too. Or if they can’t, it’s because you’ve carved out a nice little parasitic niche for yourself that’s unlikely to scale well. More corrosively, the natural human tendency is to ascribe meaning to these patterns beyond the internal workings of the market, something that makes no more sense than to say that goose entrails have meaning beyond the internal workings of the goose. The meaning of the Swiss franc didn’t change just because you had a consistent pattern of market behavior around the EURCHF cross. Deviation in the expected value of the Swiss franc in Euro terms did not become normally distributed just because you can apply statistical methodology to the historical exchange rate data. I get so annoyed when I read things like “this wasn’t just the greatest shock in the history of forex, it was the greatest shock in the history of traded securities! a 30 standard deviation event!” Please. Stop it. Just because you can impose a normal distribution on the EURCHF cross doesn’t mean that you should. And if you’re making investment decisions because you think that this normal distribution and the internal market stability it implies is somehow “real” or has somehow changed the fundamental nature of what a currency IS … well, eventually that category error will wipe you out. Sorry, but it will.

I don’t mean to be snide about any of this (although sometimes I can’t help myself). The truth is that an aggregation of highly probabilistic entities will always surprise you, whether you’re building a baseball team or an investment portfolio. Portfolio construction – the aggregation of symbols and symbols of symbols, all of which are ultimately based on massive amounts of real world activities that may have vastly different meanings and underlying probabilistic natures – is a really difficult task under the best of circumstances for a social animal that evolved on the African savanna for an entirely different set of challenges. And these are not the best of circumstances. No, the rules always change as the Golden Age of the Central Banker begins to fade. The SNB decision was a wake-up call, whether or not you were directly impacted, to re-examine portfolios and investment behavior for category errors. We all have them. It’s only human. The question, as always, is whether we’re prepared to do anything about it.

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Catch – 22

epsilon-theory-catch-22-january-12-2015-catch-22

Four times during the first six days they were assembled and briefed and then sent back. Once, they took off and were flying in formation when the control tower summoned them down. The more it rained, the worse they suffered. The worse they suffered, the more they prayed that it would continue raining. All through the night, men looked at the sky and were saddened by the stars. All through the day, they looked at the bomb line on the big, wobbling easel map of Italy that blew over in the wind and was dragged in under the awning of the intelligence tent every time the rain began. The bomb line was a scarlet band of narrow satin ribbon that delineated the forward most position of the Allied ground forces in every sector of the Italian mainland.

For hours they stared relentlessly at the scarlet ribbon on the map and hated it because it would not move up high enough to encompass the city.

When night fell, they congregated in the darkness with flashlights, continuing their macabre vigil at the bomb line in brooding entreaty as though hoping to move the ribbon up by the collective weight of their sullen prayers. “I really can’t believe it,” Clevinger exclaimed to Yossarian in a voice rising and falling in protest and wonder. “It’s a complete reversion to primitive superstition. They’re confusing cause and effect. It makes as much sense as knocking on wood or crossing your fingers. They really believe that we wouldn’t have to fly that mission tomorrow if someone would only tiptoe up to the map in the middle of the night and move the bomb line over Bologna. Can you imagine? You and I must be the only rational ones left.”

In the middle of the night Yossarian knocked on wood, crossed his fingers, and tiptoed out of his tent to move the bomb line up over Bologna.
Joseph Heller, “Catch – 22” (1961)

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A visitor to Niels Bohr’s country cottage, noticing a horseshoe hanging on the wall, teased the eminent scientist about this ancient superstition. “Can it be true that you, of all people, believe it will bring you luck?”

“Of course not,” replied Bohr, “but I understand it brings you luck whether you believe it or not.” 

