The Narrative Giveth and The Narrative Taketh Away

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

So what’s to be done?

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

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

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Is Volatility Back?

On this special episode of the Epsilon Theory podcast, we share an excerpt from a conference call we recorded on February 13 discussing our thoughts on the market selloff earlier in the month. You’ll hear from Christopher Guptill, co-CEO and chief investment officer at Broadmark Asset Management and Dr. Ben Hunt, author of Epsilon Theory.

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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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Harvey Weinstein and the Common Knowledge Game

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

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

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

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

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

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

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

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

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

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

Not yet.

But we’re only one big Missionary statement away.

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Failure to Inflate

On episode 25 of the Epsilon Theory podcast, we’re joined by Peter Cecchini, Chief Market Strategist, Head of Equity Derivatives and Cross-Asset Strategy at Cantor Fitzgerald, to discuss one of his recent notes, “Failure to Inflate.” As Peter writes, “The theories that guide monetary policy fail to explain why growth and inflation remain so low in developed economies.” Tune in to hear why this is and what might bring about higher inflation.

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Mailbag! Midsummer 2017 Edition

Back by popular demand, it’s the Epsilon Theory Mailbag! Today’s edition covers notes from the past two months including “Tell My Horse”, “Post-Fed Follow-Up”, “Notes From the Field”, “The Goldfinch in Winter”, “Gradually and Then Suddenly”, and a podcast or two.

Keep those cards and letters coming …

I have been in Cash for the last 4 years and feel like a Wet Monkey. Expecting a 50% Market reset that simply does not happen…

I feel that The Fed has been buying stocks via ETFs since 2013, notice the slope of SPY since 2013, with a “Buy the dip” program ….

Do you think that is possible, or just the Brain Worm talking?
– James

Sorry, James, but that’s a Brain Worm talking. The Fed doesn’t need to buy stocks directly, not like the Bank of Japan, anyway. And not like the Swiss central bank. No, the Fed has deputized each and every one of us to act on its behalf, which is really the way you want to set these things up. You want to establish a meme of Central Bank Omnipotence … err, excuse me, I meant to say “expanded forward guidance” as part of “communication policy”, so that you don’t need to get your hands dirty directly. You want to control the meme. You want to control the Brain Worm. THAT’S the power of the Common Knowledge Game.

And now two letters for the time capsule. If one of my daughters ever asks me what investing was like in the Hollow Market, I’ll show her these.

I just read through your piece (and then I read it again) [“Tell My Horse”]. It was a sobering start to the day as it pretty succinctly captured and reflected back to me my broken spirit. I used to love this business. I used to believe in its methodology and the integrity of its analytics. Now, like a priest having had a crisis of faith, I can no longer stand in the pulpit and preach the gospel. I don’t [know] what to believe. I don’t know what the message is anymore. The “markets as political utility” meme strikes me as correct, but one can’t represent that to clients much less prospects. I have slowly made “accommodations” for this environment: including a quant sleeve, including more overseas exposure, including structured ETFs. All the while, I have held to my deflationary thesis and stayed long bonds and overweighted to alternative selections. Performance has been middling but sufficient. But, there is zero joy to it. The sole satisfaction comes from still believing that I am doing the “right” thing by my clients, even though the market rarely affirms my conviction. I do surround myself with like-minded (but open minded) folks, and while there is a risk of isolating oneself in an echo chamber, the constant cacophony of mainstream narratives is more than enough to provide balance with the “bull” thesis. My real fear is that we’re so far down the rabbit hole that we’ll never again see the light of day. I don’t think this business will ever be the same again (and I don’t really even know what I mean by that). Perhaps this business was never what I thought it to be! The sole goal at this point seems to be survival. I do think there will be a massive come-uppance at some point. But if so, I know there will be little satisfaction in having been “right”. Thus, it’s just one day at a time as I try to take some comfort in the wisdom of the ages that “this too shall pass”.

So I cannot thank you enough for expressing what is at the pit of my stomach. Both in the underlying distrust of the bull market, and in the Hollow Market analogy. You see our business is in fact losing its soul.

I met with a board member of the CFA Institute who lives in our area. After beating me up on fees for a half hour, he then asked about our recent GIPS compliance project. Did we find it helpful? Was it a benefit in managing accounts?

So being well trained after years of attempting to control reactions and impulses, with varying degrees of success, I was actually able to restrain myself from both dipping his head in his soup, or erupting into a cascading use of the f bomb in its many derivative forms. But I was tactful and I pray professionally pointed in my response. That compliance with GIPS costs a full analyst position, or PM position. That as fees decrease, and costs escalate we are squeezed. That as we are squeezed we cannot do more with less, so we either have to employ less CFAs or pay them substantially less, making the skill set less valuable. Did I find it helpful? No, I found it eroding my abilities to deliver the very product he wants with no pricing power.

What I did not say, but thought about substantially on my drive home, is that the other far-reaching consequence is that the institutionalization of money management has made career risk more and more an issue, as analysts and PMs become benchmark huggers, and allocators in varying percentages. That compliance standards which now prevent personal investment destroy the skill set of the “investors” that are professional PMs. That in fact the destruction of Alpha and investing skills has been the professionalization of the industry.

So I sit here invested, raising cash, feeling stupid, wondering about my personal investing skill, as I cannot figure out where to place funds with strong conviction. It’s a strange new world we work in, Ben. I feel disoriented in this Hollow Market, not trusting the upswing in the markets. Too afraid to sell out, but too afraid to implement cash into it either….. maybe I will buy some passive product…..wait, but what about excellence?

But what about excellence? That’s the cry that goes echoing through the canyons of Midtown Manhattan, fading more and more into the distance each and every day.

Lately I’ve been thinking about the old adage: “a broken clock is right twice a day”.

It is universally accepted (sans Yellen) that a correction will occur at some point in the future. The debate isn’t so much around the existence of economic cycles but around distance (time) until the back end of the current cycle arrives. I would place us (the broad Epsilon family) among the minority who believe that the inevitable correction will occur sooner rather than later. I would also admit that we (I) have been a believer of sooner rather than later for some time now. The question I keep asking myself is that if the correction does come over the nearer term. Will we (I) be vindicated, or will we (I) have been patient enough for that broken clock to be telling the current time?

I don’t have a good answer… at least not one that is satisfying.

