Risk Analysis in the Golden Age of Central Bankers


When I was a little kid we had a sand box. It was a quicksand box. I was an only child … eventually.
Steven Wright

A brief note today on what might be an arcane subject for some but is a great example of the most basic question in risk management – are you thinking about your risk questions in a way that fits the fundamental nature of your data? Do you understand the fundamental nature of your data? Our business incentivizes us to build complex and ingenious models and data analysis systems in order to generate an edge or dodge a bullet. But are we building our elaborate mental constructs on solid ground? Or on quicksand?

I’ve spent a lot of time recently talking with clients about measuring market risk across a wide range of asset classes and securities as part of an adaptive investment strategy, and I get a lot of smart questions. One of the best was deceptively simple – what do you think about using implied volatility to measure risk? – and that’s the question I want to use to illustrate a larger point.

First let’s unpack the question. Volatility is a measurement of how violently the returns of a security jump around, and in professional investment circles the word “volatility” is typically used as shorthand for risk – the higher the volatility, the greater the embedded risk. There are some valid concerns and exceptions to this conflation of the two concepts, but by and large I think it’s a very useful connection.

Within the general concept of volatility there are two basic ways of measuring it. You can look backwards at historical prices over some time period to figure out how violently those prices actually jumped around – what’s called “realized volatility” – or you can look forward at option prices for that same security and figure out how violently investors expect that prices will jump around in the future – what’s called “implied volatility”. Both flavors of volatility have important uses, even though they mean something quite different. For example, a beta measurement (how much a security’s price moves relative to an underlying index) is based on realized volatility. On the other hand, the VIX index – the most commonly reported gauge of overall market risk or complacency – is entirely based on the implied volatility of short to medium-term options on the S&P 500.

The big drawback to using realized or historical volatility is that it is, by nature, backwards looking. It tells you exactly where you’ve been, but only by extrapolation provides a signal for where you are going. In a business where you always want to be looking forward, this is a problem. Using realized volatility means that you will always be reacting to changes in the broad market characteristics of your portfolio; you will never be proactive to looming changes that might well be embedded within the “wisdom of the crowd” as found in forward-looking options prices. If you’re relying on realized volatility, no matter how sensitively or smartly you set the timing parameters, you will always be late. This was the point of the smart question I was asked: isn’t there useful information in the risk expectations of market participants, information that allows you to be proactive rather than reactive … and shouldn’t you be using that information as you seek to balance risk across your portfolio?

My answer: yes … and no. Yes, there is useful information in implied volatility for many purposes. But no, not for the purpose of asset allocation. Why not? Because we are living in the Golden Age of Central Bankers, and that wreaks havoc on the fundamental nature of market expectations data.

Here’s an example I’ve used before to illustrate this point, courtesy of Ed Tom and the Credit Suisse derivatives strategy group. Figures 1 shows the term structure (implied price level at different future times based on prices paid for options) of the VIX index on October 15th, 2012.


Figure 1: 8-Month Forward VIX Term Structure

If you recall, there was great consternation regarding the Fiscal Cliff at this time, not to mention the uncertainty surrounding the November elections. That consternation and uncertainty is reflected in the term structure, as it is much steeper than is typical for a spot VIX level of 15, indicating that the market is anticipating S&P 500 volatility to be progressively higher to an unusual degree from January 2013 onwards. The way to read this chart is that the market expects a VIX level of 18 three months in the future (January 15), 19 three and a half months in the future (January 31), 20 four months in the future (February 15), and so on. All of these results are higher than one would typically expect for future expectations of the VIX from this starting point (essentially flat at 17).

Now take a look at Figure 2, which shows the Credit Suisse estimation of the underlying distribution of VIX expectations for January 31, 2013.


The way to read this chart is that a lot of market participants have a Bullish view (low VIX) for what the world will look like on January 31, with a peak frequency (greatest number of bullish contracts) at 15 and a fairly narrow distribution of expectations around that. Another group of market participants clearly have a Bearish view (high VIX) of the world on January 31, with a peak frequency around 24 and a fairly broad distribution around that.

So what’s the problem? The problem is that Figure 1, which is what you would come up with based on public options data, says that the most likely implied price for the VIX on January 31, 2013 is 19. But Figure 2, which is based on the trading data that Credit Suisse collects, says that a VIX level of 19 is the least likely outcome. What Figure 2 tells you is that almost no one expects that the outcome will end up in the middle at a price of 19, even if that is the average implied price of all the exposures.

Usually the average implied price of a security is also the most likely estimated price outcome of the security. That is, if options on a security imply an average price of 19 a few months from now, exposures will generally form some sort of bell curve centered on the price of 19. The most common estimation of the price would be 19, with fewer people estimating a higher price and fewer people estimating a lower price. But in those situations – like expectations of future VIX levels on October 15, 2012 – where there’s not a single-peaked distribution, all of our math and all of our models and all of our intuitively held assumptions go right out the window.

Unfortunately, these bi-modal market expectation structures are now the rule rather than the exception in this, the Golden Age of the Central Banker. Why? Because monetary policy since March, 2009 has explicitly established itself as an emergency bridge for financial markets, a bridge between the real world of an anemic, under-employed, under-utilized economy and the hoped-for world of a vibrantly growing, robust economy. On its own terms, this has been an entirely successful experiment, I suspect surpassing the wildest dreams of Bernanke et al. Stock markets have been “bridged”, reflecting what the world would look like if the global economy were off to the races, while bond markets reflect what the world actually looks like with the global economy sputtering in fits and starts. The problem today is that the experiment has been too successful. Whether you are in Europe or the US or Japan or China or wherever, the only investment questions that matter are whether central banks will continue their emergency monetary policies and what happens if the bridges are removed. These are not small, incremental policy questions. These are existential questions, reflecting binary expectations of the world with an enormous chasm in-between. With a hat tip to Milton Friedman, we are all bi-modal now.

So what’s the moral of this story for portfolio management? There are four, I believe.

In the Golden Age of the Central Banker …

1) the VIX is not a reliable measure of market complacency. Remember that the VIX itself is an implied volatility construct, built on the prices paid for options on the S&P 500 two to three months in the future. We assume that whatever the VIX is reported to be, that’s the consensus market expectation, with a lot of people holding that particular view and progressively fewer people on either side of that number. This is not necessarily the case, and when binary events raise their ugly heads it is almost certainly not the case. A low VIX level might indicate a complacent market, or it might indicate two sets of investors – one very complacent and one non-complacent – who see the world entirely differently. You have no idea what the underlying market expectations look like, and this makes all the difference in determining what the VIX means.

2) the wisdom of crowds is nonexistent. I believe in the efficiency of emergent behaviors. I believe that there is a logical dynamic process to crowd behaviors. But I also believe that crowds are extremely malleable when confronted by powerful individuals or institutions that understand the strategic interaction of crowds and make a concerted effort to master the game. There’s no inherent “wisdom” here, no emergent outcome where the crowd acts like an enormous set of parallel microprocessors to arrive at Truth with a capital T. The Common Knowledge Game is controlled by the Missionary, and our current Missionaries – central bankers, politicians, famous investors and media mouthpieces – know it.

3) fundamental risk/reward calculations for directional exposure to any security are problematic on anything other than a VERY long time horizon. Game-playing has always been a big part of the market environment, and it dominates successful directional bets on a very short time horizon. Similarly, stock-picking on a fundamental basis has always been a big part of the market environment and dominates successful directional bets on a very long time horizon. Between the very short-term and the very long-term you have this mish-mash of game-playing and stock-picking. One impact of the pervasiveness of the Common Knowledge Game today is that it pushes out the time horizon on which stock-picking on a fundamental basis can really shine. If you’re in the stock-picking business the value of permanent capital has never been greater.

4) I’d rather be reactive and right in my portfolio than proactive and wrong. I started this note with an acknowledgment of the weakness of risk assessments based on realized or historical volatility – it’s inherently backwards looking and you will always, no matter how finely calibrated your system, be late to respond to changing market conditions. But here’s the thing. This is what it means to be adaptive.You can’t be adaptive without something to adapt TO. Will you miss the market turns? Will you occasionally get whipsawed in your reactive process? Without a doubt. But you won’t get killed. You won’t be on the wrong side of a binary bet that you really didn’t need to make. You won’t discover that your pretty little sand box is really filled with quicksand. The Golden Age of the Central Banker is a time for survivors, not heroes. And that’s the real moral of this story.

PDF Download (Paid Membership Required):



The Minsky Moment Meme



That’s not how it works. That’s not how any of this works.
– Esurance “Beatrice” commercial

There’s a wonderful commercial in heavy rotation on American television, where three women of a certain age are discussing one of the friend’s use of Facebook concepts such as “posting to a wall” or “status updates”. The protagonist of the scene, Beatrice, takes these concepts in an entirely literal way, attaching actual photographs to an actual wall and delivering an un-friending message in person, at which point her more hip friend says, “That’s not how it works. That’s not how any of this works.”

I have exactly the same reaction to today’s overuse and misuse of the phrase “Minsky Moment”, originally coined by PIMCO’s Paul McCulley to describe how economist Hyman Minsky’s work helped explain the market dynamics resulting from the 1998 Russian financial crisis, such as the collapse of investment firms like Long Term Capital Management. Today you can’t go 10 minutes without tripping over an investment manager using the phrase “Minsky Moment” as shorthand for some Emperor’s New Clothes event, where all of a sudden we come to our senses and realize that the Emperor is naked, central bankers don’t rule the world, and financial assets have been artificially inflated by monetary policy largesse. Please. That’s not how it works. That’s not how any of this works.

Just to be clear, I am a huge fan of Minsky. I believe in his financial instability hypothesis. I cut my teeth in graduate school on authors like Charles Kindleberger, who incorporated Minsky’s work and communicated it far better than Minsky ever did. Today I read everything that Paul McCulley and John Mauldin and Jeremy Grantham write, because (among other qualities) they similarly incorporate and communicate Minsky’s ideas in really smart ways. But I’m also a huge fan of calling things by their proper names, and “Minsky Moment” is being bandied about so willy-nilly these days as a name for so many different things that it greatly diminishes the very real value of Minsky’s insights.

So here’s the Classics Comic Book version of Minsky’s financial instability hypothesis. Speculative private debt bubbles develop as part and parcel of a business/credit cycle. This is driven by innate human greed (or as McCulley puts it, humans are naturally “pro-cyclical”), and tends to be exacerbated by deregulation or laissez-faire government policy. Ultimately the debt burdens created during these periods of market euphoria cannot by met by the cash flows of the stuff that the borrowers bought with their debt, which causes the banks and shadow banks to withdraw credit in a spasm of sudden fear. Because there’s no more credit to be had for more buying and everyone is levered to the hilt anyway, stuff either has to be sold at fire-sale prices or debts must be defaulted, either of which just makes the banks withdraw credit even more fiercely. The Minsky Moment is this spasm of private credit contraction and the forced sale of even non-speculative assets into the abyss of a falling market.

Here’s the kicker. Minsky believed that central banks were the solution to financial instability, not the cause. Minsky was very much in favor of an aggressively accommodationist Fed, a buyer of last resort that would step in to flood the markets with credit and liquidity when private banks wigged out. In Minsky’s theory, you don’t get financial instability from the Fed massively expanding its balance sheet, you get financial stability. Now can this monetary policy backstop create the conditions for the next binge in speculative private debt? Absolutely. In fact, it’s almost guaranteed to set up the next bubble. But that’s a problem for another day.

If you don’t have a levered bubble of private debt you can’t have a Minsky Moment. Do we have one today? Sorry, but I don’t see it. I see crazy amounts of public debt, a breathtaking level of nitroglycerin-like bank reserves, and a truly frightening level of political fragmentation within and between every nation on earth. All of these are problems. Big problems. HUGE problems. But none of them create a private debt bubble. To be sure, we can all see worrisome examples of speculative excess popping up in every financial market. But that’s a far cry from a bubble, even a garden-variety tech bubble or LBO bubble, much less something like the housing bubble of 2004-2007 where private Residential Mortgage-Backed Securities (RMBS) went from practically nothing to a $4 trillion debt asset class. Maybe a private debt bubble is building somewhere, but it ain’t here yet. The one place I see a potential private debt bubble is in China around infrastructure construction (which looks suspiciously like American railroad financing in the 1870’s), but even there it’s far from clear how levered this effort is, and it’s perfectly clear that the debt is inextricably intertwined with public and pseudo-public financing.

Why is the distinction between a public debt bubble (which we have) and a private debt bubble (which we don’t) so important? Because a private debt bubble is always ultimately popped as Minsky suggests, with current cash flow concerns and a surprise default prompting private lenders to turn off the spigot of credit. It doesn’t work that way with a public debt bubble. It doesn’t work that way because current cash flow is only a minor part of the sovereign debt purchase calculus, at least when it comes to a major country. It doesn’t work that way because central banks can purchase a government’s debt securities, either directly as in Japan or indirectly as in the US. It doesn’t work that way because public debt is always and in all ways a massive confidence game, dominated by the Common Knowledge Game. Put simply, sovereign debt does not have the same meaning as private debt, and that makes all the difference in the world in how our current market environment ultimately plays out.

It’s why I am negatively inclined towards investment managers that use fundamental economic rationales as the basis for some can’t-miss trade that Country ________ [fill in the blank] will inevitably implode. Just look at the difference between Spanish or Portuguese sovereign debt yields in the summer of 2012 (trading like a distressed corporate credit about to go BK) and those same bonds today (trading close to all-time highs). Did the Spanish and Portuguese economies experience some miraculous renaissance, some explosion of real economic growth to support enormously tightened spreads at a fundamental level? Yeah, right. No, what happened was that Mario Draghi and Angela Merkel made a political statement – “whatever it takes” – to create an informational structure where everyone knows that everyone knows that the European Powers That Be will not allow Spain and Portugal to default. That’s it. That’s all it took. Just words. Words that have no place in Minsky’s theory (or any economic theory), but are the beating heart of the Common Knowledge Game.

Can a public debt bubble pop? Of course it can! But the dynamic process that leads to a public debt bubble popping has very little to do with Minsky’s theory and a whole lot to do with game theory, very little to do with economics and a whole lot to do with politics. It’s this game theory piece that last week’s Epsilon Theory note, “When Does the Story Break?” tried to explain.

To recap … no money manager I know thinks that the real economy is off to the races, which is why the long end of the yield curve remains so depressed and no one trusts these stock market highs. US GDP was negative in Q1 of this year! I don’t care what the weather was like, that’s nuts. And global growth is even more anemic. But at the same time, no money manager I know thinks that the Fed will allowfinancial markets to crack. The QE genie is out of the bottle, and there’s no putting it back in regardless of whether the Taper gets all the way back to zero monthly purchases or not. There is an unbelievably strong Common Knowledge informational structure around the unlimited power of central banks to control market outcomes – what I call the Narrative of Central Bank Omnipotence – and until that confidence game is broken this public debt bubble will not be popped.

Look, I totally understand why so many investors, particularly dyed-in-the-wool value investors, are so frustrated with the repercussions of Zero Interest Rate Policy (ZIRP). When the risk-free rate is nothing, of course you are forced to reach for yield. The Fed has successfully pushed everyone into buying riskier assets than they would otherwise prefer to do. But just because you’re frustrated is no reason to believe that the situation must change. Just because you have personal experience with private debt bubbles and a catchphrase (Minsky Moment!) to describe those experiences does not mean that you are looking through the right lens at today’s market environment of a coordinated public debt bubble throughout the Western world. This is a different animal, unseen since the 1930’s, and it requires a different vocabulary and perspective. That’s what I’m trying to provide with Epsilon Theory.

PDF Download (Paid Membership Required):



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.

