The Acrobat and the Fly

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

— U2, Achtung Baby, “Acrobat” (1991)

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

— U2, Achtung Baby, “The Fly” (1991)


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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

You’re not Paul McCartney.

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

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

Being a Hypocrite Doesn’t Make You Wrong

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

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

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

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

Here he is in 2003 on derivatives:

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

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

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

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

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

Letting Ourselves Off the Hook

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

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

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

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

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


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

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


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

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

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

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This Is Why We Can’t Have Nice Things

Here’s the most powerful animal on our farm — a deer tick, well embedded, gorging itself on human blood.

Of course, it’s not the tick itself that is so powerful, but the Lyme disease it can transmit, caused by a spirochete bacterium named Borrellia burgdorferi, pictured below. As you probably know, Lyme is a terrible disease, difficult to diagnose and difficult to treat once established. Once transferred via tick saliva, the wormlike burgdorferi bacteria quickly spread throughout the human host, particularly into joints, the heart and the brain. From there, the bacteria cause symptoms including intense arthritic pain, palsy and paralysis, loss of memory and extreme fatigue. Our immune systems typically fail to create the necessary antibodies to fight the infection, due to both the antibody-suppressing qualities of tick saliva and the antibody-hiding qualities of burgdorferi. And in a process still not entirely clear but suspected to be connected to an autoimmune failure spurred by burgdorferi, these crippling symptoms can persist for years, even after all of the bacteria have been killed through aggressive therapy. This is a potent parasite, and if you’ve lived for any length of time in Connecticut, you surely know at least one family that has been hit hard by a tick-borne disease.

But Lyme disease isn’t the reason that the deer tick is the most powerful animal on our farm.

No, it’s not Lyme disease. It’s Lyme disease!.

Huh?

Lyme disease is a physiological ailment caused by bacteria and injected into your body by ticks.

Lyme disease! is a mental ailment caused by words and injected into your mind by humans.

Lyme disease! is the IDEA of Lyme disease. It’s the mental construction of a world where Lyme disease and the bloodthirsty deer ticks and the grotesque burgdorferi bacteria are EVERYWHERE, an omnipresent threat to you and your children. Lyme disease! is an infectious meme, in the true and powerful meaning of the word, not the ha-ha cartoonized meaning that we see every day on social media. Memes are self-sustaining ideas that live in the human brain. They are as alive as any bacteria or virus, and they infect every aspect of our social lives.

What do I mean? I mean that families infected with the meme of Lyme disease! don’t allow their children to hike or play in our woods. I mean that the meme-infected next door neighbors have spent hundreds of thousands of dollars to wall off — literally wall off, including river barriers — their 20+ acres from all animal life that can’t fly. I mean that we have been sued — literally sued — by meme-infected parents who thought their child might have “caught rabies” (not Lyme, but close enough) from petting our dog some hours after the dog found a dead raccoon. No, I’m not making this up. And just wait. I can promise you that I’ll get “well, actually” emails from meme-infected readers of this note.

What we have in the wilds of Fairfield County, Connecticut (and I suspect in every exurb in the country), is a large population of wealthy people who for a variety of reasons want to live closer to nature, but are scared to death of nature! … the memes that infect our brains about the risky parts of nature, memes like Lyme disease! or rabies! or coyotes!. It’s not that these aren’t actual dangers. Lyme disease is a real thing and a real risk. So is rabies. So are coyotes. But our social lives aren’t governed by the actual risks of the real-life things. They’re governed by the memes. They’re governed by the metagames.

I wrote about this from the perspective of the real-life thing in Too Clever By Half, where I described why the coyotes in our woods always lose the metagame. They win every direct interaction with us tame humans because they’re smarter and braver than we are. But they lose in the larger metagame because the townfolk have access to armed animal control officers who are required — begrudgingly and remorsefully — to kill the real-life coyotes when the coyote! meme infects enough civilians. The lesson for all coyotes, four-legged and two-legged alike, is pretty simple. Don’t trigger the townfolk. Yes, you’re smarter and braver than they are. You can win the immediate game. But you will always lose the metagame if you’re too visible in your “winning”. Always.

There’s a larger perspective here, too, and a larger lesson. It’s the perspective of all of us. The meme-infected. Like me. Like you.

In my eight years on the farm, where I spend a lot of time clearing brush and cavorting around tick-rich environments, I’ve been treated for Lyme disease twice. Both times I had an attached tick, so I pulled it off and went to the doctor. Both times the doctor didn’t even bother testing me for Lyme, but just started me on antibiotics, because you can knock Lyme out if you treat it early enough. Maybe I had Lyme and maybe I didn’t. We’ll never know.

In the immortal words of Remo Gaggi when he and his fellow mob bosses of Casino decided to whack a loyal lieutenant who had the misfortune to have a slight opportunity to rat them out, “Why take a chance?”

Look, I get it. There is zero upside for the doctor to make a measured calculation of the actual risk of Lyme disease. There’s zero upside because the doctor knows that as bad and prevalent as Lyme disease might be, Lyme disease! is even worse and more prevalent. THAT’S the disease that the doctor was treating when she prescribed the antibiotics — Lyme disease!, not Lyme disease. Because she knew that even if the correct and rational treatment for Lyme disease was to do nothing or carry out some more tests, the absolutely correct and rational treatment for Lyme disease! was an immediate course of broad-spectrum antibiotics. It’s a no-brainer. There’s no doctor in the world who can stay in business for long if she doesn’t recognize the memes that infect her patients, who doesn’t nod understandingly and overprescribe when a mother wrings her hands over her child’s “exposure” to this dread disease! or that dread disease!, regardless of the disease truth. This is the metagame of modern health care.

Ditto with financial advisors.

You’re not going to stay in business for long if you don’t recognize the memes that infect your clients, memes like the fundamentals are sound! and we’re cautiously optimistic! and stocks for the long haul! and value! and bet on America!, all of which are most effectively treated with a profound over-allocation to U.S. equities under any and all circumstances. It’s not that these aren’t true and real things. They are absolutely true and real, just like Lyme disease is absolutely a true and real thing. But the true and real thing isn’t what drives our behavior. It’s the meme! that does that. There is zero upside for a financial advisor to make a measured calculation of the actual portfolio risk of a client’s under-exposure to U.S. large-cap stocks, because the actual portfolio risk isn’t the driving risk! that the client is infected with. So all financial advisors overprescribe U.S. large-cap stocks for their clients. We all know it’s true. We don’t like it, just like no doctor likes overprescribing antibiotics, but we do it anyway.

As Hyman Roth said to Michael Corleone, this is the business we have chosen. This is the metagame of modern investment management.

But like I say, it’s bigger than that.

Five years ago, I started Epsilon Theory to talk about capital markets, and it will always be a core part of what makes me tick and what I choose to write about. But as important as it is to recognize and call out the memes that infect our markets, it’s even more important to recognize and call out the memes that infect our politics. And the human ticks who spread them. That effort starts today.