You and me both, brother.

I wonder what you think of the following- We know that the feds QE and the govts build up of massive debt fragilizes (to use a N.N. Taleb word- another genius) the economy. However, I wonder if you think there is a chance that these ridiculous policies will get bailed out if they just reduce GDP by some percentage points, say from 5pct to 2pct annually for some amount of years. This would cost us trillions of dollars in never realized growth over the long run, but it could all be blamed away on other factors of course. In a similar way to how a Ponzi scheme can dig itself out of a hole with a really lucky grand slam investment (Pharma boy Shkreli did it until he mouthed off on twtr).

In this case there may not be a financial asset crash and instead we just blow up at a WAY later date when swaths of countries can no longer pay their debts.

Do you see this as plausible? Or is it inevitable that assets eventually tank and the economy gets into real trouble again?
– David 

Absolutely plausible, although I’d bet on joint U.S.-Japan-Europe debt monetization as the weapon of mass jubilee if it comes to that (google “trillion dollar coin” and try not to gag). There’s nothing inevitable about any of this, including an asset price crash.

I think this is more “sky is falling” stuff and “getting out” out stocks and bonds and establishing a “short bias” has been proffered by many over the past years. Those that have acted on that advice are much poorer today. Not because they were less prudent but because after they took action to get out of stocks and bonds no one told them what to go in to…the price friction of getting out of stocks and bonds and then back in (forget the timing aspect) is very expensive. The loss of income is catastrophic if not timed properly. You appear to know exactly when to get out. Not sure how…

We all know that recoveries don’t die of old age but are always due to a Fed that is over tightening money supply. With $4T in excess reserves on the books of the major central banks, having a market accident, given how well capitalized now the US banks are, seems like a remote possibility. This Minsky moment that you’re holding up to us is either not happening, or at the very least, not happening any time soon.

You could well be right, and I’ll be the first to admit that my risk antennae have been quivering violently at seven of the last two market corrections. But that’s my job and my nature — to have risk antennae that suffer Type 1 errors (false positives) to avoid Type 2 errors (false negatives). I think that’s better than the alternative, certainly for wealth preservation, although it makes me totally unsuited for any job on the sell-side, ever.

I’ve gotta call ‘em like I see ‘em, though (which includes noting a couple of narrative-driven investable rallies, so I’m not exclusively a Cassandra), and what IS demonstrably different today as opposed to five years ago or three years ago or even one year ago is that the Fed has turned their barge around to engage in a program of rate hikes and balance sheet reductions. The ECB is in the process of turning their barge in the same direction. To paraphrase Churchill, this is not the beginning of the end of QE and negative rates and all of the other exercises in Magical Thinking we have endured over the past eight years, but it IS the end of the beginning. It IS an inflection point. It IS a change in the second derivative of monetary policy accommodation, a reduction in the acceleration of policy even if we’re not yet at a reduction in the level of accommodation.

Because if I’ve learned one thing as a student of markets and human behavior over the years, it’s this: markets, no matter how big and no matter how small, happen on the margins. Inflection points not only matter, they are everything to the Game of Markets. Some of my very first Epsilon Theory notes were about this [“2 Fast 2 Furious”], and I think they’re worth reviewing again today.

Geez – when are you guys going to get off this “the Fed rules the world mantra?” Do you really think in the board meetings during the AMZN – WFM negotiations that anyone really got up and said, “maybe we should wait and see what the Fed might do?“ Outside of the financial industry how many board meetings do you think have The Fed on the agenda?? I have asked many CEOs and funny I get the same answer — none! I’ve asked the ex-CFO of WMT – same answer – never! I asked him did the Fed ever come up in any strategic decisions, any mergers or acquisitions – same answer – NEVER! I’ve asked the CEO of Simon, retail – one would think might be influenced by rates – same answer – NEVER came up. Wake up and smell the roses – businessmen run the world – not central bankers.

I once asked my boss, the founder of a very successful investment firm, what his most important lesson learned had been. “Remember this, Ben,” he said. “It’s not about the money. It’s. About. The. Money.”

So I ask you, David, who makes the money? I mean, who literally makes The Money? And sets the price of The Money. And buys trillions upon trillions of dollars of stuff with The Money year after year after year. And has implanted a meme in everyone’s brain (except yours, apparently) that even if they’re not literally making money and buying stuff today … well, they might tomorrow. Or might not.

Do you think I enjoy delivering this message? Because I don’t. It makes me sick that global stocks added more than a TRILLION dollars’ worth of value over the past few weeks because Janet Yellen said something that was perceived as dovish. It makes me sick because global stocks will LOSE more than a trillion dollars’ worth of value if she turns around next week and says something that is perceived as hawkish. It’s a joke. It’s a perversion of what a small-l liberal market should be. But that doesn’t make it any less real.

“Businessmen run the world” … I wish that were true. But if wishes were horses, beggars would ride. Don’t be a beggar.

Where I continue to struggle, is why in the world a man like President Trump, who I believe cares about winning and self-promotion, more than the long-term success of our country, is going to appoint a Fed chair that will continue raising rates in 2018, when he knows that higher interest rates are anathema to higher stock and real estate prices, at least in the short-run?

What I have been telling my clients is that I have a hard time believing President Trump will elect someone who will make it harder for him to “appear” successful. You and I both know that our country needs higher “normal” rates as well as a much better taxation system (a national sales tax and get rid of the deductions for borrowing money) to truly stabilize and revitalize our economy in the long-run. But, you won’t get to better long-term policies without short-term pain . . . and we seem to be (as a country) in the pain-minimization mode at present.

Do you believe that President Trump will appoint a Federal Reserve Chair that will focus on the long-term health of the “real” economy, or just another Alan Greenspan groupie, who cares more about the level of the S&P than GDP?
– Joel

I think that Trump wants to have his cake and eat it, too, meaning that he needs both higher short-term rates AND a steepening yield curve (i.e., higher long-term rates) to support a reflation narrative for the 2018 and 2020 campaigns, and he thinks that a reflation narrative will keep the S&P chugging along (in particular, supportive of financials as part of a rotation away from growth and into value). That would be the narrative accompanying, say, Gary Cohn taking the FOMC reins — that the Fed is raising short-term rates and shrinking the balance sheet for the right reasons, thus steepening the yield curve. And you know that the Street would absolutely eat this narrative up, even though everyone also knows it’s just another Big Lie. Wait, did I just say that out loud? Scratch that. What I meant to say is that I, for one, welcome our new Goldman Sachs overlords!

