“For pigs, the ideal was a football shape. Cows were
rectangular, and sheep tended towards oblong.”
– Ron Broglio, as told to Anne Ewbank
I came across a delightful piece in the marvelous Atlas Obscura this weekend (h/t to a similarly delightful thread on this topic from @ZeenaStarbuck). Written by Anne Ewbank back in 2017, the piece is all about livestock – and livestock art – in late 18th and early 19th Century England. It’s also a charming illustration of Narrative at work.
You see, the ultimate status symbol to a gentleman farmer in
the early 19th Century wasn’t a framed photo in the subject’s 54th
Street office of him sitting, wearing a John Deere vest and John Deere hat, on
a perfectly clean John Deere tractor that is three or four series too large for
his property. It was a painting of his cow. And in a perfect world, this
painting would tell the story of a very large, very rectangular, surprisingly geometric cow. An absolute
unit, if I may use the expression.
The prevalence of this art form raises a question: in what proportions is fat, rectangular cow art the result of (1) 19th century cows being more muscular and more rectangular, (2) 19th century dilettante farmers instructing artists to display exaggerated muscles and geometry, and/or (3) 19th century British artists being a bit shit?
It’s hard to know for sure. But the unrealistic body image foisted
on this poor sheep, made manifest in a couple body parts I’ll leave you to identify,
leads me to believe that our second reason above probably bears the lion’s
share of responsibility. It was mostly story-telling.
But the things that were happening to cows, sheep and other increasingly geometric animals in the real world still played an important role in the storytelling process. Incremental improvements in certain desirable (I guess?) features through selective breeding permitted ever more fantastical imaginings of just where a sheep might develop a bulging new fat deposit. Those fantasies, in turn, were used as models in the breeding and improving of yet more animals. This bears a lot of similarity to how Ben characterizes bull markets as “climbing a wall of worry.” It’s an expression which describes how investors create artificial hurdles to pretend that they are performing critical analysis, but then construct ever more ridiculous extrapolations when those largely meaningless hurdles are miraculously scaled. Yes, but have you seen their growth in pro forma adjusted EBITDA per pixel?
In other words, beware the sheep with legs too skinny to support its body weight, and beware small truths used in service of big lies.
[Ed. note: I wrote this post in the summer of 2018, the very first note published as a completely independent Epsilon Theory. Since then, I’ve reposted it every MLK Day – in my opinion, the most important national holiday of the UNITED States of America.]
As regular readers of Epsilon Theory know, I make my home in the wilds of Connecticut today, doing my best Eddie Albert / Green Acres impersonation here on Little River Farm, but I grew up just outside of Birmingham, Alabama. My father spent his entire adult working life as an ER doc at Lloyd Noland Hospital in Fairfield, Alabama (trust me, about as far from Fairfield, Connecticut as the Earth is from Mars), starting back before emergency medicine was even a thing. My mother kept their two sons from getting into too much trouble and created a wonderful home from a (quite) modest house in an unincorporated area that’s now part of Hoover.
Lloyd Noland Hospital itself is an interesting story for a brief Epsilon Theory aside. It was the old Tennessee Coal & Iron employees hospital, dating back to 1919, acquired by US Steel when it bought TCI in the 1950s, then immediately spun off as a nonprofit foundation. The Foundation sold its assets to Tenet Healthcare in 1996, and the senior Foundation executives made a fortune. A lot of the staff, both doctors and nurses, were fired. Funny how that works. Tenet flipped the hospital to HealthSouth just three years later in a deal backed by public money. Funny how that works, too. In 2004, HealthSouth imploded in one of the largest accounting frauds in American history, and Lloyd Noland Hospital was shuttered for good. Funny how that … ah, who am I kidding … none of this is funny at all.
At least the HealthSouth CEO, Richard Scrushy, went to prison for a few years. A few.
He’s found Jesus now, of course, and if you’re looking for “a dynamic risk taking entrepreneur with a powerful track record”, he’s available to speak at your next corporate retreat. Maybe you’ll catch him on Fox Business or CNBC. Or you could buy his book. Barf.
Anyway, my wife and I took three of our daughters down to Birmingham last week to visit their cousins and their Nana, and we decided to take a morning and go see the museum at the Birmingham Civil Rights Institute. It’s been open since 1992, and I’ve only heard rave reviews. But I had never been to the museum. It’s been open for 25 YEARS, and I had never been. Why not? As my father would say, Ben, you have plenty of excuses, but not a single reason.
Well, that’s not exactly true. I had a reason, just not a good one. My bad reason: I didn’t want to be lectured on civil rights. I didn’t want to be served a heaping dish of cold spinach and feel like it was my social duty to smile wanly and say “why, thank you, that was delicious. May I have some more?” What I told myself, and this is the excuse part, is that I’m a modern, educated man. I told myself that I already knew pretty much everything that needed knowing about the civil rights movement.
NARRATOR: He did not know.
Nope, not even close.
I wasn’t lectured. I wasn’t put down. I was uplifted.
Yes, it’s spinach. Yes, I walked through half of the exhibits with a lump in my throat. Yes, I was ashamed for only coming now, 25 years late. And you know what? That’s okay. I deserve that feeling of shame. I welcome that feeling of shame, because if you don’t feel shame you’re a creature of the flock, not a creature of the pack. Frankly, we need a lot more shame in the world, not as a permanent scarlet letter or as a bureaucratic tool of the Nudging State, but as a catalyst for the gut check that we all need from time to time. The gut check that requires you to come to grips with the painful past or the painful present and DEAL WITH IT as honestly as you can. The gut check that MUST be passed if you’re ever going to succeed or move forward with ANYTHING.
That’s what the Birmingham Civil Rights museum gives you. A gut check.
What makes the museum so effective in communicating a difficult story well? Just that. They present it as a story, as a narrative. Not a cartoon story of Superheroes, although it’s impossible to avoid some degree of hagiography when it comes to this stuff, and not a cartoon story of Social Justice™, either, although here, too, it’s impossible to eliminate completely the heavy-handed nudging of the Smileyface State. No, it’s mostly a story of … people. Of the actual lives of actual people. It’s immersive and it’s real. It creates a compelling narrative arc, but not in a way that feels scripted or forced. What do I mean? I mean that the very last exhibit of the museum is a gigantic room, filled only with photographic portraits of African Americans who endured the civil rights struggles of Birmingham in the 1960s. Not activists, necessarily, just people. No one famous. No one with a statue somewhere. A chemistry teacher. A church deacon. A housewife. Not photographs of heroic actions back in the day, but a simple portrait of how they look today. Which is … old. Weathered. But oh my god … PROUD.
And that brings me to the point of all this. Because my gut check wasn’t just an examination of the shame I felt in coming to this museum 25 years too late. There was another gut check, too. Where was my family in all of this? Because unlike the people in those photographs, I wasn’t feeling particularly proud.
I was born in 1964 at St. Vincent’s Hospital, on the edge of downtown Birmingham. I think that’s where almost everyone of my cohort and my race was born in Birmingham in those days. And unlike Lloyd Noland Hospital, St. Vincent’s is still around. Looks like it’s going strong, in fact. I understand that lots of babies, white and black, are born there every day.
Eight months before I was born, not two miles distant from St. Vincent’s Hospital, these four girls were killed in the dynamite bombing of the 16th Street Baptist Church, right across the street from where the museum stands today. It took 14 years to bring one of the killers to justice, 38 years to convict two more.
The girls’ names are (left to right) Carol Denise McNair, Carole Robertson, Addie Mae Collins, and Cynthia Wesley. I’d like for us to remember these names and not the killers’ names.
Twelve months before I was born, even closer to St. Vincent’s Hospital, Bull Connor sicced dogs on civil rights marchers and ordered the Birmingham Fire Department to attack with high-pressure hoses.
You’ve probably seen these photographs before. They’re pretty famous. Or infamous, I guess. What you might not know, however, is that most of the people in these photographs are children.
Yes, black children were intentionally attacked and detained by Bull Connor’s Police and Fire Departments, specifically because they wanted “to send a message”, something that seems particularly poignant given the “deterrence” rationale given by today’s White House in defense of its immigration policy, where brown children have been intentionally separated from their parents and detained indefinitely.
What’s also true, of course, is that there was nothing accidental about the Birmingham Childrens Crusade of 1963. Children didn’t march in some organic display of civil rights awareness.
Children were intentionally deployed by march organizers – “used”, if you will – in order to galvanize national public opinion against segregationist policies and political leaders.
On that note … this most famous picture of the Bull Connor era in Birmingham? It’s not at all what you think it is. The young man in the photo had nothing to do with the protest. He was just trying to get home. And the policeman in the photo was trying to restrain the dog and protect the young man, not sic the dog on him. But the photo was so evocative, so perfect for the narrative that civil rights organizers and journalists wanted to disseminate, that it didn’t matter.
Malcolm Gladwell devoted a wonderful podcast to this picture and its (mis)use, available here.
But my question remains. Where was my family in all of this?
How is it possible that all of this was happening just down the street from where I was born, just a few miles from where I would live my entire pre-adult life, and I NEVER got a glimpse or heard a word about ANY of this? How is it possible that I would grow up without these events touching my life in any way, shape, or form? Because they didn’t. At all. More directly, why didn’t my father do something … no, scratch that … why didn’t my father do ANYTHING to support the civil rights movement happening in his backyard? Because he didn’t. At all.
To be clear, my father wasn’t a Bull Connor or George Wallace supporter. He thought they were thugs. He definitely wasn’t a segregationist or an avowed racist, and – quite the rarity – he wasn’t an unavowed racist, either, the sort of man who mutters the n-word under his breath and laughs uproariously at the “jokes”. I mean, I’m not going to say something stupid like “he didn’t have a racist bone in his body”, because I don’t think you could say that about any white person born in America in 1934, like my father. Hell, you couldn’t say that about anyone born in 1964, like me. But I’ll say this. For his day and his place, my father was as colorblind and as woke in his personal and professional life as anyone I’ve ever known. I’ve got a hundred memories of watching my father act with grace and humanity and camaraderie in interracial social settings, and not one – not ONE – of hostility or a mean-spirit. But in his political life – in his life as a citizen – he was AWOL from the defining struggle of his day. Why?
I think I found the answer to that question at the Birmingham Civil Rights museum, and I’ll use the Montgomery bus boycott of 1955 – 1956 to illustrate.
We’re all familiar with Rosa Parks, the seamstress who refused to give up her seat on a Montgomery bus to a white man, and was duly arrested, tried, and fined for breaking this prototypical Jim Crow law. What we’re less familiar with, however, are the politics and the NARRATIVE of the civil rights protest that followed in the wake of Parks’ arrest.
First, it wasn’t just Rosa Parks who refused to give up her seat, and several of those arrested were children.
Look at the charges filed against this 15-year-old girl – assault and battery for refusing to give up a bus seat. Look at the sentence here – the girl is declared a ward of the state, legally and permanently separated from her parents. This happened nine months before Rosa Parks was arrested.
Like the Childrens Crusade of 1963, it was no accident that a 15-year-old was on the front lines of a civil rights battle. The girl in this case – Claudette Colvin – was a member of the NAACP Youth Council, and her mentor – Rosa Parks – was the secretary of the NAACP Montgomery Chapter. Like the Birmingham children eight years later, Colvin was intentionally placed in harm’s way with the explicit goal of becoming a cause celebre that would be sympathetic to a national audience.
And it worked. National media coverage of the Montgomery bus boycott was highly critical of the arrests, particularly Colvin’s. In fact, the Colvin case – much more so than Rosa Parks’ own case – was the backbone of the Supreme Court decision in Browder v. Gayle, which struck down the Montogomery bus segregation laws as unconstitutional.
But Alabama media coverage – the media coverage that my father would have seen – focused entirely on the agency of the NAACP in breaking the law. There was zero assessment or discussion of the law itself. There was enormous assessment of the de facto illegality of the acts and the intentional use of children to perform illegal acts. In fact, E.D. Nixon, the head of the NAACP in Alabama during this span, decided not to proceed with a boycott of the Montgomery bus system after Colvin’s arrest precisely because – as effective as the Colvin Narrative might be on the national stage – he thought the child-used-by-NAACP Narrative would undermine the boycott’s effectiveness on the ground in the Montgomery area. Instead, he wanted an adult to be the face of the event, and that’s why Rosa Parks, arrested nine months later, is on a postage stamp but Claudette Colvin is not.
This War of Narratives, one acting nationally and one acting locally, escalated dramatically as the Rosa Parks arrest catalyzed a full-scale boycott of the Montgomery bus system in December 1955. Just as he had chosen Rosa Parks as the public face of the arrest, Nixon chose Martin Luther King, Jr., then a 26-year-old minister new to the Montgomery area, as the public face of this largescale protest action, MLK’s first. As with the choice of Parks, Nixon’s choice of MLK was brilliant from a Narrative construction and delivery perspective. E.D. Nixon played one hell of a metagame!
The white Narrative response was pretty effective, too, though. Rather than fight the boycott on the “merits” of segregation and Jim Crow laws, the status quo Narrative effort focused almost entirely on the illegality of the boycott. Yes, I know this sounds bizarre to the modern ear, but calling for a boycott of a commercial service used to be illegal. I’m not making this up.
Let me say this again, with emphasis: only a few decades ago, you would be arrested if you said out loud that people should stop going to Starbucks or Walmart or Amazon or SeaWorld or Chick-fil-A or Exxon or Red Hen or whatever.
This wasn’t just an Alabama thing and it wasn’t just a segregationist South thing. It was an anti-Labor thing across the country. It was a status quo political thing.
The Montgomery bus boycott was defined as illegal, which allowed the construction of a VERY effective Narrative that the organizers were, by definition, criminals.
That MLK mug shot at the start of this note … that’s not from his Birmingham arrest, where he wrote his masterpiece “Letter From a Birmingham Jail”, but from his Montgomery arrest, where a grand jury indicted him and close to 100 others on felony charges of “conspiracy” against a business enterprise. MLK was sentenced to a $500 fine or a YEAR in the state penitentiary. No joke. More than a year, actually. He spent two weeks in jail before the fine was paid. For his words. For the criminal harm done by his “hate speech”, as it was defined then.
THAT’S the Narrative that my father heard. THAT’S the Narrative that moderate whites all over the South heard. It didn’t turn my father into a segregationist or a racist. But that was never the intent. The intent was to take my father off the political board. By constructing a dominant and immersive Narrative where opposing the status quo was defined as criminal, status quo institutions made it impossible for my father to actively support the civil rights movement. Why? Because to act in that way would mean self-identifying as a criminal, and that’s something my father would never do. It’s not that my father was oh-so concerned about the State seeing him as a criminal, although yeah, there’s that. My father’s pack was his family, and he wasn’t about to do anything that might draw the gaze of the State, which he distrusted immensely, onto his family. The bigger issue, though, was that my father could not abide seeing HIMSELF as a criminal, and that was the meaning of civil rights activism in the Narrative ocean in which 1960s Alabama white people swam: civil rights activism = criminality.
The goal of Narrative creation by status quo Missionaries like politicians and oligarchs is rarely to change your mind. It’s rarely to try and switch you from one side to the other side. It’s rarely to get you to vote FOR them or to buy FROM them. Because you already do.
The goal of most Narratives is to take you off the board.
The goal of most Narratives is to convince you to sit down and shut up.
In our investment lives, we are told to sit down and shut up when it comes to industrially necessary eggs, investment products like ETFs and passive index funds. We are told by trillion dollar asset managers, who just happen to dominate the market in ETFs and passive index funds, that our fiduciary fitness is defined by our opposition to “high fees”. We are told that we are acting against our client’s best interests – i.e. we must self-identify as bad guys if not outright criminals – if we don’t focus on investment fees as our be-all-and-end-all consideration. None of this will turn independent-thinking financial advisors into outright Vanguard-indexing pod people. But it will absolutely make independent-thinking financial advisors doubt themselves and their own virtue if they start to question the party line. You’re not one of those bad guys trying to screw over your clients by putting them into actively managed funds, are you? No, of course you’re not.
In our political lives, we are told to sit down and shut up when it comes to law-breaking Others, like child-using MS-13 gangbangers or Muslim-country-originating ISIS terrorists or … on the other side … statue-protecting Charlottesville Nazis or Putin-loving White House traitors. We are told by trillion dollar political/media machines that our patriotic fitness is defined by our opposition to these cartoon foes. None of this will convince independent-thinking Republicans to vote Democrat or independent-thinking Democrats to vote Republican. But it will absolutely make both independent-thinking Republicans and independent-thinking Democrats doubt themselves and their own virtue if they start to question the (literally) party line. You’re not one of those bad guys trying to screw over America by supporting the criminals/terrorists/Nazis/traitors, are you? No, of course you’re not.
Last summer I wrote a note – Always Go To the Funeral– to introduce the social and game theory dynamics in play with all of this. At the time I didn’t see how our Narrative shock collars could possibly get any stronger.
And yet here we are. The shock collars are zapping us harder and harder. Our respective yards encompassed by our respective invisible fences are getting smaller and smaller.
Red Hen … ZAP!
Child prisons … ZAP!
Supreme Court … ZAP!
MS-13 … ZAP!
Russia … ZAP!
I’m not saying that you should fight the Man, whatever that means to you.
I’m saying that the Man is very, very active in these Narrative efforts to take you off the board, to convince you to sit down and shut up as an investor or as a voter. I’m saying that once you start looking for these efforts, you will see them everywhere.
I’m saying that the Man is very, very skilled at defining your choices in ways that don’t seem at all like they’ve been defined for you. In ways that seem like common sense. In ways that seem like common decency. In ways that make you believe that YOU are the bad guy if you question the Narrative.
I’m saying that’s not true. I’m saying that you’re not a bad person for questioning the party line. I’m saying that you may still make the choice to take yourself off the board, but make it a choice. I’m saying that the sense of shame you may feel when you wrestle with these issues isn’t a sign of weakness, but a sign of strength. I’m saying that you may feel alone and besieged and full of self-doubt as you wrestle with these issues, but only because that’s the way that your social animal brain is hard-wired. Not because you are truly alone.
If I could go back in time and tell my father, gone more than 20 years now, ONE thing it would be that. You are not alone. Because I suspect he felt pretty darn lonely as he wrestled with all this. I think it would have meant the world to him to talk this through with a member of his pack, to try and figure it out together.
And that’s why I write Epsilon Theory. This is the blessing it has given me. To connect me with other free-thinking and truth-seeking human beings, from all over the world and from every walk of life, who are wrestling with this most basic question: how do we make our way in a fallen world without losing ourselves in the process?
I never had a chance to talk with my father about that. Not directly, anyway. But I can talk with you. And I’ll tell you what I wish I had been able to tell my father.
You are not alone.
We are Second Foundation Partners, the publishers of Epsilon Theory, and we are committed to real change in the practice of investing and the practice of citizenship. We are an independent voice for change, with no obligation to anyone but our readers, our clients, and our partners – our Pack!
We invite you to join us, not just because we can help you become a better investor, but because ALL of us can help ALL of us become better citizens. This is the power of the crowd watching the crowd. It builds cathedrals, it starts revolutions, and it moves markets. It’s the most powerful force in the social world, and we invite you to join us in figuring it out … and putting it to work.
The wind blows where it wishes, and you hear the sound of it, but cannot tell where it comes from and where it goes.
― The Bible, John 3:8
As Narrative abstractions — cartoons — become our short-hand for things that used to have meaning, our models become more and more untethered from the reality they seek to reproduce. When wind becomes the thing-that-makes-the-leaves-move, then wind becomes a bear rubbing his back on the bark.
He that breaks a thing to find out what it is has left the path of wisdom.
― The Lord of the Rings, J.R.R. Tolkien
Pursuing better returns by uncovering absolute truths about the companies and governments we invest in is not a serious enterprise in the face of markets rife with Narrative abstractions. It is a smiley-faced lie, a right-sounding idea that doesn’t work, and which we know doesn’t work. Selling the idea that it does to clients is the territory of the raccoon and the coyote. We can pursue it, or we can do the right things for ourselves and our clients. But not both.
Disneyland is presented as imaginary in order to make us believe that the rest is real, whereas all of Los Angeles and the America that surrounds it are no longer real, but belong to the hyperreal order and to the order of simulation. It is no longer a question of a false representation of reality (ideology) but of concealing the fact that the real is no longer real…
― Simulacra and Simulation, Jean Baudrillard (1981)
How does Wall Street maintain the respectability of dishonest businesses? By declaring victory over straw men — active management is dead! Hedge funds lost the Buffett bet, beta won! Risk parity / vol-targeting / AI funds / quant funds are to blame! If you must sell that L.A. is real, you must create Disneyland.
“All right,” said Susan. “I’m not stupid. You’re saying humans need… fantasies to make life bearable.”
REALLY? AS IF IT WAS SOME KIND OF PINK PILL? NO. HUMANS NEED FANTASY TO BE HUMAN. TO BE THE PLACE WHERE THE FALLING ANGELS MEETS THE RISING APE.
“Tooth fairies? Hogfathers? Little—”
YES. AS PRACTICE. YOU HAVE TO START OUT LEARNING TO BELIEVE THE LITTLE LIES.
“So we can believe the big ones?”
YES. JUSTICE. MERCY. DUTY. THAT SORT OF THING.
“They’re not the same at all!”
YOU THINK SO? THEN TAKE THE UNIVERSE AND GRIND IT DOWN TO THE FINEST POWDER AND SIEVE IT THROUGH THE FINEST SIEVE AND THEN SHOW ME ONE ATOM OF JUSTICE, ONE MOLECULE OF MERCY. AND YET — Death waved a hand. AND YET YOU ACT AS IF THERE IS SOME IDEAL ORDER IN THE WORLD, AS IF THERE IS SOME…SOME RIGHTNESS IN THE UNIVERSE BY WHICH IT MAY BE JUDGED.
“Yes, but people have got to believe that, or what’s the point—”
MY POINT EXACTLY.
― Hogfather, Terry Pratchett (1997)
So long as the government requires financial markets to act as a utility, and so long as it makes more sense for big tech companies to hire evangelists than CEOs — until the farmer comes out with his gun – we have only a few choices:
We can be raccoons:We can recognize the overwhelming influence of abstractions and continue to sell products and ideas that don’t.
We can be coyotes: We can recognize the overwhelming influence of abstractions and DESIGN new products and ideas that don’t.
We can be victims: We can let the raccoons and coyotes run rampant over the farm.
We can insulate: We can push back from the table and try to do the things that aren’t abstractions. Real things. Physical things. Things that put spendable currency in our accounts.
We can engage: We can do our best to think about how to change our investment strategies and processes to respond to abstraction-driven markets.
These aren’t mutually exclusive, although only two are worthwhile. Ben’s DNA is long vol, so he wrote about how to insulate. My DNA is short vol. This note is first in a series on how to engage.
Speaking of DNA, there are few fields of study I find as thrilling as the intersection of anthropology and genetic geneaology. What I mean by that is how people lived, died and moved, and how their cultures and lineages moved with them. Yes, if kicking off notes with the old King James didn’t give you enough of a hint, I’m a big hit at parties.
Some of the appeal of genetic anthropology comes from the simple pleasures it offers, like the satisfaction of watching white supremacist idiots discover that they are mutts just like the rest of us.
The second appeal is the grand scale of ancestry and human movement, even over cosmologically infintestimal periods of time. This appeal is timeless. For example, in a legend common to three of the world’s great religions, God promises to multiply Abraham’s descendants as the stars of the heaven and as the sand on the seashore. It’s a pretty attractive promise, but temper your excitement — it was a reward for being a hair’s breadth away from murdering his son. The promises are poetic, of course, but the scope of the two is surprisingly different.
There are somewhere around 100 billion to one trillion stars in the Milky Way, an estimate which would vary based on how you estimated the galaxy’s total mass through the gravity it exerted and based on what you assumed was the average type of star. We’ve discovered a Wolf-Rayet star in the Magellanic Cloud with mass perhaps 300 times that of our sun, for example. It is so much larger than our sun that its surface would reach almost a third of the current distance to Mercury. Icarus wouldn’t stand a chance. On the other hand, we’ve discovered a red dwarf only 19 light-years away with less than 10% of the mass of the sun. But the 100 billion to one trillion range is a fair estimate. Earth has already seen 100 billion human lives. It will (hopefully) see its trillionth at some point between the year 2500 and 3000, if y’all could stop killing each other. Still, if you’re willing to ignore that we can see stars from other galaxies, too, I think we can prematurely give this one to Abraham.
As for the sand, there are about seven or eight quintillion grains on the earth. There’s just no way, even if Elon manages to get us off this planet before the next mass extinction event.
Interestingly, if you look backward, that isn’t quite true. When it comes to lineage, exponential math doesn’t always work going forward. One couple dies without any offspring, while another has a dozen children. But it always works going backward. Everyone has two parents and four grandparents. Based on most of those traditions holding that Abraham lived around 2,000 BC, we can estimate that the average living person has about 1.5 quindecillion ancestors from that time. Given that there were only about 72 million people alive at the time, that means that each of those individuals, on average, shows up in your family tree about 20 duodecillion times. That’s a 20 with 39 zeros. Congratulations! Math is amazing, and you are inbred.
The third appeal is that the really interesting findings are new. Very new. Anthropologists, of course, have theorized about the propagation and spread of cultures through comparative review of ancient art, tools, jewelry, burial sites and artifacts for centuries. Linguists can lean on anthropological techniques, but can also compare similar or derived grammar, vocabulary, and the like to identify how languages originated and spread. Maybe even some sense of where they came from. DNA has been used to develop and cultivate theories about human migrations and the spread of cultures for a shorter time, but in earnest starting in the late 1990s into the early 2000s. These studies have principally relied on the DNA of living individuals. Scientists examine current populations and theorize how ancient populations would have had to migrate to create the current distribution of various genetic admixtures — archetypes of varying compositions that can be generalized, like “Near Eastern Farmers.”
But in the last five years, the real excitement has been in the enrichment and analysis of ancient DNA. That means that, instead of just looking at modern populations and developing models to predict how they may have gotten there, we instead may look at the actual DNA of people who lived and died in some place in the distant past. We don’t have to guess how people moved and where they came from based on second-hand sources, like the DNA of people living in the same place thousands of years later, or on the pottery that they left behind.
We can know the truth.
Desperate for Wind
The allure of a fundamental truth is powerful. It’s the draw of science, and it’s a good thing. Understanding the true physical properties of materials and substances, for example, is the foundation of just about every good thing in our world. I mean, except for justice, mercy, duty, that sort of thing. We have the food we eat because those who went before discovered human chemical and enzymatic processes for digestion, and learned the mineral, chemical, water and solar needs for the plants that would be digestible. We have the devices we carry in our pockets because many thousands of researchers, designers and other scientists discovered the electrical conductivity of copper, the thermal conductivity of aluminum, the fracture toughness of various types of glass and a million other things.
I grew up around this kind of thinking. My dad worked for the Dow Chemical Company for some 40 years. Most of that time he spent as a maintenance engineer, an expert in predicting and accounting for the potential failure of devices and equipment used in the production (mostly) of polyethylene. His professional life’s work was perfecting the process of root-cause analysis. There may not be anyone in the world who knows more about how and why a furnace in a light hydrocarbons facility might fail. It may sound hyperspecialized, but that kind of laser-focused search for truth is something I took and take a lot of pride in.
Investors are hungry for that kind of clarity about markets. But it doesn’t exist. In The Myth of Market In-Itself, I wrote about investors’ vain obsession with finding root causes in media, economic news and Ks and Qs. Ben recently wrote about it pseudo-pseudonymously as Neb Tnuh, mourning the conversion of Real Things into cartoons, crude abstractions that investors are forced to treat like the authentic article:
Do I invest on the basis of reality, meaning the fact that wage inflation is, in fact, picking up in a remarkably steady fashion in the real economy? Or do I invest on the basis of Narrative abstractions that I can anticipate being presented and represented to markets at regularly scheduled moments of theater? Because the investment strategy for the one is almost diametrically opposed to the investment strategy for the other.
