PDF Download (Paid Subscription Required): The Narrative Matrix
It’s 1999, and Mr. Anderson (a.k.a. Neo) has a desk job. His hacking leads him to Morpheus, who suggests Neo’s perceived reality is nothing more than a computer simulation – a virtual reality created by an artificial intelligence (AI) called the Matrix. The AI has created a utopian version of what is a far more dystopian reality. In fact, the AI uses energy from enslaved and unwitting participants’ bodies to sustain itself. Morpheus is convinced Neo is ‘The One’ who can hack The Matrix. Philosophically, the Matrix asks the age-old, philosophical question: is reality the product of some objective truth or is it the product of subjective perception? Perhaps more importantly, does it really even matter? After all, ignorance is often bliss.
The Matrix might be the ultimate narrative – one so pervasive and enveloping that it transforms participants’ reality. It presents an extreme and fictional case study that may be informative of the narratives we see in today’s world – particularly in politics and financial markets. The impetus for this meme was a presentation in Toronto last week hosted by Waratah Capital and featuring Epsilon Theory’s Ben Hunt. As the conversation over dinner unfolded, I perceived a feeling of congenial unease – as if we all knew we are living in a Matrix of sorts. Many narratives today have proponents committed to preventing hacks. The Chinese authorities’ coronavirus narrative, consisting of a controlled and linear disease spread but contrasted by one of exponential recovery, is emblematic of how managed narratives can pose clear and present danger. Central banks have similar incentives towards achieving their own social agenda – the dual mandate. Independent thought or discordant views are often unwelcome or simply not understood.
Understanding how a narrative is structured and how it has evolved is essential to processing the information it contains. Ben characterized his own almost Nietzschean stages of awakening towards a deeper understanding of how narratives work in three phases. First, he characterized himself early in his journey as a ‘weak form narrativist.’ (As I wrote this, I needed to add the word narrativist to my dictionary, but it is a worthy addition.) From there, he moved to a ‘semi-strong form narrativist.’ Eventually, he moved to where he is now: a ‘strong form narrativist.’ As one can easily discern from the moniker, a strong form narrativist believes reality and perception essentially merge within narrative, and for a loooong time.
What I enjoyed most about the stages of awakening was its symmetry to various forms of market efficiency – weak, semi-strong and strong. In a world of strong form market efficiency, there is no room for participants to interpret data. There is no room for narratives to influence perception or interpretation. There is no room for conceptual advantage or disadvantage. By that model, information in its unadulterated form is almost immediately reflected in price. To be clear, as a Columbia graduate (and just because it makes common sense), I have never been a buyer of the notion of efficient markets (especially of the strong form variety). The efficient market narrative itself has become something its creators’ purely theoretical framework never intended. When narratives become a religious devotion, they may persist for what may seem an eternity – until they don’t.
I have come to regard informational perception – often the product of a narrative or narratives – as the key to understanding how markets price assets. Within this framework, fundamentals provide an equilibrating anchor to which price is ultimately drawn, but sentiment most often drives divergence from that price. These fundamental equilibria are most often short-lived and are an exception to what is more often persistent disequilibrium. Figure 1 illustrates the equilibrating fundamental anchor, around which narrative-driven sentiment may rhythmically diverge. Different kinds of narratives demonstrate different life cycles and have different rhythms.
Narratives may be borne of different causes. What gives birth to a narrative often impacts its persistence and the persistence of the virtual reality it creates. At times, narratives are explicitly crafted ‘by fiat’ (as with the US-China trade deal) or at other times they are more organically grown (as with the organic narratives on Robinhood driving the likes of Virgin Galactic stock). Fiat narratives often evolve quickly and are not always easy to identify, typically because governmental bodies may exert influence over more credible entities who report data and manage the message. Often, the message reads: “It’s for your own good.” On the other hand, organic narratives may take years to evolve. In such cases, after several successful TV seasons, reality TV CEOs of average talent become real life super-star executives. How? People believe the legitimacy of a media-generated reality – especially when it is personalized and becomes pervasive consistently over time. Social media, in particular, may create a computer-generated virtual reality of sorts for many who live their lives through their virtual avatars. Social media and Web-based content may also foster the normalization of extremes. This is a powerful way in which either fiat or organically grown narratives may change social norms.
