We’ve had a heckuva busy year at Epsilon Theory, so to ring out 2017 I thought it might be helpful to distribute a master list of our publications over the past 12 months. We’re long essay writers trying to make our way in a TLDR world, so even the most avid follower may well need a map!
It’s also a good opportunity to give thanks where thanks are due.
First, a heartfelt thank you to my partners at Salient for contributing a ton of resources to make Epsilon Theory happen, never once asking me to sell product, and allowing me the leeway to speak my mind with a strong voice that would make a less courageous firm blanch. Epsilon Theory isn’t charity, and it’s the smart move for a firm playing the long game, but no less rare for all that.
Second, an equally heartfelt thank you to the hundreds of thousands of readers who have contributed their most precious resource – their time and attention – to the Epsilon Theory effort. We live in a world that is simultaneously shattered and connected, where we are relentlessly encouraged to mistrust our fellow citizens IRL but to engage with complete strangers on social media. It’s an atomized and polarized existence, which works really well for the Nudging State and the Nudging Oligarchy, less well for everyone else. The lasting impact of Epsilon Theory won’t be in what we publish, but in how we’re able to bring together truth-seekers of all stripes and persuasions, because it’s your engagement with the ideas presented here that will change the world. I know that sounds corny, but it’s happening.
Now on to the 2017 publishing map.
Our big initiative for this year was to publish two coherent sets of long-form notes, one by yours truly and one by my partner Rusty Guinn.
My series of essays is called Notes From the Field. As many long-time readers know, I’m originally from Alabama but now live out in the wilds of Fairfield County, Connecticut, on a “farm” of 44 acres. I put that word in quotations because although we have horses and sheep and goats and chickens and bees, my grandfather – who owned a pre-electrification, pre-refrigeration, pre-pasteurization dairy farm in the 1930s – would surely enjoy a good belly laugh at my calling this a farm. Still, I’ve learned a few things over the years from the farm and its animals, and they’ve helped me to become a better investor.
Notes From the Field: The eponymous note has two essays: “Fingernail Clean”, introducing the concept of the Industrially Necessary Egg – something we take for granted as proper and “natural” when it’s anything but, and “Structure is a Cruel Master”, introducing the genius of both humans and bees – our ability to build complex societies with simple algorithms.
Horsepower: The horse and horse collar revolutionized European agriculture in the 10th and 11th centuries, a revolution that lives on in words like “horsepower” and changed the course of human civilization. Today we are struggling with a productivity devolution, not revolution, and there is nothing more important for our investments and our politics and our future than understanding its causes and remedies.
The Arborist: We are overrun with Oriental Bittersweet, privet, and kudzu — or as I like to call them, monetary policy, the regulatory state, and fiat news — invasive species that crowd out the small-l liberal virtues of free markets and free elections. What to do about it? Well, that’s citizenship, and I’ve got some ideas.
Always Go To the Funeral: Going to the funeral is part of the personal obligation that we have to others, obligation that doesn’t fit neatly or at all into our bizarro world of crystalized self-interest, where scale and mass distribution are ends in themselves, where the supercilious State knows what’s best for you and your family, where communication policy and fiat news shout down authenticity, where rapacious, know-nothing narcissism is celebrated as leadership even as civility, expertise, and service are mocked as cuckery. Going to the funeral is at the heart of playing the meta-game – the game behind the game – of social systems like markets and elections, and it’s something we all need to understand so that we’re not played for fools.
Sheep Logic: We think we are wolves, living by the logic of the pack. In truth we are sheep, living by the logic of the flock. In both markets and politics, our human intelligences are being trained to be sheep intelligences. Why? Because that’s how you transform capital markets into a political utility, which is just about the greatest gift status quo political institutions can imagine.
Clever Hans: You don’t break a wild horse by crushing its spirit. You nudge it into willingly surrendering its autonomy. Because once you’re trained to welcome the saddle, you’re going to take the bit. We are Clever Hans, dutifully hanging on every word or signal from the Nudging Fed and the Nudging Street as we stomp out our investment behavior.
Pecking Order: The pecking order is a social system designed to preserve economic inequality: inequality of food for chickens, inequality of wealth for humans. We are trained and told by Team Elite that the pecking order is not a real and brutal thing in the human species, but this is a lie. It is an intentional lie, formed by two powerful Narratives: trickle-down monetary policy and massive consumer debt financing.
The Three-Body Problem: What if I told you that the dominant strategies for human investing are, without exception, algorithms and derivatives? I don’t mean computer-driven investing, I mean good old-fashioned human investing … stock-picking and the like. And what if I told you that these algorithms and derivatives might all be broken today?
Rusty’s series of essays, Things that Matter (and Things that Don’t), connects to mine with his just published The Three-Body Portfolio. It’s a wonderful piece on its own (I can’t believe I didn’t think of the Soylent Green reference – Epsilon is people!) and is a great segue to his 2017 serial opus. In chronological order:
With A Man Must Have a Code, Rusty begins the conversation about why we think that all investors ought to have a consistent way of approaching their major investment decisions.
In I am Spartacus, Rusty writes that the passive-active debate doesn’t matter, and that the premise itself is fraudulent.
In What a Good-Looking Question, Rusty writes that trying to pick stocks doesn’t matter, and is largely a waste of time for the majority of investors.
In Break the Wheel, Rusty argues that fund picking doesn’t matter either, and he takes on the cyclical, mean-reverting patterns by which we evaluate fund managers.
In And they Did Live by Watchfires, Rusty highlights how whatever skill we think we have in timing and trading (which is probably none) doesn’t matter anyway.
In Chili P is My Signature, Rusty writes that the typical half-hearted tilts, even to legitimate factors like value and momentum, don’t matter either.
In Whom Fortune Favors (Part 2 here), Rusty writes that quantity of risk matters more than anything else (and that most investors probably aren’t taking enough).
In You Still Have Made a Choice, Rusty writes that maximizing the benefits of diversification matters more than the vast majority of views we may have on one market over another.
In The Myth of Market In-Itself (Part 2 here), Rusty writes that investor behavior matters, and he spends a lot of electrons on the idea that returns are always a reflection of human behavior and emotion.
In Wall Street’s Merry Pranks, Rusty acknowledges that costs matter, but he emphasizes that trading costs, taxes and indirect costs from bad buy/sell behaviors nearly always matter more than the far more frequently maligned advisory and fund management expenses.
These are baby-doll Southdowns, and yes, they’re exactly as cute as they look in this picture. We only have four today on our “farm”, as sheep have a knack for killing themselves in what would almost be comical fashion if it weren’t so sad. We keep them for their so-so wool, which we clean and card and spin and knit. It’s so-so wool because the Southdowns were bred for their meat, not their fleece, and I can’t bring myself to raise an animal for its meat. Well, I could definitely raise birds for meat. Or fish. But not a charismatic mammal like a baby-doll Southdown.
Here’s the thing I’ve learned about sheep over the years. They are never out of sight of each other, and their decision making is entirely driven by what they see happening to others, not to themselves. They are extremely intelligent in this other-regarding way. My sheep roam freely on the farm, and I never worry about them so long as they stay together, which they always do. But if I only count three in the flock, then I immediately go see what’s wrong. Because something is definitely wrong.
That’s the difference between a flock and a pack. A flock is a social structure designed to promote other-awareness. It has no goals, no coordinating purpose other than communication. A flock simply IS. A pack, on the other hand, is a social structure designed to harness self-aware animals in service to some goal requiring joint action — the raising of cubs, the hunting of meat, etc. Both the flock and the pack are extremely effective social structures, but they operate by entirely different logics.
We think we are wolves, living by the logic of the pack.
In truth we are sheep, living by the logic of the flock.
Jealousy, turning saints into the sea Swimming through sick lullabies Choking on your alibis But it’s just the price I pay Destiny is calling me Open up my eager eyes Cause I’m Mr. Brightside ― The Killers, “Mr. Brightside”
It was only a kiss. Leave it to a Las Vegas band to write the best song ever about the most powerful other-regarding emotion — jealousy. That’s Laurence Fishburne as Othello on the left and Kenneth Branagh as Iago on the right, actors’ actors both.
Right now you are down and out and feeling really crappy
And when I see how sad you are It sort of makes me… Happy!
Sorry, Nicky, human nature- Nothing I can do! It’s… Schadenfreude! Making me feel glad that I’m not you.
― Avenue Q (2003)
There’s no way that a grown-up musical with Sesame Street puppets should work, but Avenue Q does. “Schadenfreude” is my favorite tune from the show, as well as the second-most powerful other-regarding emotion that drives our world.
Jukeboxes made a nice comeback when the user interface started showing you what other people had chosen to play, both in the past and coming up.
Once you start looking for the Jukebox Effect — the intentional effort to force you into other-regarding flock behavior — you see it everywhere.
All the world will be your enemy, Prince with a Thousand Enemies, and whenever they catch you, they will kill you. But first they must catch you, digger, listener, runner, prince with the swift warning. Be cunning and full of tricks and your people shall never be destroyed.
―Richard Adams, Watership Down (1972)
I’ve got an unexpurgated print of this card sitting on my desk. A prey animal like a rabbit would find Watership Down unrecognizable. Not because reality is any less dominated by fang and claw, but because the protagonists are protagonists, driven by independent will and self-regarding decision making. It’s a Hero’s Journey, which makes it a great read but poor rabbit socio-biology.
I’ve seen things you people wouldn’t believe. Attack ships on fire off the shoulder of Orion. I watched C-beams glitter in the dark near the Tannhäuser gate. All those moments will be lost in time… like tears in rain… Time to die.
― Bladerunner (1982)
The movie Bladerunner was based on the Philip K. Dick novella, Do Androids Dream of Electric Sheep?, and inherent in the question is the reason we root for the androids over the humans. It’s the same reason we root for Hazel and the other intrepid rabbits of Watership Down. They’re dreaming and striving for a better life. They’re fighters. They have gumption.
In reality, neither sheep nor rabbits nor androids have gumption.
She’s a replicant, isn’t she?
I’m impressed. How many questions does it usually take to spot them?
I don’t get it, Tyrell.
How many questions?
Twenty, thirty, cross-referenced.
It took more than a hundred for Rachael, didn’t it?
[realizing Rachael believes she’s human] She doesn’t know.
She’s beginning to suspect, I think.
Suspect? How can it not know what it is?
― Bladerunner (1982)
That’s the Big Question. How can we not know what we are? it not know what it is?
Better to live a day as a lion than 100 years as a sheep.
― Benito Mussolini (1883 – 1945)
― Donald Trump retweet (Feb. 28, 2016)
Really? I’ll take the 100 years, thank you very much. Life is too precious, and this, too, shall pass.
Such a vainglorious statement by such a preening man. Mussolini, that is. Find a film clip and watch how he uses his hands.
Our compliance departments require us to say that retweets are not endorsements. But of course they are.
The copycat phenomenon is real. As more and more notable and tragic events occur, we think we’re seeing more compromised, marginalized individuals who are seeking inspiration from those past attacks.
―Andre Simon, head of FBI Behavioral Analysis Unit 2 (Threat Assessment)
Mass shooters are not Lone Wolves. They are Lone Sheep.
Tom Junod at Esquire featured FBI agent Andre Simon in his must-read 2014 article, “A Radical New Look at Mass Shooters.” Three years later and we’re still having the wrong debate, focusing on gun control rather than mental health and intervention. Why? Because the gun control debate has enormous political efficacy for both the Left and the Right, where the mental health debate has none. Steve Bannon’s fondest dream is for Democrats to make Federal gun control a key issue in the 2020 electoral cycle. We are, YET AGAIN, being intentionally shepherded by political entrepreneurs into a pernicious Competitive Game of domestic identity politics.
Behold, I send you forth as sheep in the midst of wolves; be ye therefore wise as serpents, and harmless as doves.
There’s no domesticated animal species that has had more of a reputational fall from grace than the sheep. To call someone a sheep today is just about the worst insult there is. To call someone a sheep is to call them stupid and — more pointedly — stupidly obedient and in thrall to some bad shepherd.
It wasn’t always this way. Jesus isn’t insulting you when He calls you a sheep. The point of all those Biblical allegories isn’t that sheep are stupidly obedient or easily led, but that the healthy life of a willful sheep requires a good shepherd.
Ask anyone who actually keeps sheep. Sheep are weird. Sheep are evolved to have a very different intelligence than humans. But sheep are not stupid. Sheep are not obedient. And sheep are definitely not easily led.
Of course, no one except a dilettante farmer like me keeps sheep today, so all of the Old Stories about sheep and shepherds have lost their punch. They’ve all been diminished through the modern lens of sheep-as-idiot-followers.
Today most people dismiss the notion that good shepherds — i.e., individuals with expertise and wise counsel in some difficult to navigate field like … I dunno … investing — exist at all. And they utterly reject the idea that it’s actually okay not to have a fully formed and forcefully held opinion on anything and everything, that it’s not a sign of personal failure to say “I don’t know” and follow another’s lead.
It’s not just the media careers and media business models that are built on the notion of the Constant Hot Take — an unending stream of contrarian opinions expressed in the most incendiary way possible, solely for the entertainment value of contrarian opinions expressed in the most incendiary way possible — it’s the millions of hours that so many non-media civilians will spend engaged on Twitter or Facebook or whatever to construct their own steady stream of Hot Takes and bon mot responses. All tossed out there like bottles into the vast social media ocean, never to wash up on any inhabited shore, lost in some great Sargasso Sea of impotent and forgotten texts.
Why? Why does @RandoBlueStateLawyer with 45 followers spend the better part of every afternoon thinking about his next brilliant riposte to the latest Republican Hot Take on Obamacare reform? Why does @RandoRedStateRetiree spend every evening working himself into a MAGA apoplexy that can only be sated by retweeting his 19,001st Hannity blurb?
To answer that question, I want to go back to the Old Stories. I want to share with you what sheep are really like.
Sheep are evolved to have a specific type of intelligence which has the following hallmarks.
Enormous capacity for other-regarding behaviors. Sheep are unbelievably sensitive to what other sheep are doing and their emotional states. If another sheep is happy — i.e., it’s found a good source of food, which is the only thing that makes a sheep happy — then every other sheep in the flock is filled with jealousy (there’s really no other word for it) and will move in on that good thing. If another sheep is alarmed — which can be from almost anything, as bravery is not exactly a trait that tends to be naturally selected in a prey species — then every other sheep in the flock is immediately aware of what’s going on. Sometimes that means that they get alarmed, too. As often, though, it’s just an opportunity to keep going with your own grazing without worrying about the alarmed sheep bumping into your happy place.
Zero altruism and overwhelming selfishness. The most popular misconception about sheep is that they are obedient followers. It’s true that they’re not leaders. It’s true that they are incredibly sensitive to other sheep. But it’s also true that they are the most selfish mammal I’ve ever encountered. They don’t lead other sheep or form leadership structures like a pack because they don’t care about other sheep. Every sheep lives in a universe of One, which makes them just about the most non-obedient creature around.
The determination to pursue any behavior that meets Hallmark #1 and #2 to absurd ends, even unto death. My worst sheep suicide story? The first year we kept sheep, we thought it would make sense to set up a hay net in their pen, which keeps the hay off the ground and lets the sheep feed themselves by pulling hay through the very loose loops of the net. Turned out, though, that the loops were so loose that a determined sheep could put her entire head inside the net, and if one sheep could do that, then two sheep could do that. And given how the hay net was hung and how these sheep were sensing each other, they started to move clockwise in unison, each trying to get an advantage over the other, still with their heads stuck in the net. At which point the net starts to tighten. And tighten. And tighten. My daughter found them the next morning, having strangled each other to death, unable to stop gorging themselves or seeking an advantage from the behavior of others. The other sheep were crowded around, stepping around the dead bodies, pulling hay for themselves out of the net. That was a bad day.
In both markets and in politics, our human intelligences are being trained to be sheep intelligences.
That doesn’t make us sheep in the modern vernacular. We are not becoming docile, stupid, and blindly obedient. On the contrary, we are becoming sheep as the Old Stories understood sheep … intensely selfish, intensely intelligent (but only in an other-regarding way) and intensely dogmatic, willing to pursue a myopic behavior even unto death.
Why are we being trained to think like sheep? Because sheep are wonderful prey animals. They pay the rent with their fleece, and when push comes to shove you can eat them, too. Plus they’re not helpless prey animals. Sheep are quite competent and rather self-sufficient prey animals, which from a smart owner’s perspective is really what you want. If sheep were truly docile and stupid, then they’d be way too much trouble to keep. Nope, with sheep you can let them wander around all day and do their thing. Just keep them from killing themselves in some really stupid accident and you can harvest them for years and years and years.
How are we trained to think like sheep? By the rewards we receive from our modern social institutions for other-regarding flock behaviors like jealousy (feeling sad when others are glad) and schadenfreude (feeling glad when others are sad), and by the penalties we receive for self-regarding pack behaviors like honor and shame. If you’ve ever kept a pack animal like a dog, you know how clearly they can experience a sense of shame, that feeling when you believe you’ve let the pack down through your personal failure. Sheep have no shame. Not a bit. Shame requires self-evaluation and self-judgment against some standard of obligation to the pack, concepts which would make sheep laugh if they could. Sheep are enormously other-aware, but never other-obliged. They’re high-functioning sociopaths, shameless creatures of jealousy and schadenfreude, which is exactly the type of human most purely designed to succeed in the modern age.
The mechanism for all this sheep training, particularly in our investment lives, is what game theory calls the Common Knowledge Game. Once you start noticing it, you will see it everywhere.
I’ve written about the Common Knowledge Game a lot in Epsilon Theory, starting in the original “Manifesto” and continuing with notes like “A Game of Sentiment” and “When Does the Story Break”. But let’s review this core game of sheep logic one more time, with feeling. So here’s the classic thought experiment of the Common Knowledge Game — The Island of the Green-Eyed Tribe.
On the Island of the Green-Eyed Tribe, blue eyes are taboo. If you have blue eyes you must get in your canoe and leave the island the next morning. But there are no mirrors or reflective surfaces on the island, so you don’t know the color of your own eyes. It is also taboo to talk with each other about eye color, so when you see a fellow tribesman with blue eyes, you say nothing. As a result, even though everyone knows there are blue-eyed tribesmen, no one has ever left the island for this taboo. A Missionary comes to the island and announces to everyone, “At least one of you has blue eyes.”