Like many Epsilon Theory readers, I am Neb Tnuh. Like Neb, I want to evaluate businesses and governments again. I want to understand their business models, evaluate their prospects against their competitors and subtitutes, quantify the return I can expect and the return I ought to demand for the risk, and seek out investment opportunities where the former exceeds the latter. I want this. But like everything else in life, wanting something to be possible doesn’t make it so.
It also doesn’t make it noble. Arch-raccoon James Altucher fancies himself Neb Tnuh, too:
“But business is just a vehicle for transforming the ideas in your head into something real, something tangible, that actually improves the lives of others. To create something unique and beautiful and valuable is very hard. It’s very special to do. It doesn’t happen fast.” ― James Altucher
And sure, there are ways to pull away from the table. There are ways to be short abstractions, like Neb recommends. Before he wrote The Icarus Moment, he wrote Hobson’s Choice, which described some of the few ways that all the Neb Tnuhs out there can reject the false choice between investing on the basis of a reality that is decoupled from risk and return, or not investing at all. These are strategies to insulate against Narrative abstractions, and I think they should be larger parts of almost every investor’s portfolio. Am I being explicit and actionable enough here? I’m talking about more real assets.
But a strategy which only insulates isn’t practical. It’s not practical for asset owners with boards, or actuarial returns, or a need to hit traditional benchmarks. It’s not practical for individuals who may not have the luxury, wealth or flexibility to, oh, I don’t know, buy an airport or 3,000 acres of northern red oak forests in Georgia. It probably isn’t desirable either. First, that level of underdiversification implies an extreme difference in return expectation, and I’m not going to leave that free lunch on the table. Neither should you. Second, the raison d’etre of turning the market into a utility, of propagating central bank missionaries and evangelist CEOs is the belief that those behaviors are at least somewhat predictable. If we’re not applying that in some measure to the rest of our portfolios, we’ve probably left something else on the table.
And so, unless we would be victims of the coyotes and raccoons who would sell us their own panaceas to this investing environment, we must engage with Narrative-driven markets. But it is hard. It is hard because the nature of abstractions is to require far more information — which usually means more time, too — to change their state. Think about when you’re explaining some complicated analogy to someone and they get confused (did you like my meta joke?). How much longer does it take you to get your conversation back on track? Think about the Keynsian Newspaper Beauty Contest. When you’re playing at the third or fourth level, how much more difficult is it to hold the pattern of what you’re evaluating in your mind, and how much more difficult is it to change that pattern to respond to new information once you’ve approximated it with some other thing, some heuristic or placeholder?
When an asset’s price, volatility behavior or direction is being driven by agreed-upon abstractions, so too is the required information to change its state far greater than usual. Missionaries explain away bad news, or create a new pro forma metric. Media members promote the new spin on the story. Supplicants call on confirmation bias to interpret it based on their existing thesis. And the contrarians who could move the price have all gone to the Hamptons for the decade. Notice how volatility spikes briefly and then disappears?
The question on whether to engage, or to try your luck with strategies that presume a strong, efficient link between economic facts and asset prices, is a question of timing. Unless your investment horizon — by which I mean the horizon over which your trade can go profoundly against you without your getting fired (if you’re a professional) or changing your mind (whether or not you’re a professional) — is more than 10 years, I simply don’t think you can have any confidence that your fundamental analysis has anything more than even odds. Sorry. And in case you were wondering, the answer is no. I don’t care who you are. You do not have a 10+ year horizon to survive being told by Mr. Market you were wrong without being fired or putting yourself under extreme pressure to change your mind.
Investing in a Time of Icarus
But we have already written about a lot of this. You know that Ben and I have said that many of these strategies just aren’t going to work the way that they used to, or when we’re looking for low-hanging fruit, that they haven’t worked the way that we all expected them to. You know that we think this is largely the result of markets and economies becoming utilities, Narrative replacing economic sensibility, and governments and oligarchs stepping into their own as missionaries for that utility and the Narratives that support it.
But what do we do? What do we do differently?
I’ve written about part of the answer fairly plainly in the Things that Matter and the Things that Don’t Matter series from 2017. There is a finite, definable list of investment principles which matter all the time, even in an Icarus Moment. Ben has written about the second element, which is to insulate.
For those who want to engage and continue the search for alpha, the answer depends.
First, it depends on the definition of alpha. When I say alpha, I mean any asset class-level decision that causes a portfolio to deviate from either the most diversified possible portfolio or a market cap-weighted portfolio of all global financial assets. I also mean any security-level decision that causes a portfolio to deviate from the broadest possible market-cap weighted benchmark for that asset class. It’s a simple definition that doesn’t get pedantic about whether a systematic active strategy is really a kind of “beta.” Sure it is. Or no, it’s not. It’s a stupid debate. I don’t care.
Second, it depends on the type of investment strategy you are using. It also depends on your methodology for implementing that strategy. Incorporating both of these requires some kind of framework to discuss.
Here’s what we’ll do: the dimensions I will use for the framework will be different from style boxes, and they’ll be different from categories used by many hedge fund index providers or asset allocators. I will define the categories instead by how I think they interact with an Icarus Moment, or a Three-Body Market — with a market in which asset price movements are heavily influenced by Narratives over an extended period of time.
The first dimension of those categories is what basis on which the strategy seeks to predict future asset prices (by which I include relative future asset prices). I roughly split strategy types into three categories: Economic Models, Behavioral Models and Idiosyncratic Models. Economic Models, in my definition, seek to predict future asset prices principally on the basis of actual and projected economic data about an economy, a financial market or an issuer, whether it’s a company or a government. Behavioral Models may incorporate some elements of Economic Models, but are principally driven by suppositions and beliefs about the behaviors of other market participants rather than the underlying companies. Idiosyncratic Models include various strategies which may even seek to exert direct influence on the future price of an asset.
For the second dimension of the framework, I think it is useful to separate investment strategies which are Systematic from those which are Discretionary. By Systematic Strategies, I refer to alpha-seeking strategies that reflect more-or-less static, if potentially emergent, beliefs about how prices are determined by certain characteristics or states, and whether those characteristics or states are directly related to economic data or more clearly influenced by observable investor behaviors. The second category, Discretionary Strategies, refers to those in which there may be a process associated with similar beliefs, but in which the decision is made based on the judgment of a human portfolio manager. There are frequently observer effects in any investment strategy (i.e. where the act of observing something changes it), but particularly so in Narrative-driven markets. The systematic/discretionary dimension is important to understanding how this can manifest.
Those two dimensions give us six broad categories, which I have filled in with general descriptions of strategies that I think fall into each. There are things I haven’t captured here, but not many. Of active traditional and non-traditional investment strategies in public markets, I’m comfortable that this captures more than 80%. Close enough for government work.
Over the next few months, I will write a piece covering each of these six categories. My aim with this exercise is three-fold. For those who elect to both insulate and engage:
I want to tell you the strategies that I don’t think will work.
I want to tell allocators / asset owners how I think the evaluation of the strategies that may work should change.
I want to tell asset managers how I think they should consider adapting their strategies so that they still work in this environment.
If you think that I have bad news for the strategies on the left third of the table, thank you for paying attention. If you’re looking for a prize at the bottom, there is none.
If you can steal an idea, why can’t you plant one there instead?
Okay, this is me, planting an idea in your mind. I say: don’t think about elephants. What are you thinking about?
Right, but it’s not your idea. The dreamer can always remember the genesis of the idea. True inspiration is impossible to fake.
No, it’s not.
— Inception (2010)
Cobb is right. It’s not impossible. When we are deep in our element as analysts of economies and issuers, we are supremely confident. We know the critical assumptions in our portfolios, models and projections cold. But when we apply ourselves to assessing what others’ views may be, with understanding what is ‘priced in’, we begin to doubt. Deeper into the hole, where we grapple with what other price-setters are treating as the consensus of yet other investors, our models break. More importantly, our confidence evaporates. Our vulnerability to those stories explodes. So how do you feel about your positioning today?
The dream of retreat to a world where we can win by understanding what’s really happening underneath the hood is a siren call. We remember the first time we figured out how to identify potentially unpriced optionality in a business model. When we absolutely pegged that fatally flawed assumption in the new management team’s cost reduction plan that no one else saw. You know. The good ol’ days.
There are brief flashes in which central bank or inflation narratives, fiscal policy angles, next-thing rotation pitches from the sell-side and “cash coming off the sidelines” think pieces seem to fade to the background and we see daylight again. And sure enough, it’s another head fake. That long-awaited rotation back to value unwinds after two or three sessions, and we start grumbling about “algos” and passive investors and volatility-targeted strategies and extravagant tech multiples and cryptocurrency excesses and are there mountain lions around here?
So, once we’ve made the plant, how do we go out? Hope you have something more elegant in mind than shooting me in the head.
What’s a kick?
This, Ariadne, would be a kick.
<Kicks the leg of the chair Arthur is leaning back in, causing him to catch and collect himself>
— Inception (2010)
It’s easy, if a bit heartbreaking at times, to move on from a fundamental investment thesis. Most good ones have a list of sell disciplines describing exactly how they fail, anyway. It’s slightly tougher to change our perspectives on how other investors are likely to behave. But once we acknowledge that everybody knows that everybody knows something, it is almost impossible to know what sort of evidence we can rely on to reject it. That has a lot of important implications, but one more than any other: Narratives tend to influence prices far, far longer than we expect.
“I don’t know half of you half as well as I should like; and I like less than half of you half as well as you deserve.”
This was unexpected and rather difficult. There was some scattered clapping, but most of them were trying to work it out and see if it came out to a compliment.
— J.R.R. Tolkien, The Lord of the Rings, Speech from Bilbo’s 111th Birthday Party
From time to time I speak to and run seminars with students at colleges in Texas, usually with business school students or participants in student-run investment funds. Like any instructor, I have a go-to challenge question. It is a question to spark inquiry, to raise a skeptical eye to the priors with which we approach many of the fundamental questions of investing. It’s also an asshole question. Because, like most instructors, I am an asshole.
“What”, I ask the students, “is the most important single driver of today’s price of ExxonMobil stock?”
It’s the worst kind of question, because I’m obviously asking it for the sole purpose of telling everyone they’re wrong. Still, it’s fun to watch the arguments between very bright students. “Value” is always among the first two or three responses. “Well, what do you mean by value?” I prod, usually yielding a response about multiples. “Value may influence your returns going forward, but a multiple IS the price, so that can’t be it,” a student usually responds, before the discussion descends into bickering and debate over fundamental data which may drive pricing. Earnings? EBITDA? Cash Flow? Oil Price? No, future expectations for oil prices!
It’s yesterday’s price, I tell them.
It feels like a throwaway, the sort of dad joke enjoyed only by middle-aged professionals in tweed playing at being a professor. But for investors trained by schools, banks or long-only shops in the various churches of fundamental stock-picking, it is a necessary and important reminder. Most approaches to security analysis inherently view each day as a tabula rasa. We wake up and decide to evaluate all available information about companies and their securities, determine that the appropriate price either has or hasn’t changed and send our updated limits to the desk. Except that isn’t how this works at all. Like almost anything else in public and political spheres, prices are always determined around the margin.
Consider the tax cut debate the U.S. just endured, and the language used by politicians and media to discuss the issue. Each tax plan is presented as either a cut or a hike, and good or evil on that basis (or on how said cut or hike disproportionately favors one class or another). Did you hear a single analyst discuss what absolute level for a particular income category would generate the most revenue? What would be the fairest on either an objective or subjective basis? Stimulate the most consumption or investment? A politician who never said a word about a static 20% tax rate might be furious with the idea of taking it from 15% to 16%, for example. This is true across every kind of policy issue, and across budget issues for every corporation and household in America. We rarely, if ever, discuss and debate policy issues or investment decisions on an absolute, aggregated basis. Our evaluations are always, always, always on the margin.
This is doubly true for financial markets, where these marginal determinations are made daily. That means that exogenously influenced, random and economically sensible drivers of variations in prices, and, most importantly, the narratives built around them, all become part of the accepted structure of a security’s price going into the next trading day. Strong efficient-markets hypothesis adherents would say that this is wrong, and that any trading not reflective of currently available information would be quickly stamped out and the price returned to an appropriate representation of all available facts (whatever those are). Strong EMH adherents are also too busy being served negative calorie donuts glazed with a 1937 Chateau D’Yquem reduction from a polished unicorn’s horn, so be grateful that the rest of us can have a serious conversation about investing in peace.
That said, the basic idea isn’t wrong, is it? Over enough time, securities prices can diverge enough from the price of comparable investments in ways that influence enough investors to abandon the idea that the accumulated information contained in yesterday’s price is right. EMH assumes that this happens insanely quickly, and the rest of us sane people recognize that it takes some time. In fact, I’d say the world today largely falls into three camps: (1) rare EMH holdovers in academia, (2) kinda-sorta efficient market folks that believe information just propagates slowly, and sentiment…er..something something Brownian motion, and (3) those who believe that prices reflect a shifting mix of fundamental financial data, investor preferences, objective functions and attempts to guess the preferences and objective functions of others.
Some would characterize these differences as a simple question of time horizon.
But are they?
Dick Thaler’s Party Trick
If you’ve ever had a professional dinner with Dick Thaler (maybe personal dinners with him go this way too, but I have never been invited), you’ve probably heard him give his telling of the Keynesian Beauty Contest that Ben has written about several times.
In Keynes’s version of the contest, you win by correctly picking the woman from a series of pictures in a newspaper that you think will be voted as the most beautiful by everyone participating. First-degree thinking, in Keynes’s parlance, is to pick the woman you believe is the most beautiful. Second-degree thinking is picking the woman that you believe the other participants will believe is the most beautiful. Degrees above that require thinking less about beauty or what others will think is beautiful, and more about what the contestants are likely to think about one another. There is no neat solution to this illustration, of course, because we don’t really know what others find beautiful. We are even less certain about what others will believe about their peers’ ability to judge beauty. This uncertainty makes it particularly apt as an analogy to the practice of investment management, but Thaler’s version has the added feature of applying simple mathematics in the place of subjective determinations. That’s useful because it allows us to quantify consistent behavioral tendencies in the game.
Thaler’s version is a little different, and goes something like this:
Everyone at the table must pick a number between 0 and 100. The winner will be the person who chooses the number that is closest to 2/3 of the average.
Because there are multiple calculations that a person might ignore or fail at, I’m taking some liberty of interpretation, but I think the first-degree answer to this question is 33. The player will realize that he has no information to guide his first step within the 0-to-100 range, so he concludes that the average of 50 is the only sensible place to start. We’ll give him credit for realizing that he must be 2/3 of that number, and thus arrives at 33.
Unlike Keynes’s contest, Thaler’s also has a ‘real’ solution. You’ve seen it replicated (albeit in a flawed format that isn’t Pareto-optimal) in the movie A Beautiful Mind. You know, the bar scene with the blonde? Also, why is every example of game theory a creepy story about old male economists picking beautiful women? Anyway, Thaler’s problem has a single solution that is a Nash Equilibrium: zero. If everyone can calculate 33, then surely they’ll figure out 22, 15, 10, and all the way down. By the time you’re playing 23rd-Degree Dinner with Dick, you’ve already gotten down to two digits of zero. A computer would tell you this instantly. But then, a computer would also assume that all the people playing understood AND remembered limits from their first week of calculus. There’s no shame if you don’t. I mean, there is, but it’s politer to say that there isn’t.
When we have played this game with clients, audiences, classrooms and colleagues, my experience is that the winning guess consistently falls between 15 and 22, usually closer to 22. I expect, but don’t know, that Thaler would give you a similar value.
What does this mean? Or at the least, what does it imply?
First, it should be obvious that every sufficiently large iteration of this game will include some people who don’t understand it at all. Some won’t have a natural grasp of expected value and won’t start from 50, but from some other number they expect will be popular. These people will tend to increase the average winning point total somewhat, since they aren’t following the averaging and iterative mathematical process that forces all the numbers downward. If you want some real-world examples of what this person looks like, Google “Bitcoin Price Target.”
The second group of participants — usually a small group — are those who understand the basic principles of the problem but think that everyone else is a moron who doesn’t. They bet on 33. These are your first-degree thinkers. This is basically every graduate of every business school in the world until he has to manage an actual P&L for the first time.
The third group of participants — usually larger than the second — understand the math all too well, and assume that everyone else can, too. They provide the real solution of zero, or if they have a modicum of wisdom to pair with that beautiful brain and neckbeard combo, add a couple points to catch the stragglers who are too slow to catch on. They drag down the winning score. Ben wrote about these people earlier this week in Too Clever by Half. They’re the coyotes.
The bulk of participants, however, answer between 22 and 33. They understand that the principle is to recognize that you want to be 2/3 of the answer everyone will guess. Since the most basic answer without getting into guessing others’ behavior is 33, they go one layer deeper and judge it to be sufficient. This is second-degree Keynes. In this way, Keynes’s example is much more like financial markets, because it incorporates compounding uncertainty at every level. We know what we think. We have a pretty good guess at what others think. But building a mental model of what others think others will think is an order of magnitude more challenging, because it requires perspective not only on the underlying — a woman’s beauty — but on others’ prejudices and biases about the other judges!
Playing a third-degree game is too daunting a task to consider for most, and so curiously, even in the mathematically deterministic version of the game that has a Nash equilibrial ‘correct’ answer, the takeaway is the same as in the beauty contest: you usually win by guessing that others are playing a mix of one to two degrees of the Common Knowledge Game. Some people buy and sell on fundamentals, and some on how they think people will react to them.
But as Ben discussed in The Three-Body Problem, we think that this is changing. We think it has changed. We think that the violent expansion of communications policy by global central banks and the accompanying expansion of always-on media has meant more participants shifting to third-degree thinking. The reason we talk about Narrative so much is that we find it a useful meta-expression of and proxy for exactly the kind of mental model a third-degree participant must construct. When we refer to Narrative, we mean it as an expression of what everyone knows that everyone knows.
If you accept that Narrative is exerting greater influence on asset prices, you will lose if you play the traditional strategy. You will lose if you assume that others are playing one- or two-degree strategies.
The Fundamentals are Sound
So what did everybody know that everybody knows over the last couple weeks? And when you looked at the game unfolding, what strategy were you playing?
I’ve written about the silliness of trying to ascribe specific causes to market action, but I’m willing to stand on this as probably, approximately correct. Let me tell you what I think happened. Then let me tell you what I think other people think happened. And if you’ll bear with me, let me tell you what I think markets will ultimately decide everybody knows that everybody knows happened.
I think that there was already an emerging Inflation Narrative coming into 2018, although not much actual inflation to show for it. Ben has written credibly about this on several occasions. Torsten Slok at Deutsche Bank put out a nice chart highlighting breakevens leading into the events of last week (don’t get too cynical about the forced perspective of sell-side axis ninjas, please).
Source: Deutsche Bank 2018
I think that a roaring start for risk assets in early January gave tactical allocators, macro shops and hedge funds an opportunity to bank early returns (and incentive fees) by taking off risk. I say “think,” but “know” would be nearer the truth. I have the receipts, as it were.
I think these funds thought that the emerging Inflation Narrative warranted pulling back some of that risk not just in risky assets but across their book, including in rates (sovereign debt). I think this accelerated and compounded confidence in the Inflation Narrative.
I think that many market participants thought that the focal point of the event through the end of January was not inflationary expectations, but frothiness of equity markets. I think they thought this because that is where their focus had been as a result of the remarkable returns of 2017 and 2018 and the length of time since the last S&P decline of any significance. I think media bears this out, but it’s story, not fact.
I think that the resulting spike in volatility on February 2nd and into February 5th confirmed and exacerbated what most people thought about the proximate cause of the correction. As a result, the weight of market behaviors shifted from response to a rate shock or rise in inflationary expectations to a classic risk-off trade.
I think that with the relaxation in volatility since the events of late January into February 5th many investors think that the event was an equity and volatility event. A moment of irrational pessimism brought on by blow-ups in vol-selling and vol-targeting.
I think that more large institutional allocators today than at any point since the early 1980s know that their peersknow that inflation, if and when it comes, will fundamentally change how they must build, allocate and manage portfolios.
I think that instead of focusing on this, other investors are comforting themselves with an age-old mantra: “The Fundamentals are Sound.”
“The Fundamentals are Sound” on the U.S. economy. On stocks. This was just a correction that we needed after things got a little frothy. It was short-term sentiment. It was risk parity and vol-targeting funds driving markets lower for no reason after a jump in vol. If you loved the Dow at 26,000, you ought to really love it now.
“The Fundamentals are Sound” on cryptocurrencies. The price action doesn’t matter. It’s the technology that matters. As long as you research and understand the technology and what it has the potential to do to overcome overcentralized, centrally planned banking and transactional systems, you won’t lose. All the smartest people, all the people who have really done their research on this technology, the people who get it, are not sweating these price moves.
Amazing. Every word of what I just said is wrong.
Well, it isn’t that the statement isn’t factual. It may be.
It’s that we have no idea if and when it is going to matter. You can argue all you want that it’s a random walk to a known destination, but as the walk gets longer, that distinction becomes less meaningful.
Sure, it serves a useful purpose to use this language with some clients, in that it keeps them from taking rash actions to change their asset allocation without a real basis for doing so. If you’re a financial advisor and telling your client this fact helps to keep them from dumping all of their risky assets, then you have my blessing and more. But we must be honest with ourselves. If we believe that “Fundamentals are Sound” is necessarily a relevant statement after a correction like this, we must acknowledge that it also carries two embedded assumptions that are so extreme that it’s worth taking a step back to truly unpack them.
It requires us to believe that yesterday’s price was the right one.
It requires us to believe that non-fundamental influences on price (second-degree or third-degree issues) have not changed either, or that they will revert soon.
The silliness of the first ought to be self-explanatory. The “Fundamentals are Sound” relative to what? Relative to how they manifested in prices yesterday? Last week? How they would have manifested over the last 30 years? Absolute pronouncements of appropriate valuation and marginal thinking about price changes are a risky combination.
Understanding the second is a bit nearer to my purpose here. After events like this, it is appropriate to ask: do I think that the decision-making processes of other investors have changed? Do I think that those investors’ views of other investors’ positioning and decision-making has changed? Furthermore, do I think that any of the broad Narratives reflective of how investors are responding to one another have changed, or that they have strengthened or weakened?
Now, my confidence about the mechanics I’m describing here is high, but I don’t judge my ability to evaluate using these mechanics to be higher than any of yours. In fact, many of you are probably shrewder investors than I. But I think a lot of investors will be coming out of the last two weeks saying that nothing has changed, or focusing on how long it will take to bounce back from a couple weeks of fear-driven market behavior. I think that may be a mistake. Why?
Because it takes much longer to unwind third-degree thinking. Narratives last.
Think about the Keynes game again. Imagine that I drew a feature on one of the men or women from the beauty contest to make them most distinctive, and perhaps more polarizing. Let’s say a diamond nose stud, or a face tattoo. How long does it take you to figure out how your first-degree thinking about the game changes? Second? Third? How much more data would you need to conclude that there was a change, and how would that differ for thinking at each degree? How many more events to give you insight into responses? There’s a reason Narrative-driven markets last far longer than we expect them to. Time passes more slowly in a dream-within-a-dream than it does in a single dream alone.
Again, I think investors who look at risky or speculative assets and say, “I like this just as much, and I don’t really see why it should have gone down this much,” may well be right. I think that they’d be justified in having some expectation that volatility will fall, and that some of the correction would be recaptured over coming weeks and months as people forgot why they felt the need to go risk-off for three days in February.
But I think it’s not the Friday and Monday sell-offs and whether they were “justified” that will end up mattering. It’s what happened the week before that we should be paying attention to.
If the events of that week did anything, it was to further convince me that market participants have bought into the Inflation Narrative — even well in advance of strong data on actual inflation. So while I don’t have any valuable short-term positioning thoughts (and I never will, so don’t ask), I think that the surprising strength and persistence of this Narrative — and Narratives in general — has real implications for us as asset allocators and alpha-seekers. Even alpha-seekers in the Craftsmanship Alpha mode.
We all talk a big game about diversification, and rightfully so. Look, I wrote a piece that called it the second most important thing in investing. But how big a part do TIPS (Treasury Inflation Protection Securities) play in your portfolios? Commodities? Other real assets? Many of these have been such abominable relative investment opportunities over the last 35 years that they frequently aren’t even considered as asset classes. In some generous cases they’re called alternatives or diversifiers, but few investors today consider them in the same context as stocks and bonds.
As the Inflation Narrative heats up, I believe asset allocators will have to seriously evaluate the extent to which this tacit assumption is still appropriate. They will have to grapple with whether nominal bonds have the same crisis risk aversion and diversification characteristics that they have over the last couple decades. But here’s the rub. They will have to do so in a prospective, long-term way that may not have the benefit of a recent high-confidence in-sample and out-of-sample period for their backtests. Are you ready to tell your committees that you think sovereign bonds may not be the same safe asset in certain types of major equity drawdowns? Are you ready to suggest what to do about that? Are you prepared to stake your career on it?
It’s not uncharted territory. There is nothing new under the sun, after all. But it’s territory that few of us have trod during our careers. And if you’re staring at the ground, trying to convince yourself that it’s solid before every step, you may be missing where we’re headed.
We have to be humble, too. If you’ve been talking about an emerging Inflation Narrative for a few months, we know enough about behavioral biases to recognize that you’ll start seeing ‘evidence’ of it everywhere you look. But that’s kind of how Narrative works in the first place, y’all. In the end, we don’t have all the answers, but we do think we know how to think about these questions.
It adorns a rail bridge that soars above I-45 in Houston. More than 300,000 cars pass by it every day. It has been modified a couple times by other street artists, but every time it goes back.
It’s a complicated statement, and I suspect people read it different ways. To most, it means to Be Someone Important. To matter. It’s an external way of reading it: to have an impact. To be engaged. To have your contributions to the world, or humanity or some other measure weighed and acknowledged as a net positive. To be known and well-thought of.
There’s another reading that is more internal in perspective: to find the whole person that we are. Not an amalgam of symbols and identities and tribal affiliations, or of words we use to describe those things and hide ourselves behind language. To be a man or woman in full. To be someone.
At this moment I’m a man with complete tranquility…I’ve been a real estate developer for most of my life, and I can tell you that a developer lives with the opposite of tranquility, which is perturbation. You’re perturbed about something all the time. You build your first development, and right away you want to build a bigger one, and you want a bigger house to live in, and if it ain’t in Buckhead, you might as well cut your wrists. Soon’s you got that, you want a plantation, tens of thousands of acres devoted solely to shooting quail, because you know of four or five developers who’ve already got that. And soon’s you get that, you want a place on Sea Island and a Hatteras cruiser and a spread northwest of Buckhead, near the Chattahoochee, where you can ride a horse during the week, when you’re not down at the plantation, plus a ranch in Wyoming, Colorado, or Montana, because truly successful men in Atlanta and New York all got their ranches, and of course now you need a private plane, a big one, too, a jet, a Gulfstream Five, because who’s got the patience and the time and the humility to fly commercially, even to the plantation, much less out to a ranch? What is it you’re looking for in this endless quest? Tranquility. You think if only you can acquire enough worldly goods, enough recognition, enough eminence, you will be free, there’ll be nothing more to worry about, and instead you become a bigger and bigger slave to how you think others are judging you.
— Tom Wolfe, A Man in Full
There is nothing wrong with wanting to Be Someone in the external sense. But it is perilous. When our engagement with our communities and our societies is driven by a desire to have the greatest possible impact on the world, we are prone to competitive behaviors and to seeing competitive behaviors in others. At a time when we are already being forced into a Competitive Game, it isn’t a long road from well-intentioned desire to be known for changing the world to existential defensiveness, where we become slaves to how we think others are judging us, or worse, where we impose that slavery on others.
“He was slightly eccentric. He had very unusual taste but was happy so long as he was doing his own thing.”
