I sat on the porch
Listened to the rain
Smoked a cigarette
And counted to ten

Oh no, here it comes again
That funny feeling

― Camper Van Beethoven, Oh No! (1985)

A quick post-Fed follow-up to “Tell My Horse”, the best-received Epsilon Theory note to date (thank you!). I’ll jump right into what I’ve got to say, without the usual 20 pages of movie quotes and the like. Well, I’ve got one quote above, because I can’t help myself. They’re the lyrics to the best break-up song ever, and they’re what Janet Yellen was singing to the market on Wednesday.

Let’s review, shall we? Last fall, the Fed floated the trial balloon that they were thinking about ways to shrink their balance sheet. All very preliminary, of course, maybe years in the future. Then they started talking about doing this in 2018. Then they started talking about doing this maybe at the end of 2017. Two days ago, Yellen announced exactly how they intended to roll off trillions of dollars from the portfolio, and said that they would be starting “relatively soon”, which the market is taking to be September but could be as early as July.

Now what has happened in the real world to accelerate the Fed’s tightening agenda, and more to the point, a specific form of tightening that impacts markets more directly than any sort of interest rate hike? Did some sort of inflationary or stimulative fiscal policy emerge from the Trump-cleared DC swamp <sarc>? Umm … no. Was the real economy off to the races with sharp increases in CPI, consumer spending, and other measures of inflationary pressures? Umm … no. On the contrary, in fact.

Two things and two things only have changed in the real world since last fall. First, Donald Trump — a man every Fed Governor dislikes and mistrusts — is in the White House. Second, the job market has heated up to the point where it is — Yellen’s words — close to being unstable, and is — Yellen’s words — inevitably going to heat up still further.

What has happened (and apologies for the ten dollar words) is that the Fed’s reaction function has flipped 180 degrees since the Trump election. Today the Fed is looking for excuses to tighten monetary policy, not excuses to weaken. So long as the unemployment rate is on the cusp of “instability”, that’s the only thing that really matters to the Fed (for reasons discussed below). Every other data point, including a market sell-off or a flat yield curve or a bad CPI number — data points that used to be front and center in Fed thinking — is now in the backseat.

I’m not the only one saying this about the Fed’s reaction function. Far more influential Missionaries than me, people like Jeff Gundlach and Mohamed El-Erian, are saying the same thing. If you think that this Fed still has your back, Mr. Investor, the way they had your back in 2009 and 2010 and 2011 and 2012 and 2013 and 2014 and 2015 and 2016 … well, I think you are mistaken. I think Janet Yellen broke up with you this week.

The Fed is tightening, and they’re not going to stop tightening just because the stock market goes down 5% or 10% or (maybe) even 20%. Bigger game than propping up market prices is afoot, namely consolidating a reputation as a prudent central banker before the inevitable Trump purge occurs, and consolidating that reputation means keeping the evilest of all evil genies — wage inflation — firmly stoppered inside its bottle.

Let’s be clear, not all inflation is created equal. Financial asset price inflation? Woo-hoo! Well done, Mr. or Mrs. Central Banker. That’s what we’re talkin’ about! Price inflation in goods and services? Hmm … a mixed bag, really, particularly when input price inflation can’t be passed through and crimps corporate earnings. But we can change the way we measure all this stuff and create a narrative around the remaining inflation being a sign of robust growth and all that. So no real harm done, Mr. or Mrs. Central Banker.

Wage inflation, though … ahem … surely you must be joking, Mr. or Mrs. Central Banker. How does that possibly advance economic efficiency and social utility? I mean, even a first year grad student can prove with mathematical certainty that wage inflation only sparks a wage-price spiral where everyone is worse off. What’s wrong with you, don’t you believe in math? Don’t you believe in science? Hmm, maybe you’re just not as smart as we thought you were. But I’m sure you’ll be very happy as an emeritus professor at a large Midwestern state university. No, Ken Griffin is not interested in taking a meeting.

I know I sound like a raving Marxist to be saying this, that the Federal Reserve system and all its brethren systems were established specifically to serve the interests of Capital in its age-old battle with Labor. But yeah, that’s exactly what I’m saying. Propping up financial markets? That’s a nice-to-have. Preserving Capital as the apex predator in our social ecosystem? There’s your must-have.

Whatever you think full employment might be in the modern age, 4.3% is at the finish line. And 4.1% or 3.9% or wherever the unemployment rate is going over the next few months is well past the finish line. You’re already seeing clear signs of labor shortages, particularly skilled labor shortages, in lots of geographies. Wage inflation is baked in, and modern populist politics make it impossible for corporations to play the usual well-we’re-off-to-Mexico-then card. Not that wages in Mexico or China are really that much better anymore, depending on what you’re doing, and there are inflationary wage pressures there, too.

Bottom line: I think that the Fed is going to do whatever it takes to prevent wage inflation from getting away from them, and shrinking the balance sheet is going to be a vital part of that tightening, maybe the most important part. Why? Because the Fed thinks it will push the yield curve higher as it lets its bonds and mortgage securities roll off, which will help the banks and provide an aura of “growth” and a cover story for the interest rate hikes. Otherwise you’ve got an inverted yield curve and a recession and who knows what other sources of reputational pain.

But here’s the problem, Mr. Investor. Ordinarily if the Fed was determined to take the punchbowl away by tightening monetary policy and raising interest rates, your reaction function was pretty clear. Get out of stocks and get into bonds. Wait out the inevitable bear market and garden-variety business cycle recession, and then get back into stocks. Or just ride your 60/40 vanilla stock/bond allocation through the cycle, which is the whole point of the 60/40 thing (even, though, of course, you’re really running a 95/5 portfolio from a risk perspective). But now you’re going to have both stocks *and* bonds going down together as the Fed hikes rates and sells bonds, in a reversal of both stocks *and* bonds going up together over the past eight years as the Fed cut rates and bought bonds.

Hmmm. ‘Tis a dilemma. What to do when indiscriminate long-the-world doesn’t work? What to do when nothing works? Maybe, with apologies to the old Monty Python line, active management isn’t quite dead yet. And just at the point of maximum capitulation to the idea that it is. Wouldn’t be the first time. In fact, that’s kinda how maximum capitulation works.

Is everything as neat and clean in reality as I’m making it out to be? Of course not. Other central banks are still buying bonds. Maybe global growth pulls everything through. Maybe President Pence/Ryan/whoever-is-fourth-in-line pushes through all the tax cuts and regulatory rollback and infrastructure build programs that your little old capitalist heart desires. Plus, this isn’t some cataclysmic event like “China floats the yuan” or “Italy has a bad election”. It’s a slow burn.

But I think that if your investment mantra is “don’t fight the Fed”, you now must have a short bias to both the U.S. equity and bond markets, not the long bias that you’ve been so well trained and so well rewarded to maintain over the past eight years. This is a sea change in how to navigate a policy-driven market, and it’s a sea change I expect to last for years.

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Hobson’s Choice


If you don’t like what’s being said, change the conversation.

– Don Draper, Mad Men: “Love Among the Ruins” (2009)

It is better for reputation to fail conventionally than to succeed unconventionally.

– John Maynard Keynes, “The General Theory of Employment, Interest, and Money” (1936)

– “Five Easy Pieces” (1970)
Bobby: What do you mean you don’t make side orders of toast? You make sandwiches, don’t you?
Waitress: Would you like to talk to the manager?
Bobby: You’ve got bread and a toaster of some kind?
Waitress: I don’t make the rules.
Bobby: Okay, I’ll make it as easy for you as I can. I’d like an omelet, plain, and a chicken salad sandwich on wheat toast, no mayonnaise, no butter, no lettuce, and a cup of coffee.
Waitress: A number two, chicken salad san, hold the butter, the lettuce, and the mayonnaise, and a cup of coffee. Anything else?
Bobby: Yeah. Now all you have to do is hold the chicken, bring me the toast, give me a check for the chicken salad sandwich, and you haven’t broken any rules.
Waitress: You want me to hold the chicken, huh?
Bobby: I want you to hold it between your knees.
Waitress: You see that sign, sir? Yes, you’ll all have to leave. I’m not taking any more of your smartness and sarcasm.
Bobby: You see this sign? [sweeps all the water glasses and menus off the table]

Honestly, if you’re given the choice between Armageddon or tea, you don’t say “what kind of tea?”

– Neil Gaiman (b. 1960)

In the end the Party would announce that two and two made five, and you would have to believe it. … The heresy of heresies was common sense. And what was terrifying was not that they would kill you for thinking otherwise, but that they might be right.

– George Orwell, “1984” (1949)

You had a choice: you could either strain and look at things that appeared in front of you in the fog, painful as it might be, or you could relax and lose yourself.

– Ken Kesey, “One Flew Over the Cuckoo’s Nest” (1962)

And, first, we will ask you to consider with us, how and in what respect the kings of Argos and Messene violated these our maxims, and ruined themselves and the great and famous Hellenic power of the olden time. Was this because they did not know the truly excellent saying of Hesiod, that the half is often greater than the whole?

– Plato, “The Dialogues of Plato: Laws, Book III” (c. 370 BC)

Some people see the glass half full. Others see it half empty. I see a glass that’s twice as big as it needs to be.

– George Carlin (1937 – 2008)

Five Easy Pieces for the World-As-It-Is


Our story so far…

In the second half of 2014, export volumes in every major economy on Earth began to decline, the result of divergent monetary policies that crystallized with the Fed’s announced tightening bias in the summer of 2014. This decline in trade activity – which is far more impactful than a decline in trade value, because it means that the global growth pie is structurally shrinking – accelerated in 2015 and 2016 as Europe and Japan intentionally devalued their currencies to protect their slices of the global trade pie. In game theoretic terms, Europe and Japan have been “free riders” on the global system, using currency devaluation to undercut the prices of competing US and Chinese products in a way that avoids domestic political pain.

But if there’s an iron law of international politics, it’s this: once the strategic interaction between nations begins to shift from cooperation to competition, once a principal player decides to defect and go for free rider benefits, then the one and only equilibrium of the new game has ALL principal players abandoning cooperation and competing with each other. Moreover, once one principal player begins to compete with a new and terrible weapon (i.e., mustard gas in World War I or negative interest rates in monetary policy or Trump-esque debate tactics in a Republican primary), then all principal players must adopt those tactics or lose the game. Universal competition is a highly stable equilibrium, both on the international stage and the domestic stage, particularly in the way it plays out in domestic politics, where there is never a shortage of populist politicians ready and willing to blame global trade for a host of ills. And because universal competition is such a stable equilibrium, typically only a giant crisis – one that shakes the principal players to their domestic political cores – gets you back, maybe, to a Cooperative game.

 Yikes, that sounds pretty dire, Ben. Are you sure? What about some prominent sell-side economists who recently published notes saying that you’re wrong about global trade? While it’s true, say these voices of consensus, that global trade values as measured in dollars are declining as commodities slide and the dollar gets stronger, aggregate global trade volumes are not contracting, so we really don’t have anything to worry about.

Hmm … here’s what the World Trade Organization (the gold standard in the field) says about seasonally-adjusted quarterly export volumes in the four economies that matter for international relations. The chart below starts with the low-water mark of all four geographies in Q1 2009, draws a line to the respective high-water marks hit in the second half of 2014, and then connects to the current index value. I find this sort of minimum-to-maximum-to-current data representation to be a very effective way of isolating inflection points in data series that should (if all is well with the world) grow at a pretty steady linear clip. And no, that’s not an error in the Japan and China graphs. Both countries’ export volumes peaked more than 5 years ago, essentially flatlined (a dip and recovery around the European crisis of 2012 not shown), and rolled over in late 2014. It’s pretty stunning, right? This is the primary reason why I think Japan gets no respect with their monetary policy experiments, and why I think we are already past the event horizon for China to float or otherwise devalue their currency. China has been trying to jumpstart industrial production growth for years now, nothing has worked, and the downturn since Q3 2014 not only puts them embarrassingly behind both the US and Europe in export activity, but also gives the lie to the idea that they can stimulate their way out of this.

Source: World Trade Organization, as of 12/09/15. For illustrative purposes.

