Essence of Decision

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The essence of ultimate decision remains impenetrable to the observer — often, indeed, to the decider himself.

John F. Kennedy (1917 – 1963)

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“The Manhattan Projects” by Jonathan Hickman and Nick Pitarra (©Image Comics)

I have found that the best way to give advice to your children is to find out what they want and then advise them to do it.
―Harry Truman (1884 – 1972)

As far as I was concerned, his decision was one of non-interference ­— basically, a decision not to upset the existing plans.
―Lt. Gen. Leslie Groves (1896 – 1970), commanding officer of the Manhattan Project, discussing Truman’s okay to drop atomic weapons on both Hiroshima and Nagasaki.

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“Ah,” she cried, “you look so cool!”

Their eyes met, and they stared together at each other, alone in space. With an effort she glanced down at the table.

“You always look so cool,” she repeated.

She had told him that she loved him, and Tom Buchanan saw.

 ― F. Scott Fitzgerald, “The Great Gatsby” (1925)

And that was the end of the party. When Tom Buchanan saw.

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Lear: Create her child of spleen, that it may live
And be a thwart disnatur’d torment to her!
Let it stamp wrinkles in her brow of youth,
With cadent tears fret channels in her cheeks,
Turn all her mother’s pains and benefits
To laughter and contempt, that she may feel
How sharper than a serpent’s tooth it is
To have a thankless child!
― William Shakespeare, “King Lear” Act 1 Scene 4 (1606)
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Once-revered central bank failed to foresee the crisis and has struggled in its aftermath, fostering the rise of populism and distrust of institutions.

Jon Hilsenrath, “The Great Unraveling: Years of Missteps Fueled Disillusion with the Economy and Washington” (August 26, 2016)

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John Hale: Theology, sir, is a fortress; no crack in a fortress may be accounted small.
  Arthur Miller, “The Crucible” (1953)

Few of us can easily surrender our belief that society must somehow make sense. The thought that the State has lost its mind and is punishing so many innocent people is intolerable. And so the evidence has to be internally denied.

The structure of a play is always the story of how the birds came home to roost.

That’s a very good question. I don’t know the answer. But can you tell me the name of a classical Greek shoemaker?

Arthur Miller (1915 – 2005)

That last, one of my all-time favorite quotes, was in response to a shoe manufacturer who asked why Miller’s job should be subsidized while his was not. Miller’s finest accomplishment: when McCarthy and crew forced him to testify in their Communist witch hunt, he refused to name names. Miller was a leftie and a huge ego. And a freedom lover. Imagine that.

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Yet each man kills the thing he loves

By each let this be heard

Some do it with a bitter look

Some with a flattering word

The coward does it with a kiss

The brave man with a sword

 ― Oscar Wilde, “The Ballad of Reading Gaol” (1898)

We’ll get the kiss, not the sword. Don’t know when, but it’s going to kill this market that the Fed loves.

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In 1969, Graham Allison published an academic paper about the Cuban Missile Crisis, which he turned into a 1971 book called Essence of Decision. That book made Allison’s career. More than that, the book provided a raison d’être for the Kennedy School of Government at Harvard, which — combined with Allison’s fundraising prowess — transformed a sleepy research institute into the most prominent public policy school in the world.

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The central idea of Essence of Decision is this: the dominant academic theory to explain the world’s events is a high-level, rational expectations model based on formal economics, a theory that ignores the impact of bureaucratic imperatives and institutional politics. If you look at the Cuban Missile Crisis through all three lenses, however, you get a much better picture of what actually happened in October 1962. In fact, the more you dig into the Cuban Missile Crisis, the more it seems that the actual people involved (on both sides … Allison wrote a follow-up edition in 1999 when Russian archives opened up post-Gorbachev) made their actual decisions based on where they sat (bureaucracy) and where they stood (internal politics), not on some bloodless economic model. Publicly and after the fact, JFK and RFK and all the others mouthed the right words about geopolitical this and macroeconomic that, but when you look at the transcripts of the meetings (Nixon wasn’t the first to tape Oval Office conversations), it’s a totally different story.

Allison’s conclusion: the economic Rational Actor model is a tautology — meaning it is impossible to disprove — but that’s exactly why it doesn’t do you much good if you want to explain what happened or predict what’s next. It’s not that the formal economic models are wrong. By definition and by design, they can never be wrong! It’s that the models are used principally as ex-post rationalizations for decisions that are actually made under far more human, far more social inputs. Any big policy decision — whether it’s to order a naval blockade or an air strike on Cuba, or whether it’s to drop atomic bombs on Hiroshima AND Nagasaki, or whether it’s to raise interest rates in September or December or not at all — is a combination of all three of these perspectives. But for Allison’s money, we’d do better if we focused more on the bureaucratic and political perspectives, less on the rational expectations perspective.

Allison is writing this in 1969! And here we are, almost 50 years later, still consumed by a theology of formal economic models, still convinced that Fed decision-making can be explained or predicted by our armchair analysis of Taylor Rule inputs. From an anthropological perspective, it’s pretty impressive how the high priests of academic economics have expanded their rule. From a human perspective, it’s awfully depressing.

What follows is my analysis of the Fed’s forthcoming decision on interest rates from a bureaucratic and an internal politics perspective. Seen through these lenses, I think they hike. Maybe I’m wrong. These things are always probabilistic shades of gray, never black and white. But what I’m certain about is that the bureaucratic and internal politics perspectives give a different, higher probability of hiking than the rational expectations/modeling perspective. So heads up.

First the bureaucratic perspective.

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What I’m calling the bureaucratic perspective, Allison calls the “Organizational Behavior” perspective. His phrase is better. It’s better because entities like the Federal Reserve are, of course, large bureaucracies, but what we’re trying to analyze here is not the level of do-nothing inertia that we usually associate with the word “bureaucracy”. What we’re trying to analyze is the spirit or culture of the organization in question. What is the institutional memory of the Fed? What do personnel, not just the Fed governors but also the rank-and-file staffers, believe is the proper role of the institution? Most importantly, how do these personnel seek to protect their organization and grow its influence within the jungle of other organizations seeking to grow their influence?

The spirit, culture, and personnel composition of the modern Federal Reserve is almost identical to that of a large research university. That’s not a novel observation on my part, but a 30-year evolution commonly noted by Fed watchers. Why is this important? It’s important because it means that the current marriage between Fed and markets is a marriage of convenience. As an organization, the Fed doesn’t really care whether or not markets go up or down, and as an institution it’s not motivated by making money (or whether or not anyone else makes money). Like all research universities, the Fed at the organizational level is motivated almost entirely by reputation. Not results. Reputation. A choice between “markets up but reputation fraying” and “markets down but reputation preserved” is no choice at all. The Fed will choose the latter 100% of the time. I can’t emphasize this point strongly enough. From a bureaucratic perspective, the Fed absolutely Does. Not. Care. whether or not the market goes up, down, or sideways. When they talk about “risk” associated with their policy choices, they mean risk to their institutional reputation, not risk to financial asset prices. And today, after more than two years of a “tightening bias” and “data dependency”, there’s more reputational risk associated with staying pat than with raising rates in a one-and-done manner.

Why? Because the public Narrative around extraordinary monetary policy and quantitative easing has steadily become more and more negative over the past three years, and the public Narrative around negative rates in particular is now overwhelmingly in opposition. When I did my Narrative analysis of financial press sentiment surrounding Brexit prior to that vote, I always thought that would be the most hated thing I’d ever see. Nope. I’ll append the Quid maps and analysis at the end of this note for those who are interested in digging in, but here’s the skinny: the negative sentiment around negative rates is now greater than the negative sentiment around Brexit. The public Narrative around ever more accommodative monetary policy has completely turned against the Fed. And they know it.

It’s not only the overall Narrative network that has turned with a vengeance against the Fed, but also some of the most prominent Missionaries, to use the game theoretic term. Over the last few weeks we’ve seen Larry Summers take Janet Yellen directly to task, as the runner-up in the Obama Administration Fed Chair sweepstakes has apparently taken to heart the old adage that revenge is a dish best served cold. More cuttingly, if you’re Yellen, is the heel turn by Fed confidante and WSJ writer Jon Hilsenrath. His August 26thhit piece on the Yellen Fed feature article — “The Great Unraveling: Years of Missteps Fueled Disillusion with the Economy and Washington” — is the unkindest cut of them all.

I think that Summers has been emboldened and Hilsenrath has been turned because they’re picking up on the same sea change in public opinion that the Quid analysis is identifying with more precision. For Hilsenrath, here’s the centerpiece of his j’accuse: a long-running Gallup poll asking Americans to rate the relative competence of federal agencies. Yep, that’s right, the Fed — which used to have a better reputation than the FBI and NASA — is now at the absolute bottom of the heap, dragging behind (by a significant margin) even the IRS! It’s one thing to bring up the rear in 2009 polls, what with the immediate aftermath of the deepest recession in 70+ years. But to still be at the bottom in 2014 after a stock market triples (!) and The Longest Expansion In Modern American History™? Incredible. And the most recent poll was in 2014. If anything, the Fed’s reputation is even lower today. I mean … this is really striking, and I can promise you that none of this is lost on the current custodians of the Fed’s prestige and reputation. Or, like Summers, the wannabe custodians. If you’re a professional academic politician like Summers, you can smell the blood in the water.

How Americans Rate Federal Agencies
Share of respondents who said each agency was doing either a ‘good’ or ‘excellent’ job, for the eight agencies for which consistent numbers were available.

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Source: Gallup telephone polls, most recently 1,020 U.S. adults conducted Nov. 11—12, 2014, with a margin of error of +/-4 percentage points. As reported by the Wall Street Journal.

So what does all this mean for the September FOMC meeting?

Look … does “the market” want more and more supportive policy? Of course it does. We’re addicts. But if the Fed takes a dovish stance now — and anything less than a hike is going to be perceived as a dovish stance — from an organizational perspective the Fed is risking a lot more than a market sell-off from a rate hike. It risks being blamed for anything bad that happens in the economy going forward. This is the risk of being an unpopular political actor. This is the risk of losing your reputation for competence. The Golden Rule of organizational behavior is quite simple: there must ALWAYS be plausible deniability for culpability if something goes wrong. There must ALWAYS be some other political actor to blame. Unless the Fed takes steps now to stem the erosion in their reputation and their position in the public Narrative, they will own this economy and the downturn that everyone (including the Fed) suspects is coming.

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By raising rates now, on the other hand, the Fed can declare victory. We achieved our dual mandates of price stability and full employment! Mission accomplished! And unlike George Bush and his infamously premature declaration of same, the Fed has someone to blame when the “mission” unravels (which of course it will) — those dastardly fiscal policymakers who didn’t follow up with structural reforms or pro-growth policies or whatever when they were elected this November. While the consensus view is that the Fed loathes to do anything to rock the market boat before the November election, in truth this meeting is the perfect time to act if your political goal is to declare victory and pass the buck. Hey, we did our part, says the Fed. Prudent stewards of monetary policy and all that. Now, about that consulting gig at Citadel …

That’s the bureaucratic or organizational perspective. Here’s the internal political dynamic as I see it.

An internal politics perspective is similarly driven by questions of reputation, but at the individual level rather than the organizational level. In an academic organization like the modern Fed, your internal reputation is based entirely on how smart you are, as evidenced by the research you do and the papers you write and the talks you give, not on how effective you are in any practical implementation of organizational aims. It’s not that the Fed or major research universities are intentionally ignoring or trying to put down practical implementations like teaching or outreach to commercial bank staffers, but every hour you spend doing that is an hour you’re not spending impressing your colleagues and bosses with how smart you are. It’s just how the internal political game is played, and anyone who has achieved any measure of success in an organization like this knows exactly what I’m talking about.

What this means in practice is that FOMC meetings are driven by a desire to form a consensus with the other smart people around the table, so that each of you is recognized by the other members of the consensus as being smart enough to be a member of the consensus. It’s the precise opposite of the old Groucho Marx joke: “I don’t want to be a member of any club that would have me as a member.” Every FOMC member desperately wants to be a member of the club that would have him or her as a member, because it means that you’ve been recognized as one of the smart kids. The internal political dynamic of academic cultures like the Fed, at least at the highest levels of Governor to Governor interaction, is NOT antagonistic or divisive. On the contrary, it’s cooperative and consensus-forming.

Not sure what I’m talking about? Read this Jon Hilsenrath interview of St. Louis Fed Governor Jim Bullard again (I say again because I published it for other reasons in the last Epsilon Theory note, Magical Thinking), where Bullard describes this consensus building dynamic.

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Mr. Hilsenrath: What kind of compromise would it take to get the FOMC to move in September? I mean, so the tradition is there’s some kind of — like you say, some kind of agreement. What would it take to get them there?
Mr. Bullard: Well, I have no idea, so — and it’s really — it’s really the chair’s job to fashion that. But I will say that — I’ll talk historically about the FOMC, the kinds of things that the FOMC would do. You would trade off. You would say, OK, we could hike today, but then we’ll not plan to do anything in the future. That would be one way to — one way to go about a consensus. So that often happens on the FOMC. Or vice versa. If you read the Greenspan-era transcripts, he’ll do things like, OK, we won’t go today, but we’ll kind of hint that we’re pretty sure we’re going to go next time.
Mr. Hilsenrath: Right.
Mr. Bullard: And so you get this inter-tempo kind of trade-off, and that often — that often is enough to get people to sign up.
Mr. Hilsenrath: So, hike today and then delay.
Mr. Bullard: Yeah. (Laughs.)
Mr. Hilsenrath: Or, no hike today and then no more delay.
Mr. Bullard: Yeah, yeah.
Mr. Hilsenrath: Something like that.
Mr. Bullard: Yeah, those kinds of trade-offs are, historically speaking — I’m not saying I know what Janet’s doing, because I don’t. But, historically speaking, those are the kinds of things that the FOMC has done.
Mr. Hilsenrath: I came up with my catchphrase for the — for the month. (Laughter.)
Mr. Bullard: Those are great. That’s worthy of a T-shirt. (Laughs, laughter.) You could have one on the front and one on the back.
Ms. Torry: Or a headline.
Mr. Hilsenrath: Well, that’s the St. Louis framework now, right?
Mr. Bullard: Yeah.
Mr. Hilsenrath: Hike today and then delay.
Mr. Bullard: Yeah. That’s what it would be, yeah.
― Wall Street Journal, “Transcript: St. Louis Fed’s James Bullard’s Interview from Jackson Hole, Wyo.” (August 27, 2016)

What Bullard is describing from a game theoretic perspective is a dual-equilibrium coordination game. Either it’s “Hike today and then delay” (Bullard’s preferred equilibrium outcome) or “No hike today and then no more delay”. Those are the two possible consensus outcomes. Both are stable equilibria, meaning that once you get a consensus at either phrase, there is no incentive for anyone to change his or her mind and leave the consensus. Importantly, both are robust equilibria in their gameplay, meaning that it only takes one or two high-reputation players in the group to commit to one outcome or the other in order to start attracting more and more reputation-seeking players to that same outcome. You can think of individual reputation as a gravitational pull, so that even a proto-consensus of a few will start to draw others into their orbit.

It’s always really tough to predict one equilibrium over another as the outcome in a multi-equilibrium game, because the decision-making dynamic is solely driven by characteristics internal to the group, meaning that there is ZERO predictive value in our evaluations of external characteristics like Taylor Rule inputs in 2016 or US/Soviet nuclear arsenals in 1962. (I wrote about this at length in the context of games of Chicken, like Germany vs. Greece or the Fed vs. the PBOC, in the note Inherent Vice). But my sense — and it’s only a sense — is that the “Hike today and then delay” equilibrium is a more likely outcome of the September meeting than “No hike today and then no more delay”. Why? Because it’s the position both a hawk like Fischer and a dove like Bullard, both of whom are high-reputation members, would clearly prefer. If one of these guys stakes out this position early in the meeting, such that “Hike today and then delay” is the first mover in establishing a “gravitational pull” on other members, I think it sticks. Or at least that’s how I would play the game, if I were Fischer or Bullard.