A lot of forces want to see Trump fail. Are the current Fed and Chair carrying that same agenda? Seems like they could be a lot more powerful than the politicians and the press’ infatuation with Russia, Russia, Russia. Is there a bigger motive at work here when the Fed aggressively raises rates? “Politics Always Trumps Economics”? how about “Fed Always Trumps House/Senate Investigations?

Are there examples in the past when a Fed/Chair was working to hurt the economy to make the President look bad?
– James

Back in 1960, Richard Nixon blamed his loss to JFK in large part on the Fed’s tight monetary policy, claiming that William McChesney Martin — a Truman appointee — had deliberately sabotaged the economy to damage his incumbent candidacy (Nixon ran as Eisenhower’s VP in 1960). So when Nixon won the presidency in 1968, he got rid of Martin as soon as he could and appointed Arthur Burns, who was basically Nixon’s lapdog. Nixon famously told Burns to keep interest rates low leading into the 1972 re-election campaign, and when Burns resisted, Nixon planted negative stories about him in the press until he finally gave in. So yes, politics have always been a big part of Fed policy, and I think the Yellen Fed would be perfectly happy to hang a recession around the Donald’s neck, so long as it didn’t damage their post-Fed earning potential … err, I mean, their credibility and gravitas as prudent bankers.

Of course, what’s new today and is the biggest difference-in-degree-but-not-in-kind between Trump and Nixon is that Trump plants negative stories about everyone, including the Justice Department, which is just about the most depressing thing I can write. I’ve said it before [“Virtue Signaling, or … Why Clinton is in Trouble”] and I’ll say it again: Trump breaks us, not because of his policy specifics, but because he transforms every game we play as a country — from our domestic social games to our international security games — from a Coordination Game to a Competition Game.

I travel a LOT, speaking with investor groups all over the country, of every political persuasion. Plus I have dual citizenship, having grown up in Red America and now living in Blue America, so I speak both Good Ole Boy and Team Elite fluently and without an accent. My observation from this perch is that we are utterly divided as a country, that the polarization is getting worse, and that political entrepreneurs (including the one in the White House and a whole host of smaller players on the Democratic side) are doing what political entrepreneurs always do — they’re embracing and accelerating this sea change in our social behaviors and institutions, and they’re using Fiat News to do it.

Welcome to Westworld.

Your conclusion is very clear, but I’m confused by the path you get there. You suggest that Yellen’s response function has flipped since the Trump election (implying that she is being politically partisan?), and yet you also seem to suggest that she is being consistent with the long term real job of a central banker, which is to maintain the power of capital and so prioritizing the suppression of wage inflation. Is it just co-incidental that the job market is becoming “unstable” after Trump’s election, or has that been there, ignored, for a while, and Yellen is picking it up now as an excuse to damage Trump?

Lots of letters about the Fed wanting to damage Trump. I really don’t think there’s an animus here as much as there’s an intense desire to declare institutional victory and cement a legacy. If that legacy means a headache for the Donald … well, so be it, but that’s not the primary motivation. This has been brewing for a while. I wrote a note about this last September, called “Essence of Decision.”

Yesterday I was listening to Neil Howe’s presentation at the Mauldin Strategic Investment Conference last month, during which he suggested that a recession/downturn is exactly what Trump needs to make progress on his agenda. That is, because the economy is doing so well and stocks continue to rise, no one in DC or NY has any incentive to compromise. However, should things start to go into reverse – and Fed tightening has been the trigger for almost every recession – that’s when he can really get stuff done. Thus, in the current bizarro world we live in, malice toward Trump by the Fed could actually end up helping him.
– David

Too clever by half. I once had an analyst tell me that he wished that a stock we owned would go down so that we could buy more. Ummm … no. Neither life in markets nor life in politics works that way. Buying more may be the right reaction to an unlucky beat, but show me a PM who wants to lose today in order to win more bigly tomorrow, and I’ll show you a PM who’s not long for this world. Ditto for presidents.

Would I say there will never, ever be another financial crisis? You know probably that would be going too far, but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be.

I dunno, Janet, that’s a statement that might not age well, the sort of thing that ends up as a rueful tagline on an otherwise distinguished career. Just ask Chuck Prince about dancing until the music stops. George W. about “Mission Accomplished”. Statements like this are rewardless risk. You know, kinda like negative interest rate bonds.

Good to hear Devin’s thoughts [podcast with Devin Anderson, “Does It Fly, Really?”], and that I wasn’t the only one who enjoyed McCullough’s take on Orville and Wilbur’s empirical method. Kill Devil Hills is sacred ground. When you talk about American Makers …. I’ve flown and kitesurfed that area frequently, keeping aware that I’m standing on the shoulders of giants.

On another note – people who misuse history – especially Thucydides – should have to read May’s Thinking in Time with their eyes wired open.

Two great books: David McCullough’s The Wright Brothers (2015) and Richard Neustadt and Ernest May’s Thinking in Time (1986). Thucydides wrote a great book, too. I’ve taught a course on it. But Brendan is right. The Peloponnesian War was 2,500 years ago. The U.S. ain’t Athens and China ain’t Sparta (much less the other way around, which would be a lot more accurate to the power dynamics that Thucydides actually described). So give it a rest, all you war hawks on both the left and the right. Just stop it with the “lessons from history” that you cherry pick. Want a lesson from Thucydides about war and conflict? Go read about the Syracuse campaign and then get back to me.

I was particularly struck by the below claim in your note [“Tell My Horse”]. I tried unsuccessfully to find a source on google, so I was wondering if you could help by pointing me in the direction of the data that supports this? “ETFs and index products — of which there are now more such aggregated securities listed on U.S. markets than the company stocks which comprise them!”

Here’s a link to the article that sourced the more-indices-than-stocks quote. I believe that the Economist also wrote a similar piece recently.

My background is science; I am/was a forestor. The late great Stephen Jay Gould was also a master of telling one story by telling the tale of another more common event. I read everything he wrote.

