The Acrobat and the Fly

No, nothing makes sense, nothing seems to fit
I know you’d hit out if you only knew who to hit
And I’d join the movement
If there was one I could believe in.
Yeah, I’d break bread and wine
If there was a church I could receive in,
Cause I need it now
To take the cup
To fill it up, to drink it slow
I can’t let you go
And I must be an acrobat
To talk like this and act like that,
And you can dream, so dream out loud,
And don’t let the bastards grind you down.

— U2, Achtung Baby, “Acrobat” (1991)

It’s no secret that a conscience can sometimes be a pest
It’s no secret ambition bites the nails of success
Every artist is a cannibal, every poet is a thief
All kill their inspiration and sing about their grief
Over love
A man will rise
A man will fall
From the sheer face of love
Like a fly from a wall
It’s no secret at all

— U2, Achtung Baby, “The Fly” (1991)


Maybe because of their popular appeal, or the fact that our society can’t abide a person like Bono with unapologetic earnestness about his beliefs, or because of the band’s retreat into musical weirdness and emergence into arena bombast, U2 has been treated rather uncharitably by modern commentators. But at their best, U2 were mesmerizing. Stylistically, I prefer Unforgettable Fire or War, and for sheer songwriting genius, Joshua Tree remains one of the greatest albums ever recorded.

But where art about making art (e.g., La La Land, Birdman) can sometimes veer toward self-indulgence, Achtung Baby reaches a different kind of peak. It is raw and self-critical, with no attempt at final redemption. I mean, it is melodramatic as all hell, which is kind of the concept of the whole album, but if its arc carries any absolution for the artist, it is that hypocrisy is the universal result of art and not some unique moral failing. Every artist is a cannibal, every poet is a thief.

But in the end, neither the artist’s cannibalism nor the poet’s thievery invalidate their art. You can dream, so dream out loud, and don’t let the bastards grind you down. There’s a narrow lesson in this that goes like, “You can still read Ender’s Game even though Orson Scott Card once ate a Chick-fil-A sandwich.” But there’s a bigger lesson, too: if you go around looking for hypocrisy in your enemies, you’ll always find it. Doing so will always feel good. Doing so will rarely get you closer to truth, beauty or love.


I was recently explaining to a friend and former colleague what I write about on Epsilon Theory. They asked me if it was a behavioral investing blog, and I wasn’t sure how to answer.

In a sense, yes, of course Epsilon Theory is a behavioral investing blog. We believe that humans and the stories they tell heavily influence, and sometimes determine asset prices. And we write about that. But when most people say “behavioral economics” or discuss investment strategies that account for investor behaviors, what they usually mean is “cognitive biases.”  Yes, we write about those things, too.

But except in the way that all human activities are influenced bv the way that our brains evolved to process information, Epsilon Theory isn’t really about cognitive biases. That isn’t because we don’t believe in those biases. Quite the contrary. Instead, it is a recognition that our biased brains are riding on meat puppets that spend most of their time interacting with other meat puppets. Our brains are rarely tasked with drawing conclusions from raw data. Most of the things that matter to us and our lives are social. That means that the stimuli that reach us, the basis for our judgments and opinions, are usually the outputs of other compromised brains, processed through established cultural and social structures.

It is intuitive that understanding and mastering our own biases should mean not only being aware of innate evolutionary impulses, but also understanding how they manifest in social behavior. This is what Ben meant when he wrote about acknowledging our own vulnerabilities to the introduction of memes and Narrative in This is Why We Can’t Have Nice Things. We like to think that we operate from internally coherent, epistemologically sound ethical, social and political frameworks. You don’t. I don’t. We don’t. We’re making it up as we go along and we all know it.

It is rarely possible to divorce ourselves completely from the ways in which our human brains are wired to respond to society that is increasingly aware of the ways in which other human brains are wired to respond. We cannot pretend that it doesn’t change anything that companies like Tesla and Salesforce now seek to foster rabid audiences and stabilize their stock price through targeted social media engagement strategies — what we write about on these pages as Missionary activity. We cannot pretend that it doesn’t change the priors that drive how we build investment portfolios that standing governments consider markets to be utilities for maintaining public order and assent, and actively employ communications strategies to establish Narrative around fiscal, monetary and trade policy.

And so it is that in our investing lives, and in our public, political lives, it is very difficult to refuse to play the game. Ours is a Narrative-driven world, and surviving in it means doing more than understanding how our biology predisposes us to cognitive biases. It means understanding how our engagement with social structures and with one another creates new biases and pitfalls altogether, a kind of special susceptibility to brutal logical fallacies. Many of these are so-called ecological fallacies, discussed in an ET note from 2013 that still reads very well.

Ben wrote recently that the memeification of information — the transformation of Emails into Emails! or Lyme disease into Lyme disease! — is a big part of why we can’t have nice things. I want to suggest to you that it is possible to have nice things again. Real conversations with other people that result in real outcomes. Perhaps even a move back in the direction of Cooperative Games from the Competitive Game we are in today. I argued in my essay from last August that this would require a critical mass of well-intentioned people willing to give up on, to lose, non-existential battles. I also warned that you wouldn’t like my advice. In the interest of providing you with yet more unsolicited advice that you won’t like, allow me to outline the four Competitive Game equilibrium-enforcing strategies I think we must give up if we’re going to make ourselves and our thinking less vulnerable to memes, abstractions, tribalism and Narrative.

Know in advance that in a Competitive Game, each of these four is a dominant strategy. To wit:

  • The People Who Disagree with Me are Hypocrites
  • The People Who Disagree with Me are Stupid
  • The People Who Disagree with Me are Evil
  • The People Who Disagree with Me are Controlled

If you give up using these strategies as I will recommend to you, you will lose. You will lose credibility. You will lose standing. You will lose popularity. People will believe you are losing arguments. People will believe you are less intelligent. People may believe you are less committed to ethics, morality and justice.

Wondering where you can sign up yet? Good. We’re going to lose so much, you’re going to be so sick and tired of #losing.

You’re Too Biased to Measure the Impact of Hypocrisy on Credibility

Before we get too far, however, let’s get one thing out of the way: the people who disagree with you really are hypocrites.

I don’t know the people who disagree with you and I don’t need to know. Hypocrisy has been the human condition since Adam proclaimed his holiness by blaming the apple eating on his wife (I mean, it was kind of her fault, if you think about it). But the game of find-the-hypocrite isn’t really about finding gaps between the behaviors people condemn in others and the actions those people take themselves. We all know those exist, and I hope you came here for meatier arguments than, “We’re all hypocrites, so live and let live, amirite?” No, the game is about how we go about quantifying that gap. Who is the bigger fraud, the bigger phony? It’s also about why we seek out hypocrisy in others.

You might think that this strategy would be played out by first looking for the worst actions and then aligning them with incongruous statements of condemnation. Turns out that isn’t exactly the case. Four Yale researchers in psychology published a fascinating study in 2017 on this topic. It’s a well-written, very digestible bit of research based on cleverly formulated questions. A rarity for such papers, I recommend reading the whole thing. It holds a few interesting insights:

  • People attribute more moral value to condemnations of bad acts than to claims of good acts.
  • People will forgive admitted actions that don’t jive with values, but they won’t forgive bad acts that conflict with condemnations of bad acts.

In other words, what people hate about hypocrisy isn’t the immoral act, or even the gap between values and actions. It’s the intentionally false signal from moralizing about the act. And while the paper doesn’t suggest this directly, it is my belief that this aversion is one reason why excessively strong signaling or moral condemnation, when coupled with even suspicions that someone may be acting in conflict with those signals, is so distasteful to many of us. You’ve heard of virtue signaling, I presume.

The gulf between a false signal and simple conflict between values and action may seem like a distinction without a difference, but it isn’t. It matters that our anger about hypocrisy is not the response to a moral failure, but to a failure in ideological signaling. That means that it is an opportunity to assault the credibility of those signaling.

It just so happens, of course, that credibility is one of the most important social signals we send, and one of the ones that matters most in Narrative-driven political, financial and other social and civic markets. The mechanisms of credibility within social capital are so pivotal to influence, wealth generation, capital formation, new lead generation and popularity in general that signaling “I am a credible person” becomes for many of us an objective unto itself. We may complain about Missionaries and their attempts to influence us, but we would all be Missionaries in a heartbeat if we could. For those who have read my piece exhorting us to Make America Good Again (and to stop worrying about being great), you won’t be surprised to learn where I come out on this issue. Those who have built on the sands of cringeworthy credibility signaling may come to a different conclusion.

One of our most potent weapons for winning the credibility game — or so we perceive — is seeking out and identifying hypocrisy in others. We are attracted to assaulting hypocrisy for two reasons. First, it acts as a credibility signal for us. It tells others that we are players in the great game. It tells others that we care about logical consistency and other Good Things. Second, it acts as a credibility reducer for our opponent. It challenges and reduces their believability and standing, and seeks to insinuate that they care less about intellectual honesty and logical and moral consistency. In effect, it is a force multiplier for our arguments, because once we establish that another party has made hypocritical statements, we can summon that spectre again and again to relieve us of the need to dispute further arguments on their merits.

There’s just one problem with this: we are hopelessly prone to bias in our assessments of others’ hypocrisy. Why? Because our anger about hypocrisy doesn’t begin with systematic, objective observation of moral failures or flawed reasoning under our value system. It begins with our selective observation of moral, philosophical or intellectual condemnations made by others — and guess what? We tend to pay a little more attention when someone condemns someone we like or something we believe in. In other words, when someone expresses a criticism of us, our friends, our allies and their behaviors or actions, we are simultaneously inspired to diminish that person’s credibility to protect our ego, and to search for actions that conflict with their condemnation. It’s like handing a three-year old a club and telling him that other boy over there took his favorite toy.

It’s an overwhelming bias that seems so obvious and non-partisan in its pervasiveness when you step back to view it with as much dispassion as any of us can muster. It’s why the political right quickly finds every example of a preening Hollywood numbskull moralizing about some progressive social justice issue right before they end up in TMZ for abetting the abuse of young actors and actresses.  It’s why the political left is lying in wait for any Bible-thumping family values Republican politician to get caught in an ethics scandal. It’s why there are millions of people still penning gotcha pieces on the hypocrisy of Bill Clinton supporters who criticized the moral failings of Donald Trump and why millions of people are still writing pieces on the hypocrisy of Donald Trump supporters who had criticized the moral failings of Bill Clinton. Claims of hypocrisy aren’t about morality. Claims of hypocrisy are about ideology.

But Hypocrisy! the meme isn’t about either of those things. It’s about credibility. And Hypocrisy! the meme is warm, wet garbage. In those rare moments when we are honest with ourselves, we know that the reason we accuse others of hypocrisy rarely has anything to do with a good-faith belief that it justifies devaluation of their opinions or arguments which would often stand on their own merits. Likewise, research tells us it has next to nothing to do with any moral objection on our part. No, we do it because we know that those we disagree with will use this same technique at every opportunity to devalue us and those we agree with. We know that not responding in kind makes us vulnerable.

I saw a lovely anecdote recently from Ethics and Public Policy Center fellow Pascal-Emmanuel Gobry recently, which expresses a similar idea somewhat more succinctly:

My high school best friend’s dad was one of the most talented jazz guitarists of his generation. When my friend was a kid, he asked his dad if he could teach him to play guitar. The dad was of course thrilled. “I’d love nothing more in the world, he said. But first, you’ll have to learn music notation and music theory and chords. Then I’ll teach you to play.”

My friend, being a wiseass, retorted, “Paul McCartney never learned any of that stuff, and it didn’t stop him.” My friend’s dad, being a wise man, replied, “Yeah, but you’re not Paul McCartney.”

Yeah, in the Bible Jesus calls people broods of vipers and whitewashed tombs. And Paul, and the Prophets, and saints, used salty language. Yes, there are times when such language is called for. But the reality of original sin means the odds of you using this language out of pride overwhelm the odds of using it because of the necessities of speaking love in truth.

You’re not Paul McCartney.

Whatever social structure or biological impulse evolved in us to make us respond the way we do to hypocrisy makes us uniquely unsuited to routinely rely on our detection of it as an indicator of anything other than our own bias. Neither you nor I are Paul McCartney (unless you are Paul McCartney, in which case, hello, thank you for reading and what is the weird chord in the second half of the third verse of “Let It Be” when you sing “Mother Mary” because I’ve been trying to figure out what’s happening there for 20 years).

I should be clear about the narrow point I am making, and the point I am certainly not making. From a moral and ethical perspective, there is no particular reason why being biased should prevent us from holding one another accountable for dishonesty, hypocrisy and other flaws. If we only spoke up about injustice and error when we had no dog in the fight, we would comprise an ugly society indeed. But I hope that you can see the difference between the impact of bias on the justifiable use of it as an argumentation technique and the justifiable reference to it in good faith efforts to improve our own behavior or of those who we love, trust and want to grow us with as humans.

Being a Hypocrite Doesn’t Make You Wrong

Even if we can play a mean left-handed bass and believe that we are capable of being even-handed in using accusations of hypocrisy as an element of our political and social engagement, it doesn’t take long to recognize that doing so is frequently counterproductive to the whole point of that engagement in the first place. It’s pretty simple. If what you care about is being considered right and winning those arguments, then the hypocrisy! meme is the right tool for the job. If your objective is to get to a better policy or portfolio outcome, then it isn’t.

The next time you’re looking to bring this tool out in an argument or disagreement, ask yourself: does this person’s false signaling really devalue the argument he or she is making? The data he or she is using to support it? Or is it just a tool I would use to discredit this person so that I don’t have to bother with the whole debate? It’s a bad, biased heuristic.

Consider Warren Buffett, the investing world’s moralizer-in-chief. Here he is on leverage.

Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.

Here he is in 2003 on derivatives:

No matter how financially sophisticated you are, you can’t possibly learn from reading the disclosure documents of a derivatives-intensive company what risks lurk in its positions. Indeed, the more you know about derivatives, the less you will feel you can learn from the disclosures normally proffered you. In Darwin’s words, “Ignorance more frequently begets confidence than does knowledge.”

Guess who sold protection on a bunch of munis starting in 2007, not entirely different in scope, although admittedly in scale, from similar trades that sunk AIG around the same time? Guess who, according to research from AQR, has historically generated his returns through effective leverage of 1.6-to-1?

For someone like me, who is convinced that randomness would almost certainly produce a Buffett or two through sheer chance rather than skill, applying the hypocrisy! meme is tempting. I am envious of his reputation, and I hold the good-faith belief that people who follow what Buffett does are focusing on things that don’t matter. I believe that the people who follow what he says about index funds place too much emphasis on costs and too little emphasis on getting the right level and sources of investment risk. It is so easy for me to justify why it isn’t just correct, it’s the right and moral thing to do to throw this guy under the bus for hypocrisy, to try to reduce his influence.

Except he really is an incredibly thoughtful investor with innumerable traits I wish I had, wisdom our world would be worse without, and perhaps the keenest insight into the role of temperament in the success of the investor we’ve seen in the last 50 years. The Competitive Game strategy says to seek to diminish him — to make ourselves the Fly. To kill our inspiration to sing about our grief.

But that’s just the meme talking. The fact that Buffett’s views on leverage and derivatives are insanely hypocritical don’t change the fact that he has a tremendous amount of investment wisdom to share.

Letting Ourselves Off the Hook

Maybe the worst harm this tick has in store for us, however, is the doubt it sows in us. You and I are both hypocrites. There’s a fine balance between internalizing the moral importance of honesty, consistency and forthrightness on the one hand, and not internalizing the hypocrisy! meme in ways that would cause us not to champion causes and values we believe in simply because we know we can’t live up to them on the other. This is a real danger.

In many cases, our hypocrisy is just growth. When I was 23, I put myself at odds with some genuinely nice and thoughtful people I worked with and for. Why? Because I was an arrogant ass who knew that no one could build and code a model as quickly and efficiently as I could, and because I knew that my skills in this area were creating all the company’s value. Except that wasn’t true. Of course it wasn’t true. I was a stupid kid with no concept of the value of different people and skills. Should I let this moral failure keep me from teaching young analysts today that modeling is a commodity skill? That their real value in an organization will come from cultivating trust, honing temperament, identifying business drivers that matter and becoming better communicators?

In some cases, what looks like hypocrisy is just the reality of a world of contradictions. I’ve written and, yes, moralized about the things investors waste time on, and the things they should focus on more. In these pages, I’ve condemned bad behaviors, like focusing too much time on picking stocks, on picking funds, on fees over other costs. And yet, like many who agree with me on these topics, I still spend far too much time doing each. I’ve spent days trying to figure out if my largely systematic framework for selecting U.S. stocks for our wealth management business is missing something on consumer brands. I’ve spent more time thinking about General Mills and Colgate-Palmolive than I have about things that I know will have greater long-term impact on financial markets and investor outcomes. But I know that these things are important to my clients, too. I know that it matters to them to understand what they own, and why, in a very qualitative sense. And if it matters to them, it matters to me. The hypocrisy that seems so clear in others is not always so cut and dry when we apply it to ourselves with all the details. Our life and work are complicated.

We are complicated, too. Today I relish the trappings of my Texas identity, but it wasn’t always that way. It took me five seconds to decide where I would go to college when the opportunity to escape a small town in southeast Texas presented itself more than 20 years ago. While I can’t imagine harboring that sentiment now, there’s a part of me that can’t figure how much of that refound identity is affectation, a resistance to things I didn’t like about living in the northeast, or an authentic expression of my values. We’re all complicated, conflicted, growing and changing, and there’s no nobility in allowing the hypocrisy! meme to cause us to withdraw from figuring out our own small issues, or helping our communities and societies figure out the big issues.