PDF Download (Paid Membership Required):



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.

PDF Download (Paid Membership Required):



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”.

PDF Download (Paid Membership Required):



Core Curriculum


I distributed this Epsilon Theory reading list last summer, but it never made it to the website. Given the volume of requests I receive for this and seeing as how the direct subscriber list is about 10x what it was last summer I figured it was high time to reprint.

I haven’t any right to criticize books, and I don’t do it except when I hate them. I often want to criticize Jane Austen, but her books madden me so that I can’t conceal my frenzy from the reader; and therefore I have to stop every time I begin. Every time I read Pride and Prejudice I want to dig her up and beat her over the skull with her own shin-bone.
– Mark Twain

Once upon a time in the dead of winter in the Dakota Territory, Theodore Roosevelt took off in a makeshift boat down the Little Missouri River in pursuit of a couple of thieves who had stolen his prized rowboat. After several days on the river, he caught up and got the draw on them with his trusty Winchester, at which point they surrendered. Then Roosevelt set off in a borrowed wagon to haul the thieves cross-country to justice. They headed across the snow-covered wastes of the Badlands to the railhead at Dickinson, and Roosevelt walked the whole way, the entire 40 miles. It was an astonishing feat, what might be called a defining moment in Roosevelt’s eventful life. But what makes it especially memorable is that during that time, he managed to read all of Anna Karenina. I often think of that when I hear people say they haven’t time to read.

– David McCullough

You need to read more science fiction. Nobody who reads science fiction comes out with this crap about the end of history.

– Iain Banks

A scholar is just a library’s way of making another library.
– Dan Dennett, “Consciousness Explained”

I still feel – kind of temporary about myself.

– Willy Loman (“Death of a Salesman”, by Arthur Miller)

I’ve had dozens of requests to put together a reading list for Epsilon Theory, and I’ve resisted. There’s something uncomfortable about telling people what they should read, of recommending this book but not that one to you because it happened to resonate with me. Also, as Mark Twain said, I haven’t any right to criticize other authors (unless I really, really hate their books!), and I have zero interest in engaging in the all-too-familiar academic exercise of dueling criticism. Been there, done that.

But the roads I’m trying to explore with Epsilon Theory are not the commonly traveled paths of investment theory and practice, and I can appreciate that it would be useful for my readers to have some sort of field guide for this unfamiliar territory. And from a personal perspective, it’s more than just comforting to compile a list like this. Books provide grounding. They help us feel less temporary about ourselves, to use Willy Loman’s memorable phrase, and I’m certainly no exception to that. So with the caveat that this is an entirely impressionistic and non-comprehensive exercise in what has been useful for my personal intellectual grounding, and should be thought of as pointing you to a shelf in the library from which you might want to engage in your own exercise in discovery, here goes …

Statistics and Econometric Analysis

Edward Tufte is best known today for his books on information display – The Visual Display of Quantitative Information, 2nd ed. (2001), Envisioning Information (1990), Visual Explanations: Images and Quantities, Evidence and Narrative (1997), etc.  These books are amazing in every way, both as resource and as inspiration. But less well known is Tufte’s academic career as a statistician at Princeton’s Woodrow Wilson School, where he collaborated with one of the founders of Information Theory, John Tukey. In 1974 Tufte wrote what I believe is the single best book in explaining both the basic techniques and the meaning of applied statistics – Data Analysis for Politics and Policy. Whether you’re a newbie to statistical applications or a Ph.D in econometrics, this is an incredibly useful book (and although out of print, there are plenty of used copies circulating on Amazon).

I’ve mentioned the work of Gary King, Director of Harvard’s Institute for Quantitative Social Science, in my note Rise of the Machines. If you’re already a fluent speaker of the language of econometrics, his work on ecological inference and likelihood functions is both groundbreaking and extremely useful. But one of King’s great skills is his ability to apply econometric techniques to pretty much any area of inquiry, including fields of study that, for whatever reason, tend to be strangers to this methodology. King’s book with Robert Keohane and Sid Verba – Designing Social Inquiry: Scientific Inference in Qualitative Research (1994) – is an excellent read for anyone who wants to think more rigorously about causality and inference in markets, politics, and our social lives. This is not a statistics book. It’s a how-to-think-about-statistics book.

Game Theory and Information Theory

The classic primer on game theory is Games and Decisions: Introduction and Critical Survey, by Duncan Luce and Howard Raiffa. Originally published in 1957, the 1989 edition is still in print, still assigned in courses all over the world, and is still the most comprehensive work on game theory for non-mathematicians. If you’re really interested in game theory, you must have this book. Other classic books on game theory include Robert Axelrod’s Evolution of Cooperation and Thomas Schelling’s The Strategy of Conflict. These are wonderful books, full of real-life examples of game theoretic applications. But if you only have time for one classic book on game theory, I’d recommend William Riker’s The Art of Political Manipulation (1986). The chapter on Abraham Lincoln and the strategic decision-making involved with the Lincoln-Douglas debates is alone worth the price of admission.

As for information theory, the obvious classic is Claude Shannon’s The Mathematical Theory of Communication, which served as the midwife for this entire field. It’s for the really serious student, though, the equivalent of reading Von Neumann and Morgenstern to learn about game theory. Much more accessible are two books by James Gleick: Chaos (1987) and The Information (2012). Thinking about the world in terms of information and subjective probabilities goes back at least to the 18th century work of Thomas Bayes, and two recent works – Nate Silver’s The Signal and the Noise (2012) and Sharon McGrayne’s The Theory That Would Not Die (2011) do a Gleick-ian job (high praise indeed!) of making this perspective accessible for the non-specialist.

The game and information theoretic research that I’m finding most useful today is not written by economists or political scientists, but by linguists and biologists. There’s a scope and a sweep to this work, as well as an explicit incorporation of evolutionary theory, that I find extremely useful. David Lewis’s book Convention (1969) is a good example of this, as he is trying to explain the development of social coordination solely with the tools of strategic decision-making under informational uncertainty (game theory), without resorting to the deus ex machina of human exceptionalism or consciousness.

There’s nothing special about the human animal in this perspective, no sense in which some unique reasoning capacity has created this convention that is more True with a capital T than that convention. In Signals (2010), Brian Skyrms takes the Convention games developed by Lewis to a new level of usefulness by directly incorporating evolutionary models of learning, showing how “communication and coordination of action are different aspects of the flow of information, and are both affected by signals.” It’s a dense book in parts, to be sure, but worth the effort. Markets are just as much a social exercise in communication and coordination as language, and what linguists call Convention is what economists call Common Knowledge. I think that pretty much everything that Lewis and Skyrms describe generically for language can be transferred to a better understanding of markets … there’s a lot that can be mined from this work even if it never talks about markets directly.

Markets and Risk

Of course, there are some authors that make explicit the connection between markets and either game theoretic or information theoretic concepts of risk, and they deserve special mention. Most of these will always be familiar to Epsilon Theory readers, so I’ll just list them here in no particular order. Again, this is not intended to be a comprehensive list, just what has been meaningful to me!

  • John Maynard Keynes, The General Theory of Employment, Interest, and Money (1936)
  • George Soros, The Alchemy of Finance (1987)
  • Benoit Mandelbrot, The (Mis)behavior of Markets (2004)
  • William Poundstone, Fortune’s Formula (2005)
  • Peter Bernstein, Against the Gods (1996)
  • Nassim Taleb, Fooled by Randomness (2004)

Also, each of these authors has written several books, each useful in its own way. Enjoy!

Behavior and Human Nature

Well … this is obviously a rather large area of inquiry, so I just want to note a couple of authors who are directly relevant to the Epsilon Theory perspective on markets.

First, Daniel Kahneman and Amos Tversky pretty much invented the modern academic study of behavioral economics, and their core book is an edited collection of papers (along with Paul Slovic) titled Judgment under Uncertainty: Heuristics and Biases (1982). It’s still in print. More recently Kahneman wrote Thinking, Fast and Slow (2011), which covers most of the ground of Judgment under Uncertainty but in a much more entertaining fashion.

Second, you can’t have a conversation about human behavior without discussing the work of E.O. Wilson. While it’s not as directly applicable to Epsilon Theory as the linguistic research of Brian Skyrms, Wilson’s work is formed on the same foundation of evolutionary theory and an insistence on seeing the human animal as just that and nothing more (or less). I defy you to read The Social Conquest of Earth(2012) and not think differently about the world.

Third, it would take another three pages of dense writing to engage with the intense academic debate regarding the fundamental nature of human consciousness and, by extension, human behavior and human decision-making. In a nutshell, the argument is over whether any aspect of the human mind is separate from the collection of neurons and engrams and chemicals that make up a human brain. The most outspoken proponent of the “no” position is Dan Dennett, and in books like Consciousness Explained (1992) and Darwin’s Dangerous Idea (1996) he puts forward an argument for an entirely empirical and naturalist view of the human mind that I find compelling. Dennett is an accessible writer for the non-academic, but even better is Giulio Tononi, a neuroscientist at the University of Wisconsin, who achieved in Phi: A Voyage from the Brain to the Soul (2012) a beautiful (there’s no other word for it) exposition of the naturalist view of human consciousness.

Finally, I’d be remiss if I didn’t mention a couple of historians who continue to be instrumental in developing my perspective on human nature and social behavior. As with the Market and Risk section I’ll just put this highly non-comprehensive list out there without comment.

  • Robert Caro, The Power Broker (1975)
  • Steven Englund, Napoleon: A Political Biography (2005)
  • David McCullough, The Greater Journey: Americans in Paris (2012)
  • Amity Shlaes, The Forgotten Man (2008)
  • Liaquat Ahamed, Lords of Finance (2009)


The important role of Narrative is a common thread throughout the Epsilon Theory notes, and in some ways it might be the most original concept I’ve developed for an improved understanding of markets. But it’s also the least amenable to a standard bibliography.

There’s a strong post-modern (in the academic sense of the word) component to any evaluation of Narrative, as it pervades the work of authors like Michel Foucault and Jean Baudrillard, but I have a hard time recommending their books. Do I think that Foucault and Baudrillard have important things to say, things that are relevant to a real-world investor in 2013? Yes, I do. Foucault’s Discipline and Punish(1995), for example, is a meaningful book, not only for the ostensible topic – how the social institution of the Prison was constructed on the basis of Narratives that served the interests of the powerful – but for how all social institutions, such as the Corporation and the Market, are similarly constructed on the back of similar Narratives. Those Narratives change over time, creating structural risks in the institutions that seem so permanent to anyone immersed in those institutions, and that’s definitely relevant to every investor. Unfortunately, there’s an intentional obtuseness and opacity to the language spoken in these self-consciously post-modern projects that make them inaccessible. These books are written as an enormous conceit, one which masks their useful embedded signals. So if you have a year to spare and can tolerate impenetrable language mazes … then yes, I heartily recommend Baudrillard’s Simulacra and Simulation (1995). Otherwise, not so much. The best I can do on this front is to take a useful concept from the post-modern canon – Foucault’s use of Bentham’s idea of the Panopticon, for example – and try to make it relevant in a future note.

There’s a better way to develop a sensitivity to the role of Narrative in markets than reading Baudrillard, I think, and it takes two forms.

First, I think it’s important to read as much non-mediated history as possible. Peter Vansittart wrote two excellent books – Voices 1870-1914 (1986) and Voices from the Great War (1985) – where he compiled as many written excerpts as he could find from both the famous and the ordinary as they experienced a world in structural flux. Studs Terkel did much the same with The Good War: An Oral History of World War II (1997) and Hard Times: An Oral History of the Great Depression (2005). Is there some degree of mediation in the compilation of these excerpts or the construction of these oral histories? Of course. But all the same you get a much more unvarnished picture of what it meant to live in those times, and comparing that picture with what “history” has taught us will make you a much more active and aware consumer of mediated history today.

Second, I think it’s important to know what the Stories are. This has a serious component – I think that I’ve read almost everything Joseph Campbell has written (and that’s a lot!) – but it also has a component that will strike some as flaky or less-than-serious. I read a lot of science fiction. I read a lot of comic books. To be sure, there’s an enormous range in quality in both of these fictional forms. For every Iain Banks, Neil Gaiman, or Mike Carey there are dozens of eminently forgettable sci-fi and comic authors, and the truth is that not everything written by Banks, Gaiman, and Carey is that memorable. But it’s in the consistent if not constant exposure to the Stories in all sorts of different guises, forms, and formats – some well-constructed, most less so – that one gains an appreciation for how vital and present the Stories are in the nightly news and the daily CNBC wrap-up of market events. Inside every Narrative is a Story, just wrapped up in a different set of events. The human mind may be a collection of neurons, engrams, and chemicals, but human society is in large part of collection of Narratives. It’s the Stories we tell ourselves that keep us together, and we tell the same Stories over and over, from the cradle to the grave. I think it’s important to maintain an awareness of those Stories and that aspect of social construction in our adult lives, and I am certain that I’m a better investor for it. As C.S. Lewis, who forgot more Stories than most of us will ever know, wrote “No book is really worth reading at the age of ten which is not equally – and often far more – worth reading at the age of fifty and beyond.” Amen, brother Lewis!

PDF Download (Paid Membership Required):



The Business of Epsilon Theory


I started the Epsilon Theory project nine months ago with the publication of a “Manifesto” and an email to a few hundred friends and colleagues. Since then nearly 7,000 investors across more than 2,000 financial services firms have signed up for the direct distribution list, and through forwarding and republishing the effective Epsilon Theory audience is several multiples of that. On a personal level the response has been overwhelming, humbling, gratifying…but most of all invigorating. I wake up every morning champing at the bit to write, and there are now more than 80 notes and emails on the website, with hundreds of pages of content. Epsilon Theory is tapping into and releasing a hungry energy that was there long before I started writing about it, and I am certain that we are just at the starting point of what’s possible here.

I am also certain that a crucial aspect of the Epsilon Theory project is to keep access as barrier-free as possible. Part of that is requiring minimal identifying information from readers who want to join the distribution list. Part of that is encouraging the forwarding and republishing of these notes. But the biggest part of keeping access to Epsilon Theory barrier-free is to keep access actually, in fact…free. My partners and friends here at Salient make that possible, and it’s exactly this sort of forward-thinking attitude towards information and investing that convinced me to join the firm. Not only has Salient given me the economic freedom to pursue the Epsilon Theory project without the constraint of making a living from it, but more importantly they have given me the intellectual freedom to pursue the project without the constraint of selling from it. It’s not that I don’t support Salient investment strategies or that we’re not thinking about specific investment or trading ideas that might come out of my work, but Epsilon Theory is simply not the right venue to have a conversation about specific investment ideas.

So here’s what I’d ask. If you’re interested in hearing about what we have to offer at Salient today, or if you’re interested in learning about what we’re developing for the future in an Epsilon Theory vein, let me know. Tell me more about yourself and what your interests are, and we can move that conversation forward through more appropriate channels.

If you’re not particularly interested in a direct conversation about Salient or Epsilon Theory-related investment ideas, that’s fine, too. I’m committed (and Salient is committed) to Epsilon Theory for the long haul, and I’ll keep writing like I’ve been writing so long as I’m tapping into this vast reservoir of hungry energy. Stay thirsty, my friends.

epsilon-theory-the-business-of-epsilon-theory-april-23-2014.pdf (66KB)


The Adaptive Genius of Rigged Markets



Same as it ever was, same as it ever was, same as it ever was, same as it ever was

– Talking Heads, “Once in a Lifetime”

You may be a business man or some high degree thief

They may call you Doctor or they may call you Chief

But you’re gonna have to serve somebody, yes

You’re gonna have to serve somebody

Bob Dylan, “Gotta Serve Somebody”


Horace Clark, Vanderbilt’s son-in-law, was always a favorite with the stately old gentleman. Having decided to wed the young lady, he called upon his future father-in-law, and, without preliminary, began – “Commodore, I wish your daughter in marriage.”
“You mean, you want my money,” growled Vanderbilt from his chair.
“You and your daughter be damned,” flamed out the young lawyer, as he clenched his hat in his hand and turned to leave the room.
“Hold on, young man,” said Vanderbilt, straightening himself on his feet. “Hold on. I rather like you. I only said you should not have my money. You can have my daughter.”