A preliminary observation before we get to the stuff that will annoy a lot of readers … everyone I’ve ever known, including me, comes at the question of memes and their influence on our decision-making from a very simple starting point — yes, they’re effective on other people, but not on me. I am smart enough and independent enough to be effectively immune from a meme infection.

No, you’re not.

If you get nothing else from Epsilon Theory, get this: we are ALL hard-wired — literally hard-wired through millions of years of neurological evolution — to respond positively to effective meme introduction. We are ALL programmed — literally programmed through tens of thousands of years of cultural evolution — to respond positively to effective meme introduction. It’s no exaggeration to say that our biological and cultural symbiosis with memes defines the modern human species. This is a feature, not a bug.

Eusocial animals (the “pure” form of what it means to be a social animal) swim in an ocean of constant intra-species communications. It’s why these species — the ant, the termite, the bee, and the human — are the most successful multicellular animal species on the planet. Eusocial animals have the ability to store, retrieve and broadcast information (yes, eusocial insects communally “remember” incredibly complex informational structures) in a way that non-eusocial animals simply can’t, and it allows the eusocial animal not only to survive its environment, but to master its environment. Any environment. Humans are essentially giant termites with opposable thumbs and fire, and that combination is particularly unstoppable. But it’s the termite-ness … it’s the swimming in an ocean of constant intra-species communication … that’s the most important of these qualities.

The downside, of course, is that we can no more resist the language of Hero! and Wizard! and Enemy! than an ant can resist the pheromones of its queen. These are the Old Stories and the New Stories alike. Memes are our greatest strength as a species. And our greatest weakness as individuals.

Memes are the stuff that Narratives are made of.

Fortunately, the human animal is a self-aware animal. For the most part. Kinda sorta. At least we have the ability to perceive our infection. Through a glass darkly, as the Old Stories would put it.

Self-awareness doesn’t mean some magical immunity to being influenced and played by the other players. On the contrary, if you think that you are immune to all this, well that’s prima facie evidence that you are not self-aware at all. That’s prima facie evidence that you are, in fact, the sucker in this big poker game of citizenship. No, self-awareness means a recognition that you ARE being influenced and played by the other players, so that you can use that knowledge of HOW you are being influenced and played to maintain YOUR personal liberty of mind and play YOUR best game.

We can’t change our nature as meme-susceptible human animals, but we can absolutely become better human animals, both instrumentally as game players and ultimately as citizens. We can absolutely NOT be suckers. We can absolutely NOT lose our liberty of mind — which is the only liberty that really matters — to the incessant meme-generation of the Nudging State and the Nudging Oligarchy.

So how do we avoid being the sucker within this largely invisible poker game of memes and narratives that we are immersed in from birth, a poker game that we are biologically and culturally evolved to play rather poorly?

First and most importantly, we can simply recognize that there is a logic and a process to meme introduction and contagion in the human animal. Here in Epsilon Theory I like to focus on one powerful contagion vector — the Common Knowledge Game — but there are many others. Like all of the invisible forces that drive our lives, once you start looking for embedded memes and the logic that drives them, you will see them EVERYWHERE.

Second, we can use the new tools of AI and Natural Language Processing (NLP) to visualize the meme introduction and contagion process. This is what I’ve called the Narrative Machine, and it’s as useful for understanding the behavioral drivers of politics as it is for understanding the behavioral drivers of markets. Why is visualization so important? Because it taps directly into the way our brains are hard-wired. Seeing is, in fact, believing, and by showing you visual evidence of political meme introduction and contagion, you will be far more likely to accept the worth of my broader argument. It’s why data visualization is such an important topic, and it’s why Ed Tufte is a personal hero of mine. [Optical Illusion / Optical Truth]

More generally, NLP can help visualize what I described as the “cartoonification” of political candidates and political issues. From The Icarus Moment:

Cartoons aren’t just created to mobilize positive sentiment and supportive social behaviors (although that’s pretty much all we see in capital markets, because it’s a positive-sum game, not zero-sum like politics). The negative cartoonification of Hillary Clinton was both the most vicious and the most effective gambit in the last 100 years of American politics. To be sure, The Clintons™ brought soooo much of this on themselves. If there’s ever been a political candidate more ripe to be transformed into a negative cartoon than Hillary Clinton, I am unaware of who that might be. But where Donald Trump embraces and actively creates his obvious cartoonishness, Hillary Clinton had her cartoon imposed on her unwillingly, to disastrous result. Today’s key to political and economic success is controlling your own cartoon. Yes, this is why Trump won.

So what does the Narrative Machine show us about meme construction and contagion in the last U.S. presidential election campaign?

Here’s an NLP analysis of 124,000 articles on Hillary Clinton published in non-paywalled top-tier U.S. media over the year prior to the presidential election — where linguistic similarities create clusters of articles with similar meaning, essentially a linguistic “gravity model” (for methodology background on all this, see The Narrative Machine).

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

It’s a dense narrative map because of the quantity of articles, but we can simplify the analysis by re-coloring the clusters by sentiment, and then isolating the negative attack memes.

Here’s the sentiment map. 20% of the articles are negative, including lots of negative articles in non-attack memes like Primaries! and Supreme Court!, 45% are neutral, and 34% are positive. Hold that thought.

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

And here’s the re-spun narrative map after isolating the negative attack memes:

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

Beyond the frequency of articles associated with this or that meme (Emails! clearly dominating on that dimension, with 42% of all negative meme articles published), there are three critical dimensions in an interpretation of a narrative network: geometry, time dynamics, and affect. The map above gives us our geometry, and I’ve found a scatterplot (below) to be the best visual representation of time dynamics and affect. Between the two graphs a fascinating meme contagion pattern emerges.

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

First, geometry. There’s no real information in the north/east/south/west orientation of a narrative map, but there is significant information in distance, center/periphery orientation, and inter-cluster links, all of which can be understood with a simple gravity metaphor. The greater the distance between meme clusters, the less similarity in vocabulary and grammar employed in the individual articles that comprise the clusters (less gravitational attraction between the clusters). The more central the meme cluster to the overall network, the more coherence it provides to the overall narrative (a gravitational pull exerted in all directions). The more inter-cluster links (the long strands that connect one cluster to another), the more articles that explicitly have one foot in each camp, visualizing the gravitational tethers.

What we have in the Hillary meme network is a clear outlier in the Benghazi! cluster, as well as a clear super-cluster comprised of Wall Street!, Clinton Foundation! and Emails!, with Wall Street! and Clinton Foundation! being more central to the overall Hillary cartoon-ification, despite the far greater frequency of Emails! articles. The way to think about the peripheral nature of Benghazi! and Emails!, I think, is that these memes didn’t “take” in the same immediate and easy way that Wall Street! and Clinton Foundation! “took”. To use the deer tick metaphor, whatever ticks were trying to inject the Benghazi! meme never really got fully embedded in the body politic, while the Wall Street! and Clinton Foundation! ticks gorged easily to their little tick-hearts’ content. What’s really interesting, though, is the Emails! meme. Whatever the Emails! delivery ticks lacked in embeddedness, they more than made up for it in effort.