So you talk about diversification being the ‘bird’ for all seasons. Not as flashy as the Goldfinch [“The Goldfinch in Winter”], but more reliable. I’d like to offer a viewpoint from an ecologists POV about your field and birds.

I would offer that portfolio diversification is more like your field and surrounding forests than the occasional flock of birds that visit. Because you make the effort to knock back the growth in that field you get new plants and new plant growth, which attract flocks of birds. Even to the extent of keeping them around through the year. From an ecologists POV this is called ‘robustness’; an environment that has a greater number of species co-existing has a greater chance of maintaining a greater number of species through a greater variation of conditions.

So, you keep clearing out that field occasionally and clean out the underbrush near the edge of the forest (the interface between forest & field is where the greatest local biological diversity will occur) and you will continue to be rewarded with occasional delights of all god’s creatures. I dare say you might be visited by the Fox or even the Owl in winter.

There really is a parable for investors here.

And where there’s a parable, there’s an Epsilon Theory note not too far behind! Did you know that there’s been a widescale commercial effort in Russia to domesticate the fox through genetic modification? Sometimes these notes just write themselves.

In my client reviews, I like to leave them with something thoughtful or philosophical, and many of those nuggets start in Epsilon.

One original one I wanted to share, which has likely been thought of in a different way. “it is not often that both US stocks and bonds are at all time highs at the same time – those are the things we are thinking about while managing your money”.

Have you done any research about what that means for diversification?

Your recent posting regarding the Fed’s decision to unwind its massive securities portfolio contained the following comment:

“Or just ride your 60/40 vanilla stock/bond allocation through the cycle, which is the whole point of the 60/40 thing (even, though, of course, you’re really running a 95/5 portfolio from a risk perspective).”

Is it possible to provide a brief explanation of what you meant by “95/5 portfolio from a risk perspective?” I’m a small investor, admittedly currently following a Vanguard-inspired “vanilla” strategy.

Nothing wrong with vanilla, Jim, and to Vince’s question, yes, the Salient Brain Trust has done a tremendous amount of work on what all this means for diversification. A couple of points before I suggest further reading.

  • Allocations like 60/40 are talking about the dollar amounts you have invested in different asset classes, in this case 60% of your dollars allocated to stocks and 40% of your dollars allocated to bonds. But a dollar invested in stocks has a different amount of risk associated with it than a dollar invested in bonds; i.e., the historical volatility of the stock market is a lot higher than the historical volatility of the bond market. So from a risk “budget” perspective as opposed to a dollar budget, a 60/40 stocks-to-bonds portfolio is really more like a 95/5 stocks-to-bonds portfolio.
  • Even if stocks and bonds are positively correlated, as they have been on the way up over the past eight years and as they may be on the way down (if there’s ever a down), a diversified portfolio should still own plenty of bonds. Period.
  • When we’re thinking about diversification, it’s useful to consider dimensions beyond just stocks vs. bonds. That includes the risk/volatility dimension. That includes the asset class dimension (commodities, real assets, corporate credit as distinct from government bonds, etc.) That includes the geography dimension. That includes the classic Fama/French dimensions. That includes behavioral dimensions such as momentum. Markets radiate information on many different wavelengths, not all of which are naturally visible to the human eye, but all of which are important to take into account in a well-balanced portfolio.

For further reading, particularly on the risk-budgeting approach, I’d point you to “The Free Lunch Effect: The Value of Decoupling Diversification and Risk” and any number of whitepapers on the Salient website. I’d also recommend the AQR Library as a source of smart and useful thinking on this topic.

After reading all of these, I continue to have one question: how does one set expectations for returns? Assuming a solidly built (nothing is perfect), diversified portfolio and 10(?) years, what is the curve of return with the horizontal axis being vol tolerance…
– Matt

And one more recommendation. Rusty Guinn’s latest Epsilon Theory notes, “Whom Fortune Favors, Part 1” and “Whom Fortune Favors, Continued” answer this question from Matt. Not-to-be-missed reading for anyone who deals with portfolio construction for a living.

While your logic seems counterintuitive at first, on second thought, I get that there could be a zone where rates are still low enough that raising them is inflationary not deflationary as the world is not so black and white as the investing masses assume (i.e. too much brain damage to think in greyscale). Do you have the data to support the thesis (either in our market or a similar market … am guessing we won’t have a lot of statistical significance)?

We’ve got eight years of data on the original premise of QE — that more central bank printing of money and buying of financial assets would lead to greater amounts of money getting into the real economy to spur more real economic activity — and the inescapable conclusion is that it doesn’t happen. Money goes into bank reserves but it doesn’t get out, in a classic example of a roach motel … err, I mean a liquidity trap. That fact, which was clear to all by 2012, led to a bit of a schism in the High Church of Monetary Policy, with one Pope saying that QE 1 was a good idea, but that subsequent printing and buying sprees were a wash at best, and we should stop doing more of this. That Pope’s name, believe it or not, is Ben Bernanke, which is why the U.S. denomination of the High Church is way ahead of the other denominations in unwinding their QE experiment.

Unfortunately but unsurprisingly, the other Popes weren’t convinced when Bernanke started saying that QE doesn’t really work that well in the real economy, particularly when they saw how well it could work to prop up financial asset prices and deliver political stability. As a result, the other Popes have generally been of the mind that the answer wasn’t to do something else, but to do MOAR! than the U.S. Church ever thought possible. Hence we got negative rates and efforts to outlaw cash and direct central bank buying of equities and all the other madness of the past three years in Europe and Japan. But MOAR! didn’t work in those real economies, either, although it sure did cripple the banks, which is why Pope Draghi is now coming around to Pope Bernanke’s view.

On the reverse argument — that as central banks now start to tighten monetary policy through both traditional interest rate hikes and nontraditional balance sheet contraction, inflation and loan growth will actually start to pick up — we have zero historical evidence that this will be the case because we’ve never been in this situation before.

What we do have, however, is both a supply and a demand argument for why this will happen. On the supply side, central banks pay commercial banks interest on the reserves they hold. As the Fed raises rates, they pay the banks more interest, which — given the massive reserves in the system — is a non-trivial boost to the capital position of the banks on a present value basis. Boosting the capital ratios of the banks should make them more willing to take risk and put money out. Couple that with a steeper yield curve (see my earlier response regarding the forthcoming Gary Cohn narrative) to generate higher net interest margins on these loans, and you should see the velocity of money really pick up as banks reduce lending standards and push, push, push on getting those loans out the door.

