The Narrative Giveth and The Narrative Taketh Away

No farm animals today. I’d say no TV or movie quotes, but sometimes I can’t help myself. We’ll see. Instead, a quick note to email subscribers about what I think is one of the most unstable (meaning big ups and big downs) markets we’ve seen in eight years.

The day-to-day and intraday market swings over the past six weeks have been absolutely ferocious. There really hasn’t been a big aggregate change in market levels since the middle of February (down a bit), but that modest overall decline masks a ton of ups and downs along the way, particularly over the past two weeks. If I were a betting man (and I am), my large wager would be that anyone running a tactical strategy, discretionary or systematic alike, has been whipsawed in an ugly fashion. These are the times that try traders’ souls.

So here’s the Epsilon Theory take on what’s going on.

This market, like all markets, cares about two things and two things only — the price of money and the real return on invested capital. Or, as they are typically represented in cartoon form, interest rates and growth.

This market, like all markets, will go up if either cartoon can be represented with a positive narrative. That is, even if the Fed is raising interest rates, so long as they’re doing it “for the right reasons” (meaning robust growth in the real economy), then the market can go up. Likewise, even if real economic growth is anemic, so long as that means that the Fed “has got your back”, then the market can go up. This last bit — uber-accommodative central banks the world over — is why the S&P 500 is up more than 300% over the past eight years despite enormously disappointing global growth and productivity metrics.

This market, like all markets, needs a positive narrative on risk (the price of money) or reward (the real return on capital) to go up. Any narrative will do! But when neither risk nor reward is represented with a positive narrative, this market, like all markets, will go down. And that’s where we are today.

Does the Fed have our back? No, they do not. They’ve told us and told us that they’re going to keep raising rates. And they will. The market still doesn’t fully believe them, and that’s going to be a constant source of market disappointment over the next few years. In the same way that markets go up as they climb a wall of worry, so do markets go down as they descend a wall of hope. The belief that central bankers care more about the stock market than the price stability of money is that wall of hope. It’s a forlorn hope.

Is there a positive growth narrative? Well, there WAS … not just in the U.S. but everywhere in the world, and it went under the heading of “synchronized global growth”. With the tax cut passed in December, you could absolutely make the case that we were off to the growth races, and that was, in fact, THE narrative behind the amazing January for markets.

Two negative narratives have derailed all this — Inflation and Trade War. The first strikes at the “real” aspect of real economic growth. The second strikes at the absolute or nominal level of that growth.

The inflation narrative hit markets in force after the January jobs report of February 2, where wage inflation came in “hot”. It subsided with the “Goldilocks” jobs report of March 9, where wage inflation was “contained”, and the jobs report of April 6 did little to reignite the inflation narrative. But here’s the thing. The wage inflation numbers for the past two months are wrong, crucially flawed by random differences in work-week hours from last year to this year (for more, read “The Icarus Moment”). On an apples-to-apples basis (eliminating the impact of spuriously estimated work-week hours on average hourly earnings), I estimate wage inflation in February was about 2.9%, not the reported 2.6%, and wage inflation in March was north of 3.0%, not the reported 2.7%.

My view: the inflation narrative will surge again, as wage inflation is, in truth, not contained at all.

The trade war narrative hit markets in force in late February with the White House announcement on steel and aluminum tariffs. It subsided through mid-March as hope grew that Trump’s bark was worse than his bite, then resurfaced in late March with direct tariff threats against China, then subsided again on hopes that direct negotiations would contain the conflict, and has now resurfaced this past week with still more direct tariff threats against and from China. Already this weekend you’ve got Kudlow and other market missionaries trying to rekindle the hope of easy negotiations. But being “tough on trade” is a winning domestic political position for both Trump and Xi, and domestic politics ALWAYS trumps (no pun intended) international economics.

My view: the trade war narrative will be spurred on by BOTH sides, and is, in truth, not contained at all.

Of these two claims — that both the inflation and the trade war narratives are here to stay and, frankly, you ain’t seen nothing yet — I want to dig in a bit more here on the inflation narrative claim, as that’s the narrative that’s taken a back seat over the past six weeks or so. It’s also the narrative that, over time, I think will have the larger impact on investors’ portfolios. In a very real sense (still no pun intended), getting the inflation question right is the ONLY question that a long-term investor or allocator MUST get right in order to succeed.

So here’s what the Narrative Machine is showing me about inflation.