This isn’t some weird attempt to present hypocrisy as moral, or something we should be more or less prone to forgive or criticize. None of that. It’s awful and you should stamp it out wherever you see it whenever you have the standing with someone to be influential. It is about how you will respond to the tick, the meta-meme of hypocrisy! that seeks to shut off people you would learn from, deepen your falsely held belief in your tribe’s moral superiority, and short-circuit your own brilliance out of false-humble feelings driven by knowledge of your own hypocrisy.


Now because by reason of those daily sins of which I have spoken, it is necessary for you to say, in that daily prayer of cleansing as it were, “Forgive us our debts, as we also forgive our debtors;” what will ye do? Ye have enemies. For who can live on this earth without them? Take heed to yourselves, love them. In no way can thine enemy so hurt thee by his violence, as thou dost hurt thyself if thou love him not… In this he is as thou art: thou hast a soul, and so hath he. Thou hast a body, and so hath he. He is of the same substance as thou art; ye were made both out of the same earth, and quickened by the same Lord. In all this he is as thou art. Acknowledge in him then thy brother.

— Saint Augustine of Hippo, St. Matthew’s Gospel, “Sermon on the Lord’s Prayer”


The most painful realization of all in a world awash with Narrative, of course, is that the people who disagree with us are not especially hypocritical or contradictory. It is that they are our brother. Our sister. Made out of the same earth. And probably every bit as smart, upstanding, independent-minded and, yes, flawed as we are.

When we stop telling lies about why we disagree and start telling this truth, we can grapple with the uncomfortable fact that our brothers and sisters saw the same facts and came to different conclusions. As Narratives force us into ever narrower bands of acceptable views on markets and politics, the speech we must tolerate becomes more uncomfortable, and will feel more extreme. It will also feel more contradictory. Friends, if you would end the Competitive Game, if you would triumph over tribalism, you must learn to tolerate some hypocrisy — in yourself and in others. You must embrace the Acrobat and not the Fly. How?

Dream out loud, and don’t let the bastards grind you down.

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The Fundamentals Are Sound

Cobb: What do you want?
Saito: Inception. Is it possible?
Arthur: Of course not.
Saito:  If you can steal an idea, why can’t you plant one there instead?
Arthur: Okay, this is me, planting an idea in your mind. I say: don’t think about elephants. What are you thinking about?
Saito: Elephants?
Arthur: Right, but it’s not your idea. The dreamer can always remember the genesis of the idea. True inspiration is impossible to fake.
Cobb: No, it’s not.
— Inception (2010)

Cobb is right. It’s not impossible. When we are deep in our element as analysts of economies and issuers, we are supremely confident. We know the critical assumptions in our portfolios, models and projections cold. But when we apply ourselves to assessing what others’ views may be, with understanding what is ‘priced in’, we begin to doubt. Deeper into the hole, where we grapple with what other price-setters are treating as the consensus of yet other investors, our models break. More importantly, our confidence evaporates. Our vulnerability to those stories explodes. So how do you feel about your positioning today?

— Randall Munroe, “Night Sky”, XKCD

The dream of retreat to a world where we can win by understanding what’s really happening underneath the hood is a siren call. We remember the first time we figured out how to identify potentially unpriced optionality in a business model. When we absolutely pegged that fatally flawed assumption in the new management team’s cost reduction plan that no one else saw. You know. The good ol’ days.

There are brief flashes in which central bank or inflation narratives, fiscal policy angles, next-thing rotation pitches from the sell-side and “cash coming off the sidelines” think pieces seem to fade to the background and we see daylight again. And sure enough, it’s another head fake. That long-awaited rotation back to value unwinds after two or three sessions, and we start grumbling about “algos” and passive investors and volatility-targeted strategies and extravagant tech multiples and cryptocurrency excesses and are there mountain lions around here?

Arthur: So, once we’ve made the plant, how do we go out? Hope you have something more elegant in mind than shooting me in the head.
Cobb: A kick.
Ariadne: What’s a kick?
Eames: This, Ariadne, would be a kick.
— Inception (2010)

It’s easy, if a bit heartbreaking at times, to move on from a fundamental investment thesis. Most good ones have a list of sell disciplines describing exactly how they fail, anyway. It’s slightly tougher to change our perspectives on how other investors are likely to behave. But once we acknowledge that everybody knows that everybody knows something, it is almost impossible to know what sort of evidence we can rely on to reject it. That has a lot of important implications, but one more than any other: Narratives tend to influence prices far, far longer than we expect.


“I don’t know half of you half as well as I should like; and I like less than half of you half as well as you deserve.”

This was unexpected and rather difficult. There was some scattered clapping, but most of them were trying to work it out and see if it came out to a compliment.

— J.R.R. Tolkien, The Lord of the Rings, Speech from Bilbo’s 111th Birthday Party

From time to time I speak to and run seminars with students at colleges in Texas, usually with business school students or participants in student-run investment funds. Like any instructor, I have a go-to challenge question. It is a question to spark inquiry, to raise a skeptical eye to the priors with which we approach many of the fundamental questions of investing. It’s also an asshole question. Because, like most instructors, I am an asshole.

“What”, I ask the students, “is the most important single driver of today’s price of ExxonMobil stock?”

It’s the worst kind of question, because I’m obviously asking it for the sole purpose of telling everyone they’re wrong. Still, it’s fun to watch the arguments between very bright students. “Value” is always among the first two or three responses. “Well, what do you mean by value?” I prod, usually yielding a response about multiples. “Value may influence your returns going forward, but a multiple IS the price, so that can’t be it,” a student usually responds, before the discussion descends into bickering and debate over fundamental data which may drive pricing. Earnings? EBITDA? Cash Flow? Oil Price? No, future expectations for oil prices!

It’s yesterday’s price, I tell them.

It feels like a throwaway, the sort of dad joke enjoyed only by middle-aged professionals in tweed playing at being a professor. But for investors trained by schools, banks or long-only shops in the various churches of fundamental stock-picking, it is a necessary and important reminder. Most approaches to security analysis inherently view each day as a tabula rasa. We wake up and decide to evaluate all available information about companies and their securities, determine that the appropriate price either has or hasn’t changed and send our updated limits to the desk. Except that isn’t how this works at all. Like almost anything else in public and political spheres, prices are always determined around the margin.

Consider the tax cut debate the U.S. just endured, and the language used by politicians and media to discuss the issue. Each tax plan is presented as either a cut or a hike, and good or evil on that basis (or on how said cut or hike disproportionately favors one class or another). Did you hear a single analyst discuss what absolute level for a particular income category would generate the most revenue? What would be the fairest on either an objective or subjective basis? Stimulate the most consumption or investment? A politician who never said a word about a static 20% tax rate might be furious with the idea of taking it from 15% to 16%, for example. This is true across every kind of policy issue, and across budget issues for every corporation and household in America. We rarely, if ever, discuss and debate policy issues or investment decisions on an absolute, aggregated basis. Our evaluations are always, always, always on the margin.

This is doubly true for financial markets, where these marginal determinations are made daily. That means that exogenously influenced, random and economically sensible drivers of variations in prices, and, most importantly, the narratives built around them, all become part of the accepted structure of a security’s price going into the next trading day. Strong efficient-markets hypothesis adherents would say that this is wrong, and that any trading not reflective of currently available information would be quickly stamped out and the price returned to an appropriate representation of all available facts (whatever those are). Strong EMH adherents are also too busy being served negative calorie donuts glazed with a 1937 Chateau D’Yquem reduction from a polished unicorn’s horn, so be grateful that the rest of us can have a serious conversation about investing in peace.

That said, the basic idea isn’t wrong, is it? Over enough time, securities prices can diverge enough from the price of comparable investments in ways that influence enough investors to abandon the idea that the accumulated information contained in yesterday’s price is right. EMH assumes that this happens insanely quickly, and the rest of us sane people recognize that it takes some time. In fact, I’d say the world today largely falls into three camps: (1) rare EMH holdovers in academia, (2) kinda-sorta efficient market folks that believe information just propagates slowly, and sentiment…er..something something Brownian motion, and (3) those who believe that prices reflect a shifting mix of fundamental financial data, investor preferences, objective functions and attempts to guess the preferences and objective functions of others.

Some would characterize these differences as a simple question of time horizon.

But are they?

Dick Thaler’s Party Trick

If you’ve ever had a professional dinner with Dick Thaler (maybe personal dinners with him go this way too, but I have never been invited), you’ve probably heard him give his telling of the Keynesian Beauty Contest that Ben has written about several times.

In Keynes’s version of the contest, you win by correctly picking the woman from a series of pictures in a newspaper that you think will be voted as the most beautiful by everyone participating. First-degree thinking, in Keynes’s parlance, is to pick the woman you believe is the most beautiful. Second-degree thinking is picking the woman that you believe the other participants will believe is the most beautiful. Degrees above that require thinking less about beauty or what others will think is beautiful, and more about what the contestants are likely to think about one another. There is no neat solution to this illustration, of course, because we don’t really know what others find beautiful. We are even less certain about what others will believe about their peers’ ability to judge beauty. This uncertainty makes it particularly apt as an analogy to the practice of investment management, but Thaler’s version has the added feature of applying simple mathematics in the place of subjective determinations. That’s useful because it allows us to quantify consistent behavioral tendencies in the game.

Thaler’s version is a little different, and goes something like this:

Everyone at the table must pick a number between 0 and 100. The winner will be the person who chooses the number that is closest to 2/3 of the average.

0th Degree 50.00
1st Degree 33.33
2nd Degree 22.22
3rd Degree 14.81
4th Degree 9.88
5th Degree 6.58
6th Degree 4.39
7th Degree 2.93
8th Degree 1.95
9th Degree 1.30
10th Degree 0.87
11th Degree 0.58
12th Degree 0.39
13th Degree 0.26
14th Degree 0.17
15th Degree 0.11
16th Degree 0.08
17th Degree 0.05
18th Degree 0.03
19th Degree 0.02
20th Degree 0.02
21st Degree 0.01
22nd Degree 0.01
23rd Degree 0.00

Because there are multiple calculations that a person might ignore or fail at, I’m taking some liberty of interpretation, but I think the first-degree answer to this question is 33. The player will realize that he has no information to guide his first step within the 0-to-100 range, so he concludes that the average of 50 is the only sensible place to start. We’ll give him credit for realizing that he must be 2/3 of that number, and thus arrives at 33.

Unlike Keynes’s contest, Thaler’s also has a ‘real’ solution. You’ve seen it replicated (albeit in a flawed format that isn’t Pareto-optimal) in the movie A Beautiful Mind. You know, the bar scene with the blonde? Also, why is every example of game theory a creepy story about old male economists picking beautiful women? Anyway, Thaler’s problem has a single solution that is a Nash Equilibrium: zero. If everyone can calculate 33, then surely they’ll figure out 22, 15, 10, and all the way down. By the time you’re playing 23rd-Degree Dinner with Dick, you’ve already gotten down to two digits of zero. A computer would tell you this instantly. But then, a computer would also assume that all the people playing understood AND remembered limits from their first week of calculus. There’s no shame if you don’t. I mean, there is, but it’s politer to say that there isn’t.

When we have played this game with clients, audiences, classrooms and colleagues, my experience is that the winning guess consistently falls between 15 and 22, usually closer to 22. I expect, but don’t know, that Thaler would give you a similar value.

What does this mean? Or at the least, what does it imply?

First, it should be obvious that every sufficiently large iteration of this game will include some people who don’t understand it at all. Some won’t have a natural grasp of expected value and won’t start from 50, but from some other number they expect will be popular. These people will tend to increase the average winning point total somewhat, since they aren’t following the averaging and iterative mathematical process that forces all the numbers downward. If you want some real-world examples of what this person looks like, Google “Bitcoin Price Target.”

The second group of participants — usually a small group — are those who understand the basic principles of the problem but think that everyone else is a moron who doesn’t. They bet on 33. These are your first-degree thinkers. This is basically every graduate of every business school in the world until he has to manage an actual P&L for the first time.

The third group of participants — usually larger than the second — understand the math all too well, and assume that everyone else can, too. They provide the real solution of zero, or if they have a modicum of wisdom to pair with that beautiful brain and neckbeard combo, add a couple points to catch the stragglers who are too slow to catch on. They drag down the winning score. Ben wrote about these people earlier this week in Too Clever by Half. They’re the coyotes.

The bulk of participants, however, answer between 22 and 33. They understand that the principle is to recognize that you want to be 2/3 of the answer everyone will guess. Since the most basic answer without getting into guessing others’ behavior is 33, they go one layer deeper and judge it to be sufficient. This is second-degree Keynes. In this way, Keynes’s example is much more like financial markets, because it incorporates compounding uncertainty at every level. We know what we think. We have a pretty good guess at what others think. But building a mental model of what others think others will think is an order of magnitude more challenging, because it requires perspective not only on the underlying — a woman’s beauty — but on others’ prejudices and biases about the other judges!

Playing a third-degree game is too daunting a task to consider for most, and so curiously, even in the mathematically deterministic version of the game that has a Nash equilibrial ‘correct’ answer, the takeaway is the same as in the beauty contest: you usually win by guessing that others are playing a mix of one to two degrees of the Common Knowledge Game. Some people buy and sell on fundamentals, and some on how they think people will react to them.

But as Ben discussed in The Three-Body Problem, we think that this is changing. We think it has changed. We think that the violent expansion of communications policy by global central banks and the accompanying expansion of always-on media has meant more participants shifting to third-degree thinking. The reason we talk about Narrative so much is that we find it a useful meta-expression of and proxy for exactly the kind of mental model a third-degree participant must construct. When we refer to Narrative, we mean it as an expression of what everyone knows that everyone knows.

If you accept that Narrative is exerting greater influence on asset prices, you will lose if you play the traditional strategy. You will lose if you assume that others are playing one- or two-degree strategies.

The Fundamentals are Sound

So what did everybody know that everybody knows over the last couple weeks? And when you looked at the game unfolding, what strategy were you playing?

I’ve written about the silliness of trying to ascribe specific causes to market action, but I’m willing to stand on this as probably, approximately correct. Let me tell you what I think happened. Then let me tell you what I think other people think happened. And if you’ll bear with me, let me tell you what I think markets will ultimately decide everybody knows that everybody knows happened.

I think that there was already an emerging Inflation Narrative coming into 2018, although not much actual inflation to show for it. Ben has written credibly about this on several occasions. Torsten Slok at Deutsche Bank put out a nice chart highlighting breakevens leading into the events of last week (don’t get too cynical about the forced perspective of sell-side axis ninjas, please).

Source: Deutsche Bank 2018

I think that a roaring start for risk assets in early January gave tactical allocators, macro shops and hedge funds an opportunity to bank early returns (and incentive fees) by taking off risk. I say “think,” but “know” would be nearer the truth. I have the receipts, as it were.

I think these funds thought that the emerging Inflation Narrative warranted pulling back some of that risk not just in risky assets but across their book, including in rates (sovereign debt). I think this accelerated and compounded confidence in the Inflation Narrative.

I think that many market participants thought that the focal point of the event through the end of January was not inflationary expectations, but frothiness of equity markets. I think they thought this because that is where their focus had been as a result of the remarkable returns of 2017 and 2018 and the length of time since the last S&P decline of any significance. I think media bears this out, but it’s story, not fact.

I think that the resulting spike in volatility on February 2nd and into February 5th confirmed and exacerbated what most people thought about the proximate cause of the correction. As a result, the weight of market behaviors shifted from response to a rate shock or rise in inflationary expectations to a classic risk-off trade.

I think that with the relaxation in volatility since the events of late January into February 5th many investors think that the event was an equity and volatility event. A moment of irrational pessimism brought on by blow-ups in vol-selling and vol-targeting.

I think that more large institutional allocators today than at any point since the early 1980s know that their peers know that inflation, if and when it comes, will fundamentally change how they must build, allocate and manage portfolios.

I think that instead of focusing on this, other investors are comforting themselves with an age-old mantra: “The Fundamentals are Sound.”

“The Fundamentals are Sound” on the U.S. economy. On stocks. This was just a correction that we needed after things got a little frothy. It was short-term sentiment. It was risk parity and vol-targeting funds driving markets lower for no reason after a jump in vol. If you loved the Dow at 26,000, you ought to really love it now.

“The Fundamentals are Sound” on cryptocurrencies. The price action doesn’t matter. It’s the technology that matters. As long as you research and understand the technology and what it has the potential to do to overcome overcentralized, centrally planned banking and transactional systems, you won’t lose. All the smartest people, all the people who have really done their research on this technology, the people who get it, are not sweating these price moves.

Amazing. Every word of what I just said is wrong.

Well, it isn’t that the statement isn’t factual. It may be.

It’s that we have no idea if and when it is going to matter. You can argue all you want that it’s a random walk to a known destination, but as the walk gets longer, that distinction becomes less meaningful.

Sure, it serves a useful purpose to use this language with some clients, in that it keeps them from taking rash actions to change their asset allocation without a real basis for doing so. If you’re a financial advisor and telling your client this fact helps to keep them from dumping all of their risky assets, then you have my blessing and more. But we must be honest with ourselves. If we believe that “Fundamentals are Sound” is necessarily a relevant statement after a correction like this, we must acknowledge that it also carries two embedded assumptions that are so extreme that it’s worth taking a step back to truly unpack them.

  1. It requires us to believe that yesterday’s price was the right one.
  2. It requires us to believe that non-fundamental influences on price (second-degree or third-degree issues) have not changed either, or that they will revert soon.

The silliness of the first ought to be self-explanatory. The “Fundamentals are Sound” relative to what? Relative to how they manifested in prices yesterday? Last week? How they would have manifested over the last 30 years? Absolute pronouncements of appropriate valuation and marginal thinking about price changes are a risky combination.