Let’s take the trivial case of only one tribesman having blue eyes. He has seen everyone else’s eyes, and he knows that everyone else has green eyes. Immediately after the Missionary’s statement, this poor fellow realizes, “Oh, no! I must be the one with blue eyes.” So the next morning he gets in his canoe and leaves the island.
But now let’s take the case of two tribesmen having blue eyes. The two blue-eyed tribesmen have seen each other, so each thinks, “Whew! That guy has blue eyes, so he must be the one that the Missionary is talking about.” But because neither blue-eyed tribesman believes that he has blue eyes himself, neither gets in his canoe the next morning and leaves the island. The next day, then, each is very surprised to see the other fellow still on the island, at which point each thinks, “Wait a second … if he didn’t leave the island, it must mean that he saw someone else with blue eyes. And since I know that everyone else has green eyes, that means … oh, no! I must have blue eyes, too.” So on the morning of the second day, both blue-eyed tribesmen get in their canoes and leave the island.
The generalized answer to the question of “what happens?” is that for any n tribesmen with blue eyes, they all leave simultaneously on the nth morning after the Missionary’s statement. Note that no one forces the blue-eyed tribesmen to leave the island. They leave voluntarily once public knowledge is inserted into the informational structure of the tribal taboo system, which is the hallmark of an equilibrium shift in any game. Given the tribal taboo system (the rules of the game) and its pre-Missionary informational structure, new information from the Missionary causes the players to update their assessments of where they stand within the informational structure and choose to move to a new equilibrium outcome.
Before the Missionary arrives, the island is a pristine example of perfect private information. Everyone knows the eye color of everyone else, but that knowledge is locked up inside each tribesman’s own head, never to be made public. The Missionary does NOT turn private information into public information. He does not say, for example, that Tribesman Jones and Tribesman Smith have blue eyes. But he nonetheless transforms everyone’s private information into common knowledge. Common knowledge is not the same thing as public information. Common knowledge is information, public or private, that everyone believes is shared by everyone else. It’s the crowd of tribesmen looking around and seeing that the entire crowd heard the Missionary that unlocks the private information in their heads and turns it into common knowledge.
The important thing is not that everyone hears the Missionary’s words. The important thing is that everyone believes that everyone else heard the Missionary’s words, because that’s how you update your estimation of everyone else’s estimations (why didn’t that blue-eyed guy leave the island? I know he heard the news, too … hmm … but that must mean that he, too, saw a blue-eyed guy … hmm … oh, snap.). The power source of the Common Knowledge Game is the crowd seeing the crowd, and the dynamic structure of the Common Knowledge Game is the dynamic structure of the flock. There’s no purposeful objective that animates a flock the way it does a pack, which is why you famously have people describing the “madness of crowds.” But it’s not madness, and it’s not chaos, either. A crowd is the communication mechanism for the Common Knowledge Game, with clear rules and strategies for playing and winning.
Understanding the Common Knowledge Game has been the secret of successful shepherds since time immemorial, in business, politics, religion … any aspect of our lives as social animals. The only difference today is that technological innovation provides a media toolkit for modern shepherds that the shepherds of the Old Stories could only dream of.
This is why sitcom laugh tracks exist. This is why performances, whether it’s an NFL game or Dancing with the Stars, are filmed in front of a live audience. This is why the Chinese government still bans any internet pictures of the Tiananmen Square protests, with their massive crowds, more than 20 years after they occurred. This is what John Maynard Keynes called the Newspaper Beauty Contest, which he believed (and demonstrated) was the secret to successful investing through the 1930s. This is how Dick Clark built a massive fortune with American Bandstand. He didn’t tell Middle America what music to like; he got a crowd of attractive young people to announce what music they liked (“it’s got a good beat and you can dance to it, I give it a 94, Dick!”), and Middle America took its cues from that. Not only is that all you need to motivate sheep, it’s far more effective than any efforts at direct influence.
This is why executions used to be held in public and why inaugurations still are. This is why Donald Trump cared so much about the size of his inauguration crowd. This is why he’s always talking about the viewership and ratings of his televised appearances. Trump gets it. He understands what makes the Common Knowledge Game work. It’s not what the crowd believes. It’s what the crowd believes that the crowd believes. The power of a crowd seeing a crowd is one of the most awesome forces in human society. It topples governments. It launches Crusades. It builds cathedrals. And it darn sure moves markets.
How do we “see” a crowd in financial markets? Through the financial media outlets that are ubiquitous throughout every professional investment operation in the world — the Wall Street Journal, the Financial Times, CNBC, and Bloomberg. That’s it. These are the only four signal transmission and mediation channels that matter from a financial market Common Knowledge Game perspective because “everyone knows” that we all subscribe to these four channels. If a signal appears prominently in any one of these media outlets (and if it appears prominently in one, it becomes “news” and will appear in all), then every professional investor in the world automatically assumes that every other professional investor in the world heard the signal. So if Famous Investor X appears on CNBC and says that the latest Fed announcement is a great and wonderful thing for equity markets, then the market will go up. It won’t go up because investors agree with Famous Investor X’s assessment of the merits of the Fed announcement. The market will go up because every investor will believe that every other investor heard what Famous Investor X said, and every investor will be forced to update his or her estimation of what every other investor estimates the market will do. It doesn’t matter what the Truth with a capital T is about the Fed. It doesn’t matter what you think about the Fed. It doesn’t matter what everyone thinks about the Fed. What matters is what everyone thinks that everyone thinks about the Fed. That’s how sheep logic, aka the Common Knowledge Game, works in markets.
So who owns us market sheep? The controllers of any Common Knowledge Game are the Missionaries, and the eternal Missionaries are the political executive and the market sell-side. Politicians and brokers have understood the power of this game for thousands of years, which makes the Street and the White House the constants as you examine the history of American sheepification. But they’re not the most powerful Missionaries of the modern age. No, that honor goes to our central bankers, relative newcomers to the Game, but quick studies all the same.
In his last Jackson Hole address, Ben Bernanke extols the virtues of their “communication tools”, carefully constructed media messages designed to alter investor behavior, messages that he says have been their most effective policy tools to date. Interest rates may hit a lower bound of zero, and asset purchases may lose their punch, but investors can ALWAYS be “guided”. The architect of this new and powerful toolkit? Vice Chair Janet Yellen, natch. Forward guidance and what the Fed calls communication policy are the very definition of Missionary statements, and our utter absorption in what everyone believes that everyone believes about the Fed’s impact on markets IS sheep logic.
Think that the Fed will go back to their old taciturn ways, content to let their actions speak louder than their words? Think again. Here’s Ben Bernanke again, this time in his final speech as Fed Chair:
The crisis has passed, but I think the Fed’s need to educate and explain will only grow. When Paul Volcker first sat in the Chairman’s office in 1979, there were no financial news channel on cable TV, no Bloomberg screens, no blogs, no Twitter. Today, news, ideas, and rumors circulate almost instantaneously. The Fed must continue to find ways to navigate this changing environment while providing clear, objective, and reliable information to the public.
Active central bank Narrative construction in the service of their policy goals is a permanent change in our market dynamics. The introduction of such a powerful new weapon in the Fed’s policy arsenal can no more be removed than mustard gas or tanks could be removed from national arsenals after World War I. Market prices may be mean-reverting, but “innovation” in the service of social control never is.
What do the Missionaries get out of this? What’s our equivalent of wool and mutton? It’s low volatility. It’s the transformation of capital markets into a political utility, which is just about the greatest gift that status quo political interests can imagine. When Donald Trump and Steve Mnuchin talk about the stock market being their “report card”, they’re just saying out loud what every other Administration has known for years. Forget about markets, our entire politicalsystem relies on stocks going up. If stocks don’t go up, our public pension funds and social insurance programs are busted, driving our current levels of wealth inequality from ridiculously unbalanced to Louis XVI unbalanced. If stocks don’t go up, we don’t have new collateral for our new debt, and if we can’t keep borrowing and borrowing to fuel today’s consumption with tomorrow’s growth … well, that’s no fun, now is it?
The flip side to all this, of course, is that so long as stocks DO go up, nothing big is ever going to change, You say you want a revolution? You’re a MAGA guy and you want someone to drain the Swamp? You’re a Bernie Bro and you want the rich to “pay their fair share”? Well, good luck with any of that so long as stocks go up. It’s a very stable political equilibrium we have today, full of Sturm und Drang to provide a bit of amusement and distraction, but very stable for the Haves.
And that brings us back to @RandoBlueStateLawyer and @RandoRedStateRetiree, fighting the good fight on Twitter or Facebook or wherever, speaking their Truth to their audience of dozens. They’re smart guys. Politically engaged guys. They’re angry about the mendacity of the Other Side. In another day and age they’d slam the newspaper down on the table and tell the dog what a fool that darn Truman was. Maybe write a strongly worded letter to the editor. But today they are consumed by this modern equivalent of writing a letter to the editor. They are immersed in the world of the Constant Hot Take, morning, noon and night. Why? Because Common Knowledge Game. Because they see a crowd responding to a crowd, and they are hard-wired to join in. Because it makes them feel good about themselves. Because they’ve been turned into other-regarding sheep even as they think they’re being self-regarding wolves.
In the same way that the modern story of what it means to be a sheep — docile, obedient, stupid — is totally wrong, so is the modern story of what it means to be a wolf. We think of a wolf as the epitome of rapacious independence, but wolves, like all pack animals, are far less independent (and far less greedy) than your average sheep. Unlike sheep, wolves can act outside of their group because they’re not consumed by other-regarding behavior, but those actions are ultimately in service to the pack. A sheep always acts within its group, but it’s never in service to the flock, only to its own needs.
Look, I’ll admit that I’m talking to myself as I write these words. I spend WAY too much time on Twitter, justifying it to myself in any number of ways, when in truth it’s the functional equivalent of a meth habit. At least it’s not as tough on the teeth. My wife is hooked on Facebook, my kids on god knows what social media platforms …. I’m not so naïve as to think that the answer to our collective sheepification is just to put the devices down. No, we’ve got to shift the way we use this stuff, not quit it cold turkey.
So what do we do? We stop pretending to be fake wolves and we start acting like real ones. We stop acting like animals of the flock and we start acting like animals of the pack. We reject the other-regarding emotions of jealousy and schadenfreude. Yes, even in our tweets (gulp!). We embrace self-regarding emotions like honor and — here’s where I’m going to lose everyone — shame.
Yes, we need a lot more shame in the world. The loss of our sense of shame is, I think, the greatest loss of our modern world, where — to retweet myself — scale and mass distribution are ends in themselves, where the supercilious State knows what’s best for you and your family, where communication policy and fiat news shout down authenticity, where rapacious, know-nothing narcissism is celebrated as leadership even as civility, expertise, and service are mocked as cuckery. Or to put it in sheep logic terms: the tragedy of the flock is that everything is instrumental, including our relationship to others. Including our relationship to ourselves.
Why do we need shame? Because with no sense of shame there is no sense of honor. There is no mercy. There is no charity. There is no forgiveness. There is no loyalty. There is no courage. There is no service. There is no Code. There are no ties that bind us as citizens, as fellow pack members seeking to achieve something bigger and more important than our ability to graze on as much grass as we can. Something like, you know, liberty and justice for all.
Any coin worth having has two sides. A shameless politics has no honor. A riskless market has no reward. Oh, the Missionaries will tell you that there’s honor in the shameless politics and reward in the riskless markets, and for all the high-functioning sociopaths out there I’m sure that’s true, But if you’re not totally sheepified yet, if your goal is still honorable service to your clients or your partners or your family or your nation or your species — whatever your pack may be — then you know that this is NOT true. You know that shame and risk can be deferred or displaced but never wiped clean, no matter how many Supreme Court Justices you appoint and no matter how many all-time highs the stock market hits. You know that a reputation is like a tea cup; once broken you can glue it back together, but it will always be a broken tea cup. You know that the only game worth playing is the long game.
This is the Age of the High-Functioning Sociopath. This is the Age of Sheep Logic. We have to survive it, but we don’t have to succumb to it. How do we Resist? Not by switching out blue Missionaries for red Missionaries or red Missionaries for blue Missionaries. Not by switching out one bad shepherd for another bad shepherd. We don’t have to play that game! We resist by changing the System from below, by carving out local spheres of action where we are relentlessly honorable and charitable, relentlessly un-sheeplike. We resist by Making America Good Again, one pack at a time, which is a hell of a lot harder than making America great ever was. We resist by doing right by our clients, even if that means getting slapped around by supposedly riskless markets and shameless politics. Even if that means losing clients. Even if that means losing our jobs.
A good shepherd once said that whoever shall smite thee on thy right cheek, turn to him the other also. Of course, I also knew a good Dungeonmaster who said that being lawful good didn’t mean being lawful stupid, and turning the other cheek always seemed to be kinda stupid to me. Kinda sheeplike. But then I started keeping sheep, and my perspective changed. Sheep would never turn the other cheek. But a wolf would. A wolf would take a hit for the pack. It’s the smart play for the long game. As wise as serpents, you might say.
It’s time to be wolves. Not as devourers, but as animals that know honor and shame. It’s time to be wise as serpents and harmless as doves. It’s time to remember the Old Stories. It’s time to find your pack.
How the hell did you know I didn’t have the king or the ace?
I recollect a young man putting the same question to Eddie the Dude. “Son,” Eddie told him, “all you paid was the looking price. Lessons are extra.”
― “The Cincinnati Kid” (1965)
There are only two great movies about poker — Rounders, which everyone knows, and The Cincinnati Kid, which no one knows. Steve McQueen is the Kid and Edward G. Robinson is the Old Pro, Lancey. When I was a younger man, I rooted for the Kid. Today … I’m pulling for Lancey all the way.
Six stacks, is that right, Shooter?
Well, we’ve been playing 30 hours… uh, that rate, six thousand, that makes roughly, uh, $200 an hour. Thank you for the entertainment, gentlemen. I am particularly grateful to Lancey, here; it’s been a rewarding experience to watch a great artist at work. Thank you for the privilege, sir.
Well now, you’re quite welcome, son. It’s a pleasure to meet someone who understands that to the true gambler, money is never an end in itself, it’s simply a tool, as a language is to thought.
―“The Cincinnati Kid” (1965)
Money is to gambling as a language is to thought. What a line!
Screenplay by Ring Lardner, Jr., one of the Hollywood 10 who refused to be rats for the House Un-American Activities Committee in McCarthy days. Lardner was blacklisted and sentenced to a year in prison for contempt of Congress.
True courage comes at a heavy price. Some will be willing to pay that price over the next four years.
And some won’t.
[Shooter’s wife Melba is altering a jigsaw puzzle piece with a nail file]
Melba, why do you do that?
So it’ll fit, stupid.
No, I’m not talking about that. What I’m asking is … do you, uh, have to cheat at everything?
Yes. At … solitaire. I’ve yet to see you play one game of solitaire without cheating.
Look, you’re just cheating yourself, don’t you understand? You’ll be the loser, no one else but yourself! … You’ve ruined the puzzle, now, that doesn’t go in there.
[She forces the altered piece into place]
―“The Cincinnati Kid” (1965)
I’ve known more than a few economists who had more than a little Melba in them. Quants, too. That’s Ann-Margret as Bad Girl Melba, by the way, and Karl Malden as the cuckolded Shooter. ‘Nuff said.
Daring ideas are like chessmen moved forward. They may be beaten, but they may start a winning game.
― Johann Wolfgang von Goethe (1749 – 1832)
A gambit risks a pawn for advantage later in the game. The word is derived from the Italian gamba (leg), from a wrestling move with a similar sacrifice.
In chess as in life — the only way to defeat a gambit is to accept it.
Berlin is the testicles of the West. Every time I want the West to scream, I squeeze on Berlin.
―Nikita Khrushchev, 1963
Without wishing to trade hyperbole with the Chairman, I do suggest that he reminds me of the tiger hunter who has picked a place on the wall to hang the tiger’s skin long before he has caught the tiger. This tiger has other ideas.
―John F. Kennedy, 1961
Sieges and blockades are game theory in practice, on both sides of the wall.
Photo of North Vietnamese General Giap, taken during the siege of Dien Bien Phu in 1954. In anticipation of a full-scale assault, the French took up positions (marked in green on the map) on a series of fortified hills. Rather than attack en masse, however, Giap set up artillery positions east and north of the French fortifications and wore the French down with artillery fire combined with constant probing skirmishes. In investing, I always try to think: WWGGD?
I’ve written a lot about The Common Knowledge Game – here, here, and here – because it’s the game of markets, i.e., it’s the central contribution of game theory to understanding how markets work. I’ve also written a lot about new technologies and new perspectives – here, here, and here – that help us see The Common Knowledge Game in action. Today I want to take a different cut at this topic: how can you be a better game-player? What are some specific strategies one can adopt to play the game of markets more effectively?
There’s a concept in poker that’s a useful introduction to what I want to talk about. It goes by lots of different names, but I’ll call it The Probing Bet. The idea is that you make a raise or otherwise take the initiative in a signaling interaction because, as you’ll hear time after time if you talk to good poker players, you need to find out “where you stand” in that particular hand. The betting behavior of the other poker players sitting around the table from you is like the betting behavior of the other investors sitting around the market from you: it’s over-determined, which is a $10 word that means there are far more possible explanations of what actual cards might be driving that betting behavior than are required to explain the behavior fully (see “The Unbearable Over-Determination of Oil” for an investment example).
In other words, there might be six different basic card combination categories that an opponent might hold, each of which — if you were playing that hand — has some percentage likelihood of prompting you to duplicate that opponent’s betting behavior. But if you add up those percentage likelihoods across the six different categories, you get a number way higher than 100%. As a result, if you’re trying to reverse engineer in your mind what cards your opponent might be holding, it’s really difficult to come up with anything interesting or informative. It’s difficult and not terribly fun, so most poker players don’t even try. Most poker players only play their own hand. Period. They know their own hand’s strength in an absolute or non-strategic sense, and they know what cards need to show up for them to have a really killer hand. But that’s all they really know, so their betting behavior is directly connected to the non-strategic strength of their hand, coupled with some loose sense of whether they want to play “tight” (bet per the book odds of hitting that killer hand) or “loose” (bet more than the cards justify in an absolute sense in order to set up a bluff or maybe just get lucky).