Fiat news, as Ben characterized it, is particularly powerful – especially in the absence of an offset from free press – as in China. Indeed, it is one of the reasons free press is essential to democracy and to free markets. I might suggest that fiat news is particularly well-understood within a strong form narrative framework because the forces behind the narrative are powerful enough to create a virtual reality. The mechanism of a fiat narrative’s creation may be fiscal or monetary policy, or it may be a governmental or other coordinated media programs. Misinformation campaigns and subliminal messaging has always existed, of course, but their use has seemingly become more pervasive and unabashed. It seems somewhat obvious, especially after the 2016 election and Russian interference in it, that social media plays an important role in the rapid proliferation of fiat narratives. It has enabled messaging that makes extremes (like QE) appear more normal. Once again, extremes become normal.
Whether a fiat narrative or an organic one, it is precisely the impact that narratives have on the interpretation and perception of information – especially when everybody has it – that creates opportunity. As finance professionals might say: this is what makes markets. Said differently, even when everybody in a market has exactly the same information, a ‘bid’ and ‘ask’ can still exist apart from a singular price that reflects all information. Markets are inefficient precisely because they do not price in information in some absolute sense. They price new information based on its context within a narrative. The same information may be interpreted quite differently by different market participants, especially if one participant subscribes to a different narrative than another. When we interpret market information, it is not unlike how we interpret prose. We may all read the same words, but how we interpret and perceive it – often based on experiential bias – may be quite different. That said, it remains my belief that there tends to be an equilibrating fundamental anchor to which price is drawn over time.
Indeed, memories are often more about the emotional response a narrative creates than about specific information one retains. Thus, the weight of information is amplified or diminished by the poignance of the narrative. A well-crafted narrative will create a desired emotional response. So, the strong form adaptation of narratives is precisely about (albeit not limited to) such instances, which are rife in the markets and politics right now. One-line slogans have always been an important part of politics because, if well-crafted, they have the desired emotive impact. So, what of the empirically demonstrable reality? As discussed, the narrative may lead to long-lived divergences. However, even under a strong form narrative paradigm, I remain convinced a narrative may still break. Ultimately, a reversion (at least a brief one) to the fundamental ‘equilibrium’ will occur.
A narrative may break when it creates a dislocation (a surrealistic bubble) that has become so disconnected from reality even its most ardent adopters can no longer consider it credible. This tipping point is hard to identify. Said differently, the narrative ends when its credibility (or the credibility of a key proponent) is lost. This may happen swiftly, as dissonance comes upon the duped forcefully when facts inconsistent with the narrative can no longer be denied. This is why the bubble a narrative has created over a long period may burst so unexpectedly. It may be happening right now as the COVID-19 virus begins to proliferate outside of China, and as it has become clear that scientists do not have a good understanding of how the disease is transmitted. My team at Cantor and I wrote about this on February 12th in a piece available to our institutional clients. The markets were already fragile; it may be the straw that broke the camel’s back.
History is rife with examples – especially in science – that commonly accepted establishment narratives die hard. While revered today, Albert Einstein’s early theories were spurned by peers. Lesser known, Subrahmanyan Chandrasekhar advanced his “crackpot” Black Holes theory in 1930. His colleague, Sir Arthur Eddington, wanted nothing of it. As a knight, his criticism was hard to overcome. Chandrasekhar was eventually awarded the Nobel Prize in 1983. In another example, Christian Andreas Doppler’s theory on the effects of velocity was resoundingly rejected. The Doppler Effect was accepted in 1868, but Doppler had already been dead for 15 years. I could go on and on. The good news might be that while it might take time, empiricism seems to eventually win out – even if post mortem.
In my next In the Trenches, I will address one narrative being used to justify currently extreme equity market valuations. What is that narrative? Low rates justify equity market valuations.
Well, not really …
 The theory of efficient markets itself, has taken on a narrative of its own and become a gospel of sorts – interpreted well beyond its intended, initial purpose as a simplified theoretical framework.
PDF Download (Paid Subscription Required): The Narrative Matrix