― Niels Bohr (1885 – 1962)

Here’s an easy way to figure out if you’re in a cult: If you’re wondering whether you’re in a cult, the answer is yes.
– Stephen Colbert, “I am America (And So Can You!)” (2007)

I won’t insult your intelligence by suggesting that you really believe what you just said.
– William F. Buckley Jr. (1925 – 2008)

A new type of superstition has got hold of people’s minds, the worship of the state.
– Ludwig von Mises (1881 – 1973)

The cult is not merely a system of signs by which the faith is outwardly expressed; it is the sum total of means by which that faith is created and recreated periodically. Whether the cult consists of physical operations or mental ones, it is always the cult that is efficacious.
– Emile Durkheim, “The Elementary Forms of Religious Life” (1912)

At its best our age is an age of searchers and discoverers, and at its worst, an age that has domesticated despair and learned to live with it happily.
– Flannery O’Connor (1925 – 1964)

Man is certainly stark mad; he cannot make a worm, and yet he will be making gods by dozens.
– Michel de Montaigne (1533 – 1592)

Since man cannot live without miracles, he will provide himself with miracles of his own making. He will believe in witchcraft and sorcery, even though he may otherwise be a heretic, an atheist, and a rebel.
– Fyodor Dostoyevsky, “The Brothers Karamazov” (1880)

One Ring to rule them all; one Ring to find them.
One Ring to bring them all and in the darkness bind them.
– J.R.R. Tolkien, “The Lord of the Rings” (1954)

Nothing’s changed.
I still love you, oh, I still love you.
Only slightly, only slightly less
Than I used to.
– The Smiths, “Stop Me If You’ve Heard This One Before” (1987)

So much of education, I think, relies on reading the right book at the right time. My first attempt at Catch-22 was in high school, and I was way too young to get much out of it. But fortunately I picked it up again in my late 20’s, after a few experiences with The World As It is, and it’s stuck with me ever since. The power of the novel is first in the recognition of how often we are stymied by Catch-22’s – problems that can’t be solved because the answer violates a condition of the problem. The Army will grant your release request if you’re insane, but to ask for your release proves that you’re not insane. If X and Y, then Z. But X implies not-Y. That’s a Catch-22.

Here’s the Fed’s Catch-22. If the Fed can use extraordinary monetary policy measures to force market risk-taking (the avowed intention of both Zero Interest Rate Policy and Large Scale Asset Purchases) AND the real economy engages in productive risk-taking (small business loan demand, wage increases, business investment for growth, etc.), THEN we have a self-sustaining and robust economic recovery underway. But the Fed’s extraordinary efforts to force market risk-taking and inflate financial assets discourage productive risk-taking in the real economy, both because the Fed’s easy money is used by corporations for non-productive uses (stock buy-backs, anyone?) and because no one is willing to invest ahead of global growth when no one believes that the leading indicator of that growth – the stock market – means what it used to mean. 

If X and Y, then Z. But X denies Y. Catch-22.

There’s a Catch-22 for pretty much everyone in the Golden Age of the Central Banker. Are you a Keynesian? Your Y to go along with the Central Bank X is expansionary fiscal policy and deficit spending. Good luck getting that through your polarized Congress or Parliament or whatever if your Central Bank is carrying the anti-deflation water and providing enough accommodation to keep your economy from tanking. Are you a structural reformer? Your Y to go along with the Central Bank X is elimination of bureaucratic red tape and a shrinking of the public sector. Again, good luck with that as extraordinary monetary policy prevents the economic trauma that might give you a chance of passing those reforms through your legislative process.

Here’s the thing. A Catch-22 world is a frustrating, absurd world, a world where we domesticate despair and learn to live with it happily. It’s also a very stable world. And that’s the real message of Heller’s book, as Yossarian gradually recognizes what Catch-22 really IS. There is no Catch-22. It doesn’t exist, at least not in the sense of the bureaucratic regulation that it purports to be. But because everyone believes that it exists, then an entire world of self-regulated pseudo-religious behavior exists around Catch-22. Sound familiar?