The average poker player is fascinated by his own cards. Every deal unlocks a world of seemingly endless potential, and almost all of the mental energy at a typical poker game is consumed by thoughts of “how am I going to represent my hand to my opponent?” In sharp contrast, precious little mental energy is spent asking “how can I learn more about how my opponent is representing his hand?”, even though the latter question is FAR more useful to answer. Why more useful? Because just as you are fascinated by your cards, so is your opponent fascinated by his cards. In a game of ubiquitous self-absorption, even a little bit of other-awareness goes a really long way.
What you need to whittle down an over-determined behavior is The Probing Bet, something out of the ordinary that intentionally puts capital at risk in order to narrow down the likely range of hands your opponent might hold. The Probing Bet isn’t designed to represent or signal anything about your hand (which right there makes it a foreign concept to the vast majority of players). It’s a bet designed to get more information about your opponent’s hand and the way he plays it, and it’s something you might do regardless of what cards you have in your hand. Importantly, The Probing Bet in and of itself has a negative expected return. There’s no such thing as a free lunch, and that’s as true in poker as anywhere else. If you want more information, you have to pay for it, and the cost is the potential loss of The Probing Bet. You should gladly pay that cost, however, if the additional information garnered from The Probing Bet increases the expected return of the entire deal (or future deals!) by an even greater amount.
You can find the concept of The Probing Bet in every classic game. In chess, it’s the gambit, the intentional risking of a pawn that accepts a limited loss in the short term to win a more valuable positional advantage over the entire course of the game. When offered a gambit, you’re damned if you do and damned if you don’t. If you don’t accept the offered pawn, you don’t get the piece and you lose the positional advantage anyway. But if you do accept the pawn, your degrees of freedom going forward are sorely limited. On balance, when offered a gambit you have to take it. Chess is a game of informational initiative, and playing a gambit grabs that initiative with both hands. At a cost.
You similarly find the concept of The Probing Bet in every game of nations, and it’s here that we can start making the connection (please!) to the game of markets. I know this sounds weird, but I’ve always found international maritime law to be a place where the game of nations gets crystalized in really interesting ways. Why? Because international law in general is just a short cut to equilibrium outcomes that you’d otherwise need to fight a war to arrive at — which is to say that international law is, in a very real way, MADE of game theory — and maritime law in particular has seen thousands of years of every imaginable strategic interaction in a clean and ordered way. So bear with me as I shift the metaphor from poker to naval blockades and the role of non-belligerent neutral parties. Trust me, there’s a decent payoff here.
Let’s say you’re Neutral Nation and you want to send a ship full of wheat across the ocean to Market Nation and sell it there. You’re one of many neutral nations and you don’t have a huge combatant navy, just lots of cargo ships and lots of wheat to sell. Unfortunately, Market Nation is at war with Banker Nation. Now you don’t have a dog in that fight; all you want to do is make money. But before you send your ship on its merry way, you are informed by Banker Nation’s ambassador that they have declared a blockade on Market Nation, that the list of contraband materials includes wheat, and that they are asserting the right to stop, search, and seize any neutral ships headed for Market Nation carrying such contraband. What do you do?
For a blockade to be valid under international law, two conditions must be fulfilled. First, it must be communicated to you, which in this case it clearly was (interestingly, it doesn’t have to be communicated directly, but can be understood to have been communicated “through the notoriety of the fact”, which is a fancy way of saying Common Knowledge). Second — and this is the important part — it must be an effective blockade for it to be legally binding on you, the neutral party. In other words, Croatia can’t declare a neutral party-binding blockade on Italy because it doesn’t have enough warships to cover all of the Italian ports and make that blockade effective. So if Banker Nation is some weakling, you have every right to say that you don’t recognize their blockade as effective, and any action they might take against your ships will be treated as an illegal seizure and a potential act of war. In game theory we would call this a trivial case, in that the game play is obvious — you and every other neutral country ignore the “blockade” and it collapses immediately.
But let’s say that Banker Nation has a decent-sized navy, maybe even a large navy. Let’s say that Banker Nation is able to put a warship or two around most of Market Nation’s ports most of the time. Is that an effective blockade? Banker Nation will represent that it is. Banker Nation and its ambassadors will tell you that they have an impenetrable wall of warships covering every square inch of Market Nation’s coastline. You know that this isn’t true, but you don’t know how true it is. When they say that they have an effective blockade, are they covering 100% of the ports 80% of the time? 60% of the ports 60% of the time? Does their coverage ratio go up over time? Down? Whatever the port coverage ratio might be, is that enough for you to consider the blockade “effective” and keep your cargo ships at home? The problem you face as Neutral Nation is the same problem faced by The Cincinnati Kid: the statement “my blockade is effective” is as over-determined as an opening bet in a game of Five Card Stud. You don’t know what cards Banker Nation is really holding.
So here’s what you don’t do as Neutral Nation. You don’t send cargo ship after cargo ship sailing blindly to Market Nation in the hopes that a few of them will slip through. You don’t fight the Fed Banker Nation! But what’s also a mistake is to accept the efficacy of Banker Nation’s blockade as a permanent state of the world or just on their word, even though that’s what most neutral countries will do.
So what DO you do? Let’s put this (finally!) in the context of an actual investment scenario. The ECB has famously said that they will do “whatever it takes” to keep the euro system intact. They have proclaimed unlimited resolve to purchase government and corporate debt to accomplish their goals. They have, to stick with the naval warfare metaphor, announced an effective blockade of fundamental market pressures associated with the common currency and the sovereign debt of currency bloc members. Would the Spanish 10-year bond trade 90 basis points tighter than the U.S. 10-year bond if the ECB weren’t patrolling the waters of sovereign rates markets? Please.
But at the same time, the ECB is facing extraordinary and escalating pressure on the home front — the politics of member states and their willingness to participate in a common currency system that clearly has big winners (Germany) and big losers (Italy). 2016 was rocky enough from a political perspective, but 2017 shapes up to be a real doozy, with elections in France and Germany and probably Italy … the three sine qua non countries of the eurozone. As the home front deteriorates, the ECB is going to be hard-pressed to maintain its fleet of announced balance sheet expansion programs, much less the mythical dreadnaughts of the OMT program and other super-warships that are supposedly waiting in the wings should the blockade start to fail. Draghi and the rest of Banker Nation will never admit the deterioration in the cards that they hold, but we know it’s happening. What we don’t know is how bad the deterioration actually is. What we don’t know is what has to happen before Common Knowledge shifts from “yes, the blockade is effective so don’t even try to act against the ECB” to “no, the blockade is no longer effective so let’s go do what we’ve gotta do to protect our capital and make some money if the euro isn’t going to make it.”
Since we can’t predict where we’re going to end up in the Common Knowledge Game (and I really can’t emphasize this point strongly enough … the past is a terrible predictor of the future when it comes to multiple-equilibrium games), we have to constantly assess where we are as the game unfolds. How do we do that? By making occasional Probing Bets. By placing capital at risk to see “where we stand” in the strategic dynamic of the game of markets. By experiencing the reaction of the ECB and other investors, large and small, to a potential volatility catalyst like an Italian election.
Some investors make big Probing Bets. They’re called Bond Vigilantes, and they’ve been cowering in the tall grass since 2012 when Draghi proclaimed “whatever it takes”. But they’re still there, biding their time. Just wait. In 2017 they’ll be back. Many of these game players are Missionaries themselves, and they pack an extra punch in the game-playing as a result.
But you don’t need to be a hedge fund Master of the Universe to make a Probing Bet, although maybe we should take the capitalization off and call these probing bets. You just need to get in the game. I’d like to tell you that you can figure out where we are in the euro game by watching from the sidelines and letting others place Probing Bets, but I can’t. My strong belief is that you have to live an investment before you can gain useful information from the experience. And it’s got to be a high enough cost so that you pay attention. As Old Pro Lancey would say, you can’t just pay the looking price. Does it have to be a cost in actual dollars and cents? No, although that’s a really good attention-grabber. The real price you must pay for a probing bet is even more precious than money — time. That’s the price that most of us find hardest to pay, which is why I think it makes all the behavioral sense in the world to couple it with real money. No one uses the free gym in an apartment complex.
And now for the big finish. I’ve used a macro trade (the ECB and what’s in store for the euro) as my example of the useful role of probing bets and the investment managers who play those cards, because that’s the investment arena that I play in. The exact same logic applies to ALL investment arenas and ALL active managers. What’s the big mistake that investors are making with their single-minded and headlong pursuit of passive investment strategies in the form of ETFs, index funds, and the like? Passive strategies give you ZERO information about the strategic gameplay of markets. Passive strategies, by definition, cannot make a Probing Bet. Passive strategies, by definition, will be the last to know when the state of the world has changed and will be the slowest to adapt. A portfolio composed of passive strategies is like the average poker player who just plays his own hand in a strategic vacuum. That can work out fine if you’re dealt nothing but great cards, a lot less well if you’re not.
That’s not to say that all active managers are effective information-seekers or strategic game-players. In fact, I think it’s fair to say that many, if not most, active managers and active investors are so-so game-players because they confuse caution with wisdom. It’s one thing — a perfectly reasonable thing — to create a cautious portfolio through low gross exposure or high levels of cash if your belief is that markets are more likely to go down than up AND you are placing probing bets to see if the market dynamic is somewhere other than where you think it is, i.e., more positive than you believe. And it’s also a perfectly reasonable thing to be all-in with your portfolio if your belief is that markets are likely to keep rocking AND you are placing probing bets to see if the market dynamic is somewhere other than where you think it is, i.e., more negative than you believe. What’s not so reasonable, I think, but I see every day (and I recognize from time to time when I look in the mirror!) is to take a big risk with a portfolio (and a high level of cash IS a big risk for a portfolio), without allocating a commensurate portion of my risk budget towards going the other way, towards gaining more information about how competing players are playing their hand, towards challenging my beliefs with real dollars and precious time.
And that, in a nutshell, is the best advice I’ve got for any game, whether it’s the game of poker, the game of chess, the game of nations, or the game of markets: act strongly on your beliefs, but don’t hold your beliefs strongly. That’s the cornerstone of Adaptive Investing.
[narrating] In 1966, Andy Dufresne escaped from Shawshank prison. All they found of him was a muddy set of prison clothes, a bar of soap, and an old rock hammer, damn near worn down to the nub. I remember thinking it would take a man six hundred years to tunnel through the wall with it. Old Andy did it in less than twenty. Oh, Andy loved geology. I imagine it appealed to his meticulous nature. An ice age here, million years of mountain building there. Geology is the study of pressure and time. That’s all it takes really, pressure, and time.
I played a mean harmonica as a younger man. Lost interest in it though. Didn’t make much sense in here.
Here’s where it makes the most sense. You need it so you don’t forget.
Forget that… there are places in this world that aren’t made out of stone. That there’s something inside… that they can’t get to, that they can’t touch. That’s yours.
What’re you talking about?
Let me tell you something my friend. Hope is a dangerous thing. Hope can drive a man insane.
– “The Shawshank Redemption” (1994)
Hope is a good breakfast, but it is a bad supper.
– Francis Bacon (1561 – 1626)
Where there is no hope, it is incumbent on us to invent it.
– Albert Camus (1913 – 1960)
Hope is the only good god remaining among mankind;
the others have left and gone to Olympus.
Trust, a mighty god has gone, Restraint has gone from men,
and the Graces, my friend, have abandoned the earth.
– Theognis of Megara (c. 550 BC), writing more than 2,500 years before the Trump v. Clinton election.
Dante Gabriel Rossetti, “Pandora” (1869)
A policy-controlled market, whether it’s today’s investment environment or the 1930s or the 1870s, places enormous pressure on investors … for yield and consistent return, to be sure, but even more so for a resurrection of the investment beliefs that held sway in “normal times”, for an escape from the prison of extraordinary monetary policy and its grip on market behavior. Pressure and time. That’s all it took for the Shawshank Redemption and that’s all it takes for our modern market redemption. Or it least that’s all it takes for the hope and the escape attempt. Let’s see if we’re as successful as Andy Dufresne.
When suitably crystallized, an investment hope takes on a different form. It becomes an investment theme. Today the investment hope that has crystalized into an investment theme is the notion that soon, just around the corner now, perhaps as a result of the next mystery-shrouded meeting of the world’s central bankers, perhaps as a result of the U.S. election this November, we will enjoy a coordinated global infrastructure spending boom. Of course, this isn’t deficit spending or another trillion dollar layer of debt, but is “investment in our crumbling infrastructure.” This isn’t a mirror image of China’s massive over-build in empty cities or of Obama’s shovel-ready infrastructure projects from 2009-2010, but is “really a free lunch“, to quote Larry Summers, where there’s never a Bridge-to-Nowhere or an Airport-of-One. Or so the Narrative goes.
A Narrative theme is a theme of hope, pure and simple. And because hope can and will emerge without any evidence or support from the real world, a Narrative theme can work from an investment perspective even if it’s a non-event in the real world or, stranger yet, an abject failure in the real world. In exactly the same way that you can invest alongside central bank efforts to prop up markets and drive asset prices higher without believing in your heart-of-hearts that anything these bankers say is even remotely true, so can you invest alongside a Narrative theme without believing a single word of the Narrative itself.
And to be clear, my personal belief is that Larry Summers and the rest of the “public infrastructure projects are great investments!” crowd are sniffing glue. You’re pulling forward future economic activity, that’s all. Read the latest from Howard Marks if you don’t believe me. I’m not saying that government spending is bad — on the contrary, government spending is absolutely necessary to preserve life, liberty, and the pursuit of happiness, and there’s certainly a societal “return on investment” from government spending — but don’t tell me that there’s this huge productivity-enhancing, non-quotation-marked economic return on investment generated by the government building stuff that the private sector doesn’t want to build. Don’t tell me that what China is doing with their infrastructure is “mal-investment”, but that if we do it … well, that’s different, because, you know, our infrastructure is “crumbling” instead of “gleaming” the way it is in … umm … China. Yes, LaGuardia is a miserable airport. So stipulated. But there are infinitely greater productivity gains to be had from changing our insane TSA regulations and reducing security lines than by building a new Terminal B. If you want a massive Keynesian deficit spending program on top of our massive current debt … fine, make the argument. There’s an argument to be made. But don’t put a specious “investment” wrapper around it.
But it’s exactly that specious wrapper — the Narrative — that makes all of this work as an investment theme. If a massive public works program were couched in its traditional Keynesian or neo-socialist form (you don’t see Bernie Sanders talking about the economic ROI of his infrastructure proposals), it wouldn’t have a chance with the Wall Street Journal crowd. But, hey, if a public works program is “a smart investment” … never mind that this is about as smart an investment as Moonbase Alpha (yes, I had the Space: 1999 lunchbox) or perhaps a gigantic hole in the ground … well, then, let’s muster up the usual suspects at CNBC and the Wall Street Journal op-ed staff to get behind this, and let’s convince ourselves that Donald Trump wouldn’t be a nut job president, even though every shred of evidence and plain common sense screams the contrary, because he’s, you know, a “builder.”
It’s all based on hope for real economic growth and an escape from policy-controlled markets, a hope that springs in every investor’s heart given enough pressure and enough time. It’s a hope that, as Sir Francis Bacon said, makes for a good breakfast but a bad supper. We’re in the breakfast phase of this Narrative theme still, as Missionaries (to use the game theory term) like Larry Kudlow beat the drum louder and louder for a big infrastructure spend, and it’s a drumbeat that will continue to grow until there’s a reality check or a powerful Missionary creating Common Knowledge to knock it back. That will be the dinner portion of this Narrative theme, and it will be an unpleasant meal. But I don’t see dinner being served until well after the U.S. election, no matter who takes the White House or how the balance of power shifts in Congress, and it might be a year or two later before the thin gruel of dashed hopes is served up to markets.
So even though I think this U.S. public infrastructure build has barely a whiff of merit from an economic policy perspective, even though I think its net effect once implemented will be to make the ultimate debt reset that much more horrific, I also think it’s a highly investable idea. Because that’s the way you play the Common Knowledge Game.
Common Knowledge is information that everyone believes everyone has heard. It’s why executions were once held in public, not so a big crowd can see the guy getting hanged, but so the crowd can see the crowd watching the guy getting hanged. It’s why political debates are filmed in front of a live audience. It’s why sitcoms have laugh tracks. It’s how a relatively small but highly televised protest in Cairo’s Tahrir Square toppled Mubarak. It’s why the Chinese government still cracks down on media pictures of the Tiananmen Square protests, now more than 25 years old. Common Knowledge is the game theoretic concept behind the irresistible power of the crowd watching the crowd, and as a result Common Knowledge construction by governments, corporations, and yes, central bankers is one of the most potent instruments of social control on Earth.
The Common Knowledge Game is the game of markets, and it’s been internalized by good traders for as long as markets have existed. What you think about the market doesn’t matter. What everyone thinks about the market (the consensus) doesn’t matter. What matters is what everyone thinks that everyone thinks about the market, and the way you get ahead of this game is to track the “Missionary statements” of politicians, pundits, and bankers made through the four media microphones where the Common Knowledge of markets is created: The Wall Street Journal, The Financial Times, Bloomberg, and CNBC. It’s what Keynes called The Newspaper Beauty Contest, and it drove the policy-controlled markets of the 1930s exactly as it drives markets today. Is it an easy game to play? Nope. But you don’t have to be a professional poker player to avoid being the sucker at your local game. You don’t have to be a wizard trader to be aware that the Common Knowledge Game is being played, and that it’s driving market outcomes.
Red and Andy survived more than 20 years in Shawshank prison because they never lost hope. But they were smart about the concept of hope. They didn’t let hope consume them to take stupid chances. In Red’s words, they never let hope drive them insane. That’s the same balancing act we all need to adopt here in Central Bank prison. Hope is a good thing. Hope is a human thing. But hope is also a social construct that is used intentionally by others to shape our behaviors, in markets as in life. That’s the awareness we need to be hopeful survivors here in the Silver Age of the Central Banker, and that’s the awareness I’m trying to create with Epsilon Theory.
Twain spent 11 years writing his final novel, “The Mysterious Stranger”, but never finished it. The book exists in three large fragments and is Twain’s darkest and least funny work. It’s also my personal favorite.