To paraphrase George Soros, I’m not expecting a shrinking of the global trade pie and an expansion of competitive, protectionist domestic policies; I’m observing it. Something derailed the global trade locomotive in the second half of 2014, and it doesn’t take a genius to figure out that this something was divergent monetary policy, with the Fed embarking on a public quest to tighten, and the rest of the world doubling down on monetary policy easing. This is Exhibit 1 to support the case that we’ve entered a new, more competitive international political environment, as all four major global economies suffer a simultaneous contraction in trade volumes. I’m often asked what would need to happen for me to change my structurally bearish views about the world. So here you go. If this chart changes, then my views will change.

As you can see, the published WTO data currently goes through Q3 2015. Now maybe the Q4 2015 WTO data will come out and show a new high-water mark for these principal players in the global economy. But I don’t see how. First, I’ve looked at Q4 year-over-year trade values in local currency. Not a perfect measure of volumes, but indicative. The US, Japan, and China are all clearly down year-over-year in Q4; it’s hard to tell for the EU without including intra-EU trade. Second, I’ve looked at the raw data of container volume in the major ports in the world. 2015 data isn’t available for China and Japan, but partial data is available for the largest EU port (Rotterdam) and full data for the largest two US ports (Los Angeles and Long Beach). Rotterdam is down a little in 2015 total volumes; Los Angeles and Long Beach are down a lot in export volumes, with the declines accelerating in Q4 (partially labor issues, but still). Want more? Read this FT article on structural shifts in global trade. Read this WSJ article on the expanding January US trade deficit driven by disappointing exports, or this WSJ article on enormous new US tariffs on Chinese cold-rolled steel (while you’re at it, look who the biggest direct beneficiary of these tariffs is: Indian mega-billionaire Lakshmi Mittal … I swear to god, you can’t make this stuff up … and you wonder why Bernie Sanders strikes a chord with his message?). Take a look at Chinese electricity consumption data for 2015 (highly correlated with industrial production) and tell me that we’re not seeing continued declines.

How, then, do consensus sell-side analysts claim that global trade volumes are increasing? Two ways. First, they include countries that don’t matter, like Canada and Brazil. Sorry, my friends to the north and south, but you can increase your export volumes all you like and it matters not to the Great Game. Second – and this is the really egregious data interpretation mistake – they report global trade growth byincluding intra-EU trade! It’s a statistic that the WTO reports (as they should), and they include it in their aggregated global trade number (as they should). But if you can’t see that you need to back this number out if you’re trying to understand the strategic interaction between central banks … if you can’t see that intra-EU trade is as extraneous to this analysis as trade between Texas and California … well, I really don’t know what to say.

Now even though I think it’s totally disingenuous to claim that all is well with global trade volumes, I will be the first to admit that all is not lost. Yet.

First, export volumes have rolled over since the second half of 2014, but they haven’t collapsed, certainly not in the US, anyway. Export values, on the other hand, have taken a nose dive, particularly in the US (the total value of merchandise goods exported by the US is currently off more than 15% from its high-water mark). Keep in mind, though, that I don’t think that a decline in export values is as much of an emergency alarm as a decline in volumes. Why? Because a decline in export values impacts industrial sector earnings, while a decline in export volumes impacts actual industrial sector production. I think this is exactly why we’ve seen an earnings recession in the US, particularly in any sector with a connection to trade, but not a jobs recession. When export values decline, companies are missing their revenue targets. When export volumes decline, companies are shutting down factories. This is the big question I have for the US economy: will export volume declines start catching up to export value declines? If yes, then I think we’re going to have a “real” recession. If no, then I think we’re likely to muddle through in the real economy.

Second, it’s not like you can hide the fact that this enormous barge called global trade has reversed course over the past year and a half, and it’s not like central bankers or the IMF are oblivious to what’s going on. They’re going to respond, and who knows, maybe they’ll be successful in turning this barge back around. I don’t think they have the proverbial snowball’s chance, for reasons I’ll talk about in a second, but they’re certainly going to try.

Here’s a chart of the CDS spread (the premium you have to pay to insure your bond against default) for a senior credit index of the 33 largest European financial institutions as of February 8. I used this chart in the Epsilon Theory note “Snikt” to show what it looks like when the claws of systemic risk pop out.

© Bloomberg Finance L.P., as of 02/08/16. For illustrative purposes.

But now here’s a chart of the same CDS spread as of March 11. We’ve retraced the entire move.

© Bloomberg Finance L.P., as of 03/11/16. For illustrative purposes.

What happened? Exactly what happened in August 2012, the last time Draghi built up huge expectations for a miracle cure, blew the press conference, and had to be bailed out by the Powers That Be. In short, I suspect that the allocation heads at one or two European mega-insurance firms were informed that they would be supporting risk assets, I can observe how the Narrative machine got into gear, and I am certain that real world investors do what they always do, they play the Common Knowledge Game. Hopefully, if you’ve seen this movie before, you traded around the spike in February, got out of the position entirely, and are looking for a reprise.

Is there some reality to what the Narrative machine is pumping out? Sure, there always is. I think we have to take seriously the idea that the G-20 Shanghai meeting of the world’s central bankers and finance ministers in late February was more productive than anyone thought, and that maybe the joint communiqué calling for fewer beggar-thy-neighbor currency devaluations is a temporary truce of sorts. What would this truce look like? China agrees to give it the old college try one more time with domestic credit expansion and money printing, in an effort to replace feeble foreign demand for their products with goosed-up domestic demand and fiscal deficit spending. Europe agrees to lower its negative rates as little as humanly possible, and instead concentrate on good old-fashioned asset purchases. The US agrees to sit on its hands for a while with any more rate hikes, and Japan agrees to sit on its hands for a while with any more rate cuts. Sounds like a plan to me.

So we’re in the early days of a perfectly investable rally, driven by a plausible Narrative of central bank cooperation on currencies. Reminds me for all the world of September 2007, right after every quant-oriented multi-strat fund in the world was gob-smacked in July and August (and if you’ve seen the returns for quant-oriented multi-strat funds this January and February you’ll get my point). We had a perfectly investable rally then, too, driven by the Bernanke Narrative that the sub-prime crisis was “contained” and that the real economy was just in a “mid-cycle slow-down”. All good, until Bear Stearns was taken out into the street and shot the following March. Which was itself followed by a perfectly investable rally from April to mid-summer 2008, under the pervasive Narrative that “systemic risk was off the table.” Until it wasn’t.

So forgive me if I call this a temporary truce, an investable rally before the next “shock” that no one sees coming. Forgive me if I note that yet another FT puff piece on the unappreciated genius of Mario Draghi is ultimately small comfort given that we are smack-dab in the middle of an endemic of political polarization and anti-liberal sentiment (that’s small-l liberalism, of course, the Adam Smith and John Locke sort), the sort of political plague that the world hasn’t seen since the 1930s.


We are now in a world where principled politicians are called fascists, and fascist politicians are called principled. In most Western countries, we are one Reichstag Fire away from a complete up-ending of the core liberal principles of limited government and individual rights. At least the ascendant candidates on the right have the guts, for the most part, to wear their authoritarianism on their sleeves. The other side of the political spectrum, equally ascendant, is no less anti-liberal, they’ve just adopted the façade of smiley-face authoritarianism.

Politics always trumps economics, and until someone can show me that the structural advance in anti-liberal politics is any less pronounced than the structural decline in global trade volumes, I can’t get away from my structurally bearish views about this market. Or about this world, for that matter.

So what do we do about it?


After all, as fictional gangster Hyman Roth, patterned after real-life gangster Meyer Lansky, would say, “This is the business we have chosen.” It’s all well and good to bemoan the thin gruel we are served in modern politics and markets, but it’s the only food we’ve got, and we have a responsibility to make the most of it. I’ve got some ideas, but to be useful, these ideas need to fit the reality of the investment world and the business we have chosen. Let’s talk about that for a minute.

I think that many investors, allocators, and financial advisors today find themselves in the position of Bobby Dupea, the character played brilliantly by a young Jack Nicholson in “Five Easy Pieces.” In that movie’s iconic scene, Bobby just wants to get a side order of wheat toast with his breakfast at the local diner. But he is faced with what game theorists call a Hobson’s Choice, which is part of a more general class of games that includes ultimatums and dilemmas. A Hobson’s Choice is best understood as a strategic interaction where you are presented with what at first glance seem to be multiple opportunities for free will and free choice, but where in truth you only have a single option. Bobby has an entire menu to choose from, and the diner makes toast for sandwiches all day long, but it is impossible – despite a smart proposal of pair trades and long/short exposures that would isolate the wheat toast factor – for Bobby to get what he wants. He can have an omelet with a roll, or he can have nothing. Those are his true choices.

A Hobson’s Choice is Henry Ford telling you that you can have your Model-T in whatever color you like, so long as it’s black. A Hobson’s Choice is a Klingon telling you to surrender or die. A Hobson’s Choice is Vito Corleone making you an offer that you can’t refuse.

Today we have what appears to be a wide-ranging menu of investment strategies and ideas to choose from. But like Bobby Dupea, our true range of choices turns out to be terribly limited if we show the least preference for something that goes against the grain of conventional wisdom. Specifically, the dominant conventions of modern investment are “stocks for the long haul”, “you can’t time markets”, “focus on the fundamentals”, and “buy quality”. Everything you order from the investment menu has these conventional items embedded within them, and the more you question the conventional wisdom (not that it’s all wrong or a big lie, but simply to inquire whether the conventional wisdom is perhaps less useful in unconventional times, and maybe – just maybe – you might want to have some wheat toast with your omelet) the more you risk getting kicked out of the diner.

The Hobson’s Choice that nearly every investor, allocator, or financial advisor faces today is always some variation of the famous quote from John Maynard Keynes: it’s better for your reputation (i.e., your business) to fail conventionally than to succeed unconventionally. Every investment professional I’ve ever met – every. single. one. – wrestles with this dilemma. So do I. We’ve all seen examples in our portfolio results that the conventional tools aren’t working. We know that the words we hear from our Dear Leaders and the articles we read from our Papers of Record are designed to manipulate and entertain us, not inform us. We want to succeed, and we feel in our gut that we should be trying something new and (maybe) better. But not if it means losing our clients or losing the support of our Board or losing the support of that little voice of convention inside each of our heads. It’s that last bit that’s probably the most powerful. As George Orwell so correctly observed about human psychology, the most terrifying part of hearing Big Brother say that two plus two equals five isn’t that they might kill you for believing otherwise, but that you think they might be right!

And make no mistake about it, our Hobson’s Choice is getting worse. Investing according to conventional wisdom has always been the reputationally safe decision, but in the policy-controlled markets to come, investing according to conventional wisdom may well be the only legally safe decision.

So here’s what I’m not going to do. I’m not going to discuss “alternative strategies” that are always set off to the side in a little section of their own on an investment menu, intentionally organized and presented as if to say “Careful now! Here are some exotic side dishes that you might use to spice up your core portfolio a bit, but you’d be crazy to make a meal out of this … not that we’d let you do that anyway.” I’m not going to perpetuate the Hobson’s Choice game and its charade of false choices and hidden ultimatums. Instead, I’m going to recommend alternative thinking about your portfolio here in the Silver Age of the Central Banker. I’m going to recommend five specific ideas – Five Easy Pieces – that challenge conventional wisdom and (I hope) will spark readers to think differently about their entire portfolio and investment process, not just whatever small slice of the pie is reserved for “alternative strategies”.

Five Easy Pieces for the World-As-It-Is


Because this is how we escape a Hobson’s Choice. We must look beyond the false choice. We must reject the ultimatum (act conventionally or risk your business) and find a new dimension that avoids the false choice entirely. This was the genius of Mad Men‘s Don Draper: “If you don’t like what’s being said, change the conversation.” Or to use a far more trite and shop-worn phrase, this is what “thinking outside the box” means – expanding our field of vision to incorporate not only the specific choice we’re presented with, but also the act of choosing. To escape a Hobson’s Choice we can’t look at the world as (x) OR (y), as a series of choices we make from a menu that’s handed to us. We have to step back and see the menu itself as a choice, that what we thought was (x) OR (y) is really (x OR y), and there’s a big world outside of (x OR y). Expanding our perspective and changing our conversation changes everything. It allows us to re-engage in an entirely new way with whatever investment menu we might have in whatever our World-As-It-Is might be, such that whatever investment decisions we make are truly OUR choices, not THEIR choices. Maybe for the first time.