The methodology of the Narrative Machine is described in the Epsilon Theory note by the same name. It’s a natural language processing (NLP) analysis of a large set of market relevant articles — in this case everything Bloomberg has published that talks about inflation — where linguistic similarities create clusters of articles with similar meaning (essentially a linguistic “gravity model”), and where the dynamic relationships between and within these clusters can be measured over time.

Source: Quid, Inc. For illustrative purposes only. Past performance is no guarantee of future results. Quid, Inc. is not an affiliate of Salient. Software used under license.

What you’re seeing above is the Bloomberg narrative on inflation from April 2016 through March 2017, where each of the 1,400 dots is a separate Bloomberg article that contained some mention of U.S. inflation, and where the dots are colored by publication date (blue early in the 12-month period, red late in the 12-month period). There’s meaning associated with the size of each individual dot or node, too, but not particularly useful meaning for this analysis. What’s most important here is the geometry within and the distance between the clusters of articles, each associated with “inflation and …” Trump or the Fed or gold or whatever category you see named above. This is a prototypical “complacent” narrative network, where a substantial percentage of articles are unclustered, and the clusters that exist are distant from each other, tenuously connected, and on the periphery of the narrative superstructure. When you read the individual articles here, they are ABOUT Trump or the Fed or gold or whatever, with inflation being a subsidiary topic of interest. Inflation per se is just not a particularly relevant narrative for the market over this period.

In contrast, what you’re seeing below is the Bloomberg narrative on inflation from April 2017 through March 2018. Not only do you have 2,400 unique articles in this year-over-year period, a 75% increase, but more importantly you have strikingly more narrative cohesion across the published articles. Entire narrative clusters have come into being over the course of the past 12 months, clusters like “strategists” that are in the geometric heart of the entire interlaced network, meaning that they are providing a gravitational core to the narrative superstructure. Moreover, these new clusters are truly ABOUT inflation, where this is the core topic of the article, not a side issue. It’s a difference in meaning and sentiment associated with the unstructured data of the individual articles that a human cannot possibly capture in the aggregate, no matter how voracious and comprehensive a reader he is, but is processed and visualized in a few seconds by the Quid NLP algorithms. In the NLP equivalent of time-lapse or stop-action photography, you can actually see these clusters come into existence over time and exert their gravitational pull on the entire narrative superstructure, providing what I think is an important systematic approach to visualizing and measuring market-moving structures of sentiment. THIS is the power of AI. It won’t make your regressions run any faster. It’s not particularly helpful in working with structured data at all. But it changes everything in how we SEE the ocean of unstructured data in which we all swim.

Source: Quid, Inc. For illustrative purposes only. Past performance is no guarantee of future results. Quid, Inc. is not an affiliate of Salient. Software used under license.

I’ve color-coded the article nodes by date (bluer = older, redder = more recent) to show this time-lapse effect in a single snapshot of the network. Because this is a “gravity model”, it’s meaningful that the more centrally located articles within the superstructure tend to be redder or more recent articles. Also meaningfully, the clusters themselves show this effect. Look at the blow-up of the network below, and you can see how the more recent (redder) articles in the “markets” cluster are more centrally positioned than the older (bluer) articles in the same cluster. What all this means is that the inflation narrative is becoming not only stronger (more articles, new clusters) but also — and I really can’t emphasize this point enough — the inflation narrative is becoming more coherent and “gravitationally stable” over time. The growing strength and coherence of these Narrative Machine visualizations show the creation of powerful common knowledge around inflation, where everyone knows that everyone knows that inflation is rearing its very ugly head.

Source: Quid, Inc. For illustrative purposes only. Past performance is no guarantee of future results. Quid, Inc. is not an affiliate of Salient. Software used under license.

Six months ago, in a note called “Harvey Weinstein and the Common Knowledge Game”, I wrote this:

The core dynamic of the CK Game is this: how does private knowledge become — not public knowledge — but common knowledge? Common knowledge is something that we all believe everyone else believes. Common knowledge is usually public knowledge, but it doesn’t have to be. It may still be private information, locked inside our own heads. But so long as we believe that everyone else believes this trapped piece of private information, that’s enough for it to become common knowledge.

The reason this dynamic — the transformation of private knowledge into common knowledge — is so important is that the rational behavior of individuals does not change on the basis of private knowledge, no matter how pervasive it might be. Even if everyone in the world believes a certain piece of private information, so long as it stays private — or even if it becomes public information — no one will alter their behavior. Behavior changes ONLY when we believe that everyone else believes the information. THAT’S what changes behavior. And when that transition to common knowledge happens, behavior changes fast. …

My pick for the big idea that gets taken down? The idea that inflation is dead. We all know it’s not true. We all know in our own heads that everything is more expensive today, from rent to transportation to food to iPhones. But it’s not common knowledge. Not yet.