That’s my takeaway from the scatterplot representation of time dynamics and affect, where the green dots (sub-clusters of Emails! articles) are high in affect (the x-axis, representing the strength of “emotion” in article word choice, mostly negative, but some positive, too) and almost constant in duration (the y-axis, representing time). That second phenomenon — the degree to which there was an almost constant drumbeat of Emails! articles over the course of the campaign — is particularly rare and unusual.

Here’s what a typical meme infection looks like, as shown in a histogram for Clinton Foundation!. The meme percolates in the background for a while, explodes in an outbreak of virulence and Sunday talk show segments, and then dies back down again just as quickly.

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

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

Emails!, on the other hand, had multiple outbreaks and never died down. Sure, it got crowded out by other memes here and there, as the sum-to-100% histogram above shows, but I can’t tell you how unusual it is that a meme like Emails! persisted in such a virulent form for an entire year.

In the overall narrative network, not just the negative meme creation stuff, but the entire universe of media coverage, 6% of EVERYTHING written about Hillary Clinton for a YEAR was about Emails!.

This is nuts. It’s not an accident.

And please, I’m begging you, don’t send me a “Well, actually” note yelling at me about how Hillary Clinton’s handling of her email servers was a ridiculous, mendacious and probably illegal thing, that it was, in fact, a big deal.

I AGREE.

The Emails issue was a real and true thing, just like Lyme Disease is a real and true thing.

But you are the sucker at the poker table if you don’t recognize the incommensurability between the real and true Emails issue and the Emails! meme, if you don’t recognize how YOUR political behavior and YOUR liberty of mind was impacted by Emails! in a way that Emails could never achieve.

Mine certainly was. I was so righteously aggrieved by Emails!, thinking all along it was Emails. Emails! angered me for months. It made a difference to me. And then I did this analysis and saw how the meme was constructed and promoted. I saw how I had been played. If I knew then what I know now, would it have made a difference in my NeverTrump + NeverHillary position? No. But I’m not going to let it happen again. I’m going to do everything I can to protect my liberty of mind.

And in the spirit of in-for-a-penny-in-for-a-pound, here’s another sure-fire aggravating observation on the meme construction process around the most recent U.S. presidential election, this time from the Trump narrative map.

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

Above are all the different meme clusters associated with Trump for the year prior to the election, all from top-tier U.S. media, colored by sentiment. Lots of incendiary memes in there, right? But here’s the thing. First, the overall narrative network is comprised of 167,000 articles, about 35% more coverage than Clinton received. Second, of that coverage, only 15% of the articles are negative, with 50% neutral and 34% positive. Third, of the negative memes, none had a persistence pattern like Emails!. They all spiked and faded like Clinton Foundation!.

Trump got significantly more coverage than Clinton in major media outlets.

Trump got significantly more positive coverage than Clinton in major media outlets.

Trump suffered from no infectious meme like Clinton suffered from Emails! in major media outlets.

I’m not saying whether all this is good or bad. I’m just saying that it IS. And what it isn’t.

This isn’t a Russia thing.

This isn’t a Facebook thing.

This is a mainstream media thing. A mainstream media thing comprised of people who, for the most part, would rather rip out one of their own fingernails with red-hot pincers than help Trump, but who, driven by the systemic pressures of their business and its utter reliance on Fiat News, did just that.

So what do we do about this?

Well … nothing. Or at least nothing to “fix” mainstream media directly. I say that because I don’t think it CAN be fixed, just like I don’t think mainstream political parties CAN be fixed. They can’t be fixed because both of these social institutions — media and political parties — are not broken from an  internal perspective of institutional profits and personal agency. On the contrary, they’re thriving.

Media and political parties are institutionalized ticks, and the tick business has never been better.

Look again at that Trump narrative map. Look at all the obvious negative attack memes — SNL, Late Night TV, Meryl Streep, JK Rowling, KKK, Megyn Kelly, Russia, Funny or Die, Judge Gonzalo — they’re not red! I mean, there’s some red in there, particularly for Megyn Kelly because it linked into the highly negative (and politically effective) Sexism meme, but for the most part the sentiment of the articles themselves is neutral to positive, even though they’re part of an obviously negative meme. How can this be? Sure, Fox and its ilk are going to be neutral to positive on all this, but they’re a small fraction of the universe here. Why is the “Failing New York Times” using neutral language to talk about Trump and the Ku Klux Klan? Why would they use language like “Trump’s ‘very fine people’ remark was taken by many as an endorsement of the KKK and other white supremacist groups”? There’s nothing inherently negative in those words. Why aren’t they hitting Trump harder?

Because metagame. Because the long-term evolutionary stable strategy for a tick species is not to maximize blood-sucking and egg-laying, but to balance resource gathering and reproductive success against the minimal requirements to keep the host species alive.

There’s that word. Balance. Like in “balanced” media coverage that of course is not balanced at all, but observes the forms of the free and fair press! meme that thoroughly infects all of us, not least the media participants themselves. Like in the balance of an equilibrium.

The current state of intense political fragmentation and conflict is a very stable evolutionary equilibrium for all of these professional meme-generation entities. Ratings are up. Subscribers are up. Engagement and participation are up. The host species is showing signs of exhaustion and stress, but nothing potentially fatal. If Trump did not exist, professional meme-generation entities would have to invent him.

So they did.

And once the miracle of Trump does exist, professional meme-generation entities must be careful not to kill him.

So they won’t.

Successful ticks have the same secret as successful coyotes — they play the metagame really well — and there is no more effective metagame player than giant corporate media.

They’ve been manipulating memes for a really long time. It works really well for them.

It just doesn’t work very well for us.

We are infested by ticks.

And yes, I understand that this is a horrifying photograph. I’ve used it because I want everyone to be equally horrified by the degree to which OUR ears are stoppered up by these monsters. Because as revolting as this picture may be, all of those ticks won’t kill the dog. They just destroy his hearing and ruin his brain.

Seeing is believing. Once you see the meme introduction and contagion process, you WILL take every step necessary to rid yourself of them. You WILL become more self-aware. You WILL achieve a greater liberty of mind, which is the only effective treatment for a meme infection.

And that’s what we can do. That’s what Epsilon Theory can do. Not try to be a “fact checker”, because that’s a fool’s gig in a world of Fiat News, where everything you hear is in service to this Narrative or that, a self-serving political or economic view served up with some veneer of “fact”. No, what we can do is measure what IS, without attaching any affect or opinion as to whether it is RIGHT. What we can do is visualize what has heretofore been HIDDEN, so that we can go beyond the immediate communication game and SEE the metagame.

Because you’re smart enough to make up your own damn mind.

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The Narrative Giveth and The Narrative Taketh Away

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

So what’s to be done?

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

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

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American Hustle

Irving Rosenfeld:   Did you ever have to find a way to survive and you knew your choices were bad, *but* you had to survive?