The demand argument isn’t talked about as much, because it’s not under the direct control of the regulatory mandarins of the Fed and the ECB. Central banks control all the levers on the supply side. To repeat, they literally make The Money. And they control its distribution. But they don’t control who asks for a loan or what that loan is used for. They don’t make the demand. They can influence the demand by making the price of The Money cheaper (lower interest rates), but even there they only have direct control over the price of short-term money.

My opinion is that when the price of money gets exceptionally low AND you’ve got a massive buyer of financial assets waiting in the wings, it tilts the risk and reward of debt-taking away from making stuff and towards investing in stuff, towards what’s commonly called “financialization.” I think we see this tilt everywhere in the modern economy, particularly in the largest corporations with essentially unlimited access to capital. Why take the chance of building a new factory or launching a new growth initiative when you can generate a highly predictable and substantial earnings growth rate or return on equity through a buyback or dividend program? If you don’t have unlimited access to capital — and most small businesses don’t — then you’re limited to the avoidance of making stuff without the ability to embrace financialization. So you just stall. It’s not terrible. You’re getting by. But you’re just getting by.

So what diminishes the demand for “financialization” loans and increases the demand for “productive” loans? I promise you that it’s not cutting the price of money by another 50 basis points. On the contrary, the price of money has to go UP and the reward of markets DOWN before the risk-reward calculus of debt-taking shifts back to making stuff in the real economy.

Whew! That was a long-winded explication. Here are some letters that say it more pithily than me …

That’s just crazy enough to be totally dead on.

Your idea will also accelerate the velocity of money in the great American bingo parlor of life.
– John

The current Fed policy effectively injects liquidity into the financial system through raising the IOER rate — printing money to make interest payments on reserves banks hold on deposit at the Fed. This compares to the traditional monetary where the Fed drains reserves from the financial system to drive the Fed Funds rate higher. We are years off to getting back to traditional monetary policy. Maybe not in our lifetime.

No wonder markets are going bonkers. We believe this is why the Fed has quickened its pace to start shrinking their balance sheet. Rather than being forced to overshoot interest rates, which could adversely affect the economy, the Fed will start draining reserves through balance sheet reduction hoping to introduce some risk aversion and sense back into the giddy global markets.
– Gary

You are describing [“Gradually and Then Suddenly”] a self-reinforcing positive feedback loop whch can be described mathematically as a geometric or exponential function, until it reaches a maximum.

Has the “barge” already left the dock, or will it have done so only upon the fact of FED balance sheet run-off commencing? The jawboning this week was only a damper, contemporaneous as it was with weak data. Last month’s Draghi comments whch lifted the global sovereign yield curves, I believe, was the barge tooting its horn as it departed its mooring at the dock.

Buy DUST and hold it through the FED’s asset sales.

Interesting, apparently crazy, and probably dangerous times, indeed. Good speculation and investing. Thanks for your writing.
– Robert

So you are talking about the unintended consequences of policy-driven interest rates. Hmm. John Locke talked to the parliament about the exact same thing in 1691 (sic!). Then one and a half century later came Bastiat with “That which is seen, and that which is not seen” addressing similar concept. I’d guess Adam Smith’s “invisible hand” is related to (positive) unintended consequences as well.

That’s some of the biggest names of libertarianism 🙂

Today’s short letter was so empowering and enlightening, I almost didn’t miss your beekeeper stories or movie quotes.

The counter argument would be that each country that has tried QE, has seen their economies slip back into recession when they finally took the QE punch bowl away.

This has been true in the past in the US, Europe, Japan, and China (sort of) – so could we have a recession AND inflation?
– West Coast Investor

You mean stagflation? I kinda doubt it, because it generates an unstable political equilibrium, but it’s absolutely possible. Market gives this less than zero odds, of course, which is … interesting, from a macro trading perspective.

That said, it’s smaller businesses, those without access to the financialization goodies of the modern monetary policy system, that are already suffering from a form of stagflation-lite. And on that note …

I suspect another, and perhaps more direct, answer to your question is that while we do not have wage inflation, we have compensation inflation (compensation = wages + benefits). For example (and this may be the key driver) medical costs continue to rise much faster than overall inflation and someone is paying that. To put numbers to my example: if a company is spending $4k a year on benefits on a $40k a year employee and the cost of those benefits goes up 10% then there is 1% compensation inflation. Add that to 2.5% wage inflation and you have 3.5% compensation inflation.

I have not seen anyone write about this and that may be due to the fact that there is a scarcity of good data on the subject. I am aware of this only because I have been a small company CEO.

By the way and for what it’s worth, wages in the construction industry are already off to the races. We are paying our professionals/ semi-professionals and experienced people probably 30% more than 2-3 years ago. At a meeting yesterday with one of the large Gen Contractors, they told me young guys are heading straight into field jobs out of the construction management schools (Auburn, Clemson, Ga Tech, etc) where they can make a lot more than they could coming in to an office as a trainee. This ship has turned fast in our business. I guess the difference is that we (as non-public entrepreneurs) ARE investing significantly. Just a data point thought you might want to hear.
– Alan

You don’t have to wonder, we are at 4.3% unemployment and were not seeing acceleration yet, so clearly NAIRU has been structurally lower this cycle. The other thing that is clear we will get there and it is not years away, but more likely months.

If you look at states where unemployment is lower, like NH and ME, you have wages moving up in the 4-5% Y/Y range currently so we know the concept is sound. After all we are talking about the most basic principle of economics here – supply and demand.

Companies we talk to are baffled by the government numbers, they see it and are worried about maintaining margins (raising prices). There is a fair amount of anchoring and it is important to keep in mind that each crisis occurs because people are worried about the last crisis. In this case fighting the psychology of deflation.

So yes, NAIRU is lower, but it is also likely to be a coiled spring. That realization, along with a positive correlation between stocks and bonds, will sow the seeds of the next collapse.
– Alan

In exactly the same way that almost every financial advisor I speak with feels “stuck”, so does almost every small to medium business owner I speak with. There’s a trickle-down wealth effect from their personal accounts, which is all well and good, but they’re not feeling the love from the last eight years of QE in their businesses because they can’t access the financialization wonder drug of public markets. At best they get it second hand if they can find an LBO buyer. But the LBO buyers are all mega shops today, so juiced up on the financialization steroid themselves that they don’t have time to mess around with the small to medium guys.