We’ve entered a new phase in the Golden Age of the Central Banker – the cult phase, to use the anthropological lingo. We pray for extraordinary monetary policy accommodation as a sign of our Central Bankers’ love, not because we think the policy will do much of anything to solve our real-world economic problems, but because their favor gives us confidence to stay in the market. I mean … does anyone really think that the problem with the Italian economy is that interest rates aren’t low enough? Gosh, if only ECB intervention could get the Italian 10-yr bond down to 1.75% from the current 1.85%, why then we’d be off to the races! Really? But God forbid that Mario Draghi doesn’t (finally) put his money where his mouth is and announce a trillion euro sovereign debt purchase plan. That would be a disaster, says Mr. Market. Why? Not because the absence of a debt purchase plan would be terrible for the real economy. That’s not a big deal one way or another. It would be a disaster because it would mean that the Central Bank gods are no longer responding to our prayers. The faith-based system that underpins current financial asset price levels would take a body blow. And that would indeed be a disaster.

Monetary policy has become a pure signifier – a totem. It’s useful only in so far as it indicates that the entire edifice of Central Bank faith, both its mental and physical constructs, remains “efficacious”, to use Emile Durkheim’s path-breaking sociological analysis of a cult. All of us are Yossarian today, far too rational to think that the totem of a red line on a map actually makes a difference in whether we have to fly a dangerous mission. And yet here we are sneaking out at night to move that line on the map. All of us are Niels Bohr today, way too smart to believe that the totem of a horseshoe actually bring us good luck. And yet here we are keeping that horseshoe up on our wall, because … well … you know.

The notion of saying our little market prayers and bowing to our little market talismans is nothing new. “Hey, is that a reverse pennant pattern I see in this stock chart?” “You know, the third year of a Presidential Administration is really good for stocks.” “I thought the CFO’s body language at the investor conference was very encouraging.” “Well, with the stock trading at less than 10 times cash flow I’m getting paid to wait.” Please. I recognize aspects of myself in all four of these cult statements, and if you’re being honest with yourself I bet you do, too. No, what’s new today is that all of our little faiths have now converged on the Narrative of Central Bank Omnipotence. It’s the One Ring that binds us all. 

epsilon-theory-catch-22-january-12-2015-eye

I loved this headline article in last Wednesday’s Wall Street Journal – “Eurozone Consumer Prices Fall for First Time in Five Years” – a typically breathless piece trumpeting the “specter of deflation” racing across Europe as … oh-my-god … December consumer prices were 0.2% lower than they were last December. Buried at the end of paragraph six, though, was this jewel: “Excluding food, energy, and other volatile items, core inflation rose to 0.8%, up a notch from November.” Say what? You mean that if you measure inflation as the US measures inflation, then European consumer prices aren’t going down at all, but are increasing at an accelerating pace? You mean that the dreadful “specter of deflation” that is “cementing” expectations of massive ECB action is entirely caused by the decline in oil prices, something that from the consumer’s perspective acts like an inflationary tax cut? Ummm … yep. That’s exactly what I mean. The entire article is an exercise in Narrative creation, facts be damned. The entire article is a wail from a minaret, a paean to the ECB gods, a calling of the faithful to prayer. An entirely successful calling, I might add, as both European and US markets turned after the article appeared, followed by Thursday’s huge move up in both markets.

When I say that a Catch-22 world is a stable world, or that the cult phase of a human society is a stable phase, here’s what I mean: change can happen, but it will not happen from within. For everyone out there waiting for some Minsky Moment, where a debt bubble of some sort ultimately pops from some unexpected internal cause like a massive corporate default, leading to systemic fear and pain in capital markets … I think you’re going to be waiting for a loooong time. Are there debt bubbles to be popped? Absolutely. The energy sector, particularly its high yield debt, is Exhibit #1, and I think this could be a monster trade. But is this something that can take down the market? I don’t see it. There is such an unwavering faith in Central Bank control over market outcomes, such a universal assumption of god-like omnipotence within this realm, that any internal market shock is going to be willed away.