– James Medbery, “Men and Mysteries of Wall Street” (1870)

David Byrne, of Talking Heads fame, is something of a personal hero of mine for the way he handles the business of his music. Byrne is famously protective of the copyrights associated with his work, in the sense of controlling the uses of the music for long-term goals rather than a short-term pay-off, and it’s a non-myopic approach to intellectual property I’ve tried to adopt with my own work. I also appreciate Byrne’s ability to put on a show. His music stands on its own, for sure, but Byrne was into multimedia before it was a word, and part of his genius has been an ability to reinvent consistently the experience of his music. I know it sounds crazy to anyone under the age of 30 that a Big White Suit could be both revolutionary and really cool as performance art, but there you go. More to the point, Byrne knew when to move on from the Big White Suit. He knew how to adapt to a world that was still hungry to hear what he had to say, but not if it were presented in the same way ad nauseam.


If you don’t adapt, you die. Or worse … for an artist, anyway … you become uncool and passé. Your performance art becomes performance shtick. And yes, I’m looking at you, Elvis Costello. There’s an adaptive genius to the David Byrne’s and the David Bowie’s of the world, quite separate from their musical genius, and that’s what I want to examine in this note. 


Adaptive genius is not limited to the popularly beloved and the socially respected. It’s not only, in zoo-keeping terms, the “charismatic vertebrates” like elephants and giraffes who demonstrate this quality, but also decidedly non-charismatic invertebrates like the hookworm. I’ve written before about why I believe that parasites are beautiful creatures from an evolutionary perspective, which is another way of saying that they possess adaptive genius. It’s the same sort of beauty I see in parasitic market participants who generate real alpha by feeding off a consistent informational edge they identify from either non-economic or differently-economic market participants. As I wrote in “Parasite Rex”, a giant pension fund isn’t engaged in commodity markets because it has an opinion on the contango curve of oil futures; it’s trying to find a diversifying asset class for a massive portfolio that needs inflation protection. If you’re an experienced trader in that market and you see signs of the giant pension fund lumbering through the brush … well, you’re in the wrong business if you can’t skin a few dimes here. This is what good traders DO, and the really good ones have devised effective processes so that it’s not just a one-off trade but an expression of a robust strategy.

Parasites, whether they exist in nature or in markets, are almost always models of efficiency and adaptive genius. I may dislike them. I may well be the host from which they suck out resources. I may want to squash them without mercy. But I can’t help but respect their evolutionary prowess and ability to carve out an informational advantage. And if I get the chance, I’d like to invest money with them.They’re not the only source of alpha in this world (you can also create an informational advantage by perceiving the world differently and more correctly than most), but they are, I believe the most consistent and powerful source of alpha out there.

Or at least they provide the most consistent and powerful source of alpha within the limitation of being a market participant, of being a buyer or a seller of a security in order to express an opinion on whether that security will go up or down in price in the future. Of course, if you could hijack the entire infrastructure of the market, if you could somehow develop an omniscient view of market communications and intentions under the guise of market-making or liquidity provision … then you’d be talking about some serious alpha. 

Oh wait … that’s exactly what happened with Getco and Virtu and their High Frequency Trading (HFT) brethren.

I don’t want to belabor the details of how this market infrastructure hijacking works. You’re better off reading Michael Lewis’s book or, better yet, check out Sal Arnuk and Joe Saluzzi’s Themis Trading website and read their book, “Broken Markets”. But I will share my experience of how this hijacking plays out in the professional investment world. My bona fides: co-managed a large long/short equity fund where we experienced all this on a daily basis, wrote extensively about HFT and market structure in client letters, and was part of a loose group of like-minded buy-side managers exploring these issues for the past 5 years. I was an HFT critic way before it was cool to be an HFT critic, and here’s our core complaint: in an HFT-dominated market infrastructure, you can always get your order filled but you will never get a better price than your limit. 

What does this mean? Imagine that you’re an equity PM and you want to buy $5 million worth of XYZ stock today. You have a positive fundamental view on the company, the stock’s been weak of late, and for whatever reason you’ve decided that today is a good time to pull the trigger and add to your existing position here. Average daily volume in the stock is, say, $500 million, so your order is going to be about 1% of that – not inconsequential for how the stock trades, but highly unlikely to have a big market impact. All the same, though, you tell your trading desk that you want to put a limit on the order, say 1% above wherever the price settles after the market opens. So now it’s 10:05 am, XYZ stock is trading at $50.00, and your trader hits the button to buy 100,000 shares with a limit of $50.50. Your trader is not an idiot, so of course he’s chopping up this order into smaller pieces, either via some chopping algorithm you’ve got in your order management system or, more likely, some chopping algorithm that your prime broker uses to rout the big order through various execution venues over the course of the day. There are plenty of these algorithms to choose from, all designed to hide your willingness to pay up to $50.50 for XYZ stock when it’s currently trading at $50.00.

But then the most amazing thing happens. As soon as your trader hits the button at 10:05 am to launch the buy order, volume at $50.00 – which was humming along quite nicely – strangely dries up. As if by magic, the market price for XYZ stock marches straight up, often in minimally sized 100 share lots, until it hits $50.50. At that point volume miraculously reappears, and your order starts to fill in earnest. The price might tick higher by a penny or two every now and then, which means that you stop buying, but it always seems to tick right back down to the $50.50 mark where your order continues to fill. A few minutes later you get a message from your trader that the XYZ order is done, at an average price of $50.48. Your trader is happy because he completed the order as per your instructions. You’re happy because you’ve got the 100,000 shares of XYZ at an acceptable price. But you are only minimally happy. You only achieved your reservation price, which seems odd because you saw the stock trading at $50.00 before you got active, and you’re probably seeing the stock trading at $50.00 now that you are no longer active.

No matter how hard you try to manage your trades, no matter what chopping algorithm you use or how closely you watch the Bloomberg screen, it’s as if whoever is on the other side of your trades has a bug planted in your office so that they are overhearing your conversations with the trading desk and picking off your limit orders. You rarely do better than the worst price you will tolerate, and that only happens when your trader finds a natural – a real human being who wants to sell what you want to buy, or vice versa. Otherwise your counterparty is a “liquidity provider”, some technology company whose Big Data computer systems, combined with direct data feeds and frictionless order execution authority to and from trading venues, allows them to identify the contours and depth of the aggregate limit order book in stock XYZ. Your effort to buy 100,000 shares of XYZ forms a pattern, regardless of how you try to hide it, and it’s a pattern that the powerful induction engines of HFT algorithms will quickly recognize. And once your pattern is identified within the context of a limit order book, your private information – the price you are secretly willing to pay for a share of XYZ stock – has been stolen from you just as surely as if there really were a listening device planted next to your trading desk.

Are there ways to mitigate this sad state of affairs … or rather, this minimally happy state of affairs? Sure. You set tighter limits. You look for opportunities to provide liquidity rather than just absorb it. You trade less frequently but more aggressively. You hire experienced traders who can tell when a machine is picking them off and know where to look for naturals. But it’s only a mitigation, not a solution. A good trader on an equity desk used to be able to make you money by beating the volume-weighted average price (VWAP) on a consistent basis. Today it’s all VWAP all the time, thin gruel that supplies enough calories and nutrients to keep you alive, but tastes like … thin gruel. Institutional investors are angry about HFT because it has turned actively managed order execution and tactical portfolio decision-making from a source of fun and profit into a dreary toll-paying exercise. Day after day, trade after trade, we are skinned. And we know it. But it’s always just within the tolerance levels that we ourselves set, which is really the brilliance of the whole thing.

When you talk to anyone in the HFT world, you inevitably get three arguments as to why the current situation really isn’t a problem.

#1 – “But our margins are razor thin. We really don’t make much money in our business, or at least we don’t make much money anymore, because the secret is out and it’s so darn expensive to maintain our machines.”

My response: Boo-freakin’-hoo.

#2 – “But we provide a valuable service to markets with our liquidity provision. Without our participation the bid-ask spread in every trade would be wider, and market volumes would plunge.”

My response: Look, I admire the fact that you are not an Ebola-esque parasitoid that kills its host in a gory, blood-spewing mess, but rather something more akin to a parasitic worm that provides its host with a bit of protection against certain auto-immune diseases as it gorges itself. It’s an evolutionarily stable strategy (ESS), and I think it’s adaptive genius. Really, I wish I had thought of this whole HFT idea myself, and I’m more than a little jealous. But give me a break about liquidity and bid-ask spreads. The life of an active manager was so much more fun and profitable (or at least that was our perception of the experience) with lower liquidity and wider bid-ask spreads. We’ll take our chances in a worm-less market environment, thank you very much.

#3 – “But there’s always going to be someone extracting rents from the market infrastructure. We’re certainly no worse than the parasites before us, and in some ways we’re better for you.”

My response: Ummm … that’s a pretty good point.

I love to read memoirs and first-hand accounts of markets, and recently I’ve been focused on the late 19th century, particularly the period 1873 – 1879 … what was called back then the Great Depression until the 1930’s rolled around and the name had to be changed to the Long Depression (even more apropos for the UK, where the depression/recession lasted until 1896). The story of the Long Depression is one of a market panic and a liquidity crisis that collapsed financial institutions everyone thought were too big to fail, followed by a 20+ year period of puzzlingly high unemployment, anemic growth, political fragmentation, and experimental monetary policy. Sound familiar?

But even as one reads these memoirs and histories for whatever macro-economic lessons they might provide for coping with our own Long Recession, you cannot help but be struck by the constant discussion of market structure in these materials. And it’s not a dry description of the formal aspects of the market. No, for the most part it’s a full-throated celebration of the men and the institutions that controlled the flow of information within markets by controlling the machinery of markets. Men like Cornelius “Commodore” Vanderbilt, who was renowned for setting up friends and relatives with “points” and “tips” so as to drive the price of some stock way up, only to betray them with one last false tip that would give the Commodore a chance to exit his long position and then turn around and short the stock, crushing both the price and his “friend”. Men like Jay Gould and Diamond Jim Fisk, who bribed entire state legislatures to get their way on market rules and came within an inch of cornering the entire US gold market.

You can’t have a market in a mass society without constructing a robust market infrastructure. What is that infrastructure? It’s not a building on the corner of Broad Street and Wall. It’s not a trading pit on South Wacker. Market infrastructure is a collection of rules for the playing of a massive game.Market infrastructure is information. And whoever masters those rules, whoever sees the information flowing between market participants most clearly, whoever can create private information by becoming embedded within that information flow … well, one way or another they’re going to make a fortune, and one way or another it’s going to come out of the hide of the rest of us.

Ultimately, I think the problem for HFT liquidity providers is not that they are skinning investors, but that they are outsiders. They’re doing what the keepers of the market infrastructure keys have always done – skin investors, retail and institutional alike, to the outer limits of what technology and the law allows. But while their outward behavior and appearance may be familiar, they are clearly an alien species on the inside, without so much as a microgram of Wall Street DNA. They are Rakshasa’s. HFT liquidity providers are technology companies disguised as financial intermediaries. They hijacked the market infrastructure in the aftermath of the Great Recession, stealing it away from under the noses of the big financial firms who had come to see control over market structure as their birthright, and they had a good run. But now the big boys want their market infrastructure back, and they’re going to get it.

I won’t be shedding any tears for the demise of the HFT shops, and there’s no small amount of entertainment value in the witch hunts and show trials to come. But I’m not so naïve as to expect some magical return to the halcyon trading days of yesteryear where, to paraphrase Garrison Keillor and his description of the children of Lake Wobegon, all of our trades beat VWAP. The big boys will co-opt the Big Data skinning techniques of the HFT shops, just as they have always co-opted the technologies of social control and surveillance. Oh sure, they will make the theft of my private information regarding limit orders even more palatable than the HFT guys did, because that’s the genius of a highly evolved, highly adaptive parasite – they possess an extremely robust ESS (evolutionarily stable strategy). But you can’t un-ring this Big Data bell.

No, Dylan said it best. You gotta serve somebody, and that certainly goes for all of us who choose to participate in modern markets. There is a rigged quality to all market structures in all times and in all societies, and you’re going to serve whoever controls the information flow of the market, because that’s what market structure IS. This was true in 1870, it was true in 1970, and it will be true in 2070. But don’t worry, you’ll hardly feel a thing. In fact, you’ll be happy to serve – albeit minimally happy, and increasingly to the limits of your minimal happiness – those who are manning the market structure gates, because that’s the adaptive genius of these particular parasites. Same as it ever was, same as it ever was, same as it ever was, same as it ever was.

PDF Download (Paid Membership Required):



Beta Earthquake


One of the things I like to keep my eye on when I’m puzzling out what’s going on in the market are the specific company factors that loosely define concepts like Momentum and Value. I do this because any sort of big market move, like we’ve seen over the past week, is inherently over-determined and over-explained. That is, there are dozens of “reasons” trotted out by the financial media and various experts, ALL of which are probably right to a certain degree. The trick is to see if you can identify an underlyingexplanation that both accounts for a large chunk of the various rationales AND distinguishes or predicts unexpected nuances between the rationales. Here’s an example of what I mean.

We all know that momentum-driven, high-beta stocks have been particularly slammed of late. Even as the overall market maintained its highs (until last Friday, anyway), particular sub-sectors like Internet stocks or biotech stocks have been crushed. What we’d like to know is whether this is somehow specific to a certain group of stocks – call them Momentum stocks – or whether these stocks are just the canary in the coal mine due to their high-beta nature for a more broadly based market dislocation. So let’s not look just at Momentum factors over the year to date (which we know have been slammed), but also factors connected with Value and Quality. If high Value and high Quality stocks have done well as high Momentum stocks have done poorly, then there’s no need to look deeper than that. Momentum is the culprit, and maybe this market trauma will be contained there. On the other hand, if there are weirdnesses or distinctions between the three broad categories, then something deeper is probably at work.

For Value I’ll use free cash flow (FCF) yield as a quick-and-dirty indicator of the concept, and for Quality I’ll use cash flow return on invested capital (Cash ROIC). We can argue about alternative measures of these categories, and there’s certainly some conceptual overlap between Value and Quality, but I think these are pretty well-acknowledged, if not standard, operationalizations of what Value and Quality mean. For both, I’ll chart the isolated performance of each factor against the MSCI US large-cap universe. Again, maybe you’ll get different results if you look at different universes of stocks or different operationalizations of Value and Quality. Knock yourself out.

Here’s the year-to-date performance chart for my Value factor, FCF yield:


Source: FactSet, Salient Capital Advisors, LLC, April 2014.

Pretty much what you’d expect if the answer to our puzzle were simply: Momentum Is Bad. FCF yield turned on a dime the last week in February, just as Momentum stocks started to tank, and hasn’t really looked back since.

But here’s the year-to-date performance chart for my Quality factor, cash flow ROIC:


Source: FactSet, Salient Capital Advisors, LLC, April 2014.

Unlike Value, Quality did not turn up at all as Momentum collapsed. Instead, it has continued to drift down along with Momentum.