“American Hustle” (2013)

Only when I wake up in the morning. Nothing but caper movie quotes today. Seems appropriate.

epsilon-theory-american-hustle-november-17-2016-the-sting

Doyle Lonnegan: I put it all on Lucky Dan; half a million dollars to win.
Kid Twist: To win? I said *place*! “Place it on Lucky D-” That horse is gonna run second!
Doyle Lonnegan: [There is a pause, and Lonnegan runs horrified to the betting booth] There’s been a mistake! Gimme my money back!
― “The Sting” (1973)

epsilon-theory-american-hustle-november-17-2016-gaga

I suspect there were more than a few Doyle Lonnegan moments in Silicon Valley and the Hamptons last Tuesday night. Here, for example, is Lady Gaga looking particularly distraught, as photographed in her Rolls Royce. No, really.

Wanda: [after Otto breaks in on Wanda and Archie in Archie’s flat and hangs him out the window] I was dealing with something delicate, Otto. I’m setting up a guy who’s incredibly important to us, who’s going to tell me where the loot is and if they’re going to come and arrest you. And you come loping in like Rambo without a jockstrap and you dangle him out a fifth-floor window. Now, was that smart? Was it shrewd? Was it good tactics? Or was it stupid?
Otto West: Don’t call me stupid.
Wanda: Oh, right! To call you stupid would be an insult to stupid people! I’ve known sheep that could outwit you. I’ve worn dresses with higher IQs. But you think you’re an intellectual, don’t you, ape?
Otto West: Apes don’t read philosophy.
Wanda: Yes they do, Otto. They just don’t understand it. Now let me correct you on a couple of things, OK? Aristotle was not Belgian. The central message of Buddhism is not “Every man for himself.” And the London Underground is not a political movement. Those are all mistakes, Otto. I looked them up.
“A Fish Called Wanda” (1988)

Gonna be lots of Ottos in this administration. I count three in cabinet-level appointments so far.


epsilon-theory-american-hustle-november-17-2016-the-grifters

Lilly Dillon: You’re working some angle, and don’t tell me you’re not because I wrote the book!
Roy Dillon: What about you? You still handling playback money for the mob?
Lilly Dillon: THAT’s me. That’s who I am. You were never cut out for the rackets, Roy.
Roy Dillon: How come?
Lilly Dillon: You aren’t tough enough.
Roy Dillon: Not as tough as you, huh?
Lilly Dillon: Get off the grift, Roy.
Roy Dillon: Why?
Lilly Dillon: You haven’t got the stomach for it.
“The Grifters” (1990)

Anjelica Huston’s best work. Worth watching just for Bobo and the oranges, hands down one of the most psychologically horrific scenes in American cinema. John Cusack plays Lily’s son, and she’s right: he doesn’t have the stomach for this line of work. Neither do a lot of portfolio managers.

Randolph Duke: Exactly why do you think the price of pork bellies is going to keep going down, William?
Billy Ray Valentine: Okay, pork belly prices have been dropping all morning, which means that everybody is waiting for it to hit rock bottom, so they can buy low. Which means that the people who own the pork belly contracts are saying, “Hey, we’re losing all our damn money, and Christmas is around the corner, and I ain’t gonna have no money to buy my son the G.I. Joe with the kung fu grip! And my wife ain’t gonna f… my wife ain’t gonna make love to me if I got no money!” So they’re panicking right now, they’re screaming “SELL! SELL!” to get out before the price keeps dropping. They’re panicking out there right now, I can feel it.
Randolph Duke: [on the ticker machine, the price keeps dropping] He’s right, Mortimer! My God, look at it!
“Trading Places” (1983)

Like any good trader, Billy Ray has internalized the Common Knowledge Game.

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Louis Winthorpe III: Randolph. Mortimer.
Mortimer Duke: Winthorpe, my boy, what have you got for us?
Louis Winthorpe III: Well, it’s that time of the month again. Payroll checks for our employees, which require your signatures. And no forgetting to sign the big ones!
Mortimer Duke: We seem to be paying some of our employees an awful lot of money.
Louis Winthorpe III: [laughs] Can’t get around the old minimum wage, Mortimer.
“Trading Places” (1983)

Europeans take racial differences and put them on the dimension of class. Americans take class differences and put them on the dimension of race. Randolph and Mortimer do both.

epsilon-theory-american-hustle-november-17-2016-matchstick-men

Angela: She said you were a bad guy. You don’t seem like a bad guy.
Roy: That’s what makes me good at it.

Roy: For some people, money is … money is a foreign film without subtitles.
“Matchstick Men” (2003)

Nicolas Cage can act. When he wants to. Ridley Scott can direct. Always. To paraphrase Woody Allen, 90% of alpha is just showing up.

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Linus Caldwell: Um, all right, let’s go over the list again. Ah, “Swinging Priest”?
Basher Tarr: Not enough people.
Linus Caldwell: “Crazy Larry”?
Turk Malloy: Not enough people.
Linus Caldwell: “Soft Shoulder”?
Basher Tarr: Not enough people.
Linus Caldwell: “Baker’s Dozen”?
Basher Tarr: No woman
[pause]
Basher Tarr: and not enough people.
Turk Malloy: “Hell in a Handbasket”?
Linus Caldwell: [sigh] We can’t train a cat that quickly
[pause]
 Linus Caldwell:  and…
All: Not enough people.
“Ocean’s 12” (2004)

This is my new go-to line for every business or policy challenge: we can’t train a cat that quickly.

Basher Tarr: You don’t run the same gag twice … you run the next gag.
“Ocean’s 13” (2007)

epsilon-theory-american-hustle-november-17-2016-steve-bannon

The only question that matters for surviving the next four years: what’s the gag they’re running on us? What’s the narrative they’re constructing? Behold Steve Bannon, gag-meister extraordinaire.

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Rusty Ryan: Turn the machine off guys.
Turk Malloy: It is off.
Rusty Ryan: Are you kidding?
Turk Malloy: Does it sound like I’m laughing, sweetheart?
“Ocean’s 13” (2007)

Sometimes when you fire up an earthquake machine, you get a real earthquake.

There are three questions I’d like to answer in this Epsilon Theory note: what did the Narrative Machine tell us about the market immediately before and immediately after the November 8 election, what am I preparing for now as an investor, and what am I preparing for now as a citizen? I’m giddy about the first, quietly confident about the second, and pretty darn depressed about the third. Could be worse, I suppose.

On the first question, the Narrative Machine gave clear, actionable, and non-consensus signals prior to the U.S. election last week. For readers who aren’t familiar with what I mean by the Narrative Machine, I’ll refer you to this note by the same title. In a nutshell, I’m using a technology called Quid to take Big Data snapshots of large numbers of financial media articles. These snapshots show the connectivity and influence of each article to every other article, constructing a neural network or “star map” of the narratives and meaning clusters that link the articles. By looking at measures of sentiment and connectivity associated with the network, I think that I can get a good sense of market complacency around events like a Trump victory, as well as the likely direction and magnitude of market moves if an event like that comes to pass. Bottom line: I think that the Narrative Machine gives us a good sense of what’s priced into markets.