It’s just another manifestation of the central truth of life in 2017, on every level of aggregation and scale — if you’re in the Club, life is good. If you’re not, life is very very anxious.

Ben, I just read the piece that you sent out yesterday [“Gradually and Then Suddenly”] and I have a question for you regarding productivity. Other authors that I have read have put forth the theory that productivity growth is low because we are measuring productivity in a manner that doesn’t fit the new economy. In other words, measuring widgets produced per hour is not the accurate measure of productivity in the digital economy. They admitted that we don’t know yet how to measure productivity in the digital economy but that we would be well served to think about it.

I would very much like to hear your thoughts about their theory.
– Ann

I got a lot of good letters on the Great Productivity Debate, too many to address directly in what is already an overly long Mailbag. I’ve reposted a handful below, because they do a good job of covering the waterfront. The topic deserves a full-fledged Epsilon Theory note of its own, so that’s what I’ll do next week in a new Note From the Field. I’ve already got the title picked out: “Horsepower.”

Political hamstringing of entrepreneurs, yes. Focus on stock price not business, yes. But a simpler causation is that cheap money and open borders help suppress real wages (and, via govt spending and consumer credit, both, make up for them ) and THEREFORE mean less need to substitute with invested capital, in turning keeping marginal gain to labour low-added and so reacting back on itself.
– Sean

– Justin

Can you address the role of globalization on your theory of inflation going up with monetary tightening? I believe the world is awash in industrial capacity brought on mostly by Chinese overbuilding in numerous industries. I know the Chinese can’t subsidize forever, but right now they seem to be cranking out product they have no idea where it will go. Solar panels is a great example. Look what happened to the price of solar panels since January? They are selling with a negative gross margin! Every other competitor is going out of business. I think the same may be true for steel and other industrial commodities. Why invest in more capacity when you can’t compete with a Mercantilist.
– John

My theory Ben is social networking is what’s keeping Prod Growth from happening. People are spending way too much time on FB and the like snapping selfies in front of fountains, inputting jokes and nonsense and not working!.. They’re not even driving their cars properly but stuck with their darn face in front of a nonsense networking device…my 0.02
– Steve 

I can point to one other potential reason we aren’t seeing inflation and lower productivity – at least in engineering and construction. There are a whole lot of boomers retiring and taking with them both their experience and higher pay. The new folks are coming on at much lower pay but are also much less productive. The good news, if I’m right, is that we will start to see increasing productivity as these folks are assimilated into the work place. Assuming of course we don’t have a downturn first.
– Brian

Perhaps one of the reasons productivity gains are so low is that the latest wave of the “New Economy” are companies like Uber, Door Dash and EZ Home. They provide personal services which are pretty low productivity and even with the .com overlay, there are limits to what one worker can do. For example, Uber drivers can only carry a few people around at one time, and probably only generate $60,000/yr in gross revenue working full time. The corporate organization leverages this into a high productivity and growth story on their level, but it is built on a large low productivity business. I’m sure they all have plans (fantasies?) of someday replacing all their field workers with robots, in which case productivity might soar, but that is a ways down the road.

I live in Menlo Park, Ca and the local economy (and perhaps productivity) is growing at a fast pace because companies like Uber are headquartered here. I suspect that other parts of the country are growing much more slowly or not at all because they have the low productivity economic activity that supports Uber and the like but don’t benefit from the corporate leverage.

Thanks for your stimulating articles! I never took econ but was a bad math major. To me econ theory seems to rest on two axiomatic relationships: supply and demand, unemployment and wages. In the 1980’s, we bought well-made solid wood shiny brown furniture for thousands of dollars apiece. There has been no physical depreciation, and yet those pieces today go for hundreds of dollars. Similarly for oriental rugs, sterling silver, china, etc. Only those pieces deemed worthy by the ultra-rich seem to ‘hold’ their value. Meanwhile, the overall ‘quality’ is going down (this means regular replacement of shovels, software, hardware, and phones). That combined with atrocious service (except for the ultra-rich) and regular discovery that what one just bought is actually a ‘second’ inevitably leads to consumer demand malaise, except for consumables. It is no wonder then that the children of the boomers aren’t buying material possessions, except for baby stuff. Famous economists call this area ‘aggregate demand’, and when they have to consider NIRP to stimulate aggregate demand, you know the goose is cooked. Spending on consumables, vacations, and experiences would increase; savings would decrease, and so on. The above four axiomatic econ words just do not mean much in today’s fast food, landfill economy. They are glittering generalizations of an economy that once was. I don’t know what the replacement terminology should be, but I know it’s out there somewhere.
– John

You have missed the boat on unemployment and wage inflation. As long as more people enter the work force and have the proper skills then wages do not have to increase. There are other factors but job automation and people entering the work force seem to be the current keys.
– Jam

How is the productivity improvement of the rise of Uber or Google search or online shopping on Amazon captured by the gov’t? They are not.

There are hundreds of examples like this. They don’t improve some form of production, they change how we run our personal lives by vastly improving our non working efficiency. Some technology, like smart phones, have revolutionized our personal lives and have a bleed over effect in productivity but that is minor in comparison to the non working efficiency. Since people use their smart phones at work for personal reasons you might even conclude they reduce efficiency.
– Art

I’ve never thought to link the fact that the current low growth in productivity seems to rule out the concept that technological advancements aren’t the driving force behind low wage growth.

In saying that, can you not see a case whereby technology is driving people out of once productive jobs (manufacturing etc) and into poorly productive and lower paying jobs (retail, hospitality, etc) where they work a similar amount of hours? In this case we still have the same amount of production (with machines/new tech doing the bulk of the work) AND the same amount of hours worked, but with the % of hours worked in poorly productive sectors now representing a much greater % of the overall total?

In other words, both the numerator and denominator stay the same, thus it appears productivity has slowed to stall speed, but the real story is the change in distribution as to who benefits from productivity advances AND what is happening to those displaced by technology, i.e you move from working 8hrs/day on a factory line contributing $100k/pa to GDP, to driving for a cab/Uber 8hrs/day and contributing $40k/pa?