What does this mean? What is an underlying explanation that can account for Momentum failing and Value working, but Quality NOT working? When one of my colleagues here at Salient saw these charts he said, “looks to me like the market is trading on a narrative of risk appetites and fear rather than toward some notion of seeking fundamentals or selling overbought growth stocks; otherwise Quality would be working, too.” To which I replied, “Amen, brother!”  The notion that this market sell-off is limited to biotech or Internet or some other high-flying sub-sector because the market “realized” that these stocks were too expensive or out of concern with earnings this quarter (both explanations that I’ve seen of late in the WSJ and FT), just doesn’t hold water. These high-beta stocks are being hit hardest because they are at the epicenter of a broad market or beta earthquake. This is what it meansto be high-beta…you live by the broad market sword and you die by the broad market sword.

What’s the source of this beta earthquake? What tectonic plate is shifting beneath our feet? Only the bedrock bull Narrative of the past five years – “the Fed has got your back.” As I wrote last week, the Common Knowledge on Fed policy is starting to shift. The crowd is sniffing the air, sensing a change in the easing/tightening Narrative and acting on that by selling – and the less fundamentally-grounded the security the more furious the selling – just as they acted on prior market-positive shifts in the easing/tightening Narrative by buying – and the less fundamentally-grounded the security the more furious the buying.

Is this the Big One? Is this the beta earthquake that sends the stock market down into correction or bear market territory? I have no idea. Or rather, if you can tell me what US growth data looks like over the next six months then I’d be happy to make a market prediction, but I certainly don’t have a US growth crystal ball and I don’t think you have one, either.

Anemic growth remains the Goldilocks scenario for markets, not so cold as to make for a recession but not so hot as to take the Fed out of play for “emergency” monetary policy implemented on a permanent basis. Good real-world news is bad for markets, and vice versa, because that’s the dynamic that impacts Common Knowledge around the Fed. The market is in a tough spot right now, as good news will not make the market go higher (Fed stays on the tightening path) and bad news can make the market go lower if it’s really bad news (or if the Fed gives more signals that they’re tightening regardless of how bad the news gets).

This tough spot is made even tougher by both a market fatigue with Fed jawboning (excuse me… communication policy) and a growing sense, fair or not, that the Yellen Fed is kind of flailing around right now. The dominant Narrative by a mile is still Central Bank Omnipotence, where the Fed is responsible for all market outcomes, but there are definitely signs of a growing counter-Narrative, one that I call “The Incompetent Magician”, that bears close watching. The Incompetent Magician Narrative is a story that’s very dangerous for markets, because it’s a story of loss of control. This is what makes private sources of liquidity dry up, this is what makes for a deep bear market, and this is what would drive gold into the stratosphere. The Incompetent Magician Narrative has been around for decades, usually resting deep in the depths of counter-cultural media and the like, sort of like a flu virus that can lay dormant for years within an animal population. Over the past few weeks, though, I’ve seen a few outbreaks of this virus, or at least a strain of the virus, within mainstream media. Nothing to be concerned with yet, but like I say…something that bears watching.

PDF Download (Paid Membership Required):



The King is Dead. Long Live the King.


Le roi est mort, vive le roi!
French proclamation as coffin of old king is placed into burial vault of Saint Denis Basilica.

The throne shall never be empty; the country shall never be without a monarch.
English Royal Council on death of Henry III in 1272, proclaiming Edward I king even though he didn’t get the news until months later.

Every time I thought I’d got it made
It seemed the taste was not so sweet
So I turned myself to face me
But I’ve never caught a glimpse
Of how the others must see the faker
I’m much too fast to take that test
David Bowie, “Changes” 

What we’re witnessing right now in US markets is a shift in the Narrative structure around Fed policy, and it’s hitting markets hard because the Narrative structure around the Fed as an institution has never been stronger or more constant.

As more and more generally positive US growth data comes out, most recently in last Friday’s jobs report, the Narrative around Fed policy is shifting from “The Fed will keep rates low forever and ever, amen” to “the Fed is on rails to raise rates sooner and more than you thought”. And that’s a real bummer if you’re long this market, particularly in a momentum or high-beta name.

A Narrative is just another name for what game theory calls Common Knowledge, which for my money is the most powerful force in human society. Common Knowledge is what topples governments, builds cathedrals, and starts (or ends) wars. It darn sure moves markets, particularly in a period of extreme global political fragmentation and stress, as we last saw in the 1930’s and before that in the 1870’s. As Keynes noticed (and successfully traded on with his own investments), market sentiment is driven by the creation or dissolution of Common Knowledge, and you can’t play the Game of Sentiment well if you’re not focused on it.

Common Knowledge is not just public information. It’s public information that everyone thinks that everyone thinks. It’s a signal that’s broadcast publicly by a powerful “missionary” like Yellen or Draghi or a Famous Investor on CNBC or a Famous Journalist in the WSJ, so that we all know that we all heard the message. And if we think that everyone else has heard the message, then the rational behavior is to act as if the message is true, regardless of our private beliefs or observations. This is the Emperor’s New Clothes…each of us can see with our own eyes that the guy is naked, but we’re not really looking at the Emperor. We’re looking at the crowd. Each of us is looking at all of us, and all of us know it.

So when the WSJ tells us that the Friday jobs report was good and strong, when Jon Hilsenrath tells usthat this jobs report keeps the Fed “on track”, when Fed Governor Bullard tells us today that Fed actions have been “sufficiently aggressive”, when Janet Yellen tells us that she has a schedule in mind for raising rates…well, those are powerful public statements by incredibly influential missionaries. This is what creates Common Knowledge. We all heard these statements, and more importantly we all believe that everyone else heard these statements, too. So now we will all start to act as if the statements are true for Fed policy, no matter what we privately think the Fed will do or not do, and that behavior becomes a self-fulfilling prophecy, a snowball rolling downhill, as more and more of all of us start to believe that this is what all of us believe. This is the power of a crowd looking at a crowd, and it’s a bitch.

What we’re not seeing – and this is why the Narrative shift in Fed policy intentions is hitting the market so hard – is a change in the underlying and more fundamental Narrative that has controlled global markets for the past five years…the Narrative of Central Bank Omnipotence. I’ve written about this a lot (here and here, in particular), so I won’t repeat all that, but the Common Knowledge structure around the Fed and other central banks in general terms is that the Fed is responsible for market outcomes. It’s not that the “Fed has got your back” or that the Fed will always make the market go up. It’s that the Fed is large and in charge. Central bankers giveth, and central bankers taketh away. That’s the Narrative of Central Bank Omnipotence.

It’s become fashionable of late to say that the Fed doesn’t have as much impact on markets today as it has in recent years. This is, I think, an entirely wrong-headed reading of the game-playing in markets today. Or more charitably, from a game-theoretic perspective there has been zero evidence of a diminution in the underlying Common Knowledge belief structure that the Fed and its brethren are responsible for market outcomes. On the contrary, as these last few days and weeks and months suggest, a belief in the Fed as the ultimate arbiter of markets has never been stronger. The modern Goldilocks market environment is growth strong enough to avoid outright recession, but weak enough to keep the Fed in play. Whenever (and wherever, as this dynamic has been mirrored in Europe, China, and Japan) signs of strong growth and thus diminished central bank support have emerged, markets have sold off. It’s only when growth falters and the drumbeat of increased or continued central bank support re-emerges that markets recover. When real world good news is market bad news, and vice versa, then rest assured that the Narrative of Central Bank Omnipotence is alive and well.

This Common Knowledge belief structure around the institution of the Fed is like the Common Knowledge belief structure around the institution of the monarchy in feudal Europe – incredibly powerful, phenomenally resistant to change, and imbued through popular belief with the power to determine economic outcomes. The Narrative around a particular Fed policy or Chair or regime will change and shift, just as the particular monarch sitting on a throne changed over time. But the underlying institution and its ability to shape the world through its core or existential Narrative changes much more slowly. Importantly, it’s the maintenance of the institution – not the maintenance of any particular king or any particular set of policies – that’s crucial for social control. That was true in 13th century England and 18th century France, and it’s just as true in 21st century western democracies with central banks.

Bottom line: “don’t fight the Fed” is a reflection of the institutional power of the Fed and the Narrative of Central Bank Omnipotence. It cuts both ways. You don’t want to be short anything when the Fed is easing, and it’s hard to be long anything when the Fed is tightening. The crowd is picking up on a shift in the easing/tightening Narrative and is beginning to act on that by selling, just as they acted on prior market-positive shifts in the easing/tightening Narrative by buying. Different monarchs; same monarchy. What’s to come? More of the same, I suspect. Good real world news is bad market news, and vice versa, for as far as the eye can see. Why? Because the crowd is not going to fight the Fed.

PDF Download (Paid Membership Required):



Hollow Men, Hollow Markets, Hollow World



Apocalypse Now (1979), based on “Heart of Darkness” by Joseph Conrad

Kurtz: Did they say why, Willard, why they want to terminate my command?
Willard:I was sent on a classified mission, sir.
Kurtz:It’s no longer classified, is it? Did they tell you?
Willard:They told me that you had gone totally insane, and that your methods were unsound.
Kurtz:Are my methods unsound?
Willard:I don’t see any method at all, sir.
Kurtz:I expected someone like you. What did you expect? Are you an assassin?
Willard:I’m a soldier.
Kurtz:You’re neither. You’re an errand boy, sent by grocery clerks, to collect a bill.


It is my belief no man ever understands quite his own artful dodges to escape from the grim shadow of self-knowledge. 

The question is not how to get cured, but how to live.

– Joseph Conrad (1857 – 1924)

Billions of dollars are flowing into online advertising. But marketers also are confronting an uncomfortable reality: rampant fraud.
About 36% of all Web traffic is considered fake, the product of computers hijacked by viruses and programmed to visit sites, according to estimates cited recently by the Interactive Advertising Bureau trade group.

– Wall Street Journal, “The Secret About Online Ad Traffic: One-Third Is Bogus”, March 23, 2014

Over the last decade, institutional management of equity portfolios has increased from 54% to 81%. …

Institutional buys and sells accounted for 47% of trading volume between 2001 and 2006, but only 29% of trading volume since 2008.…

One of the most significant results of the tension between fewer market participants and larger parent order sizes is that the share of ‘real’ trading volume has declined by around 40% in the last five years.

– Morgan Stanley QDS, “Real Trading Volume”, Charles Crow and Simon Emrich, April 11, 2012

I first saw Apocalypse Now as a college freshman with two roommates, a couple of years after it had been released, and I can still recall the dazed pang of shock and exhaustion I felt when we stumbled out of the theatre. Nobody said anything on the drive back to campus. We were each lost in our thoughts, trying to process what we had just seen. Our focus was on Marlon Brando’s Col. Kurtz, of course, because we were 18-year old boys and he was a larger than life villain or anti-hero or superman or … something … we weren’t quite sure what he was, only that we couldn’t forget him.

When I reflect on the movie today, though, I find myself thinking less about Kurtz than I do about Martin Sheen’s Capt. Willard. Both Kurtz and Willard were self-aware. They had no illusions about their own actions or motivations, including the betrayals and murders they carried out. Both Kurtz and Willard saw through the veneer of the Vietnam War. They had no illusions regarding the essential hollowness of the entire enterprise, and they saw clearly the heart of darkness and horrific will that was left when you stripped away the surface trappings. So what made Willard stick with the mission? How was Willard able to navigate within a world he knew was playing him falsely, while Kurtz could not? I don’t want to say that I admire Willard, because there’s nothing really admirable there, and this isn’t going to be a web-lite note along the lines of “Three Things that Every Investor Should Learn from Apocalypse Now”. But there is a quality to Willard that I find useful in recalling whenever I am confronted with hard evidence that the world is playing me falsely. Or at least it helps keep me from shaving my head and going rogue.

The WSJ article cited above – where it now seems that more than one-third of all Web traffic is fake, generated by bots and zombies to create ad click-throughs and fake popularity – is a good example of what I’m talking about. One-third of all Web traffic? Fake? How is that possible? I mean … I understand how it’s technologically possible, but how is it possible that this sort of fraud has been going on for so long and to such a gargantuan degree that I don’t know about it or somehow feel it? I’m sure that anyone in e-commerce or network security will chuckle at my naïveté, but I was really rocked by this article. What else have I been told or led to believe about the Web is a lie?

But then I remember conversations I have with non-investor friends when I describe to them how little of trading volume today is real, i.e., between an actual buyer and an actual seller. I describe to them how as much as 70% of the trading activity in markets today – activity that generates the constantly changing up and down arrows and green and red numbers they see and react to on CNBC – is just machines talking to other machines, shifting shares around for “liquidity provision” or millisecond arbitrage opportunities. Even among real investors, individuals or institutions who own a portfolio of exposures and aren’t simply middlemen of one sort or another, so much of what we do is better described as positioning rather than investing, where we are rebalancing or tweaking a remarkably static portfolio against this generic risk or that generic risk rather than expressing an active opinion on the pros or cons of fractional ownership of a real-world company. Inevitably these non-investor friends are as slack-jawed at my picture of modern market structure as I am when I read this article about modern Web traffic structure. How can this be, they ask? I shrug. There is no answer. It just is.

My sense is that if you talk to a professional in any walk of life today, whether it’s technology or finance or medicine or law or government or whatever, you will hear a similar story of hollowness in their industry. The trappings, the facades, the faux this and faux that, the dislocation between public narrative and private practice … it’s everywhere. I understand that authenticity has always been a rare bird on an institutional or societal level. But there is something about the aftermath of the Great Recession, a something that is augmented by Big Data technology, that has made it okay to embrace public misdirection and miscommunication as an acceptable policy “tool”. It’s telling when Jon Stewart, a comedian, is the most authentic public figure I know. It’s troubling when I have to assume that everything I hear from any politician or any central banker is being said for effect, not for the straightforward expression of an honest opinion.

The question is not “Is it a Hollow World?”. If you’re reading Epsilon Theory I’m pretty sure that I don’t have to spend a lot of words convincing you of that fact. Nor is the question “How do we fix the Hollow World?”. Or at least that’s not my question. Sorry, but being a revolutionary is a young man’s game, and the pay is really bad. More seriously, I don’t think it’s possible to organize mass society in a non-hollow fashion without doing something about the “mass” part. So given that we are stuck in the world as it is, my question is “How do we adapt to a Hollow World?”.  As Conrad wrote, the question is not how to get cured, but how to live. How do we make our way through the battlefield of modern economics and politics, a world that we know is hollow and false in so many important ways, without losing our minds and ending up in a metaphorical jungle muttering “the horror, the horror” to ourselves?


Two suggestions for adapting to the Hollow Market piece of a Hollow World, one defensive in nature and one for offense.

On defense, recognize that modern markets are, in fact, quite hollow and everything you hear from a public voice is being said for effect. But that doesn’t mean that the underlying economic activity of actual human beings and actual companies is similarly fake or bogus. The trick, I think, is to recognize the modern market for what it IS – a collection of socially constructed symbols, exactly like the chips in a casino, that we wager within games that combine a little skill with a lot of chance. There is a relationship between the chips and the real-world economic activity, but that relationship is never perfect and often exists as only the slimmest of threads. The games themselves are driven by the stories we are told, and there are rules to this game-playing that you can learn. But it’s a hard game to play, and it’s even harder to find a great game-player who will bet your chips on your behalf. A better strategy for most, I think, is to adopt an attitude of what I call profound agnosticism, where we assume that ALL of the stories we hear (including the narratives of economic science) are equally suspect, and we make no pretense of predicting what stories will pop up tomorrow or how the market will shape itself around them. What we want is to have as much connection to that underlying economic activity of actual human beings and actual companies as possible, and as little connection as possible to the game-playing and story-telling, no matter how strongly we’ve been trained to believe in this story or that. I think what emerges from this attitude can be an extremely robust portfolio supported by more-than-skin-deep diversification … a portfolio that balances historical risks and rewards rather than stories of risk and reward, a portfolio that looks for diversification in the investment DNA of a security or strategy as well as the asset class of a security or strategy.