—Malcolm Churchill, speaking about his father, Lt. Col Jack Churchill
“I felt as if I were walking with destiny, and that all my past life had been but a preparation for this hour and this trial.
— Winston Churchill
‘To Pee or Not to Pee?’
That was the headline the day after I defused a dirty bomb in Paris.
‘Germany: 1, England: 5’
Missed that game. I was breaking up an undercover spy ring at the Pentagon.
[Eggsy points at the Charles and Diana wedding cover]
My first mission. Foiled the assassination of Margaret Thatcher.
Not everybody had thanked you for that one.
The point is, Eggsy, nobody thanked me for any of them. Front page news and all these occasions are celebrity nonsense. Because it’s the nature of Kingsman that our achievements remain secret. A gentleman’s name should appear in the newspaper only three times: When he’s born, when he marries, and when he dies. And we are, first and foremost, gentlemen.
— Kingsman: The Secret Service (2014)
There were two notable men in the Second World War who bore the surname Churchill. Both were British, and both are famous. I’m sure that you know at least one I’m talking about, but maybe not the other. Both were men in full.
Sir Winston Churchill, Prime Minister of the United Kingdom, is regarded by many historians and other chroniclers of the times as the most indispensable man of the 20th Century. More importantly, he is regarded by me that way. As author, orator, humorist, strategist, motivator and statesman, he was a man from another time at a time when the rush of modernity required exactly that.
The other, Lieutenant-Colonel John Malcolm Thorpe Fleming Churchill, was no relation to the prime minister, but had every bit of the more noteworthy Churchill’s quirky personality. He was a newspaper editor, actor and male model born in Hong Kong who toured Burma on a motorcycle while stationed by the British Army there during the ‘20s. When war broke out again in 1939, he joined the British Expeditionary Forces in France. His tenure in Europe was an eventful one.
THE Churchill wanted to Be Someone. His tongue was only planted partially in cheek when he famously (and somewhat apocryphally) said that history would be kind to him because he intended to write it. He cared deeply about how he was perceived and about his reputation. His speeches were famously rich with evocative language and calculated delivery, and he cultivated a preternatural ability to induce emotional response. At that unique point in time, the stalwart British needed a man who would make himself great to make his nation capable of greatness. To modern sensibilities this carries a whiff of distasteful inauthenticity. Our culture so prizes the trappings of humility that the proud hero who knows he is a hero and plays the role willingly is typically considered to be no hero at all. Sir Winston would have reared back his head in laughter at such a heaping load of tosh.
The OTHER Churchill wanted to Be Someone, too. That someone was Mad Jack. He was a character straight out of a storybook, and not some soft Caldecott Medal-winning heartwarmer. We’re talking one of those German tailor-chopping-off-the-kid’s-thumbs-because-he-wouldn’t-stop-sucking them storybooks. In some of his early action in May 1940, he signaled the attack on a German position at L’Epinette by shooting a barbed arrow from an English longbow into a German sergeant. After joining the Commandos, his first campaign brought him to the shores of Norway, where he jumped out of the landing boat, grabbed his bagpipe and blew The March of the Cameron Men before pulling out a grenade and tossing it at the German position.
Later, he landed in Sicily with his pipes on his back and broadsword in his hand. After that, he moved on to Molina. There, together with a corporal he grabbed for the mission, Churchill captured a German position…along with the 42 Nazi troops manning it. In Yugoslavia he was the last man standing from his unit after heavy mortar fire, and fired every weapon he could find at advancing Germans until he ran out of ammo. What did he do then? Well, obviously, he jumped up, grabbed his pipes and played Will Ye No Come Back Again until he got knocked out by a grenade.
He was captured and escaped. Captured and escaped again. Walked 100 miles to Italy and lived out the rest of his life in peace. No, I’m kidding. He rescued 700 doctors and patients in Palestine, defended a medical convoy from 250 insurgent fighters, did more acting, designed surfboards, built coal-fired riverboats and rode motorcycles throughout the English countryside until he finally decided the world was too boring in 1996.
There’s nothing wrong with wanting to Be Someone like Winston Churchill. I think highly enough of him that I named my firstborn son after him (pictured right). There’s nothing wrong with aspiring to greatness, or with seeking reputation. The desire to have an impact on the world usually comes from a good place.
But in seeking to promote our brands, in our search for greater impact and influence, we are doing a lot of things that are killing our ability to have real dialogue with one another. As we grapple with how to break ourselves out of the Competitive Game we’re being forced into, we must also understand the forces that are keeping us there. Here are some of the ways in which our desire for our small voice to have an impact among 7 billion others is keeping us there instead.
The Principal / Agent Problem in Media
In Fiat Money, Fiat News, Ben discussed how, in the same way that bad money drives good money out of circulation, fake news drives real news out of circulation. Like money, this can manifest itself in two ways: through true counterfeiting of the news itself, or through biased presentations of facts published as advocacy by institutions acting as principals. In other words, fiat news. Some of those institutions are sovereign entities — like, say, Russia — that have an interest in promoting their interests through both fake and fiat channels. But some, probably most, of those in the business of fiat news are the media outlets themselves.
The media’s indispensable function is its ability to make available information that others do not want disseminated, especially when those others are governments, corporations and other powerful entities and individuals. In this function, journalists act as agents for the public, and do it a significant service. In some cases, that service really changed the world. The intent was to reveal and inform, and the outcome was a shift in the course of history.
This is changing. It has changed. From its historical role as agent, news media has increasingly set itself up as a principal. How? Rather than informing and allowing the dice to fall as they may, the media often now enters the fray with a view on the right outcome for the dice. Most media institutions have the good sense not to include outright lies, of course. But when you have an interest in the outcome of the story rather than its capacity to inform, you end up with fiat news like this, where CNN intentionally cuts off a portion of the video that would ruin the intent of their story, which is very obviously not to inform. You end up with fiat news like this, where you must read 7 paragraphs into a story to discover that a man being executed confessed to raping and murdering a 16-year old girl. Even that fact is couched in dismissive language that is very obviously intended to guide the reader to a salacious conclusion.
It’s not hard to come up with all sorts of explanations for why this is happening, from the consolidating ownership of media outlets, to the democratization of news via cheap internet venues that create a lowest-common-denominator effect, to the infotainment impact of always-on cable news. I think the root cause is more insidious. Through the feedback processes of each of those things and the resultant ways in which journalism is now taught at universities, a very significant portion of those entering the media want to Be Someone like Winston, not Jack. They are becoming journalists because they want to change the world. And so, in setting out to change the world, to borrow from the Washington Post’s insipid masthead postscript (“Democracy dies in darkness!”), they cease to be a light that shines in all dark places, and become instead a hand that guides the light to only those dark places that fit their aims.
Don’t believe me? Just take a look at these responses to a question posed by the Future Journalism Project survey from a couple years ago, which asked “Why did you become a journalist?”
“Soon you find out that you can really make a difference.” “It can change the world.” “I’ve always wanted to change the world.” “I developed a sense of injustice [sic] for the underdog, because the underdog, I felt, was me.” “I learned that injustice is part of our world, but that need not be a hopeless feeling. Not when you’re a journalist.”
It’s not that these are bad sentiments, or that they’re coming from bad people. Quite the contrary. But when the institutions that are supposed to act in service to the public start taking sides in the public debate through their news practices, even if it comes from a good-hearted place, from a desire to Be Someone, it is a terrible thing. In the same way that our American constitutional experiment is built upon the need for the rule of law despite the theoretical existence of benevolent kings, we should demand a similar standard from our media. When the media acts as principal, they, perhaps more than any other political institution in the world, serve to strengthen the equilibrium of the Competitive Game we are in.
Whataboutism, Grand Narratives and the
Hunt for Hypocrisy
The tribal layperson is guilty, too. The same competitive forces that push us into promoting our views and drowning out those we disagree with when we’re entrusted with impartiality like the media have similar effects on us in our personal lives. After all, if we are to make ourselves and our tribe great, we can do so by defending ourselves or by tearing others down. The most common form —whataboutism— tries to do both. It’s a major part of the hunt for hypocrisy that dominates so much of the dialogue of the Competitive Game.
The Soviets made famous and frequent use of it during the Cold War. Václav Havel characterized its most common construction as a debate between two parties:
Your subway does not operate according to the timetable.
Well, in your country you lynch blacks.
The basic idea is to transition the discussion of an issue that threatens one’s tribe from a substantive one to a discussion of relative credibility. Sure, you may want to criticize the efficiency of our implementation of state-run, state-owned transportation, but we refuse to even broach the issue with people who still have racism in their country. Or: I don’t need to listen to a Roy Moore argument from the party that defended Bill Clinton. In other words, the tu quoque fallacy has taken the place of most every form of debate that used to be common to our national politic.
For a modern perspective, look at the below from Ben Shapiro, who I think is actually a pretty thoughtful conservative. This was his initial take on the day when the claims that Roy Moore assaulted a 14-year old girl some decades ago came to light:
Now, bear in mind, Shapiro followed this up with a clarifying comment asserting that Moore should step away in shame, full stop. The reality is that there are infinitely worse perpetrators. Paul Krugman, once a legitimate economist (no, really), can now be summoned by sacrificing three unblemished rabbits in a candlelit pentagram and repeatedly chanting “tu quoque” in monotone. But the blurb above is still fascinating — in one fell swoop, it accurately explains and decries the problem created by whataboutism, and in doing so uses that as an opportunity to engage in some hypothetical whataboutism of its own. This is how it works:
Someone from our Tribe does or says something dumb or evil.
We see a narrative forming ascribing that dumb or evil thing as a trait of our Tribe.
We are frustrated by the injustice of that, since the other Tribe is way worse on that dimension.
Instead of disavowing that trait in our Tribe without qualification, we say, “Well, what about them and THIS thing they did.”
Sometimes whataboutism isn’t just about trying to assault our opponents and weaken their credibility with outright claims of hypocrisy. Sometimes it’s demanding that every person we debate with follow our priorities of issues, or that they follow the forms we prefer for discussing them. I think you know what I’m talking about, because we see it all the time:
In the rare moments when our political and social dialogue isn’t “Well, what about what your tribe did”, it is often “If you said this, why didn’t you say this?” We are endlessly charitable in assuming that our own philosophies are consistent with our words and actions, but we fill in the gaps for others with far less kindness. If someone engaged in a Competitive Game against us doesn’t condemn an action as quickly as they ought to, if they don’t use the same number of exclamation marks as when they criticized someone else’s actions a month before, if they want to discuss or write about X when much bigger issue Y just happened, if they don’t balance and season every single political or social statement they make with comments on any possible related issue, we attack.
We have no choice, we think. We were destined for this. We have to fight this battle, and we have to win, because it’s not acceptable to be the party that is more associated with this Bad Thing. But when we see every battle as existential, when we seek to purposely dominate others by inserting meaning they never intended, when we search for every hint of hypocrisy to make ourselves great, to Be Someone in the great conversations of our time, we perpetuate the Competitive Game.
‘Collective Munchausen Syndrome’
While the ways in which the Competitive Game drives us to dominate and diminish others through language are perhaps most prevalent, so much of what it means to Be Someone is still locked up in identity. Lebanese-Canadian evolutionary behavioral scientist Gad Saad coined the above expression to describe how people in large social settings have taken to competitions in (usually imagined) victimhood. From Donald Trump complaining about #FakeNews and the mean jokes of the SNL cast, to the sorts of absurd ethnographic intersectionalist ramblings you’ll find coming out of most sociology departments, practically everyone across the sociopolitical spectrum is in on this game. There are few behaviors which are more conducive to maintaining the strong equilibrium of our Competitive Game (and to establishing some strategic dominance within that game) than establishing the strongest victimhood credentials. The reason? Because like the other strategies here, it simultaneously argues that our voice ought to be louder and that other voices ought to be silenced completely. It is a tactic perfectly engineered for this time.
Some will misunderstand my meaning here, I think. It would be stupid to deny that privilege, the word typically used to cast someone as an anti-victim, exists. If you can’t accept that certain birth circumstances make your success and ease of navigating our society easier or harder, you’re not approaching the question seriously. If you can’t accept that certain life experiences will have similar impacts, you’re being obtuse. But there’s a marked difference between (1) recognizing those truly different starting places and working wherever possible to eliminate them within society, on the one hand, and (2) concluding that they constitute a system of oppression that can only be addressed by empowering those who would silence the views of any they would call privileged, on the other. The prevalence of this approach is a nightmare for any hopes of escaping the Competitive Game. The answer to this, as I argue in Gandalf, GZA and Granovetter, is only for a critical mass of citizens and voters to choose to hear all voices, knowing that no individual may be reduced to her privilege or victimhood.
We respond to symbols and events based on millions of experiences, and no one can tell us what they mean to us.
OK. So now what?
Well, in the last three notes on this topic, including this one, I’ve written about a range of things I think we can do to hit escape velocity from the Competitive Game equilibrium.
We can stop using identity to shut out opinions we don’t like.
We can stop abusing the trust people put in us to represent their interests by promoting our own.
But what else?
For those of us who think about improving civic engagement, who want to be citizens, I have a humble suggestion: stop trying to be Winston Churchill. I recognize that this counsel is likely to be as popular as my advice from Before and After the Storm (i.e. learn to lose). I’m not saying not to be ambitious. I’m saying that instead of identifying strategies for debate and discussion which elevate us while they demean and debase our opponents, instead of making every matter existential, instead of choosing grand rhetoric, instead be the most independent, extraordinary, true version of who you are. If you can manage to find a truly independent voice in your personal, political and financial life, pursue it with reckless abandon. Don’t set it to the side so that you can build a brand or make an impact.
Trust me. If you’ve decided to Be Someone like Mad Jack, you’re going to have an impact. So get your ass out of the boat, grab your bow, strap on your broadsword and sound the pipes. All that’s left is to decide what song you’re going to play.
The best part about this job, other than being recognized in random bars by 50-year old financial advisors who are always good to buy me a drink (hey, you take your celebrity where you can), is the correspondence with readers. I began writing Epsilon Theory 3+ years ago from a pretty dark place, and it’s still where I end up a lot of the time. But from the outset I started getting emails from really smart people, truth-seekers all, making their way in this world of mendacity and inauthenticity without succumbing to it, and it’s given me — if not an optimism — then at least the occasional absence of despair about the world my daughters will inherit.
I try to respond to all the notes I receive, but what usually happens is that the really good ones — the ones that require more than a flip answer — end up being marked unread and shunted to the “need response” folder on Outlook, only to die a lingering death of inattention over the following weeks. Ultimately I just mark the entire folder as read and let them pass on to the Great Archive in the sky, as it’s the only way I can live with the guilt. So to all of those Jacobs and Williams of the world … I am truly sorry.
As a partial repentance, if not solution, I’m going to make a regular habit of what I always found to be the most enjoyable part of Bill Simmons’ Sports Guy blog — the reader Mailbag. Geez, I miss the old Bill Simmons. Like Simmons of old, I’ll try to keep it entertaining rather than pedantic, and to that end I’ll sprinkle in some of the haters, as I find them occasionally fun when they’re not threatening rape or murder (Bill Simmons never had to deal with the Zerohedge commentariat). As it happens, I got more than the usual quota of great emails from my most recent note “The Evolution of Competition,” my take on the political and social polarization running rampant in Trumpworld. So without further ado …
I forwarded your note to my better half and she thought it was really good, BUT…
from your note: “…If you cooperate in a game of Chicken — i.e., you’re driving your tractor straight on at Kevin Bacon’s pick-up truck and you veer off from the looming crash…”
She needs you to rethink some things, and after she explained the facts to me, I thought it might be important for you (although I’m sure you have already heard from many of your 40-something-female-readers-who-have-watched-Footloose-multiple times!)
They were BOTH on tractors.
And this is the bender for your game analysis. Kevin Bacon tried and FAILED to jump off his tractor. He was FOILED by his shoe lace and thus WON the game of chicken BY ACCIDENT. Very interesting.
I’m gonna need some follow up from you on this one Ben, as she is leaning on me pretty hard to let you know that you’re not done with this Footloose incident!!
A lot of games of Chicken are won by accidental (or intentional) incompetence. For example, if I see that Kevin Bacon is stuck on his tractor and can’t possibly jump off even if he wanted to, then my only rational choice … the only way to avoid MY death in a crash … is to jump off my tractor. By limiting his competence and degrees of freedom, Kevin Bacon paradoxically becomes more powerful in a game of Chicken.
A variation on this theme is to convince your opponent that you’re not necessarily powerless to decide otherwise, but that you’re so mentally incompetent that you really don’t care if you live or die. Henry Kissinger and Richard Nixon famously played this “madman” strategy (in the form of being crazy enough to launch nukes even if it drew China and USSR into war) to get the North Vietnamese government to attend peace talks in Paris.
Good piece. Decency and ability to stay above the fray is almost non-existent at this point. Not to be nerdy but I keep replaying the Star Wars quote “So this is how liberty dies – with thunderous applause” (About the only good thing that came from those terrible prequels.).
That’s a good quote! As for the quality of the prequels … I mean, obviously you’re right. I can’t remember any of the Episode 1-3 quotes because I hear everything in a Jar-Jar Binks accent. And the acting … well, let’s be generous and call it Godfather 3 Sofia Coppola-esque. But isn’t it time for a bit of perspective on the entire canon? In meme terms, I think “Star Wars” is the functional equivalent of “Ronald Reagan”, in that both have evolved into expressions of almost pure nostalgia. Fun fact: the word “nostalgia” derives from the Greek nostos (return home) and algos (pain). There’s a wincing quality to so much about the Star Wars movies and the Reagan Administration, but it’s completely trumped by some sort of warm fuzzy emotional balm. I’d like to figure out how to bottle that.
Nice job. Were you pro Gaga or anti Gaga? Your readers deserve to know!
I was anti-Gaga in the ET note “American Hustle” for what I saw as pretty profound inauthenticity around the U.S. election. But how about that SuperBowl™ performance, huh? I thought that was great. Seriously. And with game theoretic implications, too …
During the halftime show of the Super Bowl on FOX, after Lady Gaga’s performance, they went back to the studio and had someone ready to report on what the reaction to the halftime show was on social media. My immediate reaction – 1) How could I possibly trust FOX to give me an accurate take on the social media reaction to the halftime show that they just broadcast? 2) I don’t care. 3) Doesn’t anyone who does care (and is therefore already monitoring social media for themselves) already know?
Actually, I thought Fox was pretty brilliant in their coverage of Lady Gaga’s halftime show. They assumed that we were incapable of determining for ourselves whether or not it was a good performance until we were told by others (Missionaries in game theory terms) whether or not it was a good show. And they’re absolutely right. A classic example of The Common Knowledge Game in action.
I am a pretty competitive person/athlete and always lost at Chicken versus my brother. I am still trying to repair the Chicken self-image.
Me, too, and to my younger brother, to boot. Although I would bet he would say the same thing about me. It’s amazing how these social competitions in a Chicken format stick with us for a lifetime.
Spot on. I’m doing daily battle with my family and best friends back home, and getting nowhere.
It’s the “back home” aspect of all this that’s particularly difficult on our social lives, I think. Geography has simultaneously become irrelevant with modern communication technology and the only thing that matters with the balkanization of economic opportunity.
This guy is just butt hurt that Trump won. He is a delusional asshole. He thinks that what his side did was about is cooperation.
His idea of cooperation is me giving him half of my money and my wife giving him a *** while my kids wash his car.
In exchange he will offer my family some constructive criticism on how we can become better human beings.
Suddenly when I grab him by the back of his neck and throw him out of my house he finds my behavior objectionable.
What a douche.
Ah, the haters. I included this note because I think there’s an important point here. The meaning of Trump to BarkingCat is personal empowerment. Trump changes the story that this guy tells himself about himself, which is the most important story that we have!
In the mind’s eye of BarkingCat, he is now the powerful one, able to grab me by the scruff of my neck and physically throw me out of his house. It doesn’t matter that, in reality, the Takers and the Powerful are now more in control of his house and his real-world life than ever before. I mean, if you think we lived in a world of, by, and for the 1% before (and we did), you ain’t seen nothing yet. But the real-world impact of Trump isn’t what drives behavior. In politics as in markets, it’s always the story that drives our behavior, particularly the story we tell ourselves about ourselves.
You know where I see this phenomenon a lot? In SEC college football. Some of the most virulent (and I mean that word in its clinical sense) fans of Alabama football have zero connection to the University of Alabama other than that they live in the same state as Nick Saban. But, like BarkingCat, they derive enormous personal empowerment and psychic benefit from a totemic connection to a powerful man. Roll Tide!
The premise is that all cooperation habits we’ve developed, our ways of getting along, are breaking down to be replaced purely with competition. If the premise were right, the rest of his argument might well follow. But the premise is wrong.
Trump found a NEW COALITION. He often speaks of the LOVE at his events. Trumpsters may compete in business, but basically we like each other and won’t tend to be all that cut-throat, most of us anyway. (Trump himself is more cut-throat than most of us. Look at how he’s dumped Giuliani and Christie now that he’s done with them. But that’s beside the point.) Within this new coalition, we are able to slough off some of the strange bedfellows we were put with before, to treat them in a more arms-length way. We have an alternative to the old coalitions the social engineers had cornered us into.
Coalitions are constantly reconfiguring themselves on the basis of shared interests. There are millions of people who have always despised the right but lo, in the past few months the right has popped up as the counterculture. It’s now anti war and pro labour. It’s all about free speech and diversity of thought. The left is now the establishment and is making a big effort to crack down on the counter culture that it brands as racist and attacks with violent thugs.
Amazing really, the right is now about peace love and togetherness and the left is angry decisive and hatefilled.
I don’t hate my colleagues for having opposed Trump, but I dare not say I supported him or they would hate and ostracise me. That’s why Trump is always speaking about love. Because hate is on the other side.
Strange days. Everything is the opposite of what it’s supposed to be. People need to understand this.
– Beijing Expat
I gotta say, this was the most unexpected thread in the comments and email I received, this notion that there’s all this Love with a capital L embedded in Trump-the-man and Trump-the-movement.
I think what’s going on here is an expression of the same emotions that you see in oral histories of any protest movement. Why do people go march in the streets and stop traffic and maybe break some windows (literally or figuratively)? Because it’s FUN. There’s an enormous sense of camaraderie and excitement derived from sticking it to the Man, whether you’re in Berkeley, California in 1968 or Mobile, Alabama in 2016.
Just don’t confuse tribal attachment with Love. Because your tribal leaders, whether you’re on the left, the right, or wherever, will eventually sell you down the river. Every single time.
I think he was trying not to offend and that’s why he could never fully approach his point. He just took swats and glancing blows. I find it offensive.
Blood alone turns the wheels of history.
Two brief comments from a guy who believes that “blood alone turns the wheels of history” but is offended by my tone in an email.
You’re delusional. You need to read, “The Art Of The Deal,” and “The Art Of The Comeback” to get better informed about Trump. CNN and MSNBC are not good sources. For instance Trump fixed the Wollman Rink in NY City after the city gov’t had screwed it up for 6 years at a cost of $9M in tax payer money. Trump VOLUNTEERED to fix it. He did it under schedule (given 6 months) and budget (given $3M). I would call that a win-win. It is more than a win-win, it was a game changer that traditional accounting methods don’t credit Trump with the true impact. Traditional methods would say he saved a mere $0.6M (his cost was $2.4M) because traditional accounting does not include the $9M wasted by the gov’t not to mention the 6 years.
You no doubt see that somehow as a win-lose or a lose-lose. The Trump approach broke the status quo paradigm that just was not working and was very expensive. He brings that same game to the stifling U.S. gov’t bureaucracies and international agreements. I anticipate change in those areas that you can’t begin to comprehend and with your poor accounting practices of what counts as win and what counts as a lose you are way off base. Apparently you think it is a win-win to run the U.S. international policies through the Clinton Foundation where motives are clearly self-serving rather than out in the open via the State Dept.
The depth of your ignorance on the Trump business style is breathtaking. Your assumptions on how well the system was working pre-Trump is much like Mayor Koch who screwed up the Wollman Rink for 6 years. Koch thought things were just fine. And your assumptions on Trump being win-lose or lose-lose are equally naive.
The Wollman Rink. Ed Koch. Hilarious. This guy “knows” Trump by reading Trump’s books, and thinks I’m ill-informed.
I’ve been reading Epsilon Theory for a while now. I find your material thoughtful, often brilliant, always entertaining.
Recently you have put forth a few ideas that to me seem biased and confuse cause and effect.
I think that the idea that this country has up to now been playing a politically cooperative game is quite simply wrong. For the last two presidencies there has been virtually no cooperation between the two political parties. Neither party has any inclination nor any motivation to play a politically cooperative game. This is what must be changed and this is the challenge for America. But I digress.
I believe that there are two distinct and opposing views for the future direction of the country. Let’s call these agendas. One agenda is to move toward a “Great Society”, now probably more correctly termed a “Global Great Society”. The other agenda is to remain an autonomous country with the personal freedoms, rights, and responsibilities we have always expected as Americans.
Trump is not a great divider who somehow maneuvered his way to the presidency and is ushering in political non-cooperation. Trump is the effect, the pushback against one agenda by voters with a different agenda who have come to realize that this is indeed a non-cooperative political game. The election of Trump simply illustrates that voters have come to realize that we are already deeply entrenched in a non-cooperative political game.
I get your point, but I disagree. Trump didn’t just stumble onto a non-cooperative political game in full bloom. He’s a remarkable political entrepreneur who recognized, accelerated, and transformed the zeitgeist. I mean, look at the Republican primary. This wasn’t some grand struggle between globalist Great Society oligarchs and hardscrabble defenders of liberty (and if it were, you’ll have a hard time convincing me that Trump is the latter rather than the former). Trump rolled the field of fellow Republicans because he played the game differently. His gameplay was always Defect and never Cooperate, which was totally new, totally effective, and totally irreversible. It’s like Napoleon (another remarkable political entrepreneur) and the levée en masse (mass conscription). Once Napoleon invented the draft and put a couple of hundred thousand troops on the battlefield, every other country had to follow suit, transforming the game of international conflict forever. One thing I’ve noticed among both Trump haters and Trump lovers: they usually don’t give him enough credit. He’s more than a symptom.
You should go back to writing about investments. Your biases continue to direct you.
The move from Cooperation to Competition (in this case) has proceeded from two conservative realizations:
That the veneer of cooperation maintained by liberals is false; that the Left has been competing all along. ‘Nice’, cooperative public television is about as even-handed as Pol Pot, and just as willing to dictate your life.
That there CANNOT be a balance in benefits arising from the arrangement of cooperation, because of fundamentally different values.
Trump is their big F U to the perceived hypocrisy of continuing to cooperate (even if they don’t like him).
Many Europeans are arriving at the same conclusion.
What was the pro-Trump “conservative realization” in the Republican primary? That he was tougher on conservative shibboleths like public television or Planned Parenthood or Great Society programs than his competitors? Please. This notion that Donald Trump is somehow the great flowering of the conservative movement is just pure revisionist hokum.
I’ve enjoyed reading your column over the years but you are seriously disappointing me lately. I can understand your left leanings make it difficult to grasp how at least one half of your readers feel, but to put something in writing as vile as the statement “So, for example, if you voted for Clinton as an affirmation of a personal identity that rejects the racism and sexism you see in Trump, your natural assumption is going to be that anyone who voted for Trump similarly did so as an affirmation of a personal identity, but one that accepts racism and sexism.”, is totally uncalled for and extremely offensive not just to President Trump, but to all of us who supported a change from the Elite Class we’ve been forced to stomach for the past 20 years.
I’m sorry you’re not comfortable now. Welcome to my world for the past twenty years.
You’ve totally missed my point. I wrote this note because I am so effin’ tired of being called a racist or a sexist because I don’t think that Donald Trump is evil incarnate. There are MILLIONS of people in this country who think that I am a bad human being because I don’t hate Trump. And by the same token, there are MILLIONS of people in this country who think that I am a bad human being because I don’t think that Hillary Clinton is evil incarnate, either. That’s why I wrote this note.