Stanley: I thought you were called Lucifer.
George: I know. “The Bringer of the Light” it used to be. Sounded a bit poofy to me. Everything I’ve ever told you has been a lie. Including that.
Stanley : Including what?
George : That everything I’ve ever told has been a lie. That’s not true.
Stanley : I don’t know WHAT to believe.
George : Not me, Stanley, believe me!
A must-see movie, and I don’t mean the 2000abomination with Brendan Fraser, but the genius 1967 version by Peter Cook and Dudley Moore. Plus Raquel Welch as Lust. Yes, please.
Henry Hill: Ladies and gentlemen, either you are closing your eyes to a situation you do not wish to acknowledge, or you are not aware of the caliber of disaster indicated by the presence of a pool table in your community!
The Music Man (1962)
The Pied Piper legend, originally a horrific tale of murder, finds its source in the earliest written records of the German town of Hamelin (1384).
The story begins: “it is 100 years since our children left.”
As Tolstoy famously said, there are only two stories in all of literature: either a man goes on a journey, or a stranger comes to town. Of the two, we are far more familiar and comfortable with the first in the world of markets and investing, because it’s the subjectively perceived narrative of our individual lives. We learn. We experience. We overcome adversity. We get better. Or so we tell ourselves.
But when the story of our investment age is told many years from now, it won’t be remembered as a Hero’s Journey, but as a classic tale of a Mysterious Stranger. It’s a story as old as humanity itself, and it always ends with the same realization by the Stranger’s foil: what was I thinking when I signed that contract or fell for that line? Why was I so naïve?
The Mysterious Stranger today, of course, is not a single person but is the central banking Mafia apparatus in the US, Europe, Japan, and China. The leaders of these central banks may not be as charismatic as Robert Preston in The Music Man, but they hold us investors in equal rapture. The Music Man uses communication policy and forward guidance to get the good folks of River City to buy band instruments. Central bankers use communication policy and forward guidance to get investors large and small to buy financial assets. It’s a difference in degree and scale, not in kind.
The Mysterious Stranger is NOT a simple or single-dimensional fraud. No, the Mysterious Stranger is a liar, to be sure, but he’s a proper villain, as the Brits would say, and typically he’s quite upfront about his goals and his use of clever words to accomplish those goals. I mean, it’s not like Kay doesn’t know what she’s getting herself into when she marries into the Corleone family. Michael is crystal clear with her, right from the start. But she wants to believe so badly in what Michael is telling her when he suddenly reappears in her life, that she suspends her disbelief in his words and embraces the Narrative of legitimacy he presents. I think Michael actually believed his own words, too, that he would in fact be able to move the Family out of organized crime entirely, just as I’m sure that Yellen believed her own words of tightening and light-at-the-end-of-the-tunnel in the summer of 2014. Ah, well. Events doth make liars of us all.
Draw your own comparisons to this story arc of The Godfather, with investors playing the role of Kay and the Fed playing the role of Michael Corleone. I think it’s a pretty neat fit. It ends poorly for Kay, of course (and not so great for Michael). Let’s see if we can avoid her fate.
This is a -94% correlation, remarkably strong for any two securities, much less two – pipelines and the dollar – that are not obviously connected in any fundamental or real economy sort of way. But this is always what happens when the Mysterious Stranger comes to town: our traditional behavioral rules (i.e., correlations) go out the window and are replaced with new behavioral rules and correlations as we give ourselves over to his smooth words and promises. Because that’s what a Mysterious Stranger DOES – tell compelling stories, stories that stick fast to whatever it is in our collective brains that craves Narrative and Belief.
There’s nothing particularly new about this phenomenon in markets, as there have always been “story stocks”, especially in the technology, media, and telecom (TMT) sector where you have more than your fair share of charismatic management storytellers and valuation multiples that depend on their efforts.
My favorite example of a “story stock” is Salesforce.com (ticker CRM), a $55 billion market cap technology company with 19,000 employees and about $6.5 billion in revenues. I’m pretty sure that Salesforce.com has never had a single penny of GAAP earnings in its existence (in FY 2016 the company lost $0.07 per share on a GAAP basis). Instead, the company is valued on the basis of non-GAAP earnings, but even there it trades at about an 80x multiple (!) of FY 2017 company guidance of $1.00 per share. Salesforce.com is blessed with a master story-teller in its CEO, Marc Benioff, who – if you’ve ever heard him speak – puts forth a pretty compelling case for why his company should be valued on the basis of bookings growth and other such metrics. Of course, the skeptic in me might note that it is perhaps no great feat to sell more and more of a software service at a loss, particularly when your salespeople are compensated on bookings growth, and the cynic in me might also note that for the past 10+ years Benioff has sold between 12,500 and 20,000 shares of CRM stock every day through a series of 10b5-1 programs. But hey, that’s why he’s the multi-billionaire (and a liquid multi-billionaire, to boot) and I’m not. Here’s the 5-year chart for CRM:
Not bad. Up 138% over the past five years. A few ups and downs, particularly here at the start of 2016, although the stock has certainly come roaring back. But when you dig a little deeper …
There are 1,272 trading days that comprise this 5-year chart. 21 of those trading days, less than 2% of the total, represent the Thursday after Salesforce.com reports quarterly earnings (always on a Wednesday after the market close). If you take out those 21 trading days, Salesforce.com stock is up only 35% over the past five years. How does this work? What’s the causal process? Every Wednesday night after the earnings release, for the past umpteen years, Benioff appears on Mad Money, where Cramer’s verdict is always an enthusiastic “Buy, buy, buy!” Every Thursday morning after the earnings release, the two or three sell-side analyst “axes” on the stock publish their glowing assessment of the quarterly results before trading begins. It’s not that every investor on Thursday believes what Cramer or the sell-side analysts are saying, particularly anyone who’s short the stock (CRM always has a high short interest). But in a perfect example of the Common Knowledge Game, if you ARE short the stock, you know that everyone else has heard what Cramer and the sell-side analysts (the Missionaries, in game theory lingo) have said, and you have to assume that everyone else will act on this Common Knowledge (what everyone knows that everyone knows). The only logical thing for you to do is cover your short before everyone else covers their short, resulting in a classic short squeeze and a big up day. Now to be sure, this isn’t the story of every earnings announcement … sometimes even Marc Benioff and his lackeys can’t turn a pig’s ear of a quarter into a silk purse … but it’s an incredibly consistent behavioral result over time and one of the best examples I know of the Common Knowledge Game in action.
But wait, there’s more. Now let’s add the Fed’s storytelling and its Common Knowledge Game to Benioff’s storytelling and his Common Knowledge Game. Over the past five years there have been 43 days where the FOMC made a formal statement. If you owned Salesforce.com stock for only the 43 FOMC announcement days and the 21 earnings announcement days over the past five years, you would be UP 167%. If you owned Salesforce.com stock for the other 1,208 trading days, you would be DOWN 8%.
Okay, Ben, how about other stocks? How about entire indices? Well, let’s look again at that Alerian MLP index. Over the past five years, if you had owned the AMZ for only the 43 FOMC announcement days over that span, you would be UP 28%.If you owned it for the other 1,229 trading days you would be DOWN 39%. Over the past two years, if you had owned the AMZ for only the 16 FOMC announcement days over that span, you would be UP 18%. If you owned it for the other 487 trading days you would be DOWN 48%. Addition by subtraction to a degree that would make Lao Tzu proud.
I’ll repeat what I wrote in Optical Illusion / Optical Reality… it’s hard to believe that MLP investors should be paying a lot more attention to G-7 meetings and reading the Fed governor tea leaves than to gas field depletion schedules and rig counts, but I gotta call ‘em like I see ‘em. In fact, if there’s a core sub-text to Epsilon Theory it’s this: call things by their proper names. That’s a profoundly subversive act. Maybe the only subversive act that really changes things. So here goes. Today there are vast swaths of the market, like emerging markets and commodity markets and industrial/energy stocks, that we should call by their proper name: a derivative expression of FOMC policy. Used to be that only tech stocks were “story stocks”. Today, almost all stocks are “story stocks”, and the Common Knowledge Game is more applicable to helping us understand market behaviors and price action than ever before.
You see this phenomenon clearly in the entire S&P 500, as well, although not as starkly with a complete plus/minus reversal in performance between FOMC announcement days and all other days. Over the past five years, if you had owned the SPX for only the 43 FOMC announcement days over that span, you would be UP 17%. If you owned it for the other 1,229 trading days you would be UP 28%. Over the past two years, if you had owned the SPX for only the 16 FOMC announcement days over that span, you would be UP 5%. If you owned it for the other 487 trading days you would be UP 2%.
What do I take from eyeballing these charts? The Narrative effect and the impact of the Common Knowledge Game have accelerated over the past two years (ever since Draghi and Yellen launched the Great Monetary Policy Schism of June 2014); they’re particularly impactful during periods when stock prices are otherwise declining, and they’re spreading to broader equity indices. That’s what it looks like to me, at least.
So what does an investor do with these observations? Two things, I think, one a practical course of action and one a shift in perspective. The former being more fun but the latter more important.
First, there really is a viable research program here, and what I’ve tried to show in this brief note is that there really are practical implementations of the Common Knowledge Game that can support investment strategies dealing with story stocks. I want to encourage anyone who’s intrigued by this research program to take the data baton and try this on your favorite stock or mutual fund or index. You can get the FOMC announcement dates straight from the Federal Reserve website. This doesn’t require an advanced degree in econometrics to explore.
I don’t know where this research program ends up, but it’s my commitment to do this in plain sight through Epsilon Theory. Think of it as the equivalent of open source software development, just in the investment world. I suspect it’s hard to turn the Common Knowledge Game into a standalone investment strategy because you’re promising that you’ll do absolutely nothing for 98 out of 100 trading days. Good luck raising money on that. But it’s a great perspective to add to our current standalone strategies, especially actively managed funds. Stock-pickers today are being dealt one dull, low-conviction hand after another here in the Grand Central Bank Casino, and the hardest thing in the world for any smart investor, regardless of strategy, is to sit on his hands and do nothing, even though that’s almost always the right thing to do. Incorporating an awareness of the Common Knowledge Game and its highly punctuated impact makes it easier to do the right thing – usually nothing – in our current investment strategies.
And that gets us to the second take-away from this note. The most important thing to know about any Mysterious Stranger story is that the Stranger is the protagonist. There is no Hero! When you meet a Mysterious Stranger, your goal should be simple: survive the encounter.
This is an insanely difficult perspective to adopt, that we (either individually or collectively) are not the protagonist of the investing age in which we live. It’s difficult because we are creatures of ego. We all star in our own personal movie and we all hear the anthems of our own personal soundtrack. But the Mysterious Stranger is not an obstacle to be heroically overcome, as if we were Liam Neeson setting off (again! and again!) to rescue a kidnapped daughter in yet another “Taken” sequel. At some point this sort of heroism is just a reflection of bad parenting in the case of Liam Neeson, and a reflection of bad investing in the case of stock pickers and other clingers to the correlations and investment meanings of yesterday.
The correlations and investment meanings of today are inextricably entwined with central bankers and their storytelling. To be investmentsurvivors in the low-return and policy-controlled world of the Silver Age of the Central Banker, we need to recognize the impact of their words and incorporate that into our existing investment strategies, while never accepting those words naïvely in our hearts.
For the last six months I’ve been trying to figure out how to incorporate reader correspondence into Epsilon Theory. We’ve reached a point of both reader quantity (well more than 60,000 active email subscribers here at year end, >5x where we started the year) and reader quality (I’d put the sheer firepower of ET subscribers up against any distribution list in the world) such that it feels kinda silly and selfish to put this off any longer. Plus I think that for the Epsilon Theory project to take the next big step forward, it needs the sort of reader engagement you only get by opening a window for direct participation and expression. In exactly the same way that the greatest force in fundamentally unmoored markets is the power of the crowd watching the crowd, so do I want to apply those principles of the Common Knowledge Game to help grow Epsilon Theory itself.
It doesn’t have to be a huge participation window, as the last thing that the world needs is another snarkier-than-thou comments page with anonymous participation. I admire (and spend way too much time on) sites like ZeroHedge and Deadspin, but it’s not the turf I’m comfortable with. Of course, the only thing worse than an unfettered commentariat is a shackled commentariat. If there’s anything more sad and dull than the comments page you get on mainstream sites like ESPN and the WSJ, someone please tell me. Or better yet, don’t.
For a while I thought that a Bill Simmons-esque occasional Mailbag note (and of course I’m talking about pre-media mogul Bill Simmons here) might be the answer, but the trail that Simmons blazed for sports commentary just doesn’t work as well for market commentary. There’s a weight and permanence to market outcomes that I need to take seriously — with all due respect to long-suffering Jets fans and their chances of making it past the first round of the playoffs with Ryan Fitzpatrick as quarterback, I get emails from people whose actual livelihoods are on the line. Similarly there’s a gravity and a thoughtfulness to so much of the correspondence I receive, and I need to respect that, too. Sure, nothing would make me happier than to debate the top 5 Patrick Swayze movie quotes of all time (as if anyone could debate whether “Nobody puts Baby in a corner” gets the #1 slot), but I want the pop culture references to add a little flavor to a serious investment discussion, not the other way around.
So here’s the plan.
First, I’m going to start a regular podcast with my partner Jeremy Radcliffe (who, among other qualities, has a much better radio voice than I do) where we’ll be taking questions and reading from submitted emails and tweets to help drive the conversation. I’m as excited about this as anything we’ve done with Epsilon Theory. There’s a great vibe here, really good production values … definitely worth giving a try if you’re a podcast aficionado.
Second, we’re going to redesign the Epsilon Theory website to create a framework for short daily or near-daily blurbs that I’ll use to respond to selected reader comments or questions. I’ve been wanting to do this … forever … as there’s so much happening in the world that deserves a quick take from an Epsilon Theory perspective but doesn’t rise to the level of a full-fledged email note. Over time, we’ll use this function to allow for guest posts and new voices.
Third, we’re going to take several steps to improve access to prior Epsilon Theory notes, not just in terms of search but more importantly in terms of discovery. Check out the Quid website for a preview of what’s coming, but the basic idea is to create a “star map” of all prior Epsilon Theory notes with a graphical representation of the thematic clusters and thematic linkages between notes. It’s a fascinating graphical interface for content organization and display, and I think it has the potential to transform static blog archives into dynamic content discovery tools. If, like me, you always found the most interesting books on the library shelf near the book you were actually searching for, you’re going to love these Quid maps.
I’ll be giving regular progress updates on the new Epsilon Theory content and functions via Twitter, so if any of this interests you, please follow me there. I’m also open to ideas that readers might have on how to move this project forward.
What’s not changing? First and foremost, I’ll continue to tell the Epsilon Theory story in a way that tries to be passionate without being shrill, different without being fringe. Sometimes I’ll miss that mark, but at least it won’t be a dull ride. One of the reasons I want to start incorporating some new voices within the Epsilon Theory framework is that I do find myself sounding, as one reader commented, more and more “like my dad when he is railing away at the world we live in.” It’s true … I’m more easily annoyed these days. Certainly I’m overwhelmed by the political urges toward smiley-face fascism I see everywhere, as well as the seemingly inexhaustible stores of mendacity that wash over us daily. And yes, there’s a caricaturish-ness to that pose, which we all recognize in our fathers and any number of Tennessee Williams plays. I’m okay with that on a personal level, because it’s my honest reaction to the Golden Age of the Central Banker, but I don’t want Epsilon Theory to suffer the same fate as a sports team that stops listening to the voice of a head coach over time. I mean … if Nick Saban can bring in Lane Kiffin as his offensive coordinator, the least I can do is open up the Epsilon Theory sand box a bit.
I also remain committed to not taking myself too seriously, and as evidence I’ll conclude this State of the Union note with two other reader comments, each of which illustrates a wearying (and worrying) dimension of our social lives as market participants.
Please give concrete examples of your main points. For example: “This will cause Chinese Foxcon [sic] to go up in value because Apple will pay them in US dollars that will be exchanged for 20% more Chinese yuans.” A few sentences with specific examples would be much more useful than hurricane analogies.
Sorry, but you have me confused with a tout service RealMoney Pro. The day I have to start picking stocks in Epsilon Theory is the day I quit.
So what are you pimping with this newsletter? It reads like the writer ‘almost’ graduated from a community college before suffering a severe head trauma, and then started spit – balling on the Govt’s dime while suckling on the Obamacare teat. Is that you, Mike’s brother?
Geez, a simple “unsubscribe” email would suffice (and here’s a helpful tip for those so inclined … ALL CAPS and multiple exclamation points do not make the automated unsubscribe process more effective).
Lots of disturbingly angry guys out there these days (and yes, they’re all guys). Maybe it was always this way, but somehow I don’t think so. This guy signed his own name, which in a sense made his reaction even more disturbing, but usually the real haters – the guys who talk about killing you and your family – take refuge behind anonymous postings. For most I’m sure it’s like putting on a costume and acting a part. But for some I’m not so sure.
Still, if the disturbingly angry comments are the worst part of this project, it’s the other 99.99% of the comments and emails that are the best. Honestly, this is what keeps me going – the concrete knowledge that there is a vast reservoir of smart, well-intentioned market professionals who are nobody’s fools and are determined to find their own path in the narrower and narrower space between fringe and pablum. Thanks to all of you who have made Epsilon Theory part of your regular informational diet in 2015, and a special thanks to those of you who have taken the time to engage with the project through your correspondence and recommendations. And of course, a special thanks to my partners at Salient who continue to make this effort possible in the first place. It’s entirely the smart, non-myopic thing for us to do, but no less rare for that!
The Gross-out: the sight of a severed head tumbling down a flight of stairs. It’s when the lights go out and something green and slimy splatters against your arm.
The Horror: the unnatural, spiders the size of bears, the dead waking up and walking around. It’s when the lights go out and something with claws grabs you by the arm.
And the last and worst one: Terror, when you come home and notice everything you own has been taken away and replaced by an exact substitute. It’s when the lights go out and you feel something behind you, you hear it, you feel its breath against your ear, but when you turn around, there’s nothing there.
– Stephen King
You’re gonna need a bigger boat.
