Epsilon Theory Professional
There’s something weird happening in Narrative-world, and I’ve been trying to figure out what it means since we published our monthly Narrative Monitors update last week (attached to this email). I still can’t figure it out, but instead of continuing to wrestle in silence, I’m going to tell you what I find odd and ask what you think it means … if anything.
You know, I was a big fan of stock buybacks back when I was running a fund, and I still think that most of the macro reasons to oppose stock buybacks are silly.
But when I look at it from a micro or individual company perspective, there is no doubt in my mind that stock buybacks have been totally hijacked by corporate management and boards over the past few years to sterilize exercised options and restricted stock units.
I’m not THAT into dominoes, but I am into figuring out what’s next for changes in the Fed narrative and how that impacts markets.
More evidence that the Common Knowledge around the Fed has shifted dramatically, and more evidence for where this shows up next in markets …
I think these emergency actions in the repo market – and to be sure, these ARE emergency actions – and now the expansion of the balance sheet to get more cash into the system, are the clearest indications yet that the Fed has lost its fundamental credibility with Mr. Market.
THE FED IS CONCERNED ABOUT “MAINTAINING A FIRM GRIP” ON ITS CONTROL OVER THE PRICE OF MONEY.
As they say in the twitterverse, let that sink in.
There are two necessary narratives for EM investing to work:
1) Yay, EM growth!
2) Yay, EM property rights!
Both of these narratives are broken, which means the *business* of EM investing is broken. Heads up: this is not a mean-reverting thing.
The line between the anchor and the boat has been cut. The line between the fisherman and the fish has been cut.
Everyone knows that everyone knows that central bank actions have no connection to real economic outcomes. THIS is the new common knowledge, and I don’t know how or where or when, but I think it changes everything.
Our most impactful structural attribute of narrative is Attention – the level of “drum-beating” for a certain narrative relative to all of the OTHER narratives taking place.
So it matters that the Inflation narrative is close to all-time lows in its Attention score coming into September, while both the Central Bank narrative AND the Trade & Tariff narrative are at all-time highs in their Attention scores coming into September.
I’ve never seen a US-oriented macro query that yielded more non-US narrative clusters.
Also, the past few days in markets have felt like 2008-2009, where the only thing that mattered for markets was risk-on/risk-off, and that “factor” swamped whatever else you were doing in your investment process. This isn’t as all-pervasive as risk-on/risk-off, but whatever it is (rates-on/rates-off?), it’s as impactful in the value/growth context.
First, I think I think that the “cover story” for the Fed – that they act to help the real economy – has evaporated.
Second, I think I think Trump has lost the financial media over the Trade War in the same way that LBJ lost Walter Cronkite over the Vietnam War.
The news about Jeffrey Epstein’s death on Saturday hit me hard, as did the escalation in the Hong Kong protests over the weekend, as did the collapse in Argentina’s currency and stock market on Monday. As the kids would say, I was shook. And I’m still trying to figure out what I think about all this, both as a citizen and as an investor.
The First Horseman was a tightening Fed, and markets suffered its wrath in Q4 last year.
Markets are now suffering the Second Horseman, as China “surprised” markets with a sharp devaluation of the yuan last night in response to higher/broader tariffs that Trump threatened to impose last week.
Here are the questions Rusty and I are asking now, along with our answers …
I’ve been looking at narrative maps for a long time now, and I don’t think I’ve ever seen as complacent a market narrative as what our Narrative Machine research is showing around US Fiscal Policy.
Here’s how we analyze this research.
I’ve met Rick Rieder and Larry Fink a couple of times, but I don’t know them. At all. Maybe they’re decent guys. Maybe they really believe in their heart of hearts that it’s wise public policy for the ECB to buy equities. I truly don’t know.
But if it walks like a Raccoon and talks like a raccoon …
That line about dancing by Chuck Prince is the perfect quote for any age and any asset class where institutions intentionally take risks they know are foolish, but risks they believe are manageable because there’s a greater fool looking to get on the dance floor after them.
The greater fool theory is the driving force behind the bid for negative-yielding debt, whether it’s European government bonds or European investment grade corporate debt.
Yes, we’re still in a zeitgeist of Central Bank Omnipotence, where deflationary shocks simply can’t take the market down for much or for long. That said, the Cohesion measure of both Trade & Tariffs and Central Bank Omnipotence is really breaking down, meaning that there is enormous narrative confusion over how the rate cut trajectory plays out … far more confusion than the 100% implied market odds of a cut would imply.
The major update in today’s research deck is a simulation of a market neutral / absolute return strategy using our narrative-driven S&P 500 sector underweight/overweight signals. Prior to this we had presented simulations of an unconstrained “Beta1” portfolio (always 100% net long, but allowing leverage and short positions, roughly the equivalent of a 150/50 portfolio) and a constrained “Long-only” portfolio (always 100% net long AND 100% gross long, so no leverage and no short positions). Both of these strategies were designed to test for an excess return versus the S&P 500, essentially as generic long-equity replacements for S&P 500 exposure.
US Sector Strategies Presentation Deck (downloadable PDF)
For ET Professional subscribers only.
It’s easy to get waaaay too precious when it comes to professional kitchens, whether we’re talking about restaurants or a trading desk.
But credit default swaps are like chef knives. They’re not an affectation, but a necessary tool for so many tasks. Even if you don’t cook or trade a portfolio professionally, you’ll want to own a good knife and you’ll want to know the mechanics and the rationale of a CDS trade.
Each month we update our five narrative Monitors and summarize the main findings from each.
The big reveal for May? There’s a tremendous amount of narrative complacency out there, particularly on Trade and Tariffs, which means this market has a long way down if the narrative focuses on negotiation failure. It’s not focusing there yet, but that’s what you want to watch for.
Wage stagnation in 2016 was actually much worse than you were told. Did this make a difference in the Midwestern states that swung the election, in that actual labor conditions were worse than everyone thought they were? I think yes.
Wage growth in 2018 was actually much better than you were told. Did this make a difference in the current Fed/Wall Street/White House narrative that inflation is dead and the easy money punchbowl can be maintained without consequence? I think yes.
When Donald Trump tells you that there’s no inflation, that up is down and black is white, that monetary policy … It’s toasted! … you’ve gotta believe him, right? Right?
Actually, for investment purposes, you do. When everyone knows that everyone knows that inflation is dead, that IS the common knowledge. And the common knowledge must be respected.
Why does it matter whether you think profit margin expansion has been driven more by globalization (Bridgewater) or financialization (Epsilon Theory)?
Because central banks can continue to drive financialization and earnings margin expansion even as globalization collapses.
Whether you’re a trader or a portfolio manager or a financial advisor or an allocator, ET Pro can help you identify both the inflection points and the trajectory of the market Zeitgeist – particularly the question that any long-term portfolio owner MUST get roughly right in order to succeed: are we in an inflationary or deflationary world, and how quickly (if at all) and in what ways is that world changing?
You can make a lot of money collecting Golden Age comics. The Silver Age, though? Meh. The story arcs and narratives are a joke. The art is so-so at best. The publishers are just squeezing the installed base, and the creators are just mailing it in. They’re old, but so what?
Same with the Silver Age of Central Bankers. It’s hard to make money, particularly in Emerging Markets, when it’s every man for himself among DM central banks.
Narrative Monitors
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