On offense, look for investment opportunities where you have information that reflects an economic reality at odds with the public voices driving a market phenomenon. This is where you will find alpha. This is where you can generate potential returns when the economic reality is ultimately revealed as just that – reality – and the voices shift into some other story and the market matches what’s real. These opportunities tend to be discrete and occasional trades as opposed to long-standing strategies, because that’s the nature of the information beast – you will rarely capture it in a time and place where you can act on it. Almost by definition, if the information is being generated by a public voice it’s probably not actionable, or at the very least the asymmetric risk/reward will have been terribly muted. But when you find an opportunity like this, when you have a private insight or access to someone who does against a market backdrop of some price extreme … well, that’s a beautiful thing. Rare, but worth waiting for.


I’ll close with a few selected lines from TS Eliot’s The Hollow Men, because I’m always happy to celebrate a time when poets wore white-tie and tails, and because I think he’s got something important to say about information and communication, authenticity and deception.

                                                                 Between the idea
                                                                 And the reality
                                                                 Between the motion           
                                                                 And the act
                                                                 Falls the Shadow

What is the Shadow? I believe it’s the barrier that communication inevitably creates among humans, including the mental barriers that we raise in our own minds in our internal communications – our thoughts and self-awareness. Sometimes the Shadow is slight, as between two earnest and committed people speaking to each other with as much authenticity as each can muster, and sometimes the Shadow is overwhelming, as between a disembodied, mass-mediated crowd and a central banker using communication as “policy”. Wherever you find a Shadow you will find a hollowness, and right now the Shadows are spreading. This, I believe, creates both the greatest challenge and opportunity of our investment lives … not to pierce Eliot’s Shadows or to succumb to Conrad’s Heart of Darkness in our hollow markets, but to come to terms with their existence and permanence … to evade their influence as best we can, all the while looking for opportunities to profit from their influence on others.

PDF Download (Paid Membership Required):



Two Shifting Narratives


Two brief observations on incipient shifts in powerful Narratives …

First, China. The pleasant charade that recent currency intervention was nothing more than an effort to reverse the “one-way bet” of speculators and to “increase volatility” as part of China’s accession to some brotherhood of liberal nations is starting to crumble.  Let me put it this way … you know that your preferred Narrative is in trouble when even the WSJ runs a piece titled “Yuan’s Decline Raises Concerns Over Currency War”. This is something I’ve written a lot about recently, here and here, and the political repercussions of slowing growth in China continue to make my risk antennae quiver. Politically speaking, weak real economic growth can be papered over by Fed-engineered financial asset price inflation in the US and by la dolce vita social policies in Europe. Neither option is available to Chinese leadership. China needs to make and sell more things – domestically, internationally, whatever – to keep the political machinery from coming unglued, and that’s the lens through which I see the China story.

Second, the Fed. I’ve been somewhat surprised by the trial balloons and back-bench grumblings posted recently by our favorite Fed amanuensis, Jon Hilsenrath – the latest out just this morning. It’s too soon to read a lot into this (although it can’t make Yellen, whose professional Narrative is all about being a “consensus builder”, terribly happy), but of note was the criticism leveled at Michael Woodford, probably the most influential economist you’ve never heard of. Woodford is the guy behind the notion that the Fed can create a market reality just by saying something. He is the academic theory behind recent “communication policy” practice. Consumer spending and business investment not up to snuff? Want to get that inflation engine started? Just say that you’re going to keep rates artificially low waaaaay longer than you ordinarily would. No need for reasons or justifications or credibility. Simply saying it will drive market expectations and thus make it so. (Here’s a link to a recent Woodford paper on all this, “Fedspeak”).

Is there a germ of truth in Woodford’s theory? Absolutely. Words matter, and the Fed’s words matter more than anyone’s. But this is the classic mistake that academic economists always make – the quasi-religious belief in theory over practice, in the triumph of bloodless ideas over the market’s fang and claw. Woodford’s ideas are sweet music to the enormous egos of the academics who control the Fed: you can save the world just by stating your brilliant policy intentions. Your words will become self-fulfilling prophecies as the markets shape themselves in expectation of your mighty deeds.

And so what do we get? Horror shows like Bernanke’s press conferences last summer or Yellen’s press conference last week. Here’s what I wrote last September after one of Bernanke’s performances in the Epsilon Theory note, “Uttin on the Itz”:



“In Young Frankenstein, Mel Brooks and Gene Wilder brilliantly reformulate Mary Shelley’s Frankenstein, a tragedy in the classic sense, as farce. The narrative crux of the Brooks/Wilder movie is Dr. Frankenstein’s demonstration of his creation to an audience of scientists – not with some clinical presentation, but by both Doctor and Monster donning top hats and tuxedos to perform “Puttin’ on the Ritz” in true vaudevillian style. The audience is dazzled at first, but the cheers turn to boos when the Monster is unable to stay in tune, bellowing out “UTTIN’ ON THE IIIITZ!” and dancing frantically. Pelted with rotten tomatoes, the Monster flees the stage and embarks on a doomed rampage. Wilder’s Frankenstein accomplishes an amazing feat – he creates life! – but then he uses that fantastic gift to put on a show. So, too, with QE. These policies saved the world in early 2009. Now they are a farce, a show put on by well-meaning scientists who have never worked a day outside government or academia, who have zero intuition for, knowledge of, or experience with the consequences of their experiments.”

Now, less than a year later, we are suffering through exactly the same sort of miserable song-and-dance routine, just with a different actor playing the Gene Wilder role. If the Fed was surprised by the rotten tomatoes thrown up on the stage last year, they ain’t seen nothing yet.

epsilon-theory-two-shifting-narratives-march-24-2014.pdf (213KB)


Surely You Can’t Be Serious



The Secret of life is honesty and fair dealing. If you can fake that you’ve got it made.

These are my principles, and if you don’t like them…

well, I’ve got others.

I’m not crazy about reality, but it’s still the only place to get a decent meal.

A child of five could understand this. Send me someone to fetch a child of five.

Room service? Send up a larger room. 
Groucho Marx (1890 – 1977)

In periods of great global stress, like after a World War or a Great Depression, it’s not only our politics and economics that are thrown for a loop, but also our art and entertainment. New art, and comedy in particular, that rejects or makes fun of the ancien regime after some enormous crisis is as old as Aristophanes. This art is subversive, often masking its contempt with “low comedy” like puns and slapstick, and no one in the past century was better at this than Groucho Marx. I’ve lately found myself thinking of Fed communications as a form of performance art … some sort of Dada-ist comedy routine where Groucho might stick his head out from behind a curtain and photobomb the press conference … and never more so than yesterday. If only it were so.

Yellen’s press conference was a disaster. Why? Because she said too much. Because on the one hand she took away the insane linkage between monetary policy and the unemployment rate – an ill-conceived and counter-productive misreading of market game-playing that I wrote about ad nauseam last summer, here and here – but on the other hand she gave a specific timing target for raising rates after QE is all tapered out. Combine this with the three-times-in-a-row pattern of cutting monthly QE purchases by $10 billion per meeting, and now even Jon Hilsenrath is projecting specific calendar dates for raising rates.

I mean, you really can’t make this stuff up. Did the Fed learn nothing from last summer? This isn’t an academic exercise, where statements are qualified and softened by exhaustive footnotes and asides so that no one is ever wrong. The market is a beast, not the review committee for the Quarterly Journal of Economics. Of course the market is going to leap at and devour a statement like Yellen’s 6 months comment, and you’d think that the Fed Chair would know that.

All together now, one more time with feeling: ambiguity is good; transparency is bad. You might think that transparency would be helpful in “shaping market expectations” the way you like, but you would be wrong. That’s not how the game is played. Can I nominate Bill Belichick for the Fed, at least as far as press conferences are concerned?

And I’m very sympathetic to Kocherlakota’s dissent … if you ARE going to take a stand with an explicit linkage to unemployment rates, then you can’t just say “oh, never mind that” less than a year later and expect that whatever new standards you set out for rate-setting are going to be particularly effective in molding expectations. It’s not a matter of credibility, per se. That’s a very specific word with a very specific meaning in game theory, and the simple truth is that the Fed will always be credible enough to be an effective game player. The problem is actually that the Fed is too credible, and that Yellen’s remark about raising rates within 6 months of stopping QE3 takes on far more import than was intended.

Sigh. Look, maybe I’m over-reacting here. Maybe we are all so freaking exhausted by the constant use of communication as policy, by the unceasing effort of the Fed and its media intermediaries to play the market, by the Orwellian nature of a monetary policy apparatus where everything is spoken for effect, that we will all just go about our business and slog along. And I’m sure we will see lots of back-tracking over the next few weeks, lots of data-dependence talk, lots of “Yellen really didn’t say anything new”, yada yada yada. But my fear is that we’ve set the stage for, if not an inflection point in the path of the stock market, then another rate shock similar to but smaller than last summer’s … an aftershock, in geological terms.

What am I looking for to see how this plays out? I think we are now even more strongly in a good-news-is-bad-news (and vice-versa) world. If we start seeing some strong economic data come out over the next few weeks and months, then I think the market – particularly the bond market and emerging markets – could get pretty squirrelly. Not that US stocks would be immune from this. Remember, the modern day Goldilocks environment for stocks has nothing to do with a happy medium between growth and inflation, but everything to do with growth being weak enough to keep an accommodative Fed in play. Strong growth data would augment a Common Knowledge structure that the Fed is on track to raise rates sooner and more rather than later and less, and that’s no fun for anyone. Then again, if global growth data remains weak – and you really can’t look at what’s coming out of China, Europe, or Japan and think that the global growth story is anything but weak – that creates enough uncertainty about the Fed’s path (not to mention the cover for political and economic Powers That Be to wage a full-scale media war to keep monetary policy in QE la-la land forever) to support the markets. Sounds a lot like Freedonia to me. Rufus T. Firefly for President?

PDF Download (Paid Membership Required):




Panopticon schematic, 1791Michel Foucault, 1975 © Camera Press

The Panopticon: a new mode of obtaining power of mind over mind, in a quantity hitherto without example.
– Jeremy Bentham, founder of modern utilitarianism (1748 – 1832) 

But the guilty person is only one of the targets of punishment. For punishment is directed above all at others, at all the potentially guilty. 

– Michel Foucault, “Discipline and Punish: The Birth of the Prison”

Visibility is a trap. 

– Michel Foucault, “Discipline and Punish: The Birth of the Prison”

There is little doubt that hedge funds have entered a new era of transparency and public openness – a transformation that I believe will benefit investors, the public, and regulators… One immediate benefit of this requirement to your industry should be that transparency will enable you to shed the secretive, “shadowy” reputation that some would say has unfairly surrounded you.
– Mary Jo White, SEC Chair, speech to Managed Funds Association, October 18, 2013

The advance of civilization is nothing but an exercise in the limiting of privacy.
– Isaac Asimov, “Foundation’s Edge”

Whatever games are played with us, we must play no games with ourselves, but deal in our privacy with the last honesty and truth.
– Ralph Waldo Emerson (1803-1882)

In 1791, Jeremy Bentham published a book describing what was clearly a revolutionary design for prisons, factories, schools, hospitals – any institutional building where a few administer instruction, discipline, or care to the many. This design, what Bentham called a Panopticon, was trumpeted as “Morals reformed — health preserved — industry invigorated — instruction diffused — public burdens lightened — Economy seated, as it were, upon a rock — the Gordian knot of the poor-law not cut, but untied — all by a simple idea in Architecture!” No shrinking violet here, but the booming, confident voice of the father of utilitarianism, a man who wrote 30,000,000 words in a lifetime of social activism.


Jeremy Bentham, by Henry William Pickersgill

A Panopticon has a large circular watchtower in the middle of a larger circle of cells or offices or classrooms or whatever functional task space is appropriate for the building at hand. The outer circle of cells has inner walls and doors made of transparent windows, and the reverse is true of the central watchtower, which is completely opaque as seen from the outside. From the watchtower you can see perfectly into every cell, but from a cell you can see nothing in the watchtower. Importantly, any occupant of a cell can see pretty much every other occupant of every other cell.

The beauty of the Panopticon, per Bentham, was that the occupants of each cell would soon come to police themselves. That is, the only thing necessary to create the perception of being watched and monitored and punished for bad behavior was the constant possibility of being watched and monitored and punished for bad behavior, together with the communal witnessing of your fellow prisoners behaving as if they were watched and monitored and punished for bad behavior. It’s not necessary for a guard or overseer to watch each prisoner at all times; what’s necessary is for each prisoner to live in a perfectly transparent cell, so that each prisoner thinks that he is being watched at all times. As Bentham wrote, the Panopticon design was a means of controlling the minds of prisoners or workers through mental force, as opposed to the traditional goal in 18th century prisons and workhouses of controlling bodies through brute force. Just like the warden in Cool Hand Luke, just like Dick Clark with American Bandstand, Bentham understood the enormous power of the crowd seeing the crowd. What he added to the calculus of social control was the important catalyst of transparency.

Thinking of transparency and openness as an instrument of social mind control is a hard pill to swallow in an era of social media and reality TV. So many of us embrace personal openness and the sharing of our thoughts…so many of us, as Christopher Hitchens ruefully noted about himself, run towards a camera instead of run away…that it seems almost un-American, rather impolite, and certainly anti-modern to maintain privacy and secrecy in our social relationships. We live in an age where transparency is lauded as a personal virtue and touted as a hallmark of liberty, where public confession is a celebrated ritual and a trusty engine of popular entertainment, where our employers expect as a matter of course that our private lives will merge with our business lives to allow constant access and attention. We live in an age where government requires disclosure of private investment strategies and holdings under the guise of “risk management”, where failure to disclose a private opinion on public securities can be a crime, where – as Dave Egger’s chillingly writes in The Circle –  “Secrets are Lies”, “Sharing is Caring”, and “Privacy is Theft”.

Transparency has nothing to do with freedom and everything to do with control, and the more “radical” the transparency the more effective the control…the more willingly and completely we police ourselves in our own corporate or social Panopticons. This was Michel Foucault’s argument in his classic post-modern critique Discipline and Punish: The Birth of the Prison, which – just because it was written in an intentionally impenetrable post-modernist style, and just because Foucault himself was a self-righteous, preening academic bully as only a French public intellectual can be – doesn’t make it wrong. The human animal conforms when it observes and is observed by a crowd, at first for fear of discipline but ultimately because that discipline is internalized as belief and expectation.

To be clear, I’m not saying that transparency is a bad thing for the society or institutions that enforce it. I simply want to call it by its proper name…an extremely powerful instrument of social control, not a “benefit” for the watched. Firms like Bridgewater that famously require a culture of transparency are, I believe, far more efficient and robust than their competitors that don’t. To take a trivial example apropos in mid-March, do you think that a lot of time is wasted at Bridgewater during work hours by employees sending around NCAA tournament brackets? Yeah, right. Not because there’s some “rule” against researching your NCAA bracket while at work, but because it would be unthinkable (and I mean that in a purely literal sense of the word) to do so within the glass walls of an effective Panopticon. A Panopticon crushes any sense of complacency in its residents, and that’s a really big plus for a modern institution. For the residents themselves, of course, that lack of complacency may manifest itself as a wee bit of constant stress. Or to take an example from the investment industry as a whole, SEC Chair Mary Jo White is absolutely right when she says that transparency is good for regulators. Heck, it’s greatfor regulators. But she’s entirely disingenuous when she touts the removal of secrecy as a good thing for private investment funds.