Okay, Ben, fair enough. If you’re right, though, what do we do about it? How are markets likely to react to the shock of a largely unanticipated rate hike?

In the short term, I don’t think there’s much doubt that it would be a negative shock, because as I write this the implied “market odds” of a rate hike here in September are not even 20%. My analysis suggests that the true odds are about three times that, as I give a slight edge to the “Hike today and then delay” equilibrium over “No hike today and then no more delay”. Do I think it’s a sure thing that they hike next week? Give me a break. Of course I don’t. But if I can be dealt enough hands where the true odds of something occurring are three times the market odds of something occurring …

The medium-to-long term market reaction to whatever the Fed decides next week is going to be driven less by the hike-or-no-hike decision and more by the Fed-directed Narrative that accompanies that rates decision. That is, if they hike next week and start talking about how this is the next step of a “normalization” process where the Fed will try to get rates back up to 3% or 4% in a couple of years … well, that’s a disaster for markets. That’s a repeat of the December rate hike fiasco, and you’ll see a repeat of the January-February horror show, where the dollar is way up, commodities and emerging markets are way down, and everyone starts freaking out over China and systemic risk again. But if they hike next week and start talking about how they’re rethinking the whole idea of normalization, that maybe rates will be super-low on a semi-permanent basis, or at least until productivity magically starts to improve … well, that’s maybe not such a disaster for markets. Ditto if they don’t hike next week. If the jawboning associated with a no-hike in September sets up a yes-hike in December as a foregone conclusion, that’s probably just as bad (if not worse) for markets than a shock today.

Of course, the Fed is well aware of the power of their “communication policy” and the control it exerts over market behavior. Which means that whenever the Fed hikes — whether it’s next week or next month or next meeting or next year — they’re going to sugarcoat the decision for markets. They’re going to fall all over themselves saying that they’re still oh-so supportive of markets. They’re going to proclaim their undying love for markets even as they take actions to distance themselves.

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But here’s the thing. The Fed is now revealing its one True Love — its own reputation and its own political standing — and that’s going to be a bombshell revelation to investors who think that the Fed loves them. Investors are like Tom Buchanan in The Great Gatsby. We’re married to this really swell girl, and we get invited to these really great parties, but then we see that Daisy is truly in love with Jay Gatsby, not us. And everything changes. Maybe not on the surface, but deep down, where it really matters. I’m not saying that the Fed abandons the markets. After all, Daisy stays married to Tom. But everything changes in that moment of realization that she truly loves someone else, not you, and that’s what the next Fed hike will mean to markets.

That’s when the party stops.


Appendix: Quid Narrative Analysis

For a recap of how I’m using the Quid tool kit to analyze financial media narrative formation and evolution, please refer to the Epsilon Theory note The Narrative Machine. Below are two slides from Quid providing a quick background on the process.

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Source: Quid

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Source: Quid

Here’s the network of all 941 Bloomberg articles over the past year mentioning negative rates, colored by topic cluster:

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Source: Quid

This is a prototypical focused narrative network, indicative of articles that are truly “about” negative rates, as opposed to articles about something else that provides the clustering characteristics and only mention negative rates in passing. So now let’s look at the same network, but colored by sentiment rather than by topic clustering.

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Source: Quid

Fully 50% of the articles are negative, 42% neutral, and only 7% are positive in their sentiment.

How does this compare to other Bloomberg networks and other sentiment scores? Horribly. The only subject issue that even comes close is Brexit, with 47% negative, 42% neutral, and 10% positive in the weeks leading up to the vote. Post-vote, the negative sentiment around Brexit drops to the mid-twenties.

To be sure, few topics associated with monetary policy have an overtly positive sentiment distribution, at least in recent years. For example, here’s a chart of the Quid sentiment scores for all Bloomberg articles mentioning Quantitative Easing (QE), by year over the past three years. The Narrative is steadily deteriorating, but we’re still not close to negative articles taking the lead over neutral articles.

Sentiment Scores for Bloomberg Articles Mentioning QE, by Year

9/13 – 9/14 9/14 – 9/15 9/15 – 9/16
Neutral 58% 52% 48%
Negative 24% 31% 38%
Positive 17% 16% 13%

Source: Quid

One final network observation. Of the positively-oriented Bloomberg articles, they tend to cluster in the topic circled below. That topic? Gold. The articles have a positive sentiment because negative rates are great for gold prices. Of course, that’s a very negative thing from the Fed’s reputational perspective, which means that many of the articles that speak positively about negative rates are actually intimating something negative about central bankers! Bottom line: there is no more hated policy initiative in the world than negative rates.

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Source: Quid

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Crisis Actors and a Reichstag Fire

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Man in Bar: Tomorrow, I’m gonna be a hero.
Gideon: I’m sorry?
 Man in Bar: You may just be a patsy, but you’re an important one. In fact, I don’t think I’ve ever met a bigger crisis actor than you before. … This is for our country!
[Man in Bar shoots Gideon in neck, killing him]
— “Mr. Robot: eps2.0_unm4sk-pt1.tc” (2016)

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Göring: Why would some poor slob on a farm want to risk his life in a war when the best that he can get out of it is to come back to his farm in one piece? … It is always a simple matter to drag the people along, whether it is a democracy or a fascist dictatorship or a Parliament or a Communist dictatorship.

The people can always be brought to the bidding of the leaders. That is easy. All you have to do is tell them they are being attacked and denounce the pacifists for lack of patriotism and exposing the country to danger. It works the same way in any country.

— Gustave Gilbert, interview recording of Hermann Göring for “Nuremberg Diary” (1947)

Hermann Göring and the Nazis didn’t burn the Reichstag down in 1933. They left that to a simpleton Communist patsy (that’s him in the photo; quite the ur-terrorist, no?). But Göring and the Nazis used the Reichstag fire as their excuse to arrest thousands, establish Hitler as the Führer and unleash a decade-plus of fascist horror on Germany and the world. History is rhyming today, as it always does.

epsilon-theory-crisis-actors-chaplin-hitler-july-26-2016 Hynkel, the dictator, ruled the nation with an iron fist. Under the new emblem of the double cross, liberty was banished, free speech was suppressed and only the voice of Hynkel was heard. epsilon-theory-crisis-actors-erdogan-july-26-2016
― Charlie Chaplin, “The Great Dictator” (1940)

Just need a little hair dye on that Erdogan moustache, and I think we’re good to go.

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Harry Angel: You’re crazy. I know who I am. You’re trying to frame me. You’re trying to frame me. Cyphre, I know who I am. You murdered them people. I never killed nobody. I didn’t kill Fowler, and … and I didn’t kill Toots, and I didn’t kill Margaret, and I didn’t kill Krusemark, I didn’t kill no one!
Louis Cyphre: I’m afraid you did, Johnny.
Harry Angel: My name’s not Johnny!
Louis Cyphre: All killed by your own hand. Guided by me, naturally. Frankly, you were doomed from the moment you slit that young boy in half, Johnny … for twelve years you’ve been living on borrowed time and another man’s memories.
― Alan Parker, “Angel Heart” (1987)

My favorite De Niro role, worth watching just for the fingernails and the way the man eats an egg.

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I shouted out,
Who killed the Kennedys?
When after all
It was you and me.

― Jagger and Richards “Sympathy for the Devil” (1968)

Four people died at the 1969 Altamont concert, including a front row murder during the Stones set. It’s fun to strut on stage and sing about this stuff, until the Hells Angels show you what you’re singing about.

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When you strike at a king, you must kill him.
Ralph Waldo Emerson (1803 – 1882)

Omar:    Come at the king, you best not miss.

David Simon, “The Wire” (2002)

Everything I know about politics, I learned from “The Wire”. That and a Ph.D. in Government from Harvard. But mostly “The Wire”.

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Sam Spade: I hope they don’t hang you, precious, by that sweet neck. Yes, angel, I’m gonna send you over. The chances are you’ll get off with life. That means if you’re a good girl, you’ll be out in 20 years. I’ll be waiting for you. If they hang you, I’ll always remember you.
― John Huston, “The Maltese Falcon” (1941)

I think it’s a guy thing, this willingness to be a patsy for a cause, be it love, or lust, or greed, or religion … or a political party. Don’t be a patsy. Be a Sam Spade. Be an Omar.

A “crisis actor” is a familiar theme in all sorts of conspiracy theories. Basically, the idea is that terrorist attacks and the like are false-flag operations, where nefarious government agencies kill their own citizens, directly or indirectly, in order to instill fear and maintain popular support for the smiley-face authoritarianism of the modern State. Crisis actors are the patsies hired by the agencies to weep and wail for the cameras, creating the initial Narrative of terror and supporting the follow-on Narrative of steely government resolve to track down the supposed bad guys.

As per usual with conspiracy theories, the specifics of their claims about crisis actors are nonsense. It’s not “the same girl” crying at Newtown and Orlando and Nice, as the photos on conspiracy websites claim. CNN isn’t a secret division of the CIA. Neil Armstrong really did walk on the moon.

But as also per usual with conspiracy theories, they’re not thinking big enough. Crisis acting isn’t found in the secret construction of a crime scene. It’s found in the public construction of a social Narrative. It’s found in the public statements of the Missionaries (to use the game theory term) who create Common Knowledge — what everyone knows that everyone knows.

Hermann Göring and Erdogan are crisis actors, pretending that the Nazis or the Islamists are the only force standing between the Motherland and political traitors within and abroad, pretending that their “emergency policies” are anything less than a permanent seizure of political control.

It’s oh so easy to look at what’s going on in Turkey and shake our heads and tsk-tsk that awful Erdogan and the awful anti-democratic things he’s doing over there. Because it IS awful. What’s happening today in Turkey is absolutely a carbon copy of what happened in Germany in 1933 with the Reichstag Fire, and every Western president and prime minister and chancellor and secretary of state and foreign minister — all of whom are mouthing the same diplo-speak pablum about the Islamist fascists of 2016 that their counterparts mouthed about the Nazi fascists of 1933 — will have the same stain on their souls. Not that I’m sure many of this 2016 crowd have a soul left to stain. As Gertrude Stein famously said about Oakland, and I’m saying about these crisis actors, there’s no there there. Whatever human beings they used to be, it seems they’ve been absorbed by their public cartoons, which is really just … sad.

But look homeward, angel. Look homeward, too.

Paul Krugman and Tom Friedman and Jim Cramer and their media Missionary kin are also crisis actors, pretending that the Brexit vote was a deluded, colossal mistake perpetrated on innocent UK voters by economic traitors within and abroad.

Janet Yellen and Mario Draghi and their central bank Missionary kin are also crisis actors, pretending that their “emergency policies”, now more than seven years old, are anything less than a permanent political shift in the global allocation of money and credit.

I mean, can’t we just stop these charades surrounding “the Horror of Brexit” and “data dependence”? Can’t we just admit that it’s all an exercise in — to use the Fed’s terminology — “communication policy”, where words are chosen for effect rather than to convey true belief or opinion … or what we would call in normal human interaction “lying”?

Of course we can’t. Whether you’re Göring or Erdogan or Yellen or Draghi, once you start weaving that tangled web of deception, you can’t un-weave it. Once you sell your soul to the Narrative Devil you can’t buy it back. Erdogan can’t walk his purge back even if he wanted to. Yellen can’t walk her dot plots and forward guidance back even if she wanted to. Draghi and Kuroda are never going to go on stage and shrug their shoulders and say “oops, sorry ‘bout that.” At least St. Louis Fed Governor Jim Bullard didn’t have to flee to Greece for his “failed dot plot coup”.

And yeah … I understand that I’m tarring central bankers and their fellow travelers with the fascist brush. Because the road to hell is paved with good intentions as well as bad. Because there IS a moral equivalence between the means used by Göring and Erdogan to accomplish their ends and the means used by central bankers to accomplish theirs. Do the differing ends and the better intentions matter? Of course they do. And that’s why Ben Bernanke gets $250,000 per speech and Hermann Göring got a cyanide pill in his prison cell. But the shared means of false Narrative and crisis acting matter, too, because they create a world of profound inauthenticity, where ALL public speech is deemed suspect and self-serving — because it is! — and where ANY public speech, no matter how demagogue-ish or false or borderline insane, is deemed functionally equivalent to any other speech. Because it is. It’s what I call Gresham’s Law of Narrative: inauthentic speech drives authentic speech out of circulation, just like bad money drives good money out of circulation. If the function of public speech is to persuade rather than inform — and that’s precisely the function of forward guidance and every other status quo political statement of the past seven years — then it’s just comical for those same status quo institutions to complain now that their political opponents are “lying”. No, they’re just more effective persuaders. They’re just better liars.

And yeah … I’m saying that the rise of Trump and Farage and Le Pen and their ilk is a direct consequence of the communication policy toolkit and the crisis acting employed by every Western central banker and politician over the past seven years. That’s exactly what I’m saying.

As for us investors … we’re the “poor slobs on a farm” that Hermann Göring talks about in his prison cell interviews during the Nuremberg Trials. We don’t want to go to war, whether it’s a real-life war like Erdogan is waging or an ersatz war like Yellen and Draghi are waging. As Göring said, the best outcome for us is that we get home to our farms alive. Why in the world would we sign up for that?

We sign up for it because we are biologically hard-wired over millions of years and socially soft-wired over tens of thousands of years to respond to Narrative. We are social animals in the scientific, technical sense of the phrase, and we — along with our termite, ant, and bee cousins — are the four most successful multi-cellular animal species on Earth because of it. The hallmark of what biologists call a eusocial species isn’t just that it communicates. It swims in an ocean of communication. It is evolved to be immersed in constant communication. How many waking minutes of every day are you away from some sort of message from other humans? Five? Ten? For me it’s however long my morning shower takes. That’s about it. Probably about the same amount of time that an ant or a termite goes without a message from another ant or termite. That’s the human animal for you … basically a giant termite with fire. As a eusocial species, we can no more ignore a message from Janet Yellen than an ant can ignore a pheromone from its queen. Not only can we not ignore it, but it WILL move us, in some small way, at least.

Thankfully, though, unlike an ant we have self-awareness. Or at least the capacity for self-awareness. We can recognize that this process of Narrative influence is happening to ourselves and to others, and we can resist if we choose to.

Now, we will probably go along with whatever the Narrative is suggesting we do, because that’s usually the smart play. We know that there are millions of other ants hearing the queen’s message, and we know that each of them will be moved by her message. Plus — and this is the big insight from game theory, the engine for all of these Common Knowledge behaviors — we know that all of the other ants are thinking about US in exactly the same way we are thinking about THEM. Knowing that, it is entirely rational for each of us to act AS IF the queen’s message is True with a capital T.

But acting AS IF doesn’t mean acting AS. That’s what the patsy does. The patsy is the guy who believes, deeply madly truly, that the queen’s message is True with a capital T, forever and ever, amen. The patsy is the guy without self-awareness. The patsy is the guy who doesn’t recognize that he’s being played. As the old poker saying goes, if you’ve been playing cards for half an hour and you don’t know who the sucker is … it’s you. The entire reason I write Epsilon Theory is to do my small part in preventing people from becoming suckers, from accepting Missionary statements at face value, from believing in their heart of hearts that maybe 2 + 2 = 5 and that maybe the Emperor is wearing a fine suit of clothes after all. The inescapable human Truth, of course, is that we are ALL being played ALL the time. But if you’re self-aware, you can resist. You can resist in your heart even if you comply in your behavior, and you can resist in your behavior if and when you choose. You know that you are being played, and you choose to go along with the game. For now.

Okay, Ben, all very heroic and heartfelt, but what do we do?

Well… here’s what we don’t do. We don’t “fight the Fed”, and we don’t stick our head in the sand and pretend that the status quo Missionaries can’t construct highly investable rallies. You know, like the rally we’re experiencing right now. But by the same token we don’t allow ourselves to become a patsy for the Fed or the ECB or the DNC or the RNC or the WSJ or the NYT or CNBC or whatever other institutional collection of initials asks you to play the fool. We should never trust the Fed or any other Missionary, because one day we’re going to need to, if not fight them, then at least take ourselves off their battlefield.