I didn’t vote for Trump (nor Clinton … left prez line blank) because I think he takes us from the frying pan into the fire. But I do understand that we’ve been in a frying pan for 24+ years.
I don’t see Hitler.
Neither do I. I think Trump is a narcissist and an ass, not a Fascist. Like most people in the financial services world, I deal with narcissists and asses every day … they’re not Hitler clones because the only thing they’re really true-believers about is their own self-aggrandizement. Steve Bannon? There’s more than a little Big Lie and Fascism in his self-avowed “economic nationalism”, but he can’t front the band, so he’s no Hitler. Elizabeth Warren? I dunno. More the Madame Defarge type, knitting by the guillotines. Mark Zuckerberg, though, now embarked on his ‘listening tour” through America? Bears watching. Yes, I went there. Big Brother tech plus smiley-face billionaires scare me that much.
There is an old saying that really applies these days. I believe it was from Benjamin Franklin or my mother. “Believe none of what you hear, and only half of what you see.” Unfortunately people don’t let facts get in the way of the Truth.
Agreed (although I thought it was MY mother).
Your note describes what happens to society, including the best educated, when philosophy disappears. And when 95 million+ people are boycotting the workforce.
Too much time on your hands? Then pay attention to Drudge, ZeroHedge, Huffington Post, etc. Or Ashley Judd, Madonna, Rosie O’Donnell. Or Hannity. Supposedly smart, educated people react what’s going on as if they are watching pro wrestling.
No schooling in or acquaintance with philosophy? Then react to all these mindless, emotion-laden messages like a puppet on a string, unable to resist any impulse to react or comment. We should be dropping Meditations from helicopters.
Helicopter Meditations instead of helicopter money? Yes, please.
Once again another good piece. I have seen the same in myself, the question I’ve been thinking is how does it end? or what comes next? You used car crashes, good analogy. I hope society is not using Takata airbags.
I’m totally stealing that line.
Well done on a tough topic. I am reminded a bit of the religious discussion, where you believe that anyone who doesn’t agree with you burns in hell forever. Somehow, we have to find a way to discuss “my truth” while recognizing “your truth”.
Yes, there are clear parallels between what we’re experiencing as a society today and any religious schism. Not sure what the equivalent of the Peace of Westphalia will be for us, but that’s what it’s going to take for us to get out of this.
Started re-reading Virus of the Mind at 4:00 this am. Some dangerous “memes” are replicating themselves.
Virus of the Mind is a 2011 collection of essays on memes, including (perhaps confusingly) the Richard Dawkins essay, “Viruses of the Mind,” that pretty much started the conversation. Required reading.
It seems to me that the Trump phenomena (there are many) are moving us towards the kind of crisis outcome that Neil Howe and William Strauss write about in The Fourth Turning. We only have to wait till the mid-20’s to see the rebuilding of the national and international organizations to allow the next flourishing. Sadly, the crisis usually culminates in a war – if it has to happen this time, let’s hope it is a small one with no big bangs!
I get more questions and comments about The Fourth Turning than any other book. It’s also required reading, although I remain … not suspicious … but unconvinced that demographic and super-cyclical transitions are investable ideas in any meaningful way. Meaningful to me, anyway.
Something I wanted to share about Trump. He is the antithesis of orthodoxy. And this makes him dangerous given that all issues seem to be structured as binary choices between two different orthodoxies. Globalist v. Nationalist, Progressive v. Conservative, Anti-this v. Pro-that. It’s everywhere. But what I realized is that the Republican v. Democrat is not one of them. They are the same in fact.
Spot on. I’ve written about this polarization and shift in political identification in a couple of notes. It’s not so much the growing distance between the median Democrat and the median Republican that’s worrisome for stable policy in a two-party system. It’s that voter self-identification is becoming more and more distinct from party self-identification, so that “Democrat” or “Republican” is no longer shorthand for a wide range of behaviors. The last time we saw this (and not just in the U.S.) was in the 1930s.
About 10 days ago, marveling and laughing at how everyone back home was going absolutely nuts, I had a Eureka moment. I realized that Trump viewed his Presidency as the biggest and most complicated turn-around in the history of the world. He is following the turn-around playbook exactly. Looking at what he does and how he does it, using this prism, everything falls into a logical pattern. It even becomes logically predictable.
Interesting piece. I think you may be missing a subtlety with regards to Trump’s negotiating style. He tends to be a “hard out of the gate” negotiator. His process is to push the other side to the mental and emotional breaking point, then back off to assure a “deal” gets done. He has a certain intuitive ability to find out exactly how far he can push, then back off. He’s been operating this way for almost 50 yrs. in the most competitive real estate environment in the world – NYC. It’s not a game of chicken where he doesn’t care if the deal gets done, then he walks away leaving the other party so pissed-off that they refuse to ever do business with him again. If that were true, he would have pissed off everyone in NYC by now and would never get a deal done. His brash outward appearance is quite paradoxical when compared to his pragmatism. He is not a very ideological person. His ultimate goal in any transaction is to maximize efficiency. To make that omelet, you gotta break a few eggs
Now does that make him a likeable character? Hell no! I personally don’t like the guy, but I believe he is the right agent of change that was needed for the current context. In any complex dynamic system, change is only born out of extremes. We were at a point in time where the extreme of Globalism had run its course. As always happens, a counter-vailing force was introduced to send the persistence of Globalism into a bout of turbulence. Hopefully this leads to a new trend in the opposite direction, but that hasn’t materialized yet. We will deal with some anti-persistence (turbulence) for a while. That’s a good thing. Change (turbulence) is messy both intellectually and emotionally, but it’s a necessary pain we must transcend. As the turbulence subsides, a new trend will emerge and gain some of its own persistence. It’s a wild ride living on this rock hurtling 1,000 mph through space. Best bet is to hold on, and try to enjoy the ride/view.
These are both smart emails. I put them together because they touch on the run-America-like-a-business meme. I get the appeal of that idea, and I think these readers are correct in that this is a big part of the story that Trump tells himself. I’m also sure that his negotiation style is very effective in business, particularly the NY real estate business (as Mark says, it’s straight out of a Roger Fisher “Getting to Yes” class). But I think it’s both an ineffective and highly damaging negotiation style when it comes to Madisonian political institutions, particularly when coupled with Big Brother tech and enormous concentrations of private wealth. That’s my big problem with Trump, and that’s what I mean when I say that he breaks us.
I suppose that the men we have elected as President are generally representative of our Zeitgeist. It may be at times that spirit is not very strong or clearly defined resulting in a sort of caretaker President. At other times, like now, it is pretty strong and sharply defined. Trump is a very real individual occupying the White House — and Mar a Lago, Trump Tower and whatnot. He also is the result of some sort of cumulative consensus about what matters, what should be done and how it should be done. This Zeitgeist concerns me more than the man because it amplifies him and possibly would continue on even if he doesn’t.
My fund of historic knowledge isn’t sufficient, but it is all I have. I’ve thought about how other so called developed nations that marched into totalitarianism moved back to more civil and pluralistic states. The only examples I’ve come up with where this happened peacefully are Spain and Portugal. And that took about six decades. Some might suggest Burma but I think that jury is still having lunch. Otherwise it seems that a comprehensive social collapse usually brought about by international or civil war has been required to exhaust the spirit of the totalitarian ghost and thoroughly discredit the ideas it promulgated. Germany, Italy and England (Cromwell) come to mind. Most of the others are still totalitarian.
I hope my paucity of historic information has obscured many shining examples of societies that awoke from their paranoid dreams of universal competition to remember the benefits of being nice and cooperative. I hope I’ve dramatically exaggerated the fix we are in. I hope…..
I don’t think you’ve exaggerated the fix we’re in. Not at all. I think we’re more likely to see 21st century totalitarianism delivered with a smiley-face than a jackboot, but only because the technology of persuasion is that good. And I also think that the ultimate winners in this struggle for control is less likely to be Trump and his apologists than whoever leads the Thermidorian Reaction against Trump.
I have increased my conversation-avoidance skills (something as a libertarian / monetarists / Classical economics-leaning guy I had to learn to do to live in NYC) since the Trump election. As you note, today, everything is a trip wire.
Many years ago, I realized (1) you very, very rarely change people’s minds even a little bit, (2) I don’t really care that much if I do and (3) even if I did, it would not have any impact on changing anything in the world. Hence, I try not to talk with anyone, but a very small number of people, about, to be honest, anything that means anything as – probably should have started here – I’m tired of arguing (see points 1 – 3 as to why).
Hence, my day to day, which was always a bit of topic avoidance, has been in full-on topic-avoidance mode since the election.
I fear my exhaustion is only going to increase.
People are quick to take offense (where none was intended) at the slightest indication I am not on board with their political or economic leanings. Not nearly as much “give and take”, but more “take it or leave it”. I find myself having to explain that certain economic/investment principles I hold dear are not an endorsement of Trump (or any political stripe) and that because I happen to eschew identity politics doesn’t make me a lesser human, it just means I hold that certain unintended consequences happen when following certain paths of behavior. Hard to believe that such innocuous sounding phrases can be “trigger words” for those who are seeking redress for slights no matter how small or unintended.
I’ve been called many names by people who either refuse to have rational discussions or refuse to consider views that are alternative to their own. When I explain the situation we are currently in, nationally, in terms of economic consequences (game theory is generally too far out there for the average citizen) and how I am trying to make a buck (no different than under the previous six administrations) for myself and for clients, I’m treated with borderline loathing and disdain.
There is a feral quality to the angst experienced by those who lost in this election, something I’ve not experienced before. Trying to maintain a level head and an even-handed view of the world has become its own challenge. My response has been to start at home (getting things straight with my wife about what a Trump presidency does and does not mean, news media hysteria to the contrary), then work on our circle of friends, all well-educated but deeply biased to the blue side of the ledger, both socially and politically. The experience with our friends was interesting in that they know and like me, personally, but it took a three hour dinner party and some follow up, to finally get through to them that Tweets do not policy make and reactions to same do not make good bases for decisions, economic or otherwise.
Thanks for the lucid and erudite essays. They help more than you know.
I’ve anonymized these two emails as best I can because they speak for me and, I think, lots of others out there.
The last two lines in your piece, “Know Thyself” and “Treat others as you would have them treat you” are the essential wisdoms from two traditions – Buddhism and Christianity. Buddhism attempts to guide a person seeking a true understanding and relationship with themselves and Christianity seeks to guide people toward a true, healthy relationship with others.
A minister I heard last summer (he was an old Episcopalian who formally taught at Harvard Divinity) lamented that we, our culture, has sunk toward the “morbid pursuit of advantage”. Which I find to be such a brilliant phrase that I have frequently recalled it. That is the Competition Game in a nutshell. Morbid – because it is ultimately deadly. Deadly to the soul and deadly to the culture.
The “morbid pursuit of advantage”. Yep, that’s our zeitgeist.
Thanks for this. It is exactly what I’ve been experiencing and have tried to formulate into words, and the words into actions.
Good lessons for us and our children, and sooner or later we will all be forced to hear it. Like it or not.
They will run and not grow weary, they will walk and not grow faint. Isaiah 40. Keeps me focused on perseverance.
Words into actions. Perseverance. Sounds like a plan.
Thank you for taking the time to write this and share your thoughts. After having read it only once, I don’t know what to say, but I do know what I am going to do. I am going to share this with my 14 year old daughter. I am certain that it will foster a meaningful discussion and teach us both a few things.
As many readers know, I have four daughters. I write Epsilon Theory for them. And now for Natalie’s daughter, too. This is how we keep the darkness at bay. One daughter at a time.
I have found that the best way to give advice to your children is to find out what they want and then advise them to do it. ―Harry Truman (1884 – 1972)
As far as I was concerned, his decision was one of non-interference — basically, a decision not to upset the existing plans. ―Lt. Gen. Leslie Groves (1896 – 1970), commanding officer of the Manhattan Project, discussing Truman’s okay to drop atomic weapons on both Hiroshima and Nagasaki.
“Ah,” she cried, “you look so cool!”
Their eyes met, and they stared together at each other, alone in space. With an effort she glanced down at the table.
“You always look so cool,” she repeated.
She had told him that she loved him, and Tom Buchanan saw.
― F. Scott Fitzgerald, “The Great Gatsby” (1925)
And that was the end of the party. When Tom Buchanan saw.
Create her child of spleen, that it may live
And be a thwart disnatur’d torment to her!
Let it stamp wrinkles in her brow of youth,
With cadent tears fret channels in her cheeks,
Turn all her mother’s pains and benefits
To laughter and contempt, that she may feel
How sharper than a serpent’s tooth it is
To have a thankless child!
― William Shakespeare, “King Lear” Act 1 Scene 4 (1606)
Once-revered central bank failed to foresee the crisis and has struggled in its aftermath, fostering the rise of populism and distrust of institutions.
Theology, sir, is a fortress; no crack in a fortress may be accounted small.
― Arthur Miller, “The Crucible” (1953)
Few of us can easily surrender our belief that society must somehow make sense. The thought that the State has lost its mind and is punishing so many innocent people is intolerable. And so the evidence has to be internally denied.
The structure of a play is always the story of how the birds came home to roost.
That’s a very good question. I don’t know the answer. But can you tell me the name of a classical Greek shoemaker?
― Arthur Miller (1915 – 2005)
That last, one of my all-time favorite quotes, was in response to a shoe manufacturer who asked why Miller’s job should be subsidized while his was not. Miller’s finest accomplishment: when McCarthy and crew forced him to testify in their Communist witch hunt, he refused to name names. Miller was a leftie and a huge ego. And a freedom lover. Imagine that.
Yet each man kills the thing he loves
By each let this be heard
Some do it with a bitter look
Some with a flattering word
The coward does it with a kiss
The brave man with a sword
― Oscar Wilde, “The Ballad of Reading Gaol” (1898)
We’ll get the kiss, not the sword. Don’t know when, but it’s going to kill this market that the Fed loves.
In 1969, Graham Allison published an academic paper about the Cuban Missile Crisis, which he turned into a 1971 book called Essence of Decision. That book made Allison’s career. More than that, the book provided a raison d’être for the Kennedy School of Government at Harvard, which — combined with Allison’s fundraising prowess — transformed a sleepy research institute into the most prominent public policy school in the world.
The central idea of Essence of Decision is this: the dominant academic theory to explain the world’s events is a high-level, rational expectations model based on formal economics, a theory that ignores the impact of bureaucratic imperatives and institutional politics. If you look at the Cuban Missile Crisis through all three lenses, however, you get a much better picture of what actually happened in October 1962. In fact, the more you dig into the Cuban Missile Crisis, the more it seems that the actual people involved (on both sides … Allison wrote a follow-up edition in 1999 when Russian archives opened up post-Gorbachev) made their actual decisions based on where they sat (bureaucracy) and where they stood (internal politics), not on some bloodless economic model. Publicly and after the fact, JFK and RFK and all the others mouthed the right words about geopolitical this and macroeconomic that, but when you look at the transcripts of the meetings (Nixon wasn’t the first to tape Oval Office conversations), it’s a totally different story.
Allison’s conclusion: the economic Rational Actor model is a tautology — meaning it is impossible to disprove — but that’s exactly why it doesn’t do you much good if you want to explain what happened or predict what’s next. It’s not that the formal economic models are wrong. By definition and by design, they can never be wrong! It’s that the models are used principally as ex-post rationalizations for decisions that are actually made under far more human, far more social inputs. Any big policy decision — whether it’s to order a naval blockade or an air strike on Cuba, or whether it’s to drop atomic bombs on Hiroshima AND Nagasaki, or whether it’s to raise interest rates in September or December or not at all — is a combination of all three of these perspectives. But for Allison’s money, we’d do better if we focused more on the bureaucratic and political perspectives, less on the rational expectations perspective.
What follows is my analysis of the Fed’s forthcoming decision on interest rates from a bureaucratic and an internal politics perspective. Seen through these lenses, I think they hike. Maybe I’m wrong. These things are always probabilistic shades of gray, never black and white. But what I’m certain about is that the bureaucratic and internal politics perspectives give a different, higher probability of hiking than the rational expectations/modeling perspective. So heads up.
First the bureaucratic perspective.
What I’m calling the bureaucratic perspective, Allison calls the “Organizational Behavior” perspective. His phrase is better. It’s better because entities like the Federal Reserve are, of course, large bureaucracies, but what we’re trying to analyze here is not the level of do-nothing inertia that we usually associate with the word “bureaucracy”. What we’re trying to analyze is the spirit or culture of the organization in question. What is the institutional memory of the Fed? What do personnel, not just the Fed governors but also the rank-and-file staffers, believe is the proper role of the institution? Most importantly, how do these personnel seek to protect their organization and grow its influence within the jungle of other organizations seeking to grow their influence?
The spirit, culture, and personnel composition of the modern Federal Reserve is almost identical to that of a large research university. That’s not a novel observation on my part, but a 30-year evolution commonly noted by Fed watchers. Why is this important? It’s important because it means that the current marriage between Fed and markets is a marriage of convenience. As an organization, the Fed doesn’t really care whether or not markets go up or down, and as an institution it’s not motivated by making money (or whether or not anyone else makes money). Like all research universities, the Fed at the organizational level is motivated almost entirely by reputation. Not results. Reputation. A choice between “markets up but reputation fraying” and “markets down but reputation preserved” is no choice at all. The Fed will choose the latter 100% of the time. I can’t emphasize this point strongly enough. From a bureaucratic perspective, the Fed absolutely Does. Not. Care. whether or not the market goes up, down, or sideways. When they talk about “risk” associated with their policy choices, they mean risk to their institutional reputation, not risk to financial asset prices. And today, after more than two years of a “tightening bias” and “data dependency”, there’s more reputational risk associated with staying pat than with raising rates in a one-and-done manner.
Why? Because the public Narrative around extraordinary monetary policy and quantitative easing has steadily become more and more negative over the past three years, and the public Narrative around negative rates in particular is now overwhelmingly in opposition. When I did my Narrative analysis of financial press sentiment surrounding Brexit prior to that vote, I always thought that would be the most hated thing I’d ever see. Nope. I’ll append the Quid maps and analysis at the end of this note for those who are interested in digging in, but here’s the skinny: the negative sentiment around negative rates is now greater than the negative sentiment around Brexit. The public Narrative around ever more accommodative monetary policy has completely turned against the Fed. And they know it.
I think that Summers has been emboldened and Hilsenrath has been turned because they’re picking up on the same sea change in public opinion that the Quid analysis is identifying with more precision. For Hilsenrath, here’s the centerpiece of his j’accuse: a long-running Gallup poll asking Americans to rate the relative competence of federal agencies. Yep, that’s right, the Fed — which used to have a better reputation than the FBI and NASA — is now at the absolute bottom of the heap, dragging behind (by a significant margin) even the IRS! It’s one thing to bring up the rear in 2009 polls, what with the immediate aftermath of the deepest recession in 70+ years. But to still be at the bottom in 2014 after a stock market triples (!) and The Longest Expansion In Modern American History™? Incredible. And the most recent poll was in 2014. If anything, the Fed’s reputation is even lower today. I mean … this is really striking, and I can promise you that none of this is lost on the current custodians of the Fed’s prestige and reputation. Or, like Summers, the wannabe custodians. If you’re a professional academic politician like Summers, you can smell the blood in the water.
How Americans Rate Federal Agencies Share of respondents who said each agency was doing either a ‘good’ or ‘excellent’ job, for the eight agencies for which consistent numbers were available.
Source: Gallup telephone polls, most recently 1,020 U.S. adults conducted Nov. 11—12, 2014, with a margin of error of +/-4 percentage points. As reported by the Wall Street Journal.
So what does all this mean for the September FOMC meeting?
Look … does “the market” want more and more supportive policy? Of course it does. We’re addicts. But if the Fed takes a dovish stance now — and anything less than a hike is going to be perceived as a dovish stance — from an organizational perspective the Fed is risking a lot more than a market sell-off from a rate hike. It risks being blamed for anything bad that happens in the economy going forward. This is the risk of being an unpopular political actor. This is the risk of losing your reputation for competence. The Golden Rule of organizational behavior is quite simple: there must ALWAYS be plausible deniability for culpability if something goes wrong. There must ALWAYS be some other political actor to blame. Unless the Fed takes steps now to stem the erosion in their reputation and their position in the public Narrative, they will own this economy and the downturn that everyone (including the Fed) suspects is coming.
By raising rates now, on the other hand, the Fed can declare victory. We achieved our dual mandates of price stability and full employment! Mission accomplished! And unlike George Bush and his infamously premature declaration of same, the Fed has someone to blame when the “mission” unravels (which of course it will) — those dastardly fiscal policymakers who didn’t follow up with structural reforms or pro-growth policies or whatever when they were elected this November. While the consensus view is that the Fed loathes to do anything to rock the market boat before the November election, in truth this meeting is the perfect time to act if your political goal is to declare victory and pass the buck. Hey, we did our part, says the Fed. Prudent stewards of monetary policy and all that. Now, about that consulting gig at Citadel …
That’s the bureaucratic or organizational perspective. Here’s the internal political dynamic as I see it.
An internal politics perspective is similarly driven by questions of reputation, but at the individual level rather than the organizational level. In an academic organization like the modern Fed, your internal reputation is based entirely on how smart you are, as evidenced by the research you do and the papers you write and the talks you give, not on how effective you are in any practical implementation of organizational aims. It’s not that the Fed or major research universities are intentionally ignoring or trying to put down practical implementations like teaching or outreach to commercial bank staffers, but every hour you spend doing that is an hour you’re not spending impressing your colleagues and bosses with how smart you are. It’s just how the internal political game is played, and anyone who has achieved any measure of success in an organization like this knows exactly what I’m talking about.
What this means in practice is that FOMC meetings are driven by a desire to form a consensus with the other smart people around the table, so that each of you is recognized by the other members of the consensus as being smart enough to be a member of the consensus. It’s the precise opposite of the old Groucho Marx joke: “I don’t want to be a member of any club that would have me as a member.” Every FOMC member desperately wants to be a member of the club that would have him or her as a member, because it means that you’ve been recognized as one of the smart kids. The internal political dynamic of academic cultures like the Fed, at least at the highest levels of Governor to Governor interaction, is NOT antagonistic or divisive. On the contrary, it’s cooperative and consensus-forming.
Not sure what I’m talking about? Read this Jon Hilsenrath interview of St. Louis Fed Governor Jim Bullard again (I say again because I published it for other reasons in the last Epsilon Theory note, Magical Thinking), where Bullard describes this consensus building dynamic.
What kind of compromise would it take to get the FOMC to move in September? I mean, so the tradition is there’s some kind of — like you say, some kind of agreement. What would it take to get them there?
Well, I have no idea, so — and it’s really — it’s really the chair’s job to fashion that. But I will say that — I’ll talk historically about the FOMC, the kinds of things that the FOMC would do. You would trade off. You would say, OK, we could hike today, but then we’ll not plan to do anything in the future. That would be one way to — one way to go about a consensus. So that often happens on the FOMC. Or vice versa. If you read the Greenspan-era transcripts, he’ll do things like, OK, we won’t go today, but we’ll kind of hint that we’re pretty sure we’re going to go next time.
And so you get this inter-tempo kind of trade-off, and that often — that often is enough to get people to sign up.
So, hike today and then delay.
Or, no hike today and then no more delay.
Something like that.
Yeah, those kinds of trade-offs are, historically speaking — I’m not saying I know what Janet’s doing, because I don’t. But, historically speaking, those are the kinds of things that the FOMC has done.
I came up with my catchphrase for the — for the month. (Laughter.)
Those are great. That’s worthy of a T-shirt. (Laughs, laughter.) You could have one on the front and one on the back.
What Bullard is describing from a game theoretic perspective is a dual-equilibrium coordination game. Either it’s “Hike today and then delay” (Bullard’s preferred equilibrium outcome) or “No hike today and then no more delay”. Those are the two possible consensus outcomes. Both are stable equilibria, meaning that once you get a consensus at either phrase, there is no incentive for anyone to change his or her mind and leave the consensus. Importantly, both are robust equilibria in their gameplay, meaning that it only takes one or two high-reputation players in the group to commit to one outcome or the other in order to start attracting more and more reputation-seeking players to that same outcome. You can think of individual reputation as a gravitational pull, so that even a proto-consensus of a few will start to draw others into their orbit.
It’s always really tough to predict one equilibrium over another as the outcome in a multi-equilibrium game, because the decision-making dynamic is solely driven by characteristics internal to the group, meaning that there is ZERO predictive value in our evaluations of external characteristics like Taylor Rule inputs in 2016 or US/Soviet nuclear arsenals in 1962. (I wrote about this at length in the context of games of Chicken, like Germany vs. Greece or the Fed vs. the PBOC, in the note Inherent Vice). But my sense — and it’s only a sense — is that the “Hike today and then delay” equilibrium is a more likely outcome of the September meeting than “No hike today and then no more delay”. Why? Because it’s the position both a hawk like Fischer and a dove like Bullard, both of whom are high-reputation members, would clearly prefer. If one of these guys stakes out this position early in the meeting, such that “Hike today and then delay” is the first mover in establishing a “gravitational pull” on other members, I think it sticks. Or at least that’s how I would play the game, if I were Fischer or Bullard.
Okay, Ben, fair enough. If you’re right, though, what do we do about it? How are markets likely to react to the shock of a largely unanticipated rate hike?
In the short term, I don’t think there’s much doubt that it would be a negative shock, because as I write this the implied “market odds” of a rate hike here in September are not even 20%. My analysis suggests that the true odds are about three times that, as I give a slight edge to the “Hike today and then delay” equilibrium over “No hike today and then no more delay”. Do I think it’s a sure thing that they hike next week? Give me a break. Of course I don’t. But if I can be dealt enough hands where the true odds of something occurring are three times the market odds of something occurring …
The medium-to-long term market reaction to whatever the Fed decides next week is going to be driven less by the hike-or-no-hike decision and more by the Fed-directed Narrative that accompanies that rates decision. That is, if they hike next week and start talking about how this is the next step of a “normalization” process where the Fed will try to get rates back up to 3% or 4% in a couple of years … well, that’s a disaster for markets. That’s a repeat of the December rate hike fiasco, and you’ll see a repeat of the January-February horror show, where the dollar is way up, commodities and emerging markets are way down, and everyone starts freaking out over China and systemic risk again. But if they hike next week and start talking about how they’re rethinking the whole idea of normalization, that maybe rates will be super-low on a semi-permanent basis, or at least until productivity magically starts to improve … well, that’s maybe not such a disaster for markets. Ditto if they don’t hike next week. If the jawboning associated with a no-hike in September sets up a yes-hike in December as a foregone conclusion, that’s probably just as bad (if not worse) for markets than a shock today.
Of course, the Fed is well aware of the power of their “communication policy” and the control it exerts over market behavior. Which means that whenever the Fed hikes — whether it’s next week or next month or next meeting or next year — they’re going to sugarcoat the decision for markets. They’re going to fall all over themselves saying that they’re still oh-so supportive of markets. They’re going to proclaim their undying love for markets even as they take actions to distance themselves.
But here’s the thing. The Fed is now revealing its one True Love — its own reputation and its own political standing — and that’s going to be a bombshell revelation to investors who think that the Fed loves them. Investors are like Tom Buchanan in The Great Gatsby. We’re married to this really swell girl, and we get invited to these really great parties, but then we see that Daisy is truly in love with Jay Gatsby, not us. And everything changes. Maybe not on the surface, but deep down, where it really matters. I’m not saying that the Fed abandons the markets. After all, Daisy stays married to Tom. But everything changes in that moment of realization that she truly loves someone else, not you, and that’s what the next Fed hike will mean to markets.
That’s when the party stops.
Appendix: Quid Narrative Analysis
For a recap of how I’m using the Quid tool kit to analyze financial media narrative formation and evolution, please refer to the Epsilon Theory note The Narrative Machine. Below are two slides from Quid providing a quick background on the process.