This also explains the growth in inequality, with those who own the technology/plant benefiting from the increased productivity of their business, while “labour” suffers with stagnating/declining wages. Seems to all fit in with the secular stagnation and growth in under employment themes too.

Good letters all. To be continued next week.

I also got a lot of good letters pointing out that “it’s the debt, stupid”. In other words, that it’s going to be deflation and economic weakness just as far as the eye can see. Here are a few …

The biggest question I have about this analysis comes from the fact that all these companies that have been buying back stock this entire decade are now up to their eyeballs in debt, and (depending on how this debt is structured) rising rates are going to crush earnings and free cash flow sooner or later. This will lead to crushing the broad market and the wealth effect it has created. Inflation offers a way out, but will inflation pick up fast enough to outrun the monster of corporate debt service?

Isn’t the Fed (or shouldn’t they be) more concerned with the demographically-induced effects on consumption than they are with potential inflation? Haven’t we seen this movie before, with the biggest demographic disaster in the formerly second largest economy sucking wind for 20 years + of ZIRP? Then again, maybe Japan only had to start raising rates ca 1995 to reach escape velocity, according to your logic herein.

Isn’t the real issue the shifting of consumption and production away from the developed world to the emerging economies? Millions every day joining the global economy, urbanizing, getting credit cards and bank accounts? Isn’t the more apt analogy the one to 20th century Europe as America thrived?
In previous notes, you have discussed the possible effects of nationalist/populist leaders, both here and abroad. The real question I’m curious about: would a trade/immigration war be inflationary or deflationary?
– John

Ben, on most things we see eye to eye. However, on this one I’ll take the under. I don’t think wage inflation is or is going to be a problem at all. The 4.3% UE rate is an utter fiction. Low paying service jobs are the only ones driving any labor “growth”, and the largest segment of the population securing these jobs is people over 55 years of age. Further, I think that any Fed “tightening” will be whitewashed by other global CBs continuing to prime the pump to the tune of > $2.5TR per year. There can be no credit contraction without GDP cratering and equities falling off a cliff, and equities can’t be allowed to fall off a cliff as then the faux “recovery” narrative will be exposed and untold amounts of debt will be subject to default. Fed and all CBs are stuck. More of the same coming.
– Bill

Thanks for sending this. It is obviously appealing intuitively, because it is so counter-intuitive. It makes sense, within its own parameters. The question is will this scenario play out, and I fear that no-one knows, because no-one has ever been in this position before.

He doesn’t seem interested in the problem of the quantity of debt — public corporate and household – that are now burdening economies. But for many people, including myself, that is the primary issue.

See this as an example of what happens when you start to treat the debt as unpayable and stop pretending that it’s fine. In this case, the US is moving it from private to public debt, because the larger deficit also has to be funded. You can’t make debt disappear without huge balance-sheet consequences (aka bankruptcy).

What if the reason why corporates are not investing is because there is no final demand out there to satisfy? That the current final demand is debt-driven and not real. That demand is in secular decline, for demographic reasons (ie Harry Dent approach).

Bottom line: I don’t think he is drilling deep enough to get to the bottom of the mysteries he is discussing.
– P.

I’m actually very sympathetic to this view, that the massive debt of the world hangs like a millstone around our collective neck, preventing any sustained resurgence in growth, and you can find plenty of Epsilon Theory notes expressing that. But my views have “evolved”, to steal a line from our new White House Communications Director. I think that in the land of the blind, the one-eyed man is king. I think that 2.5% to 3% real economic growth is absolutely attainable here in the U.S., massive debt or no massive debt, and that will feel like 4-5% growth back in the day. I think that there’s enough entrepreneurialism and desire still left in the American tank that changing the debt-taking risk/reward calculus from investing in stuff (financialization, if you can get it) to making stuff can absolutely drive 2.5 – 3% real growth in this country. Will changing the risk/reward calculus be painless for markets and the real economy? No. Is it worth it? Yes

And now for a big Mailbag finish … 

On the side, I write financial poems. Here’s my latest on our fabled Fed:

Chaperoning the Dance
Arrive at the Spring Fling, not a soul on the dance floor.
For you and other teachers, watching over’s a chore.
You encourage some kids. None budge and desperation ensues.
Eventually, spike the punch and pray for the effects of the booze.
For some of the kids, all it takes is a couple of sips.
They are the brave few who start shaking their hips.
Slowly but surely, others get the urge to join in.
Satisfied by your work, success brings on your grin.
Unthinkable just a few hours ago, some ruckus is brewing.
To your horror, most students are now tobacco chewing.
We’ve much surpassed the time to encourage more fun.
You try and sneak away the punch bowl to curb this run.
Despite prospect for future hangovers, the students protest.
Your actions make you the villain, the one to detest.
Controlling the party is a thankless task.
Be careful with the power. Ration that flask!
– Tim

Actually not half bad.

It may be that you lived in an alternate universe in which Fess Parker had a different role [“Notes From the Field”], but when I wore my coonskin cap, I sang about Davy Crocket, not Daniel Boone.
– Kit

Fess Parker played both Daniel Boone AND Davy Crockett in the respective TV shows! The Daniel Boone show ran for five or six years while Davy Crockett only aired a few times as a special series on The Wonderful World of Disney. Yep, that was my Sunday night ritual — Mutual of Omaha’s Wild Kingdom, followed by whatever was showing on The Wonderful World of Disney. Simpler times, for good and for ill.

And then there’s this: scientists have embedded 5 frames of the “Horse in Motion” into the DNA of bacteria. And people think memes are far-fetched.

Gif and image written into the DNA of bacteria – BBC News

Images and a short film are inserted into bacteria DNA and recovered with 90% accuracy.

Complex times, for good and for ill.

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Gradually and Then Suddenly

“How did you go bankrupt,” Bill asked.

“Two ways,” Mike said. “Gradually and then suddenly.”

“What brought it on?”

“Friends,” said Mike. “I had a lot of friends.”

Ernest Hemingway, The Sun Also Rises (1926)

What do socialism and modern monetary policy have in common? Magical thinking. For both, it’s true on the giddy years up, and it’s true on the sad years down.