I think what we need to DO is identify the potential political and economic catalysts coming down the pike and figure out which of these are potential Humpty Dumpty moments — crack-ups in the current system of global credit allocation that are too large for the central banks to piece back together again with their crisis acting and Narrative creation efforts. Then we need to track that Narrative effort so we can get the timing right on these massive catalysts. Because as any coup-launcher or Fed-fighter or volatility-embracer knows, if you’re wrong on timing … you’re just wrong. Starting with the next Epsilon Theory note — “The Narrative Machine” — I’ll be launching a new chapter in this project by demonstrating a set of tools for tracking Narrative evolution and impact. If you’re not yet on the direct distribution list, you can sign up here. I’m pretty excited about where this is going, and hope you’ll join me.

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When Narratives Go Bad

How many things served us yesterday as articles of faith, which today are fables for us?

– Michel de Montaigne, The Complete Essays (1580)

That same night, I wrote my first short story. It took me thirty minutes. It was a dark little tale about a man who found a magic cup and learned that if he wept into the cup, his tears turned into pearls. But even though he had always been poor, he was a happy man and rarely shed a tear. So he found ways to make himself sad so that his tears could make him rich. As the pearls piled up, so did his greed grow. The story ended with the man sitting on a mountain of pearls, knife in hand, weeping helplessly into the cup with his beloved wife’s slain body in his arms.

– Khaled Hosseini, The Kite Runner (2003)

A fable for our times, the ultimate disposition of extraordinary monetary policy. Bad news is good news until bad news is all we know. Global growth is the wife.

epsilon-theory-when-narratives-go-bad-july-7-2016-atlantic The idea of negative interest rates strikes many people as odd. Economists are less put off by it. … The anxiety about negative interest rates seen recently in the media and in markets seems to me to be overdone. Logically, when short-term rates have been cut to zero, modestly negative rates seem a natural continuation; there is no clear discontinuity in the economic and financial effects of, say, a 0.1 percent interest rate and a -0.1 percent rate.

– Former Fed Chair Ben Bernanke, “What Tools Does the Fed Have Left?”, March 18, 2016

Bernanke is right – economists are not put off by the idea of negative rates. And that’s exactly the problem. There’s a huge discontinuity between a 0.1 percent interest rate and a -0.1 percent interest rate, but economists don’t see it because it’s a BEHAVIORAL discontinuity. Positive rates permit investing behaviors based on fundamentals and compounding. Negative rates require investing behaviors based on hope for a greater fool.

epsilon-theory-when-narratives-go-bad-july-7-2016-rainbow

My Sunday school teachers had turned Bible narrative into children’s fables. They talked about Noah and the ark because the story had animals in it. They failed to mention that this was when God massacred all of humanity.

– Donald Miller, Blue Like Jazz: Nonreligious Thoughts on Christian Spirituality (2003). The condescension of modern status quo Narrative construction is staggering. It’s a mistake to do this with kids, and it’s a bigger mistake to do this with voters and investors.

A major European power, a longtime defender of liberal democracy, pluralism and free markets, falls under the sway of a few cynical politicians who see a chance to exploit public fears of immigration to advance their careers. They create a stark binary choice on an incredibly complex issue, of which few people understand the full scope — stay in or quit the E.U.

– New York Times columnist Tom Friedman, doing his part to create a status quo protecting Narrative post-Brexit, where government “unforgivably” abdicated its responsibility by “allowing” foolish citizens who can’t possibly know their own self-interest to vote on something that’s “incredibly complex” and can only be understood by wise men … like Tom Friedman.

epsilon-theory-when-narratives-go-bad-july-7-2016-marie-antoinette He spotted the entourage and security personnel that signaled another important person’s plane. With the temperature over 103 degrees, Mr. Clinton, rather than chatting on the scorching cement, climbed aboard to say hello to Attorney General Loretta E. Lynch.

– New York Times “reporter” Amy Chozick, in a yeoman effort to maintain the status quo protecting Narrative. Nothing to see here folks, move along, just a sociable man trying to get out of the heat.

Marie Antoinette (1755 – 1793)

epsilon-theory-when-narratives-go-bad-july-7-2016-duck-soupDuck Soup (1933)

Minister of Finance: Here is the Treasury Department’s report, sir. I hope you’ll find it clear.
Rufus T. Firefly: Clear? Huh. Why a four-year-old child could understand this report.
Rufus T. Firefly: Run out and find me a four-year-old child, I can’t make head or tail of it.

epsilon-theory-when-narratives-go-bad-july-7-2016-fiddlers-three

Stooges: Simple Simon met a pieman,
Going to the fair;
Says Simple Simon to the pieman,
Let me taste your ware.
Said the pieman to Simple Simon,
Show me first your penny.
Said Simple Simon to the pieman:
Moe: Scram! Ya don’t get any! [throws pie in face]

You can learn a lot about political Narrative creation by looking at dominant forms of satire and comedy. Satire today is as arch and elitist as the status quo institutions it defends, in sharp contrast to the populist, slapstick comedy of the Marx Brothers or the Three Stooges. I’ll bet there’s a 99% correlation between UK Leave voters and people who think Benny Hill is funny, and the same between UK Remain voters and people who think John Oliver is funny. For the Tom Friedmans of the world, the solution is simple: “educate” people that John Oliver is hilarious, but you’re a racist dope if you laugh at Benny Hill. Yeah, that’ll work.

epsilon-theory-when-narratives-go-bad-july-7-2016-hamilton

I wrote my way out of hell.
I wrote my way to revolution.
I was louder than the crack in the bell.
I wrote Eliza love letters until she fell.
I wrote about The Constitution and defended it well.
And in the face of ignorance and resistance,
I wrote financial systems into existence.
And when my prayers to God were met with indifference,
I picked up a pen, I wrote my own deliverance.
– Lin-Manuel Miranda, Hamilton (2015)

Why does “Hamilton” work? Because it’s not arch and it’s not elitist. Because it takes one of the most powerful and long-lived Narratives in modern history – the Founding Fathers – and tells the story without irony, without condescension, and without the (literal) whitewashing of other storytellers.

The Old Stories still work when you play them straight. Thank you, Lin-Manuel.

epsilon-theory-when-narratives-go-bad-july-7-2016-sandman

Choronzon: I am a dire wolf, prey-stalking, lethal prowler.
Morpheus: I am a hunter, horse-mounted, wolf-stabbing.
Choronzon: I am a horsefly, horse-stinging, hunter-throwing.
Morpheus: I am a spider, fly-consuming, eight legged.
Choronzon: I am a snake, spider-devouring, poison-toothed.
Morpheus: I am an ox, snake-crushing, heavy-footed.
Choronzon: I am an anthrax, butcher bacterium, warm-life destroying.
Morpheus: I am a world, space-floating, life-nurturing.
Choronzon: I am a nova, all-exploding… planet-cremating.
Morpheus: I am the Universe — all things encompassing, all life embracing.
Choronzon: I am Anti-Life, the Beast of Judgment. I am the dark at the end of everything. The end of universes, gods, worlds … of everything. Sss. And what will you be then, Dreamlord?
Morpheus: I am hope.
Neil Gaiman, The Sandman, Vol. 1: Preludes and Nocturnes (1991)

There was a tale he had read once, long ago, as a small boy: the story of a traveler who had slipped down a cliff, with man-eating tigers above him and a lethal fall below him, who managed to stop his fall halfway down the side of the cliff, holding on for dear life. There was a clump of strawberries beside him, and certain death above him and below. What should he do? went the question.

And the reply was, Eat the strawberries.

The story had never made sense to him as a boy. It did now.

– Neil Gaiman, American Gods (2001)

The fin of any siècle is almost always a rough ride, even if we end up dreaming a better dream. In investing as in life there’s never enough time, and we are beset on all sides. Eat the strawberries.

Here’s my most basic view on everything that’s happening in the world right now, politically, economically, socially … all of it: the Fix is still in, but it’s getting harder and harder to maintain.

The Fix is the status quo, and it goes by different labels of identity depending on what you’re talking about. “European Union” is one of those labels. “Central Banking” is one. “Clinton” is another. They aren’t real things at all, but are statements of shared identity that channel our behavior in highly predictable patterns that are, in turn, highly useful to The Powers That Be, and are maintained by expressions of Common Knowledge such as “everyone knows that everyone knows that Brexit was a grievous mistake” or “everyone knows that everyone knows that low interest rates spur the economy.” Those expressions of Common Knowledge are also called Narratives, and the Narratives are dying.

And yes, I know that this all sounds suspiciously philosophical and divorced from our investing reality, but bear with me for a moment, because the punchline here is going to be that I think what I’m describing is the ONLY thing that matters for our investing reality. Our reality is not determined by the antics of the flesh-and-blood Hillary Clinton or Donald Trump, but by the status quo ideas and institutions represented by and threatened by the human-shaped cartoons we call “Hillary Clinton” and “Donald Trump”. To figure out what’s next for markets, we have to figure out why “Clinton” – shorthand for globalism (it’s not called The Clinton Global Initiative for nothing) and a sort of technocratic, condescending, principle-less, democracy-suspicious manner of governing – is failing. We have to figure out why Bill Clinton’s stroll across the Phoenix tarmac to chat up the Attorney General was a) reported at all, and b) greeted by derision and despair within his own party. If you don’t like my use of the label “Clinton” or if you think I’m being too political, replace it with “Brussels” or “Beijing”. It’s all the same thing, just three different shades of gray.

And I really couldn’t care less, professionally at least, what actually transpired between Bill Clinton and Loretta Lynch, or what Hillary Clinton actually believed about her email security classifications. What I care deeply about, however, is how the Narrative around these events is being shaped and reshaped, because that Narrative will determine the path and outcome of every election and every market on Earth. And what I can tell you is that I am shocked by the diminishing half-life of status quo protecting Narratives, by the inability of Big Institutions and Big Money and Big Media and Big War and Big Academia to lock down an effective story that protects the State, even when their competition is primarily comprised of clowns (dangerous clowns, but clowns all the same) like Donald Trump and Nigel Farage. There’s a … tiredness … to the status quo Narratives, a Marie Antoinette-ish world weariness that sighs and pouts about those darn peasants all the way to the guillotine.

We’ve seen this before. History is littered with failed Narratives, once-powerful arrays of Common Knowledge that somehow lose their ability to compel human behavior and eventually become mere myth. That’s where Narratives go to die. They become fables, stories that we chuckle at, stories that we shake our heads at and ask “did people really believe in all that?” Michel de Montaigne – who invented the essay as a literary form and was the first blogger, albeit more than 400 years before Al Gore invented the Internet – wrote about the devolution of faith to fable back in the 16th century. It’s a phenomenon as old as humanity itself. Manifest Destiny … Cultural Revolution … these were Narratives every bit as powerful in their day as European Union or Clinton in ours. Now they’re historical curiosities, something you come across on a Wikipedia bender.

epsilon-theory-when-narratives-go-bad-july-7-2016-american-progress

John Gast, “American Progress” (ca. 1872)

epsilon-theory-when-narratives-go-bad-july-7-2016-mao-zedong

Mao Zedong Thought poster (ca. 1970)

The rarity isn’t the Narrative that dies and fades into myth, but the Narrative that survives by re-inventing itself, by finding its words and stories repurposed and retold for a modern ear. For example, the Narrative of the American Founding Fathers is as potent today as it was 100 years ago, maybe more so, and that was before Hamilton gave it a new telling and a new power chord.

Why are the status quo protecting Narratives faltering so badly? I think it’s because status quo political and economic institutions – particularly Central Banks – have failed to protect incomes and have pushed income and wealth inequality past a political breaking point. They made a big bet: we’re going to bail-out/paper-over the banks to prevent massive losses in the financial sector, we’re going to inflate the stock market so that the household sector feels wealthier, and we’re going to make vast sums of money available for the corporate and government sectors to borrow really cheaply. And as the McKinsey chart here shows, by Q2 2014 they had largely succeeded on all counts, certainly in getting the corporate and government sectors to borrow trillions in new debt.

epsilon-theory-when-narratives-go-bad-july-7-2016-global-stock

The result, or so the thinking went, of all this pump-priming or bridge-building or whatever metaphor you please would be for all four basic sectors of the global economy – households, corporations, governments, and financial institutions – to consume more and invest more and fail never, which would in turn create a virtuous, self-sustaining cycle of risk taking, real growth, and real wealth creation.

epsilon-theory-when-narratives-go-bad-july-7-2016-john-oliver

It was a reasonable bet to make. But the bet failed. Why? There’s a book or two to write on this, but I’ll sum it up this way: you can no more force corporations to invest for growth if they don’t believe it’s safe than you can force people to watch John Oliver if they don’t think he’s funny. Sure, they’ll tell you that they think he’s funny, because everyone knows that everyone knows that John Oliver is funny, and they need to go along with the Common Knowledge to be successful social animals. But in their heart of hearts, they don’t think John Oliver is funny. Now to be clear, I’m picking on John Oliver to make a point. Personally, I think he’s funny. Some of the time. Well … kind of funny. I guess. Okay, I don’t really think he’s very funny. Sorry. And the truth is that if you paid me to watch HBO, just as Central Banks are basically paying corporations to borrow money, I’m going to watch 20 Game of Thrones re-runs before I watch a single episode of Last Week Tonight with John Oliver, just as corporations are going to buy back stock and hoard cash 20 times more than invest in new jobs or new equipment.

So what does this have to do with incomes? Two things.

First, little of the increased corporate or government borrowing trickled down into jobs or wage income growth. We’ve all seen the charts. Real wage growth is nonexistent in the Western world. Second, to make it feasible for corporations and governments to borrow these trillions of dollars in the first place, every bit of Central Bank balance sheet expansion (buying bonds) and balance sheet “twist” (buying longer duration bonds) and expansion of allowable securities for purchase (buying more kinds of bonds) and imposition of negative rates (charging you interest if you don’t buy longish-term bonds) was designed to – you guessed it – buy more bonds and thus drive up bond prices and drive down interest rates, particularly longish-term bond prices and longish-term interest rates. That’s great if you’re an investor looking for a percentage return on your bond portfolio. That’s terrible, however, if you’re an investor looking for an income from your bond portfolio. Over the past seven years, Central Banks have rewarded the return-seeking bond buyer many times over, and they’ve done nothing but punish the income-seeking bond buyer.

Put these two income squelchers together – zero wage income growth because corporations aren’t investing for growth and less-than-zero investment income growth because Central Banks have crushed rates – and you have a vast swath of the voting public in every developed nation on Earth that (rightfully!) feels aggrieved and left behind by the gleaming economic recovery that the status quo Narrative Missionaries tout at every turn. Notably, the failure of wage income growth skews younger and Democrat/left. The failure of investment income growth skews older and Republican/right. The status quo Narratives could survive (and have many times) an assault from one wing of the electorate or the other. But from both simultaneously? It’s going to be a close call.

But here’s the even larger problem lurking in the not-so distant future, and it’s found in the behavioral WHY of return-seeking bond buyers versus income-seeking bond buyers. These are two entirely different investor populations from a behavioral perspective, with different languages and different investment genotypes. When I hear an investor or financial advisor ask, “Why in the world would I buy a Swiss bond with a -0.5% interest rate?” I know that I’m talking to an income-seeking bond buyer. The return-seeking bond buyer, on the other hand, says “Hey, if you’re right about the world, those Swiss bonds currently yielding -0.5% are going to -1.0%, which means that the price is going up. Where can I buy one of those?”

The only rational owner of a negative rate bond is a pure return seeker; there are zero income seekers holding negative rate bonds. Why is this a problem? Because income seekers will continue to own bonds even if the price goes down (for a while, anyway; at the very least, they are sticky owners). Return seekers, on the other hand, are not sticky owners at all. They will only own a bond if they think that the price is going up – meaning in this case that yields will continue to become even more negative, i.e., that there’s a greater fool (probably in the form of a Central Bank) willing to pay higher and higher prices for these income-destroying bonds – and they will sell in a heartbeat if they think this dynamic is changing.