Understanding the second is a bit nearer to my purpose here. After events like this, it is appropriate to ask: do I think that the decision-making processes of other investors have changed? Do I think that those investors’ views of other investors’ positioning and decision-making has changed? Furthermore, do I think that any of the broad Narratives reflective of how investors are responding to one another have changed, or that they have strengthened or weakened?

Now, my confidence about the mechanics I’m describing here is high, but I don’t judge my ability to evaluate using these mechanics to be higher than any of yours. In fact, many of you are probably shrewder investors than I. But I think a lot of investors will be coming out of the last two weeks saying that nothing has changed, or focusing on how long it will take to bounce back from a couple weeks of fear-driven market behavior. I think that may be a mistake. Why?

Because it takes much longer to unwind third-degree thinking. Narratives last.

Think about the Keynes game again. Imagine that I drew a feature on one of the men or women from the beauty contest to make them most distinctive, and perhaps more polarizing. Let’s say a diamond nose stud, or a face tattoo. How long does it take you to figure out how your first-degree thinking about the game changes? Second? Third? How much more data would you need to conclude that there was a change, and how would that differ for thinking at each degree? How many more events to give you insight into responses? There’s a reason Narrative-driven markets last far longer than we expect them to. Time passes more slowly in a dream-within-a-dream than it does in a single dream alone.

Again, I think investors who look at risky or speculative assets and say, “I like this just as much, and I don’t really see why it should have gone down this much,” may well be right. I think that they’d be justified in having some expectation that volatility will fall, and that some of the correction would be recaptured over coming weeks and months as people forgot why they felt the need to go risk-off for three days in February.

But I think it’s not the Friday and Monday sell-offs and whether they were “justified” that will end up mattering. It’s what happened the week before that we should be paying attention to.

If the events of that week did anything, it was to further convince me that market participants have bought into the Inflation Narrative — even well in advance of strong data on actual inflation. So while I don’t have any valuable short-term positioning thoughts (and I never will, so don’t ask), I think that the surprising strength and persistence of this Narrative — and Narratives in general — has real implications for us as asset allocators and alpha-seekers. Even alpha-seekers in the Craftsmanship Alpha mode.

We all talk a big game about diversification, and rightfully so. Look, I wrote a piece that called it the second most important thing in investing. But how big a part do TIPS (Treasury Inflation Protection Securities) play in your portfolios? Commodities? Other real assets? Many of these have been such abominable relative investment opportunities over the last 35 years that they frequently aren’t even considered as asset classes. In some generous cases they’re called alternatives or diversifiers, but few investors today consider them in the same context as stocks and bonds.

As the Inflation Narrative heats up, I believe asset allocators will have to seriously evaluate the extent to which this tacit assumption is still appropriate. They will have to grapple with whether nominal bonds have the same crisis risk aversion and diversification characteristics that they have over the last couple decades. But here’s the rub. They will have to do so in a prospective, long-term way that may not have the benefit of a recent high-confidence in-sample and out-of-sample period for their backtests. Are you ready to tell your committees that you think sovereign bonds may not be the same safe asset in certain types of major equity drawdowns? Are you ready to suggest what to do about that? Are you prepared to stake your career on it?

It’s not uncharted territory. There is nothing new under the sun, after all. But it’s territory that few of us have trod during our careers. And if you’re staring at the ground, trying to convince yourself that it’s solid before every step, you may be missing where we’re headed.

We have to be humble, too. If you’ve been talking about an emerging Inflation Narrative for a few months, we know enough about behavioral biases to recognize that you’ll start seeing ‘evidence’ of it everywhere you look. But that’s kind of how Narrative works in the first place, y’all. In the end, we don’t have all the answers, but we do think we know how to think about these questions.

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Gandalf, GZA and Granovetter

Artist: Eric Geusz

I cordially dislike allegory in all its manifestations, and always have done so since I grew old and wary enough to detect its presence. I much prefer history — true or feigned — with its varied applicability to the thought and experience of readers. I think that many confuse applicability with allegory, but the one resides in the freedom of the reader, and the other in the purposed domination of the author.

J.R.R. Tolkien

I threw down my enemy, and he fell from the high place and broke the mountainside where he smote it in his ruin. Then darkness took me, and I strayed out of thought and time, and I wandered far on roads that I will not tell. Naked I was sent back — for a brief time, until my task is done. And naked I lay upon the mountaintop…I was alone, forgotten, without escape upon the hard horn of the world. There I lay staring upward, while the stars wheeled over, and each day was as long as a life-age of the earth.

— J.R.R. Tolkien, The Lord of the Rings: The Two Towers (1954), Speech by Gandalf

Gandalf is totally not Jesus, guys. Except for the fact that literally every aspect of their story arcs is identical, they have nothing in common. But understanding applicability vs. allegory is powerful.

Anytime people read my tweets, they hear it in autotune.

T-Pain

Me too, Mr. Pain. Me too.

Criminal subliminal minded rappers find it

Hard to define it, when narrow is the gate

For fat tapes and, then, played out and out of date

Then I construct my thoughts on site to renovate

And from that point, the God made a statement

Draftin’ tracements, replacements in basements

Materials in sheet-rock, to sound proof the beatbox

— GZA, “Living in the World Today”, Liquid Swords (1995)

There’s no shortage of ways to autotune our thoughts and behavior as citizens and investors. Scripts, symbols, tribalism. Some come from our own minds and some from external sources. Some we force on others. But we always, always have a choice. Do we allow others to write our scripts? Do we allow ourselves to be someone else’s agent? Or do we stake out our roles as citizens, as principals? Narrow is the gate, friends, and if you can’t construct your thoughts on site, to renovate, and soundproof the beatbox — you’ll always be someone else’s tool.

I’ve had a string of good luck lately. Or, at least, I’ve experienced a number of things that could have been much, much worse, which works out to the same thing, I think.

When I published Before and After the Storm, I was writing it from my home in Houston. I thought we would come through completely unscathed, and for the most part we did. My car flooded, but auto insurance is a lot better at covering losses like that than home insurance, and there wasn’t anything personal about what got destroyed. The things you learn in a disaster. I feel very fortunate.

Hurricane Harvey made landfall on my 10th anniversary. My wife and I met (re-met, actually) at a beach party on Surfside Beach, not terribly far from where landfall took place, and had originally planned to rent a house there to celebrate. Not in the cards this year, obviously. So we decided to celebrate that (and a nondescript birthday of my own) with a weekend away from our lovely two-boys-two-and-under with some close friends. In Vegas. That weekend.

But again, I feel fortunate. We stayed further north on the Strip. None of that keeps the mind from imagining the direst scenarios, though. What if we’d made our evening plans down there on Sunday instead of Saturday, when we walked the south end? What if we hadn’t called it an early evening on Sunday and instead decided to wander around (like you do when you’re in Vegas)? What if Willie, Robert Earl Keen or Ray Wylie Hubbard had been playing the festival (in which case I definitely would have been there)? There’s a note or two to be written about how this kind of thinking affects us as investors. The psychology of narrow misses, or at least of seeing tragedy at arm’s length.

But that’s not where my mind went. Instead, in the aftermath of the mass shooting in Las Vegas, I found myself, like many others, wondering what this vicious moron could have been thinking. A seemingly normal guy with no real motive, no obvious animus. Some compulsive behaviors, it would seem, but no more than a million other men and women. No clear ideological intent. No obvious prior evidence of sociopathy, psychopathy or really any other -pathy except for maybe antipathy. Other than the senselessness that pervades all such tragedies, the most striking observation following the attack has probably been that acts of terror, crimes and murders are being committed by people who look a lot more normal. Who may, in fact, be a lot more normal.

It’s something Malcolm Gladwell has spoken about, and which he wrote about in his 2015 piece in The New Yorker, Thresholds of Violence, and in various lighter ways in The Tipping Point. Like recently minted and well-deserving Nobel laureate Dick Thaler, Gladwell’s musings sometimes dip into the sort of paternalistic pop-science/pop-policy recommendations that grate on me a bit. But he’s onto something here. His notion is that the early mass shooters and murderers were the truly insane, those willing to independently plan, pursue and carry out a vile act. In so doing, they created a script, a pattern for others. Each successive event adds to our cultural story, and makes the script more accessible, more familiar to individuals at the margin of social norms. This lowers the threshold for another to carry out a similar attack. And so the next person who carries it out seems less clearly troubled, less self-evidently motivated by ideology. More normal.

The idea builds on the work of Stanford sociologist Mark Granovetter, who was among the first to describe this phenomenon through a range of examples. Whether it is deciding to join a riot, to eat at a Chinese-food restaurant, to buy a new kind of quintuple-levered vol-selling ETF, or any number of other everyday decisions, we judge certain aspects of our social engagement based on the quantities of others who have made similar choices. The more people join the riot, and the more those people look like us, the more likely we are to join. In other words, it’s Sheep Logic. Like that most sociopathic of animals, we make decisions in our own interest that incorporate the behavior and our observations of others not out of empathy or concern for the other, but because of their information value. This is how sociopathic behavior becomes commonplace among people who are, well, normal.

Thankfully, for most of us, this sheep-like tendency toward sociopathy doesn’t manifest itself in anything quite so horrific. But if you think that threshold effect-driven symbol devotion isn’t tearing us apart, you haven’t been paying attention. It hasn’t exactly been subtle, y’all.

Some of the symbols and stylistic tropes that force heterogeneous populations into homogenous groups are pretty obvious. Like, Gandalf-as-a-humble-leader-who-dies-sacrificially-to-save-his-followers-by-battling-a-demon[1]-on-his-descent-into-hell-after-which-he-is-resurrected-in-white-for-a-time-to-teach-and-lead-before-he-ascends-into-another-plane-to-escape-Middle-Earth-for-the-realm-of-the-angels obvious. Others less so. If you can get published in a journal for identifying the subtextual racist undertones in Starbucks Pumpkin Spice Lattes, just imagine how many different symbolic interpretations there are for something like, say, Citizen Kane’s Rosebud. Symbols, and the reverence we attach to particularly tortured interpretations of them, are the reason why English departments are still producing academic papers and why Dan Brown gets to live in a house in New Hampshire with hidden doors and secret passages.

Fascinatingly, J.R.R. Tolkien actually very famously detested allegory, the most common kind of literary symbolism. He was not particularly fond of his close friend C.S. Lewis’s world of Narnia for this reason, thinking it far too allegorical, and with one too many electric streetlamps. Whether or not he always practiced what he preached, however, Tolkien’s point remains an important one for our public discourse, where symbols — semiotics — have become the center of gravity for almost every civic conflict and debate. Most symbols we encounter are powerful shorthands, and their meaning differs based on our unique and shared experiences. The song you remember from your first dance at the high school prom was the soundtrack to someone else’s personal tragedy, and the writer of the song had nothing of the sort in mind. And that’s okay. In Tolkien’s terminology, these symbols are applicable, but neither universal nor determined by any one person for another.

In Before and After the Storm and Always Go to the Funeral, Ben and I wrote about those who seek to divide us and drive us from a cooperative game into a competitive game. You won’t be surprised to see us write that this is often achieved through the construction of narratives, loaded for bear with symbols. But with these symbols, you don’t get to decide what they mean for yourself like a favorite song. No, that decision is made for you. In Tolkien’s words, these symbols represent the purposed domination of the author. They seek to strip us of sovereignty over our own intent. They force us to choose sides. This is among the most powerful forms of narrative construction.

Ben and I have also written and talked a lot about what we think it means to be a Citizen. Above all, it means always being a principal. It means treating others as principals. Those who would rule over us to serve their own ends would make us agents. They would make us nodes in a blockchain, repeating the anonymous reports of someone else’s philosophical transactions. The Citizen rejects this impulse at every pass, in his political, personal, professional and, yes, even his financial life.

Charlottesville, Continued

Both Ben and I wrote about the issue of Confederate statues, because part of this story has applicability for us, as it does for so many Americans. For me, it is applicable for two reasons. When he was 16, my third great-grandfather volunteered for what would later become the 34th Tennessee Infantry Regiment. In the first day of the Battle of Chickamauga, his gun exploded in his face at Brock’s Field. It was an injury that impacted the rest of his life, which was short. The 11th of 12 children, he was maimed in battle but continued to fight. He married, had children and died penniless in his early 40s. His wife and children were forced to leave for Texas, where they became cotton tenant farmers. They got by. Within two generations they prospered.

Don’t cry too much for grandpa Jim. There’s a Part II. His family — my family — also owned slaves. In 1860, my fourth great-grandfather, a Methodist minister, felt he had the right to say that he owned 20 human beings. The youngest was a four-month-old boy. The oldest was a 52-year-old woman. Among them was a 30-year-old man named Jim, just like my third great-grandfather. He married a woman named Clara from the next farm, and they had a son named George. The picture to the right is of George with his wife Winnie in the late 19th century.

So what do the symbols of the Confederacy mean to me? Shame, mostly. Shame in what my family did, what they were a part of. That they weren’t on the right side of justice. That they could preach a Christian Gospel and think to own a person with a soul. Some pride, too. Pride in a young boy who was brave, who volunteered and fought for his neighbors, and was maimed as a simple infantryman. Who, I hope, stood tall when the German expatriates from Indiana raised by Johann August Ernst von Willich[2] rained down artillery and rifle fire on them and the rest of General George Maney’s brigade. Sam Watkins, a soldier in another unit in the division, wrote about it in his marvelous memoir, “Company Aytch”:

We held our position for two hours and ten minutes in the midst of a deadly and galling fire, being enfiladed and almost surrounded when General Forrest galloped up and said, ‘Colonel Field, look out you are almost surrounded; you had better fall back.’ The order was given to retreat. I ran through a solid line of blue coats. As I fell back, they were upon the right of us, they were upon the left of us, they were in front of us, they were in the rear of us…the balls whistled around our ears like the escape valves of ten thousand engines. The woods seemed to be blazing…one solid sheet of leaden hail was falling around me. I heard General Preston Smith’s brigade open. It seemed to be platoons of artillery. The earth jarred and trembled like an earthquake. Deadly missiles were flying in every direction. It was the very incarnation of death itself. I could almost hear the shriek of the death angel passing over the scene.
Sam Watkins

For me, the conflicted realities of race and patriotism — shame and pride — don’t stop there. They are a running theme in my family, as they are with so many others. Almost 52 years ago to the day, on October 22, 1965, my Uncle Jimmy was walking through the jungle near Phú Cường with a small squad of men from the 173rd Airborne Brigade, when a grenade rolled into their midst. Without a moment’s thought, a young man from Chicago and Mississippi grabbed the grenade, threw it under his body and saved the lives of four men that were walking with him. My Uncle Jimmy was one of them.

This young man, who would have no doubt endured the same racism that many black Americans knew in 1965, loved his country and his fellow man, and literally jumped on a grenade for my family. For it, he was awarded the Congressional Medal of Honor by President Johnson, and became the first black man to receive the honor during the Vietnam War. If you’re still hung up on statues and memorials, the next time you’re in Chicago, walk just north of the Navy Pier to Milton Lee Olive Park.

The picture below shows Olive’s parents receiving his posthumous medal, my Uncle Jimmy standing at attention between Olive’s father and President Johnson.

I think it’s fair to say these issues have a lot of applicability for me.

But my experience still matters a whole hell of a lot less than the experience of just about any black person in America on this topic. Do I get psychic value from knowing a relative acted bravely on the field of battle? Yes. Would I be comforted to know my country respects the tactical military brilliance of Robert E. Lee, that it was mature enough to consider that in full context of his flaws? Yes. Do I think there are strong, justifiable reasons to be extraordinarily hesitant and deliberate about anything that looks like the destruction of art, of historical records? Yes. Do any of those things measure up to how these symbols are applicable to a black man or woman in America? NO. God, it’s hard for me to fathom that they can even be represented on the same scale.

But that is the nature of civic discourse: for us to collectively weigh matters of importance, or to allow each individual the freedom to do so for himself. That is what a society which values Tolkien’s applicability does. That is what a Citizen does. It doesn’t require us to conclude that all such perspectives are equally true, or even that each person’s opinion is equally valuable. Far from it. Don’t mistake this for the postmodern view that those without personal experience don’t get a seat at the table for the discussion. Much to the contrary, the enlightenment principles of free discourse require us to allow all the arguments to be heard. On matters of social import, to be weighed. And in all cases, to be represented faithfully.

But rather than engage in true Citizenship, in the path of enlightenment, we chose another path. We chose the path of allegory, of symbols assigned to us and to others as agents and not as principals. Those bent toward purposed domination of those with conservative political leanings imposed one particular allegory: ‘statues of confederate leaders represent the spirit, culture and history of the southern United States’. An attack on the statues is therefore an attack on the spirit of culture of a huge portion of the population. The enemy are the politically correct run amok, people who wish to erase history and replace it with a sanitized version! With a lie! If you do not stand for this now, they’re going to tear down all our statues, all of our history.

The manipulating spirit of the far left in this case found a far easier target (Godwin’s Law made manifest proved too sore a temptation). Once a platoon or two of sociopathic, dunderheaded, socially awkward, spoiled white guys with an inclination toward violence rolled out the old “Blood and Soil” song and dance number, the allegory basically wrote itself: Defense of the statues IS defense of white supremacy. Defending America against Tiki-torch wielding apfelstrudelführers, as Kevin Williamson brilliantly put it, must be our aim at any cost. If we must pretend that the Occupy Wall Street trust fund kids who swapped their hipster tents for Antifa masks are our heroic vanguard, a modern form of troops storming Normandy, so be it. If we don’t, we are basically enabling the rise of Hitler!