What’s my investment point in this little diatribe? As investors in highly regulated public markets we are all operating within a Panopticon of sorts. Some of us more obviously than others, but we’re all similarly situated to a rough degree. It’s critical to understand the dynamics of the crowd watching the crowd within a regulatory environment of forced transparency so that we can have a realistic notion of what’s possible and what’s not as we try to achieve our personal or institutional investment goals.

Capturing alpha in an investment strategy requires private information. To the degree that forced regulatory transparency and Big Data technology reduce private information by turning it into common knowledge, there is less alpha in markets. That’s a cold, hard fact. Finding alpha has never been easy. It’s always been the rarest thing in the investing world, but now it’s truly an endangered species, particularly in the stock-picking world of fundamental analysis of public companies. We have moved from a regulatory environment where illegal private information was pretty much defined as stealing the orange growers’ crop report from the USDA a la Trading Places (Mortimer Duke: “Turn those machines back on!”), to an environment where the mere existence of market-beating investment returns is treated as prima facie evidence that you must have been doing something illegal to generate those returns. Professional investors today are scared to death of private information on public companies. It’s never been more expensive or difficult to acquire, and the regulatory assumption is that – if it works – then it must have been illegally obtained. No wonder, then, that so many hedge fund giants accustomed to investing on the basis of private information are sailing as fast as they can for the safe harbor of advocacy and activism, where a large position and a board seat or two may cost you dearly in terms of liquidity but allows you to legally obtain and act on private information as a company insider. And even if you don’t reach the promised land of board membership and true insider status, at least you can talk up your own book with incessant public statements about your “investment thesis” without drawing regulatory scrutiny. All of the big boys play the Common Knowledge game today, because that’s how they adapt to a Panopticon. They make themselves more visible to the crowd and make more public statements because they can create, for a while at least, their own investing reality. They know that if they speak loudly enough and long enough, enough of us little guys will follow their lead on the stock. It’s what little guys DO.

Wow, that’s a pretty bleak assessment, Ben. Isn’t there some hope for alpha still out there in the world, even for the little guys? Sure. It’s in your neighborhood. It’s in your family business. It’s in whatever you know really well, some endeavor that by dint of education or experience you happen to have private information about. That’s where you’ll find alpha. Remember Peter Lynch and “buy what you know”? There’s a lot of wisdom in that, so long as you keep in mind that in Lynch’s day you could know an Apple or a Microsoft in a way that is impossible and/or illegal today. In today’s public markets I think it’s still possible to find managers with private information, but you have to look in the cracks and crevices of the market, in relatively small niches where the traders and investors that I refer to as beautiful parasites still live. These managers tend to be relatively small, and they are almost always superb game-players, able to generate alpha by, as Keynes put it, “guessing better than the crowd how the crowd will behave.”

And remember, too, that finding alpha isn’t the only reason to invest in public markets. Liquidity is important. Tagging along with broad-based economic growth through a broad-based capital market is important. But most of all diversification is important. Harry Markowitz, the father of Modern Portfolio Theory, always bristles at that label, saying that there’s nothing modern about it at all. He’s exactly right. Portfolio theory is an old, wonderful idea. You can dress it up in scientific finery as MPT does, and there’s definitely a role for that, but there’s also a very real danger that the arcane language and self-appointed priesthood of modern economic science gets in the way of a personal appreciation of the very real benefits of a diversified portfolio. I’ve written recently about applying the Adaptive Investing lens to questions of diversification, and I’m going to continue focusing on that in the future. Because while alpha in public markets may be rare and getting rarer as private information vanishes before the onslaught of forced transparency, diversification is still there for the taking. And that’s an opportunity I’m happy to use my media microphone to encourage.

PDF Download (Paid Membership Required):






Question:Mr. President, a clarification if I may. The people who were blocking the Ukrainian Army units in Crimea were wearing uniforms that strongly resembled the Russian Army uniform. Were those Russian soldiers, Russian military?
Putin:Why don’t you take a look at the post-Soviet states. There are many uniforms there that are similar. You can go to a store and buy any kind of uniform.
Question:But were they Russian soldiers or not?
Putin:Those were local self-defense units.

– Vladimir Putin press conference, March 4, 2014

Kane:Read the cable.
Bernstein:“Girls delightful in Cuba. Stop. Could send you prose poems about scenery, but don’t feel right spending your money. Stop. There is no war in Cuba, signed Wheeler.” Any answer?
Kane:Yes. “Dear Wheeler: you provide the prose poems. I’ll provide the war.”

– Orson Welles, “Citizen Kane”

Indeed, expectations matter so much that a central bank may be able to help make policy more effective by working to shape those expectations. … Communication about policy is likely to remain a central element of the Federal Reserve’s efforts to achieve its policy goals.
– Ben Bernanke, “Communication and Monetary Policy”, November 19, 2013

There’s no one thing that’s true. It’s all true.
– Ernest Hemingway, “For Whom the Bell Tolls”

Last Friday I wrote an Epsilon Theory email highlighting the media Narrative around China’s shift in monetary policy and associated manipulation of the yuan as a prime example of The Power of Why…a facile “explanation” designed to satisfy the business model imperative of financial media (and financial advisory services, more broadly) as well as the political interests of powerful institutions, in this case the Chinese state. I wasn’t surprised that the epicenter of this Narrative was a newspaper owned by Rupert Murdoch, whose close ties to the Beijing regime are legendary, and I tried to be kind in not calling out the beat writers who I’m sure were provided with precise talking points. But I am surprised by the degree to which mainstream economists and China watchers have uniformly swallowed and promulgated the notion that this sea change in Chinese monetary policy – which is far more impactful on global economics and investing than anything that happens in the Ukraine – is not only entirely benign but part and parcel of China’s accession to liberal modernity and the brotherhood of Western nations.

There are two levels to the official Chinese line on their monetary policy shift – one for the hoi polloi and one for the professional economist/analyst community. I’ll deal with both, and apologies in advance for the density of the latter, which requires a bit of inside-baseball lingo.

The first argument is that China is seeking to end the “one-way bet” (I only wish I had copyrighted this phrase two weeks ago, like Pat Riley did with “three-peat”) on the yuan going up in value. This argument appeals to a Western, liberal-minded opposition to rigged markets and evil “speculators”. Unfortunately, it’s complete hogwash, the linguistic equivalent of US politicians who clamor for “a level playing field” while voting for the usual assortment of pork barrel goodies. It’s wordplay, entirely symbolic in nature, no different than my saying that I’d like to end the one-way bet on gravity. The Chinese government intentionally created this one-way bet, because the alternatives – either a free-floating currency or a fixed currency regime – would have resulted in unacceptable domestic economic damage in the former case or unacceptable international political damage in the latter case. The yuan has been going up in a highly predictable fashion because that’s exactly what the Chinese government wanted and imposed. To say now that they are shocked…shocked!…at the speculation this engenders is a stratagem in the best tradition of Casablanca’s Capt. Renault.

Are there speculators (I call them beautiful parasites) who eat the tiny trading crumbs created by the Chinese government’s non-economic dribbling of the yuan higher? Of course. Is the Chinese government – like governments everywhere – genuinely delighted to crush these lamprey eels if they can? Sure. But are they the reason China is shifting its monetary policy? Please.

The inside-baseball argument is more nuanced, but ultimately just as misleading. In version A, China is trying to engender a wider “volatility band” in the yuan so that it will ultimately trade like a market-oriented currency. In the still more nuanced (and thus still more appealing to economists) version B, China is seeking to reduce volatility in domestic interbank lending and associated interest rate spreads, and as a result is “transferring” that volatility to currency exchange rates. Again, all with the goal of making Chinese monetary tools and policy more in-line with Western monetary tools and policy.

The problem I have with this argument – and the reason my risk antennae are quivering – is the orchestrated and intentional linguistic focus on volatility. The word “volatility” means something. It’s an important and powerful word. There are assumptions behind the word and its meaning. Those assumptions are not just violated here; they are crushed. The word “volatility” means nothing in the context of a highly manipulated data series. Or rather, it means something entirely different from what it means in a non-manipulated context. It’s ersatz volatility. Potemkin Village volatility. Faux volatility. I could go on. Whatever it is, it doesn’t mean what you think it means.

I’ll spare you the dissertation on stochastic underpinnings of econometric concepts. Suffice it to say that what’s happening here is like someone telling you that he has a random number generator when really he’s just spouting off numbers that pop into his head and sound kind of random. Trust me, these are not random numbers. But if you treat them as random numbers, say for some encryption program, you’re going to be very sorry. Similarly, if you treat “volatility” in a yuan/dollar time series the same way you treat volatility in the euro/dollar time series, say for some relative value forex trading program…well, good luck with that. You, too, are going to be very sorry.

So why the intentional (and intentionally misleading) focus on volatility as the WHY behind a monetary policy shift? What’s at stake here and what’s really going on?

First, let me be clear on what I’m NOT saying. I am not saying that Chinese government economists and policy apparatchiks are out and out lying when they say that they want to crush currency speculators and diminish interbank lending volatility, particularly that latter part. I think that the Chinese government – like governments everywhere – is terrified of domestic lending seizures or dislocations and will do pretty much anything to mitigate that risk. I also think that the government functionaries who communicate with Western economists and analysts (and not coincidentally tend to speak really good English) are likely true believers in the ultimate liberalization of the Chinese economy along a more or less Western model.

But it’s not the whole truth. It’s not even, I believe, the essential truth.

The essential political truth in China – the glue that keeps the Party, the Army, and 1.4 billion people cobbled together – is economic growth. Economic growth is the fundamental WHY of the modern Chinese State, its raison d’etre. This is why Deng Xiaoping mattered so much, because he gave the Chinese State a coherent and attractive alternative to the ultimately self-destructive Permanent Revolution and Vanguard Party of Mao. But if economic growth fails in China, if the WHY of Deng Xiaoping’s vision fails…then so does the modern Chinese State. The liberal nations of the West can withstand a Great Recession, even a Great Depression, because there’s a WHY to small-l liberalism that transcends expediency and the “glory of wealth”. Not so China. Or at least not so this China, with this governing philosophy.

What I’m saying is that the Chinese government is demonstrating the primacy of domestic politics over everything else. Just like the US government is demonstrating with QE. Just like the Russian government is demonstrating in its actions against Ukraine.

What I’m also saying is that the Chinese government is communicating its monetary policy with language that tries to misdirect, that tries to mask its true political face. Just as the US government communicates its monetary policy. Just as the Russian government communicates its foreign policy.

China must maintain a certain level of economic growth. What that level is, or how we would measure or know it from the outside, I have no idea. But I have no doubt that the Chinese leadership, who live and breathe the political diktat of economic growth every single day, know it quite well. Or rather, they know it when they see it, and they know it when they don’t. Every other consideration – faux “volatility bands” and thumping of currency “speculators” foremost among them – is at best epiphenomenon or side-effect to the core imperative of delivering growth.

Is growth in China falling off a cliff? No way. If it were, we would have seen this sort of policy shift months ago, and a lot more drastic stuff today. But is growth in China uncertain, within a political environment where the governing regime is not only accustomed to certainty but requires a high threshold level of growth for its survival? Yes, I believe it is, and that is more than enough to mobilize the traditional pro-growth tools of monetary policy – easy credit and a weaker currency – into high gear.

In the Chinese context, easy money is not central bank balance sheet expansion or even lowering short rates. It’s turning a blind eye to credit expansion in the shadows. It’s guaranteeing liquidity to banks so that they don’t worry about interbank lending. It’s bailing out wealth management products. How long will they do this? Until the uncertainty goes away.

In the Chinese context, a weaker currency is not some free-floating pound that gets devalued by 20% in a day amid a flurry of recrimination and regret. It’s a carefully managed yuan that probably looks flat versus the dollar over the next 18 months rather than upward sloping. And if exports get tougher or the yen gets cheaper, maybe it’s got a downward bias. But compared to the past 8 years of a steadily increasing yuan, this is a big deal. A really big deal. It will create significant trade tensions with the US, and it will make Japan’s devaluation/inflation course that much more difficult to achieve. But you know what? China doesn’t care. The last 8 years have been a monetary policy of choice. Today we see a monetary policy of necessity. Maybe the West and its army of China apologists will go for the whole “it’s only benign volatility” line, and maybe they won’t. No matter. The Middle Kingdom takes care of its own.

PDF Download (Paid Membership Required):



Two Quick Points


Two quick Epsilon Theory points before the jobs report tomorrow.

First, remember the Goldilocks Narrative of the post-Great Recession Era…slow growth keeps the Fed in play, so disappointing but still positive job numbers are an initial shock but ultimately market friendly. Conversely, surprisingly good job numbers may be good news for the real world, but not for the market.

Second, I’m seeing clear signs of a new Technology Bull sub-Narrative in recent weeks…that there is something special and powerful about tech stocks regardless of what happens with the Fed or job numbers or the rest of the world. The investment language of Growth and the grammar of Extrapolation are running rampant, and that can create a very powerful market dynamic within a certain orbit of securities. These sub-Narratives can run for a long time.

epsilon-theory-two-quick-points-march-6-2014.pdf (26KB)


The Power of Why, Exhibit 4,512 in a Continuing Series


No man is an Iland, intire of it selfe;
Every man is a peece of the Continent, a part of the maine;
If a Clod bee washed away by the Sea, Europe is the lesse, as well as if a Promontorie were, as well
as if a Mannor of thy friends or of thine owne were;
Any man’s death diminishes me, because I am involved in Mankinde;
And therefore never send to know for whom the bell tolls;
It tolls for thee.
John Donne (1572 – 1631), “Devotions upon Emergent Occasions”

I’m often asked what I read for Epsilon Theory, and the answer is that my daily fodder is the same as everyone else’s – the NYT, the WSJ, the FT, Bloomberg, etc. But I think that I read media differently from most people, and that’s the key for an Epsilon Theory perspective. I’m not reading these articles for facts, but for the effort to lead opinion…to communicate an opinion as if it were fact. It’s not hard to read this way. Every time you see a word like “because” or anytime you read a “reason” why something happened the way it did, you just need to detach yourself from the article and consider how you are being played.

I don’t mean that in a malevolent sense. It’s what social animals DO. It’s what it means to be a social animal. Ants, bees, termites, and humans – the most successful species on the planet – are constantly signaling each other so that we can make sense of our world together. That’s the secret of our success as social animals – E Pluribus Unum, as it says on the dollar bill – and we can no more separate ourselves from playing and being played than we can from our individual consciousness. We swim in a sea of communication and signaling. It is our media in the same sense the word is used for the agar in a Petrie dish, and that’s how I think of media in the sense of newspapers and television and the like.

My favorite example? On November 24, 2008, President-elect Obama announced that he would nominate Tim Geithner as his Treasury Secretary. The S&P 500 was up about 6% that day, and Geithner’s nomination was widely credited as the “reason”. All of the talking heads on the Sunday talk shows that weekend referenced the amazing impact that Geithner had on US markets, and this “fact” was prominently discussed in his confirmation hearings. Clearly this was a man beloved by Wall Street, whose mere presence at the economic policy helm would soothe and support global markets. Yeah, right.

Was Geithner’s nomination good news? Sure. I mean…I suppose. So long as Obama didn’t nominate a raving Marxist I think it would have been a (small) positive development in the context of the collapsing world of November 2008. Was the specific nomination of specifically Tim Geithner WHY markets were up so much on November 24th? Of course not.