There is, to cop a phrase from the People’s Bank of China, a massive “one-way bet” on negative rate sovereign debt today. The momentum trade has crystallized to perfection in negative rate bonds, which has grown to become a $10+ trillion (yes, that’s trillion with a T) asset class. I think it’s the most crowded trade in the world from a behavioral or investment DNA perspective, and the moment you get even a whiff of the ECB or BOJ backing down from or reaching its limit of greater foolishness, you are going to get a rush to the exit on ALL sovereign bonds that will shake global capital markets to their core. It’ll be good times till then, as it always is, and I am seeing zero signs of Central Bankers backing down from their greater foolishness. But we have once again set up the global financial system as an inverted pyramid, with a $10 trillion asset class poised on a single, solitary piece of Common Knowledge —– what everyone knows that everyone knows. In 2008, the $10 trillion asset class of residential mortgage backed securities (RMBS) was entirely based on the Common Knowledge that it was impossible to have a nationwide decline in U.S. home prices. When that Narrative failed, the entire inverted pyramid came crashing down. In 2016, the $10 trillion asset class of negative rate sovereign bonds is entirely based on the Common Knowledge that there is no limit to the greater foolishness of Central Banks. If this Narrative fails, the entire inverted pyramid will come crashing down again. Hence my punchline: monitoring this and related status quo protecting Narratives (like the concerted effort to paint Brexit as a one-off blunder, just like Bear Stearns was painted in 2008) is the only thing that really matters for our investment reality.

What to do? Convexity, convexity, convexity. Our portfolios should minimize the maximum risk the world actually presents, not maximize the reward our crystal ball models predict. Timing, timing, timing. We need to pay attention to what matters, and right now that’s all policy and all Narrative all the time. In a negative rate world, you’ve got to think in terms of catalysts, not “stocks for the long haul”. And one more thing. To paraphrase Groucho Marx in Duck Soup, if a four-year-old can’t understand what you’re doing in your portfolio, don’t do it. For me, that means real assets and real yield, fractional ownership in real companies with real cash flows from real economic activity with real people. You know, what a stock market used to mean before it became a Central Bank casino. For more on all these points, I’d point you directly to the recent Epsilon Theory notes “Hobson’s Choice and “Cat’s Cradle.

I know that this all comes across as very negative about the world and our investing future, and that’s because it is. To use a poker analogy, we were dealt some bad cards, the Central Banks waaay overplayed the hand, and now we’ve got to figure out how to extricate ourselves without losing our entire stake. But is this a hopeless situation? No. The most important lesson I ever learned from my mentors in this business is this: always live to fight another day. We can do that. It won’t be fun and it won’t be pretty and we’ll have some scars to show for it, but we can do that. The useful lesson from the Biblical Flood Narrative isn’t a pleasant fable about Noah saving the cute and cuddly animals. The useful lesson is that hubris must be confronted, hope is always present, and that preparation and honest actions will see us through any storm. Yes, we can do that.

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Waiting for Humpty Dumpty

Humpty Dumpty sat on a wall,
Humpty Dumpty had a great fall.
All the king’s horses and all the king’s men
Couldn’t put Humpty together again.

Brexit is a Bear Stearns moment, not a Lehman moment. That’s not to diminish what’s happening (markets felt like death in March, 2008), but this isn’t the event to make you run for the hills. Why not? Because it doesn’t directly crater the global currency system. It’s not too big of a shock for the central banks to control. It’s not a Humpty Dumpty event, where all the Fed’s horses and all the Fed’s men can’t glue the eggshell back together. But it is an event that forces investors to wake up and prepare their portfolios for the very real systemic risks ahead.

There are two market risks associated with Brexit, just as there were two market risks associated with Bear Stearns.

In the short term, the risk is a liquidity shock, or what’s more commonly called a Flash Crash. That could happen today, or it could happen next week if some hedge fund or shadow banking counterparty got totally wrong-footed on this trade and — like Bear Stearns — is taken out into the street and shot in the head.

In the long term, the risk is an acceleration of a Eurozone break-up, which is indeed a Lehman moment (literally, as banks like Deutsche Bank will become both insolvent and illiquid). There are two paths for this. Either you get a bad election/referendum in France (a 2017 event) or you get a currency float in China (an anytime event). Brexit just increased the likelihood of these Humpty Dumpty events by a non-trivial degree.

What’s next? From a game theory perspective, the EU and ECB need to crush the UK. It’s like the Greek debt negotiations … it was never about Greece, it was always about sending a signal that dissent and departure will not be tolerated to the countries that matter to the survival of the Eurozone (France, Italy, maybe Spain). Now they (and by “they” I mean the status quo politicians throughout the EU, not just Germany) are going to send that same signal to the same countries by hurting the UK any way they can, creating a Narrative that it’s economic death to leave the EU, much less the Eurozone. It’s not spite. It’s purely rational. It’s the smart move.

What’s next? Every central bank in the world will step up their direct market interventions, particularly in the FX market, where it’s easiest for Plunge Protection Teams to get involved. Every central bank in the world will step up their jawboning and “communication policy” to support financial asset prices and squelch volatility. It wouldn’t surprise me a bit if the Fed started talking about a neutral stance, moving away from their avowed tightening bias. As I write this, Fed funds futures are now pricing in a 17% chance of a rate CUT in September. Yow!

What’s the result? I think it works for while, just like it worked in the aftermath of Bear Stearns. By May 2008, credit and equity markets had retraced almost the entire Bear-driven decline. I remember vividly how the Narrative of the day was “systemic risk is off the table.” Yeah, well … we saw how that turned out. Now to be fair, history only rhymes, it doesn’t repeat. Maybe this Bear Stearns event isn’t followed by a Lehman event. But that’s what we should be watching for. That’s what we should be preparing our portfolios for.

How do we prepare? I’ve got Five Easy Pieces, five suggestions for surviving these policy-controlled markets, described at length in the Epsilon Theory notes “Cat’s Cradle” and “Hobson’s Choice“. Here’s the skinny:

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

Bottom line … if you ever needed a wake-up call that every crystal ball is broken and we are in a political storm of global proportions, today is it. That’s at least 3 mixed metaphors, but you get my point. Brexit isn’t a Humpty Dumpty moment itself, and I think The Powers That Be will kinda sorta tape this egg back together. But if there’s one thing we know about broken eggs and broken teacups and broken partnerships, it’s never the same again, no matter how hard you try to put the pieces back together. My view is that a Humpty Dumpty moment, in the form of a political/currency shock from China or a core Eurozone country, is a matter of when, not if. Tracking that “when”, and thinking about how to invest through it, is what Epsilon Theory is all about.

PS — for some earlier Epsilon Theory notes on Europe, all of which are highly pertinent today, see:

  1. The Red King
  2. 1914 is the New Black
  3. 1914 is (Still) the New Black
  4. Inherent Vice
  5. Now There’s Something You Don’t See Every Day, Chauncey
  6. Finest Worksong

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Cat’s Cradle

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

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

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

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

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

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

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

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

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

Fed Governor James “Bleeding Man” Bullard

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

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

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

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

– William Wordsworth (1770 – 1850)

Splendor In the Grass (1961)

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

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

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

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

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

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

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

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

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

Sigh.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Who’s Being Naïve, Kay?


Satan: Dream other dreams, and better!

The Mysterious Stranger (1916)

Twain spent 11 years writing his final novel, “The Mysterious Stranger”, but never finished it. The book exists in three large fragments and is Twain’s darkest and least funny work. It’s also my personal favorite.


Stanley:   I thought you were called Lucifer.

George:   I know. “The Bringer of the Light” it used to be. Sounded a bit poofy to me. Everything I’ve ever told you has been a lie. Including that.

Stanley :   Including what?

George :   That everything I’ve ever told has been a lie. That’s not true.

Stanley :   I don’t know WHAT to believe.

George :   Not me, Stanley, believe me!

Bedazzled (1967)

A must-see movie, and I don’t mean the 2000 abomination with Brendan Fraser, but the genius 1967 version by Peter Cook and Dudley Moore. Plus Raquel Welch as Lust. Yes, please.


Henry Hill:   Ladies and gentlemen, either you are closing your eyes to a situation you do not wish to acknowledge, or you are not aware of the caliber of disaster indicated by the presence of a pool table in your community!

The Music Man (1962)

The Pied Piper legend, originally a horrific tale of murder, finds its source in the earliest written records of the German town of Hamelin (1384).

The story begins: “it is 100 years since our children left.”


As Tolstoy famously said, there are only two stories in all of literature: either a man goes on a journey, or a stranger comes to town. Of the two, we are far more familiar and comfortable with the first in the world of markets and investing, because it’s the subjectively perceived narrative of our individual lives. We learn. We experience. We overcome adversity. We get better. Or so we tell ourselves.

But when the story of our investment age is told many years from now, it won’t be remembered as a Hero’s Journey, but as a classic tale of a Mysterious Stranger. It’s a story as old as humanity itself, and it always ends with the same realization by the Stranger’s foil: what was I thinking when I signed that contract or fell for that line? Why was I so naïve?

The Mysterious Stranger today, of course, is not a single person but is the central banking Mafia apparatus in the US, Europe, Japan, and China. The leaders of these central banks may not be as charismatic as Robert Preston in The Music Man, but they hold us investors in equal rapture. The Music Man uses communication policy and forward guidance to get the good folks of River City to buy band instruments. Central bankers use communication policy and forward guidance to get investors large and small to buy financial assets. It’s a difference in degree and scale, not in kind.

epsilon-theory-whos-being-naive-kay-may-24-2016-music-man

The Mysterious Stranger is NOT a simple or single-dimensional fraud. No, the Mysterious Stranger is a liar, to be sure, but he’s a proper villain, as the Brits would say, and typically he’s quite upfront about his goals and his use of clever words to accomplish those goals. I mean, it’s not like Kay doesn’t know what she’s getting herself into when she marries into the Corleone family. Michael is crystal clear with her, right from the start. But she wants to believe so badly in what Michael is telling her when he suddenly reappears in her life, that she suspends her disbelief in his words and embraces the Narrative of legitimacy he presents. I think Michael actually believed his own words, too, that he would in fact be able to move the Family out of organized crime entirely, just as I’m sure that Yellen believed her own words of tightening and light-at-the-end-of-the-tunnel in the summer of 2014. Ah, well. Events doth make liars of us all.

epsilon-theory-whos-being-naive-kay-may-24-2016-godfather-2
epsilon-theory-whos-being-naive-kay-may-24-2016-godfather-3

Draw your own comparisons to this story arc of The Godfather, with investors playing the role of Kay and the Fed playing the role of Michael Corleone. I think it’s a pretty neat fit. It ends poorly for Kay, of course (and not so great for Michael). Let’s see if we can avoid her fate.

But like Kay, for now we are married to the Mob … err, I mean, the Fed and competitive monetary policies, as reflected in the relative value of the dollar and other currencies. The cold hard fact is that since the summer of 2014 there has been a powerful negative correlation between the trade-weighted dollar and oil, between the trade-weighted dollar and emerging markets, and between the trade-weighted dollar and industrial, manufacturing, and energy stocks. Here’s an example near and dear to the hearts of any energy investor, the trade-weighted dollar shown in green versus the inverted Alerian MLP index (ticker AMZ), a set of 43 midstream energy companies, principally pipelines and infrastructure, shown in blue.

epsilon-theory-whos-being-naive-kay-may-24-2016-bloomberg-1

This is a -94% correlation, remarkably strong for any two securities, much less two – pipelines and the dollar – that are not obviously connected in any fundamental or real economy sort of way. But this is always what happens when the Mysterious Stranger comes to town: our traditional behavioral rules (i.e., correlations) go out the window and are replaced with new behavioral rules and correlations as we give ourselves over to his smooth words and promises. Because that’s what a Mysterious Stranger DOES – tell compelling stories, stories that stick fast to whatever it is in our collective brains that craves Narrative and Belief.

There’s nothing particularly new about this phenomenon in markets, as there have always been “story stocks”, especially in the technology, media, and telecom (TMT) sector where you have more than your fair share of charismatic management storytellers and valuation multiples that depend on their efforts.

My favorite example of a “story stock” is Salesforce.com (ticker CRM), a $55 billion market cap technology company with 19,000 employees and about $6.5 billion in revenues. I’m pretty sure that Salesforce.com has never had a single penny of GAAP earnings in its existence (in FY 2016 the company lost $0.07 per share on a GAAP basis). Instead, the company is valued on the basis of non-GAAP earnings, but even there it trades at about an 80x multiple (!) of FY 2017 company guidance of $1.00 per share. Salesforce.com is blessed with a master story-teller in its CEO, Marc Benioff, who – if you’ve ever heard him speak – puts forth a pretty compelling case for why his company should be valued on the basis of bookings growth and other such metrics. Of course, the skeptic in me might note that it is perhaps no great feat to sell more and more of a software service at a loss, particularly when your salespeople are compensated on bookings growth, and the cynic in me might also note that for the past 10+ years Benioff has sold between 12,500 and 20,000 shares of CRM stock every day through a series of 10b5-1 programs. But hey, that’s why he’s the multi-billionaire (and a liquid multi-billionaire, to boot) and I’m not. Here’s the 5-year chart for CRM:

epsilon-theory-whos-being-naive-kay-may-24-2016-bloomberg-2

Not bad. Up 138% over the past five years. A few ups and downs, particularly here at the start of 2016, although the stock has certainly come roaring back. But when you dig a little deeper …

There are 1,272 trading days that comprise this 5-year chart. 21 of those trading days, less than 2% of the total, represent the Thursday after Salesforce.com reports quarterly earnings (always on a Wednesday after the market close). If you take out those 21 trading days, Salesforce.com stock is up only 35% over the past five years. How does this work? What’s the causal process? Every Wednesday night after the earnings release, for the past umpteen years, Benioff appears on Mad Money, where Cramer’s verdict is always an enthusiastic “Buy, buy, buy!” Every Thursday morning after the earnings release, the two or three sell-side analyst “axes” on the stock publish their glowing assessment of the quarterly results before trading begins. It’s not that every investor on Thursday believes what Cramer or the sell-side analysts are saying, particularly anyone who’s short the stock (CRM always has a high short interest). But in a perfect example of the Common Knowledge Game, if you ARE short the stock, you know that everyone else has heard what Cramer and the sell-side analysts (the Missionaries, in game theory lingo) have said, and you have to assume that everyone else will act on this Common Knowledge (what everyone knows that everyone knows). The only logical thing for you to do is cover your short before everyone else covers their short, resulting in a classic short squeeze and a big up day. Now to be sure, this isn’t the story of every earnings announcement … sometimes even Marc Benioff and his lackeys can’t turn a pig’s ear of a quarter into a silk purse … but it’s an incredibly consistent behavioral result over time and one of the best examples I know of the Common Knowledge Game in action.

But wait, there’s more. Now let’s add the Fed’s storytelling and its Common Knowledge Game to Benioff’s storytelling and his Common Knowledge Game. Over the past five years there have been 43 days where the FOMC made a formal statement. If you owned Salesforce.com stock for only the 43 FOMC announcement days and the 21 earnings announcement days over the past five years, you would be UP 167%. If you owned Salesforce.com stock for the other 1,208 trading days, you would be DOWN 8%.

epsilon-theory-whos-being-naive-kay-may-24-2016-salesforc

Okay, Ben, how about other stocks? How about entire indices? Well, let’s look again at that Alerian MLP index. Over the past five years, if you had owned the AMZ for only the 43 FOMC announcement days over that span, you would be UP 28%. If you owned it for the other 1,229 trading days you would be DOWN 39%. Over the past two years, if you had owned the AMZ for only the 16 FOMC announcement days over that span, you would be UP 18%. If you owned it for the other 487 trading days you would be DOWN 48%. Addition by subtraction to a degree that would make Lao Tzu proud.

epsilon-theory-whos-being-naive-kay-may-24-2016-alerian

I’ll repeat what I wrote in Optical Illusion / Optical Reality … it’s hard to believe that MLP investors should be paying a lot more attention to G-7 meetings and reading the Fed governor tea leaves than to gas field depletion schedules and rig counts, but I gotta call ‘em like I see ‘em. In fact, if there’s a core sub-text to Epsilon Theory it’s this: call things by their proper names. That’s a profoundly subversive act. Maybe the only subversive act that really changes things. So here goes. Today there are vast swaths of the market, like emerging markets and commodity markets and industrial/energy stocks, that we should call by their proper name: a derivative expression of FOMC policy. Used to be that only tech stocks were “story stocks”. Today, almost all stocks are “story stocks”, and the Common Knowledge Game is more applicable to helping us understand market behaviors and price action than ever before.