– “Jaws” (1975)
Back in my portfolio manager days, I was a really good short seller. I say that as a factual observation, not a brag, as it’s not a skill set that’s driven by some great intellectual or character virtue. On the contrary, most short sellers are, like me, highly suspicious of all received wisdom (even when it is, in fact, wise) and have weirdly over-developed egos that feed on the notion of “I’m right even though the world says I’m wrong”. But what set me apart as a short seller were two accidents of experience. First, I didn’t come out of Wall Street, so I wasn’t infected with the long-bias required of those business models. Second, my professional career prior to investing was all about studying mass behaviors and the informational flows that drive those behaviors.
Here’s why that’s important. The biggest difference between shorting and going long is that shorts tend to work in a punctuated fashion. One day I’ll write a full note on the Information Theory basis for this market fact, but the intuition is pretty simple. There’s a constant flow of positive information around both individual stocks (driven by corporate management) and the market as a whole (driven by the sell-side), and as a result the natural tendency of prices is a slow grind up. But occasionally you’ll receive an informational shock, which is almost always a negative, and the price of a stock or the overall market will take a sharp, punctuated decline. The hardest decision for a short seller is what to do when you get this punctuated decline. Do you cover the short, pocket a modest gain, and look to re-establish the position once it grinds higher, as it typically does? Or do you press the short on this informational validation for your original negative thesis? It’s an entirely different mindset than that of most long-only investors, who – because they have the luxury of both time and informational flow on their side – not only tend to add to their positions when the stock is working (my thesis is right, and I’m raising my target price!) but also tend to add when it’s not working (my thesis is right, and this stock is on sale!).
Solving the short seller’s dilemma requires answering one simple question: is the story broken?Is the informational shock sufficient to force long-only investors to doubt not just their facts, but – much more crucially – their beliefs, thus turning them into sellers, too? The facts of the informational shock are almost immaterial in resolving the short seller’s dilemma. Your personal beliefs about those facts are certainly immaterial. The only thing that matters is whether or not the river of information coming out of the sell-side has shifted course in a way that swamps the old belief structures and establishes new Common Knowledge.
In the meantime, what we’ve been experiencing in markets is the plain and simple fear that always accompanies a broken story. The human reaction to a broken story is an emotional response akin to a sudden loss of faith. It’s a muted form of what Stephen King defined as Terror … the sudden realization that the helpful moorings you took for granted are actually not supporting you at all, but are at best absent and at worst have been replaced by invisible forces with ill intent. The antidote to Terror? Call the boogeyman by his proper name. It’s the end of the China growth story, one of the most powerful investment Narratives of the past 20 years. And that’s very painful, as the end of something big and powerful always is. It will require investors to adapt and adjust if they want to thrive. But it’s not MORE than that. It’s not a sign of the investment apocalypse. It’s the end of one investable story, soon to be replaced with another investable story. Because that’s what we humans do.
Here’s a great illustration of what fear looks like in markets, courtesy of Salient’s Deputy CIO and all-around brilliant guy, Rusty Guinn.
These are the cumulative pro forma (i.e., purely hypothetical) returns generated by selling (shorting) the high volatility S&P 500 stocks and buying an off-setting amount of the low volatility stocks (0% net exposure, 200% gross exposure). The factor is up 10% YTD and 15% from the lows in May. Now just to be clear, this is not an actual investment strategy, but is simply a tool we use to identify what factors are working in the market at any point in time. There are any number of ways to construct this indicator, but they all show the same thing – investors have been embracing low volatility (low risk) stocks ever since Greece started to break the European stability story this summer, and that dynamic has continued with the complete breakdown of the China growth story. This is what a flight to safety looks like when you don’t trust bonds because you think the Fed is poised for “lift-off”. This is the fear factor.
Three final Narrative-related points…
First, while the breakdown in the China growth story has reached a tipping point over the past week, this is just the culmination in what has been a two year deterioration of the entire Emerging Market growth story. The belief system around EM’s has been crumbling ever since the Taper Tantrum in the summer of 2013, and it’s the subject of one of the most popular Epsilon Theory notes, “It Was Barzini All Along”. Everything I wrote then is even more applicable today.
Second, I see very little weakness in either the US growth story (best house in a bad neighborhood, mediocre growth but zero chance of recession) or the Narrative of Central Bank Omnipotence. Do I think that the Fed is being stymied in its desire to raise short rates in order to reload its monetary policy gun with conventional ammo? Yes, absolutely. Do I see a significant diminution in the overwhelming investor belief that the Fed and the ECB control market outcomes? No, I don’t. Trust me, I’m keeping my eyes peeled (see “When Does the Story Break?”), because in many respects this is the only question that matters. If this story breaks, then in the immortal words of Chief Brody when he first saw the shark, “You’re gonna need a bigger boat.”
Third, while I’m relatively sanguine about the China growth story breaking down, as I’m confident that there’s a value story waiting in the wings here, I’ll be much more nervous if the China political competence story continues to deteriorate. This is a completely different Narrative than the growth story, and it’s the story that one-party States rely on to prevent even the thought of a viable political opposition. In highly authoritarian one-party nations – like Saddam’s Iraq or the Shah’s Iran – you’ll typically see the competence Narrative focused on the omnipresent secret police apparatus. In less authoritarian one-party nations – like Lee Kuan Yew’s Singapore or Deng Xiaoping’s China – the competence Narrative is more often based on delivering positive economic outcomes to a wide swath of citizens (not that these regimes are a slouch in the secret police department, of course).From a political perspective, this competence Narrative is THE source of legitimacy and stability for a one-party State. In a multi-party system, you can vote the incompetents (or far more likely, the perceived incompetents) out of office and replace them peacefully with another regime. That’s not an option in a one-party State, and if the competency story breaks the result is always a very dicey and usually a violent power transition. I am seeing more and more trial balloons being floated in the Western media (usually with some sort of Murdoch provenance) that indicate “dissatisfaction” with this or that cadre. And it’s not just a markets story any more, as grumblings over the Tianjin fire disaster appear to me to have grown louder over the past week. I haven’t seen this sort of signaling coming out of China in 20 years, and it certainly bears close watching.
See, if I derive an equilibrium where prevalance is a non-singular event where nobody loses, can you imagine the effect that would have on conflict scenarios, arms negotiations …
When did you last eat?
… currency exchange …
When did you last eat? You know, food.
You have no respect for cognitive reverie, you know that?
Yes. But pizza – now pizza I have enormous respect for. And of course beer. [leaves]
[throws stuff down and follows] I have respect for beer. I have respect for beer!
– “A Beautiful Mind” (2001), biopic of game theorist John Nash (1928 – 2015).
If people do not believe that mathematics is simple, it is only because they do not realize how complicated life is.
Young man, in mathematics you don’t understand things. You just get used to them.
There’s no sense in being precise when you don’t even know what you’re talking about.
It is just as foolish to complain that people are selfish and treacherous as it is to complain that the magnetic field does not increase unless the electric field has a curl. Both are laws of nature.
– Four from John von Neumann(1903 – 1957), the father of modern game theory.
I’m interested in the fact that the less secure a man is, the more likely he is to have extreme prejudice. – Clint Eastwood (b. 1930)
Insecurity is the worst sense that lovers feel; sometimes the most humdrum desireless marriage seems better. Insecurity twists meanings and poisons trust. – Graham Greene, “The End of the Affair” (1951)
If freedom is short of weapons, we must compensate with willpower.
– Adolph Hitler (1889 – 1945)
One constant among the elements of 1914 – as of any era – was the disposition of everyone on all sides not to prepare for the harder alternative, not to act upon what they suspected to be true.
– Barbara Tuchman, “The Guns of August” (1962)
In a significant move to deter possible Russian aggression in Europe, the Pentagon is poised to store battle tanks, infantry fighting vehicles and other heavy weapons for as many as 5,000 American troops in several Baltic and Eastern European countries, American and allied officials say.
Be careful who you call your friends. I’d rather have four quarters than one hundred pennies. – Al Capone (1899 – 1947)
We are all impaled on the crook of conditioning.
– James Dean (1931 – 1955)
There’s nothing stable in the world; uproar’s your only music.
– John Keats (1795 – 1821)
I went on a boat ride.
A three hour tour.
They told me I was precious cargo that couldn’t be insured because of inherent vice.
What does that mean?
I don’t know.
Inherent vice in a maritime insurance policy is anything that you can’t avoid. Eggs break, chocolate melts, glass shatters, and Doc wondered what that meant when it applied to ex old ladies.
– “Inherent Vice” (2014)
I was at a conference, on deck for a presentation, and I had the chance to listen to the Q&A for the speaker ahead of me.
“Assuming no external shock, how much longer can this bull market run?”
The speaker, not exactly the most sparkling of raconteurs under the best of circumstances, first replied with the obligatory, “well, that’s a very good question”, and then proceeded to give a detailed, bone-dry explication of exactly how long he thought this market would run, the likely level of the S&P 500 top, and a few winning sectors and stock picks for good measure. It all sounded very smart, and I’m sure he was … smart, that is. But boy oh boy, if there were ever a living embodiment of von Neumann’s dictum that being precise is all too often a waste of time, this was it.
Because this wasn’t “a very good question”. It was, in fact, a pretty useless question, the functional equivalent of asking a botanist how big a tree can grow in the absence of storms, droughts, fires, blights, lightning, insects, or whatever. Answer: pretty darn big. Better answer: who cares? You don’t need my help with an investment strategy for a paradise scenario, any more than you need my help with an investment strategy for a doomsday scenario. But where we could all use some help is with an investment strategy for the Real World in-between paradise and doomsday. What we all need is a good perspective or vantage point for differentiating between this potential shock and that potential shock, for evaluating what signals to press and what signals to fade. It’s not a matter of predicting shocks, but rather a matter of reacting to incipient shocks smartly and strategically, of knowing, in the immortal words of Kenny Rogers, when to hold ‘em and when to fold ‘em. Now that’s a good question, and it’s one that Epsilon Theory is well suited to take on.
There’s a specific sort of instability in the world today – a game theoretic instability – which means that it has an identifiable pattern and rhythm you can understand in order to improve your investment strategy. It’s the instability of the game of Chicken, and once you start looking for it, you will see it everywhere here in the Golden Age of the Central Banker. Greece vs. the Troika? Chicken. Western sanctions on Russia over the Ukraine? Chicken. OPEC vs. US energy producers? Chicken. ECB vs. the Swiss National Bank? Chicken. Fed monetary policy communications to markets? Chicken. Abenomics? Chicken. US policy towards China? Chicken. ISIS vs. the world? Chicken.
Let me take a minute to describe why a game of Chicken is particularly and peculiarly unstable, because understanding the game’s dynamics is crucial for understanding how and why Chicken has become the defining strategic interaction of nations and institutions today, just as it was in the 1930s, the 1910s, and the 1870s. To make that description, I’ll be drawing on the concept of the Nash equilibrium, the most influential insight of mathematician John Nash, whose early career and lifelong struggle with mental illness was portrayed in the great movie “A Beautiful Mind”, and who was killed last month in a car accident at the age of 87 (I’d like to think that his not wearing a seatbelt while traveling on the New Jersey Turnpike was a game theoretic exercise, but that’s the Keats-ian Romantic in me talking).
The central idea of the Nash equilibrium is that a non-cooperative strategic interaction between players (for simplicity’s sake we’ll just talk about two player games, although the concept is applicable for any number of independent players) is in balance, i.e. in equilibrium, if neither player prefers to “move” from the current game position after consideration of both his preferences and potential moves AND his opponent’s preferences and potential moves AND the knowledge that both of you are thinking about the other in this manner. The Nash equilibrium takes seriously the notion that the other player is just as smart as you are and, as importantly, just as strategic as you are – meaning that both of you can look several moves ahead, and both of you are making moves that are contingent on the other player’s moves. Like all great ideas the Nash equilibrium seems simple at first blush, but it’s a deceptive simplicity, one that when applied rigorously can shed light on a raft of social interactions that otherwise seem irrational or unpredictable.
I’ll start with a common game that has a straightforward Nash equilibrium, the Prisoner’s Dilemma. I’ve written about this game in several prior notes, so I won’t go into detail here about its meaning. It’s just an example to explain the nomenclature. Below is the standard way of depicting a game between two players – in this case you and Al Capone – with each player having two behavioral choices – in this case Silence or Rat – and with the game payoffs in red for you and green for Al. The infamous Prisoner’s Dilemma outcome, where both you and Al rat on each other even though you both suffer more than you have to, is marked with the light blue oval and is the stable Nash equilibrium.
The Rat-Rat outcome is a Nash equilibrium because you don’t want to change from Rat behavior to Silence behavior (moving from the bottom right quadrant to the upper right quadrant) because your red payoff declines from -5 to -10. Ditto for Al Capone. He’s not changing his behavior from Rat to Silence (moving from the bottom right quadrant to the bottom left quadrant), as his green payoff would be worse for making the move. More interestingly, the Rat-Rat outcome is a highly predictable Nash equilibrium because no matter what quadrant or combination of behaviors you and Al start with, the game always ends up in the bottom right quadrant. Why? Because this is a non-cooperative game. Even if you and Al start in the happy upper left quadrant of Silence-Silence, where there is a +10 total utility to the shared outcome, there’s no way for Al to prevent you from choosing Rat behavior and boosting your personal payoff from +5 to +10. That wouldn’t be so bad in and of itself, but your choice to move from Silence to Rat is accompanied by Al’s payoff changing from +5 to -10, and that’s intolerable for him. So he decides to switch his behavior from Silence to Rat, to get out of what’s called the “sucker payoff” of the bottom left quadrant if that’s where you were planning to put him, or to put the sucker payoff of the upper right quadrant onto you if you were keeping your mouth shut after all. Of course, you are thinking about Al Capone in exactly the same way, and both of you know that both of you are thinking in this manner. All this combines to make the Rat-Rat outcome a very speedy equilibrium solution to the Prisoner’s Dilemma.
Now here’s the layout for the game of Chicken.
You and James Dean are each driving your car towards the cliff’s edge, but unfortunately for both you and James there isn’t a single Nash equilibrium for this game. Obviously it’s disastrous for both of you to stay in the lower right quadrant where you’re both dead and leaving behind pretty corpses. But why should you stop your car and enter the stable but embarrassing Nash equilibrium of the upper right quadrant (-10 for you, +10 for him) when it would be just as easy for James Dean to stop his car and move both of you into the far more enjoyable and just as stable Nash equilibrium of the lower left quadrant? A game of Chicken has two Nash equilibria, each just as likely as the other, each just as “natural” an outcome as the other. This is the inherent vice of the game of Chicken – it is impossible to predict the outcome of the game by looking at the fundamentals of the game. It is inherently unpredictable – not because we don’t know enough facts about the situation or because we’re not smart enough to analyze the situation – but because it is the mathematical nature of this particular beast.
I’m often asked what I think the outcome of the negotiations between Greece and the Troika will turn out to be. Will Greece leave the Euro and default on its debt? Will Germany blink? And when I answer the question by saying that I don’t know, I can feel the disappointment. Don’t you even have an opinion, Ben? You seem to know a lot of the facts here, or at least you talk a good game about domestic Greek politics and multi-level game-playing. What good is game theory and all your knowledge if you can’t even handicap the odds of a Greek default?
Game theory is useful precisely because it tells me that there is no fundamentals-based or structural methodology to handicap the odds of a Greek default! Sometimes the answer to a mathematical question is the same as the answer to a prayer or the answer to a Magic 8 Ball: NO. There is no greater understanding possible here through the use of science and mathematics. To paraphrase Von Neumann again, get used to it.
In my stump speech about investing in the Golden Age of the Central Banker, I always start by making the distinction between decisions under risk and decisions under uncertainty. In a decision under risk, you know the possible outcomes of a decision and you have a rough sense of the probabilities to associate with those outcomes. In a decision under uncertainty, you either don’t know the possible outcomes or it’s impossible to assign meaningful probability distributions to those outcomes. What’s at stake in the distinction between the two? All of modern portfolio theory and all of mainstream macroeconomic theory and all of econometric modeling – ALL of it – is based on the assumption that everyone in the world is making decisions under risk. Violate that assumption – an assumption that is as deeply buried and indecipherably written within the edifice of academic economics today as the assumption that “a nationwide decline in home prices is impossible” was deeply buried and indecipherably written within the edifice of $10 trillion worth of residential mortgage-backed securities in 2008 – and your portfolio risk analysis suddenly has a hole big enough to drive a truck through. Game theory provides a perspective and a toolkit to distinguish between decisions under risk and decisions under uncertainty. It can’t work miracles by predicting the outcome of something that’s inherently unpredictable, but it can identify the situations that are unpredictable and suggest coping mechanisms for dealing with them. And that’s a lot. It can also highlight the situations where you have made a category error, where you have a misplaced confidence in your existing risk management toolkit or perspective. And that’s a lot, too.
So what does determine the outcome of a game of Chicken? Surely it’s not just a random outcome? Well, no, it’s not random, but you’re not going to like the answer I have for you any better. The game of Chicken is not a test of power and capabilities. It is a test of will. It is governed by constructed signals of resolve, control, and – occasionally – lack of control. It is governed by Narratives, particularly by political Narratives when the game is played on an international stage. Cooler heads rarely prevail in a game of Chicken, even if they’re objectively the stronger player. Because we’re all smart enough to know how to play the game, and because we know that the other players are going around and around in their heads trying to figure it out just like we are, the game of Chicken breeds insecurity, doubt, and miscalculation like no other. Play the game enough times and it will break you. It’s un-insurable, plagued by inherent vice, and that means that it’s un-investable, too.
I promised that game theory could provide some coping mechanisms for dealing with technically uncertain (as opposed to merely risky) investment or policy environments, and I’ll write briefly about three in this note. The first two are methods for gauging which equilibrium the game of Chicken is moving towards by evaluating the relative strength of the competing player Narratives. The third is a more general observation about gameplay and timing.
First, watch for acceleration and deceleration in behaviors, not absolute levels of speed. Technically speaking, second derivatives are always more influential than first derivatives as signaling devices because they contain more information (data that makes you change your mind; see “Sometimes A Cigar is Just a Cigar” for a primer on Information Theory), and third derivatives are even more powerful. More colloquially, it’s not whether your car is going faster than James Dean’s, it’s whether you are accelerating your speed more than James is accelerating his speed. Better yet, it’s whether you start to accelerate at a faster rate than you were a second ago. Remember, the game of Chicken is all about intentions and willpower, not capabilities and structure, and pressing down on the gas pedal is the only structural (or to use a $10 word, endogenous) method of communicating those intentions.