Here’s the network of all 941 Bloomberg articles over the past year mentioning negative rates, colored by topic cluster:
This is a prototypical focused narrative network, indicative of articles that are truly “about” negative rates, as opposed to articles about something else that provides the clustering characteristics and only mention negative rates in passing. So now let’s look at the same network, but colored by sentiment rather than by topic clustering.
Fully 50% of the articles are negative, 42% neutral, and only 7% are positive in their sentiment.
How does this compare to other Bloomberg networks and other sentiment scores? Horribly. The only subject issue that even comes close is Brexit, with 47% negative, 42% neutral, and 10% positive in the weeks leading up to the vote. Post-vote, the negative sentiment around Brexit drops to the mid-twenties.
To be sure, few topics associated with monetary policy have an overtly positive sentiment distribution, at least in recent years. For example, here’s a chart of the Quid sentiment scores for all Bloomberg articles mentioning Quantitative Easing (QE), by year over the past three years. The Narrative is steadily deteriorating, but we’re still not close to negative articles taking the lead over neutral articles.
Sentiment Scores for Bloomberg Articles Mentioning QE, by Year
9/13 – 9/14
9/14 – 9/15
9/15 – 9/16
One final network observation. Of the positively-oriented Bloomberg articles, they tend to cluster in the topic circled below. That topic? Gold. The articles have a positive sentiment because negative rates are great for gold prices. Of course, that’s a very negative thing from the Fed’s reputational perspective, which means that many of the articles that speak positively about negative rates are actually intimating something negative about central bankers! Bottom line: there is no more hated policy initiative in the world than negative rates.
You may just be a patsy, but you’re an important one. In fact, I don’t think I’ve ever met a bigger crisis actor than you before. … This is for our country!
[Man in Bar shoots Gideon in neck, killing him]
— “Mr. Robot: eps2.0_unm4sk-pt1.tc” (2016)
Why would some poor slob on a farm want to risk his life in a war when the best that he can get out of it is to come back to his farm in one piece? … It is always a simple matter to drag the people along, whether it is a democracy or a fascist dictatorship or a Parliament or a Communist dictatorship.
The people can always be brought to the bidding of the leaders. That is easy. All you have to do is tell them they are being attacked and denounce the pacifists for lack of patriotism and exposing the country to danger. It works the same way in any country.
— Gustave Gilbert, interview recording of Hermann Göring for “Nuremberg Diary” (1947)
Hermann Göring and the Nazis didn’t burn the Reichstag down in 1933. They left that to a simpleton Communist patsy (that’s him in the photo; quite the ur-terrorist, no?). But Göring and the Nazis used the Reichstag fire as their excuse to arrest thousands, establish Hitler as the Führer and unleash a decade-plus of fascist horror on Germany and the world. History is rhyming today, as it always does.
Hynkel, the dictator, ruled the nation with an iron fist. Under the new emblem of the double cross, liberty was banished, free speech was suppressed and only the voice of Hynkel was heard.
― Charlie Chaplin, “The Great Dictator” (1940)
Just need a little hair dye on that Erdogan moustache, and I think we’re good to go.
You’re crazy. I know who I am. You’re trying to frame me. You’re trying to frame me. Cyphre, I know who I am. You murdered them people. I never killed nobody. I didn’t kill Fowler, and … and I didn’t kill Toots, and I didn’t kill Margaret, and I didn’t kill Krusemark, I didn’t kill no one!
I’m afraid you did, Johnny.
My name’s not Johnny!
All killed by your own hand. Guided by me, naturally. Frankly, you were doomed from the moment you slit that young boy in half, Johnny … for twelve years you’ve been living on borrowed time and another man’s memories.
― Alan Parker, “Angel Heart” (1987)
My favorite De Niro role, worth watching just for the fingernails and the way the man eats an egg.
I shouted out,
Who killed the Kennedys?
When after all
It was you and me.
― Jagger and Richards “Sympathy for the Devil” (1968)
Four people died at the 1969 Altamont concert, including a front row murder during the Stones set. It’s fun to strut on stage and sing about this stuff, until the Hells Angels show you what you’re singing about.
When you strike at a king, you must kill him. ― Ralph Waldo Emerson (1803 – 1882)
Omar: Come at the king, you best not miss.
― David Simon, “The Wire” (2002)
Everything I know about politics, I learned from “The Wire”. That and a Ph.D. in Government from Harvard. But mostly “The Wire”.
I hope they don’t hang you, precious, by that sweet neck. Yes, angel, I’m gonna send you over. The chances are you’ll get off with life. That means if you’re a good girl, you’ll be out in 20 years. I’ll be waiting for you. If they hang you, I’ll always remember you.
― John Huston, “The Maltese Falcon” (1941)
I think it’s a guy thing, this willingness to be a patsy for a cause, be it love, or lust, or greed, or religion … or a political party. Don’t be a patsy. Be a Sam Spade. Be an Omar.
A “crisis actor” is a familiar theme in all sorts of conspiracy theories. Basically, the idea is that terrorist attacks and the like are false-flag operations, where nefarious government agencies kill their own citizens, directly or indirectly, in order to instill fear and maintain popular support for the smiley-face authoritarianism of the modern State. Crisis actors are the patsies hired by the agencies to weep and wail for the cameras, creating the initial Narrative of terror and supporting the follow-on Narrative of steely government resolve to track down the supposed bad guys.
As per usual with conspiracy theories, the specifics of their claims about crisis actors are nonsense. It’s not “the same girl” crying at Newtown and Orlando and Nice, as the photos on conspiracy websites claim. CNN isn’t a secret division of the CIA. Neil Armstrong really did walk on the moon.
Hermann Göring and Erdogan are crisis actors, pretending that the Nazis or the Islamists are the only force standing between the Motherland and political traitors within and abroad, pretending that their “emergency policies” are anything less than a permanent seizure of political control.
It’s oh so easy to look at what’s going on in Turkey and shake our heads and tsk-tsk that awful Erdogan and the awful anti-democratic things he’s doing over there. Because it IS awful. What’s happening today in Turkey is absolutely a carbon copy of what happened in Germany in 1933 with the Reichstag Fire, and every Western president and prime minister and chancellor and secretary of state and foreign minister — all of whom are mouthing the same diplo-speak pablum about the Islamist fascists of 2016 that their counterparts mouthed about the Nazi fascists of 1933 — will have the same stain on their souls. Not that I’m sure many of this 2016 crowd have a soul left to stain. As Gertrude Stein famously said about Oakland, and I’m saying about these crisis actors, there’s no there there. Whatever human beings they used to be, it seems they’ve been absorbed by their public cartoons, which is really just … sad.
But look homeward, angel. Look homeward, too.
Paul Krugman and Tom Friedman and Jim Cramer and their media Missionary kin are also crisis actors, pretending that the Brexit vote was a deluded, colossal mistake perpetrated on innocent UK voters by economic traitors within and abroad.
Janet Yellen and Mario Draghi and their central bank Missionary kin are also crisis actors, pretending that their “emergency policies”, now more than seven years old, are anything less than a permanent political shift in the global allocation of money and credit.
I mean, can’t we just stop these charades surrounding “the Horror of Brexit” and “data dependence”? Can’t we just admit that it’s all an exercise in — to use the Fed’s terminology — “communication policy”, where words are chosen for effect rather than to convey true belief or opinion … or what we would call in normal human interaction “lying”?
Of course we can’t. Whether you’re Göring or Erdogan or Yellen or Draghi, once you start weaving that tangled web of deception, you can’t un-weave it. Once you sell your soul to the Narrative Devil you can’t buy it back. Erdogan can’t walk his purge back even if he wanted to. Yellen can’t walk her dot plots and forward guidance back even if she wanted to. Draghi and Kuroda are never going to go on stage and shrug their shoulders and say “oops, sorry ‘bout that.” At least St. Louis Fed Governor Jim Bullard didn’t have to flee to Greece for his “failed dot plot coup”.
And yeah … I understand that I’m tarring central bankers and their fellow travelers with the fascist brush. Because the road to hell is paved with good intentions as well as bad. Because there IS a moral equivalence between the means used by Göring and Erdogan to accomplish their ends and the means used by central bankers to accomplish theirs. Do the differing ends and the better intentions matter? Of course they do. And that’s why Ben Bernanke gets $250,000 per speech and Hermann Göring got a cyanide pill in his prison cell. But the shared means of false Narrative and crisis acting matter, too, because they create a world of profound inauthenticity, where ALL public speech is deemed suspect and self-serving — because it is! — and where ANY public speech, no matter how demagogue-ish or false or borderline insane, is deemed functionally equivalent to any other speech. Because it is. It’s what I call Gresham’s Law of Narrative: inauthentic speech drives authentic speech out of circulation, just like bad money drives good money out of circulation. If the function of public speech is to persuade rather than inform — and that’s precisely the function of forward guidance and every other status quo political statement of the past seven years — then it’s just comical for those same status quo institutions to complain now that their political opponents are “lying”. No, they’re just more effective persuaders. They’re just better liars.
And yeah … I’m saying that the rise of Trump and Farage and Le Pen and their ilk is a direct consequence of the communication policy toolkit and the crisis acting employed by every Western central banker and politician over the past seven years. That’s exactly what I’m saying.
As for us investors … we’re the “poor slobs on a farm” that Hermann Göring talks about in his prison cell interviews during the Nuremberg Trials. We don’t want to go to war, whether it’s a real-life war like Erdogan is waging or an ersatz war like Yellen and Draghi are waging. As Göring said, the best outcome for us is that we get home to our farms alive. Why in the world would we sign up for that?
We sign up for it because we are biologically hard-wired over millions of years and socially soft-wired over tens of thousands of years to respond to Narrative. We are social animals in the scientific, technical sense of the phrase, and we — along with our termite, ant, and bee cousins — are the four most successful multi-cellular animal species on Earth because of it. The hallmark of what biologists call a eusocial species isn’t just that it communicates. It swims in an ocean of communication. It is evolved to be immersed in constant communication. How many waking minutes of every day are you away from some sort of message from other humans? Five? Ten? For me it’s however long my morning shower takes. That’s about it. Probably about the same amount of time that an ant or a termite goes without a message from another ant or termite. That’s the human animal for you … basically a giant termite with fire. As a eusocial species, we can no more ignore a message from Janet Yellen than an ant can ignore a pheromone from its queen. Not only can we not ignore it, but it WILL move us, in some small way, at least.
Thankfully, though, unlike an ant we have self-awareness. Or at least the capacity for self-awareness. We can recognize that this process of Narrative influence is happening to ourselves and to others, and we can resist if we choose to.
Now, we will probably go along with whatever the Narrative is suggesting we do, because that’s usually the smart play. We know that there are millions of other ants hearing the queen’s message, and we know that each of them will be moved by her message. Plus — and this is the big insight from game theory, the engine for all of these Common Knowledge behaviors — we know that all of the other ants are thinking about US in exactly the same way we are thinking about THEM. Knowing that, it is entirely rational for each of us to act AS IF the queen’s message is True with a capital T.
Okay, Ben, all very heroic and heartfelt, but what do we do?
Well… here’s what we don’t do. We don’t “fight the Fed”, and we don’t stick our head in the sand and pretend that the status quo Missionaries can’t construct highly investable rallies. You know, like the rally we’re experiencing right now. But by the same token we don’t allow ourselves to become a patsy for the Fed or the ECB or the DNC or the RNC or the WSJ or the NYT or CNBC or whatever other institutional collection of initials asks you to play the fool. We should never trust the Fed or any other Missionary, because one day we’re going to need to, if not fight them, then at least take ourselves off their battlefield.
I think what we need to DO is identify the potential political and economic catalysts coming down the pike and figure out which of these are potential Humpty Dumpty moments — crack-ups in the current system of global credit allocation that are too large for the central banks to piece back together again with their crisis acting and Narrative creation efforts. Then we need to track that Narrative effort so we can get the timing right on these massive catalysts. Because as any coup-launcher or Fed-fighter or volatility-embracer knows, if you’re wrong on timing … you’re just wrong. Starting with the next Epsilon Theory note — “The Narrative Machine” — I’ll be launching a new chapter in this project by demonstrating a set of tools for tracking Narrative evolution and impact. If you’re not yet on the direct distribution list, you can sign up here. I’m pretty excited about where this is going, and hope you’ll join me.
How many things served us yesterday as articles of faith, which today are fables for us?
– Michel de Montaigne, The Complete Essays (1580)
That same night, I wrote my first short story. It took me thirty minutes. It was a dark little tale about a man who found a magic cup and learned that if he wept into the cup, his tears turned into pearls. But even though he had always been poor, he was a happy man and rarely shed a tear. So he found ways to make himself sad so that his tears could make him rich. As the pearls piled up, so did his greed grow. The story ended with the man sitting on a mountain of pearls, knife in hand, weeping helplessly into the cup with his beloved wife’s slain body in his arms.
– Khaled Hosseini, The Kite Runner (2003)
A fable for our times, the ultimate disposition of extraordinary monetary policy. Bad news is good news until bad news is all we know. Global growth is the wife.
The idea of negative interest rates strikes many people as odd. Economists are less put off by it. … The anxiety about negative interest rates seen recently in the media and in markets seems to me to be overdone. Logically, when short-term rates have been cut to zero, modestly negative rates seem a natural continuation; there is no clear discontinuity in the economic and financial effects of, say, a 0.1 percent interest rate and a -0.1 percent rate.
Bernanke is right – economists are not put off by the idea of negative rates. And that’s exactly the problem. There’s a huge discontinuity between a 0.1 percent interest rate and a -0.1 percent interest rate, but economists don’t see it because it’s a BEHAVIORAL discontinuity. Positive rates permit investing behaviors based on fundamentals and compounding. Negative rates require investing behaviors based on hope for a greater fool.
My Sunday school teachers had turned Bible narrative into children’s fables. They talked about Noah and the ark because the story had animals in it. They failed to mention that this was when God massacred all of humanity.
– Donald Miller, Blue Like Jazz: Nonreligious Thoughts on Christian Spirituality (2003). The condescension of modern status quo Narrative construction is staggering. It’s a mistake to do this with kids, and it’s a bigger mistake to do this with voters and investors.
A major European power, a longtime defender of liberal democracy, pluralism and free markets, falls under the sway of a few cynical politicians who see a chance to exploit public fears of immigration to advance their careers. They create a stark binary choice on an incredibly complex issue, of which few people understand the full scope — stay in or quit the E.U.
– New York Times columnist Tom Friedman, doing his part to create a status quo protecting Narrative post-Brexit, where government “unforgivably” abdicated its responsibility by “allowing” foolish citizens who can’t possibly know their own self-interest to vote on something that’s “incredibly complex” and can only be understood by wise men … like Tom Friedman.
He spotted the entourage and security personnel that signaled another important person’s plane. With the temperature over 103 degrees, Mr. Clinton, rather than chatting on the scorching cement, climbed aboard to say hello to Attorney General Loretta E. Lynch.
Simple Simon met a pieman,
Going to the fair;
Says Simple Simon to the pieman,
Let me taste your ware.
Said the pieman to Simple Simon,
Show me first your penny.
Said Simple Simon to the pieman:
Scram! Ya don’t get any! [throws pie in face]
You can learn a lot about political Narrative creation by looking at dominant forms of satire and comedy. Satire today is as arch and elitist as the status quo institutions it defends, in sharp contrast to the populist, slapstick comedy of the Marx Brothers or the Three Stooges. I’ll bet there’s a 99% correlation between UK Leave voters and people who think Benny Hill is funny, and the same between UK Remain voters and people who think John Oliver is funny. For the Tom Friedmans of the world, the solution is simple: “educate” people that John Oliver is hilarious, but you’re a racist dope if you laugh at Benny Hill. Yeah, that’ll work.
I wrote my way out of hell.
I wrote my way to revolution.
I was louder than the crack in the bell.
I wrote Eliza love letters until she fell.
I wrote about The Constitution and defended it well.
And in the face of ignorance and resistance,
I wrote financial systems into existence.
And when my prayers to God were met with indifference,
I picked up a pen, I wrote my own deliverance. – Lin-Manuel Miranda, Hamilton (2015)
Why does “Hamilton” work? Because it’s not arch and it’s not elitist. Because it takes one of the most powerful and long-lived Narratives in modern history – the Founding Fathers – and tells the story without irony, without condescension, and without the (literal) whitewashing of other storytellers.
The Old Stories still work when you play them straight. Thank you, Lin-Manuel.
I am a dire wolf, prey-stalking, lethal prowler.
I am a hunter, horse-mounted, wolf-stabbing.
I am a horsefly, horse-stinging, hunter-throwing.
I am a spider, fly-consuming, eight legged.
I am a snake, spider-devouring, poison-toothed.
I am an ox, snake-crushing, heavy-footed.
I am an anthrax, butcher bacterium, warm-life destroying.
I am a world, space-floating, life-nurturing.
I am a nova, all-exploding… planet-cremating.
I am the Universe — all things encompassing, all life embracing.
I am Anti-Life, the Beast of Judgment. I am the dark at the end of everything. The end of universes, gods, worlds … of everything. Sss. And what will you be then, Dreamlord?
I am hope.
― Neil Gaiman, The Sandman, Vol. 1: Preludes and Nocturnes (1991)
There was a tale he had read once, long ago, as a small boy: the story of a traveler who had slipped down a cliff, with man-eating tigers above him and a lethal fall below him, who managed to stop his fall halfway down the side of the cliff, holding on for dear life. There was a clump of strawberries beside him, and certain death above him and below. What should he do? went the question.
And the reply was, Eat the strawberries.
The story had never made sense to him as a boy. It did now.
– Neil Gaiman, American Gods (2001)
The fin of any siècle is almost always a rough ride, even if we end up dreaming a better dream. In investing as in life there’s never enough time, and we are beset on all sides. Eat the strawberries.
Here’s my most basic view on everything that’s happening in the world right now, politically, economically, socially … all of it:the Fix is still in, but it’s getting harder and harder to maintain.
The Fix is the status quo, and it goes by different labels of identity depending on what you’re talking about. “European Union” is one of those labels. “Central Banking” is one. “Clinton” is another. They aren’t real things at all, but are statements of shared identity that channel our behavior in highly predictable patterns that are, in turn, highly useful to The Powers That Be, and are maintained by expressions of Common Knowledge such as “everyone knows that everyone knows that Brexit was a grievous mistake” or “everyone knows that everyone knows that low interest rates spur the economy.” Those expressions of Common Knowledge are also called Narratives, and the Narratives are dying.
And yes, I know that this all sounds suspiciously philosophical and divorced from our investing reality, but bear with me for a moment, because the punchline here is going to be that I think what I’m describing is the ONLY thing that matters for our investing reality. Our reality is not determined by the antics of the flesh-and-blood Hillary Clinton or Donald Trump, but by the status quo ideas and institutions represented by and threatened by the human-shaped cartoons we call “Hillary Clinton” and “Donald Trump”. To figure out what’s next for markets, we have to figure out why “Clinton” – shorthand for globalism (it’s not called The Clinton Global Initiative for nothing) and a sort of technocratic, condescending, principle-less, democracy-suspicious manner of governing – is failing. We have to figure out why Bill Clinton’s stroll across the Phoenix tarmac to chat up the Attorney General was a) reported at all, and b) greeted by derision and despair within his own party. If you don’t like my use of the label “Clinton” or if you think I’m being too political, replace it with “Brussels” or “Beijing”. It’s all the same thing, just three different shades of gray.
And I really couldn’t care less, professionally at least, what actually transpired between Bill Clinton and Loretta Lynch, or what Hillary Clinton actually believed about her email security classifications. What I care deeply about, however, is how the Narrative around these events is being shaped and reshaped, because that Narrative will determine the path and outcome of every election and every market on Earth. And what I can tell you is that I am shocked by the diminishing half-life of status quo protecting Narratives, by the inability of Big Institutions and Big Money and Big Media and Big War and Big Academia to lock down an effective story that protects the State, even when their competition is primarily comprised of clowns (dangerous clowns, but clowns all the same) like Donald Trump and Nigel Farage. There’s a … tiredness … to the status quo Narratives, a Marie Antoinette-ish world weariness that sighs and pouts about those darn peasants all the way to the guillotine.
We’ve seen this before. History is littered with failed Narratives, once-powerful arrays of Common Knowledge that somehow lose their ability to compel human behavior and eventually become mere myth. That’s where Narratives go to die. They become fables, stories that we chuckle at, stories that we shake our heads at and ask “did people really believe in all that?” Michel de Montaigne – who invented the essay as a literary form and was the first blogger, albeit more than 400 years before Al Gore invented the Internet – wrote about the devolution of faith to fable back in the 16th century. It’s a phenomenon as old as humanity itself. Manifest Destiny … Cultural Revolution … these were Narratives every bit as powerful in their day as European Union or Clinton in ours. Now they’re historical curiosities, something you come across on a Wikipedia bender.
John Gast, “American Progress” (ca. 1872)
Mao Zedong Thought poster (ca. 1970)
The rarity isn’t the Narrative that dies and fades into myth, but the Narrative that survives by re-inventing itself, by finding its words and stories repurposed and retold for a modern ear. For example, the Narrative of the American Founding Fathers is as potent today as it was 100 years ago, maybe more so, and that was before Hamilton gave it a new telling and a new power chord.
Why are the status quo protecting Narratives faltering so badly? I think it’s because status quo political and economic institutions – particularly Central Banks – have failed to protect incomes and have pushed income and wealth inequality past a political breaking point. They made a big bet: we’re going to bail-out/paper-over the banks to prevent massive losses in the financial sector, we’re going to inflate the stock market so that the household sector feels wealthier, and we’re going to make vast sums of money available for the corporate and government sectors to borrow really cheaply. And as the McKinsey chart here shows, by Q2 2014 they had largely succeeded on all counts, certainly in getting the corporate and government sectors to borrow trillions in new debt.
The result, or so the thinking went, of all this pump-priming or bridge-building or whatever metaphor you please would be for all four basic sectors of the global economy – households, corporations, governments, and financial institutions – to consume more and invest more and fail never, which would in turn create a virtuous, self-sustaining cycle of risk taking, real growth, and real wealth creation.
It was a reasonable bet to make. But the bet failed. Why? There’s a book or two to write on this, but I’ll sum it up this way: you can no more force corporations to invest for growth if they don’t believe it’s safe than you can force people to watch John Oliver if they don’t think he’s funny. Sure, they’ll tell you that they think he’s funny, because everyone knows that everyone knows that John Oliver is funny, and they need to go along with the Common Knowledge to be successful social animals. But in their heart of hearts, they don’t think John Oliver is funny. Now to be clear, I’m picking on John Oliver to make a point. Personally, I think he’s funny. Some of the time. Well … kind of funny. I guess. Okay, I don’t really think he’s very funny. Sorry. And the truth is that if you paid me to watch HBO, just as Central Banks are basically paying corporations to borrow money, I’m going to watch 20 Game of Thrones re-runs before I watch a single episode of Last Week Tonight with John Oliver, just as corporations are going to buy back stock and hoard cash 20 times more than invest in new jobs or new equipment.
So what does this have to do with incomes? Two things.
First, little of the increased corporate or government borrowing trickled down into jobs or wage income growth. We’ve all seen the charts. Real wage growth is nonexistent in the Western world. Second, to make it feasible for corporations and governments to borrow these trillions of dollars in the first place, every bit of Central Bank balance sheet expansion (buying bonds) and balance sheet “twist” (buying longer duration bonds) and expansion of allowable securities for purchase (buying more kinds of bonds) and imposition of negative rates (charging you interest if you don’t buy longish-term bonds) was designed to – you guessed it – buy more bonds and thus drive up bond prices and drive down interest rates, particularly longish-term bond prices and longish-term interest rates. That’s great if you’re an investor looking for a percentage return on your bond portfolio. That’s terrible, however, if you’re an investor looking for an income from your bond portfolio. Over the past seven years, Central Banks have rewarded the return-seeking bond buyer many times over, and they’ve done nothing but punish the income-seeking bond buyer.
Put these two income squelchers together – zero wage income growth because corporations aren’t investing for growth and less-than-zero investment income growth because Central Banks have crushed rates – and you have a vast swath of the voting public in every developed nation on Earth that (rightfully!) feels aggrieved and left behind by the gleaming economic recovery that the status quo Narrative Missionaries tout at every turn. Notably, the failure of wage income growth skews younger and Democrat/left. The failure of investment income growth skews older and Republican/right. The status quo Narratives could survive (and have many times) an assault from one wing of the electorate or the other. But from both simultaneously? It’s going to be a close call.
But here’s the even larger problem lurking in the not-so distant future, and it’s found in the behavioral WHY of return-seeking bond buyers versus income-seeking bond buyers. These are two entirely different investorpopulations from a behavioral perspective, with different languages and different investment genotypes. When I hear an investor or financial advisor ask, “Why in the world would I buy a Swiss bond with a -0.5% interest rate?” I know that I’m talking to an income-seeking bond buyer. The return-seeking bond buyer, on the other hand, says “Hey, if you’re right about the world, those Swiss bonds currently yielding -0.5% are going to -1.0%, which means that the price is going up. Where can I buy one of those?”
The only rational owner of a negative rate bond is a pure return seeker; there are zero income seekers holding negative rate bonds. Why is this a problem? Because income seekers will continue to own bonds even if the price goes down (for a while, anyway; at the very least, they are sticky owners). Return seekers, on the other hand, are not sticky owners at all. They will only own a bond if they think that the price is going up – meaning in this case that yields will continue to become even more negative, i.e., that there’s a greater fool (probably in the form of a Central Bank) willing to pay higher and higher prices for these income-destroying bonds – and they will sell in a heartbeat if they think this dynamic is changing.
There is, to cop a phrase from the People’s Bank of China, a massive “one-way bet” on negative rate sovereign debt today. The momentum trade has crystallized to perfection in negative rate bonds, which has grown to become a $10+ trillion (yes, that’s trillion with a T) asset class. I think it’s the most crowded trade in the world from a behavioral or investment DNA perspective, and the moment you get even a whiff of the ECB or BOJ backing down from or reaching its limit of greater foolishness, you are going to get a rush to the exit on ALL sovereign bonds that will shake global capital markets to their core. It’ll be good times till then, as it always is, and I am seeing zero signs of Central Bankers backing down from their greater foolishness. But we have once again set up the global financial system as an inverted pyramid, with a $10 trillion asset class poised on a single, solitary piece of Common Knowledge —– what everyone knows that everyone knows. In 2008, the $10 trillion asset class of residential mortgage backed securities (RMBS) was entirely based on the Common Knowledge that it was impossible to have a nationwide decline in U.S. home prices. When that Narrative failed, the entire inverted pyramid came crashing down. In 2016, the $10 trillion asset class of negative rate sovereign bonds is entirely based on the Common Knowledge that there is no limit to the greater foolishness of Central Banks. If this Narrative fails, the entire inverted pyramid will come crashing down again. Hence my punchline: monitoring this and related status quo protecting Narratives (like the concerted effort to paint Brexit as a one-off blunder, just like Bear Stearns was painted in 2008) is the only thing that really matters for our investment reality.
What to do? Convexity, convexity, convexity. Our portfolios should minimize the maximum risk the world actually presents, not maximize the reward our crystal ball models predict. Timing, timing, timing. We need to pay attention to what matters, and right now that’s all policy and all Narrative all the time. In a negative rate world, you’ve got to think in terms of catalysts, not “stocks for the long haul”. And one more thing. To paraphrase Groucho Marx in Duck Soup, if a four-year-old can’t understand what you’re doing in your portfolio, don’t do it. For me, that means real assets and real yield, fractional ownership in real companies with real cash flows from real economic activity with real people. You know, what a stock market used to mean before it became a Central Bank casino. For more on all these points, I’d point you directly to the recent Epsilon Theory notes “Hobson’s Choice“ and “Cat’s Cradle“.