The magic of the technique is this: for those to whom the symbol has personal applicability, the allegory that replaces it is nearly impossible to resist. If you have some affinity for the south (which is no crime at all, folks), or if you believe that history is worthy of protection with integrity, these are defensible points of view to have. If you’re especially sensitive to both active and passive forms of racism, you’re in very good (if sadly incomplete) company. But under the control of those who would make us agents, allegory uses these affinities and applicabilities as a Trojan Horse, entering as defensible, admirable points of view and pouring out into the streets of Troy as straw men to focus our rage on any who might assault them. Our defense of the south evolves into a perspective that sees attacks on monuments of the Confederacy as a broad attack on us and our culture. Our righteous anger at racists transitions into frothing rage at any who happen to share a point of view on what from our history is worthy of remembering. Those who had never stopped in contemplation — whether out of pride or shame or anger — before a monument in their lives now saw it as some existential thing that reflected the ill will of our fellow Citizens acting as principals.

But it didn’t. They — we — had already been made into agents.

Enter the Anthems

Our next test (you know, the anthem thing?) didn’t go much better.

The flag and the anthem are among the clearest examples of varying applicability, because flags are literally designed to function as symbols and representations of the state or a ruling party. To many uniformed men and women and to their families and friends, it is a binding tie, a symbol of sacrifice and service. To the patriotic, it can be (varyingly) an emblem of affinity for culture, for opportunities provided, for values shared in connection with the nation. To others, it is a reminder that they feel like second-class citizens in some way. A sharp allusion to the hypocrisy they see, that a country could emphasize freedom and equality, and yet deny both to some for so long. All these are feelings formed by experiences, some anecdotal and narrow in import, and some broad and worthy of extrapolation. They are formed by thoughtful conclusions, some rightfully constructed and some hopelessly flawed. They are not equal. But they are the views of Citizens and principals.

When Colin Kaepernick began his protest of the anthems, most of us didn’t notice, since we were sitting at home on our couches, distracted by beer, friends and smartphones. Say what you will about a young man who decries oppression wearing a t-shirt celebrating one of the 20th century’s great oppressors, who bemoans a lack of mutual respect wearing socks that stylized policemen as pigs wearing hats. But he was clearly acting as a principal, a man responding to what these symbols meant to him based on his judgments and his experiences, right or wrong.

Fueled by competitive game-driven rhetoric from the president, the right’s response took us away from the path of the Citizen. The personally applicable meaning of the symbol immediately became a monolith, an immutable national standard. To sit during the anthem wasn’t what the person doing it said it was, it was a symbol of disrespect toward the military, the police, the nation, our values, our Constitution. It was a sign of hatred of the country, and if he didn’t like living here, why doesn’t he just move? There is no intrinsic, no fundamental reason why this action in context of this symbol should have that meaning, except that we all agreed that it did. Instead of treating those protesting as principals — which doesn’t mean agreeing, but does require from a Citizen some attempt at understanding — we made them agents. We assigned them views and intents they never themselves conceived. In so doing, we made ourselves agents as well.

True to form, the American left took the bait. I don’t know if we’re really all going to laugh about this in a decade or two, but the attempts at symbol construction here are frighteningly absurd. In response to the shenanigans above, we got proclamations about acceptable forms that the protest symbol must take. Because the Dallas Cowboys knelt together before the anthem and not during it, it was bullshit. Craven and useless. Anyone who stands for the anthem stands for white supremacy! Richard Sherman informed us that if we didn’t condemn the president’s rhetoric, we were complicit. This is increasingly the shape that our debates take. Why are you angrier about this issue than that issue? Why did you tweet/post/talk more about this one issue than this other issue that I think is more important? How dare you not observe the forms that reflect the right-sounding thoughts in the manner I prefer? Did you use the proper skin tone in your emoji-laden message?

You could call all of this a more rigorous way of describing political correctness, and you’d be pretty near the truth. The left remains, I think, the most pernicious source of this scourge to an enlightened society. The Foucaltian language of privilege and oppression, while it may at times be an accurate reflection of the realities of inequality, bias and circumstance that we must assault as a society, can never be the language of the Citizen, because it inherently rejects the idea that certain people can be principals. It says that a person born in privilege is always an agent of his bias, and that he may not have the sovereignty of a principal in various arbitrarily chosen political issues. Yet for all that, under President Trump it has instead been the right that has been the proximate cause of allegory and political correctness, I think. As Ben has pointed out, this is how this political environment is trying to break us.

Agents and Markets

So what is a Citizen to do? And what of the Citizen in markets?

In markets, it should be a reminder that strong enough narratives make agents of us all. You need only to look at VIX-based instrument markets to observe just how willing we are to forgo our views as principals to join in a group-based thinking. In Part I of my recent note, The Myth of Market In-Itself, I introduced some of the ways in which behavior influences markets, but it is in Part II that I will dive more into the archetypes and languages in which principals become agents.

It should also be a reminder to those of us with clients that it is important to listen to what they are telling us. About their desires, their intents, their motivations. The robo-adviser, style-box generation is happy to slot us into a category and tell us who we are. Even outside of this, the investment industry has constructed entire business models out of gaming characteristics to suit investor archetypes and the superficial things that are likely to attract them to buy. As an industry, we don’t treat our clients like principals, and it’s a problem.

But whether or not we are in markets, the refrain you will hear from us is to resist being drawn into the competitive game. Resist being drawn to allegory. Resist being made into an agent, and reject doing so to others.

[1] OK, a Balrog of Morgoth, which is technically among the Maiar kin to Sauron that aligned themselves with Melkor when he rebelled against the Valar that Eru had sent to shepherd their collective vision for the world. So not really a demon, but “wings of shadow, wreathed in flame?” Imma call it a demon. Don’t @ me, Stephen Colbert.
[2] This is a really fascinating man. A Prussian noble who renounced his titles and became confidante and eventual competitor to Karl Marx, Willich counted Friedrich Engels as his aide-de-camp during the socialist revolutions of 1848-1849. He ultimately found Marx to be too conservative, and challenged him to a duel that Marx rejected. Willich then left for America, where he recruited and led a division of men from Indiana and Ohio, mostly German expatriates. They were among the most decorated units in the Union Army.

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AI BS Detectors & the Origins of Life (by Silly Rabbit)

Confidence levels for the Social and Behavioral Sciences

DARPA recently put out an RFI:

…requesting information on new ideas and approaches for creating (semi)automated capabilities to assign ‘Confidence Levels’ to specific studies, claims, hypotheses, conclusions, models, and/or theories found in social and behavioral science research (and) help experts and non-experts separate scientific wheat from wrongheaded chaff using machine reading, natural language processing, automated meta-analyses, statistics-checking algorithms, sentiment analytics, crowdsourcing tools, data sharing and archiving platforms, network analytics, etc.

A visionary and high value RFI. Wired article on the same, enticingly titled, DARPA Wants to Build a BS Detector for Science.

Claude Berrou on turbo codes and informational neuroscience

Fascinating short interview with Claude Berrou, a French computer and electronics engineer who has done important work on turbo codes for telecom transmissions and is now working on informational neuroscience. Berrou describes his work through the lens of information and graph theory:

My starting point is still information, but this time in the brain. The human cerebral cortex can be compared to a graph, with billions of nodes and thousands of billions of edges. There are specific modules, and between the modules are lines of communication. I am convinced that the mental information, carried by the cortex, is binary. Conventional theories hypothesize that information is stored by the synaptic weights, the weights on the edges of the graph. I propose a different hypothesis. In my opinion, there is too much noise in the brain; it is too fragile, inconsistent, and unstable; pieces of information cannot be carried by weights, but rather by assemblies of nodes. These nodes form a clique, in the geometric sense of the word, meaning they are all connected two by two. This becomes digital information…

Thermodynamics in far-from-equilibrium systems

I’m a sucker for methods to try to understand and explain complex systems such as this story by Quanta (the publishing arm of the Simons Foundation — as in Jim Simons or Renaissance Technologies fame) of Jeremy England, a young MIT associate professor, using non-equilibrium statistical mechanics to poke at the origins of life.

Game theory

And finally, check out this neat little game theory simulator which explores how trust develops in society. It’s a really sweet little application with fun interactive graphics framed around the historical 1914 No Man’s Land Ceasefire. Check out more fascinating and deeply educational games from creator Nicky Case here.

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Pressure and Time

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Red: [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.
Red: I played a mean harmonica as a younger man. Lost interest in it though. Didn’t make much sense in here.
Andy Dufresne: Here’s where it makes the most sense. You need it so you don’t forget.
Red: Forget?
Andy Dufresne: 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.
Red: What’re you talking about?
Andy Dufresne: Hope.
Red: 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)

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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.

epsilon-theory-pressure-and-time-june-7-2016-space-1999

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.

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1914 is (still) the New Black

There are decades where nothing happens; and there are weeks where decades happen.

Vladimir Lenin (1870 – 1924) 

In 1914, Europe had arrived at a point in which every country except Germany was afraid of the present, and Germany was afraid of the future. 

Sir Edward Grey (1862 – 1933) 

Last week’s email, “1914 is the New Black”, was the most widely read Epsilon Theory note to date, and given yesterday’s events it bears repeating, as the echoes of 1914 are growing louder and louder. We are, I think, likely embarked on the death spiral phase of a game of Chicken, just as in the summer of 1914. The stakes are, for now at least, not nearly as cataclysmic today as they were a century ago, but the social and political dynamics are eerily alike.

I’m often asked how to get a better take on a historical event like the lead-up to World War I, and the answer is that there’s no substitute for immersing yourself in what people were actually saying and writing at the time the events transpired. If you’re lucky, perhaps you’ll pick a period that also attracted the attention of a gifted historian like a Robert Caro or a David McCullough. Second best, I’ve found, is to find a gifted editor or anthologist to smooth the path a bit. One such anthologist is Peter Vansittart, who collected a wide range of original texts in his classic books, “Voices: 1870 – 1914” and “Voices from the Great War”. I’ve taken some of those texts and appended them below. They speak for themselves, I hope, to illustrate the defining characteristic of a spiraling game of Chicken – all sides begin to speak in terms of “having no choice” but to take aggressive actions to defend their own interests.

Before the quotes, though, three other historical observations:

  1. The Austrian ultimatum to Serbia – long seen as the proximate cause of World War I – was accepted by the Serbian government almost in its entirety. Unfortunately, that “almost” part made all the difference. An important anecdote to remember the next time someone calls your attention to Tsipras’s acceptance of 90% of the Eurogroup reform ultimatum.
  2. Anti-establishment voters are always underrepresented in establishment polls. Noted segregationist and Alabama governor George Wallace won the 1972 Democratic Party primary in Michigan despite showing third in polls. Daniel Ortega and his Sandinista regime lost the 1990 Nicaraguan election by 10 percentage points to Violeta Chamorro despite leading by more than 10 points in every pre-election poll. The Syriza NO landslide was no surprise here, and this is an important phenomenon to keep in mind when you start to see opinion polls from Italy and France published over the next few days.
  3. Politics always trumps economics. My favorite 1914 quote in this regard is from Lord Cunliffe, governor of the Bank of England from 1913 – 1918, who famously declared that war was impossible because “The Germans haven’t the credits.” So what if Greek banks run out of euros? The Greek government will make their own, or maybe issue California-style IOUs and dare the Eurogroup to boot them out of the currency. If you think that an ECB squeeze can put this political genie back in the bottle, you’re making the same classic error as Walter Cunliffe did.

And now the quotes.

I held a council at 10:45 to declare war with Germany. It is a terrible catastrophe but it is not our fault. An enormous crowd collected outside the palace; we went on the balcony both before and after dinner. When they learned that war had been declared, the excitement increased and May and I with David went on to the balcony; the cheering was terrific

King George V (1865 – 1936) 

England alone carries the responsibility for peace or war, no longer us.

Kaiser Wilhelm II (1859 – 1941) 

In this most serious moment I appeal to you to help me. An ignoble war has been declared to a weak country. The indignation in Russia shared fully by me is enormous. I foresee that very soon I shall be overwhelmed by the pressure brought upon me and be forced to take extreme measures which will lead to war. To try and avoid such a calamity as a European war, I beg you in the name of our old friendship to do what you can to stop your allies from going too far. — Nicky

Tsar “Nicky” Nicholas II (1868 – 1918) in a letter to his cousin, Kaiser “Willy” Wilhelm II 

Now Tsarism has attacked Germany, now we have no choice, now there is no looking back. 

Kurt Eisner (1867 – 1919) 

Necessity knows no law; we must hack our way through. 

Theobald von Bethmann-Hollweg (1856 – 1921) in a speech to German Reichstag 

The few neutral states are not sympathetic toward us. Germany has not a friend in the world, she stands utterly alone and has only herself to depend on. … How different it all was a few weeks ago, when we launched so brilliant a campaign – now a bitter disillusionment is setting in. And how much we shall have to pay for all that is being destroyed! 

Helmuth von Moltke the Younger (1848 – 1916) in a letter to his wife 

In this war it is a question … of German civilization against barbarous Slavdom. 

Helmuth von Moltke the Younger (1848 – 1916)

The year 1914 in America seemed the crest of a wave of passionate idealism among young people, and of passionate selfishness among middle-aged people. 

John Cowper Powys (1872 – 1963)

July 25: Unbelievably large crowds are waiting outside the newspaper offices. News arrives in the evening that Serbia is rejecting the ultimatum. General excitement and enthusiasm, and all eyes turn towards Russia – is she going to support Serbia? The days pass from 25 to 31 July. Incredibly exciting; the whole world is agog to see whether Germany is now going to mobilize.

July 31: Try as I may I simply can’t convey the splendid spirit and wild enthusiasm that has come over us all. We feel we’ve been attacked, and the idea that we have to defend ourselves gives us unbelievable strength … You still can’t imagine what it’s going to be like. Is it all real, or just a dream?
diary of Herbert Sulzbach, “With the German Guns” (1935) 

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1914 is the New Black

Man in Black: All right. Where is the poison? The battle of wits has begun. It ends when you decide and we both drink, and find out who is right … and who is dead.

“The Princess Bride” (1987) 

Time is a game played beautifully by children.

Heraclitus of Ephesus (535 – 475 BC) 

How can you hide from what never goes away?

Heraclitus of Ephesus (535 – 475 BC)

epsilon-theory-1914-is-the-new-black-june-29-2015-change

Whoever cannot seek the unforeseen sees nothing, for the known way is an impasse.

– Heraclitus of Ephesus (535 – 475 BC)

Let me just say that I am very negatively surprised by today’s decisions by the Greek government. That is a sad decision for Greece because it has closed the door on further talks, where the door was still open in my mind.

Jeroen Dijsselbloem, head of Eurogroup finance ministers

The judge smiled. Men are born for games. Nothing else. Every child knows that play is nobler than work. He knows too that the worth or merit of a game is not inherent in the game itself but rather in the value of that which is put at hazard. Games of chance require a wager to have meaning at all. Games of sport involve the skill and strength of the opponents and the humiliation of defeat and the pride of victory are in themselves sufficient stake because they inhere in the worth of the principals and define them. But trial of chance or trial of worth all games aspire to the condition of war for here that which is wagered swallows up game, player, all.

Cormac McCarthy, “Blood Meridian, or The Evening Redness in the West” (1985) 

I have always thought that in revolutions, especially democratic revolutions, madmen, not those so called by courtesy, but genuine madmen, have played a very considerable political part. One thing is certain, and that is that a condition of semi-madness is not unbecoming at such times, and often even leads to success.

Alexis de Tocqueville (1805 – 1859) 

Children and lunatics cut the Gordian knot which the poet spends his life patiently trying to untie.

Jean Cocteau (1889 – 1963) 

epsilon-theory-1914-is-the-new-black-june-29-2015-power

If you don’t like how the table is set, turn over the table.

– Frank Underwood, “House of Cards” (2013)

Nothing like a good Friday-after-the-close blockbuster to set the stage for an interesting week.

At 1am Saturday morning Athens time, the Greek government called for a nationwide referendum to vote the Eurogroup’s reform + bailout proposal up or down. The vote will happen on Sunday, July 5th, but Greece will default on its IMF debt this Wednesday, and as a result the slow motion run on Greek banks is about to get a lot more fast motion unless capital controls are imposed. If you want to get into the weeds, Deutsche Bank put out a note, available here, that I think is both a well-written and comprehensive take on the facts at hand. As for the big picture, I’ve attached last week’s Epsilon Theory note (“Inherent Vice“), as this referendum is EXACTLY the sort of self-binding, “rip your brakes and steering wheel out of the car” strategy I wrote about as a highly effective way to play the game of Chicken.

Look, I have no idea whether or not Tsipras will be successful with this gambit. But I admire it. It’s a really smart move. It’s a wonderful display of what de Tocqueville praised as the “condition of semi-madness” that was so politically effective in 1848, and I suspect will be today. Plus, you can’t deny the sheer entertainment value of hearing Dijsselbloem splutter about how he was open to a revised, revised, Plan X from Greece all along, if only Tsipras would continue with this interminable charade. “The door was still open, in my mind.” Priceless.

So long as Tsipras can avoid market anarchy and TV coverage of violent ATM mobs this week, I think the NO vote is likely to win. The referendum is worded and timed in a way that allows very little room for Antonio Samaras and other Syriza opponents to turn the vote into a referendum on the Euro itself, which has proven to be a successful approach in the past. Particularly as the Eurogroup rather ham-handedly denied the request for a one-week extension in the default deadline, the referendum is being framed by Syriza as what Cormac McCarthy called a “condition of war”, an over-arching game where “that which is wagered swallows up game, player, all.” It may well be a close vote, but it’s hard to vote YES for a public humiliation of your own country under any circumstances, much less when that YES vote is being portrayed as giving aid and comfort to the enemy.

Here’s how I see the game playing out after the vote.

If Greece votes to accept the Eurogroup reform proposal after all, then the game of Chicken resolves itself within the stable Nash equilibrium of a shamed Greece and a triumphant Euro status quo. I would expect an enormous risk-on rally in equities and credit, particularly in Euro-area financials. Hard to say about rates … peripheral Euro debt (Italy, Spain) should rally, and German Bunds might, too, as the Narrative will be that Germany “won”. But reduction of systemic risk is a negative for any flight-to-safety trade, so this outcome is probably not good for Bunds in the long term, or US Treasuries over any term.