The “not yet” is now. The stage is now set for an explosive market re-evaluation of inflation and its impact on the price of money and the real return on invested capital. This is no longer a complacent crowd. This is now a highly focused crowd. The crowd is now watching the crowd in regards to inflation. Everyone knows that everyone knows that inflation is an important issue. The only thing missing is the Missionary statement, the little girl crying out that the Emperor has no clothes. That’s when common knowledge crystalizes into behavior. That’s the freak-out moment for markets.

What is the crystalizing Missionary statement? I think it’s wage inflation in a future jobs report.

In exactly the same way that random observations of work-week hours have artificially depressed the average hourly wage inflation cartoon reported by the BLS over the past two months, there is a 100% chance that random observations of work-week hours will artificially magnify the wage inflation cartoon reported by the BLS in some future months. This is not an opinion. This is, as they say, math.

For example, if the 12-minute difference in the March 2017 work-week (34.3 hours) and the March 2018 work-week (34.5 hours) had been reversed, the reported wage inflation last Friday would have clocked in at 3.3%. Let me repeat that. Three-point-three percent. That is an Emperor-has-no-clothes moment.

When will we get this “shockingly hot” wage inflation number? I have no idea. That’s what it means to have a random number series as part of your cartoonish data estimation process. It’s random. Again, this is math.

But here’s the last 6+ years of the data series so you can see for yourself what the year-over-year comps are for work-week hour estimations, or as I like to call it, ROUND (RANDOM (34.3 , 34.6), 0.1).

We won’t hit any prior year 34.5 readings until the end of calendar 2018, where a random reading in the historical range is most likely to present a real shocker, but any of the next five months have a year-over-year comp where the wage inflation number, which I think is now above 3%, is at least more likely to be accurately represented via the average hourly wage cartoon.

To steal a line from Game of Thrones (see, told you I couldn’t help myself), we’re now at the point where the catch phrase is about to shift from “Inflation is Coming” to “Inflation is Here.” And if that’s married with disappointing growth from say, oh, I dunno … a TRADE WAR WITH CHINA … well, that’s not just inflation, that’s stagflation. And that’s the market equivalent of the Night King and the White Walkers running rampant over all of Westeros. Is that the most likely scenario? No. Is it a scenario that we need to take seriously? Absolutely.

So what’s to be done?

Well, it’s time to stop thinking about what inflation means for your portfolio, much less stagflation, and start doing something about it. And yes, I know our inflation-investing muscles are severly atrophied. Time to start flexing those muscles. Time to start exercising those muscles. Because you’re going to need them.

For an allocator, I think the core inflation-investing muscles are real assets, broadly defined. I wrote about this two years ago in “Hobson’s Choice”, and I wouldn’t change a word today. More broadly, the premise here is to push back from the table games here at the doubly-abstracted Public Market Casino, get closer to real cash flows from real things for real people, and think “pricing power, pricing power, pricing power” in every bit of analysis that you do. You’d also be well served to start reading Rusty Guinn’s new Epsilon Theory series, “Investing With Icarus”, which is just getting off the ground and will have a lot more to say about all of this.

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Harvey Weinstein and the Common Knowledge Game

I’ve written a lot about the Game of Markets, aka the Common Knowledge Game, most recently in Sheep Logic. The thing about the Common Knowledge Game, though, is that once you start looking for it, you see it everywhere, not just in our investment lives, but also in our social and political lives. The public unmasking of Harvey Weinstein as a serial rapist (that’s the word, people) is an archetypical play of the Common Knowledge Game, and recognizing its dynamics should open everyone’s eyes to how other high and mighty people and ideas can take a fall.

The core dynamic of the CK Game is this: how does private knowledge become  not public knowledge  but common knowledge? Common knowledge is something that we all believe everyone else believes. Common knowledge is usually also public knowledge, but it doesn’t have to be. It may still be private information, locked inside our own heads. But so long as we believe that everyone else believes this trapped piece of private information, that’s enough for it to become common knowledge.

The reason this dynamic — the transformation of private knowledge into common knowledge  is so important is that the social behavior of individuals does not change on the basis of private knowledge, no matter how pervasive it might be. Even if everyone in the world believes a certain piece of private information, no one will alter their behavior. Behavior changes ONLY when we believe that everyone else believes the information. THAT’S what changes behavior. And when that transition to common knowledge happens, behavior changes fast.