This is a good example of what I’m talking about. Investment convention holds that you should be fully invested throughout a market cycle. Otherwise you must be—gasp!—a market timer. Boo! Hiss! If there’s a worse insult in the investment world or a quicker way to get fired by your client than to be called a market timer, I’m not aware of it. And god forbid that you actually propose an “alternative strategy” that embraces market timing. But of course, we’re ALL market timers, we just do it in a conventionally acceptable way by “shifting to defensive sectors” or “keeping our powder dry” or “managing risk” (whatever that means). We’re all hypocrites when it comes to our professed faith in full investment, because we don’t really believe in it. We all want to get out of markets when they’re going down, we all want to get into markets when they’re going up, and we all think that we have some insight into what’s next.

And that, of course, is the source of the actual wisdom in this conventional wisdom. We really don’t have a crystal ball to predict whether the market will be up or down tomorrow or over the next week or over the next month or over the next year. We really do have biologically evolved social behaviors that push us to sell low and buy high. Whatever you think you should do as a short-term trade, you’re probably wrong. Left to our own devices, almost all of us are almost always better off to put our investments in a drawer, close our eyes, and walk away.

So here’s the question. How do we change the conversation so that a rigorously conceived adjustment in portfolio exposure to risk assets isn’t characterized as market timing? Because as soon as a strategy is characterized as market timing, then it’s a Hobson’s Choice situation, where you don’t really have a choice but to reject it. Now I’m not talking about reading ZeroHedge and selling because you got all freaked out by an article, and I’m not talking about watching CNBC and buying because you got all bulled up by a talking head. That IS market timing, of an indefensible sort. But is there a defensible sort of portfolio exposure adjustment, one that has a foundation strong enough to allow a non-Hobson’s Choice implementation? My answer: yes. In fact, I think there are two such approaches.

First, markets are more volatile when countries are playing a Competitive game than when they’re playing a Cooperative game. Now granted, this is a prediction of a sort, but it’s a prediction of political dynamics – which is exactly what the game theory toolkit is designed to do – as opposed to a market prediction like whether the S&P 500 will be up or down next week. I think this is where Epsilon Theory can make a unique analytical contribution. The international political regime matters to markets. It matters a lot. I am convinced that we have entered a new, analyzable, competitive regime of domestically stressed nations, and that means that we have a deflationary hurricane brewing. What I don’t know (yet) is whether this is going to be a Category 1 hurricane, a Category 3 hurricane, or a Category 5 hurricane. If China floats the yuan – and that’s the big catalyst I think has a decidedly non-trivial chance of occurring – then it’s Category 5. If they don’t, it’s something less. But regardless, a Competitive global trade game is going to be a big storm. Trim your sails. Whatever that means to you and your investment process, whether it’s increasing cash, reducing net or gross exposure, shifting to long-dated Treasuries … whatever … that’s what I think you should do when the world plays a Competitive game. Does that make me a market timer? Well, if that’s the conversation you’re stuck in … yes. But it’s not the conversation I’m having, either with others or myself.

Second, although I can’t predict future market returns, I can observe how volatile the market has been in the short, medium, and long-term past. It’s that George Soros quote again: I’m not predicting; I’m observing. I can also tell you about my personal appetite for risk and volatility. Put these two items together and you have the foundation for a new conversation about investing, a conversation based on observable risk rather than predicted reward. Is observed volatility going up above a level where I am personally comfortable? Well, let’s take my market exposure down. Is observed volatility going down below that level? Well, let’s take my market exposure up. There are a dozen variations on this theme: call it risk balancing or risk parity or volatility targeting or whatever. But whatever you call it, I think it is a better way of staying invested in markets through thick and thin. Just less invested when thick and more invested when thin.

A systematic risk balancing strategy is at the core of what I have been describing as Adaptive Investing over the past two years. That and an appreciation for the political dynamics that underpin markets, creating different investment regimes as the game-playing moves from one equilibrium state to another. There is zero crystal ball gazing in a risk balancing strategy – zero. In that sense it is entirely compatible with the investment convention of not trying to time markets. But the alternative thinking I’m suggesting here is that “full investment over a market cycle” works better if it’s risk being fully invested over a market cycle, not dollars. It’s a new twist on an old idea, and once you start thinking of risk budgets first and dollar budgets second, everything changes.


The usefulness of the game theory toolkit isn’t limited to understanding the dynamics of strategic interactions between international political players like central banks. It’s also useful in understanding the dynamics of strategic interactions between market players. It’s also the rigorous foundation for changing the conversation about another market convention: focus on the fundamentals. Are fundamentals important? Of course they are. Knowing the fundamentals of an investment is like knowing how to play the cards you’re dealt in a poker game. But as any successful poker player will tell you, it’s not enough to play the cards well. More importantly, you also have to play the player.


Wall Street players today aren’t like a historical Jay Gould or a fictional Gordon Gecko, ruthless seat-of-their-pants robber barons with a great eye for arbitrage and leverage. To be sure, it’s not the ruthless part that’s missing today, or the eye for arbitrage and leverage. No, what’s changed from the past and what Hollywood still doesn’t get is that the whole instinctive, seat-of-the-pants thing is totally dead.


Wall Street players today are creatures of process. They are Bill Belichick and Nick Saban, seemingly joyless automatons who do nothing but win (Roll Tide!) because they are monomaniacally focused on efficient process in every aspect of their organization and constant incremental adaptation to new information. It’s not just the quants that have uniformly adopted a process-focused business strategy, but every successful investment firm, regardless of discipline or market focus. Ray Dalio at Bridgewater, certainly the most out-there proponent of Belichick-ian process discipline in the investment world, is best known for creating the largest hedge fund in the world. More interesting to me, though, is how the meme of process and incremental adaptation – principally authored by Dalio – is now part of the internal Narrative of every investment firm on Earth. Note that I’m saying this meme is part of the Narrative of these firms, not their investment DNA. Like all good memes, the belief in process and incremental adaptation is principally an instrument of internal social control, part of the modern day Panopticon (“what, you don’t believe in process? hmm, not sure that you’re going to fit here.”), as well as an instrument of external social expression (“you can trust us … we’re process-oriented!”).

Why is this primacy of process so important for understanding market dynamics? Because it means that while there is no single mode of market participant behavior, no single way of playing the market game, there is an underlying dimension – a common behavioral denominator, if you will – of prioritizing process and incremental adaptation. To torture the poker analogy a bit more, you have tens of thousands of poker tables in operation every day, with hundreds of different poker variations being played … No Limit Texas Hold ‘Em here, 5 Card Draw there, etc. Some players have big stacks, some have small stacks, some play tight, some play loose. But they are ALL process-oriented players. They are ALL watching each other and the cards closely, they are ALL reacting to each other and the cards in an incremental process-oriented way, and they are ALL “learning” in an incremental process-oriented way.

I don’t think you have to be a poker expert to recognize that there’s game-playing power to be found in the recognition of a common behavioral denominator, no matter how deeply it runs. In truth, the deeper it is, the more powerful it is. This is the structural reason why the Common Knowledge Game is such a useful way to analyze market dynamics in the modern age. The market-playing crowd is always looking at the market-playing crowd, and the crowd is hardwired – not by biology but by business process – to “learn” a similar reaction to similar Missionary statements.

This is also the structural reason why I believe trend-following strategies are so interesting and effective in modern markets. In a very real sense, all of these process-focused and iteratively-learning investors are themselves augmenting whatever initial stimulus they’re all looking at, creating trends where none was present before. If you’ve never read George Soros’s “Alchemy of Finance”, now might be a good time to start. What’s perhaps even more interesting – and this will have to be a tease because it deserves several Epsilon Theory notes on its own – is whether it’s possible to design alearning-following investment strategy. Now that would be something.


Okay, this is a big one. What is negative carry? It’s time working against you. It’s the price you pay to carry or hold a position. Investors HATE negative carry, because almost all investment conventions are based on the assumption that time works for you, not against you. What’s the basis of “stocks for the long haul”? Time working for you. What’s the basis of compounding, which is nothing less than the most powerful investment idea in all of human history? Time working for you. What’s the basis of retirement planning, saving, and – in a very real sense – the entire concept of investment? Time working for you.

The damaging impact of negative interest rates on bank earnings and all that is very true and very real. But far more damaging is the impact of negative interest rates on these basic IDEAS about what it means to be an investor in public markets. If you see the world as principally a market of ideas and memes, rather than as a market of capital and labor – and this is exactly the perceptual lens I’m trying to explore with Epsilon Theory – then I don’t see how you can’t be freaked out by what’s happening today. Certainly it’s why I’ve gotten much more alarmist over the past few months in what I write. We are seeing huge chunks of stone being taken out almost daily from these central idea pillars of public markets. As market participants lose faith in the idea that time is on your side, as they start to question the idea that there’s an inherent up-and-to-the-right arrow to any price-over-time chart … the entire financial advisory world is going to burn.

So what do you do?

I suggest we start thinking like a short seller. We don’t have to BE short sellers, but we all need to THINK like short sellers. Why? Because short sellers naturally live in a negative carry world, both in their investments and their ideas. Dividends and yield-bearing securities constantly chip away at the value of a short seller’s portfolio. Similarly, the long-biased information flow promoted by corporate management and the sell-side constantly chips away at the investment theses embedded in a short seller’s portfolio. Time always works against a short seller (particularly in a zero or negative interest rate world … boy, do I miss the 5% interest paid on the cash generated from borrowing shares), and successful short sellers have learned to think differently as a result.

1) If you’re wrong on timing, you’re just wrong. A successful short seller focuses on near-term catalysts, and that’s exactly the focus that I think most investors could adopt, or at least incorporate, in this environment. If there’s no catalyst to force investors to recognize the value that you think exists in a stock, then it doesn’t exist. When a short seller reads a sell-side buy recommendation that begins with something like “For the patient, long-term investor…” they almost always look to short the stock, because it almost always means that the near-term catalysts are very negative for the company. But by the same token, a long-biased investor who thinks like a short seller is happy to buy a company with positive near-term catalysts even if the long-term prospects don’t look so great. In fact, that’s exactly how I would characterize risk assets in general today – structurally awful in the long-term as global trade and global cooperation and the idea of a positive risk-free rate and the liberal tenets of free markets die a little more every day, but with positive short-term catalysts as central bankers and their sell-side apologists rally the troops one more time. Every position is a rental if you’re thinking like a short seller.Nothing is owned.

A catalyst-oriented, everything-is-a-rental way of thinking sounds easy, but it’s the hardest thing you’ll ever do. It’s hard because it’s utterly unforgiving. Meaning, you can never forgive yourself. Here are the two thought processes that have ruined more catalyst-oriented investors than anything else:

“Huh? No price reaction yet to this realized catalyst that I so brilliantly anticipated? Well, I suppose the market just needs a little more time to absorb its importance.”

“Golly, the earnings call just ended and the company didn’t make the announcement I thought they would. Oh, well, I’m sure they’ll announce it next quarter.”

Bzzzzt! Sorry, that’s our tacky buzzer and you’ve just been eliminated from the game. When the catalyst happens – whether or not it impacts the price of the stock or bond like you think it should – you get out. If the time frame or event frame for the catalyst expires – whether or not the catalyst actually occurs – you get out. Thinking like a short seller means no excuses, particularly in the easiest place to make excuses – inside our own heads.

2) The question that really matters: is the story broken? I’ve written about this at length, so I won’t repeat all that here. But I’ll give you an example of a story that ALWAYS breaks in a squirrely market: financial engineering. If you’re long a company because “management is buying back lots of stock” or “there’s a tax-advantaged spin-out possible here” or something similar … well, good luck with that in a risk-off environment. I’m not saying that financial engineering is bad. On the contrary, I love financial engineering. Seriously. It’s an incredibly powerful tool for potentially making money. What I’m saying is that a financial engineering STORY is inherently pro-cyclical – it always works better than you expect in a rising market and worse than you expect in a declining market. A stock with a broken story will go down a lot more than what’s “fair”, and that’s a very unpleasant ride. Fortunately, all stories heal and all stories evolve, which makes for some potential buying opportunities. But you won’t recognize those opportunities (or you’ll probably butcher the timing) unless you’re focusing on what really matters – the story.