Three quick examples of the primacy of change (and change of change) in determining market outcomes in Chicken environments:
What was the Fed Narrative that brought markets back from the abyss in the spring and summer of 2009? Answer: “green shoots” – the notion that even though the US and global economy were still declining, they were getting worse at a decelerating rate.
What was the market reaction to Bernanke’s summer of 2013 Narrative that the Fed was not going to put on the brakes, but they were going to “ease off the accelerator” a bit? Answer: Taper Tantrum – a sharp decline in almost all asset classes in almost every market around the world, as investors reacted to the change in intentions signaled by the Fed (for more on this, see one of my first Epsilon Theory notes, “2 Fast 2 Furious”).
Now fast forward to today and ask yourself why we are NOT seeing a similar sell-off in global markets as the Fed very publicly goes about its business of preparing to raise short rates. Answer: because from a second derivative perspective putting on the brakes is the same thing as taking your foot off the accelerator. Deceleration is deceleration; you’re just crossing the zero-line when you put your foot on the brake. There is no essential change in intentions from the Taper Tantrum to today, and that’s why this Narrative-dominated market continues to set new highs.
Second, watch for self-binding behaviors, particularly suicidal self-binding behaviors. These are very powerful Narratives for signaling intentions, and they are variations of the classic Chicken-winning strategies of ripping your brakes or steering wheel out of the car, or acting so crazy that your opponent believes that you prefer death to defeat.
By suicidal self-binding behaviors I mean politically suicidal, like John Boehner’s go-to move in negotiations with the White House, where he “has no choice” but to take a hard line or else face a revolt from the Republican caucus, but I also mean physically suicidal. And before you say that this is only something that ISIS jihadists would do, consider that last week the US Defense Department floated a trial balloon in The New York Times saying that they were considering moving up to 5,000 US troops into Baltic and Eastern European countries. Now the press articles emphasized all the tanks and equipment that would be pre-positioned there, making it seem as if this would be a very potent fighting force, ready to take on a new Evil Empire if one materialized from Moscow. Please. These soldiers would be in Eastern Europe for exactly the same reason we stationed US soldiers in West Berlin during the Cold War: they are there to die. In the event of a Russian attack, their job is to be killed so that the resulting hue and cry would guarantee an all-out NATO military response. Sorry, but it’s true. It’s a classic “tripwire” strategy, and the thing about tripwires is that they have to be broken in order to work. Of course, the Russians know exactly what the moves are here, which makes them less likely to engage in full-frontal military actions in the first place, which is exactly the Pentagon’s goal. It’s an effective way of playing the game of deterrence, which is a form of Chicken, but less effective and more risky the deeper you place the tripwire into Russia’s sphere of influence. Color me nervous. Really, I don’t see how the game is worth the candle here.
Third, there is one redeeming quality about the game of Chicken – it takes a long time to play. Unlike the Prisoner’s Dilemma, where you typically get to the single Nash equilibrium so fast it makes your head spin (and usually too quickly to react effectively in your portfolio), Chicken players tend to have a mutual interest in pushing back the day of reckoning as much as they can. That’s because no matter how confident you are that you’re “winning” with your clever signals and Narratives, neither your true will nor your opponent’s true will are knowable or observable directly. Chicken is a game played through a glass, darkly. It’s ultimately as unpredictable for the players as it is for investors, and if there’s one group that hates unpredictability even more than professional investors it’s professional politicians.
The upshot of all this for investors is two-fold:
Take your time in dis-engaging from the game. Yes, a game of Chicken is inherently unpredictable and hence inherently un-investable, but you have plenty of time to exit. Moreover, the passage of time can often make the ultimate car crash much less painful. For example, while a Greek default and Euro exit will spark trouble no matter when it occurs, it’s absolutely less destabilizing today with most of the debt in the hands of the Troika than three years ago when that debt was spread all over the private banking sector.
Don’t freak out on any individual signal or Missionary statement, but don’t ring the all-clear bell, either. Because Chicken is a game of constructed signals and Narratives signifying hidden will and intentions, there’s almost always “room” for players to volley market-moving statements back and forth, regardless of the objective or structural characteristics at hand. In other words, it is virtually impossible for a single signal to push the outcome into either Nash equilibrium. When does time run out in a game of Chicken? When you see competing Narratives of “we have no choice” you’ve entered the death spiral phase of the game. That’s when it’s time to head for the hills, and quickly.
I’ll close this note with the same line that I find myself using over and over again. The Golden Age of the Central Banker is a time for investment survivors, not investment heroes, and the ubiquity of inherently unstable games of Chicken is a big reason for that advice. There’s no shame in picking your battles, in recognizing what’s investable and what’s not. There’s also no reason to panic. But it’s not easy to make that differentiation if you’re looking at an uncertain world through risk-colored glasses. Time for a new set of lenses, one that takes seriously the patterns of strategic interaction and behavioral dynamics that rocked the world in the 1870s, the 1910s, the 1930s, and … I suspect … the years immediately ahead of us.
Neurosis is the inability to tolerate ambiguity. – Sigmund Freud (1886 – 1939)
To learn which questions are unanswerable, and not to answer them: this skill is most useful in times of stress and darkness. – Ursula K. Le Guin, “The Left Hand of Darkness” (1969)
Is everything connected, so that events create resonances like ripples across a net? Or do things merely co-occur and we give meaning to these co-occurrences based on our belief system? Lieh-tzu’s answer: it’s all in how you think. – “The Liezi”, ancient Taoist text attributed to Lie Yukou (c. 400 BC)
She’s a replicant, isn’t she?
I’m impressed. How many questions does it usually take to spot them?
I don’t get it, Tyrell.
How many questions?
Twenty, thirty, cross-referenced.
It took more than a hundred for Rachael, didn’t it?
[realizing Rachael believes she’s human] She doesn’t know.
She’s beginning to suspect, I think.
Suspect? How can it not know what it is?
– “Bladerunner” (1982)
I remember when I was a very little girl, our house caught on fire. I’ll never forget the look on my father’s face as he gathered me up In his arms and raced through the burning building out to the pavement. I stood there shivering in my pajamas and watched the whole world go up in flames. And when it was all over I said to myself. “Is that all there is to a fire?” – Jerry Lieber and Mike Stoller, “Is That All There Is?”, as recorded by Peggy Lee (1969)
I call our world Flatland, not because we call it so, but to make its nature clearer to you, my happy readers, who are privileged to live in Space. – Edwin A. Abbott, “Flatland: A Romance of Many Dimensions” (1884)
Homey don’t play that game.
– Damon Wayans, “In Living Color” (1992)
There’s only one question that matters today in markets: why is the government bond market going up and down like a yo-yo? How is it possible that the deepest and most important securities in the world are currently displaying all the trading stability of a biotech stock?
As with all market questions of singular importance and vast attention, these are questions of meaning. We seek the why and we seek the cause because we are desperate to understand what it means. We are – all of us – convinced that this market behavior must mean something profound. Surely this insane quivering within the bond market means that we are on the cusp of a quantum shift in the market landscape. Surely this is the rumbling of a deep tectonic plate that presages a massive earthquake. Surely, as more than one Master of the Universe proclaimed at SALT the other week, the long-awaited bear market in government debt is nigh.
Maybe. Or maybe all those Masters of the Universe are just talking their book. I know … shocking.
We are all market neurotics today, in the Freudian sense of the word, incapable of handling ambiguity in Narrative after 5+ years of global coordination and cooperation among The Monetary Powers That Be, 5+ years of being told by a monolithic Voice of Command how we should think about every single data point that crosses our Bloomberg screen. This is the most hated bull market in history, precisely because we all believe that it is a creature of policy and Narrative, and when the Voices are silent or they say conflicting things, we start to freak out. We run from pillar to post, getting whipsawed at every turn. Importantly, the whipsawing is occurring in the securities that are most closely linked to policy and Narrative – government bonds – and that’s why I believe that what we’re experiencing is more akin to neurosis than some shift in market fundamentals.
Here’s my point: volatility ≠ instability. Or more precisely, a system can be volatile or unstable in a local sense but highly stable in a global sense.
Unfortunately, however, because we live in the local rather than the global … because every bit of our modern financial services system, particularly financial media, is by business necessity focused on the local rather than the global … we are as unaware of our true positioning in the world as Rachael in “Bladerunner”. Or Deckard, who sure seems like a replicant to me. From a local perspective these bond market gyrations make it seem as if we are totally unmoored and markets are on the brink of some life-altering change. From a global perspective, however, this is a tempest in a teacup.Or to paraphrase the late, great Peggy Lee, is that all there is to a bond market fire?
Okay, Ben, that’s quite a mouthful: “unstable in a local sense but highly stable in a global sense”. Translation, please?
The Rosetta Stone here is Information Theory, and to introduce that it’s probably easiest if I quote directly and extensively from one of my very earliest Epsilon Theory notes, “Through the Looking Glass”. I wrote this almost exactly 2 years ago, back when I only had a few hundred readers, so it should be fresh for 99% of the audience. It’s a lot to digest, but I promise that you won’t see markets in the same way once you finish. Information Theory is, in fact, the beating heart of Epsilon Theory. That said, one of the beautiful things about releasing content into the wild is that readers can do with it what they will. For the TLDR / Short Attention Span Theatre crowd, click here to skip to the chase on page 10.
Defining the strength of a signal as the degree to which it changes assessments of future states of the world dates back to Claude Shannon’s seminal work in 1948, and in a fundamental way back to the work of Thomas Bayes in the 1700’s. Here’s the central insight of this work: information is measured by how much it changes your mind. In fact, if a signal doesn’t make you see the world differently, then it has zero information. As a corollary, the more confident you are in a certain view of the world, the more new information is required to make you have the opposite view of the world and the less information is required to confirm your initial view. There’s no inherent “truth” to any signal, no need to make a distinction between (or even think of) this signal as having true information and that signal as having false information. Information is neither true nor false. It is only more or less useful in our decision-making, and that’s a function of how much it makes us see the world differently. As a result, the informational strength of any signal is relative. The same signal may make a big difference in my assessment of the future but a tiny difference in yours. In that case, we are hearing the same message, but it has a lot of information to me and very little to you.
Let’s say that you are thinking about Apple stock but you are totally up in the air about whether the stock is going up or down over whatever your investment horizon might be, say 1 year. Your initial estimation of the future price of Apple stock is a coin toss … 50% likelihood to be higher a year from now, 50% likelihood to be lower a year from now. So you do nothing. But you start reading analyst reports about Apple or you build a cash-flow model … whatever it is that you typically do to gather information about a potential investment decision.
The graph below shows how Information Theory would represent the amount of signal information (generically represented as bits) required to change your initial assessment of a 50% likelihood of Apple stock going up over the next year to a post-signaling assessment of some new percentage likelihood. These are logarithmic curves, so even relatively small amounts of information (a small fraction of a generic bit) will change your mind about Apple pretty significantly, but more and more information is required to move your assessment closer and closer to certainty (either a 0% or a 100% perceived likelihood of the stock going up).
Of course, your assessment of Apple is not a single event and does not take place at a single point in time. As an investor you are constantly updating your opinion about every potential investment decision, and you are constantly taking in new signals. Each new update becomes the starting point for the next, ad infinitum, and as a result all of your prior assessments become part of the current assessment and influence the informational impact of any new signal.
Let’s say that your initial signals regarding Apple were mildly positive, enough to give you a new view that the likelihood of Apple stock going up in the next year is 60%. The graph below shows how Information Theory represents the amount of information required to change your mind from here. The curves are still logarithmic, but because your starting point is different it now only requires 80% of the information as before to get you to 100% certainty that Apple stock will go up in the next year (0.8 generic bits versus 1.0 generic bits with a 50% starting estimation). Conversely, it requires almost 140% of the same negative information as before to move you to certainty that Apple stock is going down.
What these graphs are showing is the information surface of your non-strategic (i.e., without consideration of others) decision-making regarding Apple stock at any given point in time. Your current assessment is the lowest point on the curve, the bottom of the informational “trough”, and the height of each trough “wall” is proportional to the information required to move you to a new assessment of the future probabilities. The higher the wall, the more information required in any given signal to get you to change your mind in a big way about Apple.
Now let’s marry Information Theory with Game Theory. What does an information surface look like for strategic decision-making, where your estimations of the future state of the world are contingent on the decisions you think others will make, and where everyone knows that everyone is being strategic?
I’m assuming we’re all familiar with the basic play of the Prisoner’s Dilemma, and if you’re not just watch any episode of Law and Order. Two criminals are placed in separate rooms for questioning by the police, and while they are both better off if they both keep silent, each is individually much better off if he rats his partner out while the partner remains silent. Unfortunately, in this scenario the silent partner takes the fall all by himself, resulting in what is called the “sucker pay-off”. Because both players know that this pay-off structure exists (and are always told that it exists by the police), the logical behavior for each player is to rat out his buddy for fear of being the sucker.
Below on the left is a classic two-player Prisoner’s Dilemma game with cardinal expected utility pay-offs as per a customary 2×2 matrix representation. Both the Row player and the Column player have only two decision choices – Rat and Silence – with the joint pay-off structures shown as (Row , Column) and the equilibrium outcome (Rat , Rat) shaded in light blue.
The same equilibrium outcome is shown below on the right as an informational surface, where both the Row and the Column player face an expected utility hurdle of 5 units to move from a decision of Rat to a decision of Silence. For a move to occur, new information must change the current Rat pay-off and/or the potential Silence pay-off for either the Row or the Column player in order to eliminate or overcome the hurdle. The shape of the informational surface indicates the relative stability of the equilibrium as the depth of the equilibrium trough, or conversely the height of the informational walls that comprise the trough, is a direct representation of the informational content required to change the conditional pay-offs of the game and allow the ball (the initial decision point) to “roll” to a new equilibrium position. In this case we have a deep informational trough, reflecting the stability of the (Rat , Rat) equilibrium in a Prisoner’s Dilemma game.
Now let’s imagine that new information is presented to the Row player such that it improves the expected utility pay-off of a future (Silence, Rat) position from -10 to -6. Maybe he hears that prison isn’t all that bad so long as he’s not a Rat. As a result the informational hurdle required by the Row player to change decisions from Rat to Silence is reduced from +5 to +1.
The (Rat , Rat) outcome is still an equilibrium outcome because neither player believes that there is a higher pay-off associated with changing his mind, but this is a much less stable equilibrium from the Row player’s perspective (and thus for the overall game) than the original equilibrium.
With this less stable equilibrium framework, even relatively weak new information that changes the Row player’s assessment of the current position utility may be enough to move the decision outcome to a new equilibrium. Below, new information of 2 units changes the perceived utility of the current Rat decision for the Row player from -5 to -7. Maybe he hears from his lawyer that the Mob intends to break his legs if he stays a Rat. This is the equivalent of “pushing” the decision outcome over the +1 informational hurdle on the Row player’s side of the (Rat , Rat) trough, and it is reflected in both representations as a new equilibrium outcome of (Silence , Rat).
This new (Silence , Rat) outcome is an equilibrium because neither the Row player nor the Column player perceives a higher expected utility outcome by changing decisions. It is still a weak equilibrium because the informational hurdle to return to (Rat , Rat) is only 1 informational unit, but all the same it generates a new behavior by the Row player: instead of ratting out his partner, he now keeps his mouth shut.
The Column player never changed decisions, but moving from a (Rat , Rat) equilibrium to a (Silence , Rat) equilibrium in this two time-period example resulted in an increase of utility from -5 to +10 (and for the Row Player a decrease from -5 to -6). This change in utility pay-offs over time can be mapped as:
Replace the words “Column Utility” with “AAPL stock price” and you’ll see what I’m going for. The Column player bought the police interrogation at -5 and sold it at +10. By mapping horizontal movement on a game’s informational surface to utility outcomes over time we can link game theoretic market behavior to market price level changes.
Below are two generic examples of a symmetric informational structure for the S&P 500 and a new positive signal hitting the market. New signals will “push” any decision outcome in the direction of the new information. But only if the new signal is sufficiently large (whatever that means in the context of a specific game) will the decision outcome move to a new equilibrium and result in stable behavioral change.
In the first structure, there is enough informational strength to the signal to overcome the upside informational wall and push the market to a higher and stable price equilibrium. In the second structure, while the signal moves the market price higher briefly, there is not enough strength to the signal to change the minds of market participants to a degree that a new stable equilibrium behavior emerges.
All market behaviors – from “Risk-On/Risk-Off” to “climbing a wall of worry” to “buying the effin’ dip” to “going up on bad news” – can be described with this informational structure methodology.
For example, here’s how “going up on bad news” works. First, the market receives a negative Event signal – a poor Manufacturing ISM report, for example – that is bad enough to move the market down but not so terrible as to change everyone’s mind about what everyone knows that everyone knows about the health of the US economy and thus move the market index to a new, lower equilibrium level.
Following this negative event, however, the market then receives a set of public media signals – a Narrative – asserting that in response to this bad ISM number the Fed is more likely to launch additional easing measures. This Narrative signal is repeated widely enough and credibly enough that it changes Common Knowledge about future Fed policy and moves the market to a new, higher, and stable level.
So what is the current informational structure for the S&P500? Well, it looks something like this:
The market equilibrium today is like a marble sitting on a glass table. It is an extremely unstable equilibrium because the informational barriers that keep the marble from rolling a long way in either direction are as low as they have been in the past five years. Even a very weak signal is enough to push the marble a long way in one direction, only to have another weak signal push it right back. This is how you get big price movements “for no apparent reason”.
Why are the informational barriers to equilibrium shifts so low today? Because levels of Common Knowledge regarding future central bank policy decisions are so low today. The Narratives on both sides of the collective decision to buy or sell this market are extremely weak. What does everyone know that everyone knows about Abenomics? Very little. What does everyone know that everyone knows about Fed tapering? Very little. What does everyone know that everyone knows about the current state of global growth? Very little. I’m not saying that there’s a lack of communication on these subjects or that there’s a lack of opinion about these subjects or that there’s a lack of knowledge about these subjects. I’m saying that there’s a lack of Common Knowledge on these subjects, and that’s what determines the informational structure of a market.