The classic example of this is the fable of The Emperor’s New Clothes. Everyone in the teeming crowd possesses the same private information — the Emperor is walking around as naked as a jaybird. But no one’s behavior changes just because the private information is ubiquitous. Nor would behavior change just because a couple of people whisper their doubts to each other, creating pockets of public knowledge that the Emperor is naked. No, the only thing that changes behavior is when the little girl (what game theory would call a Missionary) announces the Emperor’s nudity loudly enough so that the entire crowd believes that everyone else in the crowd heard the news. That’s when behavior changes.

And so it was with Harvey Weinstein. Apparently it was no great secret that he is a serial rapist. Apparently everyone in Hollywood was familiar with the stories. It was ubiquitous private knowledge, and pretty darn ubiquitous public knowledge. I mean, if you’re making jokes about it on 30 Rock, it’s not exactly a state secret.

But there was never a Missionary. There was never anyone willing to shout the information so loudly and so publicly that it became common knowledge. That’s what Rose McGowan did, and that’s the power of Twitter and modern celebrity to establish Missionaries and create common knowledge.

Once that common knowledge was created, once all the private holders of all of Weinstein’s dirty secrets believed that everyone else believed that he is a serial rapist, then everyone’s behavior changed on a dime. His publicists and lawyers and partners and colleagues and board of directors and wife were shocked … shocked! … to hear of his behavior, and certainly would no longer be representing him or working with him or associating with him ever again, even though NOTHING had changed in the information they already possessed. Ditto with Weinstein’s other victims. Their behavior changed, as well. That’s not a knock or a slam on them. In the absence of common knowledge, staying quiet whether you’re an abettor or a victim — is the rational thing to do. In fact, this is what Weinstein and his abettors count on, that their threats and shaming and bribes will set up a Hobson’s Choice for victims. Sure you can go public, but no one will believe you and then we will ruin you. So yeah, go ahead. It’s your choice. Of course no one goes public, because a Hobson’s Choice is not a real choice. Only a victim with Missionary power (and that’s a really rare thing) has the option to not just go public with the story — because simply going public is not enough to change behavior  but to create common knowledge with the story.

What are the broader lessons to take from all this? I’ve got two.

First, there’s enormous economic, political, and social power in being a Missionary, and social media has completely transformed the Missionary creation process just over the past few years. This is why it matters how many Facebook followers you have and how many RTs you get on Twitter. This is why Donald Trump adopted social media so early and used it so prolifically. Twitter in particular is a Common Knowledge platform of great power. Having lots of followers isn’t “monetizable” in the sense of traditional marketing. But that doesn’t mean it’s not incredibly valuable. Put differently, celebrity in and of itself has never been a greater source of political power than it is today. Why? Because Common Knowledge Game.

Second, there’s a lot of ubiquitous private information about powerful people and powerful ideas trapped in the crowd today, just waiting for a Missionary to release it as common knowledge. The more powerful the person or the idea to be brought low, the bigger the Missionary (and platform) required. But nothing’s too big, and once the common knowledge is created, behavior changes fast. My pick for the big idea that gets taken down? The idea that inflation is dead. We all know it’s not true. We all know in our own heads that everything is more expensive today, from rent to transportation to food to iPhones. But it’s not common knowledge. Each of us may believe that inflation walks among us, but none of us believes that everyone else believes that inflation is here.

Not yet.

But we’re only one big Missionary statement away.

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Cat’s Cradle

“No wonder kids grow up crazy. A cat’s cradle is nothing but a bunch of X’s between somebody’s hands, and little kids look and look and look at all those X’s . . .”
“And?”
“No damn cat, and no damn cradle.”

The Fourteenth Book is entitled, “What Can a Thoughtful Man Hope for Mankind on Earth, Given the Experience of the Past Million Years?”
It doesn’t take long to read The Fourteenth Book. It consists of one word and a period.
This is it: “Nothing.”

– Kurt Vonnegut, “Cat’s Cradle” (1963)

Negative rates are ice-nine. If you don’t know what ice-nine is, read the book. Spoiler alert: the world ends.

TIAA will end the voluntary expense waiver on the CREF Money Market Account by April 14, 2017. This decision was reached after ongoing discussions with the TIAA and CREF boards, as well as our state insurance regulator. It is anticipated that unless interest rates rise sufficiently, one or more classes of the CREF Money Market Account may have negative yields after the waiver ends.