So what strategies inherently “think” like a short seller? Managed futures and trend-following, for sure. Everything is a rental for a trend follower, by definition, and trends – because they are created by market behaviors, not the underlying qualities of a company – are inherently linked to the stories and narratives that shape behavior. More basically, any trader and any trading strategy tends to think like a short seller, and I believe there’s room for these strategies to work in markets dominated by a Competitive international game. Ditto for some global macro strategies. Doesn’t mean any of these strategies will work, of course, only that they possess what I think are some of the necessary qualities (as opposed to the sufficient qualities) to succeed.

But when I say it’s important to think like a short seller in a negative carry world, I don’t mean that we have to go out and hire short selling managers. Because I will tell you that there are plenty of short sellers who think like long-only guys, and are thus the worst possible discretionary managers to turn to in this environment. The really crucial action, though, and it’s an action we can all take inside our own heads even if we’re not able or not allowed to actually do short selling, is to step back and reconsider all of our investment menu choices if time no longer works so clearly in our favor. That’s the existential issue every investor, allocator, or advisor needs to wrestle with, no matter how painful that is. Otherwise, to use Ken Kesey’s phrase from “One Flew Over the Cuckoo’s Nest,” you’re choosing to let yourself be lost in the fog. And that’s a Hobson’s Choice of an entirely different sort.


I’m pretty sure that I was the first to come up with the phrase “Central Bank Omnipotence.” It was in one of my very first notes – “How Gold Lost Its Luster, How the All-Weather Fund Got Wet, and Other Just-So Stories” – back in the summer of 2013, a note that even today remains one of the most popular in the Epsilon Theory canon. For the next six months or so, however, I would go around and talk with institutional investors about the Narrative of Central Bank Omnipotence – that markets acted as if central bank policy determined market outcomes – and I got enormous pushback. No, no, I heard, we’re on the cusp of a self-sustaining real economic recovery here in the US, and whatever the Fed and other central banks are doing, whatever the market reaction might be, it’s just a bridge to the happy days of “normal” markets ahead. And this is after the Taper Tantrum, mind you. It really wasn’t until the spring of 2014 that the steady drip, drip, drip of the Central Bank Omnipotence meme became a tsunami, and by the fall of 2014 it was impossible to find anyone who didn’t believe in their heart of hearts that Central Banks, for good or for ill, determined market outcomes.

I bring this up because I’ve read lots of suggestions, particularly after the one day half-life of effectiveness for Kuroda’s negative rates announcement on January 28 and the one hour half-life of effectiveness for Draghi’s negative rates announcement on March 11, that the Narrative of Central Bank Omnipotence is dying. But then you get a day like March 12, where the Narrative engine springs to life in support of Draghi’s “bold move”, and now I read that the Narrative of Central Bank Omnipotence is alive and well.

Here’s what I think. As the strategic interaction between the four largest economies in the world shifts from self-enforced cooperation to self-enforced competition, from a Golden Age to a Silver Age, so does the market’s Common Knowledge or Narrative regarding that strategic interaction. But it doesn’t die, any more than the strategic interaction dies. Think of it as the same song, but now in a minor key. So long as every CNBC talking head genuflects in the direction of central banks in every single conversation, so long as front page articles about central banks dominate every day’s issue of the WSJ and FT … then the Narrative of Central Bank Omnipotence is alive and well. The power of the Narrative is that we believe that all market outcomes are somehow the result of central bank policy, not that central bank policy necessarily generates a good or even intended market outcome. It’s a narrative of Omnipotence, not Competence or Omniscience. The day that central bankers give up, the day that Yellen or Draghi appears on stage and says, “Well, there’s really nothing more we can do. It’s just out of our hands now. Sorry ’bout that.” … that’s the day that we lose our religion and the Narrative dies.

Ultimately, we’re no closer to “normal” markets driven by fundamentals here in the Silver Age of the Central Banker – the age of strife and competition – than we were in the Golden Age of the Central Banker – the age of cooperation and great deeds. In fact, we’re farther away than ever. It’s a policy-driven market just as far as the eye can see.

Policy-driven markets change the rules, both the formal rules of regulation and – more importantly – the informal rules of correlation, and they change these rules in predictably surprising ways. That is, the regulatory rule changes will always be surprisingly to the left or surprisingly to the right, never what you might expect by a central tendency theorem. That goes for correlation surprises, too. Both tails are equally fair game for a shock. I mean, the euro had a four percent trough to peak move on March 11! Two percent down and then two percent up. You think that didn’t blow up some correlation and volatility trades?

When I say don’t trust the models – and by models I mean pretty much of all mainstream portfolio and investment analysis, basically anything that says “Here’s a pattern we observe from some period of time over the last 40 years, and now we’re going to extrapolate what the future holds because of that observed pattern.” – I mean two things. First, we haven’t had a policy-driven market like this since the 1930s, so whatever historical data was used to power whatever model you’re using needs to be taken with a grain of salt (read “I Know It Was You, Fredo“, “Inherent Vice“, “Funny How?“, and “Ghost in the Machine” for more, and of course you can read anything by Nassim Nicholas Taleb or Benoit Mandelbrot for the same message presented in book form). Second, investors are not only risk/reward maximizers, but they are also regret minimizers. Almost all of modern econometrics, particularly portfolio analysis, is an exercise in risk/reward maximization and thus fails to connect with investors who are focused on concerns of regret minimization (read “It’s Not About the Nail” for more).

What this means in practice is that most portfolios are too flabby in what I’ll call the Big Middle – the large portfolio allocation that most investors, large and small, maintain in large cap stocks. The easy way out when it comes to investment conventions and the Hobson’s Choice we all face when it comes to portfolio construction is always to add more S&P 500 exposure. The old IT saying used to be that no one ever got fired for buying IBM, and the current financial advisory saying should be that no one ever got fired for buying more Apple. Although maybe they should.

I’m not saying that capital invested in the Big Middle must always be reallocated to make for a more convex, more diversified portfolio. But I am saying that every bit of your portfolio should be purposeful. I am also saying that there’s a lot of wisdom for investing in what Plato said about politics almost 2,500 years ago (and he was quoting a guy who lived 400 years earlier), that the half is often greater than the whole. Meaning? Meaning that you get better outcomes when half of your citizens or half of your investments are organized efficiently and with right purpose than if all your citizens or all of your investments are organized haphazardly or without common purpose. Or for a more modern slant, I like George Carlin’s take, that while some see a glass half-full and some see a glass half-empty, he sees a glass that’s twice as big as it needs to be. Many portfolios are twice as big as they need to be. Not in dollars, of course (may your portfolio get much larger in that regard), but in terms ofinefficient, mushy allocation to low risk, low reward, highly correlated investments.

What goes into a purposeful portfolio in the Silver Age of the Central Banker? A lot of optionality, for one thing, which does not necessarily require expression through options and derivatives (although that certainly makes it easier) and is another way of saying convexity. A keen sense of correlation and correlation change, for another, which does not necessarily require expression through covariance matrices (although that certainly makes it easier) and is another way of saying diversification. While the terms can be daunting, the logic and practice aren’t so much. Like thinking in terms of a risk budget instead of a dollar budget, it’s more of a matter of perspective than anything else.

One exercise I find useful is to think of different future scenarios for the world (not because I’m trying to predict which one will happen, but precisely because I can’t!) and then to consider how my current exposures and strategies are likely to fare in those futures. My goal isn’t to figure out the scenario where I think I’ll do the best, because then I’ll start hoping for it and consciously or unconsciously will start to assign a higher probability of it occurring, but to figure out the scenario where I’ll do the worst (both in absolute terms and relatively to whatever I compare myself to). I’m trying to minimize my maximum regret – minimax regret, a powerful game theoretic tool for dealing with technical uncertainty, where you’re not sure that you’ve identified all the potential outcomes and you’re certainly not sure of the probability distribution to assign to those outcomes – and I do so by planting seeds (buying exposure with either embedded or overt optionality) in that least happy scenario. I find that this iterative, new information-friendly exercise changes the conversation you can have with others or yourself, away from a needlessly daunting conversation on risk/reward maximization and towards a more fruitful conversation on being an investment survivor in a decidedly dangerous time.


And now for the big finish.

Last summer I wrote a note called “The New TVA”, which made a direct comparison between the political dynamics of the 1930s and the political dynamics of today. What amazes me (still), is how the political conversations then are almost identical to the political conversations now.


Just switch out FDR for Obama and you could easily imagine this cartoon being about healthcare or some such rather than New Deal legislation.

Here’s the skinny for that note: in the same way that FDR had an existential political interest in generating inflation and preventing volatility in the US labor market, so does the US Executive branch today (regardless of what party holds the office) have an existential political interest in generating inflation and preventing volatility in the US capital markets. Transforming Wall Street into a political utility was an afterthought for FDR, a nice-to-have but not a must-have, as Wall Street was not yet a Main Street phenomenon. Today the relative importance of the labor markets and capital markets have completely switched positions. Wall Street is now decidedly a Main Street phenomenon, and every status quo politician – again, regardless of party, and let’s remember that the Fed is part of the Executive Branch – keenly desires to keep the genie of unfettered fear and greed firmly stopped up in its bottle. Georges Clemenceau, French Prime Minister before and after World War I, famously said that “war is too important to be left to the generals.” Today, the quote would be “markets are too important to be left to investors.”

But it was only after Draghi’s ECB announcement last Thursday that I think I see how a policy-driven market becomes a policy-controlled market. The ECB took a page from the Bank of Japan’s playbook and announced that they would now buy non-bank investment grade corporate credit as part of their QE asset purchases, and that’s at least as big of a deal as the BOJ taking a page from the ECB playbook in January and adopting negative interest rates. When two of the Big 4 adopt any policy, a point becomes a line and an idiosyncrasy becomes a pattern. The direct purchase of corporate securities by central banks is now in the official tool kit of every central bank. You cannot un-ring this bell. It is a “Goodfellas moment” of enormous consequence.

In one fell swoop, Draghi has essentially made useless the most effective portfolio hedge I know against systemic risk – shorting investment grade credit through the CDS market. And he conceived this plan when senior bank debt CDS spreads (the best indicator of systemic risk levels I know) were only 120 bps wide! Imagine what’s going to happen the next time spreads blow out to 200 bps wide, much less if we ever got close to the 350 bps spread of 2011. My point, of course, is that Draghi isn’t going to allow CDS spreads to blow out again. Ever. Not even a little bit. The ECB will intervene directly in credit spreads from here to eternity, first in sovereign debt, now in non-bank corporate debt, tomorrow in bank corporate debt. That’s how a policy-driven market becomes a policy-controlled market, not by outlawing short sales or credit default swaps, but by sitting down at the poker table with an infinitely large stack of chips relative to any other player. The ECB can now run over anyone who sits down at the European corporate credit poker table. Thanks, but I’d rather not play, no matter what cards I’m dealt.

So if I can’t protect my portfolio through effective shorts, and the Powers That Be are determined to turn public markets into political utilities, but I’m structurally bearish on the ability of the Powers That Be to prevent domestic political shocks and international political conflict of 1930-ish proportions, what’s to be done with public market investing other than the occasional short-term trade? Two things, I think.

First, I think it makes sense to use public markets for their liquidity and for tapping whatever this utility-like rate of return the Powers That Be have in mind. But I also think it makes sense to tap global beta through risk balancing strategies, because I really do think we’re in for a bad storm, and I don’t trust Captain Yellen or Captain Draghi to guide the ship for my benefit rather than their own political benefit. As for any effort to find alpha in public markets? Forget it.