The inherent problem is that any market movement is over-determined. There are far more reasons that might account for a market move than actually account for the move, and that’s without any consideration of stochastic factors or game-playing behaviors. But the questions of “Why is the market up?” or “Why is the market down?” are the only questions that matter in the heat of a big move up or a big move down, and no one who is in the business of answering such questions is ever going to say “I don’t know” or “no reason”. You MUST provide an acceptable answer, or whoever is asking the question is quickly going to find someone else to replace you. Fortunately, you can’t be proved wrong if you ascribe market causality to a contemporaneous event, so it’s the totally safe play to say that the November 24th 2008 market was up “because” of Geithner. And once a prominent opinion-leader like the WSJ says it’s true, it’s not only a safe answer…it’s the only answer that’s safe.

The ability to convince someone that you know WHY a security is up or a security is down is at the heart of the entire financial advisory industry, maybe the entire financial services sector. It is the Power of Why, and it has no inherent connection to any true causal connection or the way the world truly works. Maybe it’s all true. Probably it’s partially true. But it really doesn’t matter one way or another.

Once you start thinking of everything communicated by humans as a signal, as an intentional effort to make you see the world differently than you saw it before, your world will change. This is the great insight of Information Theory – that information is measured by how much it changes your mind, that the strength of any communication has nothing to do with truth or accuracy, but only with the subjective impact it has on your perceptions – and it’s an enormously useful insight for making sense of markets.

Two days ago the WSJ ran the online headline “China Intervenes to Lower Yuan” together with a series of articles to support the thesis that recent declines in the yuan’s value versus the dollar were the result of Chinese central bank intervention and some sort of master plan to achieve some set of policy goals. I want to include and comment on a selection from one of those accompanying articles – “Why the Yuan’s Decline Matters” – not to criticize the author (I could just as easily chosen any number of other authors from any number of other media outlets), but as an example of what I mean by the Power of Why.

Here’s what happened:
China’s yuan has fallen steadily against the U.S. dollar in the past week. On Wednesday, The Wall Street Journal reported that it wasn’t market forces or traders behind the move, but that the Chinese central bank was deliberately pushing the currency lower. That a central bank would do this on purpose has caught some off-guard, especially since the yuan was long seen by investors as a currency that was only going up.

Why does this matter now? Why are they doing it?
Currently, the yuan trades within a tight range set by the central bank every day. But, short-term traders and increasing demand is almost constantly pushing the currency higher within that range. By denting the currency’s value on purpose, the central bank is trying to spook away these traders who will now have to worry about the possibility China does this again. With fewer “speculators” trading the yuan, China hopes to have an easier path to widen the yuan’s trading range further and, in the much longer term, make the yuan a free-floating currency that’s driven only by economic and market forces.

Why does China want to free its currency in the long term?
Having a freely traded currency opens up a wide door for the yuan to become much more prominent in trade and payments across the globe. Perhaps most importantly to China, a freely convertible currency also makes the yuan a more attractive option for other central banks’ stockpiles of cash, also known as their foreign exchange reserves. Currently the U.S. dollar dominates as the number-one reserve currency in the world—that’s why so many central banks hold U.S. government bonds even when the U.S. economy doesn’t look to rosy. China wants the yuan to challenge the dollar’s long-established role, and gradually freeing its currency is a critical step to get there.

Why else?
China is also trying to push its economy away from relying so much on exports and investment. It, instead, wants more of its growth to come from domestic demand. Making the yuan behave more like a market-driven currency fits into this broader plan.

Okay. So the party line (no pun intended) is that the Chinese government is massively intervening in their currency market to make the yuan “more like a market-driven currency”. The party line is that the Chinese government is forcing its currency lower in order “to push its economy away from relying so much on exports and investment”.

Two reactions. First, I consider myself to be something of a connoisseur of opinion-leading writing, and from an artistic or aesthetic point of view I am quite simply blown away by the creativity and execution of this Orwellian masterpiece. It’s the same reaction I have when I see a politician oh-so-naturally jab at the air or flash a wry grin during a particularly moving speech. It’s a beautiful thing to see a professional excelling at his or her craft, and never so much than at moments like this when the craft becomes art.

On the other hand – from a risk management point of view – these articles made me throw up in my mouth a little bit.

Governments don’t make their currency cheaper to reduce their reliance on exports and investment. They make their currency cheaper to spur export-led growth. The problem that the world has with China as a currency manipulator is not that the yuan has been going up. The problem is that it hasn’t been going up fast enough. And now it’s being forced down.

Look, I understand why the Chinese government wants the yuan lower. The political imperative in China is still growth. Period, end of story. Net exports are the swing factor in every country’s GDP growth rates, and China is not an exception, it is the foremost exemplar. Do you think China is happy about the yen going down, down, down? Do you think China is happy about competing in export markets for advanced industrial products – because that’s what China manufactures today – with an inexorably appreciating currency? Do you really think they’re going to sit there and just take it?

I also understand why the Chinese government would prefer to characterize their actions as part of some grand domestic reform agenda, where they just need a wee bit more anti-market, export-supporting currency manipulation in order to move forward towards a glorious future of pro-market, domestic-focused life in the brotherhood of liberal nations. Pardon me if I am skeptical.

And finally, I understand why the financial media reports the Chinese government’s party line (including some after-the-fact “we really didn’t intervene that much” stories in the FT yesterday) as a True Fact rather than as a Narrative. When a market event like a plummeting yuan occurs the only thing that matters is presenting a plausible WHY, and China provided just that. Whether that story is the whole truth, some partial truth, or the equivalent of crediting Tim Geithner’s nomination for a 6% move up in the market…well, that’s really beside the point if you’re a financial media publisher. But it’s certainly not beside the point if you’re an investor or an allocator.

PDF Download (Paid Membership Required):



Don’t Fear the Reaper



Buck Finemann, seventy two years old. Cantankerous old geezer. No-one liked him much, but they allowed him to play poker with them once a week because he was a terrible card player and had been known to lose as much as seventy five cents in a single evening.

– Carl Kolchak, “Kolchak: The Nightstalker – Horror in the Heights”

Rakshasa: Known first in India, these evil spirits encased in flesh are spreading.

– E. Gary Gygax, “Advanced Dungeons & Dragons, 1st Edition, Monster Manual”

So may the outward shows be least themselves.
The world is still deceived with ornament.

Thus ornament is but the guiled shore
To a most dangerous sea, the beauteous scarf
Veiling an Indian beauty—in a word,
The seeming truth which cunning times put on
To entrap the wisest.

– Shakespeare, “The Merchant of Venice”

I would guess that not more than 1 in 100 Epsilon Theory readers remembers Darren McGavin in Kolchak: The Nightstalker. It’s a television series that only ran one year in the mid-1970’s, plus a couple of made-for-TV movies, but for whatever reason it made a big impression on me. A perpetually down-on-his-luck news wire stringer, Kolchak was a truth-seeker and a puzzle-solver, even if his truths and puzzles were found in the hidden corners and supernatural mysteries of 1970’s Chicago. Kolchak was Mulder before The X-Files was a gleam in Chris Carter’s eye.


My favorite Nightstalker episode involved a Rakshasa, an evil Indian spirit that could take the form of whatever human its victim trusted the most. For the unfortunate Buck Finemann it was his rabbi; for Kolchak (who thought himself immune because he trusted no one) it was his elderly neighbor. For weeks afterwards I enjoyed scaring myself by imagining that my family and friends were actually Rakshasas, just waiting for the most psychologically crushing moment to pounce. A few years later, when the first AD&D Monster Manual was released, I can’t tell you how delighted I was to see my old friend the Rakshasa playing a prominent role, captured perfectly by Dave Trampier’s drawing of a pipe-smoking tiger.

Almost all cultures have their mythological version of an evil shape-shifter who replaces a loved one. Sometimes it’s a child switched at birth; sometimes it’s an adult doppelgänger. The human animal has a primal fear of the counterfeit human…an alien consciousness possessing a perfectly “normal” human body…and it remains one of the foremost tropes for horror media, from “Invasion of the Body Snatchers” to “The Thing” to “The Omen”. We love to scare ourselves by imagining Rakshasas and their ilk.

In Indian mythology, however, the Rakshasa is less inherently malevolent than it is simply foreign or alien. It is an Outsider, with an entirely non-human conception of social organization and purpose, and it is this differentness, particularly when coupled with an intimately familiar external appearance, that frightens us. When the Other looks like us, we take it as a betrayal and we assume it must be a threat. External appearance is a signal, as powerful to us as a pheromone is to an ant, and as a eusocial animal we are biologically evolved and culturally trained to respond to these signals…positively to a familiar appearance and negatively to the unfamiliar. But the human animal makes immediate assumptions based on external appearance that go far beyond simple positive and negative affect. Virtually all of our communications – including the meaning we ascribe to language – are part and parcel of the cognitive models we form based on external appearance. There are plenty of good evolutionary reasons why the human animal places such an inordinate reliance on external appearances to drive our Bayesian decision-making processes, plenty of reasons why we are so suspicious of differentness, so trusting of sameness. But all of these good reasons were developed for small group subsistence on the African savanna 100,000 years ago, not modern mass society.

In 1952 John Steinbeck published East of Eden, the book he considered to be his masterpiece. There’s a passage in this book – a startling conversation between the wealthy farmer Samuel and his Cantonese cook, Lee – which reveals beautifully the chasm of meaning and understanding in our communications perniciously created by our group-oriented, external appearance-focused, social animal nature. It’s a genius observation of the human condition, and I hope it prompts you to read the book.

“Lee,” he said at last, “I mean no disrespect, but I’ve never been able to figure out why you people still talk pidgin when an illiterate baboon from the black bogs of Ireland, with a head full of Gaelic and a tongue like a potato, learns to talk a poor grade of English in ten years.”

Lee grinned. “Me talkee Chinese talk,” he said.

“Well, I guess you have your response. And it’s not my affair. I hope you’ll forgive me if I don’t believe it, Lee.”

Lee looked at him and the brown eyes under their rounded upper lids seemed to deepen until they weren’t foreign any more, but man’s eyes, warm and understanding. Lee chuckled. “It’s more than a convenience,” he said. “It’s even more than self-protection. Mostly we have to use it to be understood at all.”

Samuel showed no sign of having observed any change. “I can understand the first two,” he said thoughtfully, “but the third escapes me.”

Lee said. “I know it’s hard to believe, but it has happened so often to me and to my friends that we take it for granted. If I should go up to a lady or gentleman, for instance, and speak as I am doing now, I wouldn’t be understood.”

“Why not?”

“Pidgin they expect, and pidgin they’ll listen to. But English from me they don’t listen to, and so they don’t understand it.”

“Can that be possible? How do I understand you?”

“That’s why I’m talking to you. You are one of the rare people who can separate your observation from your preconception.”…“I’m wondering whether I can explain,” said Lee. “Where there is no likeness of experience it’s very difficult. I understand you were not born in America.”

“No, in Ireland.”

“And in a few years you can almost disappear; while I, who was born in Grass Valley, went to school and several years to the University of California, have no chance of mixing.”

“If you cut your queue, dressed and talked like other people?”

“No. I tried it. To the so-called whites I was still a Chinese, but an untrustworthy one; and at the same time my Chinese friends steered clear of me. I had to give it up.” 

– John Steinbeck, “East of Eden”

Steinbeck didn’t know it, but his observation of the false differentness generated by race is exactly what evolutionary science reveals. In fact, from a human evolutionary perspective, the external characteristics that we associate with race have almost nothing to do with fundamental differentness or genetic diversity.


This is a Wikimedia Commons map of the human migration out of Africa (upper left of diagram, North Pole in the center), showing our inexorable advancement to every corner of the globe. By testing the persistent mutations of mitochondrial DNA of modern humans (passed from mothers to their children, so tracing the matrilineal line), we can identify which genetic populations (called haplo-groups) precede others, and by how long. The earliest splits of the mtDNA haplogroup occurred within Africa itself (L1, L2, and L3) between 130,000 and 170,000 years ago. Once out of Africa the human animal migrated first to South and Southeast Asia (60 – 70,000 years ago), then to Europe (40 – 50,000 years ago), and from there to East Asia, North America, and South America.

What does this mean? It means that four Khoisan who live within 200 miles of each other are, genetically speaking, more fundamentally different from each other than Mao Zedong and Ronald Reagan.


Nature. 2010 February 18; 463(7283): 943-947 (National Institutes of Health Public Access)


It’s not that the Khoisan are somehow more primitive or “less evolved” than Europeans or Asians. They are just as evolved as any other group of humans. It simply means that because their respective tribes separated from each other about 150,000 years ago, their genetic codes have mutated independently for a lot longer than the Chinese and American tribes. Mao and Reagan share a common matrilineal ancestor from maybe 40,000 years ago. !Gubi and G/aq’o, on the other hand, have to go back 150,000 years to find their common mother. There is enormous genotype differentiation between the various sub-linguistic groups of the Khoisan despite very little phenotype differentiation…from a human perspective the Khoisan are a veritable Amazon rainforest of genetic diversity. They don’t look different, but genetically speaking they are VERY different. On the other hand, the genetic diversity found within a modern, cosmopolitan city – no matter how much of an ethnic and racial melting pot it might be – is quite low by comparison. It’s a hard concept to grasp because it goes against the “evidence” of our own eyes, but the distinction between genotype and phenotype (and the primacy of the former for explanatory usefulness) is about as important a concept as there is in evolutionary theory.

Fair enough, Ben…thanks for the science lesson. But what in the world does all this have to do with investing?

The notion of the Other – the concept of differentness – is at the heart of portfolio theory, modern or otherwise. Portfolio theory works because of the Other, because of non-correlated and independent investment choices with differentiated return profiles. If the human animal has a hard time perceiving the Other correctly, if we are poor judges of what does and does not make for fundamental diversity, then we have a big problem with portfolio theory…a problem that will never be perceived, much less addressed, if we do not focus on our evolutionary baggage to become better judges of what generates substantive portfolio diversification. There is no bigger issue in portfolio risk management than the accurate identification of diversifying exposures, no more important topic for an Epsilon Theory perspective.

Here’s my point: we place waaaay too much emphasis on a security’s external appearance – its asset class or sector – in making our portfolio decisions. We place waaaay too much emphasis on a manager’s external appearance – his style box – in making our portfolio decisions. Do we need this sort of simplifying classification or modeling as part of our investment evaluation process? Sure. But to define the diversification qualities of an investment in terms of its phenotype rather than its genotype…well, that’s a mistake. I think that there is enormous room for improvement in constructing smart portfolios if we can stop staring at surface appearances and start focusing on the investment DNA of securities and strategies.

Of course, there’s no such thing as a genetic sequencing assay for an investment or a strategy, so what does this mean in practice, that we should focus on the investment DNA of a security or strategy? If we’re not going to measure the diversification of a portfolio by externally visible characteristics such as asset class or style box, then what are we supposed to do? I think the answer is to look at the externally visible attribute that is most closely linked to the diversity of the human haplogroup: languageI’ve written about this at length, so won’t repeat all that here. The basic idea, though, is that just as linguistic evolution maps almost perfectly to human adaptive radiation and the way our species spread into new environments out of Southern Africa, so, too, are there investment languages and grammars that map to the underlying “DNA” of a security or strategy. The ancient investment languages are Value (together with its grammar, Reversion to the Mean) and Growth (together with its grammar, Extrapolation), and the relative mix of these languages in the description and practice of securities and strategies reveals an enormous amount about their hidden “genotype”.

From this Epsilon Theory perspective, a portfolio comprised of various large-cap US industrial and banking stocks (almost all of which speak a strong Value dialect) would receive much less diversification benefit than a traditional perspective would suggest from an allocation to a macro hedge fund that used various reversion-to-the-mean strategies for currency trades. Conversely, I suspect that a portfolio holding Microsoft (Value-speaking) could receive a significant diversification benefit from adding Salesforce.com (Growth-speaking), even though they are both large-cap tech stocks. I think that there are dozens of ways to put this focus on investment language, investment grammar, and by extension – investment genotype – into practical use for the construction of better-diversified portfolios, and I’ll be spending a lot of time in the coming months testing these applications.