If Greece votes to reject the proposal, then either the game resolves itself within the stable Nash equilibrium of a shamed Euro status quo and a triumphant Greece (if the ECB and EU decide to cave to some form of the original Greek proposal), or we enter the death spiral phase of a game of Chicken, as all parties start to talk about how they “have no choice” but to crash their cars. That latter course is the far more likely path, I think, given how the various Euro Powers That Be are already positioning themselves. It’s all so very 1914-ish. Draghi’s cap on bank-supporting Emergency Liquidity Assistance (ELA) is the modern day equivalent of Czar Nicholas II’s troop mobilization. Good luck walking that back.

If we go down the death spiral path and some form of Greek exit from the Euro-system, I expect the dominant market Narrative to be that Greece committed economic suicide and that the rest of Europe will be just fine, thank you very much. That should prevent a big risk-off market move down, or at least keep it short-lived (although you should expect Bunds and USTs to do their risk-off thing here). Unless you’re a hedge fund trying to make a killing on those really cheap Greek bonds you bought two years ago, there’s no reason to panic even if we’re on the death spiral.

Over time, however, I expect that dominant Narrative to be flipped on its head. Greece will quickly do some sort of deal with Russia (hard currency for port access?), and then the IMF will strike a deal because that’s what the IMF does. More and more people will start to say, “Hey, this isn’t so bad”, which is actually the worst possible outcome for Draghi and Merkel. At that point, you’ll start to see the Narrative focus on the ECB balance sheet and credibility, and as Italian and Spanish rates start to creep up and as the spread to Bunds starts to widen, people will recall that ECB QE only has national banks buying their own debt … the Bundesbank ain’t propping up Italian sovereign debt. I suspect it will be a slow motion contagion, all taking place in the Narrative and expressed in Italian, Spanish, and French politics over the next 12 months or so. The Red King will start to wake.

One last point on how the market Narrative will shift if we go down the death spiral path, and that’s the dog that will stop barking. The incessant and often silly focus on Fed “lift-off” is about to go on summer hiatus, which can’t happen soon enough for me. 

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Inherent Vice

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Nash: 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 …
Charles: When did you last eat?
Nash: … currency exchange …
Charles: When did you last eat? You know, food.
Nash: You have no respect for cognitive reverie, you know that?
Charles: Yes. But pizza – now pizza I have enormous respect for. And of course beer. [leaves]
Nash: [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).

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  1. If people do not believe that mathematics is simple, it is only because they do not realize how complicated life is.
  2. Young man, in mathematics you don’t understand things. You just get used to them.
  3. There’s no sense in being precise when you don’t even know what you’re talking about.
  4. 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) 

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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.

New York Times, “US Is Poised to Put Heavy Weaponry in Eastern Europe“, June 13, 2015

Be careful who you call your friends. I’d rather have four quarters than one hundred pennies.
Al Capone (1899 – 1947) 

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We are all impaled on the crook of conditioning.

– James Dean (1931 – 1955)

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There’s nothing stable in the world; uproar’s your only music.

– John Keats (1795 – 1821)

Shasta Fay: I went on a boat ride.
Doc: A three hour tour.
Shasta Fay: They told me I was precious cargo that couldn’t be insured because of inherent vice.
Doc: What does that mean?
Shasta Fay: I don’t know.
Doc: 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.

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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.

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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.

On the flip side of the self-binding spectrum, intentional ambiguity can also be a very effective strategy for playing Chicken, particularly if you’re starting from a structurally stronger position than your opponent. What is not effective at all, however, is to switch back and forth between ambiguity and self-binding, as we have seen from time to time with the Fed (data dependence versus strong forward guidance) and constantly with this White House, particularly in its foreign policy.

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.

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Sometimes a Cigar is Just a Cigar

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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)

epsilon-theory-sometimes-a-cigar-is-just-a-cigar-may-22-2015-bladerunner

Deckard: She’s a replicant, isn’t she?
Tyrell: I’m impressed. How many questions does it usually take to spot them?
Deckard: I don’t get it, Tyrell.
Tyrell: How many questions?
Deckard: Twenty, thirty, cross-referenced.
Tyrell: It took more than a hundred for Rachael, didn’t it?
Deckard: [realizing Rachael believes she’s human] She doesn’t know.
Tyrell: She’s beginning to suspect, I think.
Deckard: 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) 

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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).

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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.

epsilon-theory-sometimes-a-cigar-is-just-a-cigar-may-22-2015-new-signal-2

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.

epsilon-theory-sometimes-a-cigar-is-just-a-cigar-may-22-2015-prisoners-dilemma-equilibrium

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. 

epsilon-theory-sometimes-a-cigar-is-just-a-cigar-may-22-2015-prisoners-dilemma-equilibrium-2

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).

epsilon-theory-sometimes-a-cigar-is-just-a-cigar-may-22-2015-prisoners-dilemma-equilibrium-3

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:

epsilon-theory-sometimes-a-cigar-is-just-a-cigar-may-22-2015-prisoners-dilemma-row-player

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.

epsilon-theory-sometimes-a-cigar-is-just-a-cigar-may-22-2015-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.

epsilon-theory-sometimes-a-cigar-is-just-a-cigar-may-22-2015-behavioral-change-2

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.

epsilon-theory-sometimes-a-cigar-is-just-a-cigar-may-22-2015-behavioral-change-3.jpg

So what is the current informational structure for the S&P500? Well, it looks something like this:

epsilon-theory-sometimes-a-cigar-is-just-a-cigar-may-22-2015-informational-structure

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 words of 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.

epsilon-theory-sometimes-a-cigar-is-just-a-cigar-may-22-2015-bond

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.

Because here’s the thing: the informational surface is only flat in this immediate vicinity of current bond prices. There are enormous Common Knowledge walls just off to the left and just off to the right of the price line segment shown above, Common Knowledge structures created by the entirely successful efforts by central bankers to mold investor behaviors and by the entirely unsuccessful efforts by central bankers to fix the real economy.

epsilon-theory-sometimes-a-cigar-is-just-a-cigar-may-22-2015-bond-3

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.

And that leads me to my other main point: a highly stable equilibrium cuts both ways, for good and for bad. Another way of saying that you’re in a highly stable equilibrium is to say that you’re well and truly stuck. Yes, there are HUGE informational barriers to prevent economic behaviors that would create a recession in the US or horribly crush any major market or asset class. But by the same token, there are also HUGE informational barriers to prevent economic behaviors that would spark robust growth in the US or wildly elevate any major market or asset class. I’m not saying that the doomsday or heavenly scenarios are impossible. I’m saying that it would take an almost unimaginably large amount of new information to change people’s minds about what everyone knows that everyone knows about markets today, for either scenario to occur. Could happen. But I really don’t think that’s how you want to place your bets. My money is on the long grey slog of the Entropic Ending.

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.

epsilon-theory-sometimes-a-cigar-is-just-a-cigar-may-22-2015-bond-2

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.

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It’s Still Not About the Nail

Reader reaction to the March 31 Epsilon Theory note, “It’s Not About the Nail”, was probably the strongest and most positive for any note to date. The message in a nutshell: financial advisors of all stripes and sizes would be well-served to do more than serve up old-school diversification platitudes in this Brave New World of a bull market that everyone hates, and the behavioral insights of regret minimization are an effective framework for making that adaptation.

This is a message that bears repeating, and thanks to Institutional Investor that’s what’s happening. A condensed version of “It’s Not About the Nail” can be found on the Institutional Investor website here, that piece will appear in the print magazine later this month in their “Unconventional Wisdom” column, and I’ve appended it below.

I think the reason this message strikes a chord is that it not only puts into words what a lot of people are feeling in an inchoate fashion, but also suggests a toolkit for improving the strained dialog between advisors and investors. It’s possible to take our tried and tested (but tired) notions of portfolio construction and energize them with the tools of game theory and behavioral economics, so that we get to the meaning of words like “diversification” and “de-risking”.

In the note I presented one way of thinking about all this in simple graphical terms, by taking the historical risk and reward of a portfolio or a subset of a portfolio and just seeing what the impact of a diversifying strategy would actually have been as seen in risk/reward space.

epsilon-theory-its-still-not-about-the-nail-april-14-2015-historical-risk-reward

The goal here is to move the original portfolio (the gold ball) up and to the left into the green triangle that marries both the traditional meaning of diversification (maximization of reward per unit of risk) and the behavioral meaning of de-risking in a bull market (minimization of the risk of underperformance). There ARE strategies that accomplish this goal, but the trick is finding the strategies that do this for the actual portfolio you have today, not some hypothetical portfolio or index.

We’ve built a set of tools at Salient within our systematic strategies group to analyze the historical impact of a wide range of diversifying strategies from a wide range of asset managers on actual portfolios, and then to map the impact of various diversifying strategies in risk/reward space. It’s not rocket science, and I’m sure any number of Epsilon Theory readers could develop a similar toolkit, but we’ve found it to be a very useful process for not only evaluating, but also communicating how diversifying strategies can make an existing portfolio better for an investor’s needs. Sometimes Salient strategies show up well in this analysis; sometimes they don’t. If you’re familiar with the Progressive Car Insurance commercials with Flo, you get the idea.

If you’re an investment professional and/or financial advisor with a portfolio you’d like to have analyzed in this manner, reply to this email or drop me a note at bhunt@salientpartners.com , and I’d be delighted to set it up for you.

As with all things Epsilon Theory-related, there’s no fee or obligation associated with this analysis. Thanks again to my partners and colleagues here at Salient for their commitment to releasing useful intellectual property into the wild. I think it’s a smart, non-myopic view of what it means to be an asset manager in the modern age, but a rare bird nonetheless.

All the best,
Ben


There’s a massive disconnect between advisors and investors today, and it’s reflected in both declining investment activity as well as a general fatigue with the consultant-client conversation. Consultants continue to preach the faith of diversification, and their clients continue to genuflect in its general direction. But diversification as it’s currently preached is perhaps the most oversold concept in financial advisor-dom, and the sermon isn’t connecting. Fortunately, behavioral economics offers a fresh perspective on portfolio construction, one that lends itself to what we call Adaptive Investing.

Investors aren’t asking for diversification, which isn’t that surprising after six years of a bull market. Investors only ask for diversification after the fire, as a door-closing exercise when the horse has already left the burning barn. What’s surprising is that investors are asking for de-risking, similar in some respects to diversification but different in crucial ways. What’s also surprising is that investors are asking for de-risking rather than re-risking, which is what you’d typically expect at this stage of such a powerful bull market.

Why is this the most mistrusted bull market in recorded history? Because no one thinks it’s real. Everyone believes that it’s a by-product of outrageously extraordinary monetary policy actions rather than the by-product of fundamental economic growth and productivity — and what the Fed giveth, the Fed can taketh away.

This is a big problem for the Federal Reserve, as its efforts to force greater risk-taking in markets through large-scale asset purchases and quantitative easing have failed to take hold in investor hearts and minds. Yes, we’re fully invested, but just because we have to be. To paraphrase the old saying about beauty, risk-taking is only skin deep for today’s investor, but risk-aversion goes clear to the bone.

It’s also the root of our current adviser-investor malaise. How so? Because de-risking a bull market is a very different animal than de-risking a bear market. As seen through the lens of behavioral economics, de-risking is based on regret minimization (not risk–reward maximization like diversification), and the simple fact is that regret minimization is driven by peer comparisons in a bull market. In a bear market your primary regret — the thing you must avoid at all costs — is ruin, and that provokes a very direct physical reaction. You can’t sleep. And that’s why de-risking Rule No. 1 in a bear market is so simple: Sell until you can sleep at night. Go to cash.

In a bull market, your primary regret is looking or feeling stupid, and that provokes a very conflicted, very psychological reaction. You want to de-risk because you don’t understand this market, and you’re scared of what will happen when the policy ground shifts. But you’re equally scared of being tagged “a panicker” and missing “the greatest bull market of this or any other generation.” And so you do nothing. You avoid making a decision, which means you also avoid the consultant-client conversation. Ultimately everyone — advisor and investor alike — looks to blame someone else for their own feelings of unease. No one’s happy, even as the good times roll.

So what’s to be done? Is it possible to both de-risk a portfolio and satisfy the regret minimization calculus of a bull market?

In fact, our old friend diversification is the answer, but not in its traditional presentation as a cure-all bromide. Diversification can certainly de-risk a portfolio by turning down the volatility, and it’s well suited for a bull market because it can reduce volatility without reducing market exposure. The problem is that diversification can take a long time to prove itself, and that’s rarely acceptable to investors who are seeking the immediate portfolio impact of de-risking, whether it’s the bear market or bull market variety.

What we need are diversification strategies that can react quickly. That brings me back to adaptive investing, which has two relevant points for de-risking in a bull market.

First, your portfolio should include allocations to strategies that can go short. If you’re de-risking a bull market, you need to make money when you’re right, not just lose less money. Losing less money pays off over the long haul, but the path can be bumpy.

Second, your portfolio should include allocations to trend-following strategies, which keep you in assets that are working and get you out of those that aren’t. The market is always right, and that’s never been more true — or more difficult to remember — than now in the Golden Age of the Central Banker.

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It’s Not About the Nail

epsilon-theory-its-not-about-the-nail-march-31-2015-yoda

Do, or do not. There is no try.”

– Yoda, “Star Wars: Episode V – The Empire Strikes Back” (1980)

I see it all perfectly; there are two possible situations – one can either do this or that. My honest opinion and my friendly advice is this: do it or do not do it – you will regret both.
Soren Kierkegaard, “Either/Or: A Fragment of Life” (1843)

The only victories which leave no regret are those which are gained over ignorance.
Napoleon Bonaparte (1769 – 1821)

Maybe all one can do is hope to end up with the right regrets.
Arthur Miller, “The Ride Down Mt. Morgan” (1991)

Of all the words of mice and men, the saddest are, “It might have been.”
Kurt Vonnegut, “Cat’s Cradle” (1963)

One can’t reason away regret – it’s a bit like falling in love, fall into regret.
Graham Greene, “The Human Factor” (1978)

epsilon-theory-its-not-about-the-nail-march-31-2015-cash.jpg

I bet there’s rich folks eatin’

In a fancy dining car.

They’re probably drinkin’ coffee

And smokin’ big cigars.

Well I know I had it comin’.

I know I can’t be free.

But those people keep-a-movin’

And that’s what tortures me.

– Johnny Cash, “Folsom Prison Blues” (1955)

epsilon-theory-its-not-about-the-nail-march-31-2015-paul-anka

Regrets…I’ve had a few.

But then again, too few to mention.

– Paul Anka, Frank Sinatra “My Way” (1969)

The Moving Finger writes; and, having writ,
Moves on: nor all thy Piety nor Wit
Shall lure it back to cancel half a Line,
Nor all thy Tears wash out a Word of it.
Omar Khayyam, “Rubaiyat” (1048 – 1141)

You can tell it any way you want but that’s the way it is. I should of done it and I didn’t. And some part of me has never quit wishin’ I could go back. And I can’t. I didn’t know you could steal your own life. And I didn’t know that it would bring you no more benefit than about anything else you might steal. I think I done the best with it I knew how but it still wasn’t mine. It never has been.”
Cormac McCarthy, “No Country for Old Men” (2005)

Jesse: Yeah, right, well, great. So listen, so here’s the deal. This is what we should do. You should get off the train with me here in Vienna, and come check out the capital.
Celine: What?
Jesse: Come on. It’ll be fun. Come on.
Celine: What would we do?
Jesse: Umm, I don’t know. All I know is I have to catch an Austrian Airlines flight tomorrow morning at 9:30 and I don’t really have enough money for a hotel, so I was just going to walk around, and it would be a lot more fun if you came with me. And if I turn out to be some kind of psycho, you know, you just get on the next train.

Alright, alright. Think of it like this: jump ahead, ten, twenty years, okay, and you’re married. Only your marriage doesn’t have that same energy that it used to have, y’know. You start to blame your husband. You start to think about all those guys you’ve met in your life and what might have happened if you’d picked up with one of them, right? Well, I’m one of those guys. That’s me, y’know, so think of this as time travel, from then, to now, to find out what you’re missing out on. See, what this really could be is a gigantic favor to both you and your future husband to find out that you’re not missing out on anything. I’m just as big a loser as he is, totally unmotivated, totally boring, and, uh, you made the right choice, and you’re really happy.

Celine: Let me get my bag.

Richard Linklater, “Before Sunrise” (1995)

For it falls out
That what we have we prize not to the worth
Whiles we enjoy it, but being lacked and lost,
Why, then we rack the value, then we find
The virtue that possession would not show us
While it was ours.
William Shakespeare, “Much Ado About Nothing” (1612)

When to the sessions of sweet silent thought
I summon up remembrance of things past,
I sigh the lack of many a thing I sought,
And with old woes new wail my dear time’s waste:
William Shakespeare, “Sonnet 30” (1609)

epsilon-theory-its-not-about-the-nail-march-31-2015-nirvana

No, I don’t have a gun.

– Nirvana, “Come As You Are” (1992)

I spend a lot of my time speaking with investors and financial advisors of all stripes and sizes, and here’s what I’m hearing, loud and clear. There’s a massive disconnect between advisors and investors today, and it’s reflected in both declining investment activity as well as a general fatigue with the advisor-investor conversation. I mean “advisor-investor conversation” in the broadest possible context, a context that should be recognizable to everyone reading this note. It’s the conversation of a financial advisor with an individual investor client. It’s the conversation of a consultant with an institutional investor client. It’s the conversation of a CIO with a Board of Directors. It’s the conversation of many of us with ourselves. The wariness and weariness associated with this conversation runs in both directions, by the way.