You see this phenomenon clearly in the entire S&P 500, as well, although not as starkly with a complete plus/minus reversal in performance between FOMC announcement days and all other days. Over the past five years, if you had owned the SPX for only the 43 FOMC announcement days over that span, you would be UP 17%. If you owned it for the other 1,229 trading days you would be UP 28%. Over the past two years, if you had owned the SPX for only the 16 FOMC announcement days over that span, you would be UP 5%. If you owned it for the other 487 trading days you would be UP 2%.

epsilon-theory-whos-being-naive-kay-may-24-2016-s-p-500

What do I take from eyeballing these charts? The Narrative effect and the impact of the Common Knowledge Game have accelerated over the past two years (ever since Draghi and Yellen launched the Great Monetary Policy Schism of June 2014); they’re particularly impactful during periods when stock prices are otherwise declining, and they’re spreading to broader equity indices. That’s what it looks like to me, at least.

So what does an investor do with these observations? Two things, I think, one a practical course of action and one a shift in perspective. The former being more fun but the latter more important.

First, there really is a viable research program here, and what I’ve tried to show in this brief note is that there really are practical implementations of the Common Knowledge Game that can support investment strategies dealing with story stocks. I want to encourage anyone who’s intrigued by this research program to take the data baton and try this on your favorite stock or mutual fund or index. You can get the FOMC announcement dates straight from the Federal Reserve website. This doesn’t require an advanced degree in econometrics to explore.

I don’t know where this research program ends up, but it’s my commitment to do this in plain sight through Epsilon Theory. Think of it as the equivalent of open source software development, just in the investment world. I suspect it’s hard to turn the Common Knowledge Game into a standalone investment strategy because you’re promising that you’ll do absolutely nothing for 98 out of 100 trading days. Good luck raising money on that. But it’s a great perspective to add to our current standalone strategies, especially actively managed funds. Stock-pickers today are being dealt one dull, low-conviction hand after another here in the Grand Central Bank Casino, and the hardest thing in the world for any smart investor, regardless of strategy, is to sit on his hands and do nothing, even though that’s almost always the right thing to do. Incorporating an awareness of the Common Knowledge Game and its highly punctuated impact makes it easier to do the right thing – usually nothing – in our current investment strategies.

And that gets us to the second take-away from this note. The most important thing to know about any Mysterious Stranger story is that the Stranger is the protagonist. There is no Hero! When you meet a Mysterious Stranger, your goal should be simple: survive the encounter.

This is an insanely difficult perspective to adopt, that we (either individually or collectively) are not the protagonist of the investing age in which we live. It’s difficult because we are creatures of ego. We all star in our own personal movie and we all hear the anthems of our own personal soundtrack. But the Mysterious Stranger is not an obstacle to be heroically overcome, as if we were Liam Neeson setting off (again! and again!) to rescue a kidnapped daughter in yet another “Taken” sequel. At some point this sort of heroism is just a reflection of bad parenting in the case of Liam Neeson, and a reflection of bad investing in the case of stock pickers and other clingers to the correlations and investment meanings of yesterday.

The correlations and investment meanings of today are inextricably entwined with central bankers and their storytelling. To be investment survivors in the low-return and policy-controlled world of the Silver Age of the Central Banker, we need to recognize the impact of their words and incorporate that into our existing investment strategies, while never accepting those words naïvely in our hearts.


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Optical Illusion / Optical Truth

epsilon-theory-optical-illusion-optical-truth-may-4-2016-tufte

epsilon-theory-optical-illusion-optical-truth-may-4-2016-cholera-2Portion of original dot map by Dr. John Snow, the founding father of epidemiology, showing the clusters of cholera cases in the London epidemic of 1854. The visual representation of Snow’s data analysis convinced local authorities to shut down the contaminated public well at ground zero of the cholera outbreak, although it would be another 20 years before Snow’s arguments in favor of germ theory and a direct connection between cholera and fecal contamination of water supply would be widely accepted.

John Snow, “On the Mode of Communication of Cholera” (1855)

Anscombe’s Quartet: four datasets that appear identical using summary statistical methods (mean, variance, correlation, linear regression), but are completely different in meaning and composition – a difference that is clearly revealed through visual inspection.

epsilon-theory-optical-illusion-optical-truth-may-4-2016-quartet

Frank Anscombe, “Graphs in Statistical Analysis” American Statistician v.27 no.1 (1973), drawing by Schutz 

epsilon-theory-optical-illusion-optical-truth-may-4-2016-minard-map

Charles Joseph Minard, “Carte Figurative” of Napoleon’s 1812 Russian Campaign (1869)

The Minard Map: a map of Napoleon’s disastrous invasion of Russia in 1812, showing six distinct data dimensions (troop strength, temperature, distance marched, geographic latitude and longitude, direction of travel, location at event dates) in 2-dimensional form.

Mephistopheles:Here too it’s masquerade, I find:
As everywhere, the dance of mind.
I grasped a lovely masked procession,
And caught things from a horror show…
I’d gladly settle for a false impression,
If it would last a little longer, though.
epsilon-theory-optical-illusion-optical-truth-may-4-2016-mephistopheles

Edouard de Reszke as Mephistopheles
in Gounod’s opera “Faust” (c. 1880)

So, so you think you can tell
Heaven from Hell,
Blue skies from pain.
Can you tell a green field
From a cold steel rail?
A smile from a veil?
Do you think you can tell?

– Roger Waters, “Wish You Were Here” (1975)

A great deal of intelligence can be invested in ignorance when the need for illusion is deep.

– Saul Bellow, “To Jerusalem and Back” (1976)

It is difficult to get a man to understand something, when his salary depends on his not understanding it.

– Upton Sinclair, “I, Candidate for Governor: And How I Got Licked” (1935)

Knowledge kills action; action requires the veils of illusion.

– Friedrich Nietzsche, “The Birth of Tragedy” (1872)

To find out if she really loved me, I hooked her up to a lie detector. And just as I suspected, my machine was broken.

– Jarod Kintz, “Love Quotes for the Ages. Specifically Ages 19-91” (2013)

Edward Tufte is a personal and professional hero of mine. Professionally, he’s best known for his magisterial work in data visualization and data communication through such classics as The Visual Display of Quantitative Information (1983) and its follow-on volumes, but less well-known is his outstanding academic work in econometrics and statistical analysis. His 1974 book Data Analysis for Politics and Policy remains the single best book I’ve ever read in terms of teaching the power and pitfalls of statistical analysis. If you’re fluent in the language of econometrics (this is not a book for the uninitiated) and now you want to say something meaningful and true using that language, you should read this book (available for $2 in Kindle form on Tufte’s website). Personally, Tufte is a hero to me for escaping the ivory tower, pioneering what we know today as self-publishing, making a lot of money in the process, and becoming an interesting sculptor and artist. That’s my dream. That one day when the Great Central Bank Wars of the 21st century are over, I will be allowed to return, Cincinnatus-like, to my Connecticut farm where I will write short stories and weld monumental sculptures in peace. That and beekeeping.

But until that happy day, I am inspired in my war-fighting efforts by Tufte’s skepticism and truth-seeking. The former is summed up well in an anecdote Tufte found in a medical journal and cites in Data Analysis:

One day when I was a junior medical student, a very important Boston surgeon visited the school and delivered a great treatise on a large number of patients who had undergone successful operations for vascular reconstruction. At the end of the lecture, a young student at the back of the room timidly asked, “Do you have any controls?” Well, the great surgeon drew himself up to his full height, hit the desk, and said, “Do you mean did I not operate on half of the patients?” The hall grew very quiet then. The voice at the back of the room very hesitantly replied, “Yes, that’s what I had in mind.” Then the visitor’s fist really came down as he thundered, “Of course not. That would have doomed half of them to their death.” God, it was quiet then, and one could scarcely hear the small voice ask, “Which half?”

‘Nuff said.

The latter quality — truth-seeking — takes on many forms in Tufte’s work, but most noticeably in his constant admonitions to LOOK at the data for hints and clues on asking the right questions of the data. This is the flip-side of the coin for which Tufte is best known, that good/bad visual representations of data communicate useful/useless answers to questions that we have about the world. Or to put it another way, an information-rich data visualization is not only the most powerful way to communicate our answers as to how the world really works, but it is also the most powerful way to design our questions as to how the world really works. Here’s a quick example of what I mean, using a famous data set known as “Anscombe’s Quartet”.

Anscombe’s Quartet
I II III IV
x y x y x y x y
10.0 8.04 10.0 9.14 10.0 7.46 8.0 6.58
8.0 6.95 8.0 8.14 8.0 6.77 8.0 5.76
13.0 7.58 13.0 8.74 13.0 12.74 8.0 7.71
9.0 8.81 9.0 8.77 9.0 7.11 8.0 8.84
11.0 8.33 11.0 9.26 11.0 7.81 8.0 8.47
14.0 9.96 14.0 8.10 14.0 8.84 8.0 7.04
6.0 7.24 6.0 6.13 6.0 6.08 8.0 5.25
4.0 4.26 4.0 3.10 4.0 5.39 19.0 12.50
12.0 10.84 12.0 9.13 12.0 8.15 8.0 5.56
7.0 4.82 7.0 7.26 7.0 6.42 8.0 7.91
5.0 5.68 5.0 4.74 5.0 5.73 8.0 6.89

In this original example (developed by hand by Frank Anscombe in 1973; today there’s an app for generating all the Anscombe sets you could want) Roman numerals I – IV refer to four data sets of 11 (x,y) coordinates, in other words 11 points on a simple 2-dimensional area. If you were comparing these four sets of numbers using traditional statistical methods, you might well think that they were four separate data measurements of exactly the same phenomenon. After all, the mean of x is exactly the same in each set of measurements (9), the mean of y is the same in each set of measurements to two decimal places (7.50), the variance of x is exactly the same in each set (11), the variance of y is the same in each set to two decimal places (4.12), the correlation between x and y is the same in each set to three decimal places (0.816), and if you run a linear regression on each data set you get the same line plotted through the observations (y = 3.00 + 0.500x).

But when you LOOK at these four data sets, they are totally alien to each other, with essentially no similarity in meaning or probable causal mechanism. Of the four, linear regression and our typical summary statistical efforts make sense for only the upper left data set. For the other three, applying our standard toolkit makes absolutely no sense. But we’d never know that — we’d never know how to ask the right questions about our data — if we didn’t eyeball it first.

epsilon-theory-optical-illusion-optical-truth-may-4-2016-anscombes-quartet

Okay, you might say, duly noted. From now on we will certainly look at a visual plot of our data before doing things like forcing a line through it and reporting summary statistics like r-squared and standard deviation as if they were trumpets of angels from on high. But how do you “see” multi-variate datasets? It’s one thing to imagine a line through a set of points on a plane, quite another to visualize a plane through a set of points in space, and impossible to imagine a cubic solid through a set of points in hyperspace. And how do you “see” embedded or invisible data dimensions, whether it’s an invisible market dimension like volatility or an invisible measurement dimension like time aggregation or an invisible statistical dimension like the underlying distribution of errors?

The fact is that looking at data is an art, not a science. There’s no single process, no single toolkit for success. It requires years of practice on top of an innate artist’s eye before you have a chance of being good at this, and it’s something that I’ve never seen a non-human intelligence accomplish successfully (I can’t tell you how happy I am to write that sentence). But just because it’s hard, just because it doesn’t come easily or naturally to people and machines alike … well, that doesn’t mean it’s not the most important thing in data-based truth-seeking.

Why is it so important to SEE data relationships? Because we’re human beings. Because we are biologically evolved and culturally trained to process information in this manner. Because — and this is the Tufte-inspired market axiom that I can’t emphasize strongly enough — the only investable ideas are visible ideas. If you can’t physically see it in the data, then it will never move you strongly enough to overcome the pleasant fictions that dominate our workaday lives, what Faust’s Tempter, the demon Mephistopheles, calls the “masquerade” and “the dance of mind.” Our similarity to Faust (who was a really smart guy, a man of Science with a capital S) is not that the Devil may soon pay us a visit and tempt us with all manner of magical wonders, but that we have already succumbed to the blandishments of easy answers and magical thinking. I mean, don’t get me started on Part Two, Act 1 of Goethe’s magnum opus, where the Devil introduces massive quantities of paper money to encourage inflationary pressures under a false promise of recovery in the real economy. No, I’m not making this up. That is the actual, non-allegorical plot of one of the best, smartest books in human history, now almost 200 years old.

So what I’m going to ask of you, dear reader, is to look at some pictures of market data, with the hope that seeing will indeed spark believing. Not as a temptation, but as a talisman against the same. Because when I tell you that the statistical correlation between the US dollar and the price of oil since Janet Yellen and Mario Draghi launched competitive monetary policies in mid-June of 2014 is -0.96 I can hear the yawns. I can also hear my own brain start to pose negative questions, because I’ve experienced way too many instances of statistical “evidence” that, like the Anscombe data sets, proved to be misleading at best. But when I show you what that correlation looks like …

epsilon-theory-optical-illusion-optical-truth-may-4-2016-bloomberg-1

© Bloomberg Finance L.P., for illustrative purposes only

I can hear you lean forward in your seat. I can hear my own brain start to whir with positive questions and ideas about how to explore this data further. This is what a -96% correlation looks like.

What you’re looking at in the green line is the Fed’s favored measure of what the US dollar buys around the world. It’s an index where the components are the exchange rates of all the US trading partners (hence a “broad dollar” index) and where the individual components are proportionally magnified/minimized by the size of that trading relationship (hence a “trade-weighted” index). That index is measured by the left hand vertical axis, starting with a value of about 102 on June 18, 2014 when Janet Yellen announced a tightening bias for US monetary policy and a renewed focus on the full employment half of the Fed’s dual mandate, peaking in late January and declining to a current value of about 119 as first Japan and Europe called off the negative rate dogs (making their currencies go up against the dollar) and then Yellen completely back-tracked on raising rates this year (making the dollar go down against all currencies). Monetary policy divergence with a hawkish Fed and a dovish rest-of-world makes the dollar go up. Monetary policy convergence with everyone a dove makes the dollar go down.

What you’re looking at in the magenta line is the upside-down price of West Texas Intermediate crude oil over the same time span, as measured by the right hand vertical axis. So on June 18, 2014 the spot price of WTI crude oil was over $100/barrel. That bottomed in the high $20s just as the trade-weighted broad dollar index peaked this year, and it’s been roaring back higher (lower in the inverse depiction) ever since. Now correlation may not imply causation, but as Ed Tufte is fond of saying, it’s a mighty big hint. I can SEE the consistent relationship between change in the dollar and change in oil prices, and that makes for a coherent, believable story about a causal relationship between monetary policy and oil prices.

What is that causal narrative? It’s not just the mechanistic aspects of pricing, such that the inherent exchange value of things priced in dollars — whether it’s a barrel of oil or a Caterpillar earthmover — must by definition go down as the exchange value of the dollar itself goes up. More impactful, I think, is that for the past seven years investors have been well and truly trained to see every market outcome as the result of central bank policy, a training program administered by central bankers who now routinely and intentionally use forward guidance and placebo words to act on “the dance of mind” in classic Mephistophelean fashion. In effect, the causal relationship between monetary policy and oil prices is a self-fulfilling prophecy (or in the jargon du jour, a self-reinforcing behavioral equilibrium), a meta-example of what George Soros calls reflexivity and what a game theorist calls the Common Knowledge Game.

The causal relationship of the dollar, i.e. monetary policy, to the price of oil is a reflection of the Narrative of Central Bank Omnipotence, nothing more and nothing less. And today that narrative is everything.