Here’s the Quid map of Bloomberg articles talking about Trump in weeks T-5 through T-2.

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The skinny: there was never any complacency in markets about a Trump win. There was negative sentiment, but no complacency. Maybe the Huffington Post thought there was only a 5% chance of a Trump win, but markets were taking it much more seriously than that.

Now here’s the Quid map of Bloomberg articles talking about Trump in the week immediately preceding the election.

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Still just as focused (the 7.6 score here is only slightly less attentive and concentrated than the 8.5 score of markets after the Brexit vote), but look at the sentiment score. We’ve moved from highly negative to only slightly negative. More to the point, it’s the change in score that’s really important, so this Narrative map is telling us that not only is a Trump victory priced into current market price levels, but if he were to win, the market wouldn’t go down much, if at all. That’s in sharp contrast to the consensus view (you know who you are), that not only was the market highly complacent about the prospects of a Trump win, but also that a Hillary defeat would be a disaster for markets, with projections for as much as 12% down.

My commitment to the Narrative Machine research project is to make it as public as possible. Mass email is a poor distribution method, so I tweeted about these findings on Monday, November 7 (@EpsilonTheory) and spoke about them on a Salient-hosted conference call on Tuesday, November 8. But I’m also managing portfolios for Salient now as part of the internal reorganization we announced in October, so I have a responsibility there, too. Long story short … follow me on Twitter to stay the most engaged with this project.

So what’s next for markets?

First, the positive market Narrative regarding tax repatriation, regulatory reform, and fiscal stimulus in the form of infrastructure spending is for real. And by “real”, I don’t mean that I have any confidence AT ALL that these policies will have any permanent effect or multiplier effect or anything like that on the real economy. Sorry. Maybe regulatory reform has a long-lasting impact. Maybe. No, by “real”, I mean that this policy “reform” is a highly effective signal in the Common Knowledge Game and that it will make stocks go up regardless of its impact (or not) on the real economy. Ain’t that enough? It’s enough for me. The Trump reform and infrastructure Growth Narrative is a tailwind for stocks and a headwind for bonds for the next four years because we want to Believe. True that.

epsilon-theory-american-hustle-november-17-2016-borgSecond, nothing about the Trump reform and infrastructure Growth Narrative is sufficient, in my view, to undo the overwhelmingly negative constraints that massive global debt places on global growth. The Silver Age of the Central Banker is still in full force,with a shrinking global trade pie and domestic political imperatives that accelerate that decline rather than reverse it. Competitive monetary policy is the Borg. First it swallows up currencies, because that’s what currencies are — a reflection of your country’s monetary policy versus other countries’ monetary policies. Then it swallows up commodities — things that don’t have their own cash flow dynamics. Then it swallows up entire economies and swaths of the markets that are levered to commodities — emerging markets in general and developed market segments like industrials, energy and transports in particular. Ultimately it all comes down to monetary policy, and its primary reflection in currencies. It’s the Borg. Resistance is futile.

Here’s an updated chart showing the massive negative correlation between the dollar and oil. This is the trade-weighted broad dollar index in white, as measured by the vertical axis on the left, and this is the inverted spot price of crude oil in green, as measured by the vertical axis on the right. The chart starts in June 2014, because that’s when competitive monetary policy and the Silver Age of the Central Banker begins, when Mario Draghi doubled down on ECB asset purchases and negative interest rates at the same time that Janet Yellen declared her intentions to raise interest rates and forswore more asset purchases.

epsilon-theory-american-hustle-november-17-2016-quid-bloomberg-commodity

Source: Bloomberg, L.P. as of 11/8/16. For illustrative purposes only.

Yes, you get short-lived divergences in the lockstep negative correlation, first at the end of 2014 when OPEC announces that they’re out of the price-fixing game, and then again a month ago when OPEC announces that they’re back in the price-fixing game. The joke’s on OPEC. And global macro investors who still think that OPEC matters, I suppose, but mostly on OPEC. The half-life of whatever OPEC does or doesn’t do is measured in days … weeks at most. What is persistent, what is irresistible, what is the Borg in this equation is whether the dollar is going up or down.

The Trump reform and infrastructure Growth Narrative makes the dollar go up. If the Fed raises rates in December the dollar will go up still more. If you get a bad vote in Italy in a few weeks the dollar will go up still more. If you get any sort of geopolitical shock or U.S. domestic political craziness the dollar will go up still more. Dollar up is bad. Dollar down is good. I don’t know how to say it more plainly than that, and all the Belief in the world about tax reform and repealing Dodd-Frank and all that doesn’t change this reality. Maybe you see that and maybe you don’t. I can promise you, though, that China sees it.

So that’s where I am as an investor. I’m positive on U.S. equities because we’ve got a four year tailwind from the Trump reform and infrastructure Growth Narrative. That’s not going away no matter what China or Europe does. On the other hand, I’m negative on global risk assets, particularly anything connected to global trade finance, because we’re players in several giant games of Chicken and I think at least one of these is going to break bad. But at least I’m looking at the right things (I think), like what’s happening to the dollar and to European financial credit spreads, and that’s what gives me the hope that I can navigate these risks and these rewards. That and the ability to go short.

So I’m giddy about the potential of the Narrative Machine and I’m hopeful that I can maneuver through the investment storms out there. Why am I so down about American politics?

epsilon-theory-american-hustle-november-17-2016-cutlerWell, you gotta admit that this September Epsilon Theory note, “Virtue Signaling, or Why Clinton is in Trouble”, has aged pretty well. Turns out that Hillary Clinton was, in fact, the Jay Cutler of this election cycle, a highly talented but highly flawed performer whose team refused to sell out for her. I stand by everything I wrote in this piece — each candidate will be remembered in Common Knowledge as the Yoko Ono of their respective party, breaking up an all-time great band to make an album or two of dubious, to be generous, quality.

And that means I also stand by what I wrote about Donald Trump. I think he breaks us. Why? Because everything is a deal to Trump. Everything is a transaction, from a vote to a policy to a personal relationship. We all know people like this, men who — as the old Wall Street saying goes — would sell their mother for an eighth. Donald Trump transforms positive-sum Cooperative Games into zero-sum Competitive Games. It’s his nature … his great gift as a New York real estate developer, but his fatal flaw as a politician. Is he “a fighter”? Can he “get deals done”? Sure, and there’s value in that. But OUR great gift as Americans is that we are blessed with positive-sum Cooperative Games in the form of limited government and the political culture to maintain those limitations. Our political culture has been changed by Trump. The teacup has been broken. Can we glue it back? I suppose. But like a broken marriage or a broken partnership it’s never the same. It’s always a broken teacup.

I’m not saying that this broken political culture is Trump’s fault. Like I said, it’s his nature to transform everything he touches into a competitive strategic interaction. I can’t blame him any more than I can blame my Sheltie for barking at the wind. If you don’t want barking, don’t get a Sheltie. But the FACT is that we’ve got a Game Changer for our political culture as president, and there’s no walking that back.