TIAA Plan Update Review Guide 2016 [italics mine]
Emily Dickinson (1830 – 1886)

A great Hope fell
You heard no noise
The Ruin was within.

Admit it. You assume her poetry is soft because she’s a woman and writes about flowers. Read it again. Emily Dickinson is a total badass. You don’t even feel the slice of her work, but then you see the blood.

I saw her today at the reception
In her glass was a bleeding man
She was practiced at the art of deception
Well I could tell by her blood-stained hands
You can’t always get what you want
You can’t always get what you want
You can’t always get what you want
But if you try sometimes you just might find
You just might find You get what you need
– Mick Jagger and Keith Richards, “You Can’t Always Get What You Want” (1969)

Fed Governor James “Bleeding Man” Bullard

The Federal Reserve Bank of St. Louis is changing its characterization of the U.S. macroeconomic and monetary policy outlook. An older narrative that the Bank has been using since the financial crisis ended has now likely outlived its usefulness, and so it is being replaced by a new narrative. The hallmark of the new narrative is to think of medium- and longer-term macroeconomic outcomes in terms of regimes. The concept of a single, long-run steady state to which the economy is converging is abandoned, and is replaced by a set of possible regimes that the economy may visit. Regimes are generally viewed as persistent, and optimal monetary policy is viewed as regime dependent. Switches between regimes are viewed as not forecastable.

James Bullard, “The St. Louis Fed’s New Characterization of the Outlook for the U.S. Economy” (June 2016)

Jim Bullard’s resignation letter here in the Silver Age of the Central Banker, as he adopts the game theoretic concept of minimax regret theory and the postmodern social theoretic concept of narrative construction.

Though nothing can bring back the hour
Of splendour in the grass, of glory in the flower;
We will grieve not, rather find
Strength in what remains behind;

– William Wordsworth (1770 – 1850)

Splendor In the Grass (1961)

Warren Beatty and Natalie Wood’s best work. I experience this movie so differently today, as the father of four teenage daughters, than I did watching it as a young man. In investing as in life, we all love and lose. The question is how you deal with it.

If we will be quiet and ready enough, we shall find compensation in every disappointment.
– Henry David Thoreau (1817 – 1862

In his classic work on game theory, “The Strategy of Conflict”, Nobel Prize winner Tom Schelling begins by writing about cooperative games, where players are trying to arrive at a common outcome for a mutual benefit. This is a different class of games from the competitive games like Chicken and Prisoner’s Dilemma that we usually consider when we think about game theory, but in truth it’s the cooperative games that account for so much more of our daily lives and social interactions. For example, driving on the right-hand side of the road (or the left-hand side in the UK) is an example of a cooperative game equilibrium. The only thing that matters is that we agree on which side of the road we drive on, not that my preferred side or your preferred side ends up being the final choice.

The most interesting cooperative games are those where — unlike driving conventions — we don’t have a government or other authority telling us what our agreement should be. Even more interesting are those games where we can’t communicate directly with the other players to talk through the appropriate equilibrium behavior that works for all concerned. For example, let’s say that a friend and I agree to meet in New York City at 1 pm tomorrow. Unfortunately, we neglected to agree on a location to meet, and now I have absolutely no way to communicate with my friend, or vice versa. What do we do?

As Schelling writes, almost everyone will, in fact, meet their friend successfully tomorrow at 1 pm in New York City. Where? By the big clock in the middle of Grand Central Station. Why? Because there is Common Knowledge — something that everyone knows that everyone knows — to guide both me and my friend to this outcome. Now Schelling doesn’t call it Common Knowledge — he calls it a focal point — but it’s exactly the same thing. And once you start looking for focal points that drive our strategic behavior in the cooperative games that comprise our daily social lives, you see them everywhere.

Okay, Ben, all kinda interesting, but what’s the point? The point is that when governments undertake emergency actions and extraordinary policies, they obliterate the focal points that make our cooperative games of investing and market making possible.