I know that this all comes across as very negative about the world and our investing future, and that’s because it is. To use a poker analogy, we were dealt some bad cards, the Central Banks waaay overplayed the hand, and now we’ve got to figure out how to extricate ourselves without losing our entire stake. But is this a hopeless situation? No. The most important lesson I ever learned from my mentors in this business is this: always live to fight another day. We can do that. It won’t be fun and it won’t be pretty and we’ll have some scars to show for it, but we can do that. The useful lesson from the Biblical Flood Narrative isn’t a pleasant fable about Noah saving the cute and cuddly animals. The useful lesson is that hubris must be confronted, hope is always present, and that preparation and honest actions will see us through any storm. Yes, we can do that.
[narrating] In 1966, Andy Dufresne escaped from Shawshank prison. All they found of him was a muddy set of prison clothes, a bar of soap, and an old rock hammer, damn near worn down to the nub. I remember thinking it would take a man six hundred years to tunnel through the wall with it. Old Andy did it in less than twenty. Oh, Andy loved geology. I imagine it appealed to his meticulous nature. An ice age here, million years of mountain building there. Geology is the study of pressure and time. That’s all it takes really, pressure, and time.
I played a mean harmonica as a younger man. Lost interest in it though. Didn’t make much sense in here.
Here’s where it makes the most sense. You need it so you don’t forget.
Forget that… there are places in this world that aren’t made out of stone. That there’s something inside… that they can’t get to, that they can’t touch. That’s yours.
What’re you talking about?
Let me tell you something my friend. Hope is a dangerous thing. Hope can drive a man insane.
– “The Shawshank Redemption” (1994)
Hope is a good breakfast, but it is a bad supper.
– Francis Bacon (1561 – 1626)
Where there is no hope, it is incumbent on us to invent it.
– Albert Camus (1913 – 1960)
Hope is the only good god remaining among mankind;
the others have left and gone to Olympus.
Trust, a mighty god has gone, Restraint has gone from men,
and the Graces, my friend, have abandoned the earth.
– Theognis of Megara (c. 550 BC), writing more than 2,500 years before the Trump v. Clinton election.
Dante Gabriel Rossetti, “Pandora” (1869)
A policy-controlled market, whether it’s today’s investment environment or the 1930s or the 1870s, places enormous pressure on investors … for yield and consistent return, to be sure, but even more so for a resurrection of the investment beliefs that held sway in “normal times”, for an escape from the prison of extraordinary monetary policy and its grip on market behavior. Pressure and time. That’s all it took for the Shawshank Redemption and that’s all it takes for our modern market redemption. Or it least that’s all it takes for the hope and the escape attempt. Let’s see if we’re as successful as Andy Dufresne.
When suitably crystallized, an investment hope takes on a different form. It becomes an investment theme. Today the investment hope that has crystalized into an investment theme is the notion that soon, just around the corner now, perhaps as a result of the next mystery-shrouded meeting of the world’s central bankers, perhaps as a result of the U.S. election this November, we will enjoy a coordinated global infrastructure spending boom. Of course, this isn’t deficit spending or another trillion dollar layer of debt, but is “investment in our crumbling infrastructure.” This isn’t a mirror image of China’s massive over-build in empty cities or of Obama’s shovel-ready infrastructure projects from 2009-2010, but is “really a free lunch“, to quote Larry Summers, where there’s never a Bridge-to-Nowhere or an Airport-of-One. Or so the Narrative goes.
A Narrative theme is a theme of hope, pure and simple. And because hope can and will emerge without any evidence or support from the real world, a Narrative theme can work from an investment perspective even if it’s a non-event in the real world or, stranger yet, an abject failure in the real world. In exactly the same way that you can invest alongside central bank efforts to prop up markets and drive asset prices higher without believing in your heart-of-hearts that anything these bankers say is even remotely true, so can you invest alongside a Narrative theme without believing a single word of the Narrative itself.
And to be clear, my personal belief is that Larry Summers and the rest of the “public infrastructure projects are great investments!” crowd are sniffing glue. You’re pulling forward future economic activity, that’s all. Read the latest from Howard Marks if you don’t believe me. I’m not saying that government spending is bad — on the contrary, government spending is absolutely necessary to preserve life, liberty, and the pursuit of happiness, and there’s certainly a societal “return on investment” from government spending — but don’t tell me that there’s this huge productivity-enhancing, non-quotation-marked economic return on investment generated by the government building stuff that the private sector doesn’t want to build. Don’t tell me that what China is doing with their infrastructure is “mal-investment”, but that if we do it … well, that’s different, because, you know, our infrastructure is “crumbling” instead of “gleaming” the way it is in … umm … China. Yes, LaGuardia is a miserable airport. So stipulated. But there are infinitely greater productivity gains to be had from changing our insane TSA regulations and reducing security lines than by building a new Terminal B. If you want a massive Keynesian deficit spending program on top of our massive current debt … fine, make the argument. There’s an argument to be made. But don’t put a specious “investment” wrapper around it.
But it’s exactly that specious wrapper — the Narrative — that makes all of this work as an investment theme. If a massive public works program were couched in its traditional Keynesian or neo-socialist form (you don’t see Bernie Sanders talking about the economic ROI of his infrastructure proposals), it wouldn’t have a chance with the Wall Street Journal crowd. But, hey, if a public works program is “a smart investment” … never mind that this is about as smart an investment as Moonbase Alpha (yes, I had the Space: 1999 lunchbox) or perhaps a gigantic hole in the ground … well, then, let’s muster up the usual suspects at CNBC and the Wall Street Journal op-ed staff to get behind this, and let’s convince ourselves that Donald Trump wouldn’t be a nut job president, even though every shred of evidence and plain common sense screams the contrary, because he’s, you know, a “builder.”
It’s all based on hope for real economic growth and an escape from policy-controlled markets, a hope that springs in every investor’s heart given enough pressure and enough time. It’s a hope that, as Sir Francis Bacon said, makes for a good breakfast but a bad supper. We’re in the breakfast phase of this Narrative theme still, as Missionaries (to use the game theory term) like Larry Kudlow beat the drum louder and louder for a big infrastructure spend, and it’s a drumbeat that will continue to grow until there’s a reality check or a powerful Missionary creating Common Knowledge to knock it back. That will be the dinner portion of this Narrative theme, and it will be an unpleasant meal. But I don’t see dinner being served until well after the U.S. election, no matter who takes the White House or how the balance of power shifts in Congress, and it might be a year or two later before the thin gruel of dashed hopes is served up to markets.
So even though I think this U.S. public infrastructure build has barely a whiff of merit from an economic policy perspective, even though I think its net effect once implemented will be to make the ultimate debt reset that much more horrific, I also think it’s a highly investable idea. Because that’s the way you play the Common Knowledge Game.
Common Knowledge is information that everyone believes everyone has heard. It’s why executions were once held in public, not so a big crowd can see the guy getting hanged, but so the crowd can see the crowd watching the guy getting hanged. It’s why political debates are filmed in front of a live audience. It’s why sitcoms have laugh tracks. It’s how a relatively small but highly televised protest in Cairo’s Tahrir Square toppled Mubarak. It’s why the Chinese government still cracks down on media pictures of the Tiananmen Square protests, now more than 25 years old. Common Knowledge is the game theoretic concept behind the irresistible power of the crowd watching the crowd, and as a result Common Knowledge construction by governments, corporations, and yes, central bankers is one of the most potent instruments of social control on Earth.
The Common Knowledge Game is the game of markets, and it’s been internalized by good traders for as long as markets have existed. What you think about the market doesn’t matter. What everyone thinks about the market (the consensus) doesn’t matter. What matters is what everyone thinks that everyone thinks about the market, and the way you get ahead of this game is to track the “Missionary statements” of politicians, pundits, and bankers made through the four media microphones where the Common Knowledge of markets is created: The Wall Street Journal, The Financial Times, Bloomberg, and CNBC. It’s what Keynes called The Newspaper Beauty Contest, and it drove the policy-controlled markets of the 1930s exactly as it drives markets today. Is it an easy game to play? Nope. But you don’t have to be a professional poker player to avoid being the sucker at your local game. You don’t have to be a wizard trader to be aware that the Common Knowledge Game is being played, and that it’s driving market outcomes.
Red and Andy survived more than 20 years in Shawshank prison because they never lost hope. But they were smart about the concept of hope. They didn’t let hope consume them to take stupid chances. In Red’s words, they never let hope drive them insane. That’s the same balancing act we all need to adopt here in Central Bank prison. Hope is a good thing. Hope is a human thing. But hope is also a social construct that is used intentionally by others to shape our behaviors, in markets as in life. That’s the awareness we need to be hopeful survivors here in the Silver Age of the Central Banker, and that’s the awareness I’m trying to create with Epsilon Theory.
Twain spent 11 years writing his final novel, “The Mysterious Stranger”, but never finished it. The book exists in three large fragments and is Twain’s darkest and least funny work. It’s also my personal favorite.
Stanley: I thought you were called Lucifer.
George: I know. “The Bringer of the Light” it used to be. Sounded a bit poofy to me. Everything I’ve ever told you has been a lie. Including that.
Stanley : Including what?
George : That everything I’ve ever told has been a lie. That’s not true.
Stanley : I don’t know WHAT to believe.
George : Not me, Stanley, believe me!
A must-see movie, and I don’t mean the 2000abomination with Brendan Fraser, but the genius 1967 version by Peter Cook and Dudley Moore. Plus Raquel Welch as Lust. Yes, please.
Henry Hill: Ladies and gentlemen, either you are closing your eyes to a situation you do not wish to acknowledge, or you are not aware of the caliber of disaster indicated by the presence of a pool table in your community!
The Music Man (1962)
The Pied Piper legend, originally a horrific tale of murder, finds its source in the earliest written records of the German town of Hamelin (1384).
The story begins: “it is 100 years since our children left.”
As Tolstoy famously said, there are only two stories in all of literature: either a man goes on a journey, or a stranger comes to town. Of the two, we are far more familiar and comfortable with the first in the world of markets and investing, because it’s the subjectively perceived narrative of our individual lives. We learn. We experience. We overcome adversity. We get better. Or so we tell ourselves.
But when the story of our investment age is told many years from now, it won’t be remembered as a Hero’s Journey, but as a classic tale of a Mysterious Stranger. It’s a story as old as humanity itself, and it always ends with the same realization by the Stranger’s foil: what was I thinking when I signed that contract or fell for that line? Why was I so naïve?
The Mysterious Stranger today, of course, is not a single person but is the central banking Mafia apparatus in the US, Europe, Japan, and China. The leaders of these central banks may not be as charismatic as Robert Preston in The Music Man, but they hold us investors in equal rapture. The Music Man uses communication policy and forward guidance to get the good folks of River City to buy band instruments. Central bankers use communication policy and forward guidance to get investors large and small to buy financial assets. It’s a difference in degree and scale, not in kind.
The Mysterious Stranger is NOT a simple or single-dimensional fraud. No, the Mysterious Stranger is a liar, to be sure, but he’s a proper villain, as the Brits would say, and typically he’s quite upfront about his goals and his use of clever words to accomplish those goals. I mean, it’s not like Kay doesn’t know what she’s getting herself into when she marries into the Corleone family. Michael is crystal clear with her, right from the start. But she wants to believe so badly in what Michael is telling her when he suddenly reappears in her life, that she suspends her disbelief in his words and embraces the Narrative of legitimacy he presents. I think Michael actually believed his own words, too, that he would in fact be able to move the Family out of organized crime entirely, just as I’m sure that Yellen believed her own words of tightening and light-at-the-end-of-the-tunnel in the summer of 2014. Ah, well. Events doth make liars of us all.
Draw your own comparisons to this story arc of The Godfather, with investors playing the role of Kay and the Fed playing the role of Michael Corleone. I think it’s a pretty neat fit. It ends poorly for Kay, of course (and not so great for Michael). Let’s see if we can avoid her fate.
This is a -94% correlation, remarkably strong for any two securities, much less two – pipelines and the dollar – that are not obviously connected in any fundamental or real economy sort of way. But this is always what happens when the Mysterious Stranger comes to town: our traditional behavioral rules (i.e., correlations) go out the window and are replaced with new behavioral rules and correlations as we give ourselves over to his smooth words and promises. Because that’s what a Mysterious Stranger DOES – tell compelling stories, stories that stick fast to whatever it is in our collective brains that craves Narrative and Belief.
There’s nothing particularly new about this phenomenon in markets, as there have always been “story stocks”, especially in the technology, media, and telecom (TMT) sector where you have more than your fair share of charismatic management storytellers and valuation multiples that depend on their efforts.
My favorite example of a “story stock” is Salesforce.com (ticker CRM), a $55 billion market cap technology company with 19,000 employees and about $6.5 billion in revenues. I’m pretty sure that Salesforce.com has never had a single penny of GAAP earnings in its existence (in FY 2016 the company lost $0.07 per share on a GAAP basis). Instead, the company is valued on the basis of non-GAAP earnings, but even there it trades at about an 80x multiple (!) of FY 2017 company guidance of $1.00 per share. Salesforce.com is blessed with a master story-teller in its CEO, Marc Benioff, who – if you’ve ever heard him speak – puts forth a pretty compelling case for why his company should be valued on the basis of bookings growth and other such metrics. Of course, the skeptic in me might note that it is perhaps no great feat to sell more and more of a software service at a loss, particularly when your salespeople are compensated on bookings growth, and the cynic in me might also note that for the past 10+ years Benioff has sold between 12,500 and 20,000 shares of CRM stock every day through a series of 10b5-1 programs. But hey, that’s why he’s the multi-billionaire (and a liquid multi-billionaire, to boot) and I’m not. Here’s the 5-year chart for CRM:
Not bad. Up 138% over the past five years. A few ups and downs, particularly here at the start of 2016, although the stock has certainly come roaring back. But when you dig a little deeper …
There are 1,272 trading days that comprise this 5-year chart. 21 of those trading days, less than 2% of the total, represent the Thursday after Salesforce.com reports quarterly earnings (always on a Wednesday after the market close). If you take out those 21 trading days, Salesforce.com stock is up only 35% over the past five years. How does this work? What’s the causal process? Every Wednesday night after the earnings release, for the past umpteen years, Benioff appears on Mad Money, where Cramer’s verdict is always an enthusiastic “Buy, buy, buy!” Every Thursday morning after the earnings release, the two or three sell-side analyst “axes” on the stock publish their glowing assessment of the quarterly results before trading begins. It’s not that every investor on Thursday believes what Cramer or the sell-side analysts are saying, particularly anyone who’s short the stock (CRM always has a high short interest). But in a perfect example of the Common Knowledge Game, if you ARE short the stock, you know that everyone else has heard what Cramer and the sell-side analysts (the Missionaries, in game theory lingo) have said, and you have to assume that everyone else will act on this Common Knowledge (what everyone knows that everyone knows). The only logical thing for you to do is cover your short before everyone else covers their short, resulting in a classic short squeeze and a big up day. Now to be sure, this isn’t the story of every earnings announcement … sometimes even Marc Benioff and his lackeys can’t turn a pig’s ear of a quarter into a silk purse … but it’s an incredibly consistent behavioral result over time and one of the best examples I know of the Common Knowledge Game in action.
But wait, there’s more. Now let’s add the Fed’s storytelling and its Common Knowledge Game to Benioff’s storytelling and his Common Knowledge Game. Over the past five years there have been 43 days where the FOMC made a formal statement. If you owned Salesforce.com stock for only the 43 FOMC announcement days and the 21 earnings announcement days over the past five years, you would be UP 167%. If you owned Salesforce.com stock for the other 1,208 trading days, you would be DOWN 8%.
Okay, Ben, how about other stocks? How about entire indices? Well, let’s look again at that Alerian MLP index. Over the past five years, if you had owned the AMZ for only the 43 FOMC announcement days over that span, you would be UP 28%.If you owned it for the other 1,229 trading days you would be DOWN 39%. Over the past two years, if you had owned the AMZ for only the 16 FOMC announcement days over that span, you would be UP 18%. If you owned it for the other 487 trading days you would be DOWN 48%. Addition by subtraction to a degree that would make Lao Tzu proud.
I’ll repeat what I wrote in Optical Illusion / Optical Reality… it’s hard to believe that MLP investors should be paying a lot more attention to G-7 meetings and reading the Fed governor tea leaves than to gas field depletion schedules and rig counts, but I gotta call ‘em like I see ‘em. In fact, if there’s a core sub-text to Epsilon Theory it’s this: call things by their proper names. That’s a profoundly subversive act. Maybe the only subversive act that really changes things. So here goes. Today there are vast swaths of the market, like emerging markets and commodity markets and industrial/energy stocks, that we should call by their proper name: a derivative expression of FOMC policy. Used to be that only tech stocks were “story stocks”. Today, almost all stocks are “story stocks”, and the Common Knowledge Game is more applicable to helping us understand market behaviors and price action than ever before.
You see this phenomenon clearly in the entire S&P 500, as well, although not as starkly with a complete plus/minus reversal in performance between FOMC announcement days and all other days. Over the past five years, if you had owned the SPX for only the 43 FOMC announcement days over that span, you would be UP 17%. If you owned it for the other 1,229 trading days you would be UP 28%. Over the past two years, if you had owned the SPX for only the 16 FOMC announcement days over that span, you would be UP 5%. If you owned it for the other 487 trading days you would be UP 2%.
What do I take from eyeballing these charts? The Narrative effect and the impact of the Common Knowledge Game have accelerated over the past two years (ever since Draghi and Yellen launched the Great Monetary Policy Schism of June 2014); they’re particularly impactful during periods when stock prices are otherwise declining, and they’re spreading to broader equity indices. That’s what it looks like to me, at least.
So what does an investor do with these observations? Two things, I think, one a practical course of action and one a shift in perspective. The former being more fun but the latter more important.
First, there really is a viable research program here, and what I’ve tried to show in this brief note is that there really are practical implementations of the Common Knowledge Game that can support investment strategies dealing with story stocks. I want to encourage anyone who’s intrigued by this research program to take the data baton and try this on your favorite stock or mutual fund or index. You can get the FOMC announcement dates straight from the Federal Reserve website. This doesn’t require an advanced degree in econometrics to explore.
I don’t know where this research program ends up, but it’s my commitment to do this in plain sight through Epsilon Theory. Think of it as the equivalent of open source software development, just in the investment world. I suspect it’s hard to turn the Common Knowledge Game into a standalone investment strategy because you’re promising that you’ll do absolutely nothing for 98 out of 100 trading days. Good luck raising money on that. But it’s a great perspective to add to our current standalone strategies, especially actively managed funds. Stock-pickers today are being dealt one dull, low-conviction hand after another here in the Grand Central Bank Casino, and the hardest thing in the world for any smart investor, regardless of strategy, is to sit on his hands and do nothing, even though that’s almost always the right thing to do. Incorporating an awareness of the Common Knowledge Game and its highly punctuated impact makes it easier to do the right thing – usually nothing – in our current investment strategies.
And that gets us to the second take-away from this note. The most important thing to know about any Mysterious Stranger story is that the Stranger is the protagonist. There is no Hero! When you meet a Mysterious Stranger, your goal should be simple: survive the encounter.
This is an insanely difficult perspective to adopt, that we (either individually or collectively) are not the protagonist of the investing age in which we live. It’s difficult because we are creatures of ego. We all star in our own personal movie and we all hear the anthems of our own personal soundtrack. But the Mysterious Stranger is not an obstacle to be heroically overcome, as if we were Liam Neeson setting off (again! and again!) to rescue a kidnapped daughter in yet another “Taken” sequel. At some point this sort of heroism is just a reflection of bad parenting in the case of Liam Neeson, and a reflection of bad investing in the case of stock pickers and other clingers to the correlations and investment meanings of yesterday.
The correlations and investment meanings of today are inextricably entwined with central bankers and their storytelling. To be investmentsurvivors in the low-return and policy-controlled world of the Silver Age of the Central Banker, we need to recognize the impact of their words and incorporate that into our existing investment strategies, while never accepting those words naïvely in our hearts.
If you don’t like what’s being said, change the conversation.
– Don Draper, Mad Men: “Love Among the Ruins” (2009)
It is better for reputation to fail conventionally than to succeed unconventionally.
– John Maynard Keynes, “The General Theory of Employment, Interest, and Money” (1936)
What do you mean you don’t make side orders of toast? You make sandwiches, don’t you?
Would you like to talk to the manager?
You’ve got bread and a toaster of some kind?
I don’t make the rules.
Okay, I’ll make it as easy for you as I can. I’d like an omelet, plain, and a chicken salad sandwich on wheat toast, no mayonnaise, no butter, no lettuce, and a cup of coffee.
A number two, chicken salad san, hold the butter, the lettuce, and the mayonnaise, and a cup of coffee. Anything else?
Yeah. Now all you have to do is hold the chicken, bring me the toast, give me a check for the chicken salad sandwich, and you haven’t broken any rules.
You want me to hold the chicken, huh?
I want you to hold it between your knees.
You see that sign, sir? Yes, you’ll all have to leave. I’m not taking any more of your smartness and sarcasm.
You see this sign? [sweeps all the water glasses and menus off the table]
Honestly, if you’re given the choice between Armageddon or tea, you don’t say “what kind of tea?”
– Neil Gaiman (b. 1960)
In the end the Party would announce that two and two made five, and you would have to believe it. … The heresy of heresies was common sense. And what was terrifying was not that they would kill you for thinking otherwise, but that they might be right.
– George Orwell, “1984” (1949)
You had a choice: you could either strain and look at things that appeared in front of you in the fog, painful as it might be, or you could relax and lose yourself.
– Ken Kesey, “One Flew Over the Cuckoo’s Nest” (1962)
And, first, we will ask you to consider with us, how and in what respect the kings of Argos and Messene violated these our maxims, and ruined themselves and the great and famous Hellenic power of the olden time. Was this because they did not know the truly excellent saying of Hesiod, that the half is often greater than the whole?
– Plato, “The Dialogues of Plato: Laws, Book III” (c. 370 BC)
Some people see the glass half full. Others see it half empty. I see a glass that’s twice as big as it needs to be.
– George Carlin (1937 – 2008)
Five Easy Pieces for the World-As-It-Is
Our story so far…
In the second half of 2014, export volumes in every major economy on Earth began to decline, the result of divergent monetary policies that crystallized with the Fed’s announced tightening bias in the summer of 2014. This decline in trade activity – which is far more impactful than a decline in trade value, because it means that the global growth pie is structurally shrinking – accelerated in 2015 and 2016 as Europe and Japan intentionally devalued their currencies to protect their slices of the global trade pie. In game theoretic terms, Europe and Japan have been “free riders” on the global system, using currency devaluation to undercut the prices of competing US and Chinese products in a way that avoids domestic political pain.
But if there’s an iron law of international politics, it’s this: once the strategic interaction between nations begins to shift from cooperation to competition, once a principal player decides to defect and go for free rider benefits, then the one and only equilibrium of the new game has ALL principal players abandoning cooperation and competing with each other. Moreover, once one principal player begins to compete with a new and terrible weapon (i.e., mustard gas in World War I or negative interest rates in monetary policy or Trump-esque debate tactics in a Republican primary), then all principal players must adopt those tactics or lose the game. Universal competition is a highly stable equilibrium, both on the international stage and the domestic stage, particularly in the way it plays out in domestic politics, where there is never a shortage of populist politicians ready and willing to blame global trade for a host of ills. And because universal competition is such a stable equilibrium, typically only a giant crisis – one that shakes the principal players to their domestic political cores – gets you back, maybe, to a Cooperative game.
Yikes, that sounds pretty dire, Ben. Are you sure? What about some prominent sell-side economists who recently published notes saying that you’re wrong about global trade? While it’s true, say these voices of consensus, that global trade values as measured in dollars are declining as commodities slide and the dollar gets stronger, aggregate global trade volumes are not contracting, so we really don’t have anything to worry about.
Hmm … here’s what the World Trade Organization (the gold standard in the field) says about seasonally-adjusted quarterly export volumes in the four economies that matter for international relations. The chart below starts with the low-water mark of all four geographies in Q1 2009, draws a line to the respective high-water marks hit in the second half of 2014, and then connects to the current index value. I find this sort of minimum-to-maximum-to-current data representation to be a very effective way of isolating inflection points in data series that should (if all is well with the world) grow at a pretty steady linear clip. And no, that’s not an error in the Japan and China graphs. Both countries’ export volumes peaked more than 5 years ago, essentially flatlined (a dip and recovery around the European crisis of 2012 not shown), and rolled over in late 2014. It’s pretty stunning, right? This is the primary reason why I think Japan gets no respect with their monetary policy experiments, and why I think we are already past the event horizon for China to float or otherwise devalue their currency. China has been trying to jumpstart industrial production growth for years now, nothing has worked, and the downturn since Q3 2014 not only puts them embarrassingly behind both the US and Europe in export activity, but also gives the lie to the idea that they can stimulate their way out of this.
To paraphrase George Soros, I’m not expecting a shrinking of the global trade pie and an expansion of competitive, protectionist domestic policies; I’m observing it. Something derailed the global trade locomotive in the second half of 2014, and it doesn’t take a genius to figure out that this something was divergent monetary policy, with the Fed embarking on a public quest to tighten, and the rest of the world doubling down on monetary policy easing. This is Exhibit 1 to support the case that we’ve entered a new, more competitive international political environment, as all four major global economies suffer a simultaneous contraction in trade volumes. I’m often asked what would need to happen for me to change my structurally bearish views about the world. So here you go. If this chart changes, then my views will change.
As you can see, the published WTO data currently goes through Q3 2015. Now maybe the Q4 2015 WTO data will come out and show a new high-water mark for these principal players in the global economy. But I don’t see how. First, I’ve looked at Q4 year-over-year trade values in local currency. Not a perfect measure of volumes, but indicative. The US, Japan, and China are all clearly down year-over-year in Q4; it’s hard to tell for the EU without including intra-EU trade. Second, I’ve looked at the raw data of container volume in the major ports in the world. 2015 data isn’t available for China and Japan, but partial data is available for the largest EU port (Rotterdam) and full data for the largest two US ports (Los Angeles and Long Beach). Rotterdam is down a little in 2015 total volumes; Los Angeles and Long Beach are down a lot in export volumes, with the declines accelerating in Q4 (partially labor issues, but still). Want more? Read this FT article on structural shifts in global trade. Read this WSJ article on the expanding January US trade deficit driven by disappointing exports, or this WSJ article on enormous new US tariffs on Chinese cold-rolled steel (while you’re at it, look who the biggest direct beneficiary of these tariffs is: Indian mega-billionaire Lakshmi Mittal … I swear to god, you can’t make this stuff up … and you wonder why Bernie Sanders strikes a chord with his message?). Take a look at Chinese electricity consumption data for 2015 (highly correlated with industrial production) and tell me that we’re not seeing continued declines.
How, then, do consensus sell-side analysts claim that global trade volumes are increasing? Two ways. First, they include countries that don’t matter, like Canada and Brazil. Sorry, my friends to the north and south, but you can increase your export volumes all you like and it matters not to the Great Game. Second – and this is the really egregious data interpretation mistake – they report global trade growth byincluding intra-EU trade! It’s a statistic that the WTO reports (as they should), and they include it in their aggregated global trade number (as they should). But if you can’t see that you need to back this number out if you’re trying to understand the strategic interaction between central banks … if you can’t see that intra-EU trade is as extraneous to this analysis as trade between Texas and California … well, I really don’t know what to say.
Now even though I think it’s totally disingenuous to claim that all is well with global trade volumes, I will be the first to admit that all is not lost. Yet.