If you’ve been reading my notes immediately before and after the June Fed meeting (“Tell My Horse” and “Post-Fed Follow-up”), you know that I think we now have a sea change in what the Fed is focused on and what their default course of action is going to be. Rather than looking for reasons to ease up on monetary policy and be more accommodative, the Fed and the ECB (and even the BOJ in their own weird way) are now looking for reasons to tighten up on monetary policy and be more restrictive. As Jamie Dimon said the other day, the tide that’s been coming in for eight years is now starting to go out. Caveat emptor.

The question, then, isn’t whether the barge of monetary policy has turned around and embarked on a tightening course — it has — the question is how fast that barge is going to move AND whether or not the market pays more attention to the actual barge movements than what the barge captain says. I promise you that the barge captains of both the Fed and the ECB believe they can tighten and taper without killing the market so long as they jawbone this constantly. This is the Common Knowledge Game in action, this is the Missionary Effect, this is Communication Policy … this is everything that I’ve been writing about in Epsilon Theory over the past four years! And as we saw with the market’s euphoric reaction to Yellen’s prepared remarks for her Humphrey-Hawkins testimony last Wednesday, which were presented as oh-so dovish when they really weren’t, this jawboning strategy could absolutely work. It WILL absolutely work unless and until we get undeniably “hot” inflation numbers — particularly wage inflation numbers — from the real world.

So what’s up with that? How can we have wage inflation running at a fairly puny 2.5% (Chart 1 below) when the unemployment rate is a crazy low 4.3% (Chart 2 below) and other indicators, like the NFIB’s survey of “Small Business Job Openings Hard to Fill” (Chart 3 below) are similarly screaming for higher wages?

Chart 1: US Average Hourly Earnings, annual % change

Source: Bloomberg Finance L.P. as of 7/13/17. For illustrative purposes only.

Chart 2: US Unemployment Rate

Source: Bloomberg Finance L.P. as of 7/13/17. For illustrative purposes only.

Chart 3: NFIB Small Business Job Openings Hard to Fill

Source: Bloomberg Finance L.P. as of 7/13/17. For illustrative purposes only.

The answer, I think, can be found in Chart 4 below: vanishing labor productivity. Productivity is the amount of stuff that workers make (output) divided by the amount of time it takes them to make it (hours worked). You can have productivity growth for good reasons like in the 1980s and 1990s and early 2000s (more stuff made per hour worked as companies invested in things like the personal computer or the Internet) or bad reasons like in 2009 and 2010 (massive layoffs, so making a bit less stuff but over waaay fewer hours worked).

Productivity growth for the right reasons (I know, I sound like a contestant on The Bachelorette) is just about the most important economic goal that policy makers have, because it’s how you get your economy growing in a sustainable, non-inflationary way, and for the past seven years we’ve had none of it. By the way, if new technologies were really responsible for keeping wage inflation down (something I hear all the time), we would have seen that through increasing labor productivity. We haven’t.

Chart 4: US Labor Productivity Growth (2-year moving average)

Source: Bureau of Labor Statistics as of 7/13/17. For illustrative purposes only.

This is a huge question for the Fed, maybe the biggest question they have. How is it possible — with the most accommodative monetary policy in the history of the world, with the easiest money to borrow that corporations have ever experienced, with all the amazing technological advancements that we read about day in and day out — that companies have not invested more in plant and equipment and technology to improve their labor productivity, to make more with the people they’ve got?

The answer, of course, is the answer that the Fed will never admit. The reason companies aren’t investing more aggressively in plant and equipment and technology is BECAUSE we have the most accommodative monetary policy in the history of the world, with the easiest money to borrow that corporations have ever seen. Why in the world would management take the risk — and it’s definitely a risk — of investing for real growth when they are so awash in easy money that they can beat their earnings guidance with a risk-free stock buyback? Why in the world would management take the risk — and it’s definitely a risk — of investing for GAAP earnings when they are so awash in easy money that they can hit their pro forma narrative guidance by simply buying profitless revenue? Why in the world would companies take any risk at all when the Fed has eliminated any and all negative consequences for playing it safe? It’s like going to a college where grade inflation makes an A- the average grade. Sure, I could bust a gut to get that A, but why would I do that?

How does this apply to wage inflation? It’s the same thing. Why in the world would a company pay up to fill a position when it’s a risk they really don’t need to take? Yeah, we’ve got job openings, and yeah, our skill positions are increasingly going unfilled, and yeah, we’d like to expand and grow … I suppose. But, hey, we’re hitting our numbers just fine as it stands and, if you hadn’t noticed, our stock price hit a new high yesterday. Why mess up a good thing?

How does this change? As the Fed slowly raises rates, as the barge slowly chugs down the tightening river, it will force companies to play it less safe. It will force companies to take on more risk. It will force companies to invest more in plant and equipment and technology. It will force companies to pay up for the skilled workers they need. You want wage inflation? You want productivity growth? Then raise rates!

And god forbid if we actually get a tax reform bill passed. That’s the off-to-the-races moment.

My point is a simple one. In exactly the same way that QE was deflationary in practice when it was inflationary in theory, so will the end of QE be inflationary in practice when it is deflationary in theory. That’s the real world impact I’m talking about, the world of wages and output and productivity. You know, the real world that used to be the touchstone of our markets.

And here’s my other point. In the Bizarro-world that central bankers have created over the past eight years, raising rates isn’t going to have the same inflation-dampening effect that it’s had in past tightening cycles, at least not until you get to much higher rates than you have today. It’s going to accelerate inflation by forcing risk-taking in the real world, which means that the barge is going to have to move faster and faster the more it moves at all. I think that today’s head-scratcher for the world’s central banks — why haven’t our easy money policies created inflation in the real world? — will soon be replaced by a new head-scratcher — why haven’t our tighter money policies tamed inflation in the real world?

My view: as the tide of QE goes out, the tide of inflation comes in. And the more that the QE tide recedes, the more inflation comes in. I know that this sounds like a nutty scenario today, with everyone talking about how inflation is dead and gone, and how the Fed will be “fighting” inflation by raising rates, but I gotta call ‘em like I see ‘em. It’s a scenario that neither central banks nor markets have contemplated in any serious way, but it’s going to be a focus for Epsilon Theory.

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Funny How?


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

“Goodfellas” (1990)


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

“Seinfeld” (1994)

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

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

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

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

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

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

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


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

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

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

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


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

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

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