Example: look at the prevalent Democratic meme today, that Trump voters were either motivated by racism directly, or that they willfully tolerated a racist candidate … which is just a paler shade of racism. Okay. I get the argument, although I would ask why Clinton didn’t get the support of working class white voters in Wisconsin, Michigan, and Pennsylvania who voted for Obama twice. Were they racist all along and just hiding it really well? But leave aside the merits of the argument, because there’s no changing anyone’s mind these days on the merits of anything (which is kinda my point). My question is a different one. If you really believe this … if you believe in your heart of hearts that Trump voters are racists … where do you go with this? Or rather, what does politics mean to you now? Politics is no longer a “marketplace of ideas” if you think the other side is comprised of bad guys. You’re not trying to win them over. You’re trying to beat them. Not because you think you’re right (although you do), but because you think you MUST beat them or else your own survival is at stake. It’s not only a zero-sum Competitive Game; it’s a zero-sum Competitive Game of self-defense, which means that anything — anything! — goes.

I’m not trying to pick on the Democratic memes (although they’re such easy targets). You see exactly the same sort of popular Narratives on the Republican side about Democratic voters. To summarize this vast oeuvre, if you’re willing to vote for the evil Hillary and her coven of soul-devouring, child-stealing, gun-confiscating, tax-raising, war-starting warlocks and witches … well, you must either be a sheep or a thieving Team Elite wannabe. Either way, you’re contemptible. Contemptibles and Deplorables, not Democrats and Republicans. My point is that if you believe that the people on the other side of a political argument are not just wrong, but are basically bad people, then the meaning you ascribe to politics — your political culture — is entirely different than if you think the other side is comprised of basically good people. You don’t cooperate with bad people, and the political institutions you favor if you’re surrounded by bad people are very different — and very un-American, in the de Tocqueville-ian sense of that word — than what the Founders came up with.

Look, Trump is no Hitler — that’s Erdogan’s shtick — and Trump’s preening egomania is actually a good thing because it crowds out ideological fervor. I mean, he’s not building a political machine to instantiate His Hugeness in institutional form. But there will be people around him who will try, and unfortunately, if I were a betting man — and I am — I’d bet on them to succeed. The rewards are too great and the technological tools at their disposal are too powerful and the political culture is too conducive to the effort and if it’s not them it will be the Thermidorean political reaction of the Left, and that depresses the bejeezus out of me. True that, too.

But that’s the World As It Is, a world of incredible technological promise that thrills the puzzle-solver in me, a world of reasonably interesting market patterns that gives hope to the investor in me, and a world of ascendant soft authoritarians that chastens the small-l liberal in me. I don’t think I’m alone. Put it all together, and my attitude is perfectly summed up by the most perfect ending in all of American literature.

So we beat on, boats against the current, borne back ceaselessly into the past.

Onwards. Together. Please.

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The Narrative Machine

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Alex: There was me, that is Alex, and my three droogs, that is Pete, Georgie, and Dim, and we sat in the Korova Milkbar trying to make up our rassoodocks what to do with the evening. The Korova Milkbar sold milk-plus, milk plus vellocet or synthemesc or drencrom, which is what we were drinking. This would sharpen you up and make you ready for a bit of the old ultra-violence.
“A Clockwork Orange” (1971). Society is a clockwork, with gears constructed of language and guns.

epsilon-theory-narrative-machine-august-17-2016-corbusier

A house is a machine for living in.

Le Corbusier (1887 – 1965), pioneer of modern architecture.

We live our lives inside machines, visible and invisible, tangible and intangible.

epsilon-theory-narrative-machine-august-17-2016-no-mouth-must-scream

HATE. LET ME TELL YOU HOW MUCH I’VE COME TO HATE YOU SINCE I BEGAN TO LIVE. THERE ARE 387.44 MILLION MILES OF PRINTED CIRCUITS IN WAFER THIN LAYERS THAT FILL MY COMPLEX. IF THE WORD HATE WAS ENGRAVED ON EACH NANOANGSTROM OF THOSE HUNDREDS OF MILLIONS OF MILES IT WOULD NOT EQUAL ONE ONE-BILLIONTH OF THE HATE I FEEL FOR HUMANS AT THIS MICRO-INSTANT. HATE. HATE.

― Harlan Ellison, “I Have No Mouth and I Must Scream” (1967). In Ellison’s post-apocalyptic horror, the last five humans on earth live inside a giant omnipotent machine where the only escape is death. It’s The Matrix 30 years before The Matrix was written, and 1,000x nastier.

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Mathematics, which most of us see as the most factual of all sciences, constitutes the most colossal metaphor imaginable.

It is easy to make a simple machine which will run toward the light or away from it, and if such machines also contain lights of their own, a number of them together will show complicated forms of social behavior.

Two quotes from Norbert Wiener (1894 – 1964). Wiener received his Ph.D. in mathematics from Harvard at age 17, volunteered to fight in World War I as an enlisted man, but couldn’t get a teaching job at Harvard because he was a Jew. Wiener found a home at MIT, where he became the father of cybernetic theory, aka the mathematics of machine behavior.

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How does the economy really work?

This simple but not simplistic video by Ray Dalio, Founder of Bridgewater Associates, shows the basic driving forces behind the economy, and explains why economic cycles occur by breaking down concepts such as credit, interest rates, leveraging and deleveraging.

Ray Dalio, “How the Economic Machine Works”. In the three years since Dalio released this short-form film, it has been viewed more than 3 million times.

Machines were the ideal metaphor for the central pornographic fantasy of the nineteenth century, rape followed by gratitude.

Robert Hughes, “The Shock of the New” (1980). A writer’s writer and a critic’s critic. As honest in his self-assessment as his assessment of art and society. It’s a bit uncomfortable, isn’t it? Honesty always is.

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Self-operating napkin

Many of the younger generation know my name in a vague way and connect it with grotesque inventions, but don’t believe that I ever existed as a person. They think I am a nonperson, just a name that signifies a tangled web of pipes or wires or strings that suggest machinery.

Rube Goldberg (1883 – 1970)

So, in the interests of survival, they trained themselves to be agreeing machines instead of thinking machines. All their minds had to do was to discover what other people were thinking, and then they thought that, too.

― Kurt Vonnegut, “Breakfast of Champions” (1973). If there’s a better description of modern markets, I have yet to find it. We have become agreeing machines. Because our survival requires it.

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For God’s sake, let us be men

not monkeys minding machines

or sitting with our tails curled

while the machine amuses us.

Monkeys with a bland grin on our faces.

D.H. Lawrence (1885 – 1930). Yes. For God’s sake.

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Antonie Van Leeuwenhoek (1632 – 1723), the father of microbiology, alongside a schematic of his microscope and drawings of the “animalcules” he found in a drop of water. Van Leeuwenhoek was a hobbyist lens maker, and he discovered a process for making very small, very high quality glass spheres which provided unparalleled magnification. He never shared his most powerful lenses, nor his manufacturing process, in order to maintain a monopoly on his discoveries. The glass-thread-fusing process died with him and was not rediscovered until 1957, long since supplanted by ground lenses.