But, Ben, what about stock picking? Yeah, what about stock picking? You can read the S&P scorecard here. How did that actively managed US equity fund work out for you last year? Or the last 5 years? Or the last 10 years? Here’s my issue with stock picking. Most stock pickers look at companies pretty much exclusively through the lens of “quality” – a quality management team, a quality earnings profile, a fortress balance sheet, etc. Unfortunately, this is the worst possible investment perspective to use in a policy-driven market, much less a policy-controlled market. It does not outperform a broad passive index. It does not generate alpha. Again with the George Soros quote: I’m not expecting it; I’m observing it. I know, I know. Heresy. But ask yourself this. Do you really think that the mandarins of the Fed or the ECB or the BOJ care one whit about whether this company or that company has a higher stock price? Of course not. They want ALL companies to have a higher stock price, and as a result the policies they are going to implement will inevitably help the weakest, lowest quality companies the most. Now if investing in quality-uber-alles is the conventional conversation you need to have to justify participating in public markets, I get it. But to me it’s just another form of fighting the Fed, and for me it’s always a losing conversation.

Second, I think it makes sense to use public markets if that’s the best way to own real assets. Why real assets? Because while nothing is immune to the predation of illiberal governments and the capricious rule-making and rule-breaking of central banks, real assets are at least insulated from both. What real assets? I have a very broad definition, including not only the obvious suspects like real estate and infrastructure and commodities, but also gold and intellectual/digital property. Actually, I think of gold as very similar to many forms of intellectual property, as its worth is found in behavioral preferences and affect, not in some intrinsic or commercial use case.

All real assets are not created equal, of course. I’d much rather own an asset that generates some sort of cash flow than one that just sits there, but price will usually (although not always) take care of that differentiation. The most important consideration, I think, particularly when using public markets, is to get as close as you can to the fractional ownership share in the asset itself and as far away as you can from the casino chip. What that means in practice is getting as high up in the capital stack as you can while still having an equity claim on assets. For a highly levered or distressed company that probably means being in the senior secured debt. For a more typical company that might mean being in the preferred equity shares, if they exist, or choosing between this company’s equity and that company’s equity. It’s making this sort of evaluation where I think that active managers, whether it’s in equity or in fixed income, can prove themselves, and where I think there’s a role for fundamentally-oriented, stock-picking active managers. It’s not because I think they can stock pick their way to outperformance versus a passive index while we’re in a policy-driven or policy-controlled market, but because I think they can identify a margin of safety in my public market ownership of real assets and real cash flows better than a passive index. Now that’s a conversation worth having with active managers here in the Silver Age of the Central Banker.

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Rewardless Risk

Faramir: Then farewell! But if I should return, think better of me.
Denethor: That depends on the manner of your return.

J.R.R. Tolkien “The Lord of the Rings” (1954)


I’m going full-nerd with the “Lord of the Rings” introduction to today’s Epsilon Theory note, but I think this scene — where Denethor, the mad Steward of Gondor, orders his son Faramir to take on a suicide mission against Sauron’s overwhelming forces — is the perfect way to describe what the Bank of Japan did last Thursday with their announcement of negative interest rates. The BOJ (and the ECB, and … trust me … the Fed soon enough) is the insane Denethor. The banks are Faramir. The suicide mission is making loans into a corporate sector levered to global trade as the forces of global deflation rage uncontrollably.
Negative rates are an intentional effort to weaken your own country’s banks. Negative rates are a punitive command: go out there and make more bad loans where risk is entirely uncompensated, or we will, in effect, fine you. The more bad loans you don’t make, the bigger the fine. Negative rates are only a bit worrying in today’s sputtering economies of Europe, Japan, and the US because the credit cycle has yet to completely roll over. But it is rolling over (read anything by Jeff Gundlach if you don’t believe me), it is rolling over everywhere, and when it really starts rolling over, any country with negative rates will find it to be significantly destabilizing for their banking sector.

There’s a reason that the Fed kept paying interest on bank reserves even in the darkest, most deflationary days of the Great Recession. Yes, it’s the Fed’s job to support full employment. Yes it’s the Fed’s job to maintain price stability. But the Fed’s job #1 — the reason the Federal Reserve was created in the first place — is to maintain the stability of the banking system. Go ask a US moneycenter bank how things would have turned out in 2008 if the positive interest coming in on their reserves had been flipped to negative interest going out on their reserves. Go ask a US regional bank how things would have turned out if they had made even more rewardless risk loans in 2006 and 2007 under the pressure of negative rates.

Look, I get the “theory”. I understand that weakening the yen is an existential domestic political issue for Kuroda and Abe, just as weakening the euro is an existential domestic political issue for Draghi and Merkel, just as weakening the yuan is an existential domestic political issue for Zhou and Xi. And I understand that policy-addicted markets will respond exuberantly to anything that can be described as central bank support for financial asset price inflation. Hey, I’m an addict, too.

But what I’m concerned about is not the theory but the practice. What I’m concerned about is the intentional destabilization of the global financial system for domestic political purposes. What I’m concerned about is the Fed’s inevitable adoption of negative rates, something Alan Blinder pushed for in 2008 and Ben Bernanke is pushing for now.

When the ECB instituted negative rates, that was just a point. The BOJ’s move last Thursday makes a line. Now we have a pattern. Now we have a market that expects MOAR! Now we have a Fed that will undoubtedly implement negative rates when things get squirrely again, even if there are some in the Fed who I’m sure are shaking their heads at all this.

I’ve come to expect every elected politician or politician wannabe to rail against “the bankers” and the terrible mess they’ve made of the world with their “predatory lending” and “easy credit”, even though this is exactly what every politician in the world desires. But I didn’t expect central bankers to betray their own charges. I didn’t expect central bankers to throw their own domestic banks into a battle they can’t win.

You know what negative rates are? They are the final stripping away of the illusion that central bankers somehow exist above and separately from domestic politics, that they are wise and able stewards of financial stability. Nope. They’re Denethors.

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You Can Either Surf, or You Can Fight

Kilgore: Smell that? You smell that?
Lance: What?
Kilgore: Napalm, son.  Nothing else in the world smells like that.

– Apocalypse Now (1979)

Hello, hello, hello, how low? [x3]
– Nirvana, Smells Like Teen Spirit (1991)

Outside the bus the smell of sulfur hit Bond with sickening force.  It was a horrible smell, from somewhere down in the stomach of the world.
– Ian Fleming, Diamonds Are Forever (1956)

There’s more than a whiff of 2008 in the air. The sources of systemic financial sector risk are different this time (they always are), but China and the global industrial/commodity complex are even larger tectonic plates than the US housing market, and their shifts are no less destructive. There’s also more than a whiff of 1938 in the air (hat tip to Ray Dalio), as we have a Fed that is apparently hell-bent on raising rates even as a Category 5 deflationary hurricane heads our way, even as the yield curve continues to flatten.

What really stinks of 2008 to me is the dismissive, condescending manner of our market Missionaries (to use the game theory lingo), who insist that the US energy and manufacturing sectors are somehow a separate animal from the US economy, who proclaim that China and its monetary policy are “well contained” and pose little risk to US markets. Unfortunately, the role and influence of Missionaries is even greater today in this policy-driven market, and profoundly misleading media Narratives reverberate everywhere.

For example, we all know that it’s the overwhelming oil “glut” that’s driving oil prices down and wreaking havoc in capital markets, right? It’s all about OPEC versus US frackers, right?

Here’s a 5-year chart of the broad-weighted US dollar index (this is the index the Fed publishes, which – unlike the DXY index and its >50% Euro weighting – weights all US trading partners on a pro rata basis) versus the price of WTI crude oil. The red line marks Yellen’s announcement of the Fed’s current tightening bias in the summer of 2014.


Source: Bloomberg, January 2016.

Ummm … this nearly perfect inverse relationship is not an accident. I’m not saying that supply and demand don’t matter. Of course they do. What I’m saying is that divergent monetary policy and its reflection in currency exchange rates matter even more. Where is the greatest monetary policy divergence in the world today? Between the US and China. What currency is the largest contributor to the Fed’s broad-weighted dollar index? The yuan (21.5%). THIS is what you need to pay attention to in order to understand what’s going on with oil. THIS is why the game of Chicken between the Fed and the PBOC is so much more relevant to markets than the game of Chicken between Saudi Arabia and Texas.

But wait, there’s more.

>My belief is that a garden variety, inventory-led recession emanating from the energy and manufacturing sectors is already here. Maybe I’m wrong about that. Maybe I spend too much time in Houston. Maybe low wage, easily fired service sector jobs are the new engine for US GDP growth, replacing the prior two engines – housing/construction 2004-2008 and energy/manufacturing 2010-2014. But I don’t see how you can look at the high yield credit market today or projections of Q4 GDP or any number of credit cycle indicators and not conclude that we are rolling into some sort of “mild” recession.

My fear is that in addition to this inventory-led recession or near-recession, we are about to be walloped by a new financial sector crisis coming out of Asia.

What do I mean? I mean that Chinese banks are not healthy. At all. I mean that China’s attempt to recapitalize heavily indebted state-owned enterprises through the equity market was an utter failure. I mean that China is going to need every penny of its $3 trillion reserves to recapitalize its banks when the day of reckoning comes. I mean that China’s dollar reserves were $4 trillion a year ago, and they’ve spent a trillion dollars already trying to manage a slow devaluation of the yuan. I mean that the flight of capital out of China (and emerging markets in general) is an overwhelming force. I mean that we could wake up any morning to read that China has devalued the yuan by 10-15%.

Look … the people running Asian banks aren’t idiots. They can see where things are clearly headed, and they are going to do what smart bankers always do in these circumstances: TRUST NO ONE. I believe that there is going to be a polar vortex of a credit freeze coming out of Asia that will look a lot like 1997. Put this on top of the deflationary impact of China’s devaluation. Put this on top of an inventory-led recession or near recession in the US, together with high yield credit stress. Put this on top of massive market complacency driven by an ill-placed faith in central banks to save the day. Put this on top of a potentially realigning election in the US this November. Put this on top of a Fed that is tighteningStorm warning, indeed.

So what’s to be done? As Col. Kilgore said in “Apocalypse Now”, you can either surf or you can fight. You can adopt strategies that can make money in this sort of environment (historically speaking, longer-term US Treasuries and trend-following strategies that can go short), or you can slog it out with a traditional equity-heavy portfolio.

Also, as some Epsilon Theory readers may know, I co-managed a long/short hedge fund that weathered the 2008 systemic storm successfully. There were trades available then that, in slightly different form, are just as available today. For example, it may surprise anyone who’s read or seen (or lived) “The Big Short” that the credit default swap (CDS) market is even larger today than it was in 2008. I’d welcome a conversation with anyone who’d like to discuss these systemic risk trades and how they might be implemented today.

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Storm Warning


Unfortunately for mariners, the total amount of wave energy in a storm does not rise linearly with wind speed, but to its fourth power. The seas generated by a forty-knot wind aren’t twice as violent as those from a twenty-knot wind, they are seventeen times as violent. A ship’s crew watching the anemometer climb even ten-knots could well be watching their death sentence.

Sebastian Junger, “The Perfect Storm: A True Story of Men Against the Sea” (2009)

[the crew watch emergency surgery performed on the ship’s deck]

Able Seaman: Is them ‘is brains, doctor?
Dr. Stephen Maturin: No, that’s just dried blood. THOSE are his brains.

“Master and Commander: The Far Side of the World” (2003)

[the Konovalov’s own torpedo is about to strike the Konovalov]

Andrei Bonovia: You arrogant ass. You’ve killed *us*!
“The Hunt for Red October” (1990)

Can everyone saying “a 25 bps rate hike doesn’t change anything” or “manufacturing is a small part of the US economy today, so the ISM number doesn’t mean much” or “trade with China is only a few percent of US GDP, so their currency devaluation isn’t important” just stop? Seriously. Can you just stop? Maybe if you were making these statements back in the ‘80s – and by that I mean the 1880s, back when the US was effectively a huge island in the global economy – it would make some sense, but today it’s just embarrassing.