Here’s something smart that I read about this relationship between oil prices and monetary policy back in November 2014 when oil was north of $70/barrel:

I think that this monetary policy divergence is a very significant risk to markets, as there’s no direct martingale on how far monetary policy can diverge and how strong the dollar can get. As a result I think there’s a non-trivial chance that the price of oil could have a $30 or $40 handle at some point over the next 6 months, even though the global growth and supply/demand models would say that’s impossible. But I also think the likely duration of that heavily depressed price is pretty short. Why? Because the Fed and China will not take this lying down. They will respond to the stronger dollar and stronger yuan (China’s currency is effectively tied to the dollar) and they will prevail, which will push oil prices back close to what global growth says the price should be. The danger, of course, is that if they wait too long to respond (and they usually do), then the response will itself be highly damaging to global growth and market confidence and we’ll bounce back, but only after a near-recession in the US or a near-hard landing in China.

Oh wait, I wrote that. Good stuff.

epsilon-theory-optical-illusion-optical-truth-may-4-2016-economist

But that was a voice in the wilderness in 2014, as the dominant narrative for the causal factors driving oil pricing was all OPEC all the time. So what about that, Ben? What about the steel cage death match within OPEC between Saudi Arabia and Iran and outside of OPEC between Saudi Arabia and US frackers? What about supply and demand? Where is that in your price chart of oil? Sorry, but I don’t see it in the data. Doesn’t mean it’s not really there. Doesn’t mean it’s not a statistically significant data relationship. What it means is that the relationship between oil supply and oil prices in a policy-controlled market is not an investable relationship. I’m sure it used to be, which is why so many people believe that it’s so important to follow and fret over. But today it’s an essentially useless exercise in data analytics. Not wrong, but useless … there’s a difference!

Of course, crude oil isn’t the only place where fundamental supply and demand factors are invisible in the data and hence essentially useless as an investable attribute. Here’s the dollar and something near and dear to the hearts of anyone in Houston, the Alerian MLP index, with an astounding -94% correlation:

epsilon-theory-optical-illusion-optical-truth-may-4-2016-bloomberg-2

© Bloomberg Finance L.P., for illustrative purposes only

Interestingly, the correlation between the Alerian MLP index and oil is noticeably less at -88%. Hard to believe that MLP investors should be paying more attention to Bank of Japan press conferences than to gas field depletion schedules, but I gotta call ‘em like I see ‘em.

And here’s the dollar and EEM, the dominant emerging market ETF, with a -89% correlation:

epsilon-theory-optical-illusion-optical-truth-may-4-2016-bloomberg-3

© Bloomberg Finance L.P., for illustrative purposes only

There’s only one question that matters about Emerging Markets as an asset class, and it’s the subject of one of my first (and most popular) Epsilon Theory notes, “It Was Barzini All Along”: are Emerging Market growth rates a function of something (anything!) particular to Emerging Markets, or are they simply a derivative function of Developed Market central bank liquidity measures and monetary policy? Certainly this chart suggests a rather definitive answer to that question!

And finally, here’s the dollar and the US Manufacturing PMI survey of real-world corporate purchasing managers, probably the most respected measure of US manufacturing sector health. This data relationship clocks in at a -92% correlation. I mean … this is nuts.

epsilon-theory-optical-illusion-optical-truth-may-4-2016-bloomberg-4

© Bloomberg Finance L.P., for illustrative purposes only

Here’s what I wrote last summer about the inexorable spread of monetary policy contagion.

Monetary policy divergence manifests itself first in currencies, because currencies aren’t an asset class at all, but a political construction that represents and symbolizes monetary policy. Then the divergence manifests itself in those asset classes, like commodities, that have no internal dynamics or cash flows and are thus only slightly removed in their construction and meaning from however they’re priced in this currency or that. From there the divergence spreads like a cancer (or like a cure for cancer, depending on your perspective) into commodity-sensitive real-world companies and national economies. Eventually – and this is the Big Point – the divergence spreads into everything, everywhere.

I think this is still the only story that matters for markets.

The good Lord giveth and the good Lord taketh away. Right now the good Lord’s name is Janet Yellen, and she’s in a giving mood. It won’t last. It never does. But it does give us time to prepare our portfolios for a return to competitive monetary policy actions, and it gives us insight into what to look for as catalysts for that taketh away part of the equation.

epsilon-theory-optical-illusion-optical-truth-may-4-2016-cholera

Most importantly, though, I hope that this exercise in truth-seeking inoculates you from the Big Narrative Lie coming soon to a status quo media megaphone near you, that this resurgence in risk assets is caused by a resurgence in fundamental real-world economic factors. I know you want to believe this is true. I do, too! It’s unpleasant personally and bad for business in 2016 to accept the reality that we are mired in a policy-controlled market, just as it was unpleasant personally and bad for business in 1854 to accept the reality that cholera is transmitted through fecal contamination of drinking water. But when you SEE John Snow’s dot map of death you can’t ignore the Broad Street water pump smack-dab in the middle of disease outcomes. When you SEE a Bloomberg correlation map of prices you can’t ignore the trade-weighted broad dollar index smack-dab in the middle of market outcomes. Or at least you can’t ignore it completely. It took another 20 years and a lot more cholera deaths before Snow’s ideas were widely accepted. It took the development of a new intellectual foundation: germ theory. I figure it will take another 20 years and the further development of game theory before we get widespread acceptance of the ideas I’m talking about in Epsilon Theory. That’s okay. The bees can wait.

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The Placebo Effect

epsilon-theory-the-placebo-effect-april-20-2016-migraineBOTOX® is the only FDA-approved, preventive treatment that is injected by a doctor every 12 weeks for adults with Chronic Migraine (15 or more headache days a month, each lasting 4 hours or more). BOTOX® prevents up to 9 headache days a month (vs up to 7 for placebo). BOTOX® therapy is not approved for adults with migraine who have 14 or fewer headache days a month.

Allergan website, April 18, 2016

I’ve had four or five true migraines in my life, mostly from getting whacked on the head with something like a baseball or a sharp elbow in basketball, and I honestly can’t imagine how horrible it must be to suffer from chronic migraines, defined by the FDA as 15 or more migraines per month with headaches lasting at least four hours. So I was happy to see a TV ad saying that the FDA had approved Botox as an effective treatment for chronic migraines, preventing up to 9 headache-days per month. That’s huge!

But in the fast-talking coda for the ad, I heard something that made me do a double-take. Yes, Botox can knock out up to 9 headache-days per month. But a placebo injection is almost as good, preventing up to 7 headache-days per month.

Now 9 is better than 7 … I get that … and that’s why the FDA approved the drug as efficacious. Still. Really? Most of the reports I’ve read say that the cost of a Botox migraine treatment is about $600. That’s just the cost of the drug itself. So what the FDA is telling us is that a saline solution injection (costing what? $2) is almost 80% as effective as the $600 drug, so long as it was presented to the patient as a “true” potential therapy. If I’m an Allergan shareholder I’m thanking god every day for the placebo effect.

And not for nothing, but I’d really like to learn more about why Botox was NOT approved for migraine sufferers with fewer than 15 headache-days per month. If I were a gambling man (and I am), I’d be prepared to wager a significant amount of money that Botox significantly reduces headache-days at pretty much any level of chronic-ness, from 1 day to 30 days per month, but that at lower migraine frequencies a placebo is just as efficacious as Botox. In other words, I’d bet that ALL migraine sufferers would benefit from a $600 Botox shot, but I’d also bet that ALL migraine sufferers would benefit from a cheap saline shot so long as the doctor told them it was a brilliant new drug, and they’d get as much or MORE benefit from the cheap saline shot than from Botox if they’re “just” enduring eight or nine migraine headaches. Per month. Geez. Of course, there’s no economic incentive to provide the cheap placebo injection nor the unapproved (and hence unreimbursed) Botox shot if you have fewer than 15 headache-days per month. Bottomline: I’d bet that millions of people who don’t meet the 15 day threshold are suffering from terrible pain that could absolutely be alleviated at a very reasonable cost if it weren’t criminally unethical and (worse) terribly unprofitable to lie about the “truth” of a placebo treatment.

Of course, we have no such restrictions, ethical or otherwise, when it comes to monetary policy, and that’s the connection between investing and this little foray into the special hell that we call healthcare economics. The primary instruments of monetary policy in 2016 – words used to construct Common Knowledge and mold our behavior, words chosen for effect rather than truthfulness, words of “forward guidance” and “communication policy” – are placebos. Like a fake migraine therapy, the placebos of monetary policy are enormously effective because they act on the brain-regulated physiological phenomena of pain (placebos are essentially useless on non-brain-regulated phenomena like joint instability from a torn ligament or cellular chaos from cancer). Even in fundamentally-driven markets there’s a healthy balance between pain minimization and reward maximization. In a policy-driven market? The top three investing principles are pain avoidance, pain avoidance, and pain avoidance. We’re just looking to survive, not literally but in a brain-regulated emotional sense, and that leaves us wide open for the soothing power of placebos.

I get lots of comments from readers who don’t understand how markets can continue to levitate higher with anemic-at-best global growth, stretched valuation multiples, and an earnings recession in vast swaths of corporate America. This week I’m reading lots of comments post the failed Doha OPEC meeting that oil prices are doomed to see a $20 handle now that there’s no supply limitation agreement forthcoming. Yep, that’s the real world. And there’s zero monetary or fiscal policy in the works that has any direct beneficial impact on any of this.

But that’s not what matters. That’s not how the game is played. So long as the Fed and the ECB and the BOJ are playing nice with China by talking down the dollar regardless of what’s happening in the real world economy, then it’s an investable rally in all risk assets, and oil goes up more easily than it goes down, regardless of what happens with OPEC. The placebo effect of insanely accommodative forward guidance that has zero impact on the real economy is in full swing. Oil prices are driven by forward guidance and the dollar, not real world supply and demand. Every day that Yellen talks up global risks and talks down the dollar is another day of a pain-relieving injection, regardless of whether or not that talk is “real” therapy.

Does this mean that we’re off to the races in the market? Nope. The notion that we have a self-sustaining recovery in the global economy is laughable, and that’s what it will take to stimulate a new greed phase of a rip-roaring bull market. But by the same token I have no idea what makes this market go down, so long as we have monetary policy convergence rather than divergence, and so long as we have a Fed that loses its nerve and freaks out if the stock market goes down by more than 5%. So long as the words of a monetary policy truce hold strong, this isn’t a world that ends in fire and it isn’t a world that ends in ice. It’s the long gray slog of an Entropic Ending. Anyone else intrigued by the potential of a covered call strategy in this environment? I sure am.

But wait, Ben, isn’t a covered call strategy (where you’re selling call options on your long positions) the opposite of convexity? Haven’t you been saying that a portfolio should have more convexity – i.e. optionality, i.e. buying options rather than selling options – rather than less? Yes. Yes, I have. But optionality isn’t the same thing as owning options. In the same way that I want portfolio optionality that pays off in a fire scenario (a miracle happens and global growth + inflation surges forward) and portfolio optionality that pays off in an ice scenario (China drops a deflationary atom bomb by floating the yuan), so do I want portfolio optionality that pays off in a gray slog scenario. That’s where covered calls (and covered puts for short positions) come into play. It’s all part of applying the principles of minimax regret to portfolio construction, where we don’t try to assign probabilities and expected return projections to our holdings, but where we think in terms of risk tolerance and minimizing investment pain for any of the market scenarios that could develop in a politically fragmented world. It’s all part of having an intentional portfolio, where every exposure plays a defined role with maximum capital efficiency, as opposed to an accidental portfolio where we just slather on layer after layer of “quality” large cap stocks.

The Silver Age of the Central Banker gives me a headache. I bet it does you, too. Let’s take our relief where we can find it, placebo or no, but let’s not mistake forward guidance for a cure and let’s not forget that sometimes pretty words just aren’t enough. The truth is that the global trade pie is still shrinking and domestic politics are still anti-growth in both the US and Europe. Neither math nor human nature gives me much confidence that the currency truce can hold indefinitely, and I still think that every policy China has undertaken is exactly what I would do to prepare for floating (i.e. massively devaluing) the yuan. It’s at moments like this, though, that I remember the short seller’s creed: if you’re wrong on timing, you’re just wrong. I don’t know the timing of the bigger headaches to come, the ones that words and placebos won’t fix. What I do know, though, is that an investable rally in risk assets today gives us some breathing space to prepare our portfolios for the even more policy-controlled markets of the future. Let’s not waste this opportunity.

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My Passion is Puppetry

Campaign
Company
Launch Date
epsilon-theory-my-passion-is-puppetry-april-6-2016-progressive-insurance “Flo” Progressive Insurance 2008
epsilon-theory-my-passion-is-puppetry-april-6-2016-geico “Rhetorical Question”
“Happier Than A … ”
“Did You Know?”
“It’s What You Do”
GEICO 2009
2012
2013
2014
epsilon-theory-my-passion-is-puppetry-april-6-2016-allstate “Mayhem” Allstate 2010
epsilon-theory-my-passion-is-puppetry-april-6-2016-farmers “University of Farmers” Farmers Insurance 2010
epsilon-theory-my-passion-is-puppetry-april-6-2016-state-farm-jingle “Magic Jingle” State Farm 2011
2011
epsilon-theory-my-passion-is-puppetry-april-6-2016-esurance “That’s Not How It Works” Esurance 2014
epsilon-theory-my-passion-is-puppetry-april-6-2016-nationwide “Chicken Parm You Taste So Good” Nationwide 2014

We are supposedly living in the Golden Age of television. Maybe yes, maybe no (my view: every decade is a Golden Age of television!), but there’s no doubt that today we’re living in the Golden Age of insurance commercials. Sure, you had the GEICO gecko back in 1999 and the caveman in 2004, and the Aflac duck has been around almost as long, but it’s really the Flo campaign for Progressive Insurance in 2008 that marks a sea change in how financial risk products are marketed by property and casualty insurers. Today every major P&C carrier spends big bucks (about $7 billion per year in the aggregate) on these little theatrical gems.

This will strike some as a silly argument, but I don’t think it’s a coincidence that the modern focus on entertainment marketing for financial risk products began in the Great Recession and its aftermath. When the financial ground isn’t steady underneath your feet, fundamentals don’t matter nearly as much as a fresh narrative. Why? Because the fundamentals are scary. Because you don’t buy when you’re scared. So you need a new perspective from the puppet masters to get you to buy, a new “conversation”, to use Don Draper’s words of advertising wisdom from Mad Men. Maybe that’s describing the price quote process as a “name your price tool” if you’re Flo, and maybe that’s describing Lucky Strikes tobacco as “toasted!” if you’re Don Draper. Maybe that’s a chuckle at the Mayhem guy or the Hump Day Camel if you’re Allstate or GEICO. Maybe, since equity markets are no less a financial risk product than auto insurance, it’s the installation of a cargo cult around Ben Bernanke, Janet Yellen, and Mario Draghi, such that their occasional manifestations on a TV screen, no less common than the GEICO gecko, become objects of adoration and propitiation.

epsilon-theory-my-passion-is-puppetry-april-6-2016-bernanke epsilon-theory-my-passion-is-puppetry-april-6-2016-yellen epsilon-theory-my-passion-is-puppetry-april-6-2016-draghi

For P&C insurers, the payoff from their marketing effort is clear: dollars spent on advertising drive faster and more profitable premium growth than dollars spent on agents. For central bankers, the payoff from their marketing effort is equally clear. As the Great One himself, Ben Bernanke, said in his August 31, 2012 Jackson Hole speech: “It is probably not a coincidence that the sustained recovery in U.S. equity prices began in March 2009, shortly after the FOMC’s decision to greatly expand securities purchases.” Probably not a coincidence, indeed.

Here’s what this marketing success looks like, and here’s why you should care.

This is a chart of the S&P 500 index (green line) and the Deutsche Bank Quality index (white line) from February 2000 to the market lows of March 2009.

epsilon-theory-my-passion-is-puppetry-april-6-2016-bloomberg

Source: Bloomberg Finance L.P., as of 3/6/2009. For illustrative purposes only.