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Copernicus gets all the credit, but his 1543 theory of a heliocentric solar system with circular planetary orbits was a practical dud compared to Ptolemy’s earth-centric theory from 1,400 years earlier. The Copernican model just didn’t work very well. It took better data through new instruments (Tycho Brahe’s observatory) plus better theory through new math (Johannes Kepler’s elliptical orbits) before we finally got it right. But even then, the idea of a heliocentric solar system with elliptical planetary orbits didn’t find popular acceptance until powerful institutions in Northern Europe found it useful to champion this new idea as part of their fight with the Catholic Church and other powerful European institutions.

Modern portfolio theory = Ptolemaic theory. Are powerful institutional investors ready to fight?

Every successful institution, from a marriage to a superhero to a firm to a nation, needs an origin story.

The origin story of arguably the most successful hedge fund institution of the modern world – Bridgewater Associates – is that of Ray Dalio, working out of a small New York apartment in 1975 and publishing a newsletter of “Daily Observations.” The newsletter came first, not the hedge fund, and it was the compelling strength of Dalio’s writings about markets and what he would later term “the Economic Machine” that convinced a few institutional investors to give him some actual capital to invest. The rest, as they say, is history.

In 1975, Dalio struck just the right chord at just the right time with his metaphor of an Economic Machine – the idea that macroeconomic reality across time and place could be understood as a cybernetic system, with rules and principles and behaviors stemming from those rules and principles (essentially, lots and lots of if-then statements and recursive loops, with observable inputs from real-world economic fundamentals). As importantly as being an effective communicator, Dalio was actually right. Bridgewater has translated the metaphor of the Economic Machine into actionable investments for 40 years, with a track record that speaks for itself.

Today I want to propose a new metaphor for the world as it is – a Narrative Machine – where macroeconomic reality is still understood as a cybernetic system, but where the translation of “reality” (all of those economic fundamentals and if-then statements of the Economic Machine) into actual human behaviors and actual investment outcomes takes place within a larger Machine of strategic communication and game playing.

The Narrative Machine isn’t a rejection of the Economic Machine, any more than the theory of relativity rejects Newton’s Laws of Motion. In most places and most times, good old Newtonian physics is all you need to understand the world and take actions to succeed in that world. But there are times and places, like when you’re traveling near the speed of light, where Newtonian physics doesn’t work very well and you need a broader theory – Einsteinian physics – to understand the world and take actions to succeed in that world. A policy-controlled market, like we had in the 1930s and we have again today, is the investment equivalent of traveling near the speed of light. The Economic Machine theory – by which I mean any approach to investing that focuses on tangible macroeconomic fundamentals – just doesn’t work very well in a policy-controlled market. We need an extension of the Economic Machine to succeed in this time and this place, just like the theory of relativity extends Newtonian physics, and that’s what I think the Narrative Machine provides.

Unless you’re an Aristotle or an Einstein, advancement and extension of theory doesn’t just happen by sitting in a room and thinking it up. You need new data. You need better data. You need a new way of looking at the data. Kepler’s idea of elliptical orbits to advance and extend the Copernican theory of a heliocentric solar system couldn’t happen without the new astronomical data provided by Tycho Brahe’s observatory. For a negative example, I think the advancement of germ theory was set back by at least a century because Van Leeuwenhoek refused to share his new technology for looking at microscopic data. But at least astronomy and microbiology have something tangible to look at and measure. How do we SEE the Narrative Machine? How do we observe an invisible network of social interaction? How do we touch the intangible?

For my entire professional career, dating back to my first days as a graduate student and spanning three different vocations and three decades, I’ve been wrestling with that question. I think I caught a small piece of the puzzle with my dissertation and the book that came out of that (Getting to War), and I think that I’ve painted around the edges of the puzzle over the past three years with Epsilon Theory. I was pretty sure that the Narrative Machine was observable if the right Big Data technology could be applied (in the lingo, contextual analysis of affect, meaning, and network connectivity across large pools of unstructured text), but I’ve been involved with Big Data way before anyone called it Big Data, and every time someone claimed to have a solution to this problem it turned out to be far less than meets the eye. On that note, if you enjoy a little dose of schadenfreude (and really, who doesn’t?) do a quick search on Microsoft’s acquisition of Fast Search or, even more shivering, Hewlett Packard’s acquisition of Autonomy, two companies that claimed solutions here. So it was with some trepidation and certainly a healthy skepticism that I started working with Quid, a private company based in San Francisco that has developed a technology for network visualization of unstructured texts.

I think Quid is onto something, in large part because they’re not trying to answer directly the questions I’m asking. Instead, I think they’ve developed a novel process for seeing the invisible world of contextual connections and networks – something analogous to Van Leeuwenhoek’s novel process for seeing the invisible world of microbes – and I’m using their “microscope” to do my own research and answer my own questions. I like that Quid is a tool provider, not a solution provider, so that the analysis here, for better or worse, is my own. On the next few pages I’ll provide an example of some of the research I’m currently doing with the Quid microscope, and I hope it will give you a sense of why I think that we’re getting glimpses of the Narrative Machine with this new instrument.

I’ve written at some length about Brexit and the Narrative that emerged in its immediate aftermath, a Narrative that not only stopped the immediate sell-off in global risk assets in its tracks, but actually reversed the market decline and drove financial asset prices to new highs. To recap, I called Brexit a Bear Stearns event rather than a Lehman event, predicting that creators of Common Knowledge (what game theory calls Missionaries) would successfully characterize the event as an idiosyncratic fluke rather than a systemic risk, exactly as the collapse of Bear Stearns was portrayed in the spring of 2008. In other words, Brexit was NOT a Humpty Dumpty moment, where all the Fed’s horses and all the Fed’s men couldn’t put the egg shell back together again.

Now I have lots of anecdotal evidence of the sort of Narrative creation that I’m hypothesizing here. One of my favorites is a July 13thFinancial Times article titled “Anger at JP Morgan’s ‘Unhelpful’ Brexit Warnings”, where “Senior bankers in London are growing frustrated with JP Morgan Chase’s public warnings that it may cut thousands of jobs in the UK, saying such remarks send an unhelpfully negative message.” Or if I may paraphrase, “The UK government is angry at JP Morgan for not lying about Brexit like they were told to do.” I’ve got a hundred examples like this, examples of a concerted effort by every status quo government and media opinion leader to paint the Brexit vote as a one-off crazy mistake that will probably be reversed and certainly won’t be repeated anywhere else in Europe. But the plural of anecdote is not data, and until now I haven’t an effective instrument to see whether the media data supports what I think is happening.

On the left is a Quid visualization of the clusters and network relationships between the 2,422 Brexit-mentioning articles published by Bloomberg in the 4 weeks prior to the June 23rd vote. On the right is a Quid visualization of the 4,283 such articles published by Bloomberg in the 4 weeks after the vote. This is what the formation of a coherent Narrative looks like. These are snapshots of the Narrative Machine.