Specifically, extraordinary monetary policy has obliterated the focal points of price discovery. When you no longer have Common Knowledge regarding the price of money, you don’t have Common Knowledge regarding the price of anything. For more than seven years now, investors have been sitting down at the poker table ready to play the cards they’re dealt, only to find that central bankers with infinitely high stacks of chips have sat down at the table, too. And as any experienced poker player knows, the cards are meaningless if you tangle with an opponent like this. Maybe you think that was a bad flop. Maybe you think Nestle investment grade debt is worth 99 cents. But what you think about valuation and intrinsic worth Does. Not. Matter. when the infinite stack player says with his inexhaustible string of bets of massive size that this was actually a wonderful flop and that Nestle investment grade debt is actually worth $1.10 and the Emperor is actually wearing a beautiful suit of clothes. The very act of stock-picking or bond-picking or security selection in general has become nothing more than a bad joke in vast swaths of global markets. It’s a crooked game — a moke’s game — but it’s the only game in town.

Specifically, extraordinary regulatory policy has obliterated the focal points of liquidity. When you no longer have Common Knowledge regarding the ability of banks to make markets and hold an inventory of securities, you don’t have Common Knowledge regarding the liquidity of anything. The market risk from a Brexit “Leave” vote, for example, has absolutely nothing to do with anything in the real economy, and next to nothing as a signal or precedent for the core currency union of the EU. Instead, the market risk from a Brexit “Leave” vote is a liquidity shock in currency, rates, credit, or derivative securities that sets off a chain reaction of liquidity shocks across global risk assets. This sort of liquidity shock is temporary, to be sure, but that’s no consolation at all if you find yourself stopped out of a position. When trillions of dollars in risk assets move by several percentage points because a few thousand quid switched from one line or another in a UK betting parlor, or because the latest online poll with suspect (to be kind) methodology is printed by a tabloid … you can’t tell me that market liquidity and structural normalcy is more than skin deep. We swing from pillar to post and endure mini-Flash Crashes on a regular basis because too often the act of making a market in, say, equity index volatility is a potential career-ender for anyone sitting on a bank trading desk, and that’s entirely the result of unintended consequences from financial regulations like Dodd-Frank.

It’s the combination of focal point obliteration, from both monetary policy and regulatory policy sources, that creates the most powerful and destructive earthquakes in our investment landscape. For example, I’m often asked if I think that negative rates will ever come to the U.S. My answer: they’re already here by proxy (U.S. Treasury rates are so low today because German Bunds are negative out to 10 years duration), and negative rates will hit the U.S. in earnest and in practice early next year. How? Major U.S. money market fund providers like TIAA-CREF have already announced plans to stop providing fee waivers as new regulations force fund type consolidation, which will create negative rates in the safe, liquid funds that remain. It’s baked in. It’s going to happen. As George Soros is fond of saying, I’m not predicting. I’m observing. And nothing will ever be the same. If you think that the current anguished cries from savers and retirees and public pension plans are loud now … if you think that the rewardless risk of modern markets can’t get any worse … well, just wait until your money market fund starts charging you interest for the privilege of investing your cash in short-term government obligations. Just wait until Nestle floats a negative interest rate bond. Just wait until borrowing money, not lending money, becomes a profit center. Just wait until the entire notion of compounding — without exaggeration the most important force in human economic history — is turned on its head and becomes a wealth destroyer.

Sigh.

You know, I’ve written a lot of Epsilon Theory notes over the past three years. As I figure it, about three novels’ worth and just over the halfway mark of War and Peace. But in all that time and across all those notes I’ve never felt so … resigned … to the fact we are ALL well and truly stuck. The Fed is stuck. The ECB and the BOJ are stuck. The banks are stuck. Corporations are stuck. Asset managers are stuck. Financial advisors are stuck. Investors are stuck. Republicans are stuck. Democrats are stuck. We are all stuck in a very powerful political equilibrium where the costs of changing our current bleak course of ineffective monetary policy and counter-productive regulatory policy are so astronomical that The Powers That Be have no alternative but to continue with what they know full well isn’t working.

It’s through this lens of resignation that I think we should view one of the most fascinating Missionary statements of the past 20 years, St. Louis Fed Governor Jim Bullard’s latest paper, where he says that the entire exercise of Fed guidance and dot plots and planning for interest rate increases and interest rate normalization is a complete and utter waste of time. In fact, he goes farther than that. Bullard writes that forward guidance is actually highly counter-productive and credibility destroying, because it teases us with the notion that normalization is possible, when, in fact, absent some deus ex machina miracle, it’s not. My god, you think I’m a downer? This is the President of the St. Louis Fed, saying that everything the FOMC has been doing for the past four years is just a bad joke! Or as Vonnegut would say, there’s “no damn cat and there’s no damn cradle” in the oh-so-complex hand weaving that Bernanke and Yellen have crafted with forward guidance, no matter how hard we look. The Emperor has no clothes.