Advisors continue to preach the faith of diversification, and investors continue to genuflect in its general direction. But the sermon isn’t connecting. Investors continue to express their nervousness with the market and dissatisfaction with their portfolio performance, and advisors continue to nod their heads and say they understand. It reminds me of Jason Headley’s brilliant short film, “It’s Not About the Nail”, with the advisor reprising Headley’s role. Yes, the advisor is listening. But most find it impossible to get past what they believe is the obvious answer to the obvious problem. Got a headache? Take the nail out of your head. Nervous about the market? Diversify your portfolio. But there are headaches and then there are headaches. There is nervousness and then there is nervousness. It’s not about the nail, and the sooner advisors realize this, the sooner they will find a way to reconnect with their clients. Even if it’s just a conversation with yourself.

epsilon-theory-its-not-about-the-nail-march-31-2015-nail

Investors aren’t asking for diversification, which isn’t that surprising after 6 years of a bull market. Investors never ask for diversification after 6 years of a bull market. They only ask for it after the Fall, as a door-closing exercise when the horse has already left the burning barn. What’s surprising is that investors are asking for de-risking, similar in some respects to diversification but different in crucial ways. What’s surprising is that investors are asking for de-risking rather than re-risking, which is what you’d typically expect at this stage of such a powerful bull market.

Investors are asking for de-risking because this is the most mistrusted bull market in recorded history, a market that seemingly everyone wants to fade rather than press. Why? Because no one thinks this market is real. Everyone believes that it’s a by-product of outrageously extraordinary monetary policy actions rather than the by-product of fundamental economic growth and productivity, and what the Fed giveth … the Fed can taketh away.

This is a big problem for the Fed, as their efforts to force greater risk-taking in markets through LSAP and QE (and thus more productive risk-taking, or at least inflation, in the real economy) have failed to take hold in investor hearts and minds. Yes, we’re fully invested, but only because we have to be. To paraphrase the old saying about beauty, risk-taking is only skin deep for today’s investor, but risk-aversion goes clear to the bone.

It’s also the root of our current advisor-investor malaise. De-risking a bull market is a very different animal than de-risking a bear market. And neither is the same as diversification.

Let’s take that second point first.

Here’s a simple representation of what diversification looks like, from a risk/reward perspective.

epsilon-theory-its-not-about-the-nail-march-31-2015-historical-risk-rewardFor illustrative purposes only.

The gold ball is whatever your portfolio looks like today from a historical risk/reward perspective, and the goal of diversification is to move your portfolio up and to the left of the risk/reward trade-off line that runs diagonally through the current portfolio position. Diversification is all about increasing the risk/reward balance, about getting more reward per unit of risk in your portfolio, and the goodness or poorness of your diversification effort is defined by how far you move your portfolio away from that diagonal line. In fact, as the graph below shows, each of the Good Diversification outcomes are equally good from a risk/reward balance perspective because they are equally distant from the original risk/reward balance line, and vice versa for the Poor Diversification outcomes.

epsilon-theory-its-not-about-the-nail-march-31-2015-historical-risk-reward-2

For illustrative purposes only.

Diversification does NOT mean getting more reward out of your portfolio per se, which means that some Poor Diversification changes to your portfolio will outperform some Good Diversification changes to your portfolio over time (albeit with a much bumpier ride).

epsilon-theory-its-not-about-the-nail-march-31-2015-historical-risk-reward-3

For illustrative purposes only.

It’s an absolute myth to say that any well-diversified portfolio will outperform all poorly diversified portfolios over time. But it’s an absolute truth to say that any well-diversified portfolio will outperform all poorly diversified portfolios over time on a risk-adjusted basis. If an investor is thinking predominantly in terms of risk and reward, then greater diversification is the slam-dunk portfolio recommendation. This is the central insight of Harry Markowitz and his modern portfolio theory contemporaries, and I’m sure I don’t need to belabor that for anyone reading this note.

The problem is that investors are not only risk/reward maximizers, they are also regret minimizers (see Epsilon Theory notes “Why Take a Chance” and “The Koan of Donald Rumsfeld” for more, or read anything by Daniel Kahneman). The meaning of “risk” must be understood as not only as the other side of the reward coin, but also as the co-pilot of behavioral regret. That’s a mixed metaphor, and it’s intentional. The human animal holds two very different meanings for risk in its brain simultaneously. One notion of risk, as part and parcel of expected investment returns and the path those returns are likely to take, is captured well by the concept of volatility and the toolkit of modern economic theory. The other, as part and parcel of the psychological utility associated with both realized and foregone investment returns, is captured well by the concepts of evolutionary biology and the toolkit of modern game theory.

The problem is that diversification can only be understood as an exercise in risk/reward maximization, has next to nothing to say about regret minimization, and thus fails to connect with investors who are consumed by concerns of regret minimization. This fundamental miscommunication is almost always present in any advisor-investor conversation, but it is particularly pernicious during periods of global debt deleveraging as we saw in the 1870’s, the 1930’s, and today. Why? Because the political consequences of that deleveraging create investment uncertainty in the technical, game theoretic sense, an uncertainty which is reflected in reduced investor confidence in the efficacy of fundamental market and macroeconomic factors to drive market outcomes. In other words, the rules of the investment game change when politicians attempt to maintain the status quo – i.e., their power – when caught in the hurricane of a global debt crisis. That’s what happened in the 1870’s. That’s what happened in the 1930’s. And it’s darn sure happening today. We all feel it. We all feel like we’ve entered some Brave New World where the old market moorings make little sense, and that’s what’s driving the acute anxiety expressed today by investors both large and small. Recommending old-school diversification techniques as a cure-all for this psychological pain isn’t necessarily wrong. It probably won’t do any harm. But it’s not doing anyone much good, either. It’s not about the nail.

On the other hand, the concept of de-risking has a lot of meaning within the context of regret minimization, which makes it a good framework for exploring a more psychologically satisfactory set of portfolio allocation recommendations. But to develop that framework, we need to ask what drives investment regret. And just as we talk about different notions of volatility-based portfolio constructions under different market regimes, so do we need to talk about different notions of regret-based portfolio constructions under different market regimes.

Okay, that last paragraph was a bit of a mouthful. Let me skip the academic-ese and get straight to the point. In a bear market, regret minimization is driven by existential concerns. In a bull market, regret minimization is driven by peer comparisons.

In a bear market your primary regret – the thing you must avoid at all costs – is ruin, and that provokes a very direct, very physical reaction. You can’t sleep. And that’s why Rule #1 of de-risking in a bear market is so simple: sell until you can sleep at night. Go to cash. Here’s what de-risking in a bear market looks like, as drawn in risk/reward space.

epsilon-theory-its-not-about-the-nail-march-31-2015-historical-risk-reward-4

For illustrative purposes only.

Again, the gold ball is whatever your portfolio looks like today from a historical risk/reward perspective. De-risking means moving your portfolio to the left, i.e. a lower degree of risk. The question is how much reward you are forced to sacrifice for that move to the left. Perfect De-Risking sacrifices zero performance. Good luck with that if you are reducing your gross exposure. Average De-Risking is typically accomplished by selling down your portfolio in a pro rata fashion across all of your holdings, and that’s a simple, effective strategy. Good De-Risking and Poor De-Risking are the result of active choices in selling down some portion of your portfolio more than another portion of your portfolio, or – if you don’t want to go to cash – replacing something in your portfolio that’s relatively volatile with something that’s relatively less volatile.

In a bull market, on the other hand, your primary regret is looking or feeling stupid, and that provokes a very conflicted, very psychological reaction. You want to de-risk because you don’t understand this market, and you’re scared of what will happen when the policy ground shifts. But you’re equally scared of being tagged with the worst possible insults you can suffer in our business: “you’re a panicker” … “you missed the greatest bull market of this or any other generation”. Again, maybe this is a conversation you’re having with yourself (frankly, that’s the most difficult and conflicted conversation most of us will ever have). And so you do nothing. You avoid making a decision, which means you also avoid the advisor-investor conversation. Ultimately everyone, advisor and investor alike, looks to blame someone else for their own feelings of unease. No one’s happy, even as the good times roll.

So what’s to be done? Is it possible to both de-risk a portfolio and satisfy the regret minimization calculus of a bull market?

Through the lens of regret minimization, here’s what de-risking in a bull market looks like, again as depicted in risk/reward space:

epsilon-theory-its-not-about-the-nail-march-31-2015-historical-risk-reward-5

For illustrative purposes only.

Essentially you’ve taken all of the bear market de-risking arrows and moved them 45 degrees clockwise. What would be Perfect De-Risking in a bear market is only perceived as average in a bull market, and many outcomes that would be considered Good Diversification in pure risk/reward terms are seen as Poor De-Risking. I submit that this latter condition, what I’ve marked with an asterisk in the graph above, is exactly what poisons so many advisor-investor conversations today. It’s a portfolio adjustment that’s up and to the left from the diagonal risk/reward balance line, so you’re getting better risk-adjusted returns and Good Diversification – but it’s utterly disappointing in a bull market as peer comparison regret minimization takes hold. It doesn’t even serve as a Good De-Risking outcome as it would in a bear market.

Now here’s the good news. There are diversification outcomes that overlap with the bull market Good De-Risking outcomes, as shown in the graph below. In fact, it’s ONLY diversification strategies that can get you into the bull market Good De-Risking area. That is, typical de-risking strategies look to cut exposure, not replace it with equivalent but uncorrelated exposure as diversification strategies do, and you’re highly unlikely to improve the reward profile of your portfolio (moving up vertically from the horizontal line going through the gold ball) by reducing gross exposure. The trick to satisfying investors in a bull market is to increase reward AND reduce volatility. I never said this was easy.

epsilon-theory-its-not-about-the-nail-march-31-2015-historical-risk-reward-6

For illustrative purposes only.

The question is … what diversification strategies can move your portfolio into this promised land? Also (as if this weren’t a challenging enough task already), what diversification strategies can work quickly enough to satisfy a de-risking calculus? Diversification can take a long time to prove itself, and that’s rarely acceptable to investors who are seeking the immediate portfolio impact of de-risking, whether it’s the bear market or bull market variety.

What we need are diversification strategies that can act quickly. More to the point, we need strategies that can react quickly, all while maintaining a full head of steam with their gross exposure to non-correlated or negatively-correlated return streams. This is at the heart of what I’ve been calling Adaptive Investing.

Epsilon Theory isn’t the right venue to make specific investment recommendations. But I’ll make three general points.

First, I’d suggest looking at strategies that can go short. If you’re de-risking a bull market, you need to make money when you’re right, not just lose less money. Losing less money pays off over the long haul, but the long haul is problematic from a regret-based perspective, which tends to be quite path-sensitive. Short positions are, by definition, negatively correlated to the thing that they’re short. They have a lot more oomph than the non-correlated or weakly-correlated exposures that are at the heart of most old-school diversification strategies, and that’s really powerful in this framework. Of course, you’ve got to be right about your shorts for this to work, which is why I’m suggesting a look at strategies that CAN go short as an adaptation to changing circumstances, not necessarily strategies that ARE short as a matter of habit or requirement.

Second, and relatedly, I’d suggest looking at trend-following strategies, which keep you in assets that are working and get you out of assets that aren’t (or better yet, allow you to go short the assets that aren’t working). Trend-following strategies are inherently behaviorally-based, which is near and dear to the Epsilon Theory heart, and more importantly they embody the profound agnosticism that I think is absolutely critical to maintain when uncertainty rules the day and fundamental “rules” change on political whim. Trend-following strategies are driven by the maxim that the market is always right, and that’s never been more true – or more difficult to remember – than here in the Golden Age of the Central Banker.

Third, these graphs of portfolio adjustments in risk/reward space are not hypothetical exercises. Take the historical risk/reward of your current portfolio, or some portion of that portfolio such as the real assets allocation, and just see what the impact of including one or more liquid alternative strategies would be over the past few years. Check out what the impact on your portfolio would be since the Fed and the ECB embarked on divergent monetary policy courses late last summer, creating an entirely different macroeconomic regimeSeriously, it’s not a difficult exercise, and I think you’ll be surprised at what, for example, a relatively small trend-following allocation can do to de-risk a portfolio while still preserving the regret-based logic of managing a portfolio in a bull market. For both advisors and investors, this is the time to engage in a conversation about de-risking and diversification, properly understood as creatures of regret minimization as well as risk/reward maximization, rather than to avoid the conversation. As the old saying goes, risk happens fast. Well … so does regret. 

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Why Take a Chance?

epsilon-theory-why-take-a-chance-february-24-2015-casino

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

— “Casino” (1995)

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

— “Casino” (1995)

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

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

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

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

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

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

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

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

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

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

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The Clash of Civilizations

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Thomas Cole, “The Course of Empire: Destruction” (1836)

In the emerging world of ethnic conflict and civilizational clash, Western belief in the universality of Western culture suffers three problems: it is false; it is immoral; and it is dangerous.

– Samuel P. Huntington, “The Clash of Civilizations and the Remaking of World Order” (1996)

The West won the world not by the superiority of its ideas or values or religion … but rather by its superiority in applying organized violence. Westerners often forget this fact; non-Westerners never do.

– Samuel P. Huntington (1927 – 2008)

The argument now that the spread of pop culture and consumer goods around the world represents the triumph of Western civilization trivializes Western culture. The essence of Western civilization is the Magna Carta, not the Magna Mac. The fact that non-Westerners may bite into the latter has no implications for their accepting the former.

– Samuel P. Huntington (1927 – 2008)

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Islam’s borders are bloody and so are its innards. The fundamental problem for the West is not Islamic fundamentalism. It is Islam, a different civilization whose people are convinced of the superiority of their culture and are obsessed with the inferiority of their power. 

– Samuel P. Huntington (1927 – 2008)

Q:     What do you think of Western civilization?
A:     I think it would be a good idea. 

– Mahatma Gandhi (1869 – 1948)

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Adrian Veidt: It doesn’t take a genius to see that the world has problems.
Edward Blake: No, but it takes a room full of morons to think they’re small enough for you to handle.

– “Watchmen” (2009)

Our civilization is flinging itself to pieces. Stand back from the centrifuge.

– Ray Bradbury, “Fahrenheit 451” (1953)

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Upon learning of Cardinal Richelieu’s death, Pope Urban VIII is alleged to have said, “If there is a God, then Cardinal de Richelieu will have much to answer for. If not … well, he had a successful life.”
Henry Kissinger, “Diplomacy” (1994)

Corrupt politicians make the remaining ten percent look bad.

– Henry Kissinger (b. 1923)

Poor old Germany. Too big for Europe, too small for the world. 

– Henry Kissinger (b. 1923)

The most fundamental problem of politics is not the control of wickedness but the limitation of righteousness. 

– Henry Kissinger, “A World Restored: Metternich, Castlereagh and the Problems of Peace, 1812-22” (1957)

Order should not have priority over freedom. But the affirmation of freedom should be elevated from a mood to a strategy. 

– Henry Kissinger, “World Order: Reflections on the Character of Nations and the Course of History” (2014)

A more immediate issue concerns North Korea, to which Bismarck’s nineteenth-century aphorism surely applies: “We live in a wondrous time, in which the strong is weak because of his scruples and the weak grows strong because of his audacity.” 

– Henry Kissinger, “World Order: Reflections on the Character of Nations and the Course of History” (2014)

In the end, peace can be achieved only by hegemony or by balance of power.

– Henry Kissinger (b. 1923)

Isaac: Has anybody read that Nazis are gonna march in New Jersey? Ya know? I read it in the newspaper. We should go down there, get some guys together, ya know, get some bricks and baseball bats, and really explain things to ’em.
Party Guest: There was this devastating satirical piece on that on the op-ed page of the Times, just devastating.
Isaac: Whoa, whoa. A satirical piece in the Times is one thing, but bricks and baseball bats really gets right to the point of it.
Party Guest: Oh, but really biting satire is always better than physical force.
Isaac: No, physical force is always better with Nazis.

– “Manhattan” (1979)

epsilon-theory-the-clash-of-civilizations-december-29-2014-woody-allen

Lots of quotes this week, particularly from my two favorite war criminals – Sam Huntington and Henry Kissinger. Everyone has heard of Kissinger, fewer of Huntington, who may have been even more of a hawk and law-and-order fetishist than Kissinger but never sufficiently escaped the ivory towers of Harvard to make a difference in Washington. Like me, Kissinger bolted academia at his first real opportunity for a better gig and never looked back, which is probably why I always found him to be so personally engaging and fun to be around. Sam Huntington … not so much.

But Huntington’s “Clash of Civilizations” argument is not just provocative, curmudgeonly, and hawkish. It is, I think, demonstrably more useful in making sense of the world than any competing theory, which is the highest praise any academic work can receive. Supplement Huntington’s work with a healthy dose of Kissinger’s writings on “the character of nations” and you’ve got a cogent and predictive intellectual framework for understanding the Big Picture of international politics. It’s a lens for seeing the world differently – a lens constructed from history and, yes, game theory – and that’s what makes this a foundational topic for Epsilon Theory.

Huntington and Kissinger were both realists (in the Thucydides and Bismarck sense of the word), as opposed to liberals (in the John Stuart Mill and Woodrow Wilson sense of the word), which basically just means that they saw human political history as essentially cyclical and the human experience as essentially constant. Life is fundamentally “nasty, brutish, and short”, to quote Thomas Hobbes, and people band together in tribes, societies, and nation-states to do something about that. As such, we are constantly competing with other tribes, societies, and nation-states, and the patterns of that competition – patterns with names like “balance of power” and “empire” and “hegemony” – never really change across the centuries or from one continent to another. Sure, technology might provide some “progress” in creature comforts and quality of life (thank goodness for modern dentistry!), but basically technology just provides mechanisms for these political patterns to occur faster and with more devastating effect than before.