Now I chose this particular factor index (which I understand to be principally a measure of return on invested capital, such that it’s long stocks with a high ROIC, i.e. high quality, and short stocks with a low ROIC, all in a sector neutral/equal-weighted construction across a wide range of global stocks in order to isolate this factor) because Quality is the embedded bias of almost every stock-picker in the world. As stock-pickers, we are trained to look for quality management teams, quality earnings, quality cash flows, quality balance sheets, etc. The precise definition of quality will differ from person to person and process to process (Deutsche Bank is using return on invested capital as a rough proxy for all of these disparate conceptions of quality, which makes good sense to me), but virtually all stock-pickers believe, largely as an article of faith, that the stock price of a high quality company will outperform the stock price of a low quality company over time. And for the nine years shown on this chart, that faith was well-rewarded, with the Quality index up 78% and the S&P 500 down 51%, a stark difference, to be sure.

But now let’s look at what’s happened with these two indices over the last seven years.

epsilon-theory-my-passion-is-puppetry-april-6-2016-bloomberg-2

Source: Bloomberg Finance L.P., as of 3/28/2016. For illustrative purposes only.

The S&P 500 index has tripled (!) from the March 2009 bottom. The Deutsche Bank Quality index? It’s up a grand total of 10%. Over seven years. Why? Because the Fed couldn’t care less about promoting high quality companies and dissing low quality companies with its concerted marketing campaign — what Bernanke and Yellen call “communication policy”, the functional equivalent of advertising. The Fed couldn’t care less about promoting value or promoting growth or promoting any traditional factor that requires an investor judgment between this company and that company. No, the Fed wants to promote ALL financial assets, and their communication policies are intentionally designed to push and cajole us to pay up for financial risk in our investments, in EXACTLY the same way that a P&C insurance company’s communication policies are intentionally designed to push and cajole us to pay up for financial risk in our cars and homes. The Fed uses Janet Yellen and forward guidance; Nationwide uses Peyton Manning and a catchy jingle. From a game theory perspective it’s the same thing.

Where do the Fed’s policies most prominently insure against financial risk? In low quality stocks, of course. It’s precisely the companies with weak balance sheets and bumbling management teams and sketchy non-GAAP earnings that are more likely to be bailed out by the tsunami of liquidity and the most accommodating monetary policy of this or any other lifetime, because companies with fortress balance sheets and competent management teams and sterling earnings don’t need bailing out under any circumstances. It’s not just that a quality bias fails to be rewarded in a policy-driven market, it’s that a bias against quality does particularly well! The result is that any long-term expected return from quality stocks is muted at best and close to zero in the current policy regime. There is no “margin of safety” in quality-driven stock-picking today, so that it only takes one idiosyncratic stock-picking mistake to wipe out a year’s worth of otherwise solid research and returns.

So how has that stock-picking mutual fund worked out for you? Probably not so well. Here’s the 2015 S&P scorecard for actively managed US equity funds, showing the percentage of funds that failed to beat their benchmarks over the last 1, 5, and 10 year periods. I mean … these are just jaw-droppingly bad numbers. And they’d be even worse if you included survivorship bias.

% of US Equity Funds that FAILED to Beat Benchmark

1 Year 5 Years 10 Years
Large-Cap 66.1% 84.2% 82.1%
Mid-Cap 56.8% 76.7% 87.6%
Small-Cap 72.2% 90.1% 88.4%

Source: S&P Dow Jones Indices, “SPIVA US Scorecard Year-End 2015” as of 12/31/15. For illustrative purposes only.

Small wonder, then, that assets have fled actively managed stock funds over the past 10 years in favor of passively managed ETFs and indices. It’s a Hobson’s Choice for investors and advisors, where a choice between interesting but under-performing active funds and boring but safe passive funds is no choice at all from a business perspective. The mantra in IT for decades was that no one ever got fired for buying IBM; today, no financial advisor ever gets fired for buying an S&P 500 index fund.

But surely, Ben, this, too, shall pass. Surely at some point central banks will back away from their massive marketing campaign based on forward guidance and celebrity spokespeople. Surely as interest rates “normalize”, we will return to those halcyon days of yore, when stock-picking on quality actually mattered.

Sorry, but I don’t see it. The mistake that most market observers make is to think that if the Fed is talking about normalizing rates, then we must be moving towards normalized markets, i.e. non-policy-driven markets. That’s not it. To steal a line from the Esurance commercials, that’s not how any of this works. So long as we’re paying attention to the Missionary’s act of communication, whether that’s a Mario Draghi press conference or a Mayhem Guy TV commercial, then behaviorally-focused advertising — aka the Common Knowledge Game — works. Common Knowledge is created simply by paying attention to a Missionary. It really doesn’t matter what specific message the Missionary is actually communicating, so long as it holds our attention. It really doesn’t matter whether the Fed hikes rates four times this year or twice this year or not at all this year. I mean, of course it matters in terms of mortgage rates and bank profits and a whole host of factors in the real economy. But for the only question that matters for investors — what do I do with my money?nothing changes. Stock-picking still won’t work. Quality still won’t work. So long as we hang on every word, uttered or unuttered, by our monetary policy Missionaries, so long as we compel ourselves to pay attention to Monetary Policy Theatre, then we will still be at sea in a policy-driven market where our traditional landmarks are barely visible and highly suspect.

Here’s my metaphor for investors and central bankers today — the brilliant Cars.com commercial where a woman is stuck on a date with an incredibly creepy guy who declares that “my passion is puppetry” and proceeds to make out with a replica of the woman.

epsilon-theory-my-passion-is-puppetry-april-6-2016-cars-ad

What we have to do as investors is exactly what this woman has to do: get out of this date and distance ourselves from this guy as quickly as humanly possible. For some of us that means leaving the restaurant entirely, reducing or eliminating our exposure to public markets by going to cash or moving to private markets. For others of us that means changing tables and eating our meal as far away as we possibly can from Creepy Puppet Guy. So long as we stay in the restaurant of public markets there’s no way to eliminate our interaction with Creepy Puppet Guy entirely. No doubt he will try to follow us around from table to table. But we don’t have to engage with him directly. We don’t have participate in his insane conversation. No one is forcing you keep a TV in your office so that you can watch CNBC all day long!

Look … I understand the appeal of a good marketing campaign. I live for this stuff. And I understand that we all operate under business and personal imperatives to beat our public market benchmarks, whatever that means in whatever corner of the investing world we live in. But I also believe that much of our business and personal discomfort with public markets today is a self-inflicted wound, driven by our biological craving for Narrative and our social craving for comfortable conversations with others and ourselves, no matter how wrong-headed those conversations might be.

Case in point: if your conversation around actively managed stock-picking strategies — and this might be a conversation with managers, it might be a conversation with clients, it might be a conversation with an Investment Board, it might be a conversation with yourself — focuses on the strategy’s ability to deliver “alpha” in this puppeted market, then you’re having a losing conversation. You are, in effect, having a conversation with Creepy Puppet Guy.

There is a role for actively managed stock-picking strategies in a puppeted market, but it’s not to “beat” the market. It’s to survive this puppeted market by getting as close to a real fractional ownership of real assets and real cash flows as possible. It’s recognizing that owning indices and ETFs is owning a casino chip, a totally different thing from a fractional ownership share of a real world thing. Sure, I want my portfolio to have some casino chips, but I ALSO want to own quality real assets and quality real cash flows, regardless of the game that’s going on all around me in the casino.

Do ALL actively managed strategies or stock-picking strategies see markets through this lens, as an effort to forego the casino chip and purchase a fractional ownership in something real? Of course not. Nor am I using the term “stock-picking” literally, as in only equity strategies are part of this conversation. What I’m saying is that a conversation focused on quality real asset and quality real cash flow ownership is the right criterion for choosing between intentional security selection strategies, and that this is the right role for these strategies in a portfolio.

Render unto Caesar the things that are Caesar’s. If you want market returns, buy the market through passive indices and ETFs. If you want better than market returns … well, good luck with that. My advice is to look to private markets, where fundamental research and private information still matter. But there’s more to public markets than playing the returns game. There’s also the opportunity to exchange capital for an ownership share in a real world asset or cash flow. It’s the meaning that public markets originally had. It’s a beautiful thing. But you’ll never see it if you’re devoting all your attention to CNBC or Creepy Puppet Guy.

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Rewardless Risk

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

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

epsilon-theory-rewardless-risk-february-1-2016-lord-of-the-rings.jpg

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

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

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

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

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

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

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

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You Can Either Surf, or You Can Fight

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

– Apocalypse Now (1979)

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

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

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

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

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

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

/wp-content/uploads/epsilon-theory-you-can-either-surf-or-you-can-fight-january-14-2016-bloomberg.jpg

Source: Bloomberg, January 2016.

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

But wait, there’s more.

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

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

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

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

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

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

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Storm Warning

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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“Suddenly, Last Summer”

A quick Epsilon Theory email and a quick announcement. Announcement first. I’ll be giving a 1-hour webcast on Risk Premia strategies next Tuesday, August 4th, along with Salient President Jeremy Radcliffe and Salient Portfolio Manager Rob Croce, who knows more about the guts of these strategies than anyone should. The webcast qualifies for CE credit if you care about such things (and who doesn’t!) and is hosted by our friends at RIA Database. The catch … you have to be a professional investor / financial advisor to sign up. Sorry. For more information or to register for the webcast, check out: “Alternative Return Streams in Challenging Markets”

epsilon-theory-suddenly-last-summer-july-29-2015-suddenly

Dr. Cukrowicz: Mrs. Venable, loving your niece as you do, you must know there’s great risk in this operation. Whenever you enter the brain with a foreign object …
Mrs. Venable: Yes.
Dr. Cukrowicz: Even a needle thin knife.
Mrs. Venable: Yes.
Dr. Cukrowicz: In the hands of the most skilled surgeon …
Mrs. Venable: Yes, yes.
Dr. Cukrowicz: There is a great deal of risk.
Mrs. Venable: But it does pacify them. I’ve read that … it quiets them down. It suddenly makes them peaceful.
Dr. Cukrowicz: Yes, that it does do, but …
Mrs. Venable: But what?
Dr. Cukrowicz: Well, it will be years before we know if the immediate benefits of the operation are lasting or maybe just passing or perhaps … there’s a strong possibility that the patient will always be limited. Relieved of acute anxiety, yes, but limited.
Mrs. Venable: But what a blessing, Doctor, to be just peaceful. To be just suddenly peaceful. After all that horror. After those nightmares. Just to be able to lift up their eyes to a sky not black with savage devouring birds.

“Suddenly, Last Summer” (1959)

I figure not one Epsilon Theory reader in a thousand has seen “Suddenly, Last Summer”, but let me tell you … it’s got everything. Katherine Hepburn in a phenomenal performance as bizarro Aunt Vi. Elizabeth Taylor cavorting in the surf. Montgomery Clift. Lobotomies. Pedophilia. Cannibalism. Honestly, it’s kind of what you would expect if Gore Vidal took a Tennessee Williams script and just went gonzo with it. Which, in fact, is exactly what happened.
The subtext, as with so much of Southern Gothic in general and Tennessee Williams in particular, is mendacity and its crushing psychological damage. I found this quote, where Katherine Hepburn is trying to convince Montgomery Clift to lobotomize Elizabeth Taylor so that she’d forget her former life and be less fearful and anxious … less volatile, in other words … to be an eerily apt description of what Central Bankers have tried to do with markets.
We endured an event last summer that, just as in the movie, ultimately brings all the mendacity out of the shadows and into the open. When Yellen declared last summer that the Fed had now firmly embraced a tightening bias, followed by the rest of the world declaring that they were doubling down on extraordinary monetary policy easing, the entire world was set on a path where all of the political fragmentation – all of the deep fissures within and between countries – would be inexorably revealed. Suddenly last summer, the mask of global monetary policy cooperation was ripped away, and the investment world will never be the same.
epsilon-theory-suddenly-last-summer-july-29-2015-bloomberg

Here are two Bloomberg charts that show what I mean. On the top is a 5-year chart of DXY – the trade-weighted dollar index. On the bottom is a 5-year chart of WTI crude oil spot prices. Does this look like an accidental relationship to you? Can we just stop with all the hand-wringing about how there’s suddenly too much oil in the world, or how the Saudis are trying to crush US shale production, or any of the other spurious supply-and-demand “explanations” for why oil prices have collapsed? Seriously. Can we just stop?

Monetary policy divergence manifests itself first in currencies, because currencies aren’t an asset class at all, but a political construction that represents and symbolizes monetary policy. Then the divergence manifests itself in those asset classes, like commodities, that have no internal dynamics or cash flows and are thus only slightly removed in their construction and meaning from however they’re priced in this currency or that. From there the divergence spreads like a cancer (or like a cure for cancer, depending on your perspective) into commodity-sensitive real-world companies and national economies. Eventually – and this is the Big Point – the divergence spreads into everything, everywhere. Some things will go up, and some things will go down. But the days of ALL financial assets inflating in lock-step … the days of everything, everywhere going up together … that’s over.

For a lot of active investment managers, this is great news. For a lot of politicians and central bankers – particularly the weaker ones, either in resources or in willpower (yes, I’m looking at you, Alexis Tsipras) – this is terrible news. For investors? Well, it’s a mixed bag. Certainly it’s a more difficult bag, where so many of the learned behaviors of the past five years that worked so well in an environment of monetary policy coordination will fail miserably in an environment of monetary policy competition. But it beats getting a lobotomy. I think. We’ll see.

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The New TVA

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

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

epsilon-theory-the-new-tva-july-23-2015-constitutionepsilon-theory-the-new-tva-july-23-2015-jobs

epsilon-theory-the-new-tva-july-23-2015-new-yorkerThe New Yorker magazine’s cartoons of the plump, terrified Wall Streeter were accurate; business was terrified of the president. But the cartoons did not depict the consequences of that intimidation: that businesses decided to wait Roosevelt out, hold on to their cash, and invest in future years.

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

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

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

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

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

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

epsilon-theory-the-new-tva-july-23-2015-bicycles

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

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

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

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

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

epsilon-theory-the-new-tva-july-23-2015-mad-men

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

epsilon-theory-the-new-tva-july-23-2015-litteringThis dynamic of change in meaning is rare, but it takes place more often than you might think. Dueling and smoking are easy examples. Slavery is, too. Myths and legends turned into nursery rhymes and fairy tales is one of my favorite examples, as is compulsory public education … a concept that didn’t exist until the Prussian government invented it to generate politically indoctrinated soldiers who could read a training manual. Occasionally – and only when political systems undergo the existential stress of potential collapse – this dynamic of change impacts the meaning of the Market itself, and I think that’s exactly what’s taking place today. Through the magic of Narrative construction, capital markets are being transformed into political utilities. 

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

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

epsilon-theory-the-new-tva-july-23-2015-global-debtepsilon-theory-the-new-tva-july-23-2015-gdp

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Two Growth Announcements and One Not So Much

I’m with you in Rockland

where we are great writers on the same dreadful typewriter.

Allen Ginsberg, “Howl” (1956) 

Give me a long enough lever and a fulcrum on which to place it, and I will move the world.

Archimedes (287 – 212 BC) 

Play-offs?!? Don’t talk about…Play-offs?!? You kidding me? Play-offs?!?

Indianapolis Colts coach Jim Mora press conference, November 21, 2001

A brief note today about Fed “lift-off” following last Friday’s jobs report. As with so many announcements that are trumpeted with great fanfare in the Golden Age of the Central Banker, I think there’s less here than meets the eye. But before we get into that, I have two growth announcements that I think are, in fact, authentic indications of something interesting afoot.

First, Salient announced today that we closed our acquisition of Forward Management. With more than $6 billion under management, Forward is a big bite for Salient, and anyone who has been involved with a major transaction or integration knows that nothing about this stuff is easy. But it’s a risk worth taking. Why? Because there is a desperate investor need for smart, new twists on smart, old ideas … ideas like diversification, de-risking, and risk balancing. The combination of Salient and Forward engages the people and the ideas and the scale to set traditional asset management on its ear. And not a moment too soon!