First, export volumes have rolled over since the second half of 2014, but they haven’t collapsed, certainly not in the US, anyway. Export values, on the other hand, have taken a nose dive, particularly in the US (the total value of merchandise goods exported by the US is currently off more than 15% from its high-water mark). Keep in mind, though, that I don’t think that a decline in export values is as much of an emergency alarm as a decline in volumes. Why? Because a decline in export values impacts industrial sector earnings, while a decline in export volumes impacts actual industrial sector production. I think this is exactly why we’ve seen an earnings recession in the US, particularly in any sector with a connection to trade, but not a jobs recession. When export values decline, companies are missing their revenue targets. When export volumes decline, companies are shutting down factories. This is the big question I have for the US economy: will export volume declines start catching up to export value declines? If yes, then I think we’re going to have a “real” recession. If no, then I think we’re likely to muddle through in the real economy.
Second, it’s not like you can hide the fact that this enormous barge called global trade has reversed course over the past year and a half, and it’s not like central bankers or the IMF are oblivious to what’s going on. They’re going to respond, and who knows, maybe they’ll be successful in turning this barge back around. I don’t think they have the proverbial snowball’s chance, for reasons I’ll talk about in a second, but they’re certainly going to try.
Here’s a chart of the CDS spread (the premium you have to pay to insure your bond against default) for a senior credit index of the 33 largest European financial institutions as of February 8. I used this chart in the Epsilon Theory note “Snikt” to show what it looks like when the claws of systemic risk pop out.
But now here’s a chart of the same CDS spread as of March 11. We’ve retraced the entire move.
What happened? Exactly what happened in August 2012, the last time Draghi built up huge expectations for a miracle cure, blew the press conference, and had to be bailed out by the Powers That Be. In short, I suspect that the allocation heads at one or two European mega-insurance firms were informed that they would be supporting risk assets, I can observe how the Narrative machine got into gear, and I am certain that real world investors do what they always do, they play the Common Knowledge Game. Hopefully, if you’ve seen this movie before, you traded around the spike in February, got out of the position entirely, and are looking for a reprise.
Is there some reality to what the Narrative machine is pumping out? Sure, there always is. I think we have to take seriously the idea that the G-20 Shanghai meeting of the world’s central bankers and finance ministers in late February was more productive than anyone thought, and that maybe the joint communiqué calling for fewer beggar-thy-neighbor currency devaluations is a temporary truce of sorts. What would this truce look like? China agrees to give it the old college try one more time with domestic credit expansion and money printing, in an effort to replace feeble foreign demand for their products with goosed-up domestic demand and fiscal deficit spending. Europe agrees to lower its negative rates as little as humanly possible, and instead concentrate on good old-fashioned asset purchases. The US agrees to sit on its hands for a while with any more rate hikes, and Japan agrees to sit on its hands for a while with any more rate cuts. Sounds like a plan to me.
So we’re in the early days of a perfectly investable rally, driven by a plausible Narrative of central bank cooperation on currencies. Reminds me for all the world of September 2007, right after every quant-oriented multi-strat fund in the world was gob-smacked in July and August (and if you’ve seen the returns for quant-oriented multi-strat funds this January and February you’ll get my point). We had a perfectly investable rally then, too, driven by the Bernanke Narrative that the sub-prime crisis was “contained” and that the real economy was just in a “mid-cycle slow-down”. All good, until Bear Stearns was taken out into the street and shot the following March. Which was itself followed by a perfectly investable rally from April to mid-summer 2008, under the pervasive Narrative that “systemic risk was off the table.” Until it wasn’t.
So forgive me if I call this a temporary truce, an investable rally before the next “shock” that no one sees coming. Forgive me if I note that yet another FT puff piece on the unappreciated genius of Mario Draghi is ultimately small comfort given that we are smack-dab in the middle of an endemic of political polarization and anti-liberal sentiment (that’s small-l liberalism, of course, the Adam Smith and John Locke sort), the sort of political plague that the world hasn’t seen since the 1930s.
We are now in a world where principled politicians are called fascists, and fascist politicians are called principled. In most Western countries, we are one Reichstag Fire away from a complete up-ending of the core liberal principles of limited government and individual rights. At least the ascendant candidates on the right have the guts, for the most part, to wear their authoritarianism on their sleeves. The other side of the political spectrum, equally ascendant, is no less anti-liberal, they’ve just adopted the façade of smiley-face authoritarianism.
Politics always trumps economics, and until someone can show me that the structural advance in anti-liberal politics is any less pronounced than the structural decline in global trade volumes, I can’t get away from my structurally bearish views about this market. Or about this world, for that matter.
So what do we do about it?
After all, as fictional gangster Hyman Roth, patterned after real-life gangster Meyer Lansky, would say, “This is the business we have chosen.” It’s all well and good to bemoan the thin gruel we are served in modern politics and markets, but it’s the only food we’ve got, and we have a responsibility to make the most of it. I’ve got some ideas, but to be useful, these ideas need to fit the reality of the investment world and the business we have chosen. Let’s talk about that for a minute.
I think that many investors, allocators, and financial advisors today find themselves in the position of Bobby Dupea, the character played brilliantly by a young Jack Nicholson in “Five Easy Pieces.” In that movie’s iconic scene, Bobby just wants to get a side order of wheat toast with his breakfast at the local diner. But he is faced with what game theorists call a Hobson’s Choice, which is part of a more general class of games that includes ultimatums and dilemmas. A Hobson’s Choice is best understood as a strategic interaction where you are presented with what at first glance seem to be multiple opportunities for free will and free choice, but where in truth you only have a single option. Bobby has an entire menu to choose from, and the diner makes toast for sandwiches all day long, but it is impossible – despite a smart proposal of pair trades and long/short exposures that would isolate the wheat toast factor – for Bobby to get what he wants. He can have an omelet with a roll, or he can have nothing. Those are his true choices.
A Hobson’s Choice is Henry Ford telling you that you can have your Model-T in whatever color you like, so long as it’s black. A Hobson’s Choice is a Klingon telling you to surrender or die. A Hobson’s Choice is Vito Corleone making you an offer that you can’t refuse.
Today we have what appears to be a wide-ranging menu of investment strategies and ideas to choose from. But like Bobby Dupea, our true range of choices turns out to be terribly limited if we show the least preference for something that goes against the grain of conventional wisdom. Specifically, the dominant conventions of modern investment are “stocks for the long haul”, “you can’t time markets”, “focus on the fundamentals”, and “buy quality”. Everything you order from the investment menu has these conventional items embedded within them, and the more you question the conventional wisdom (not that it’s all wrong or a big lie, but simply to inquire whether the conventional wisdom is perhaps less useful in unconventional times, and maybe – just maybe – you might want to have some wheat toast with your omelet) the more you risk getting kicked out of the diner.
The Hobson’s Choice that nearly every investor, allocator, or financial advisor faces today is always some variation of the famous quote from John Maynard Keynes: it’s better for your reputation (i.e., your business) to fail conventionally than to succeed unconventionally. Every investment professional I’ve ever met – every. single. one. – wrestles with this dilemma. So do I. We’ve all seen examples in our portfolio results that the conventional tools aren’t working. We know that the words we hear from our Dear Leaders and the articles we read from our Papers of Record are designed to manipulate and entertain us, not inform us. We want to succeed, and we feel in our gut that we should be trying something new and (maybe) better. But not if it means losing our clients or losing the support of our Board or losing the support of that little voice of convention inside each of our heads. It’s that last bit that’s probably the most powerful. As George Orwell so correctly observed about human psychology, the most terrifying part of hearing Big Brother say that two plus two equals five isn’t that they might kill you for believing otherwise, but that you think they might be right!
And make no mistake about it, our Hobson’s Choice is getting worse. Investing according to conventional wisdom has always been the reputationally safe decision, but in the policy-controlled markets to come, investing according to conventional wisdom may well be the only legally safe decision.
So here’s what I’m not going to do. I’m not going to discuss “alternative strategies” that are always set off to the side in a little section of their own on an investment menu, intentionally organized and presented as if to say “Careful now! Here are some exotic side dishes that you might use to spice up your core portfolio a bit, but you’d be crazy to make a meal out of this … not that we’d let you do that anyway.” I’m not going to perpetuate the Hobson’s Choice game and its charade of false choices and hidden ultimatums. Instead, I’m going to recommend alternative thinking about your portfolio here in the Silver Age of the Central Banker. I’m going to recommend five specific ideas – Five Easy Pieces – that challenge conventional wisdom and (I hope) will spark readers to think differently about their entire portfolio and investment process, not just whatever small slice of the pie is reserved for “alternative strategies”.
Five Easy Pieces for the World-As-It-Is
Because this is how we escape a Hobson’s Choice. We must look beyond the false choice. We must reject the ultimatum (act conventionally or risk your business) and find a new dimension that avoids the false choice entirely. This was the genius of Mad Men‘s Don Draper: “If you don’t like what’s being said, change the conversation.” Or to use a far more trite and shop-worn phrase, this is what “thinking outside the box” means – expanding our field of vision to incorporate not only the specific choice we’re presented with, but also the act of choosing. To escape a Hobson’s Choice we can’t look at the world as (x) OR (y), as a series of choices we make from a menu that’s handed to us. We have to step back and see the menu itself as a choice, that what we thought was (x) OR (y) is really (x OR y), and there’s a big world outside of (x OR y). Expanding our perspective and changing our conversation changes everything. It allows us to re-engage in an entirely new way with whatever investment menu we might have in whatever our World-As-It-Is might be, such that whatever investment decisions we make are truly OUR choices, not THEIR choices. Maybe for the first time.
This is a good example of what I’m talking about. Investment convention holds that you should be fully invested throughout a market cycle. Otherwise you must be—gasp!—a market timer. Boo! Hiss! If there’s a worse insult in the investment world or a quicker way to get fired by your client than to be called a market timer, I’m not aware of it. And god forbid that you actually propose an “alternative strategy” that embraces market timing. But of course, we’re ALL market timers, we just do it in a conventionally acceptable way by “shifting to defensive sectors” or “keeping our powder dry” or “managing risk” (whatever that means). We’re all hypocrites when it comes to our professed faith in full investment, because we don’t really believe in it. We all want to get out of markets when they’re going down, we all want to get into markets when they’re going up, and we all think that we have some insight into what’s next.
And that, of course, is the source of the actual wisdom in this conventional wisdom. We really don’t have a crystal ball to predict whether the market will be up or down tomorrow or over the next week or over the next month or over the next year. We really do have biologically evolved social behaviors that push us to sell low and buy high. Whatever you think you should do as a short-term trade, you’re probably wrong. Left to our own devices, almost all of us are almost always better off to put our investments in a drawer, close our eyes, and walk away.
So here’s the question. How do we change the conversation so that a rigorously conceived adjustment in portfolio exposure to risk assets isn’t characterized as market timing? Because as soon as a strategy is characterized as market timing, then it’s a Hobson’s Choice situation, where you don’t really have a choice but to reject it. Now I’m not talking about reading ZeroHedge and selling because you got all freaked out by an article, and I’m not talking about watching CNBC and buying because you got all bulled up by a talking head. That IS market timing, of an indefensible sort. But is there a defensible sort of portfolio exposure adjustment, one that has a foundation strong enough to allow a non-Hobson’s Choice implementation? My answer: yes. In fact, I think there are two such approaches.
First, markets are more volatile when countries are playing a Competitive game than when they’re playing a Cooperative game. Now granted, this is a prediction of a sort, but it’s a prediction of political dynamics – which is exactly what the game theory toolkit is designed to do – as opposed to a market prediction like whether the S&P 500 will be up or down next week. I think this is where Epsilon Theory can make a unique analytical contribution. The international political regime matters to markets. It matters a lot. I am convinced that we have entered a new, analyzable, competitive regime of domestically stressed nations, and that means that we have a deflationary hurricane brewing. What I don’t know (yet) is whether this is going to be a Category 1 hurricane, a Category 3 hurricane, or a Category 5 hurricane. If China floats the yuan – and that’s the big catalyst I think has a decidedly non-trivial chance of occurring – then it’s Category 5. If they don’t, it’s something less. But regardless, a Competitive global trade game is going to be a big storm. Trim your sails. Whatever that means to you and your investment process, whether it’s increasing cash, reducing net or gross exposure, shifting to long-dated Treasuries … whatever … that’s what I think you should do when the world plays a Competitive game. Does that make me a market timer? Well, if that’s the conversation you’re stuck in … yes. But it’s not the conversation I’m having, either with others or myself.
Second, although I can’t predict future market returns, I can observe how volatile the market has been in the short, medium, and long-term past. It’s that George Soros quote again: I’m not predicting; I’m observing. I can also tell you about my personal appetite for risk and volatility. Put these two items together and you have the foundation for a new conversation about investing, a conversation based on observable risk rather than predicted reward. Is observed volatility going up above a level where I am personally comfortable? Well, let’s take my market exposure down. Is observed volatility going down below that level? Well, let’s take my market exposure up. There are a dozen variations on this theme: call it risk balancing or risk parity or volatility targeting or whatever. But whatever you call it, I think it is a better way of staying invested in markets through thick and thin. Just less invested when thick and more invested when thin.
A systematic risk balancing strategy is at the core of what I have been describing as Adaptive Investing over the past two years. That and an appreciation for the political dynamics that underpin markets, creating different investment regimes as the game-playing moves from one equilibrium state to another. There is zero crystal ball gazing in a risk balancing strategy – zero. In that sense it is entirely compatible with the investment convention of not trying to time markets. But the alternative thinking I’m suggesting here is that “full investment over a market cycle” works better if it’s risk being fully invested over a market cycle, not dollars. It’s a new twist on an old idea, and once you start thinking of risk budgets first and dollar budgets second, everything changes.
The usefulness of the game theory toolkit isn’t limited to understanding the dynamics of strategic interactions between international political players like central banks. It’s also useful in understanding the dynamics of strategic interactions between market players. It’s also the rigorous foundation for changing the conversation about another market convention: focus on the fundamentals. Are fundamentals important? Of course they are. Knowing the fundamentals of an investment is like knowing how to play the cards you’re dealt in a poker game. But as any successful poker player will tell you, it’s not enough to play the cards well. More importantly, you also have to play the player.
Wall Street players today aren’t like a historical Jay Gould or a fictional Gordon Gecko, ruthless seat-of-their-pants robber barons with a great eye for arbitrage and leverage. To be sure, it’s not the ruthless part that’s missing today, or the eye for arbitrage and leverage. No, what’s changed from the past and what Hollywood still doesn’t get is that the whole instinctive, seat-of-the-pants thing is totally dead.
Wall Street players today are creatures of process. They are Bill Belichick and Nick Saban, seemingly joyless automatons who do nothing but win (Roll Tide!) because they are monomaniacally focused on efficient process in every aspect of their organization and constant incremental adaptation to new information. It’s not just the quants that have uniformly adopted a process-focused business strategy, but every successful investment firm, regardless of discipline or market focus. Ray Dalio at Bridgewater, certainly the most out-there proponent of Belichick-ian process discipline in the investment world, is best known for creating the largest hedge fund in the world. More interesting to me, though, is how the meme of process and incremental adaptation – principally authored by Dalio – is now part of the internal Narrative of every investment firm on Earth. Note that I’m saying this meme is part of the Narrative of these firms, not their investment DNA. Like all good memes, the belief in process and incremental adaptation is principally an instrument of internal social control, part of the modern day Panopticon (“what, you don’t believe in process? hmm, not sure that you’re going to fit here.”), as well as an instrument of external social expression (“you can trust us … we’re process-oriented!”).
Why is this primacy of process so important for understanding market dynamics? Because it means that while there is no single mode of market participant behavior, no single way of playing the market game, there is an underlying dimension – a common behavioral denominator, if you will – of prioritizing process and incremental adaptation. To torture the poker analogy a bit more, you have tens of thousands of poker tables in operation every day, with hundreds of different poker variations being played … No Limit Texas Hold ‘Em here, 5 Card Draw there, etc. Some players have big stacks, some have small stacks, some play tight, some play loose. But they are ALL process-oriented players. They are ALL watching each other and the cards closely, they are ALL reacting to each other and the cards in an incremental process-oriented way, and they are ALL “learning” in an incremental process-oriented way.
I don’t think you have to be a poker expert to recognize that there’s game-playing power to be found in the recognition of a common behavioral denominator, no matter how deeply it runs. In truth, the deeper it is, the more powerful it is. This is the structural reason why the Common Knowledge Game is such a useful way to analyze market dynamics in the modern age. The market-playing crowd is always looking at the market-playing crowd, and the crowd is hardwired – not by biology but by business process – to “learn” a similar reaction to similar Missionary statements.
This is also the structural reason why I believe trend-following strategies are so interesting and effective in modern markets. In a very real sense, all of these process-focused and iteratively-learning investors are themselves augmenting whatever initial stimulus they’re all looking at, creating trends where none was present before. If you’ve never read George Soros’s “Alchemy of Finance”, now might be a good time to start. What’s perhaps even more interesting – and this will have to be a tease because it deserves several Epsilon Theory notes on its own – is whether it’s possible to design alearning-following investment strategy. Now that would be something.
Okay, this is a big one. What is negative carry? It’s time working against you. It’s the price you pay to carry or hold a position. Investors HATE negative carry, because almost all investment conventions are based on the assumption that time works for you, not against you. What’s the basis of “stocks for the long haul”? Time working for you. What’s the basis of compounding, which is nothing less than the most powerful investment idea in all of human history? Time working for you. What’s the basis of retirement planning, saving, and – in a very real sense – the entire concept of investment? Time working for you.
The damaging impact of negative interest rates on bank earnings and all that is very true and very real.But far more damaging is the impact of negative interest rates on these basic IDEAS about what it means to be an investor in public markets. If you see the world as principally a market of ideas and memes, rather than as a market of capital and labor – and this is exactly the perceptual lens I’m trying to explore with Epsilon Theory – then I don’t see how you can’t be freaked out by what’s happening today. Certainly it’s why I’ve gotten much more alarmist over the past few months in what I write. We are seeing huge chunks of stone being taken out almost daily from these central idea pillars of public markets. As market participants lose faith in the idea that time is on your side, as they start to question the idea that there’s an inherent up-and-to-the-right arrow to any price-over-time chart … the entire financial advisory world is going to burn.
So what do you do?
I suggest we start thinking like a short seller. We don’t have to BE short sellers, but we all need to THINK like short sellers. Why? Because short sellers naturally live in a negative carry world, both in their investments and their ideas. Dividends and yield-bearing securities constantly chip away at the value of a short seller’s portfolio. Similarly, the long-biased information flow promoted by corporate management and the sell-side constantly chips away at the investment theses embedded in a short seller’s portfolio. Time always works against a short seller (particularly in a zero or negative interest rate world … boy, do I miss the 5% interest paid on the cash generated from borrowing shares), and successful short sellers have learned to think differently as a result.
1) If you’re wrong on timing, you’re just wrong. A successful short seller focuses on near-term catalysts, and that’s exactly the focus that I think most investors could adopt, or at least incorporate, in this environment. If there’s no catalyst to force investors to recognize the value that you think exists in a stock, then it doesn’t exist. When a short seller reads a sell-side buy recommendation that begins with something like “For the patient, long-term investor…” they almost always look to short the stock, because it almost always means that the near-term catalysts are very negative for the company. But by the same token, a long-biased investor who thinks like a short seller is happy to buy a company with positive near-term catalysts even if the long-term prospects don’t look so great. In fact, that’s exactly how I would characterize risk assets in general today – structurally awful in the long-term as global trade and global cooperation and the idea of a positive risk-free rate and the liberal tenets of free markets die a little more every day, but with positive short-term catalysts as central bankers and their sell-side apologists rally the troops one more time. Every position is a rental if you’re thinking like a short seller.Nothing is owned.
A catalyst-oriented, everything-is-a-rental way of thinking sounds easy, but it’s the hardest thing you’ll ever do. It’s hard because it’s utterly unforgiving. Meaning, you can never forgive yourself. Here are the two thought processes that have ruined more catalyst-oriented investors than anything else:
“Huh? No price reaction yet to this realized catalyst that I so brilliantly anticipated? Well, I suppose the market just needs a little more time to absorb its importance.”
“Golly, the earnings call just ended and the company didn’t make the announcement I thought they would. Oh, well, I’m sure they’ll announce it next quarter.”
Bzzzzt! Sorry, that’s our tacky buzzer and you’ve just been eliminated from the game. When the catalyst happens – whether or not it impacts the price of the stock or bond like you think it should – you get out. If the time frame or event frame for the catalyst expires – whether or not the catalyst actually occurs – you get out. Thinking like a short seller means no excuses, particularly in the easiest place to make excuses – inside our own heads.
2) The question that really matters: is the story broken?I’ve written about this at length, so I won’t repeat all that here. But I’ll give you an example of a story that ALWAYS breaks in a squirrely market: financial engineering. If you’re long a company because “management is buying back lots of stock” or “there’s a tax-advantaged spin-out possible here” or something similar … well, good luck with that in a risk-off environment. I’m not saying that financial engineering is bad. On the contrary, I love financial engineering. Seriously. It’s an incredibly powerful tool for potentially making money. What I’m saying is that a financial engineering STORY is inherently pro-cyclical – it always works better than you expect in a rising market and worse than you expect in a declining market. A stock with a broken story will go down a lot more than what’s “fair”, and that’s a very unpleasant ride. Fortunately, all stories heal and all stories evolve, which makes for some potential buying opportunities. But you won’t recognize those opportunities (or you’ll probably butcher the timing) unless you’re focusing on what really matters – the story.
So what strategies inherently “think” like a short seller? Managed futures and trend-following, for sure. Everything is a rental for a trend follower, by definition, and trends – because they are created by market behaviors, not the underlying qualities of a company – are inherently linked to the stories and narratives that shape behavior. More basically, any trader and any trading strategy tends to think like a short seller, and I believe there’s room for these strategies to work in markets dominated by a Competitive international game. Ditto for some global macro strategies. Doesn’t mean any of these strategies will work, of course, only that they possess what I think are some of the necessary qualities (as opposed to the sufficient qualities) to succeed.
But when I say it’s important to think like a short seller in a negative carry world, I don’t mean that we have to go out and hire short selling managers. Because I will tell you that there are plenty of short sellers who think like long-only guys, and are thus the worst possible discretionary managers to turn to in this environment. The really crucial action, though, and it’s an action we can all take inside our own heads even if we’re not able or not allowed to actually do short selling, is to step back and reconsider all of our investment menu choices if time no longer works so clearly in our favor. That’s the existential issue every investor, allocator, or advisor needs to wrestle with, no matter how painful that is. Otherwise, to use Ken Kesey’s phrase from “One Flew Over the Cuckoo’s Nest,” you’re choosing to let yourself be lost in the fog. And that’s a Hobson’s Choice of an entirely different sort.
I’m pretty sure that I was the first to come up with the phrase “Central Bank Omnipotence.” It was in one of my very first notes – “How Gold Lost Its Luster, How the All-Weather Fund Got Wet, and Other Just-So Stories” – back in the summer of 2013, a note that even today remains one of the most popular in the Epsilon Theory canon. For the next six months or so, however, I would go around and talk with institutional investors about the Narrative of Central Bank Omnipotence – that markets acted as if central bank policy determined market outcomes – and I got enormous pushback. No, no, I heard, we’re on the cusp of a self-sustaining real economic recovery here in the US, and whatever the Fed and other central banks are doing, whatever the market reaction might be, it’s just a bridge to the happy days of “normal” markets ahead. And this is after the Taper Tantrum, mind you. It really wasn’t until the spring of 2014 that the steady drip, drip, drip of the Central Bank Omnipotence meme became a tsunami, and by the fall of 2014 it was impossible to find anyone who didn’t believe in their heart of hearts that Central Banks, for good or for ill, determined market outcomes.
I bring this up because I’ve read lots of suggestions, particularly after the one day half-life of effectiveness for Kuroda’s negative rates announcement on January 28 and the one hour half-life of effectiveness for Draghi’s negative rates announcement on March 11, that the Narrative of Central Bank Omnipotence is dying. But then you get a day like March 12, where the Narrative engine springs to life in support of Draghi’s “bold move”, and now I read that the Narrative of Central Bank Omnipotence is alive and well.
Here’s what I think. As the strategic interaction between the four largest economies in the world shifts from self-enforced cooperation to self-enforced competition, from a Golden Age to a Silver Age, so does the market’s Common Knowledge or Narrative regarding that strategic interaction. But it doesn’t die, any more than the strategic interaction dies. Think of it as the same song, but now in a minor key. So long as every CNBC talking head genuflects in the direction of central banks in every single conversation, so long as front page articles about central banks dominate every day’s issue of the WSJ and FT … then the Narrative of Central Bank Omnipotence is alive and well. The power of the Narrative is that we believe that all market outcomes are somehow the result of central bank policy, not that central bank policy necessarily generates a good or even intended market outcome. It’s a narrative of Omnipotence, not Competence or Omniscience. The day that central bankers give up, the day that Yellen or Draghi appears on stage and says, “Well, there’s really nothing more we can do. It’s just out of our hands now. Sorry ’bout that.” … that’s the day that we lose our religion and the Narrative dies.
Ultimately, we’re no closer to “normal” markets driven by fundamentals here in the Silver Age of the Central Banker – the age of strife and competition – than we were in the Golden Age of the Central Banker – the age of cooperation and great deeds. In fact, we’re farther away than ever. It’s a policy-driven market just as far as the eye can see.
Policy-driven markets change the rules, both the formal rules of regulation and – more importantly – the informal rules of correlation, and they change these rules in predictably surprising ways. That is, the regulatory rule changes will always be surprisingly to the left or surprisingly to the right, never what you might expect by a central tendency theorem. That goes for correlation surprises, too. Both tails are equally fair game for a shock. I mean, the euro had a four percent trough to peak move on March 11! Two percent down and then two percent up. You think that didn’t blow up some correlation and volatility trades?
When I say don’t trust the models – and by models I mean pretty much of all mainstream portfolio and investment analysis, basically anything that says “Here’s a pattern we observe from some period of time over the last 40 years, and now we’re going to extrapolate what the future holds because of that observed pattern.” – I mean two things. First, we haven’t had a policy-driven market like this since the 1930s, so whatever historical data was used to power whatever model you’re using needs to be taken with a grain of salt (read “I Know It Was You, Fredo“, “Inherent Vice“, “Funny How?“, and “Ghost in the Machine” for more, and of course you can read anything by Nassim Nicholas Taleb or Benoit Mandelbrot for the same message presented in book form). Second, investors are not only risk/reward maximizers, but they are also regret minimizers. Almost all of modern econometrics, particularly portfolio analysis, is an exercise in risk/reward maximization and thus fails to connect with investors who are focused on concerns of regret minimization (read “It’s Not About the Nail” for more).
What this means in practice is that most portfolios are too flabby in what I’ll call the Big Middle – the large portfolio allocation that most investors, large and small, maintain in large cap stocks. The easy way out when it comes to investment conventions and the Hobson’s Choice we all face when it comes to portfolio construction is always to add more S&P 500 exposure. The old IT saying used to be that no one ever got fired for buying IBM, and the current financial advisory saying should be that no one ever got fired for buying more Apple. Although maybe they should.
I’m not saying that capital invested in the Big Middle must always be reallocated to make for a more convex, more diversified portfolio. But I am saying that every bit of your portfolio should be purposeful. I am also saying that there’s a lot of wisdom for investing in what Plato said about politics almost 2,500 years ago (and he was quoting a guy who lived 400 years earlier), that the half is often greater than the whole. Meaning? Meaning that you get better outcomes when half of your citizens or half of your investments are organized efficiently and with right purpose than if all your citizens or all of your investments are organized haphazardly or without common purpose. Or for a more modern slant, I like George Carlin’s take, that while some see a glass half-full and some see a glass half-empty, he sees a glass that’s twice as big as it needs to be. Many portfolios are twice as big as they need to be. Not in dollars, of course (may your portfolio get much larger in that regard), but in terms ofinefficient, mushy allocation to low risk, low reward, highly correlated investments.