There is a Category 5 deflationary hurricane forming off the Chinese coast as Beijing accelerates the devaluation of the yuan against the dollar under the guise of “reform”. I say forming … the truth is that this deflationary storm has already laid waste to the global commodity complex, doing trillions of dollars in damage. I say forming … the truth is that this deflationary storm has driven inflation expectations down to levels last seen when the world was coming to an end in the Lehman aftermath. And now the Fed is going to tighten? Are you kidding me?

Look, I’m personally no fan of ZIRP and QE and “communication policy”, certainly not the insatiable market devourers they’ve become over the past few years. But you can’t just wish away the Brave New World of globally interlocked, policy-driven, machine-dominated capital markets in some wave of nostalgia and regret for “normalized” days. In an existential financial crisis, emergency government action always becomes permanent government policy, reshaping markets in similarly permanent ways. This was true in the 1930s and it’s true today. It’s neither good nor bad. It just IS. Did QE1 save the market? Yes. Did QE2 and QE3 and all the misbegotten QE children in Europe and Asia break the market? Yes. And in the immortal words of shopkeepers everywhere: you break it, you bought it. The Fed owns capital markets today, like it or not, and raising rates now, as opposed to a year ago when there was a glimmer of a chance to walk back the Narrative of central bank omnipotence, isn’t “brave” or “prudent” or “necessary” or any of the other laudatory adjectives you’ll hear from Fed media apologists after they raise. It’s simply buyer’s remorse. The Fed is sick and tired of owning the market, sick and tired of giving interviews to CNBC every time some jobs report hits the wires, sick and tired of this Frankenstein’s monster called communication policy. So they’re going to raise rates, declare victory, and hope that things go their way.

Am I annoyed by China’s currency actions and their adept use of communication policy to shape the Narrative around devaluation? Not at all. This is exactly what China must do to bolster economic growth while maintaining the pleasant diplomatic fiction that they’re not a command economy. What annoys me is the Fed’s apparent hell-bent intention to force a low-level currency war with China AND whack our own manufacturing and industrial base on the kneecaps with a crowbar, just so they can get out of the communication policy corner they’ve painted themselves into.

Three or four years ago, one of THE dominant market narratives, particularly in the value investment crowd, was the “renaissance of American manufacturing”. Not only was the manufacturing sector going to be the engine of job growth in this country (remember “good jobs with good wages”? me, neither), but this was going to be the engine of economic growth, period (remember the National Export Initiative and “doubling exports in five years”? me, neither). Now we are told that we’re just old fogies to worry about a contracting US manufacturing sector. Now we are told that a global recession in the industrial and commodity complex is well contained here in our vibrant services-led economy. Right. You want some fries with that?

So what’s to be done? You do what you always do in a deflationary, risk-off world – you buy long-dated US Treasuries. Stocks down, USTs up. Of course, if you think that the yield curve is going to steepen after the Fed does whatever it’s going to do this week … you know, because the Fed rate hike is obviously an all-clear sign that we have a robust self-sustaining economic recovery and we’re off to the races … then you want to do the exact opposite, which is to buy stocks and sell the 10-year UST. Yep, time to load up on some bank stocks if that’s your view.

What else can you do? You can read the Epsilon Theory note “I Know It Was You, Fredo” and consider ways to make your portfolio more convex, i.e., more resilient and responsive to both upside and downside surprises in these policy-driven markets. The big institutional allocators use derivative portfolio overlays to inject convexity into their portfolio, and that’s all well and good. But there are steps the rest of us can take, whether that’s adopting strategies that can short markets and asset classes (like some tactical strategies and most trend-following strategies) or whether that’s investing in niche companies and niche strategies that are designed to outperform in either a surprisingly deflationary or a surprisingly inflationary world. The trick really isn’t to choose this fund or that fund. The trick is to broaden your perception of portfolio outcomes so that you don’t have a misplaced faith in either the Fed or econometric models.

I suppose there’s one more thing we should all do. We should all prepare ourselves to perform some emergency surgery on the deck of whatever portfolio ship we’re sailing in 2016. Because with a Fed hike the currency wars will begin in earnest, magnifying the deflationary storm already wreaking havoc in industrials, energy, and materials. No sector or strategy is going to be immune, and we’re all going to suffer some casualties.

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Funny How?



Henry Hill: You’re a pistol, you’re really funny. You’re really funny.
Tommy DeVito: What do you mean I’m funny?
Henry Hill: It’s funny, you know. It’s a good story. It’s funny. You’re a funny guy. [laughs]
Tommy DeVito: What do you mean? You mean the way I talk? What?
Henry Hill: It’s just, you know. You’re just funny, it’s … funny, the way you tell the story and everything. [it becomes quiet]
Tommy DeVito: Funny how? What’s funny about it?
Anthony Stabile: Tommy, no. You got it all wrong.
Tommy DeVito: Oh, no, Anthony. He’s a big boy, he knows what he said. What did you say? Funny how?
Henry Hill: Just…
Tommy DeVito: What?
Henry Hill: Just…you know…you’re funny.
Tommy DeVito: You mean…let me understand this ’cause, you know maybe it’s me…but I’m funny how? I mean…funny like I’m a clown, I amuse you?

“Goodfellas” (1990)


George Costanza: Every instinct I have, in every aspect of life, be it something to wear, something to eat – it’s all been wrong.

“Seinfeld” (1994)

But what could a tax-the-rich plan actually achieve? As it turns out, quite a lot, experts say. Given the gains that have flowed to those at the tip of the income pyramid in recent decades, several economists have been making the case that the government could raise large amounts of revenue exclusively from this small group, while still allowing them to take home a majority of their income.
New York Times, “What Could Raising Taxes on the 1% Do? A Surprising Amount”, October 16, 2015

I was watching the Draghi press conference the other week, and I had to turn off the TV. I found myself getting so … angry … not just at what Draghi was saying, but also the live blog reaction and the live market reaction, that I decided I was better off stepping back from the actual event and trying to figure out why I was having such a powerfully negative emotional reaction to the entire charade. It’s not the charade itself. I mean, if I were outraged by every inauthentic display of central banker “communication policy” and the media lapdog response, I’d be in some sort of permanent apoplectic fit. In fact, neither the central bankers nor the media even pretend any more that extraordinary monetary policy has any sort of material impact on the real economy, which I suppose is actually progress on the authenticity scale in a perverse sort of way.

I travel a lot speaking to investors and allocators of all sizes and political persuasions. I also read a lot from a wide variety of sources, also of all sizes and political persuasions. What I’m seeing and hearing on every issue that concerns capital markets and economics is not only an accelerated polarization of policy views between the left and the right (greater “distance” between the views), but also – and more troubling – a polarization (and in many cases a non-modal distribution) of policy views within the left and the right. The kicker: I think that this polarization is almost entirely driven by monetary policy and the power/wealth inequalities it creates. Central bankers are not only planting the seeds of truly systemic instability, they are watering and tending and nurturing this particularly virulent strain of “green shoots” with their entirely intentional and entirely successful efforts to inflate financial asset prices and mandate reduced volatility in capital markets.

The fact is that maintaining massive debt and creating massive wealth – which is what central banks DO – is a political exercise, pure and simple. It’s nothing else. It’s not social science. It’s politics. Yellen and Draghi are the most powerful politicians in the world, and what makes me angry is their unwillingness to confront the essential nature of their actions, to call what they do by its real name. It makes me angry because the longer the High Church of Central Bankerdom denies and ignores the raw political impact of their actions, the more likely it is that we will have a structural political accident that will destroy every bit of the debt maintenance and wealth creation that the High Church has labored so hard to build. I think we’re getting very close to that sort of political accident.

I’m pretty sure that I agree with absolutely none of Thomas Piketty’s policy prescriptions. And the impact of his bugbear – tax policy – on wealth inequality is laughably minor compared to the impact of a triple in the S&P 500 market cap or central bank purchases of trillions of dollars of bonds. But if you don’t recognize that Piketty has a point when he says that today’s wealth inequality is both outrageous and poisonous, you’re just not paying attention. Increased wealth inequality always leads to increased political polarization, within and between countries, within and between political entities. That was true in the 1870s, that was true in the 1930s, and it’s true today.

What happens when you get greater political polarization? The center does not hold. You get Bizarro world. You get political outcomes that cannot be anticipated by econometric or median voter models. You get political outcomes that will be perceived as illegitimate by a meaningful number of citizens. You get the New York Times writing encouragingly that even with a more aggressive tax regime, the Federal government could still “allow” citizens to take home 50% of their income. Wait. What?

Here’s a fairly typical example of the polarization phenomenon I’m talking about, this from the Pew Research Center based on 1994 – 2014 data. Everything in this chart is significantly worse today, and the same chart could be drawn for every other country on earth (including one-party states like China). You could also draw a chart with exactly the same dynamic for Congress. Or FOMC voting member views on raising rates. Or financial advisor views on liquid alternatives. Seeing polarization is like seeing the homeless … once you start looking for it, you will see it everywhere.


It’s not just the distance between the median Democrat voter and the median Republican voter that concerns me, it’s the shape of the Democrat electorate and the shape of the Republican electorate. A consensus outcome, where a significant majority buys into a final decision, is more difficult when the median voters are farther apart, but by no means impossible. It’s the lack of a single modal “peak” near the median voter within each party that makes consensus so very, very difficult. Why? Because the human animal has designed any number of effective preference aggregation schemes (elections and markets, for example), but none of them work very well at all when preferences are all over the map, when there is no “peakedness” to the preference distribution. There is no voting scheme that can identify a consensus when there is no consensus to be had, and that’s true whether you’re talking about the Republican party or the American electorate at large or the FOMC or the Chinese Politburo. On the contrary, the only thing you are guaranteed to have in a “non-peaked” system is a majority of unhappy members with ANY single construction or faux presentation of consensus.

In practice, one of two things happen in this sort of non-peaked social system. Either a new political dimension is constructed such that a peaked distribution emerges and a consensus outcome can be supported (this usually takes the form of identifying a common enemy, like Commies or Billionaires, or of appealing to a higher power, like Allah or Science), or you get a political accident where fundamental rules of markets and government shift drastically. I’m not looking forward to either.

What does this mean for investors? It means that at some point in the next year or two, I think we are all going to have a Henry Hill “Goodfellas” moment, where we think that we understand the conversation going on around us, where we think that we’re engaged with our social system in the usual way … and then everything will go sideways in a split second, and we will suddenly and with extreme clarity realize that we don’t understand anything at all except that we’re sitting at a table with a maniac. Or if you want a more light-hearted metaphor, we will all have a George Costanza moment where we come to the realization that all of our instincts are wrong. Most of us, of course, have already endured more than a few of these George Costanza moments here in the Golden Age of the Central Banker. I think you ain’t seen nothing yet. It’s not the Minsky Moment I’m worried about, where some credit bubble internal to markets wreaks havoc as it pops. No, it’s the Sideways Moment that I’m worried about, where a political accident external to markets wreaks structural havoc on the entire market system.

Do I understand why Draghi is doing what he’s doing? Do I understand why the Fed is getting colder and colder feet about raising rates? Sure. They’re watching inflation expectations continue to collapse. Here’s the latest chart for the primary metric for US inflation expectations, 5-year forward rates, courtesy of the St. Louis Fed.


Inflation expectations are THE most important data point in the Fed and ECB models that drive monetary policy decision making. And those models, driven by this chart, say that you’re a fool if you raise rates now. Or if not a fool, then at the very least you’re taking on significant post-Fed career risk. Hard to see some big hedge fund shelling out the big bucks for another ex-Fed Chair if this is what makes everything go sideways.

What Draghi and Yellen are doing is exactly what happens when you abdicate social policy to models, when you pretend that you’re just a technocratic financial regulator, and I suppose that’s what makes me angriest of all. I can see where this is going politically. Everyone can see where this is going politically. And maybe we’re already too far gone to change the politically polarized course we’re on. But we have to try. We have to speak honestly about the political dimensions of extraordinarily accommodative monetary policy in its maintenance of massive debt and its creation of massive wealth. Because if we don’t speak, then others will speak for us. And we won’t like what they have to say.