The central point of “Clash of Civilizations” is that it’s far more useful to think of the human world as divided into 9 great cultures (Huntington calls them civilizations, but I’ll use the words interchangeably here) rather than as 200 or so sovereign nations. Those cultures – Western, Orthodox (Russian), Islamic, African, Latin American, Sinic (Chinese), Hindu, Buddhist, and Japonic – are persistent and profoundly influential in ways that national borders and national institutions aren’t. Huntington argues that these 9 cultures are the most meaningful current expressions of the human animal’s inherent social imperatives, and that the logic of competition between these cultures explains and illuminates human history far better than competing notions, particularly those (like Marxism and liberalism) that assume an up-and-to-the-right direction to the arrow of history.

epsilon-theory-the-clash-of-civilizations-december-29-2014-map

Marxism and liberalism are inherently optimistic visions of human society. Things are always getting better … or they will be better just as soon as people wake up and recognize their enlightened self-interest … as ideas of proletariat empowerment (Marxism) or individual rights as instantiated by free markets and free elections (liberalism) inexorably spread throughout the world. For realists like Huntington and Kissinger, on the other hand, this is nonsense. Free markets and free elections are good things (as is proletariat empowerment, frankly), but these central concepts of liberalism only mean what we Westerners think they mean if they exist within the entire context of Western culture. To insert the practices and institutions of liberalism into the Sinic culture, for example, might look awfully pretty to the Western eye and fill us with righteous pride, but it’s just a veneer. It won’t stick. The West may very well want to impose the practices and institutions of free markets and free elections for its own self-interest, and China may want to adopt the practices and institutions of free markets (but not free elections) for its own self-interest, but the logic of self-interest is a VERY different thing than the triumphalist claim that the liberal ideas of Western free markets and free elections are “naturally” spreading throughout the world.

A brief aside here on the distinction between personal beliefs and useful models. I’m not saying that I believe that authoritarian regimes and jihadist despots have some sort of moral equivalence to liberal governments, or that human rights don’t matter, or any of the other tired bromides used to tar realists. On the contrary, I personally believe that everyone in the non-Western world would be better off … MUCH better off … if their governing regimes gave a damn about individual rights and liberties in the same way that ANY governing regime in the West does. I believe that the principles of liberalism are the best ideas on social organization that the human animal has ever devised, and I’d like to spread these ideals into every corner of the globe. And you know what? On a personal level, Sam Huntington and Henry Kissinger believed exactly the same thing. Kissinger fought in the Battle of the Bulge. He won the freakin’ Bronze Star for his work tracking down Gestapo agents in Hanover. Does that sound like a moral relativist? Huntington served in the Jimmy Carter administration, for god’s sake. Talk about personal sacrifices …

But what a realist recognizes is that our personal vision of how we would like the world to be is not an accurate representation of The World As It Is, and – as Huntington wrote – it’s false, immoral, and dangerous to pretend otherwise. The World As It Is today includes the birth of an Islamic Caliphate, effectively erasing Western colonialist borders from Iraq to Syria to Libya as it spews anti-modern carnage. The World As It Is today includes the violent sundering of Ukraine along Orthodox/Western cultural lines. The World As It Is today includes an insane Sinic theocracy in North Korea with nuclear weapons. The World As It Is today includes a Japonic culture that is, in a very real sense, dying. Is a realist happy about any of this? Is a realist satisfied to shrug his shoulders and retreat into some isolationist shell? No, of course not. But a realist does not assume that there are solutions to these problems. Certainly a realist does not assume that there are universal principles like “free and fair elections” that can or should be applied as solutions to these problems. Some problems are intractable because they have been around for hundreds or thousands of years and are part and parcel of the Clash of Civilizations. They’re not going away no matter how hard some American President stomps his feet or how many drones he releases or how stern an op-ed piece is printed in the New York Times or how warm and fuzzy we feel when we see a picture of an Iraqi woman proudly displaying her finger freshly inked from voting. Yes, I know I’m an a-hole for criticizing the whole “purple revolution” thing. Doesn’t mean I’m wrong.

epsilon-theory-the-clash-of-civilizations-december-29-2014-purple

Kissinger wasn’t kidding when he said that there were two and exactly two solutions to international problems: 1) hegemony (i.e., empire) over the opposing Civilization, or 2) balance of power with the opposing Civilization. The problem, of course, is that Door #1 is awfully expensive. For example, if you’re not prepared to push Germany into recession and risk a lot of lives – and I mean a LOT of lives – by expanding the NATO umbrella over Ukraine, then there’s no way you’re going to reverse a basic balance of power reality like “Russia gets a warm water port on the Black Sea, no matter what the petty satraps in Kiev think about that”. Sorry, but that’s the “solution” if you’re not happy with Russia’s annexation of the Crimea and Eastern Ukraine, and I have yet to meet anyone who’s willing to pay that price. Are there aspects of The World As It Is where you ARE prepared to pay the high price of empire to prevent a balance of power equilibrium? It’s a short list for me, but yes, there is a list, headed by the preservation of Israel and South Korea as (largely) Western outposts in the middle of non-Western cultures. Is nation-building in Afghanistan on the list? Don’t make me laugh.

I think the crucial issue here (as it is with so many things in life) is to call things by their proper name. We’ve mistaken the self-interested imposition and adoption of so many Western artifices – the borders between Syria and Iraq are a perfect example, but you can substitute “democracy in Afghanistan” if you like, or “capital markets in China” if you want something a bit more contentious – for the inevitable and righteous spread of Western ideals on their own merits. This is a problem for one simple reason: if you think Something happened because of Reason A (ideals spreading “naturally” and “inevitably” within an environment of growing global cooperation), but it really happened because of Reason B (practices imposed or adopted out of regime self-interest within an environment of constant global competition), then you will fail to anticipate or react appropriately when that Something changes.

And here’s the kicker: change is coming. The Clash of Civilizations is not going to get better in 2015. It’s going to get worse. Why? Because for the past five years we have had a US government that was willing to pay the high price of empire to extend its monetary policy hegemony over the entire world to save the infrastructure of modern Western civilization: the US banking system and its collateral assets. Five trillion dollars later, the Fed has now declared victory and is demobilizing the QE troops. Is it a lasting victory? I don’t know and it doesn’t really matter. It’s a useless question. In the immortal words of Bill Parcells, you are what your record says you are, and the Fed’s record looks pretty darn good. So they’re declaring victory and that’s how it will go down in the history books. The better question is: what now? What happens in the rest of the world now that the peace-keeping and price-raising and prosperity-bringing delivered by five trillion dollars in asset purchases … stops?

Part of the answer – a small part of the answer – is that other central banks with printing presses will try to take up some of the slack. The BOJ will continue to weaken the yen and monetize the government’s debt, and the ECB will do the same thing, although they will do less and will be forced to jump through bizarre hoops to preserve the pleasant fiction that they’re not monetizing government debt. I say that this is a small part of the answer to the question of “what now?” – even though if you listen to the prognosticators in financial media you would think that this is the entire answer – because monetary policy divergence, as important as it is, pales in comparison to political divergence. I don’t think it’s an accident that Ukraine starts ripping itself apart as the largest monetary experiment in the history of man starts to wind down. Or that ISIS starts to remap the entire Middle East. Or that North Korea attacks Sony. Or that the price of oil drops by half as OPEC faces its greatest existential threat. Did the Fed cause these events? Of course not. But they’re not unrelated. They’re all part of the fabric of global deleveraging. This is what happens when you have a global debt crisis and politicians respond to maintain the status quo by any means necessary – the political center does not hold. Whether you’re talking about the 1870’s or the 1930’s or today, it’s always the same story … domestic coalitions and sovereign nations and international alliances that were held together by mutual absolute gains in the good times are driven apart by relative gains and losses in the bad times, and those domestic coalitions and sovereign nations and international alliances that bridge two ancient civilizations are thrown into the centrifuge most of all.

The market flash points for 2015 are not limited to the obvious suspects, like Ukraine and ISIS. In fact, most of the obvious suspects are not terribly impactful on major markets, and some have the perverse effect of providing “good news” for markets the worse their situation becomes. For example, to the degree that Ukraine-related sanctions on Russia damage German growth rates, the market believes that this forces still greater ECB market accommodation and direct propping-up of financial asset prices in the Eurozone. The non-obvious suspects I’m looking at are countries that, like Ukraine, find themselves with one foot in one civilization and one foot in another but, unlike Ukraine, are much more central to global markets. Those countries are Greece, Turkey, Iran, Egypt, and South Korea. I wrote about Greece two weeks ago, so won’t repeat all that here. Turkey, Iran, and Egypt are all the same basic story – ancient civilizations that had their day in the sun many centuries ago and are now being consumed by the Borg-like entity that is Islam. Persia, the most potent of the three cultures, is completely lost. Egypt is lost but hasn’t realized it yet, like a chicken running around with its head cut off. Turkey, the least of the three, has adopted enough Western antibodies to provide some resistance, but it’s just a matter of time before it becomes the Sick Man of Europe once again. South Korea … judging from how little it is discussed in the Western press it sometimes seems like no one cares about South Korea, and that’s a mistake. No country on earth is split between more civilizations, and no country is as sensitive AND vulnerable to the clashes that are coming down the pike.

So … am I terrified by the Clash of Civilizations? Am I getting out of the market and running for the hills? No. Not yet, anyway. So long as the market is dominated by the Narrative of Central Bank Omnipotence, any of these flash points that I’ve mentioned will inevitably be seen through the lens of monetary policy accommodation, making bad news in the real world good news for major stock markets, particularly here in the US. Global growth will get even more pathetic, of course, but that’s positive for major government bonds. Of all the flash points above I’m probably most concerned about Greece, but even then the concern is more for what Greece ultimately means for Italian politics than for what it means to Europe or major global markets directly.

What scares me about the Clash of Civilizations is that the three leaders of the three biggest civilizations – the US (Western), China (Sinic), and Russia (Orthodox) – will misplay their hands and take on another civilization directly or, worse, take on each other, and that will vaporize the Narrative of Central Bank Omnipotence in a nanosecond. The existential risk here for markets is not that China/Russia/Europe/America might “collapse”, whatever that means. No, the existential risk is that the great civilizations of the world will be “hollowed out” internally, so that the process of managing the ten thousand year old competition between civilizations devolves into an unstable game of pandering to domestic crowds rather than a stable equilibrium of balance of power. Don’t take my word for it. Take the word of America’s finest diplomat since Benjamin Franklin, writing in his final book and delivering his most important warning.

Side by side with the limitless possibilities opened up by the new technologies, reflection about international order must include the internal dangers of societies driven by mass consensus, deprived of the context and foresight needed on terms compatible with their historical character. As diplomacy is transformed into gestures geared toward passions, the search for equilibrium risks giving way to a testing of limits. … 

Because information is so accessible and communication instantaneous, there is a diminution of focus on its significance, or even on the definition of what is significant. This dynamic may encourage policymakers to wait for an issue to arise rather than anticipate it, and to regard moments of decision as a series of isolated events rather than part of a historical continuum. When this happens, manipulation of information replaces reflection as the principal policy tool. 

– Henry Kissinger, “World Order: Reflections on the Character of Nations and the Course of History” (2014)

I can’t over-emphasize how important I think this passage is, and I’ll be returning to it again in future Epsilon Theory notes. For now, though, I’ll just introduce two key game theoretic concepts at the core of Kissinger’s warning.

First, the proliferation of the most dangerous game of all – Chicken. When Kissinger writes about how “the search for equilibrium risks giving way to a testing of limits”, he’s talking about how ordinary diplomatic maneuvers can deteriorate into brinksmanship, the hallmark of the game of Chicken. I’ve written a little bit about this game in the context of the Fed-inspired “Taper Tantrum” in the summer of 2013, when Bernanke et al misread the market impact of a change in the acceleration of monetary easing, but that little episode will look like a gentle spring shower compared to the market storm that could result from a full-scale game of Chicken between, say, China and Japan over trade, exchange rates, and offshore oil and gas reserves in the South China Sea. Chicken is such a dangerous game because it has no equilibrium, no outcome where all parties prefer where they are to where they might be. This constant cycling of one unstable outcome to another typically ends in disaster because the least worst outcome for each player – the “move” that each player makes to respond strategically to the other player’s most recent limit-testing actions – doesn’t remain constant but gets progressively worse over time. The game of Chicken is a mutual spiral into oblivion, and once you start down this road it’s really hard to stop because stopping means admitting defeat.

Second, the dumbing-down of all political games into their most unstable form – the single-play game. When Kissinger writes about how political leaders come to see “moments of decision as a series of isolated events”, he’s talking about the elimination of repeated-play games and shrinking the shadow of the future. Most games seem really daunting at first glance. For example, the Prisoner’s Dilemma is famous for having a very stable equilibrium where everyone is worse off than they easily could have been with some very basic cooperation. But there’s a secret to solving the Prisoner’s Dilemma – play it lots of times with the same players. Cooperation and mutually advantageous equilibria are far easier to achieve within a repeated-play game because reputation matters. The shadow of the future looms large if you’re thinking not only about this iteration of the game and the moves ahead, but also about the next time you have to play the game, perhaps for larger stakes, and the next, and the next. Imagine if you sat down at a poker table, were dealt one hand, and were then informed that everyone would have to get up and find another table with new players, at which point only one hand would be dealt there, too. That’s a series of single-play games, and it’s just as unpleasant as it sounds, whether you’re playing poker or you’re playing politics.

It won’t surprise many regular readers of Epsilon Theory if I say that I think much of what Kissinger warns about – “societies driven by mass consensus”, “gestures geared towards passions”, “manipulation of information” – has now reached, if not its full fruition, then at least a new quantum level of advanced and ubiquitous practice. And not just in the US, but also Russia and China and everywhere in between. Twenty-three years after Sam Huntington first presented his “Clash of Civilizations” argument, the conditions for that realist confrontation to be terribly severe are finally met. 2014 wrote an unpleasant story of nascent international splintering and conflict. Unfortunately, I think it was just an introductory chapter in a much longer book.

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Signs and Portents

epsilon-theory-signs-and-portents-december-1-2014-the-omen

Young nanny: Look at me, Damien! It’s all for you.  

[she jumps off a roof, hanging herself] 
– “The Omen” (1976)  

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When one has little faith, one must survive from day to day signs.

– Stephen King, “Bag of Bones” (1998)

epsilon-theory-signs-and-portents-december-1-2014-batman

Criminals are a superstitious cowardly lot, so my disguise must be able to strike terror into their hearts. I must be a creature of the night, black,  terrible … a … a …  


– Bob Kane and Bill Finger, “Batman” (1939)

When clouds appear, wise men put on their cloaks;

When great leaves fall, the winter is at hand;
When the sun sets, who doth not look for night?

― William Shakespeare, “Richard II” (1595)

Alas, why gnaw you so your nether lip?

Some bloody passion shakes your very frame:

These are portents; but yet I hope, I hope,

They do not point at me.

― William Shakespeare, “Othello” (1603)

Destiny does not send us heralds. She is too wise or too cruel for that.

― Oscar Wilde (1854 – 1900)

Like the criminals that Bruce Wayne fought as Batman, we investors are a superstitious, cowardly lot. We are constantly ascribing way too much import to this sign or that sign, constantly freaking out over the meaning and significance of this market event or that market event. It doesn’t help that the financial media world has devolved into fiefdoms of rah-rah soothsayers on the one hand and doom-seeing end-timers on the other, so that whatever our predispositions might be we can easily find Voices of Authority to read the entrails to our liking. And it really doesn’t help that we are in the midst of the greatest crisis of faith in the markets since the 1930’s, so that – as Stephen King wrote – we survive by looking for day-to-day signs to show us what to do.

And yet sometimes a little freaking out over the signs and portents is clearly the right thing to do. Sure, if your nanny declares her loyalty to your adopted-under-mysterious-circumstances devil-child as she hangs herself outside the nursery window it’s probably a case of mental illness, but I’d also listen a little more closely to what that pesky priest says. If you’re Pierce Brosnan in the “Bag of Bones” mini-series and you think that your dead wife is sending you cryptic messages via a handful of refrigerator magnets … well, maybe you should drive into town and buy more refrigerator magnets, see if she’s got anything interesting to say. If you’re Desdemona and you’re worried that Othello’s lip-biting is a sign that he’s about to fall into a jealous, murderous rage … well, maybe you should run out of the room instead of hanging around to see if you’re right.

It’s a tough call, evaluating what’s a “true” sign and what’s a “false” sign. Are we being foolish to sell our energy stocks after oil prices took another big hit, or are we reading the market’s tea leaves correctly and saving ourselves a lot of future pain? Are we acting as Shakespeare says any wise person would in a knowable and deterministic world, by putting on our cloaks as clouds appear and looking for the night as the sun sets? Or are we mistaking our play-acting market world for the real world, putting on our cloaks as the projectionist shows us a picture of clouds and looking for the night as the stage lights dim?

Here’s the Epsilon Theory answer: the latter mistake is 1,000 times more common than the former wisdom, and the vast majority of investors would be better off if they never read the newspaper and never turned on the TV. Why? Because what they think is a “sign” is actually a signal, neither true nor false in and of itself but only more or less influential in changing their mind and other investors’ minds about the world. (for more on signals and Information Theory, see “Through the Looking Glass” and “The Music of the Spheres”) Signals are constructed. Signals are malleable. And unless you are focused on how and why signals are constructed and shaped, you will be whipsawed. You will be shaken out. You will be roped in. You will catch a falling knife. Pick your own analogy or metaphor … there are a million to choose from and anyone who has spent any time at all in the market has experienced most of them. We’ve all been there.