What Bullard wrote is a letter of resignation. Not just a letter of resignation in the sense of quitting one’s job (although that, too … if you’re not going to play the game you were appointed to play, if you’re just going to pick up your dot plot and go home, then you should actually go home), but more importantly in the emotional sense of resignation to one’s fate. It’s a capitulation, a recognition that the U.S. is well and truly stuck in the current macroeconomic regime of low growth + massive debt + insanely low interest rates, and there’s nothing the Fed can do in terms of jawboning or “communication policy” or forward guidance to get us out. So, Bullard says, let’s stop this charade of dot plots and just admit the truth: rates are not going up, maybe not EVER, until something beyond the Fed’s control shocks the world into some other macroeconomic regime.

By the way, here’s the problem with what Bullard is saying: the current regime/stable equilibrium of low growth + massive debt + negative interest rates isn’t something that just “happened”. It’s not like the Fed woke up one morning to find that some terrible houseguest soiled the sheets and overfed the dog and left a lit cigarette smoldering in the trash can. Please. Here’s a 4-year chart of the VIX, looking for all the world like a Whack-a-Mole game, as every surge in volatility is met with a mallet strike of Large Scale Asset Purchases (LSAPs), forward guidance, or (outside the U.S.) interest rate cuts well past the zero-bound.

epsilon-theory-cats-cradle-bloomberg-1
Source: Bloomberg, as of 05/31/2016

Over the past four years, we haven’t seen the VIX stick over 20 for more than 2 months. Compare this to the seven year period of Sept. 1996 – Sept. 2003, where the VIX was almost never below 20.

epsilon-theory-cats-cradle-bloomberg-2
Source: Bloomberg, as of 05/31/2016

Granted, there were some scary market moments from late 1996 through late 2003, but it’s not like the past four years have been a walk in the park. I don’t think anyone can deny that we are living today in a different regime or state of the world, where volatility is simply not allowed to raise its ugly head as it always has in the past. That’s the Entropic Regime in a nutshell — volatility is not allowed to reach historically normal levels. Not allowed by whom? By central banks, of course. S&P 500 down 8%? Gasp! We must provide more accommodation! The macroeconomic regime that Bullard finds so objectionable and resistant to any policy choices was created lock, stock, and barrel by the Fed and their regulatory cousins. They weren’t trying to lock the world into the Entropic Regime, a long gray slog where neither recession nor real growth appears, and maybe the world would have been even more wrecked if they had taken a different path, but they did what they did all the same.

My issue with Bullard is neither his assessment of the current macroeconomic regime nor the silliness of forward guidance and Fed communication policy. I am in violent agreement with Bullard in his recognition of the power of Narrative and the simple fact that all of our crystal balls are broken. But don’t tell me that the Fed “has no choice” but to accept the current macroeconomic regime, because they DO have a choice. The Fed giveth. The Fed can taketh away. It’s just a very, very, very painful choice that the Fed would have to make in order to taketh away, full of loss assignment and bankruptcy and status quo shattering. It’s a very brave choice they would have to make, a Volcker-esque choice they would have to make. And that’s why I don’t think they will ever do it.

So we’re left with Hope, hope that a miracle occurs after the November election to change our current political regime of decay and macroeconomic regime of low growth + massive debt + negative interest rates. Politically on the left, it’s hope that Hillary Clinton isn’t really as venal and principle-less and in-the-bag for Big Money and Big War as she seems. Politically on the right, it’s hope that Donald Trump doesn’t really mean what he says about Muslims and Hispanics and judges and torture and libel and debt and women and and and. On both the left and the right, it’s hope that the election will yield some massive Keynesian public infrastructure spending spree, where our “crumbling roads and bridges” are made whole, where every city gets a football stadium for the local billionaire’s use, and where high-speed rail and gleaming airports usher in a new age of productivity and easy trips to Grandma’s house. Truly, as Voltaire’s Pangloss would say, this is the best of all possible worlds.

But hope, of course, is not a strategy. What do investors and advisors and voters — The Non-Powers That Be — DO when the entire world is stuck in a powerful negative equilibrium, when we are presented with nothing but miserable choices, at the ballot box and public markets alike? How can we find “compensation in our disappointment”, to quote Thoreau? Or to be slightly more modern in our references, let’s accept that we can’t get what we want. Can we at least get what we need?