To be sure, this isn’t the first time in the history of the world that someone has suggested looking through surface characteristics such as asset class to find more useful dimensions of portfolio diversification.

For years, Ray Dalio and Bridgewater have been advocating something very similar to this notion with their argument concerning the weakness of asset class correlations in determining optimal portfolio allocations. Dalio’s point – which is the theoretical foundation of Bridgewater’s All-Weather risk parity strategy – is that the correlation of returns between asset classes like stocks and bonds is neither constant nor random. The correlation waxes and wanes over time, with long periods of negative correlation and long periods of positive correlation that must reflect some underlying force. Dalio calls this underlying force the macroeconomic “machine”, which at any given point in time reflects what other people call a “regime”…some combination of inflation and growth characteristics within a context of debt cyclicality to which stocks and bonds respond in predictable ways. Depending on the current regime (which tends to change slowly), stocks and bonds will have either a strong or weak, positive or negative correlation to each other, but there’s nothing meaningful about that correlation. What’s meaningful is the relationship or correlation between stocks and bonds to the macro regime. If you can measure the inflation/growth regime accurately and you know the performance relationship of asset classes to this underlying force, then voilà…you can construct a portfolio of stocks and bonds (and other assets, like commodities) that should perform as well as it is possible to perform within the given regime, where good performance is defined as the most reward for the least volatility. Or so the argument goes.

I think it’s a good argument. Dalio’s theory of why a risk-balanced portfolio works is not the skin-deep perspective embedded in most portfolio construction efforts. Dalio is saying that there’s nothing special about this asset class or that asset class in determining a risk-balanced portfolio, no magical ratio, 60/40 or otherwise, of stocks to bonds. The Bridgewater approach isn’t focused on “balancing” asset classes at all, because there’s really nothing of importance to balance here, no meaning in asset classes per se. Securities are simply instruments that reflect an underlying economic regime with their performance characteristics, and a portfolio should be constructed on the basis of combining these securities in the best possible risk/reward configuration given the underlying regime, period. Sometimes this will mean a lot of stocks and a few bonds; more typically this will mean a lot of bonds and a few stocks. Either way, the Bridgewater approach looks beneath the asset class skin of a security, and that’s a good start.

But it’s only a start. I want to suggest an alternative conceptual basis for risk-balanced portfolio construction, one that doesn’t rely on a deterministic model of the economy.

Moving from an asset class conception of correlation and risk to an inflation/growth regime conception of correlation and risk is not really a fundamental change in perspective. We’re still talking about external characteristics, only now we’re talking about the economy as a whole rather than asset classes or individual securities. It’s like a Hindu mystic saying that it’s wrong to conceive of the world being supported by four elephants, but that what you really need to look for is the turtle that supports the elephants.


The problem, of course, is that once you accept this concept, you have to ask what the turtle is standing on. The Bridgewater answer is that the macroeconomic turtle-machine is the first mover, the Aristotelian primum mobile, the bedrock on which everything else rests. The only acceptable complement to the beta portfolio in Bridgewater’s turtle-machine framework has to be confined to the realm of “alpha” or skill-based returns that cannot be modeled as a systematic or identifiable phenomenon. The relationships between assets and the macroeconomic machine are “timeless and universal” to quote Bridgewater co-CIO Bob Prince, which means that it’s difficult for their model to account for a regime of regimes, a long and unpredictable game by which political and social forces shape and transform the investment meaning and return correlation of a security to the macroeconomic characteristics of inflation and growth. We believe that these political and social forces are both detectable and actionable and would be more appropriately identified as components of epsilon rather than alpha.

Why is this a problem? Because as the story goes, it’s not nothing beneath that first turtle, but rather more and more turtles…all the way down in an infinite expanse of turtle-dom. In this Epsilon Theory scenario, below the economic turtle-machine is a political turtle-machine, and below that is a social turtle-machine, and below that is a human animal turtle-machine, etc. etc. The lower the turtle, the more slow-moving it is, and the more likely you can ignore its existence for the sake of expedient model prediction at any given point in time. But if you are unfortunate enough to be investing on the basis of your economic turtle-machine when one of the lower turtles lurches forward…you’re in for a nasty surprise. What might this look like? Consider that for most of the past 2,000 years it has been illegal to accept interest payments for a loan to a company, much less to securitize that sort of loan into a bond. Read The Merchant Of Venice again if you need a refresher course in the scope and power of usury laws. Or for a more recent example, consider that private residential mortgage-backed securities hardly existed prior to 2001, were a $4 trillion asset class by the end of 2007, and are now totally moribund, simply running off into oblivion. I just don’t think it’s crazy to imagine large and unpredictable shifts in the economic machine borne out of political and social change. In fact, I think it’s crazy not to expect these shifts, even if the timing and focus of the lurch is impossible to predict.

There are two ways out of the infinite turtles problem. The first, which is what I imagine the Bridgewater Elect are doing, is to expand the macroeconomic machine to include political and social sub-machines. If you’ve ever read Isaac Asimov’s Foundation Trilogy, you can easily imagine Ray Dalio as Hari Seldon, with a legion of psychohistorians figuring out more and more equations to incorporate into a massive econometric model of human society and mass behavior.

The second way out (which I favor for precisely the reasons that Seldon’s model failed) is to reject the notion of ANY mechanistic model of how the world works in favor of a profound agnosticism about what the future holds. The only constants I’m willing to accept, particularly in a period of global deleveraging and ferocious political fragmentation within and between countries, are the constants of human nature. My predictions for the markets in 2014 are that fear and greed will still reign supreme, that investors will still speak ancient languages of Value and Growth, and that emergent behaviors like the Common Knowledge Game will drive short to medium-term price levels in many securities.

I believe that a risk-balanced portfolio – if it explicitly includes both the grammar of Reversion-to-the-Mean and the grammar of Extrapolation – can be as responsive and adaptive to changing patterns and market-moving forces as you want it to be, whether or not you have the right model to explain why those patterns are shifting. As recently as 10 years ago a simplifying macroeconomic model was an absolute necessity for making sense of all the signals that the world throws at us minute after minute. A model, by definition, will ignore certain signals. It’s what models DO. They simplify the world and occasionally miss important signals so that we are not drowned by the sheer flood of less important signals. It’s a trade-off that used to be necessary…but it’s not anymore.

We are in the midst of an information processing revolution – a quantum leap forward in inductive reasoning and inference colloquially named Big Data – that is every bit as important for portfolio management as the economic theory developed by Markowitz et al in the 1950’s.Today we can measure the market world – all of it – and infer the likelihood function of any given pattern or outcome. We know what the past patterns have been and we have the tools to sound an alarm if those patterns start to change, for whatever reason. We no longer have to model the economic world and intentionally cut ourselves off from potentially useful signals because they don’t fit our preconceptions. We no longer have to be the ladies and gentlemen that Steinbeck described, unable to understand Lee if he spoke anything other than pidgin English, because otherwise he would not fit their model of who Lee was.  We can be like Samuel, one of the rare people able to separate our observations from our preconceptions. You cannot do that if you approach the world constrained by a model. Sorry, but you can’t.

The tyranny of models is rampant in almost every aspect of our investment lives, from every central bank in the world to every giant asset manager in the world to the largest hedge funds in the world. There are very good reasons why we live in a model-driven world, and there are very good reasons why model-driven institutions tend to dominate their non-modeling competitors. The use of models is wonderfully comforting to the human animal because it’s what we do in our own minds and our own groups and tribes all the time. We can’t help ourselves from applying simplifying models in our lives because we are evolved and trained to do just that. But models are most useful in normal times, where the inherent informational trade-off between modeling power and modeling comprehensiveness isn’t a big concern and where historical patterns don’t break. Unfortunately we are living in decidedly abnormal times, a time where simplifications can blind us to structural change and where models create a risk that cannot be resolved by more or better modeling! It’s not a matter of using a different model or improving the model that we have. It’s the risk that ALL economic models pose when a bedrock assumption about politics or society shifts. If you’re not prepared to look past your model…if you’re not prepared, as Steinbeck wrote, to separate your observations from your preconceptions…then you have a big invisible risk in your portfolio.

I know it’s hard to embrace what I’m describing as a profound agnosticism about the mechanics of how the world works. I know it goes against our biological grain to reject the comfort and succor of a deterministic model and an Answer. In many respects, deep agnosticism is the ultimate Other. It is a non-human perspective on how to think about the world – a Rakshasa – and I’m not expecting it to receive a warm or trusting welcome, particularly when it has the skin of some familiar investment product. But I think it’s the right way to look at a world wracked by political fragmentation, saddled with enormous debts, and engaged in the greatest monetary policy experiments ever devised by man. I think it’s the right way to look at a world of massive uncertainty, as opposed to a world of merely substantial risk, and it’s the perspective I’ll continue to take with Epsilon Theory.

PDF Download (Paid Membership Required):



Goldilocks and the Dog That Didn’t Bark

Det. Gregory:Is there any other point to which you would wish to draw my attention?
Holmes:To the curious incident of the dog in the night-time.
Det. Gregory:The dog did nothing in the night-time.
Holmes:That was the curious incident.

Arthur Conan Doyle, “Silver Blaze”

The market was down more than 2% last Monday. Why? According to the WSJ, CNBC, and all the other media outlets it was “because” investors were freaked out (to use the technical term) by poor US growth data. Disappointing ISM number, car sales, yada, yada, yada. But then the market was up more than 2% last Thursday and Friday (and another 1% this Tuesday), despite a Friday jobs report that was more negative in its own right than the ISM number by a mile. Why? According to those same media arbiters, investors were now “looking through” the weak data.

Please. This is nonsense. Or rather, it’s an explanation that predicts nothing, which means that it’s not an explanation at all. It’s a tautology. What we want to understand is what makes investors either react badly to bad news like on Monday or rejoice and “look through” bad news like on Friday. To understand this, I sing the Epsilon Theory song, once more with feeling … it’s not the data! It’s how the data is molded or interpreted in the context of the dominant market Narratives. 

We have two dominant market Narratives – the same ones we’ve had for almost 4 years now – Self-Sustaining US Growth and Central Bank Omnipotence.

The former is pretty self-explanatory. It’s what every politician, every asset manager, and every media outlet wants to sell you. Is it true? I have no idea. Probably yes (technological innovation, shale-based energy resources) and probably no (global trade/currency conflict, growth-diminishing policy decisions). Regardless of what I believe or what you believe, though, it IS, and it’s not going away so long as all of our status quo institutions have such a vested interest in its “truth”.

The latter – Central Bank Omnipotence – is something I’ve written a lot about, so I won’t repeat all that here. Just remember that this Narrative does NOT mean that the Fed always makes the market go up. It means that all market outcomes – up and down – are determined by Fed policy. If the Fed is not decelerating an easy money policy (what we’ve taken to calling the Taper), the market tends to go up. If the Fed is decelerating its easy money policy, the market tends to go down. But make no mistake, the Common Knowledge information structure of this market is that Fed policy is responsible for everything. It was Barzini all along!

How do Narratives of growth and monetary policy come together? Well, there’s one combination that the stock market truly and dearly loves – the Goldilocks scenario. That’s when growth is strong enough so that there’s no fear of recession (terrible for stocks), but not so strong as to whip the flames of inflation (not necessarily terrible for stocks, but sure to provoke Fed tightening which is terrible for stocks).

Over the past few years the Goldilocks scenario has changed. Inflation is … well, let’s be straight here … inflation is dead. I know, I know … our official measures of inflation are all messed up and intentionally constructed to keep the concept of “inflation” and the Inflation Narrative in check. I get that. But it’s the Narratives that I care about for trying to predict market behaviors, not the Truth with a capital T about inflation. If you want to buy your inflation hedge and protect yourself from the ultimate wealth-destroyer, go right ahead. At some point I’m sure you’ll be right. But I’m in a business where the path matters, and I can’t afford to make a guess about where the world may be in 5 to 10 years and just close my eyes. The Inflation Narrative is, for the foreseeable future, dead because there is zero wage inflation, which is the sine qua non for an Inflation Narrative. It’s a zombie, as all powerful Narratives are, so it will return one day. But today Goldilocks has nothing to do with inflation.

The Goldilocks scenario today is macro data that’s strong enough to keep the Self-Sustaining US Growth Narrative from collapsing (ISM >50 and positive monthly job growth) but weak enough to keep the market-positive side of the Central Bank Omnipotence Narrative in play.That’s the scenario we’ve enjoyed for the past few years, particularly last year, and it’s the scenario that our political, economic, and media “leaders” are desperate to preserve. So they will.

On Monday we had bad macro data on the heels of the Fed establishing a focal point of $10 billion in additional Taper cuts per FOMC meeting, a clear signal that monetary easing is decelerating on a predictable path. This is the market-negative side of the Central Bank Omnipotence coin, which turns bad macro news into bad market news. And so we were down 2%. And so the Powers That Be started to freak out. Did you see Liesman on CNBC after the Monday debacle? He was adamant that the Fed needed to reconsider the path and pace of the Taper.

And then we had Friday. Honest to God, I thought Liesman was going to collapse of apoplexy, what my grandmother from Scottsboro, Alabama would have called a conniption fit, right there on the CNBC set. The Fed MUST reconsider its Taper path. The Fed MUST do everything in its power to avoid even a whiff of deflationary pressures. Heady stuff. By 10 am ET that morning the WSJ was running an online lead story titled “U.S Stocks Rise as Focus Returns to Fed”, acknowledging and promulgating the dynamic behind bad macro news driving good market news.

It’s not necessary (and is in fact counter-productive from a Narrative construction viewpoint) to switch the Fed trajectory 180 degrees from Taper to no-Taper. What’s necessary is to inject ambiguity into Fed communication policy, particularly after the non-ambiguous FOMC signal of two weeks ago that led directly to Monday’s horror show. The need for ambiguity is also something I’ve written a lot about so won’t repeat here. But this is why Hilsenrath and Zandi and all the rest of the in-crowd are writing that the Taper is still on track … probably. Unless, you know, the data continues to be weak. What you’re NOT seeing are the articles and statements by the Powers That Be placing a final number on QE3, extrapolating from the last FOMC meeting to a projected QE conclusion.  And that’s the dog that didn’t bark. It’s the projection that Yellen won’t be asked about in her testimony; it’s the article that won’t be written in the WSJ or the FT. Is the Taper still on? Two weeks ago the common knowledge was “Yes, and how.” Today, after a stellar bout of Narrative construction, the answer is back to “Yes, but.” That’s the ambiguous, “data dependent” script that Yellen and all the other Fed Governors now have the freedom to re-assert. Fed support for the market is back in play.

If I’m right, what does this mean for markets? It means that our default is a Goldilocks scenario between now and the next FOMC meeting in mid-March. It means that bad macro news is good market news, and vice versa. If the next ISM manufacturing number is a big jump upwards, the market goes down. Ditto for the February jobs number. If they’re weak, though, that’s more pressure on the Fed and another leg up for markets.

Place your bets, ladies and gentlemen, the croupier is about to spin the roulette wheel. Pardon me if I sit this one out, though. My crystal ball is broken.

If I’m right, what does this mean for the real world? It means an Entropic Ending to the story … disappointing, slow and uneven growth as far as the eye can see, but never negative growth, never an honest assignment of losses to clear the field or cull the herd (two qualities that, not coincidentally, are clearly present in the growth sectors of technology and energy). That’s not my vision of a good investment world, but who cares? We’ve got to live in the world as it is, even if it’s a long gray slog.

PDF Download (Paid Membership Required):