Case in point: why are many investors puking energy sector stocks today? It’s not because they have a detailed cash flow model of the specific companies they’re selling and have calculated the incremental earnings impact of oil prices moving from a $70 handle to a $60 handle. It’s also not because there’s some credit freeze roiling financial markets and a careful balance sheet analysis shows imminent dividend cuts or debt stress throughout the sector. Will lower oil prices over a long period of time hurt earnings and crimp growth for the entire sector? Well, sure. That’s kinda what it means to invest in a cyclical stock, and if this comes as a surprise to you then I really don’t know what to say. Will lower oil prices over a long period of time create balance sheet distress in the energy sector’s more levered, go-go stocks? Absolutely. If you’re not stress testing the balance sheet, capital allocation, and distribution coverage models of the energy stocks you own, then you’re not doing your job as a risk manager. But neither earnings risk nor balance sheet risk explains why you see a spasm of energy sector selling today or back in October.

No, the selling is because the dominant Common Knowledge regarding energy sector stocks is that they move up and down with the price of oil. Common Knowledge is not what everyone knows; that’s the consensus. Common Knowledge is what everyone knows that everyone knows, and it’s the driving force behind the Game of Sentiment. Everyone knows that everyone knows energy stocks are tied to oil prices, we just took another sharp leg down in oil prices, and so energy stocks must be sold. The fact that energy stocks are down “proves” the relationship (a wonderful example of Soros’s concept of reflexivity), which adds to the selling. And “Even After Selloff, Energy Stocks Attract Few Buyers” because, as the WSJ breathlessly announces, “prices could soon plumb new depths.” Or not, but … hey, all the better to set-up that “rebound that no one was expecting” story. Until that story is written, any oil price increases are merely because “traders who had bet on lower prices locked in gains.” I find it awfully telling that this WSJ article now titled “U.S. Oil Prices Trade Higher After Selloff” was originally titled and archived as “Oil Slides as Market Struggles To Get Grip” (you can track URL’s to identify this stuff), but then the market failed to cooperate and they had to change the title!

A couple of Epsilon Theory points on all this.

The reality (not that it matters) is that energy stocks are barely correlated with the price of oil, and their correlation with each other is barely driven by oil prices. We’ve run some basic regression analyses on MLP portfolios, and since 2012 only about 7% of the total return profile of MLP’s can be “explained” (statistically speaking) by change in oil prices. The largest explanatory factor is just the S&P 500, with about 4 times the “power” of oil prices to predict MLP prices. My interpretation is not that a rising overall market is “causing” MLP stocks to work, but that the same non-fundamental monetary policy-driven forces that are driving up the overall market are also at work in the MLP space. MLP’s have both growth and yield – the two rarest things in a Fed-dominated world – so whatever market dynamics work for stocks overall have really worked for MLP’s.

For another perspective, take a look at this recent piece by Ed Tom and the Credit Suisse Equity Trading Strategy team, titled “What’s Driving Energy Sector Correlation? (Hint: It’s NOT Oil)”. Ed and his team do stellar econometric analysis of equity market derivative contracts, which means that their papers typically need some translation into plain English. Here’s the skinny: most investors think that energy stocks traded off in unison in October because they’re highly correlated to the decline in oil prices. Not true. Yes, there’s some correlation to oil, but what’s really driving this across-the-board decline is the fact that “long energy” has become a very crowded trade. So if you get a signal that spooks the long energy crowd, you’re going to get a mad rush of investors heading for the exit even if the signal isn’t truly that relevant for the fundamentals or the historical beta of energy stocks. When a trade is crowded on the long side, everyone has an itchy trigger finger to sell.

So what does matter? How can we improve our investing around energy sector stocks by thinking about oil prices as a malleable signal that drives sentiment dynamics (at least in the short and medium term) rather than as a deterministic and inexorable sign of things to come? I think what happens from here depends on the strategic interaction of four factors:

  1. How crowded is the trade (still)? The good news here is that the Credit Suisse team believes a lot of the air was let out of the long-energy crowded trade balloon in October. I think that’s probably true, although I certainly wouldn’t call it un-crowded. I also think there’s a tremendous amount of air in the more general “the Fed has got your back” crowded trade balloon, which is worrisome for all equity market sectors, including energy.
  2. What’s the investing DNA – value or growth – of the majority of energy sector holders? The notion of population dynamics and evolutionary theory is something I explored earlier this year in Epsilon Theory (here and here), and it’s a topic that I’m going to refocus on in 2015. The basic idea is that different investors have different linguistic grammars (value investors possess a mean-reversion grammar, while growth investors possess a momentum grammar), and that for a stock or sector to “work” you need the dominant Narrative grammar to fit the dominant investor type.
  3. How is the oil price Narrative framed – supply/demand fundamentals or monetary policy? I wrote about this at length in last week’s Epsilon Theory note, so won’t repeat all that here. Everything I wrote then remains true: the supply/demand fundamentals Narrative is now ascendant and I suspect will remain so for at least a couple of weeks, maybe longer. That’s important because at current supply/demand projections it’s hard (not impossible, but hard) for oil prices to get much below $70 and stay there for a long time if you believe in this Narrative. A fundamentals-driven “explanation” places a martingale on oil prices that does not exist with monetary policy-driven “explanations”.
  4. What will China and the US do with their monetary policy, and what will Saudi Arabia and Russia do with their foreign policy? Hey, your guess is as good as mine. I don’t have a crystal ball on outcomes or timing, but this is where my risk antennae are focused 99% of the time.

I don’t have settled answers to any of these questions. And I don’t have a predictive model (a risk-based econometric analysis), because not only don’t I have settled answers, but I don’t even have a sense of potential outcomes or rough probability distributions for #4. I know that’s unsatisfying to many readers (certainly it’s unsatisfying to me!), but you have to take what the market gives you, not what you wish were there. My goal is not to be a hero and make bold predictions in the Golden Age of the Central Banker. My goal is to be a survivor. My goal is to play the game a bit better than the crowd by paying attention to the construction and shaping of market signals, all the while keeping my attention focused on how politicians and bankers wrestle with a global debt crisis. Call it being reactive if you like. I prefer to call it Adaptive Investing, and that’s what I want to communicate with Epsilon Theory.

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Mike Tyson: Master Game Theorist

epsilon-theory-mike-tyson-master-game-theorist-november-6-2014-boxing

Everyone has a plan until they get hit in the mouth.
Mike Tyson

My long-term strategy turned into a 12-hour strategy.
“Survivor” contestant Dale, voted out in last week’s tribal council

Reality doesn’t interest me.
Leni Riefenstahl, acclaimed German film director and Nazi stooge

Ben, there is no such thing as a good redouble.
Grace Hunt, my grandmother, in a memorable bridge lesson

I’ve been wrestling with what to write about the Bank of Japan’s decision last Friday where … to use a ZeroHedge turn of a poker phrase … they went “all-in-er” on balance sheet expansion and monetary policy QE. It’s hard to find a middle ground here. On the one hand I could write a copycat oh-my-god-can-you-believe-what-these-madmen-are-doing note, but frankly I’m tired of being outraged, and I suspect most Epsilon Theory readers are, too. On the other hand, I really AM outraged by the increasing number of articles and emails I read where BOJ actions and Fed actions and ECB actions are celebrated in Leni Reifenstahl-esque fashion as some modern day Triumph of The Will, as if the symbolic projection of an unlimited, indomitable, and grandiose State were the highest possible achievement for political leaders. Yes, I just played the fascist card. I don’t think I’m wrong.

It was only after reading a quote from Nouriel Roubini – “They had no choice.” – that I had my hook on how to write this note. Because I think Nouriel is right, not in his evaluation of the objective parameters of the decision itself (I think he’s dead wrong on that score), but in how a slim majority of the BOJ perceived the decision at hand. I think the majority believed that they were forced to take this action, and I think that this perspective – when combined with some basic ideas from game theory – can shine some light on what might happen next.

In game theory, to say that “you have no choice” can mean one of three things.

First, it can mean that you have what’s called a “dominant strategy”, where regardless of what actions or decisions are made by other players in the game you are always better off to take a singular course of action. Kareem Abdul-Jabbar’s sky-hook was a dominant strategy in the game of basketball. No matter what his opponents did, no matter how tall they were, no matter how quick they were … Kareem could always get this shot off. He might miss the shot, but that was totally on him; a miss had nothing to do with his opponents. Dominant strategies are, as the name suggests, typically the purview of dominant players, which certainly doesn’t describe Japan in the Great Game of international politics, so I don’t think that’s a big part of what’s going on here.

epsilon-theory-mike-tyson-master-game-theorist-november-6-2014-basketball

Second, it can mean that you’ve discounted what’s called “the shadow of the future” to the point that if immediate exigencies point you in a singular direction … well, that’s the only direction you can imagine. I see this a lot in reality shows like “Survivor”, where contestants must “scramble” (to use the lingo) in a desperate effort just to last one more day in the game. As last week’s eliminated contestant Dale said, “my long-term strategy turned into a 12-hour strategy”. That’s what happens when the future is discounted severely, and I think that’s a significant piece of the BOJ decision last Friday. Even if you believe that current Japanese monetary policy creates a mighty thin tightrope over a mighty deep chasm filled with mighty hungry alligators a few years out, that means essentially nothing if you also believe that the immediate future is a political disaster without doing something in a big way. And if you’re a central banker that big something can only be more QE. It’s indicative of the degree to which monetary policy has been politicized – particularly in Japan – as central bankers now suffer from the same extreme myopia that elected politicians have always demonstrated.

epsilon-theory-mike-tyson-master-game-theorist-november-6-2014-survivor

Third, and I think predominantly in this case, it can mean that you’re not even playing a game, but that you are acting in a strategic vacuum where you are only considering your own preferences. We’ve all fallen prey to this fallacy … we plan and scheme and strategize to the nth degree, based on our own calculus of our own pluses and minuses associated with our own actions … and it all goes swimmingly until, as Mike Tyson so brilliantly put it, we get smacked in the mouth. We get popped really hard, and as we’re falling to the canvas we think “Oh yeah, I guess the other guy had a plan, too. Maybe I should have taken that into consideration.” Or as my grandmother put it when I got totally wiped out by her bridge cronies playing for a penny a point because I was solely focused on the strength of my own hand, “Ben, there is no such thing as a good redouble.” Best advice I ever got.
For five and a half years the BOJ has had a clear field to take whatever actions they wished without fear of some other, stronger central bank smacking them in the mouth. There has been a coordination of central bank purpose and effort that hasn’t been seen since … the 1985 Plaza Accords? Bretton Woods? Whatever your reference point might be from an economic history perspective, it’s been a very long time since we’ve seen such a very long period of such a non-strategic, we’re-all-in-this-together decision making backdrop for second tier central banks like the BOJ or the BOE. So it really doesn’t surprise me at all that the BOJ did what it did last Friday. Like you and me and market participants everywhere, the BOJ Governors have been very well trained to expect that the Fed has got their back, that they can act according to their own narrow and immediate self-interests without concern or fear that their actions will result in someone smacking them in the mouth.

Unfortunately for the BOJ, I think that this happy state of coordinated policy bliss ended about six months ago. I think that they have redoubled this particular contract as if they were playing bridge with doting grandparents rather than chain-smoking, penny-pinching old crones. I think that there is a clear and growing divergence between the US and the rest of the world when it comes to balance sheet expansion and monetary policy intentions, and I think that for China in particular this latest BOJ action is perceived as an aggressive provocation that must be responded to forcefully.

So what’s next? I’m waiting for China’s response. I have no idea whether the response will be (to use the political science terminology) symmetric or asymmetric in scale and delivery. That is, the response could be larger or smaller than the perceived provocation, and it may or may not be a response delivered through monetary policy. I have no idea exactly when the response will occur. But I have zero doubt that a forceful response is coming. I have zero doubt that Japan is about to get smacked in the mouth. And when that happens the monetary policy calculus in Japan … and the UK … and even the EU will take on a very different shape. The domestic political dictates may still overwhelm the international economic consequences of extraordinary monetary policy easing. In other words, Japan’s politicians (which surely includes the BOJ Governors) may still have a scrambling Survivor contestant’s view of the shadow of the future, where they’re just looking to live another day regardless of the long-term consequences. But they will no longer be making these decisions within a strategic vacuum. And that’s a very different – and more difficult – game to play.

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Calvin the Super Genius

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People think it must be fun to be a super genius, but they don’t realize how hard it is to put up with all the idiots in the world.

― Bill Watterson, “Calvin And Hobbes”

Here is the most fundamental idea behind game theory, the one concept you MUST understand to be an effective game player. Ready?

You are not a super genius, and we are not idiots. The people you are playing with and against are just as smart as you are. Not smarter. But just as smart. If you think that you are seeing more deeply into a repeated-play strategic interaction (a game!) than we are, you are wrong. And ultimately it will cost you dearly. But if there is a mutually acceptable decision point – one that both you and we can agree upon, full in the knowledge that you know that we know that you know what’s going on – that’s an equilibrium. And that’s a decision or outcome or policy that’s built to last.

Fair warning, this is an “Angry Ben” email, brought on by the US government’s “communication policy” on Ebola, which is a mirror image of the US government’s “communication policy” on markets and monetary policy, which is a mirror image of the US government’s “communication policy” on ISIS and foreign policy. We are being told what to think about Ebola and QE and ISIS. Not by some heavy-handed pronouncement as you might find in North Korea or some Soviet-era Ministry, but in the kinder gentler modern way, by a Wise Man or Woman of Science who delivers words carefully chosen for their effect in constructing social expectations and behaviors.

The words are not lies. But they’re only not-lies because if they were found to be lies that would be counterproductive to the social policy goals, not because there’s any fundamental objection to lying. The words are chosen for their truthiness, to use Stephen Colbert’s wonderful term, not their truthfulness. The words are chosen in order to influence us as manipulable objects, not to inform us as autonomous subjects.

It’s always for the best of intentions. It’s always to prevent a panic or to maintain confidence or to maintain social stability. All good and noble ends. But it’s never a stable equilibrium. It’s never a lasting legislative or regulatory peace. The policy always crumbles in Emperor’s New Clothes fashion because we-the-people or we-the-market have not been brought along to make a self-interested, committed decision. Instead the Powers That Be – whether that’s the Fed or the CDC or the White House – take the quick and easy path of selling us a strategy as if they were selling us a bar of soap.

This is what very smart people do when they are, as the Brits would say, too clever by half. This is why very smart people are, as often as not, poor game players. It’s why there aren’t many academics on the pro poker tour. It’s why there haven’t been many law professors in the Oval Office. This isn’t a Democrat vs. Republican thing. This isn’t a US vs. Europe thing. It’s a mass society + technology thing. It’s a class thing. And it’s very much the defining characteristic of the Golden Age of the Central Banker.

Am I personally worried about an Ebola outbreak in the US? On balance … no, not at all. But don’t tell me that I’m an idiot if I have questions about the sufficiency of the social policies being implemented to prevent that outbreak. And make no mistake, that’s EXACTLY what I have been told by CDC Directors and Dr. Gupta and the White House and all the rest of the super genius, supercilious, remain-calm crew.

I am calm. I understand that a victim must be symptomatic to be contagious. But I also understand that one man’s symptomatic is another man’s “I’m fine”, and questioning a self-reporting immigration and quarantine regime does not make me a know-nothing isolationist.

I am calm. I understand that the virus is not airborne but is transmitted by “bodily fluids”. But I also understand why Rule #1 for journalists in West Africa is pretty simple: Touch No One, and questioning the wisdom of sitting next to a sick stranger on a flight originating from, say, Brussels does not make me a Howard Hughes-esque nutjob.

I am calm. I understand that the US public health and acute care infrastructure is light years ahead of what’s available in Liberia or Nigeria. I understand that Presbyterian Hospital in Dallas is not just one of the best health care facilities in Texas, but one of the best hospitals in the world. But I also understand that we are all creatures of our standard operating procedures, and what’s second nature in a hot zone will be slow to catch on in the Birmingham, Alabama ER where my father worked for 30 years.

The mistake made by our modern leaders – in every public sphere! – is to believe that they are operating on a deeper, smarter, more far-seeing level of game-playing than we are. I’ve got a long example of the levels of decision-making in the Epsilon Theory note “A Game of Sentiment”, so I won’t repeat all that here. The basic idea, though, is that by announcing a consensus based on the Narrative authority of Science our leaders believe they are stacking the deck for each of us to buy into that consensus as our individual first-level decision. This can be quite effective when you’re promoting a brand of toothpaste, where it is impossible to be proven wrong in your consensus claims, much less so when you’re promoting a social policy, where all it takes is one sick nurse to make the entire linguistic effort seem staged and for effect … which of course it was. The fact that we go along with a game – that we act AS IF we believe in the Common Knowledge of an announced consensus – does NOT mean that we have accepted the party line in our heart of hearts. It does NOT mean that we are myopic game-players, unerringly led this way or that by the oh-so-clever words of the Missionaries. But that’s how it’s been taken, to terrible effect.

I am calm. But I am angry, too. It doesn’t have to be this way … this consensus-by-fiat style of policy leadership where we are always only one counter-factual reveal – the sick nurse or the sick economy – away from a breakdown in market or governmental confidence. I am angry that we have been consistently misjudged and underestimated, treated as children to be “educated” rather than as citizens to be trusted. I am angry that our most important political institutions have sacrificed their most important asset – not their credibility, but their authenticity – on the altar of political expediency, all in a misconceived notion of what it means to lead.

And yet here we are. On the precipice of that breakdown in confidence. A cold wind of change is starting to blow. Can you feel it?

PDF Download (Paid Membership Required):

http://www.epsilontheory.com/download/16168/

The Game of Thrones and the Game of Markets

Two items for the mid-week.

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

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

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

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

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

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

PDF Download (Paid Membership Required):

http://www.epsilontheory.com/download/16133/