I wrote all that right before the Fed’s Taper Tantrum in the summer of 2013, which can be understood using this Information Theory framework as a massive public relations effort by Bernanke et al to create a new Common Knowledge structure that would shape the informational contours of the market. The immediate signal of this initial effort at “communication policy” was a big red arrow pointing left, and almost all asset classes everywhere around the world took a dive as the strong signal sent the equilibrium marble skittering to the downside across the largely flat informational surface. But the longer term effect of communication policy was just as Bernanke hoped (and as he spoke about extensively in his farewell address as Fed Chair): it built an enormous Common Knowledge “wall” off to the downside left of the market informational surface – a Fed put based not on continued asset purchases, but on continued wordsof Narrative influence.
Those words form the Narrative of Central Bank Omnipotence, the overwhelming belief by market participants that central bankers in general, and the Fed in particular, determine market outcomes, and for the past two years this has been the only thing that matters in markets. I’ve been tracking and studying political Narratives for my entire professional career, close to 30 years now, and I’ve never seen anything like this. It’s a heck of a trick that Bernanke started and Draghi perfected and Yellen continues, and it’s the key, I think, to seeing recent bond market turbulence in the most useful perspective.
Everything I wrote about the informational surface of the equity market in early summer 2013 is exactly applicable to the informational surface of the bond market in early summer 2015. The bond market today is like a marble sitting on a glass table. There are very few informational structures or barriers to keep the price of US bonds from skittering this way or that, within a price range as expressed in yield terms of, say, 2.25% and 1.85% on the 10-year bond. This is what always happens when the Fed comes out and says that it’s increasingly “data dependent” …our local equilibria become much less stable when the Fed says that it hasn’t made up its collective mind about the pace or scale of monetary policy shifts.
With an informational structure like this, the 10-year bond could trade anywhere on this segment of the price line. Moreover, it takes a signal with precious little information to change people’s minds about whether the US 10-year should yield 1.90% today or 2.20% tomorrow. Precious little information means just that – precious little information – and it’s a classic mistake to infer grand theories or reach sweeping conclusions on the basis of precious little information. Don’t do that.
I really can’t emphasize this point too strongly – monetary policy since March 2009 has created a phenomenally stable global equilibrium in both markets and the real economy, an equilibrium that since the summer of 2013 no longer depends on massive asset purchases by the Fed.
Does the stability of the global equilibrium require someone to be making asset purchases, if not the Fed then the ECB or BOJ? To some degree I’m sure it does. But then I remember that Draghi’s mere words and an OMT program constructed out of whole cloth were sufficient to save the Euro in the summer of 2012. My strong sense is that the launching of central bank asset purchase programs may move the entire informational structure farther along to the right of the price line (higher prices, lower yields), and vice versa leftwards along the price line if the programs stop, but they don’t diminish the Common Knowledge structures themselves. Maybe the locally unstable price range of the US 10-year as expressed in yield terms goes to 2.75% – 2.35% if the ECB were to summarily stop its asset purchase program, but I still think you have an extremely stable global informational structure on either side of that new range, whatever it is. Among market participants today there is almost unanimity of belief that central bankers Will. Not. Allow. a global recession to occur, much less a deflationary equilibrium. But at the same time there is also almost unanimity of belief that central bankers Can. Not. Create. a global recovery, much less an inflationary equilibrium. That unanimity of belief establishes a global informational equilibrium of unparalleled strength and stability, or at least unparalleled in my experience.
I know it sounds weird for me to say that we’re living in a deep, deep valley with giant mountains on both sides of us when it feels like we’re a marble sitting on a glass table, but that’s exactly the mixed metaphor that I think accurately describes our lives as investors here in the Golden Age of the Central Banker. I know it sounds weird to think that we could be living in that deep, deep valley and yet be completely oblivious to its existence, completely convinced that the narrow field of view foisted on us day in and day out by the business imperatives of the financial services industry, especially financial media, is the only possible field of view. But myopically focused on what we are told to focus on is exactly how we humans (and replicants, too, I suppose) tend to live out our lives. Shifting our perspective to take a more global view, whether that’s on the dimension of time or emotion or, yes, asset price levels, is probably the most difficult thing any of us can hope to achieve, and it will always be an imperfect shift at best. Yet it’s never been more important to make that effort, else we allow our innate search for meaning to be subverted by mass-mediated, faux-authentic signalers that profit from making us look over here rather than over there. And I’m not just talking about market signals. It’s EVERY expression of power in the modern age – financial, political, legal, medical, etc. – that suffers from this mass-mediated form of social control, this manipulation of the Common Knowledge game. The human animal is a social animal. We are biologically evolved over millions of years to infer meaning from social signals. We swim in a sea of socially constructed signals, and we can no more ignore the words of Yellen or CNBC or a Master of the Universe than an ant can ignore the pheromones of her queen. We can’t ignore the words. But we can recognize them for what they are. We can ask ourselves “Is that all there is?” and take a more global view.
Sometimes there’s significance in signs and portents. Sometimes there’s real meaning to be gleaned from careful study of localized phenomena, from the interpretation of immediate events to generate far-reaching conclusions. Then again, sometimes a cigar is just a cigar, and that’s how I’m thinking about recent gyrations in the bond market.
One final point, perhaps the most important one I’ve got, and it’s addressed to everyone who asks questions like “so, Ben, when do you think the Fed is going to raise rates?” or “so, Ben, where do you think the price of oil goes from here?” The answer: I don’t know and I don’t really care. Seriously. These are unanswerable, entirely over-determined-in-retrospect questions, and the worst possible thing you can do with an unanswerable, entirely over-determined-in-retrospect question is to try to answer it in deterministic fashion! The popular fetish with demanding an Answer with a capital A to this sort of question is a crystallization of the market neurosis that afflicts us in the Golden Age of the Central Banker, and it’s the quickest path I know to poor investing.
What I DO care about is Adaptive Investing. What I DO care about is understanding the informational structures of the market that determine the likely market price reaction to some new signal, whether that’s a Yellen speech, an earnings report, or technical trading data. Trying to predict what that signal is going to be or when that signal is going to come is a losing proposition. Sorry, but I don’t play that game. And neither should you. My god, we need more pundit predictions about the Fed or oil prices like we need an asteroid to crash into the Earth. What we need is an investment and allocation STRATEGYfor whatever comes down the pike, whenever it occurs. That’s exactly what an Information Theory perspective on markets can provide. Take another look at this informational surface.
This graph says nothing about when and what the Fed will do. It says everything about how to THINK about the bond market in a dynamic, non-myopic way, about how to prepare for probabilistic waves of new signals and how to react once they hit. There’s an entire investment and asset allocation strategy embedded in this graph, and I think it’s the most useful contribution I can make with Epsilon Theory, far more than adding one more voice to the cacophony of Fed “predictions” that drive our collective market neurosis. We are slowly being driven nuts by the paradoxes and ambiguities of the Golden Age of the Central Banker, a maddening time in the truest sense of the word, and I don’t begrudge anyone’s coping mechanisms or business models for dealing with this clinically insane market environment. I submit, however, that our mental health and financial health are best served by taking a strategic view of markets, a view that engages with the game without succumbing blindly to it. That and a regular dose of Epsilon Theory.
The more I practice, the luckier I get. – Gary Player (b. 1935)
Luck is the residue of design. – Branch Rickey (1881 – 1965)
I’ve found that you don’t need to wear a necktie if you can hit. – Ted Williams (1918 – 2002)
They say that nobody is perfect. Then they say that practice makes perfect. I wish they’d make up their minds. – Wilt Chamberlain (1936 – 1999)
They say that nobody is perfect. Then they say that practice makes perfect. I wish they’d make up their minds. – Wilt Chamberlain (1936 – 1999)
It took me 17 years to get 3,000 hits in baseball. I did it in one afternoon on the golf course. – Hank Aaron (b. 1934)
Talent is cheaper than table salt. What separates the talented individual from the successful one is a lot of hard work. – Stephen King (b. 1947)
At one time I thought the most important thing was talent. I think now that – the young man or the young woman must possess or teach himself, train himself, in infinite patience, which is to try and to try and to try until it comes right. He must train himself in ruthless intolerance. That is, to throw away anything that is false no matter how much he might love that page or that paragraph. The most important thing is insight, that is … curiosity to wonder, to mull, and to muse why it is that man does what he does. And if you have that, then I don’t think the talent makes much difference, whether you’ve got that or not. – William Faulkner (1897 – 1962)
Talent is its own expectation, Jim: you either live up to it or it waves a hankie, receding forever. – David Foster Wallace, “Infinite Jest” (1996)
What is most vile and despicable about money is that it even confers talent. And it will do so until the end of the world. – Fyodor Dostoyevsky (1821 – 1881)
Talent is a long patience, and originality an effort of will and intense observation. – Gustave Flaubert (1821 – 1880)
There is nothing more deceptive than an obvious fact. – Arthur Conan Doyle, “The Boscombe Valley Mystery” (1891)
Mrs. Fletcher! Can I see you for a minute? [pause] Do me a favor, please, and tell me what goes on in this town!
I’m sorry, but …
I’ve been here one year, and this is my fifth murder. What is this, the death capital of Maine? On a per capita basis this place makes the South Bronx look like Sunny Brook farms!
But I assure you, Sheriff …
I mean, is that why Tupper quit? He couldn’t take it anymore? Somebody really should’ve warned me, Mrs. Fletcher. Now, perfect strangers coming to Cabot Cove to die? I mean look at this guy! You don’t know him, I don’t know him. He has no ID, we don’t know the first thing about this guy.
– “Murder, She Wrote: Mirror, Mirror, on the Wall: Part 1” (1989)
Dr. Yen Lo: His brain has not only been washed, as they say … It has been dry cleaned. – “The Manchurian Candidate” (1962)
That’s three. Nobody should have more than one talent.
– “The Talented Mr. Ripley” (1999)
My singular talent is seeing patterns that others don’t. That’s not a boast, but a fact, and frankly it’s been as much a source of alienation in my life as a source of success. As my father was fond of saying, “You know, Ben, if you’re two steps ahead it’s like you’re one step behind.” I can’t explain how I see the patterns – they just emerge from the fog if I stare long enough. It’s always been that way for me, for as far back as I have memories, and whether I’m 5 years old or 50 years old I’m always left with the same realization: I only see the pattern when I start asking the right question, when I allow myself to be, as Faulkner said, “ruthlessly intolerant” of anything that proves false under patient and curious observation.
For example, I think the wrong question for anyone watching “Murder, She Wrote” is: whodunit? The right question is: how does Jessica Fletcher get away with murder this time? Once you recognize that it’s a Bayesian certainty that the woman is a serial killer, that she controls the narrative of Cabot Cove (both figuratively as a crime novelist and literally as a crime investigator) and thus the behavior of everyone around her, you will discover a new appreciation for both the subliminal drivers of the show’s popularity as well as the acting genius of Angela Lansbury. Seriously, go back and watch the original “Manchurian Candidate” and focus on Lansbury. She’s a revelation.
Or take the Masters tournament earlier this month. I was lucky enough to attend Wednesday’s practice round, and I was sitting in a shady spot on the 10th green watching the players come by and try their luck at 15 foot putts. At first, like the other spectators, my question was: how are they such good putters? This was “the obvious fact,” to quote Sherlock Holmes, and I watched for any clues that I could adopt for my laughable game – a forward tilt of the wrist, a stance adjustment … anything, really. We all watched carefully and we all dutifully oohed and aahed when the ball occasionally dropped in the cup. But suddenly, a new pattern emerged from the fog, and I realized that we were all asking the wrong question. Instead, I started to ask myself, why are they such poor putters?
Now I realize that I just alienated at least half of the reading audience, but bear with me. I’m not saying that professional golfers are poor putters compared to you or me. Of course not. They are miracle workers compared to you or me. But it’s a stationary ball with a green topography that never changes. The speed of the greens is measured multiple times a day to the nth degree. These players have practiced putting for thousands of hours. They have superior eyesight, amazing muscular self-awareness, and precision equipment. And yet … after charting about 50 putts in the 12 – 15 foot range, the pattern of failure was unmistakable. These professional golfers were aiming at a Point A, but they would have sunk exactly as many putts if the cup had actually been located 6 inches to the right. Or 6 inches to the left. Or 12 inches back. Or 12 inches forward. The fact that a putt actually went in the hole from a distance of 12 – 15 feet was essentially a random event within a 15 x 30 inch oval, with distressingly fat probabilistic tails outside that oval. This from the finest golf players in the world. I saw Ben Crenshaw, a historically great putter who was playing in something like his 44th Masters and probably knows the 10th green better than any other living person, miss a long putt by 6 feet.
But here’s the thing. When a player took a second putt from the same location, or even close to the same location, his accuracy increased by well more than an order of magnitude. Suddenly the ball had eyes. So I went to the practice green, where I saw Jordan Spieth putt ball after ball from exactly the same location about 10 feet from the hole. He made 50 in a row before I got tired of watching. Now granted, Spieth is a wizard with the putter, a lot like Tiger was at the same age. See it; make it. But then I watched one of the no-name amateurs for a while, a guy who had no chance of making the cut, and it was exactly the same thing – putt after putt after putt rolled in from the same spot at a considerable distance.
The best golfers in the world are surprisingly poor aimers. Surprising to me, anyway. They are pretty miserable predictors of where a de novo putt is going to end up, even though we all believe that they are wonderful at this activity. But they are phenomenally successful and adaptive learners, even though we rarely focus on this activity.
I think the same pattern exists in other areas of the sports world. Take basketball free throws. I’d be willing to make a substantial bet that whatever a professional’s overall free throw shooting percentage might be – whether it’s DeAndre Jordan at 50% or Steph Curry at 90% – their shooting percentage on the second of two free throws is better at a statistically significant level than their shooting percentage on the first of two free throws. I have no idea where to access this data, but with the ubiquitous measurement of every sports function and sub-function I’m certain it must exist. Someone give Nate Silver or Zach Lowe a call!
I think the same pattern exists in the investing world, too. We are remarkably poor aimers and predictors of market outcomes, even though we collectively spend astronomical sums of money and time engaged in this activity, and even though we collectively ooh and aah over the professional who occasionally sinks one of these long putts. True story … in 2008 the long/short equity hedge fund that I co-managed was up nicely, and we were deluged by investors and allocators asking the wrong question: how did you have such a great year? At no point did anyone ask the right question: given your fundamental views and avowed process, why weren’t you up twice as much? Most investors, just like the spectators at Augusta, are asking the wrong questions … questions that conflate performance with talent, and questions that underestimate the role of process and learning in translating talent into performance.
I’m not saying that idiosyncratic talent doesn’t exist or that it isn’t connected to performance or that it can’t be identified. What I’m saying is that it’s as rare as Jordan Spieth. What I’m saying is that the talents that are most actionable in the investment world are not found in the predictions and the aiming of a single person. They are found within the learned and practiced behaviors that exist across a broad group of investment professionals. Jordan Spieth is a very talented putter and he works very hard at his craft. But there is no individual golf pro, not even Jordan Spieth, who I would trust with my life’s savings to make a single 15 foot putt. On the other hand, I would absolutely put my life’s savings on the line if I could invest in the process by which all golf pros practice their putting. I am far more interested in identifying the learned behaviors of a mass of investment professionals than I am in identifying a specific investment professional who might or might not be able to sink his next long putt.
What’s the biggest learned behavior of professionals in the investing world right now? Simple: QE works. Not for the real economy– I don’t know any professional investor who believes that the trillions of dollars in Fed balance sheet expansion has done very much at all for the real economy – but for the inflation of financial asset prices. This is what I’ve called the Narrative of Central Bank Omnipotence, the overwhelmingly powerful common knowledge that central bank policy determines market outcomes. The primary manifestation of this learned behavior today is to go long Europe financial assets … stocks, bonds, whatever. QE worked for US markets – that’s the lesson – and everyone who learned that lesson is applying it now in Europe. China, too. Here’s a great summary of this common knowledge position from a market Missionary, Deutsche Bank’s Chief International Economist Torsten Slok:
In my view, every asset allocation team in the world should have this chart hanging on their wall. Based on forward OIS curves the market expects the Fed to hike in March 2016 and the ECB to hike in December 2019. A year ago, the expectation was that the Fed and the ECB would both hike in November 2016. This discrepancy has significant relative value implications for FX, equities and rates. EURUSD should continue to go down and European equities will look attractive for many more years. Another consequence of this chart is that with ECB rates at zero for another five years, many European housing markets should continue to do well. The investment implication is clear: Expect that the benefits we have seen of QE in the US over the past 3 to 5 years will be playing out in Europe over the coming 3 to 5 years. – Torsten Slok, Deutsche Bank Chief International Economist, April 9, 2015
Just as a recap on how to play the Common Knowledge Game effectively, the goal here is to read Torsten’s note for its description and creation of common knowledge (information that everyone thinks that everyone has heard), not to evaluate it for Truth with a capital T. That’s the mistake many investors make when they read something like this … they start thinking about whether or not they personally agree with the Fed hike expectations embodied in forward OIS curves, or whether or not they personally agree with Torsten’s macroeconomic predictions on things like the European housing market, or whether or not they personally agree with the social value of the Fed or ECB policies that are impacting markets. In the Common Knowledge Game, fundamentals – whether they are of the stock-picking sort or the macroeconomic sort – don’t matter a whit, and your personal view of those fundamentals matters even less. The only thing that matters is whether or not the QE-works lesson has been absorbed by the learning process of investment professionals, and that’s driven by the lesson’s transformation into common knowledge by Missionaries like Torsten. From that perspective I don’t think there’s any doubt that what Torsten is saying is true, not with a capital T but with a little t, and that the long-Europe-because-of-ECB-QE trade has got a lot of behavioral life left to it.
One last point … I know that I’m a broken record in the fervency and persistence of my belief that Big Data is going to rock the foundations of the investment world, but this topic of talent, learning, and asking the right question is just too on-point for me to let it slide. I started this note with the alienating observation that I don’t believe that professional golfers are particularly good putters, certainly not in their ability to size up and sink a de novo putt from 15 feet or more. On the other hand, I am pretty certain that with a few months and a few million dollars, it’s possible to build a mobile robotic system with the appropriate sensors and mechanical tolerances that would sink pretty much every de novo putt it took from a distance of 15 feet. Or a robotic system that would hit 99% of its free throws. Machines are far more accurate aimers and more precise estimators of the environment than humans, and that’s a useful observation whether we’re talking about sports or investing.