Second, last Tuesday was Epsilon Theory’s second birthday. I launched this project in June 2013 with a manifesto emailed to 200 colleagues and friends. Today I am emailing this note to more than 24,000 colleagues and friends, and some multiple of that number will read the note through forwarding and the various websites that republish Epsilon Theory. My best guess is that on average a dozen people around the world are reading Epsilon Theory every second of every hour of every day.

I’m certainly no stranger to the deadly sin of pride, and any writer who tells you otherwise about his or her work is a liar. But in my more self-aware moments I try to step back and figure out what this audience growth means. It strikes me that Google made a pretty good business out of the realization that engagement, i.e. time + attention, is the most important metric in the content world, and that’s the lesson I’ve tried to take to heart. What’s most distinctive about Epsilon Theory is not the size of the audience, but the engagement of the audience, the willingness of tens of thousands of smart, successful people to invest their most valuable resource – their time – to wrestle with the ideas I’m writing about.

Because here’s the thing. The ideas I’m writing about in Epsilon Theory are not novel or new. They are good, old ideas that have been submerged by the status quo institutions that dominate our investment world. Those institutions aren’t just the mega-banks and the mega-asset managers and the mega-rich (yes, Piketty has a point, and if you don’t see this you’re just not paying attention), but are also the mega-political parties, the mega-media conglomerates, and the mega-academic complex (that last category includes all modern central banks, of course). It’s a mega-world we live in today, where virtually every signal bombarding us has been intentionally constructed to further the interests of the mega-institutions, even those signals – no, scratch that – especially those signals which purport to communicate accurate information about our social world and our role within that world.

If you’re reading Epsilon Theory, you already know this.

Maybe you haven’t said it out loud. Maybe you work for one of the mega-institutions and can only mumble the knowledge in careless moments. Maybe it’s something you’ve been feeling in your gut for a long time and haven’t had the words to express. But you know it all the same.

Or to put it another way, Epsilon Theory was there waaaaay before I started writing it. What’s most meaningful here is the self-identification of a critical mass of smart, successful people who are committed to finding their way in a world that they know is playing them false. They go along with the mega-institutions because they are, in fact, smart, successful people, but they haven’t taken the Party line into their hearts. When I started writing Epsilon Theory I thought that the mega-institutions had won. Now I know that they’re not even close. And that’s the most powerfully uplifting statement I could ever write.

This is why I make such a big deal about giving updates on Salient and Epsilon Theory growth. It’s not (only) to indulge my ego. It’s to spread the word that the mega-institutions are NOT winning, that we are NOT alone or isolated in our knowing, subterranean resistance to The Powers That Be.

Okay, Ben, enough mirror-gazing. Back to planet Earth for a brief comment on last Friday’s job report and what it means (or doesn’t mean) for investors.

First, I want to call attention to every Fed watcher’s favorite word these days: “lift-off”. As if the Fed’s first rate increase, whenever that comes to pass, is the ignition of some giant Saturn V rocket that will inexorably carry interest rates up, up, and away. Please. This is Narrative creation … really, Narrative abuse … of the first order. The next time you read or hear someone use the word “lift-off”, I’m begging you to remember Jim Mora’s classic press conference when he was asked about the Colts’ chances of making the play-offs, because it’s a dead ringer for what Janet Yellen is saying in her heart of hearts.

You think Yellen is thinking ahead to a rates lift-off? Really? The reputational risk and future payday risk associated with this first rate increase is astronomical for Yellen, much less a series of rate increases. Yes, wage inflation is slowly staggering up off the floor after being knocked unconscious for the past five years. Yes, it would be nice if the Fed were not scared to death of spooking the bond market (thank you, Captain Obvious … err, I mean former Fed governor and current BlueMountain millionaire Jeremy Stein). But the notion that we’re either off to the races in the real economy or that Yellen woke up on Monday with a political and personal deathwish to tell off the bond market is just ludicrous.

The Fed wants to raise short rates to put some bullets back in the exhausted gun of ordinary monetary policy, and that gives a totally different meaning to the notion of a rate increase today than in, say, 1994. Since when was the Fed concerned about getting in front of – gasp! – 2.3% wage inflation? No, the Fed wants to reload with conventional ammo before the next external shock or the next inventory-led slowdown, which is all smart and good and thoughtful, but they’re being forced to reload while the battle is still raging. That creates a very different decision-making and implementation path for rate increases than any historical corollary of the past 60 years, which means that any investment conclusion based on those historical corollaries is almost certainly a category error, the worst possible methodological mistake you can make. Sorry, but my crystal ball is still broken, and I think yours is, too.

Second, I want to call attention to the crucial distinction in logic (and gambling) between probabilities and odds. Will the Fed raise interest rates one day? Sure. There is a 99.999% probability that this event will occur over a long enough time period, in exactly the same way there is a 99.999% probability that a Triple Crown winner will materialize over a long enough time period. Is it profitable to attempt to predict when that day will materialize? No. The payoff odds associated with any specific meeting being THE meeting of the Fed rate increase will inevitably be poor, in exactly the same way the Belmont Stakes betting odds on American Pharoah (it kills me to misspell this word) and every other Triple Crown candidate over the past 35 years were poor. Why? Because when human beings pay great attention to any probabilistic event, they ALWAYS over-estimate the likelihood of that event occurring. This is one of the strongest findings in all of behavioral economics, and it runs rampant at both the track and the stock market. Over-estimated probabilities mean bad odds. To wit: just because American Pharoah won the Belmont stakes, and if you bet on him to win you were absolutely right, that doesn’t mean it was smart to make a bet at 3:5 odds.

I’ve got a lot more to say on the issue of investor attention, as it’s one of the most interesting areas of modern academic research on markets, but for now I’ll leave you with this. We will never know the approximately “true” probability of American Pharoah winning the Belmont stakes, because we can’t repeat the experiment a dozen or so times. What we know with near certainty, however, is that the expressed odds of 3:5 for the single experiment were worse than whatever the true probability might have been. What we also know with near certainty is that pundits LOVE infrequent probabilistic exercises like Fed meetings or Triple Crown races, and their attention magnifies investor attention in a profoundly unhealthy way. Why do pundits swarm like flies around these events? Because they are tautological exercises – without a repeated experiment, you can NEVER be proven wrong in your pre-race or pre-meeting assessment of probabilities – and that’s a great business model for them. Of course, that means it’s a terribly weak signaling model for you. My view: once you hear more than a handful of Missionaries arguing about any sort of well-publicized probabilistic event, whether it’s a horse race or an election or a Fed meeting or a jobs report or whatever, it’s un-investable. Run away. Far better to adapt to whatever the outcome turns out to be as part of a prepared strategy than to fling yourself from pillar to post in an attempt to anticipate an overly-examined, poorly-estimated, totally-gamed event. That’s not the sexy way to invest. It’s not the heroic way to invest. But if there’s one Epsilon Theory lesson that I never get tired of repeating, the Golden Age of the Central Banker is a time for investment survivors, not investment heroes.

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Why Take a Chance?

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

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

— “Casino” (1995)

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

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

— “Casino” (1995)

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

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

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

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

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

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

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

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

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

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

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7 Quick Points on Europe

#1) Here are the most relevant recent notes for an Epsilon Theory perspective on the underlying political and market risks in Europe: “The Red King” (July 14, 2014) and “Now There’s Something You Don’t See Every Day, Chauncey” (Dec. 16, 2014).

#2) Markets reacted positively to last Thursday’s announcement because Draghi doubled the amount of QE that he leaked to the press on Wednesday. Financial media pegged QE at 600 billion euros on Wednesday and 1.2 trillion euros on Thursday. Once again, Draghi played the Narrative game like a maestro.

#3) This is NOT open-ended QE. Sorry, but the Narrative game doesn’t work like this. If you mention a target date (September 2016), then that becomes the Schelling focal point, no matter how much you try to walk that back by saying it’s open-ended.

#4) Risk-sharing, or the lack thereof, matters. Draghi won approval of a doubled QE target by minimizing the mutualization of QE risk among EU countries. 80% of the bond-buying will be done by national central banks, and Germany will only buy German government bonds, France will only buy French bonds, etc. That’s important for two reasons. First, if Italy or Spain goes off the rails, then the Bundesbank’s balance sheet isn’t immediately crippled. Second, this is why German bonds are rallying just as hard (harder, really) than periphery bonds. It’s also why US bonds are rallying so hard, because you can’t maintain a huge spread between the only risk-free rates left in the world.

#5) Market complacency on Greece is a mistake. Not because Greece itself is a huge systemic threat, but because the same political dynamics in Greece are coming soon to Italy. Greece is Bear Stearns. Italy is Lehman.

#6) In tail-risk trades as in comedy, timing is everything. Even if you think that it’s an attractively asymmetric risk/reward profile to bet on a Euro crisis (and I do), this is a heavily negative carry trade. If you don’t know what the phrase “negative carry trade” means, then please don’t make this bet. If you do know what it means, then you know that you either have to play a lot of hands to make the odds work out for you (and the nature of systemic crises makes that impossible) or you have to be spot-on with your timing.

#7) In a fundamentals-driven market you need to look at fund flows; in a Narrative-driven market you need to look at Narrative flows. With Draghi’s announcement last Thursday, there is no longer a marginal provider of market-supportive monetary policy Narrative. Or to put this in game theoretic terms, the 2nd derivative of the Narrative of Central Bank Omnipotence just flipped negative. We’ve shifted from an accelerating Narrative flow to a decelerating Narrative flow, and that inflection point in profoundly important in game-playing. The long grey slide of the Entropic Ending begins.

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Catch – 22

epsilon-theory-catch-22-january-12-2015-catch-22

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

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

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

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

epsilon-theory-catch-22-january-12-2015-bohrA visitor to Niels Bohr’s country cottage, noticing a horseshoe hanging on the wall, teased the eminent scientist about this ancient superstition. “Can it be true that you, of all people, believe it will bring you luck?”

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

― Niels Bohr (1885 – 1962)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

epsilon-theory-catch-22-january-12-2015-eye

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

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

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

epsilon-theory-catch-22-january-12-2015-coyote

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

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

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

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

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

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

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We Now Return to Our Regularly Scheduled Programming

epsilon-theory-we-now-return-to-our-regularly-scheduled-programming-december-5-2014-stand-byHilsenrath Analysis: Friday’s Jobs Report Assures Global Central Banks Going in Two Directions ― Wall Street Journal, December 5th, 9:59a ET

Earlier today I tweeted that “I should write a note on Draghi today, but after 2.5 yrs of reviewing the same song and dance I’d rather put out my eye with a rusty spoon.” I feel the same way about writing a note on Jon Hilsenrath’s Missionary statements on monetary policy, but the potential ramifications of today’s jobs report and how the Narrative is being shaped around that report are just too important – particularly for the price of oil and the energy complex – to leave it alone. Over the past two weeks I’ve tried to provide an Epsilon Theory perspective on both the price of oil (“The Unbearable Over-Determination of Oil”) and the signaling role of the price of oil on energy stocks (“Signs and Portents”), and here’s the skinny: so long as the dominant Narrative around oil prices is based on global supply/demand fundamentals – even if those fundamentals are somewhat negative – that is far more constructive for oil prices and energy stocks than if the dominant Narrative around oil prices is based on monetary policy. When Saudi Arabia said, “we’re happy with oil in the 60’s”, here’s what value investors heard: “we’re not happy with oil in the 50’s”. So long as there is a perception of a floor … so long as value investors do not fear catching a free-falling knife … they will buy stuff that looks cheap. That’s what value investors DO.

The dominance of the OPEC meeting-inspired supply/demand Narrative is, I fear, short-lived, as we appear today to be returning to the regularly scheduled programming of all central banks, all the time. The dollar is starkly higher today, as the yen and euro plumb new depths. That’s on the back of the much stronger than expected jobs report today, which – as Fed amanuensis Hilsenrath “reports” – means that the Fed will be still more resolute in tightening even as the BOJ and ECB double-down on extraordinary liquidity operations. Oil is down a bit … less than I’d expect from a currency move of this magnitude … which I think is indicative that the fundamentals-driven Narrative still narrowly holds sway. How narrow? Can’t tell yet. I’ll be watching Narrative development closely next week, but there’s a non-trivial chance that the monetary policy “explanation” for oil prices will resume its pole position, and that’s problematic for the energy sector. Sorry, but I gotta call ‘em like I see ‘em.

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Hey Spike

epsilon-theory-hey-spike-october-9-2014-dogs

The strong do what they can, while the weak suffer what they must.

— Thucydides, “The History of the Peloponnesian War” (395 BC)

Global growth is really bad! Hooray!

That was the verdict of US markets yesterday, as the Fed minutes “revealed” (to use the breathless phrasing of mainstream financial media) a “growing concern” with the damaging impact of European torpor and a stronger dollar on US growth, and it’s a perfect example of why I’ve called a top in the Narrative of Central Bank Omnipotence. Not a top in market price levels (although I’m increasingly thinking that, too), but a top in market faith that price levels are completely determined by central bank policy. This is an observation that I’ve discussed at length (and perhaps ad nauseam) in recent Epsilon Theory notes like “The Ministry of Markets” and “Fear and Loathing on the Marketing Trail”, so I won’t belabor that again here.

What’s interesting to me is not this latest success of the Narrative of Fed Omnipotence. No, what’s interesting to me is this week’s failure of the Narrative of ECB Omnipotence. The Fed minutes totally bailed the market out today and (truly) revealed the Fed as the only central bank with the Common Knowledge firepower to withstand a serious growth scare. The ECB, on the other hand, has lost an enormous amount of Narrative mojo over the past week. The perception of Mario Draghi has clearly shifted from Super-Mario, willing and able to do “whatever it takes”, to what we would call in Texas “all hat and no cattle”.

Is this fair? Is this reflective of fundamental reality? No, of course not, but since when did that matter? Draghi didn’t change. Germany’s position didn’t change. Miserable European growth rates didn’t change. What changed is the direction of US monetary policy. Draghi’s beautiful words work wonders when he’s standing behind the 600-lb gorilla of the US Fed. But when that gorilla begins to stumble off along a different jungle path, as we’ve seen over the past few months … well, that’s an enormous challenge even for as skilled a Missionary as Mario Draghi. Toss in a few well-timed slashes from a master bureaucratic knife-fighter like Jens Weidmann, some disappointing macroeconomic news, and all of a sudden you’ve got a crisis in confidence with European markets.

I’m reminded of the distinction in political regime theory between “sensitivity” and “vulnerability”. Sensitivity reflects the forcefulness with which external events impact a country or institution within a given regime. Vulnerability reflects the cost of changing that regime. So, for example, while both the US and Japan would be quite sensitive to a supply shock in the price of oil from a Middle Eastern blow-up, Japan would be far more vulnerable than the US if that temporary shock became a permanent change in the oil supply picture. Because the US has more domestic energy alternatives, the long-term cost of adapting to a new and different energy world would be much greater for Japan than the US. Similarly, while both the Fed and the ECB are sensitive to growth shocks, the ECB is far more vulnerableto a world of secular growth stagnation. And the market smells that vulnerability like stink on a wet dog.

I’ll have more to say about sensitivity and vulnerability in future notes, because I think it’s a valuable concept for asset allocation and risk management. Beta and volatility are measures of sensitivity, not vulnerability, but they dominate our econometric risk measurement techniques. We need a measure of portfolio vulnerability (and this is not at all the same thing as tail risk), and I think it lives in the epsilonterm.

Today, though, the Epsilon Theory point is that we’re seeing the first unexpected ramification of a divergence in global monetary policy – the ECB is revealed as the yappy little Chester to the Fed’s bulldog Spike. Now in the cartoons there’s always a large enough scare to turn big bad Spike into a quivering mess, and that may well turn out to be the case as the global growth boogieman continues to grow in scale and scope, particularly if it spreads into the political sphere. But for now markets are still fervent believers in Fed Omnipotence, even as faith in the ECB is starting to crumble. I’m a seller of both Narratives.

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