So is that it? Is this a brave new world of BTFD market stability? Should we double down on our whack-a-mole volatility strategies? For internal market risks like leverage and debt bubble scares … yes, I think so. But while the internal market risk factors that I monitor are quite benign, mostly green lights with a little yellow/caution peeking through, the external market risk factors that I monitor are all screaming red. These are Epsilon Theory risk factors – political shocks, trade/forex shocks, supply shocks, etc. – and they’ve got my risk antennae quivering like crazy. I’ve been doing this for a long time, and I can’t remember a time when there was such a gulf between the environmental or exogenous risks to the market and the internal or behavioral dynamics of the market. The market today is Wile E. Coyote wearing his latest purchase from the Acme Company – a miraculous bat-wing costume that prevents the usual plunge into the canyon below by sheer dint of will. There’s absolutely nothing internal to Coyote or his bat suit that prevents him from flying around happily forever. It’s only that rock wall that’s about to come into the frame that will change Coyote’s world.

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My last three big Epsilon Theory notes – “The Unbearable Over-Determination of Oil”, “Now There’s Something You Don’t See Every Day, Chauncey”, and “The Clash of Civilizations” – have delved into what I think are the most pressing of these environmental or exogenous risks to the market: the “supply shock” of collapsing oil prices, a realigning Greek election, and the realpolitik dynamics of the West vs. Islam and the West vs. Russia. I gotta say, it’s been weird to write about these topics a few weeks before ALL of them come to pass. Call me Cassandra. I stand by everything I wrote in those notes, so no need to repeat all that here, but a short update paragraph on each.

First, Greece. And I’ll keep it very short. Greece is on. This will not be pretty and this will not be easy. Existential Euro doubt will raise its ugly head once again, particularly when Italy imports the Greek political experience.

Second, oil. I get a lot of questions about why oil can’t catch a break, about why it’s stuck down here with a 40 handle as the absurd media Narrative of “global supply glut forever and ever, amen” whacks it on the head day after day after day. And it is an absurd Narrative … very Heller-esque, in fact … about as realistic as “Peak Oil” has been over the past decade or two. Here’s the answer:  oil is trapped in a positive Narrative feedback loop. Not positive in the sense of it being “good”, whatever that means, but positive in the sense of the dominant oil Narrative amplifying the uber-dominant Central Bank Narrative, and vice versa. The most common prayer to the Central Banking gods is to save us from deflation, and if oil prices were not falling there would be no deflation anywhere in the world, making the prayer moot. God forbid that oil prices go up and, among other things, push European consumer prices higher. Can’t have that! Otherwise we’d need to find another prayer for the ECB to answer. By finding a role in service to the One Ring of Central Bank Omnipotence, the dominant supply-glut oil Narrative has a new lease on life, and until the One Ring is destroyed I don’t see what makes the oil Narrative shift.

Third, the Islamist attack in Paris. Look … I’ve got a LOT to say about “je suis Charlie”, both the stupefying hypocrisy of how that slogan is being used by a lot of people who should really know better, as well as the central truth of what that slogan says about the Us vs. Them nature of The World As It Is, but both are topics for another day. What I’ll mention here are the direct political repercussions in France. The National Front, which promotes a policy platform that would make Benito Mussolini beam with pride, would probably have gotten the most votes of any political party in France before the attack. Today I think they’re a shoo-in to have first crack at forming a government whenever new Parliamentary elections are held, and if you don’t recognize that this is100 times more threatening to the entire European project than the prospects of Syriza forming a government in Greece … well, I just don’t know what to say.

There’s another thing to keep in mind here in 2015, another reason why selling volatility whenever it spikes up and buying the dip are now, to my way of thinking, picking up pennies in front of a steam roller: the gods always end up disappointing us mere mortals. The cult phase is a stable system on its own terms (a social equilibrium, in the parlance), but it’s rarely what an outsider would consider to be a particularly happy or vibrant system. There’s no way that Draghi can possibly announce a bond-buying program that lives up to the hype, not with peripheral sovereign debt trading inside US debt. There’s no way that the Fed can reverse course and start loosening again, not if forward guidance is to have any meaning (and even the gods have rules they must obey). Yes, I expect our prayers will still be answered, but each time I expect we will ask in louder and louder voices, “Is that all there is?” Yes, we will still love our gods, even as they disappoint us, but we will love them a little less each time they do.

And that’s when the rock wall enters the cartoon frame.

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