But that’s not my point about Big Data. My point about Big Data is that such systems are ALSO better than humans at learning. They are ALSO better than humans at pattern recognition. I can remember when this wasn’t the case. As recently as 20 years ago you could read artificial intelligence textbooks that praised the computer’s ability to process information quickly with various backhanded compliments … yes, isn’t it amazing how wonderfully a computer can sort through a list, but of course only a human brain can perform tasks like facial recognition … yes, isn’t it amazing how many facts a computer can store in its memory chips, but of course only a human brain can truly learn those facts by placing them within the proper context. We have entire social systems – like sports and markets – that are designed to reward humans who are superior learners and pattern recognizers. Why in the world would we believe that clever and observant humans will continue to maintain their primacy in these fields when challenged by non-human intelligences that are, quite literally, god-like in their analytical talents and ruthless intolerance of what is false? At least in sports it’s illegal to have non-human participants … honestly, I can see a day where investing is reduced to sport, where we maintain human-only markets as part of a competitive entertainment system rather than as a fundamental economic endeavor. In some respects I think we’re already there.
I’ll close with a teaser. There’s still a path for humans to maintain an important role, even if it’s not a uniformly dominant role, within markets that we share with non-human intelligences. Humans are more likely than non-human intelligences to ask the right question within social systems, like markets, that are dominated by strategic interactions (i.e., games). That’s not because non-human intelligences are somehow thinking in an inferior fashion or aren’t asking questions at all. No, it’s because Big Data systems are giant Induction Machines, designed to ask ALL of the questions. The distinction between asking the right question and asking all of the questions is always interesting and occasionally vital, depending on the circumstances. More on this to come in future notes, and hopefully in a future investment strategy …
Jett Rink: Everybody thought I had a duster. Y’all thought ol’ Spindletop Burke and Burnett was all the oil there was, didn’t ya? Well, I’m here to tell you that it ain’t, boy! It’s here, and there ain’t a dang thing you gonna do about it! My well came in big, so big, Bick and there’s more down there and there’s bigger wells. I’m rich, Bick. I’m a rich ‘un. I’m a rich boy. Me, I’m gonna have more money than you ever *thought* you could have – you and all the rest of you stinkin’ sons of … Benedicts! Bick, you shoulda shot that fella a long time ago. Now he’s too rich to kill. ― “Giant” (1956)
Mussawi: Bob, what do you know about the torture methods used by the Chinese on the Falun Gong? Huh? Method number one. What’s your guess?
Water dungeon. Did you guess water dungeon? Number two method? Number two, twisting arm and putting face in feces. Not interested in two? Number three. Number three is called ‘pulling nails from fingers’. What do you think, Bob? Number three sound good to you? The purpose is to get the monks or whatever to recant their beliefs. What if I had to get you to recant? That would be pretty difficult right? Because if you have no beliefs to recant then what? Then you’re f****d is what.
― “Syriana” (2005)
And therein lies the whole of man’s plight. Human time does not turn in a circle; it runs ahead in a straight line. That is why man cannot be happy: happiness is the longing for repetition. ― Milan Kundera, “The Unbearable Lightness of Being”
Everything we see hides another thing, we always want to see what is hidden by what we see, but it is impossible. Humans hide their secrets too well. ― Rene Magritte
9 Down Clue:
– New York Times Crossword Puzzle, Saturday November 16
There is a real world connected to markets, of course, a world of actual companies selling actual goods and services to actual people. And these real world attributes of good old fashioned economic supply and demand – the fundamentals, let’s call them – matter a great deal. Always have, always will. I don’t think they matter nearly as much during periods of global deleveraging and profound political fragmentation – an observation that holds true whether you’re talking about the 2010’s, the 1930’s, the 1870’s, or the 1470’s – but they do matter.
Unfortunately it’s not as simple as looking at some market outcome – the price of oil declining from $100/bbl to $70/bbl, say – and dividing up the outcome into some percentage of monetary policy-driven causes and some percentage of fundamental-driven causes. These market outcomes are always over-determined, which is a $10 word that means if you added up all of the likely causes and their likely percentage contribution to the outcome you would get a number way above 100%.Are recent oil price declines driven by the rising dollar (a monetary policy-driven cause) or by over-supply and global growth concerns (two fundamental-driven causes)? Answer: yes. I can make a case that either one of these “explanations” on its own can account for the entire $30 move. Put them together and I’ve “explained” the $30 move twice over. That’s not very satisfying or useful, of course, because it doesn’t help me anticipate what’s next. Should I be basing my risk assessment of global oil prices on an evaluation of monetary policy divergence and what this means for the US dollar? Or should I be basing my assessment on an evaluation of global supply and demand fundamentals? If both, how do I weight these competing explanations so that I don’t end up overweighting both, which (not to get too technical with this stuff) will have the effect of sharply increasing the volatility of my forward projections, even if I’m exactly right in the ratio of the relative contribution of the potential explanatory factors.
Here’s the short answer. I can’t. As a social animal in the financial services ecosystem I can’t avoid some overweighting of the explanatory factors. The longer answer is that I believe I can reduce the naïve overweighting by a rigorous focus on Narrative formation and dissemination, a process that I’ll describe below. But before we get to that let’s examine the consequences of an investment world where the overwhelming majority of market participants are not even thinking about mitigating the naïve overweighting of the various explanatory factors for oil price movements that are rolling through their heads, and where the entire financial services sector is designed to magnify this overweighting behavior.
What do I mean by that last bit? I mean that when there’s a large move in an important aspect of the market – and a $30 plunge in the price of oil certainly qualifies on that score! – it creates an overwhelming demand from global investors, from trillions of dollars of investment capital, for an answer to a single question: WHY? Anyone in the financial services world, from the smallest FA to the largest institutional allocator, must supply an answer to that question of Why, or else the capital that you advise or allocate for will start looking for a new advisor or allocator. The rarest answer in the financial services world is “I don’t know”, even though that’s almost always the most honest answer, because the business risk of “I don’t know” is overwhelming during large market moves. Global capital creates a multi-trillion dollar demand for The Answer, and financial service providers (or at least successful financial service providers) willalways provide it.
When there’s a multi-trillion dollar market for The Answer, it should surprise no one that there is competition around the supply of The Answer. Many, many, many answers with a small-a will be supplied, each vying for contention for a slice of The Answer market. Not only is every advisor or allocator in the world today an answer-supplier in his or her own right, but also there are layers upon layers of answer supply and demand within the financial services world itself. The result is an artillery barrage of answers raining down on every market participant, including guys like me who have our own howitzers. ALL of us are caught in this barrage, and it’s LOUD.
All of us may be caught in the barrage, but very few of us have an independently grounded view of what’s going on in oil markets or a process for assimilating the answers. Unfortunately, without that independent grounding or process the sheer volume of the shouted answers becomes a form of torture.
The vast majority of market participants are like George Clooney’s CIA agent in Syriana – ungrounded and without personal conviction in the competition at hand. When Clooney is tortured, it’s only pain – pure, unadulterated, senseless pain – with no purpose or process. Clooney will say or do anything to avoid the pain, but there is nothing he can say or do that will assuage his torturer because he doesn’t have what his torturer wants. You can’t repudiate grounded beliefs under torture if you don’t have grounded beliefs to start with, and whatever belief you espouse under torture will never be a grounded belief. All you can do is shout out some new belief, some new Answer, each time you get another nail pulled off a finger … or, as we might say down in Houston, each time the price of oil goes down another $10/bbl.
Okay, Ben, interesting metaphors and all that, but what’s the investable implication of what you’re saying? Simply this: whatever volatility you think exists in future oil prices … you’re too low. There is a behavioral and market structure dynamic in play today that will amplify oil price volatility beyond whatever your combination of fundamental-driven or monetary policy-driven rationales might imply. The loudness of the artillery barrage of answers to the question of “Why is oil down” is itself a driver of increased volatility in the price of oil and energy sector stocks. And yes, this loudness (more formally, the degree and scope of competition in the answer-supply market) can be measured, which may be an interesting thing for traders to think about. Just sayin’.
Now please note that I do not mean volatility as the word is all too commonly used, as a synonym for “down”. This isn’t some self-fulfilling prophecy, where more people talking about why oil is down somehow pushes oil prices down further. That’s not it at all. What I’m saying is that when more people talk loudly and competitively about their particular Answer to why oil is down, ALL answers become more and more over-weighted. The price of oil becomes more and more over-determined. Events that seem to fit one of the Answers are trumpeted to the high heavens, and everyone rushes to buy or sell according to that event and that Answer. Until, of course, the next event comes along which fits another Answer and is in turn trumpeted on high and is in turn followed by a mad rush to buy or sell according to that event and that Answer. Risk On / Risk Off. Bigger and faster price movements up AND down. Greater than expected “error” from whatever alpha or beta model you’re using. That’s what I mean by volatility.
And the reverse is true, too. When fewer people talk loudly and competitively about their particular Answer to a pressing question of Why, I expect volatility to decline. It’s no accident, in my view, that US equity market volatility has declined with almost perfect inverse correlation to the advance in the Narrative of Central Bank Omnipotence. Today I am hard-pressed to find anyone who argues that equity markets are at current levels because economic fundamentals are so good, or more generally that market outcomes – good or bad – are driven by economic fundamentals. Instead it’s all central banks all the time. There is zero competition in the marketplace of Answers on this enormous question of Why, and I think that’s the driving force behind not only reduced volatility, but also – and far more importantly for the financial services sector – reduced market activity and reduced market interest.
What I’m describing here is another way of getting a handle on the Common Knowledge Game, which I’ve argued is the principal strategic interaction in markets where grounded beliefs are few and far between. I won’t belabor all that again, as you can read about it here and here. But whether you’re thinking in terms of Keynes’ Newspaper Beauty Contest or the Island of the Blue-Eyed Tribe or how a CIA agent responds to torture, it’s all the same dynamic. When you’re not sure of yourself and you’re trying to figure out what consensus view to adopt, as likely as not everyone else is trying to do the same thing. In these situations it’s Common Knowledge – public signals that we all believe that we all heard, aka Narratives – that largely determines each of our individual behavioral decisions.
I mentioned earlier that I believe it’s possible to mitigate these behavioral and structural impulses to overweight explanatory factors through a rigorous assessment of Narrative creation and dissemination, so I’ll turn to that now. To be clear … I don’t have The Answer for what drives oil prices. I have MY answer, which is a small-a answer because it adapts to Narrative shifts in the relative prominence of fundamental-driven factors and monetary policy driven factors. It’s also a small-a answer because it’s a self-consciously Bayesian effort at arriving at a useful assessment of what’s going on, not a Platonic effort at uncovering some eternal Truth with a capital-T. All it really means to say that you’re a Bayesian decision maker is that you ground yourself with some set of prior beliefs and then you update those beliefs with new information. Here, then, are my grounded beliefs, first on fundamentals and then on monetary policy.
On fundamentals … we have good models (good in the sense that they’ve been nicely predictive over the past several decades) for the relationship between global growth and oil prices. What all the models basically show is that US growth sets the floor and Chinese growth is the marginal driver above that floor, at least for the demand function. Without a US recession and/or a Chinese hard landing – neither of which are anywhere in sight – it’s really hard for oil to get very far below, say, $70/bbl and it’s almost impossible for the price to stay there for very long.
We also have good models for the relationship between oil supply and oil prices. Currently we have significant over-supply in the global energy markets, driven by two factors: the continued success of shale production efforts in the US (see the amazing chart below from Deutsche Bank’s Torsten Slok) and the mysteriously high production levels being maintained by Saudi Arabia.
I say mysteriously high because with 30% price declines Saudi Arabia has historically been rather quick to cut production, but they’ve been largely quiet of late. There’s a widespread belief (which I share) that there is geopolitical pressure on Saudi Arabia to maintain production levels in order to squeeze the economic vise on Russia and Iran. There are limits to this US geopolitical pressure, however, particularly with such a mistrusted Administration, and I think we’re now well past those limits.There’s also a somewhat less widespread belief (which I don’t share) that Saudi Arabia is content to maintain (or even increase) production in order to put more downward pressure on oil prices and force US shale production into unprofitable positions. While the proponents of this view are absolutely right that the threat of opening the production floodgates has always been the Saudi big stick used to maintain cartel discipline within OPEC, there’s just too much non-cartelized money, technology, and political capital invested in US shale production to slow it down in this way. It’s the Bick Benedict / Jett Rink problem from the classic movie Giant … if you’re Rock Hudson and you despise James Dean, you better get rid of him while he’s a dirt-poor wildcatter, because once he succeeds he’s too rich to kill.
Also, regardless of what happens in the short term with OPEC production targets, when you look at the production profiles of most major oil fields in the world today I think it’s very hard to see the current over-supply condition as anything but temporary, even with continued efficiency advances in the US shale fields (for a particularly apocalyptic view on all this, see the latest quarterly letter from GMO’s Jeremy Grantham). As with the global growth models, it’s really hard to get oil much below $70/bbl from a supply model perspective.
But then there’s monetary policy. For the past 30 years we’ve had general global coordination around a weaker dollar (which supports higher prices of assets, like oil, that are priced in dollars) and for the past 5 years we’ve had intensive global coordination to promote massive dollar liquidity (which also supports higher oil prices). Today that coordination has stopped, and the dollar is getting very strong very quickly as the Fed cuts back on dollar liquidity at the same time that other central banks continue to increase their own liquidity operations. As I hope that I’ve made clear in recent Epsilon Theory notes (here and here), I think that this monetary policy divergence is a very significant risk to markets, as there’s no direct martingale on how far monetary policy can diverge and how strong the dollar can get. As a result I think there’s a non-trivial chance that the price of oil could have a $30 or $40 handle at some point over the next 6 months, even though the global growth and supply/demand models would say that’s impossible. But I also think the likely duration of that heavily depressed price is pretty short. Why? Because the Fed and China will not take this lying down. They will respond to the stronger dollar and stronger yuan (China’s currency is effectively tied to the dollar) and they will prevail, which will push oil prices back close to what global growth says the price should be. The danger, of course, is that if they wait too long to respond (and they usually do), then the response will itself be highly damaging to global growth and market confidence and we’ll bounce back, but only after a near-recession in the US or a near-hard landing in China.
So now for the balancing act … is the price of oil today driven more by global growth and supply/demand factors or by monetary policy factors? I hope it doesn’t surprise anyone when I say that I think monetary policy dominates ALL markets today, including the global oil market. What’s the ratio? My personal, entirely subjective view is that oil prices over the past 3+ months have been driven by 3 parts monetary policy to 1 part fundamentals. How do I come up with this ratio? For the past 3+ months the oil Narrative has been dominated by public statements from influential answer-suppliers talking up the oil price dynamic of a rising dollar and monetary policy divergence. That’s the source of my subjective view of a 3:1 dominance for monetary policy-driven factors over fundamental-driven factors.
However – and this is the adaptive part where I play close attention to Narrative development and dissemination – the noise level surrounding this Thursday’s OPEC meeting is absolutely deafening. I mean, when the Sunday morning talking head shows are discussing OPEC and its influence on gasoline prices you know that something dramatic is happening with the Narrative. For at least this week and next the oil Narrative is going to be dominated by public statements from influential answer-suppliers talking up the oil price dynamic of OPEC decisions on fundamental global oil supply. For at least this week and next my personal, entirely subjective view of the ratio of explanatory factors is going to flip to 3 parts fundamentals to 1 part monetary policy. And since it’s hard to get the price of oil much lower than it is today on the fundamentals … well, you can draw your own conclusions about the risk/reward asymmetry over the next two weeks. Beyond that? I have no idea. I’ll just have to wait and see what happens to the Narrative.
I know this process probably sounds very reactive, as if I’m lacking all conviction about how the world works. Guilty as charged on the first count; innocent on the second. I don’t pretend that I have The Answer. I don’t pretend to have a crystal ball that tells me what OPEC is going to do this Thursday or when the next central banker will jawbone his currency down. I don’t know. Sorry. There are plenty of answer-suppliers out there who will be more than happy to tell you that they DO have that crystal ball, and if that’s what you need you’re wasting your time reading Epsilon Theory. I think that investing in a reactive manner – or as I like to call it, adaptive investing – is the best way to survive a profoundly uncertain world. That doesn’t mean that I don’t have strong ideas about how the world works, about how both monetary policy and fundamentals impact the price of oil. What it means is that it doesn’t matter what I think about the way the world works. The only thing that matters is what the market thinks about the way the world works, and in times like these the market will think whatever Common Knowledge says it should think.
It’s crucial to have strong views about how the world works, to have an independently grounded vision of the world, because otherwise I might start to think that whatever Common Knowledge is dominant at some given time … US dollar strength for the past 3+ months, OPEC impact on supply fundamentals for the next 2+ weeks … is The Answer for oil prices, forever and ever amen, and I will be whipsawed mercilessly when the Narrative shifts. And it will shift. But it’s equally crucial not to become a prisoner of my strong views about how the world works, or else at best I will miss the path that the market takes from here to there, and at worst I might be … wrong.
Here’s my Answer: there is no Answer. In a structurally unstable market, there is no stable deterministic model of discrete market-exogenous factors like global supply/demand and monetary policy to “explain” oil prices. Oil prices are systematically over-determined, particularly during times of pricing distress, and you’re kidding yourself if you think you can find the world’s secret eternal code that hides behind market outcomes. The market itself – the strategic interaction of social animals all trying to outsmart each other – is part and parcel of the code. Strategic interactions are not factors that you can plug into your model or regression analysis. They are emergent properties of a game … a game with rules and stable patterns of behavior, so it’s knowable and predictable, but not predictive in the same deterministic fashion that the econometric toolbox promises. For investors and allocators steeped in this predictive promise of econometrics, game theory will always seem like thin gruel, as postdictive rather than predictive. Fair enough. But rather than cling to my econometric toolkit and make market predictions that are less and less useful in this, the Golden Age of the Central Banker, I’d rather look at the market through the lens of game theory and Common Knowledge and Narrative so that I can adapt quickly to what IS rather than what I’d prefer it to be.
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.