To answer that question, at least from an investment perspective, I need to go back to the big Epsilon Theory note I wrote earlier this year, “Hobson’s Choice.” I’m not going to repeat much of that here (at 26 pages long, it’s a bit of a tome), except to say that it’s as close to an Epsilon Theory investment strategy as I can convey in this public venue. But here’s the skinny, with what I call Five Easy Pieces for the Investment World As It Is.

We’re in a storm. Mind your sails.
We’re in a game. Play the player.
We’re in a negative carry world. Think like a short seller.
We’re in a policy-driven market. Don’t trust the models.
A policy-controlled market is next. Look to real assets.

In and of themselves, admonitions like “Mind your sails” may not sound like much, but I promise they make sense in context. Here’s what they mean translated into market behaviors.

Mind your sails. Keep risk constant, not dollars.
Play the player. Trend-following is a thing.
Think like a short seller. Focus on catalysts.
Don’t trust the models. Minimize regret.
Look to real assets. Survive the politics.

Now the point of “Hobson’s Choice” is that these behaviors I’m describing, like “Keep risk constant, not dollars”, are new ways of describing good old-fashioned investment ideas that just so happen to conflict with other investment ideas that have become rote articles of faith in our modern, overly equity-centric vision of what it means to be a “good” investor. For example, I think that it’s nuts to stay fully invested in the stock market through thick and thin, and I would love to embrace that most-hated epithet in investing today: market timer. (Shudder!) But I can’t SAY that I’m a market timer, any more than I could say that I’m a libertarian or that I love Emily Dickinson’s poetry or that my wife and I homeschool our children … no, no, you wouldn’t take me seriously if the conversation about politics or books or education were framed in this way. It’s the same with investing. In the immortal words of John Maynard Keynes, “it is better for reputation to fail conventionally than to succeed unconventionally” (and for an Epsilon Theory twist, I’d add, “and if you fail unconventionally, then your reputation is really dead”), which means that even if you agreed with me on the virtues of market timing, you’d never adopt a strategy based on market timing, because it would be way too risky from a social perspective. I mean, just imagine the shame if your client or wife or partner thought you were a … again, I can hardly bring myself to write the words … market timer. Oh, the humanity!

So let’s change the conversation. I’m NOT a market timer. Nope, not me. Instead, I’m a risk balancer. I have fewer dollars in the market when risk goes up, and I have more dollars in the market when risk goes down. Will I be over-invested in the market when it hits a top and rolls over? Yep. Will I be under-invested in the market when it hits bottom and turns up? Yep. But I’m going to be adding to my dollar exposure all the way up and I’m going to be subtracting from my dollar exposure all the way down. I’ll take those odds. And just imagine if I did this risk balancing thing across asset classes, or maybe across yield-oriented strategies. Hey, now.

Here are the broad categories of strategies that the Five Easy Pieces market behaviors imply.

Keep risk constant, not dollars. Risk Balanced Strategies
Trend-following is a thing. Managed Futures Strategies
Focus on catalysts. Long/Short Strategies
Minimize regret. Convex Strategies (Optionality)
Survive the politics. Active Mgmt for Real Assets

Is this a comprehensive list? Of course not. But it’s a start. Over the next few months I’ll try to take each topic in turn and dig into the specifics, or at least as much of the specifics as I’m allowed in this very public setting. Some of the topics have already been discussed at some length in prior notes (for Convex Strategies, for example, be sure to read one of my personal Epsilon Theory faves, “I Know It Was You, Fredo”), others will be largely starting from scratch or going in a new direction from the past. If you’re a professional investor or allocator and want to dig in more deeply than what you read in these pages, don’t hesitate to reach out.

You know, Emily Dickinson published fewer than a dozen of her almost 1,800 (!) poems while she was alive, and if not for a determined sister with a narrow interpretation of Dickinson’s final wishes (she asked for her correspondence to be burned, and it was, but she didn’t specifically say anything about the box of poems next to her letters), all of this genius work would have been lost. In Dickinson’s day, there was way too much intermediation and way too many barriers between author and audience. We got lucky. Today, there’s way too little intermediation and way too few barriers between author and audience, such that all of us are inundated with “content” and “marketing collateral”, to use the lingo. Dickinson’s challenge was standing up. My challenge is standing out. Thanks to all of you who have actively spread the word about the Epsilon Theory project and helped build the vibrant community that we have today. Keep those cards and letters coming (I really try to respond to everything I get), and please check out the Epsilon Theory podcasts when you get a chance. It feels like we’re just getting started, and that’s something that warrants Hope, indeed.

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