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So what are we looking at here? Each dot (or node) represents a single unique article, and the Quid algorithms group nodes into colored clusters based on shared word choice and similar word positioning. If we magnify any of these clusters, in this case a cluster of articles talking about bond-buying and US Treasuries in the pre-vote data, we see that the nodes themselves differ in size according to their connectivity or centrality to the clustering principle, and that there are varying distances and numbers of connections between the nodes, as well. Each node exerts the equivalent of a gravitational pull on every other node, giving the entire structure both the appearance and the substance of a star map. Nodes can be evaluated and displayed on dimensions such as sentiment (green/positive – red/negative), as shown below, and all of these characteristics (distance, connectivity, centrality, etc.) are generated as a structured data set for further, non-visual analysis.

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Here’s what I think we’re seeing in the “coagulation” of the Bloomberg facet of the Narrative Machine.

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The pre-vote Bloomberg network structure on the left is what a complacent Narrative looks like. The articles are “about” whatever the clustering principle might be, and Brexit is typically a sideways glance, a throwaway line that’s almost always negative in sentiment. On the other hand, the post-vote network structure on the right is what an engaged Narrative looks like, where the articles are “about” Brexit and its impact on the clustering principle. Not only are we seeing a strong Narrative form on the right, but the density of lines and closeness of clusters shows that a similar tone and meaning has taken root across all these clusters. Importantly, it’s a positive tone and meaning that takes shape in the post-vote Narrative, with sentiment scores significantly higher than in the pre-vote snapshot. The sky-will-fall articles are almost all in the pre-vote sample, while the post-vote sample – as early as the Monday after the vote, which is immediately before the market starts to turn – are almost all focused on the non-systemic nature of Brexit, the likelihood of reversal, and the “mistake” that was made here.

The pre- and post-vote evolution of the Brexit Narrative structure is robust within individual Bloomberg clusters and across other major media microphones. Here, for example, is the same bond-buying / US Treasuries cluster in the post-vote Bloomberg data set (different color, but same clustering principle), and in the blow-up you can see how much more coherent and connected it is than the pre-vote cluster.

epsilon-theory-narrative-machine-august-17-2016-treasuries-bloomberg-vote

Below, the top pair of star maps are the 4-week pre-vote and post-vote network visualizations of Brexit-mentioning articles published by Reuters, and the bottom two star maps are samples from all publishers in the Quid database. All of the hypothesized Narrative patterns described above are replicated here.

epsilon-theory-narrative-machine-august-17-2016-reuters-all-sources

Okay, Ben, these diagrams and “star maps” are all very pretty. I get your metaphor of the Narrative Machine, and I get that you’re excited about a new technology that lets you see that invisible machine. But so what? How does all this translate into either actionable investment ideas or a process improvement in managing investment ideas?

When anyone asks this question (and believe me, it’s the question I’ve asked myself in one form or another for 30 years), they’re asking about two things: edge and odds. For anyone who’s trying to beat the dealer (my plug for Edward O. Thorp’s 1962 book that changed everything for me, also retold and expanded in William Poundstone’s brilliant book Fortune’s Formula) … for anyone who’s interested in alpha, this is all that matters: edge and odds. Edge is private information, an insight into the true nature of reality that other game players don’t have. Odds are the probabilistic relationship between risk and reward at any given moment in time. If you have either one of these on your side, then you’ll do well in whatever game you’re playing, if you’re dealt enough hands. If you have both on your side … and I think that a rigorous application of the Narrative Machine generates both edge and an improved assessment of odds … hey, now.

The odds revealed by the Narrative Machine are the odds of a catalyst having a major impact on price (or not). Or in slightly different words, I think that the Narrative Machine can help show us the degree to which future events are “priced-in” by the market. For example, when you’ve got a complacent, all-over-the-place Narrative leading up to a scheduled event like the Brexit vote, then even if my best guess on the voting odds is, say, 60% in favor of “Remain”, I would still place a bet on “Exit” because the Narrative-implied market payoff odds are far better than the breakeven odds of the vote.

The edge that the Narrative Machine generates is an improved reaction to a catalyst once it occurs. To be clear, I don’t think that the Narrative Machine can predict a market shock or catalyst before it happens. It’s not a crystal ball. But it is a real-time window into how the Common Knowledge Game is being constructed and played after an event occurs. For example, when you have a pervasive, systemic-risk-is-off-the-table Narrative created almost immediately following a market shock like the Brexit vote, then I would get long the market even if I believed in my heart-of-hearts (and I do) that there really IS systemic risk posed by everything that’s behind the Brexit vote.

I don’t want to over-sell the degree to which the Narrative Machine has been “weaponized” into an investable alpha source, because there are several critical aspects of network theory that remain to be implemented. Foremost of these is what network theory calls alluvial analysis, or evaluation of how different clusters “flow” into each other and away from each other over time. I’ve included two wonderful illustrations of this concept, both from a 2010 scientific journal article (“Mapping Change in Large Networks” by Martin Rosvall and Carl Bergstrom). I think the Quid technology is pretty good at what network theory calls “significance clustering”, the assignment of individual nodes into similarly colored and positioned groups – essentially a snap shot of the network at a given point in time. What we need now is a map of how those clusters evolve over time, because the meaning or organizing principle of the clusters themselves doesn’t remain constant.

epsilon-theory-narrative-machine-august-17-2016-mapping-change-large-networks-1

Rosvall and Bergstrom illustrate this beautifully in the second diagram here, where a network analysis of scientific journal articles show how neuroscience has become its own “thing” over time. We need the same alluvial maps for market Narrative clusters. I’m on it.

epsilon-theory-narrative-machine-august-17-2016-mapping-change-large-networks-2

So, yes … early days for the Narrative Machine. But, yes … a potential alpha source.

Which leads to an interesting question. If this is a new alpha source – the most valuable thing in the investment world – why am I talking about it? Isn’t this like announcing that you think you’ve found gold in California or the Yukon before you’ve staked a claim?

Good question. There’s some margin of intellectual property safety here because it’s not an easy alpha source to mine, even with cool new technologies like Quid. The internal logic of the Narrative Machine is the logic of strategic interaction (game theory), not the logic of stochastic processes (econometric inference). In plain English, I don’t think you can run a regression analysis of historical media network characteristics against historical market characteristics and get much that will be useful, at least not if you’re after edge and odds. The underlying theory here is Information Theory and the underlying math is the mathematics of entropy, and I’m reasonably confident that we’re not going to see an Excel plug-in for either of those anytime soon.

But yes, someone could “steal” this idea and run with it on their own. To which I say … fine. Better that than being another Van Leeuwenhoek, bogarting his research on his invisible world and setting back the advancement of germ theory and microbiology by a century or more. As in 1648 and 1776 and 1848 and 1917, we live in one of those rare moments in history where ideas are at stake and fundamental theories of the world are in flux. Let’s engage with that, and not hide in the convenient cubbyhole of narrow self-interest or the mentality of an agreeing machine.

We need a new perspective regarding the true nature of our economic and political clockwork, and that’s the real value of the idea of the Narrative Machine.

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