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The New TVA


War is too important to be left to the generals.
Georges Clemenceau (1841 -1929)

Competition has been shown to be useful up to a certain point and no further, but cooperation, which is the thing we must strive for today, begins where competition leaves off. … If we call the method regulation, people will hold up their hands in horror and say ‘un-American’ or ‘dangerous.’ But if we call the same process cooperation these same old fogeys will cry out ‘well done.’
Franklin Roosevelt (1882 – 1945)




The New Yorker magazine’s cartoons of the plump, terrified Wall Streeter were accurate; business was terrified of the president. But the cartoons did not depict the consequences of that intimidation: that businesses decided to wait Roosevelt out, hold on to their cash, and invest in future years.

– Amity Shlaes, “The Forgotten Man” (2007)

Quite possibly the TVA idea is the greatest single American invention of this century, the biggest contribution the United States has yet made to society in the modern world.
John Gunther, “Inside USA” (1947) 

Don Draper: This is the greatest advertising opportunity since the invention of cereal. We have six identical companies making six identical products. We can say anything we want. How do you make your cigarettes?
Lee Garner, Jr.: I don’t know.
Lee Garner, Sr.: Shame on you. We breed insect repellant tobacco seeds, plant them in the North Carolina sunshine, grow it, cut it, cure it, toast it…
Don Draper: There you go. There you go.

[Writes on chalkboard and underlines: “IT’S TOASTED.”]

Lee Garner, Jr.: But everybody else’s tobacco is toasted.
Don Draper: No. Everybody else’s tobacco is poisonous. Lucky Strikes…is toasted.

“Mad Men: Smoke Gets inYour Eyes” (2007)


“How the Children Played at Slaughtering,” for example, stays true to its title, seeing a group of children playing at being a butcher and a pig. It ends direly: a boy cuts the throat of his little brother, only to be stabbed in the heart by his enraged mother. Unfortunately, the stabbing meant she left her other child alone in the bath, where he drowned. Unable to be cheered up by the neighbours, she hangs herself; when her husband gets home, “he became so despondent that he died soon thereafter”.
The Guardian, “Grimm Brothers’ Fairytales have Blood and Horror Restored in New Translation” November 12, 2014



The California Public Employees’ Retirement System said it missed its return target by a wide margin, hurt by a sluggish global economy and an under-performing private equity portfolio. The nation’s largest public pension fund said its investments returned just 2.4% for its fiscal year, ended June 30, far below its 7.5% investment target.
Los Angeles Times, “CalPERS Misses Its Target Return by a Wide Margin” July 13, 2015

As the world moves slowly towards more economic stability, the outlook for gold is more uncertain than ever.
Wall Street Journal, “How the Street is Weighing Up Gold’s Lost Shine” July 20, 2015

When a market malfunctions, the government should not let market sentiment turn from bad to worse. It should use powerful measures to strengthen market confidence.
The People’s Daily (official China newspaper), July 20, 2015

My favorite scene from Mad Men is the picnic scene from Season 2. The Draper family enjoys a lovely picnic at some park, and at the conclusion of the meal Don tosses his beer cans into the bushes and Betty just flicks the blanket and leaves all the trash right there on the grass. Shocking, right? I know this is impossible for anyone under the age of 30 to believe, but this is EXACTLY what picnics were like in the 1960’s, even if a bit over the top in typical Draper fashion. There was no widespread concept of littering, much less recycling and all the other green concepts that are second nature to my kids. I mean … if I even thought about Draper-level littering at a Hunt picnic today my children would consider it to be an act of rank betrayal and sheer evil. I’d be disowned before they called the police and had me arrested.


Like many of us who were children in a Mad Men world, I can remember the moment when littering became a “thing”, with the 1971 public service commercial of an American Indian (actually an Italian actor) shedding a tear at the sight of all the trash blighting his native land.  Powerful stuff, and a wonderful example of the way in which Narrative construction can change the fundamental ways our society sees the world, setting in motion behaviors that are as second nature to our children as they were unthinkable to our parents. It’s barely noticeable as it’s happening, but one day you wake up and it’s hard to remember that there was a time when you didn’t believe that littering was a crime against humanity.


This dynamic of change in meaning is rare, but it takes place more often than you might think. Dueling and smoking are easy examples. Slavery is, too. Myths and legends turned into nursery rhymes and fairy tales is one of my favorite examples, as is compulsory public education … a concept that didn’t exist until the Prussian government invented it to generate politically indoctrinated soldiers who could read a training manual. Occasionally – and only when political systems undergo the existential stress of potential collapse – this dynamic of change impacts the meaning of the Market itself, and I think that’s exactly what’s taking place today. Through the magic of Narrative construction, capital markets are being transformed into political utilities. 

It’s not a unique occurrence. The last time investors lived through this sort of change in what the market means was the 1930s, and it’s useful to examine that decade’s events more closely, in a history-rhyming sort of way. What’s less useful, I think, is to spend our time arguing about whether this transformation in market meaning is a good thing or a bad thing. It is what it is, and the last thing I want to be is a modern day version of one of those grumpy old men who railed about how Roosevelt was really the Anti-Christ. What I will say, though (and I promise this will be my last indication of moral tsk-tsking, for this note anyway), is that I have a newfound appreciation for why they were grumpy old men, and I feel keenly a sense of loss for the experience of markets that I suspect my children will never enjoy as I have. I suspect they will never suffer in their experience of markets as I have, either, but there’s a loss in that, as well.

It’s totally understandable why status quo political interests would seek to transform hurly-burly capital markets into a stable inflation-generation utility, as summed up in the following two McKinsey charts.



Both of these charts can be found in the February 2015 McKinsey paper, “Debt and (not much) deleveraging”, well worth your time to peruse. Keep in mind that the data used here is from Q2 2014, back when Greece was still “fixed”, the Fed had not proclaimed its tightening bias, and China was still slowing gracefully. All of these numbers are worse today, not better.

So what do the numbers tell us? Two things. First, there’s more debt in the world today than before the Great Recession kicked off in 2008. All the deleveraging that was supposed to happen … didn’t. Sure, it’s distributed slightly differently, both by sector and by geography – and that’s critically important for the political utility thesis here – but whatever overwhelming debt levels you thought triggered a super-cyclical, structural recession then … well, you’ve got more of it now.  Second, it’s impossible to grow our way out of these debt levels. Japan, France and Italy would have to more than double their current GDP growth rates (and again, these are last year’s more optimistic projections) to even start to grow their way out of debt. Right. Good luck with that. Spain needs a triple. Even the US, the best house in a bad neighborhood, needs >3% growth from here to eternity to start making a dent in its debt. Moreover, every day you don’t achieve these growth levels is a day that the debt load gets even larger. These growth targets are a receding target, soon to be well out of reach for every country on Earth.

The intractable problem with these inconvenient facts is that there are only three ways to get out from under a massive debt. You can grow your way out, you can inflate your way out, or you can shrink your way out through austerity and/or assignment of losses. Door #1 is now effectively impossible for most developed economies. Door #3 is unacceptable to any status quo regime. So that leaves Door #2. The ONLY way forward is inflation, so that’s what it’s going to be. There is no Plan B. What sort of inflation is most amenable to modern political influence? Financial asset inflation, by a wide margin. Inflation in the real economy depends on real investment decisions by real businesses, and just as in the 1930s most business decision makers are sitting this one out, thank you very much. Or just as in the 1930s they’re “investing” in stock buy-backs and earnings margin improvement, which doesn’t help real world inflation at all. What political institutions are most capable of promoting inflation? Central banks, again by a wide margin. Just as in the 1930s, almost every developed economy in the world has a highly polarized electorate and an equally polarized legislature. The executive may be willing, but the government is weak. Far better to wage the inflation wars from within the non-elected walls of the Eccles Building rather than the White House.

Now … how to wage that inflation war with the proper Narrative armament? No one wants inflation in the sense of “runaway inflation”, to use the phrasing of doomsayers everywhere. In fact, unless you’re speaking apparatchik to apparatchik, you don’t want to use the word “inflation” at all. It’s just like Roosevelt essentially banning the word “regulation” from his Cabinet’s vocabulary. Don’t call it “regulation”. Call it “cooperation”, Roosevelt said, and even the grumpy old men will applaud. So today China calls it a “market malfunction” when their stock market deflates sharply (of course, inflating sharply is just fine). Better fix that malfunctioning machine! How can you argue with that language? But at least the political mandarins in the East are more authentic with their words than the political mandarins in the West. Here we now call market deflation by the sobriquet “volatility”, as in “major market indices suffered from volatility today, down almost one-half of one percent”, where a down day is treated as something akin to the common cold, a temporary illness with symptoms that we can shrug off with an aspirin or two. You can’t be in favor of volatility, surely. It’s a bad thing, almost on a par with littering. No, we want good things and good words, like “wealth effect” and “accommodation” and “stability” and “price appreciation”. As President Snow says in reference to The Hunger Games version of a political utility, “may the odds be always in your favor”. Who doesn’t want that?

There are two problems with the odds being always in your favor.

First, the casino-fication of markets ratchets up to an entirely new level of pervasiveness and permanence. By casino-fication I mean the transformation of the meaning of market securities from a partial ownership interest in the real-life cash flows of real-life companies to a disembodied symbol of participation in a disembodied game. Securities become chips, pure and simple. Now there’s nothing new in this gaming-centric vision of what markets mean; it’s been around since the dawn of time. My point is that with the “innovation” of ETF’s and the regulatory and technological shifts that allow HFTs and other liquidity game-players to dominate the day-to-day price action in markets, this vision is now dominant. There’s so little investing today. It’s all positioning And in a capital-markets-as-political-utility world, the State is now actively cementing that view. After World War I, French Prime Minister Georges Clemenceau famously said that war was too important to be left to the generals, meaning that politicians would now take charge. Today, the pervasive belief in every capital in the world is that markets are too important to be left to the investors. These things don’t change back. Sorry.

Second, if you’re raising the floor on what you might suffer in the way of asset price deflation, you are also lowering the ceiling on what you might enjoy in the way of asset price inflation. That’s what investing in a utility means – you’re probably not going to lose money, but you’re not going to make a lot of money, either. So to all of those public pension funds who are wringing their hands at this fiscal year’s meager returns, well below what they need to stay afloat without raising contributions, I say get used to it. All of your capital market assumptions are now at risk, subject to the tsunami force of status quo politicians with their backs up against the debt wall. Their market-as-utility solution isn’t likely to go bust in a paroxysm of global chaos, any more than it’s likely to spark a glorious age of reinvigorated global growth. Neither the doomsday scenario nor the happy ending is likely here, I think. Instead, it’s what I’ve called the Entropic Ending, a long gray slog where a recession is as unthinkable as a 4% growth rate. It’s a very stable political equilibrium. Sorry.

As the title of this note suggests, we’ve been down this road before in the 1930s. But the historical rhyming I see is not so much in the New Deal policies that directly impacted the stock market as it is in the policies that established a real-life utility, the Tennessee Valley Authority (TVA).  That’s because the nature of the existential threat posed by overwhelming debt to the US political system was different in the 1930s than it is today. When FDR took office, the flash point of that systemic threat was the labor market, not the capital market. Sure, the stock market took its hits in the Great Depression, but the relevance of the stock market to either the overall economic health of the country or – more importantly to FDR – his ability to remain in office was dwarfed by the relevance of the labor market. It’s another one of those changes in meaning that seems bizarre to the modern eye or ear. What, you mean there wasn’t 24/7 coverage of financial markets in 1932? You mean that most Americans didn’t really know what a stock certificate was, much less own one?  To succeed politically, Roosevelt had to change the meaning of the labor market, not the capital market, and that’s exactly what he did with the creation of the TVA.

The TVA was only one effort in an alphabet soup of New Deal policies that FDR rammed through in his first Administration to change the popular conception of what the labor market meant to Americans. Other famous initiatives included the National Recovery administration (NRA) and the Civilian Conservation Corps (CCC), and the common thread in all of these efforts was a VERY active Narrative management embedded in their process from the outset, with photographers and journalists hired by the White House to document the “success” of the programs. Everything I write in Epsilon Theory about today’s pervasive Narrative construction also took place in the 1930s, in amazingly similar venues and formats, down to the specific words used.

The Narrative effort worked. Not necessarily in the permanence of the institutions FDR established (the Supreme Court declared the NRA unconstitutional in 1935, and the CCC faded into obscurity with the outbreak of World War II), but in the complete reshaping of what the labor market meant to Americans and what government’s proper role within the labor market should be. Yes, there were important things lost in FDR’s political achievements (and plenty of grumpy old men to complain about that), but let’s not forget that he was re-elected THREE times on the back of these labor market policies. If that’s not winning, I don’t know what is. And if you don’t think that lesson from history hasn’t been absorbed by both Clinton™ and Bush™, you’re living in a different world than I am.

One last point on the TVA. It’s still around today as a very powerful and oddly beloved institution, and I think its lasting political success is due in large part to the fact that it – unlike the other alphabet soup institutions – was explicitly a utility. Who doesn’t like the stability of a utility in the midst of vast inequality? Who doesn’t like the odds being ever in their favor? The more that I see today’s policy impact on markets described in utility-like terms – words like “stability” and notions like “volatility is bad and a thing to be fixed” – the more confident I am that the TVA political experience of the 1930s is coming soon to the capital markets of today. Scratch that. It’s already here.

So, Ben, let’s assume you’re right and that current events are rhyming with the historical events of the last time the world wrestled with an overwhelming debt load. Let’s assume that a politically popular shift in the meaning of markets to cement its public utility function is taking shape and won’t reverse itself without a political shock of enormous proportions. What’s an investor or allocator to do, other than become a grumpy old man? Look, the hardest thing in the world is to recognize structural change when you’re embedded in the structure. If reading Epsilon Theory has given you a new set of lenses to see the relationship between State and Market, then you’ve already done the heavy lifting. From here, it’s a matter of applying that open-eyed perspective to your portfolio, not of buying this or selling that! Everyone will be different in their particular application, but I think everyone should have three basic goals:

  1. shake out the category errors in your investment assumptions, understanding that we humans are terrible judges of causality, particularly when something has worked recently;
  2. re-evaluate your capital market assumptions for a further transformation of those markets into state-run casinos and political utilities, understanding that whatever crystal ball you’ve used in the past is almost certainly broken today;
  3. adopt an investment process or find investment strategies that can adapt to the structural changes that are already underway in capital markets, understanding that the patterns of belief and meaning we think are “natural” today can change in the blink of a central banker’s eye.

Put simply, it’s time for some good new thinking on some good old ideas like diversification. It’s time to recognize the world as it is rather than lose ourselves in nostalgia for the world that was. Most of all, it’s time to call things by their proper names and stop demonizing words like “leverage” and “volatility”. These are tools, for god’s sake, neither good nor bad in and of themselves, and they’re tools we are all going to need to learn how to use if we want to be survivors in the Golden Age of the Central Banker. It’s time to get to work.

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Why Take a Chance?



Vinny Forlano: He won’t talk. Stone is a good kid. Stand-up guy, just like his old man. That’s the way I see it.
Vincent Borelli: I agree. He’s solid. An effin’ Marine.
Americo Capelli: He’s okay. He always was. Remo, what do you think?
Remo Gaggi: Look… why take a chance? At least, that’s the way I feel about it.

— “Casino” (1995)


Ace Rothstein: Four reels, sevens across on three $15,000 jackpots. Do you have any idea what the odds are?
Don Ward: Shoot, it’s gotta be in the millions, maybe more.
Ace Rothstein: Three effin’ jackpots in 20 minutes? Why didn’t you pull the machines? Why didn’t you call me?
Don Ward: Well, it happened so quick, 3 guys won; I didn’t have a chance …
Ace Rothstein: [interrupts] You didn’t see the scam? You didn’t see what was going on?
Don Ward: Well, there’s no way to determine that …
Ace Rothstein: Yes there is! An infallible way, they won!

— “Casino” (1995)

There’s only one question that matters in the Golden Age of the Central Banker: why isn’t QE working? Why hasn’t the largest monetary stimulus in the history of man – trillions of dollars of liquidity with trillions more euros and yen to come – sparked a self-sustaining recovery in the global economy?

If you’re a true-believer in modern economic orthodoxy or a central bank apparatchik the answer is simple: something must be getting in the way of our elegant theories of Zero Interest Rate Policy (ZIRP) and Large Scale Asset Purchases (LSAP), so if $4 trillion isn’t enough to break through to the Promised Land we better do $4 trillion more.

If you see the world through the lens of behavioral economics, however, you come to a very different conclusion. Something IS blocking the effectiveness of QE, but that something is human nature. Behavioral economics suggests that a little QE can change human behavior at the margins, but no amount of QE is enough to change human nature at its core.

The High Priests of the IMF, the Fed, and the ECB are blind to this because all of modern economic theory – ALL of it – is based on a single bedrock assumption: humans are economic maximizers. If something is good, then more is better and “MOAR!” is best. And if that assumption holds true, then QE works. You will indeed force productive risk-taking in the real world economy (more loans to small businesses, more growth-oriented investments in people and equipment, etc.) by making it increasingly difficult for investors to play it safe in capital markets (negative 10-year Swiss bonds, anyone?). But if that assumption is flawed, then you get exactly what we’re seeing: pervasive non-productive risk-taking in the real world economy (stock buy-backs, for example) and massive wealth transfers from savers to speculators in the capital markets.

Yes, we are maximizers of reward. But we are also minimizers of regret. That’s not because we are irrational or stupid, but because most of us draw on our portfolios for real world needs. Our investment portfolios are a means to an end, not an end in themselves. We understand that a) periodic losses are inevitable in a risky investment portfolio, no matter how well it maximizes long-term gains, and b) if we’re unlucky and suffer losses such that our portfolios decline below a certain level, then we are faced with real world risks and tough real world decisions that overshadow whatever investment logic the Fed would prefer us to have.

Regret minimization is not just for financial investors. It holds true for investors of all sorts, from a CEO deciding how to allocate cash flows to a general deciding how to allocate troops to a farmer deciding how to allocate land. For all of these decision makers, it doesn’t matter how meager the reward of playing it safe might be if an unlucky roll of the investing dice would create existential risk. In the immortal words of “Casino” mob boss Remo Gaggi as he tacitly ordered a hit on a trusted lieutenant, “Look … why take a chance?”

To be sure, some investors are paralyzed by the unreasonable fear of rolling snake-eyes 500 times in a row. Still others, as we saw with the Swiss National Bank debacle, have no idea of the risks they’re taking when they intend to play it safe. Human behavior may be governed by concerns of risk and regret, but neither concept comes easily to us. All of us, no matter how comfortable we might be swimming in the ocean of randomness that surrounds us, occasionally channel our inner Don Ward, the hapless casino employee who thinks that it’s possible that three separate slot machine jackpots could trigger within minutes of each other simply by chance.

Fortunately, a branch of game theory called “Minimax Regret” can help apply analytical rigor to both our human nature and our human failings. As the name implies, the goal of Minimax Regret is to minimize the maximum regret you might experience from a decision choice. Developed in 1951 by Leonard “Jimmie” Savage – a colleague of John von Neumann and Milton Friedman, and in general one of the most brilliant American mathematicians of the 20th century – the Minimax Regret criterion is widely used in fields as diverse as military strategy and climate science … any situation requiring a choice between extremely costly options and where the results of your decision will not become apparent for years. Are you listening, Mr. Draghi?

Unfortunately, I’m certain that neither Mr. Draghi nor the other High Priests of monetary policy are listening at all. We seem destined to learn the hard way … once again … that you can’t change human nature by government fiat. But individual investors and allocators can listen and learn from these old good ideas, and that’s how you survive the Golden Age of the Central Banker.

I wrote an introductory note about Minimax Regret strategies in October 2013 (“The Koan of Donald Rumsfeld”), and – seeing as how Central Bankers outside the US are doubling down on the QE bet – it’s time for me to dust off this line of analysis. I think that Minimax Regret is the right micro toolbox to go along with the macro toolbox of political analysis (see “Finest Worksong” and “Now There’s Something You Don’t See Every Day, Chauncey” for recent notes on this thread), and together they create the Adaptive Investing framework that’s at the heart of a practical Epsilon Theory perspective. I’ll be putting some Minimax Regret resources on the website over the next few weeks, along with some brief email and Twitter distributions to guide the effort. If you’re not already an email subscriber or Twitter follower, now would be a good time to sign up.

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Catch – 22



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

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

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

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


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

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

― Niels Bohr (1885 – 1962)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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


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

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

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

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

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

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

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The Game of Thrones and the Game of Markets


Two items for the mid-week.

First, an invitation to attend a Salient Webinar I’ll be presenting next Thursday, September 18th at 2pm ET, titled: “The Game of Thrones and the Game of Markets”. I’ll be tying together various threads from past Epsilon Theory notes, with the goal of showing how to listen to financial news and analysts to detect Narratives. Please note that the presentation is geared for financial advisors, brokers, and investment professionals, and it qualifies for one hour of CFP/CIMA®, CIMC®, or CPWA® CE credit if you care about such things. Invitation attached and registration link here.

Second, a few brief thoughts on an Epsilon Theory connection between modern capital markets and the NFL (and between Central Bankers and Roger Goodell). The connection is solipsism – a pathological egocentrism where reality is defined by an individual’s mental perceptions and constructs.

For individuals like Goodell and Yellen we’re talking about good old-fashioned individual solipsism. These are people who have never been proven wrong about anything in their professional lives. I know that sounds weird to professional investors and allocators, because we are demonstrably wrong about something every single freaking day, and it’s a hard concept to describe effectively to someone who’s never lived within a sheltered organization where empirical outcomes are either pre-ordained or immaterial. But both Goodell and Yellen have spent their entire professional careers as the modern equivalents of cloistered monks or nuns, the former within the Holy Order of the National Football League and the latter within the High Church of UC Berkeley. It’s wonderfully pleasant to live within these worlds without external consequence, where your mental constructs and pronouncements receive constant positive reinforcement, but the inevitable result is that you begin to believe that your mental constructs ARE reality. Roger Goodell truly believes that everything he has done and announced, most recently his appointment of an “independent” investigator, is obviously the right and correct course of action, and he has no idea why these actions and announcements are being questioned. He has no idea why his world is crumbling. Similarly, Janet Yellen is not being disingenuous when she talks about her ability to control “macroprudential” outcomes. In her mind (and in the minds of everyone else in today’s academic Fed), these theories ARE reality. Drain the $5 trillion in banking system reserves without market consequence? Sure, we’ve got a theory for that. No problem. As Yul Brynner would have put it in Cecil B. DeMille’s “The Ten Commandments”: So let it be written. So let it be done.

For social constructions like markets or professional sports leagues or any self-contained social world, we’re talking about a different version of solipsism – collective solipsism. I’ve written about this idea in the Epsilon Theory note “A Dogmatic Slumber”, so I won’t repeat all that here. Collective solipsism is what overwhelming Common Knowledge looks like. It’s the annihilation of an individual’s perception of reality in favor of a group perception of reality. It’s an entirely natural reaction of the human social animal to certain strategic interactions, i.e., games. It’s what I mean when I say that we are at an asymptotic peak in the social influence of the Narrative of Central Bank Omnipotence. 

When does collective solipsism fail? When does the story break? When it comes into conflict with a larger external social structure, with a larger strategic interaction. The collective solipsism of the NFL crumbles when it runs headlong into the larger political and social structure of the United States, which – amazingly enough – has 300+ million citizens who don’t play Fantasy Football, who have no idea who Ray Rice is, who listen to owners Bob Kraft or John Mara and think they’re from Mars, and who don’t hang on every word of THE Commissioner. But they’ve all seen or heard about the video. They all care about the larger issue of domestic violence. They all think they’re being lied to. And there are powerful political and economic interests in the larger game who see this conflict as working to their advantage. That’s when the story breaks.

The collective solipsism of modern markets is a much bigger game still, and will require a much larger shock and external social structure to unwind the Common Knowledge structure at the heart of all this. I can’t tell you when any of this will happen, but there are only a few social structures large enough to fit the bill. There is no more important task for risk management than monitoring those structures, and that’s what I’m trying to do with Epsilon Theory.

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