What goes into a purposeful portfolio in the Silver Age of the Central Banker? A lot of optionality, for one thing, which does not necessarily require expression through options and derivatives (although that certainly makes it easier) and is another way of saying convexity. A keen sense of correlation and correlation change, for another, which does not necessarily require expression through covariance matrices (although that certainly makes it easier) and is another way of saying diversification. While the terms can be daunting, the logic and practice aren’t so much. Like thinking in terms of a risk budget instead of a dollar budget, it’s more of a matter of perspective than anything else.
One exercise I find useful is to think of different future scenarios for the world (not because I’m trying to predict which one will happen, but precisely because I can’t!) and then to consider how my current exposures and strategies are likely to fare in those futures. My goal isn’t to figure out the scenario where I think I’ll do the best, because then I’ll start hoping for it and consciously or unconsciously will start to assign a higher probability of it occurring, but to figure out the scenario where I’ll do the worst (both in absolute terms and relatively to whatever I compare myself to). I’m trying to minimize my maximum regret – minimax regret, a powerful game theoretic tool for dealing with technical uncertainty, where you’re not sure that you’ve identified all the potential outcomes and you’re certainly not sure of the probability distribution to assign to those outcomes – and I do so by planting seeds (buying exposure with either embedded or overt optionality) in that least happy scenario. I find that this iterative, new information-friendly exercise changes the conversation you can have with others or yourself, away from a needlessly daunting conversation on risk/reward maximization and towards a more fruitful conversation on being an investment survivor in a decidedly dangerous time.
And now for the big finish.
Last summer I wrote a note called “The New TVA”, which made a direct comparison between the political dynamics of the 1930s and the political dynamics of today. What amazes me (still), is how the political conversations then are almost identical to the political conversations now.
Just switch out FDR for Obama and you could easily imagine this cartoon being about healthcare or some such rather than New Deal legislation.
Here’s the skinny for that note: in the same way that FDR had an existential political interest in generating inflation and preventing volatility in the US labor market, so does the US Executive branch today (regardless of what party holds the office) have an existential political interest in generating inflation and preventing volatility in the US capital markets. Transforming Wall Street into a political utility was an afterthought for FDR, a nice-to-have but not a must-have, as Wall Street was not yet a Main Street phenomenon. Today the relative importance of the labor markets and capital markets have completely switched positions. Wall Street is now decidedly a Main Street phenomenon, and every status quo politician – again, regardless of party, and let’s remember that the Fed is part of the Executive Branch – keenly desires to keep the genie of unfettered fear and greed firmly stopped up in its bottle. Georges Clemenceau, French Prime Minister before and after World War I, famously said that “war is too important to be left to the generals.” Today, the quote would be “markets are too important to be left to investors.”
But it was only after Draghi’s ECB announcement last Thursday that I think I see how a policy-driven market becomes a policy-controlled market. The ECB took a page from the Bank of Japan’s playbook and announced that they would now buy non-bank investment grade corporate credit as part of their QE asset purchases, and that’s at least as big of a deal as the BOJ taking a page from the ECB playbook in January and adopting negative interest rates. When two of the Big 4 adopt any policy, a point becomes a line and an idiosyncrasy becomes a pattern. The direct purchase of corporate securities by central banks is now in the official tool kit of every central bank. You cannot un-ring this bell. It is a “Goodfellas moment” of enormous consequence.
In one fell swoop, Draghi has essentially made useless the most effective portfolio hedge I know against systemic risk – shorting investment grade credit through the CDS market. And he conceived this plan when senior bank debt CDS spreads (the best indicator of systemic risk levels I know) were only 120 bps wide! Imagine what’s going to happen the next time spreads blow out to 200 bps wide, much less if we ever got close to the 350 bps spread of 2011. My point, of course, is that Draghi isn’t going to allow CDS spreads to blow out again. Ever. Not even a little bit. The ECB will intervene directly in credit spreads from here to eternity, first in sovereign debt, now in non-bank corporate debt, tomorrow in bank corporate debt. That’s how a policy-driven market becomes a policy-controlled market, not by outlawing short sales or credit default swaps, but by sitting down at the poker table with an infinitely large stack of chips relative to any other player. The ECB can now run over anyone who sits down at the European corporate credit poker table. Thanks, but I’d rather not play, no matter what cards I’m dealt.
So if I can’t protect my portfolio through effective shorts, and the Powers That Be are determined to turn public markets into political utilities, but I’m structurally bearish on the ability of the Powers That Be to prevent domestic political shocks and international political conflict of 1930-ish proportions, what’s to be done with public market investing other than the occasional short-term trade? Two things, I think.
First, I think it makes sense to use public markets for their liquidity and for tapping whatever this utility-like rate of return the Powers That Be have in mind. But I also think it makes sense to tap global beta through risk balancing strategies, because I really do think we’re in for a bad storm, and I don’t trust Captain Yellen or Captain Draghi to guide the ship for my benefit rather than their own political benefit. As for any effort to find alpha in public markets? Forget it.
But, Ben, what about stock picking? Yeah, what about stock picking? You can read the S&P scorecard here. How did that actively managed US equity fund work out for you last year? Or the last 5 years? Or the last 10 years? Here’s my issue with stock picking. Most stock pickers look at companies pretty much exclusively through the lens of “quality” – a quality management team, a quality earnings profile, a fortress balance sheet, etc. Unfortunately, this is the worst possible investment perspective to use in a policy-driven market, much less a policy-controlled market. It does not outperform a broad passive index. It does not generate alpha. Again with the George Soros quote: I’m not expecting it; I’m observing it. I know, I know. Heresy. But ask yourself this. Do you really think that the mandarins of the Fed or the ECB or the BOJ care one whit about whether this company or that company has a higher stock price? Of course not. They want ALL companies to have a higher stock price, and as a result the policies they are going to implement will inevitably help the weakest, lowest quality companies the most. Now if investing in quality-uber-alles is the conventional conversation you need to have to justify participating in public markets, I get it. But to me it’s just another form of fighting the Fed, and for me it’s always a losing conversation.
Second, I think it makes sense to use public markets if that’s the best way to own real assets. Why real assets? Because while nothing is immune to the predation of illiberal governments and the capricious rule-making and rule-breaking of central banks, real assets are at least insulated from both. What real assets? I have a very broad definition, including not only the obvious suspects like real estate and infrastructure and commodities, but also gold and intellectual/digital property. Actually, I think of gold as very similar to many forms of intellectual property, as its worth is found in behavioral preferences and affect, not in some intrinsic or commercial use case.
All real assets are not created equal, of course. I’d much rather own an asset that generates some sort of cash flow than one that just sits there, but price will usually (although not always) take care of that differentiation. The most important consideration, I think, particularly when using public markets, is to get as close as you can to the fractional ownership share in the asset itself and as far away as you can from the casino chip. What that means in practice is getting as high up in the capital stack as you can while still having an equity claim on assets. For a highly levered or distressed company that probably means being in the senior secured debt. For a more typical company that might mean being in the preferred equity shares, if they exist, or choosing between this company’s equity and that company’s equity. It’s making this sort of evaluation where I think that active managers, whether it’s in equity or in fixed income, can prove themselves, and where I think there’s a role for fundamentally-oriented, stock-picking active managers. It’s not because I think they can stock pick their way to outperformance versus a passive index while we’re in a policy-driven or policy-controlled market, but because I think they can identify a margin of safety in my public market ownership of real assets and real cash flows better than a passive index. Now that’s a conversation worth having with active managers here in the Silver Age of the Central Banker.
I’m a China bull, let’s get that out of the way first. But like anything connected with the global industrial and commodity complex today, from Emerging Markets to MLPs to oil prices, it doesn’t matter what the Truth with a capital T might be regarding the real world economic or business fundamentals. The story is broken. The stocks are broken.
I’ve written a lot here in Epsilon Theory about what’s happening in China and what it means for the China growth story to break.
Most directly on the topic, read “When the Story Breaks“. It’s a quick read and introduces an Epsilon Theory perspective for how to think about China.
Most recently on the topic, and why the Chinese currency devaluation kicks US equity markets right in the teeth, read “Storm Warning“.
Now most stories heal themselves over time, and the China growth story is no exception. Or rather, over time these broken stories evolve into a market-supportive story, for example from a growth story into a value story. You see this in market narratives all the time.
But there’s one aspect of the China story that can’t heal itself or transform into something more benign from a market perspective, and that’s the Narrative of Chinese Government Competence. To quote myself in “When the Story Breaks”:
“This is a completely different Narrative than the growth story, and it’s the story that one-party States rely on to prevent even the thought of a viable political opposition. In highly authoritarian one-party nations – like Saddam’s Iraq or the Shah’s Iran – you’ll typically see the competence Narrative focused on the omnipresent secret police apparatus. In less authoritarian one-party nations – like Lee Kuan Yew’s Singapore or Deng Xiaoping’s China – the competence Narrative is more often based on delivering positive economic outcomes to a wide swath of citizens (not that these regimes are a slouch in the secret police department, of course). From a political perspective, this competence Narrative is THE source of legitimacy and stability for a one-party State. In a multi-party system, you can vote the incompetents (or far more likely, the perceived incompetents) out of office and replace them peacefully with another regime. That’s not an option in a one-party State, and if the competency story breaks the result is always a very dicey and usually a violent power transition.”
So when I read an article this morning in a famous media outlet owned by famously Beijing-friendly Rupert Murdoch that “the impression left on investors is that Chinese authorities are out of their depth” and that “certainly with respect to the stock market, their reputation for incompetence is well-earned”, I get nervous.
I get nervous because the next move in China is going to be a political move, and political moves are never well anticipated by markets. The Beijing regime is going to take steps to defend itself, or at least insulate itself, from the growing Narrative that they are incompetent. Heads will roll. Literally, in all likelihood. But the incompetence genie is very hard to stuff back into the bottle, and depending on whose head is on the chopping block, regime stability can deteriorate very quickly. Now that’s what will make me change my bullish stance on China fundamentals, and that’s what will make the US market swoon of last August look like a gentle spring rain.
From an Epsilon Theory perspective, a collapse in the Narrative of Chinese Government Competence is the biggest systemic risk out there right now, and that’s where I’m focusing my risk antennae.
The world made two discoveries last week. Everyone is aware of the first discovery – that ISIS is not “a junior varsity team” but an able protagonist in what Pope Francis quite rightly calls “a piecemeal third World War”. Very few are aware of the second discovery – the existence of a polynomial-time algorithm to determine whether two networks, no matter how complex, are identical. Both are watershed events, part of a continuing destabilization of politics and science. Neither will impact markets very much today. Both will change markets forever in the years to come.
I won’t say much about the first discovery here, but will take this opportunity to reprint a note I wrote in December 2014, eerily right before the Charlie Hebdo attack: “The Clash of Civilizations”. I’d also point out that the all-too-predictable Orwellian response to events like the Paris attack, namely to rewrite history and expand government monitoring of our private lives, is in full swing.
For example, here’s a before and after France Inter headline (hat-tip to Epsilon Theory reader M.O.), as noted by The Daily Telegraph. The headline as it originally ran a few weeks back calls a potential terrorist infiltration of Syrian refugees a “fantasy” of the lunatic right. Immediately after the attack, the headline has been rewritten (and the body of the article partially rewritten as well), to suggest that of course one might question whether or not a few terrorists managed to sneak in with the refugees. France Inter – surprise! – is part of the state-owned media apparatus, now in full-throated advocacy for a “pitiless” war.
Given how this Narrative is developing within left-leaning European governments (hmm, amazingly enough, no marches this time around calling for solidarity with peace-loving Muslims), my political advice to left-leaning US politicians like Connecticut governor Dannel Malloy is that you might be getting a wee bit ahead of yourself by loudly and publicly promoting Syrian refugee relocation in your state. Just sayin’.
The second discovery – an algorithm that dramatically shortens the information processing power required to tell if two networks are structurally the same – requires a bit more explication. Here’s a picture of two such visibly different but structurally identical (isomorphic) networks.
For a whole host of data science applications – from cryptography to genomics to nuclear physics to, yes, finance – we’d often like to know how or if two networks or two data arrays are permutations of the same underlying structure. Maybe you could eyeball an answer to an 8-node network like the example above, but it doesn’t take much imagination to realize that this problem gets very hard very quickly for the human brain as the number of nodes increases.
Fortunately, of course, we have non-human intelligences to help us crack these problems today, but the only known algorithms or programs for computers to follow for this particular problem existed in what is called “non-deterministic polynomial” or NP-time, where the amount of time or information processing power required to carry out the algorithm increases at a staggering rate as the number of nodes increases. This is in contrast to a polynomial or P-time algorithm, where the time required to crunch the algorithm increases at a more manageable rate as the number of nodes increases. Think of it as the difference between 2n (an NP-time algorithm) and n2 (a P-time algorithm), where n is something like 1 million. 2 raised to the 1,000,000th power is an incomprehensibly large number, greater than the number of atoms in the universe. If that’s your algorithm for solving the isomorphic network problem, then it’s physically impossible for any computer, no matter how powerful, to crack the problem for a network with 1 million nodes. On the other hand, 1,000,000 squared is a trivially small number (1 trillion) as a representation of a powerful computer’s information processing capabilities. If that’s your algorithm for solving the isomorphic network problem, then there is no network too large for you to measure and compare to another network.
The isomorphic network problem was a classic example of something that most computer scientists believed could only be solved with NP-time algorithms. But last week, Laszlo Babai at the University of Chicago announced the existence of an algorithm for this class of problems that is, for all practical purposes, in P-time. Why is this important? Because it is the modern day equivalent of discovering a new continent, one that happens to exist in cyberspace rather than human space. Because it is now by no means clear that there are ANY problems of data science that are inexorably lost in the cosmic fog of NP-time algorithms. Why will this one day change markets forever? Because the ability of computers to analyze and predict (and ultimately shape) the behavior of a complex network comprised of millions of semi-autonomous agents exchanging a set of symbolic chips with each other – The Market – just took a giant step forward. If you thought that humans were a marginalized participant in public capital markets today … if you thought that the casino-fication of markets had reached some sort of natural limit … well, you ain’t seen nothing yet.
Sigh. Last week was a tough week for the human team. With the loud explosions out of Paris, the illiberal left, the illiberal right, and the illiberal jihadists are now ALL in political ascendancy. And with the quiet announcement out of Chicago, we are oh-so close to the day when no human communication over any network can be shielded or kept private from a machine intelligence. God help us as the two discoveries merge into one.
Briefly stated, the Gell-Mann Amnesia effect is as follows. You open the newspaper to an article on some subject you know well. In Murray’s case, physics. In mine, show business. You read the article and see the journalist has absolutely no understanding of either the facts or the issues. Often, the article is so wrong it actually presents the story backward—reversing cause and effect. I call these the “wet streets cause rain” stories. Paper’s full of them.
In any case, you read with exasperation or amusement the multiple errors in a story, and then turn the page to national or international affairs, and read as if the rest of the newspaper was somehow more accurate about Palestine than the baloney you just read. You turn the page, and forget what you know. – Michael Crichton (1942-2008)
Dr. Jeremy Stone:
According to this, there’ll be a super-colony of Andromeda over the entire southwest in…
Dr. Charles Dutton:
Jeremy! These are biological *warfare* maps!
Dr. Jeremy Stone:
Why, yes… so they are… uh… but… simulations, Charlie. Defensive… it’s just a scenario.
– “The Andromeda Strain” (1971)
Sometimes you read just the right book at just the right time in your life. For me, one of those books was “The Andromeda Strain”, Michael Crichton’s first (and I think best) science thriller. The 1969 book holds up unnervingly well almost 50 years later, with its spot-on description of the Orwellian impulse of modern government, both in its language and its research programs. If you enjoy Epsilon Theory but you’ve never read “The Andromeda Strain”, do yourself a favor and check it out.
I’ve been thinking about Crichton and his books for a couple of reasons. First, I just read “Lexicon”, by Max Barry, which reminded me of Crichton’s work in its pacing and science-y hook. It’s a terrific read, even if the MacGuffin – what Hitchcock famously called “the object of desire” that motivates the plot of every human story – gets a little silly by the end. Second, I always admired Crichton’s skeptical nature regarding The Powers That Be and their use of Narrative, his ability to weave a good yarn around popularized science, and of course the fact that he made a ton of money with this particular skill set. Third, by far the most common question I get from Epsilon Theory readers (more than 60,000 email subscribers now … thank you!) is for reading recommendations, and it’s high time I updated the required reading list I put together almost 2 years ago.
In truth, the reading list hasn’t changed that much. Books by Soros, Taleb, and Mandelbrot don’t lose their charge from one year to the next. So I’ll just point out two books that I think deserve more attention, two recent books that I think are getting more attention than they deserve, and a fiction genre that I find inspiring but most will just find weird.
The first book that I wish more people would read is “Probably Approximately Correct” by Leslie Valiant. Valiant is usually described as an eminent Harvard computer scientist, and that’s all true. But what I like about his title – T. Jefferson Coolidge Professor of Computer Science and Applied Mathematics – is the applied mathematics part. I’m a wannabe applied mathematician, as is every trader and allocator I know. Valiant is a pro. What is applied mathematics? It’s the grammar of life. Valiant’s book is a profound (sorry, there’s no better word) examination of algorithms and evolution, two topics near and dear to the Epsilon Theory heart. “Probably Approximately Correct” is a tour de force of modern science (and philosophy), as notable for its humility as for its insight.
What’s the pay-off? Keen insight into what makes for a successful process.
We live in an age of process, where the most successful among us – whether it’s a football coach like Nick Saban or Bill Belichick, or an investor like Bridgewater’s Ray Dalio – are consumed by the notion of algorithmic implementations and the primacy of process. Is a bit of, shall we say, joie de vivre lost in the translation of human behavior into reducible and repetitive machine action? No doubt, and if you’ve ever listened to a Belichick press conference you know exactly what I’m talking about. But boy does it work.
Confession: I had always thought that Ray Dalio’s “Principles” were one part brilliance, when he talks about human behavior and what makes for success, and two parts hooey, when he talks about his particular conception of Natural Law and how it informs Bridgewater’s management process. After reading Valiant’s book, I think that I understand for the first time what Dalio is trying to say. Valiant successfully breathes life into Natural Law, a concept that’s been left for dead since … I dunno … Hobbes? Aquinas? The funny thing is that I’m pretty sure Valiant isn’t thinking about philosophical conceptions of Natural Law, much less the foundations of a successful investment or management process when he’s writing about algorithms, but … whoops, there it is!
The second book I think more people should be reading here in the Golden Age of the Central Banker isn’t a single book, but is the body of work of one tough lady – Hannah Arendt. I’ve just finished “Arendt and America”, by Richard King, and once again I find myself so grateful for being dunked headfirst into a big barrel of cold Arendt water. I mean, take one look at this picture and you know exactly who you’re dealing with – a true survivor, not the Larry David sort, a human being who’s seen and heard and lived through the cold fire of totalitarianism, and who’s now going to tell you exactly what she thinks about your cute and comfortable life. Yow. Read “The Origins of Totalitarianism” if you’re up for a heavy load. Read “Eichmann in Jerusalem” (available here online) if you want an introductory dose of speaking truth to power. Arendt coined the phrase “the banality of evil” in her observations of Eichmann’s trial, and that phrase is never far from my mind when I read the news of the world.
On the other hand, I’m not crazy about two books recently published to high praise – “Phishing for Phools” by George Akerlof and Robert Shiller, and “Superforecasting” by Philip Tetlock and Dan Gardner. Smart guys all, with well-deserved reputations for academic excellence. But …
The central concept of “Phishing for Phools” is that human beings often make decisions that are contrary to their best interests. We buy a big ole sugary cinnamon roll. We take out a mortgage with high fees rolled into the financing. We do these things because we are “manipulated” and “easily confused.” Fair enough. Nolo contendere. But sometimes I just want an enormous cinnamon roll. Sometimes I want an extra side of bacon, and yes, I know full well that it’s bad for me. More fundamentally, I DON’T want government “guiding” me towards George Akerlof’s and Robert Shiller’s conception of healthy life choices, no matter how much I might personally agree with those choices. Thanks but no thanks, George and Bob. Do I want to eliminate the EPA and FDA? No, I don’t. Do I think there’s a proper role for government in regulating commercial speech? Yes, I do. But I also think that a central governing algorithm based on the primacy of individual rights rather than some aggregate social benefit is more likely to get us to a policy outcome that is probably approximately correct. Hmm … see what I did there?
I’ve got a similar problem with “Superforecasting”. On the one hand, it’s hard to argue with Tetlock and Gardner’s prescription for good decisionmaking – you should “think probabilistically”, evaluate realistically how well your predictions turn out, and possess enough humility “to admit error and change course”. Again, fair enough. Again, nolo contendere. But I think there’s a classic methodological mistake here when we get – again – to the policy or prescriptive message. Inferring the best predictive characteristics of a general population of decisionmakers from a sampling of decisionmakers who most closely “fit” a backwards-looking model is fraught with danger. It’s a close relative of the error that lots of traders make when they inductively derive a set of weights to assign to a set of variables within a discrete historical sample, and then they inevitably discover that – surprise! – those variable weights are far from optimal once you go out of the historical sample and into real life. Sorry, but I feel like we’ve seen this movie way too many times.
One last point in this brief note, and that’s the important role of fiction in the bedside reading of any investment survivor. There’s no better way to sensitize yourself to the story-telling (excuse me … I mean “communication policy”) of central bankers and other politicians than to immerse yourself in the story-telling of Narrative-centric authors like Chuck Palahniuk, Haruki Murakami, and Dave Eggers. My personal fave of late: Chuck Palahniuk’s comic book (excuse me … I mean “serial graphic novel”). Yes, a comic book – “Fight Club 2” – the best exposition of the power of memes and popular narratives since … well, since Mike Carey’s comic book “The Unwritten”. I realize that I’ll get 50 unsubscribe emails just for writing about fiction in general and comic books in particular, but I bring them up in my recommended reading list for two reasons. First, I think they’re smart, authentic, and entertaining. Second, it is astonishing to me how the examination and appreciation of Narrative pervades every aspect of modern art and literature, from the high-brow to the lowest-brow. We’re not idiots. We know we’re being played. We may suffer the occasional bout of “Gell-Mann Amnesia”, to use Crichton’s description of our innate willingness to take stories outside of our direct experience at face value, but by and large we all make an effort to see behind the face and evaluate the motivations of the finger-wagging Missionary. It’s the conceit and the fatal flaw of both the illiberal left and the illiberal right to underestimate the perceptiveness of we-the-people, and so long as our art and literature – particularly our pop art and our pop literature – remind us of the game that’s being played I think we’re going to come out of this okay.
You’re a pistol, you’re really funny. You’re really funny.
What do you mean I’m funny?
It’s funny, you know. It’s a good story. It’s funny. You’re a funny guy. [laughs]
What do you mean? You mean the way I talk? What?
It’s just, you know. You’re just funny, it’s … funny, the way you tell the story and everything. [it becomes quiet]
Funny how? What’s funny about it?
Tommy, no. You got it all wrong.
Oh, no, Anthony. He’s a big boy, he knows what he said. What did you say? Funny how?
Just…you know…you’re funny.
You mean…let me understand this ’cause, you know maybe it’s me…but I’m funny how? I mean…funny like I’m a clown, I amuse you?
– “Goodfellas” (1990)
Every instinct I have, in every aspect of life, be it something to wear, something to eat – it’s all been wrong.
– “Seinfeld” (1994)
But what could a tax-the-rich plan actually achieve? As it turns out, quite a lot, experts say. Given the gains that have flowed to those at the tip of the income pyramid in recent decades, several economists have been making the case that the government could raise large amounts of revenue exclusively from this small group, while still allowing them to take home a majority of their income. – New York Times, “What Could Raising Taxes on the 1% Do? A Surprising Amount”, October 16, 2015
I was watching the Draghi press conference the other week, and I had to turn off the TV. I found myself getting so … angry … not just at what Draghi was saying, but also the live blog reaction and the live market reaction, that I decided I was better off stepping back from the actual event and trying to figure out why I was having such a powerfully negative emotional reaction to the entire charade. It’s not the charade itself. I mean, if I were outraged by every inauthentic display of central banker “communication policy” and the media lapdog response, I’d be in some sort of permanent apoplectic fit. In fact, neither the central bankers nor the media even pretend any more that extraordinary monetary policy has any sort of material impact on the real economy, which I suppose is actually progress on the authenticity scale in a perverse sort of way.
I travel a lot speaking to investors and allocators of all sizes and political persuasions. I also read a lot from a wide variety of sources, also of all sizes and political persuasions. What I’m seeing and hearing on every issue that concerns capital markets and economics is not only an accelerated polarization of policy views between the left and the right (greater “distance” between the views), but also – and more troubling – a polarization (and in many cases a non-modal distribution) of policy views within the left and the right. The kicker: I think that this polarization is almost entirely driven by monetary policy and the power/wealth inequalities it creates. Central bankers are not only planting the seeds of truly systemic instability, they are watering and tending and nurturing this particularly virulent strain of “green shoots” with their entirely intentional and entirely successful efforts to inflate financial asset prices and mandate reduced volatility in capital markets.
The fact is that maintaining massive debt and creating massive wealth – which is what central banks DO – is a political exercise, pure and simple. It’s nothing else. It’s not social science. It’s politics. Yellen and Draghi are the most powerful politicians in the world, and what makes me angry is their unwillingness to confront the essential nature of their actions, to call what they do by its real name. It makes me angry because the longer the High Church of Central Bankerdom denies and ignores the raw political impact of their actions, the more likely it is that we will have a structural political accident that will destroy every bit of the debt maintenance and wealth creation that the High Church has labored so hard to build. I think we’re getting very close to that sort of political accident.
I’m pretty sure that I agree with absolutely none of Thomas Piketty’s policy prescriptions. And the impact of his bugbear – tax policy – on wealth inequality is laughably minor compared to the impact of a triple in the S&P 500 market cap or central bank purchases of trillions of dollars of bonds. But if you don’t recognize that Piketty has a point when he says that today’s wealth inequality is both outrageous and poisonous, you’re just not paying attention. Increased wealth inequality always leads to increased political polarization, within and between countries, within and between political entities. That was true in the 1870s, that was true in the 1930s, and it’s true today.
What happens when you get greater political polarization? The center does not hold. You get Bizarro world. You get political outcomes that cannot be anticipated by econometric or median voter models. You get political outcomes that will be perceived as illegitimate by a meaningful number of citizens. You get the New York Times writing encouragingly that even with a more aggressive tax regime, the Federal government could still “allow” citizens to take home 50% of their income. Wait. What?
Here’s a fairly typical example of the polarization phenomenon I’m talking about, this from the Pew Research Center based on 1994 – 2014 data. Everything in this chart is significantly worse today, and the same chart could be drawn for every other country on earth (including one-party states like China). You could also draw a chart with exactly the same dynamic for Congress. Or FOMC voting member views on raising rates. Or financial advisor views on liquid alternatives. Seeing polarization is like seeing the homeless … once you start looking for it, you will see it everywhere.
It’s not just the distance between the median Democrat voter and the median Republican voter that concerns me, it’s the shape of the Democrat electorate and the shape of the Republican electorate. A consensus outcome, where a significant majority buys into a final decision, is more difficult when the median voters are farther apart, but by no means impossible. It’s the lack of a single modal “peak” near the median voter within each party that makes consensus so very, very difficult. Why? Because the human animal has designed any number of effective preference aggregation schemes (elections and markets, for example), but none of them work very well at all when preferences are all over the map, when there is no “peakedness” to the preference distribution. There is no voting scheme that can identify a consensus when there is no consensus to be had, and that’s true whether you’re talking about the Republican party or the American electorate at large or the FOMC or the Chinese Politburo. On the contrary, the only thing you are guaranteed to have in a “non-peaked” system is a majority of unhappy members with ANY single construction or faux presentation of consensus.
In practice, one of two things happen in this sort of non-peaked social system. Either a new political dimension is constructed such that a peaked distribution emerges and a consensus outcome can be supported (this usually takes the form of identifying a common enemy, like Commies or Billionaires, or of appealing to a higher power, like Allah or Science), or you get a political accident where fundamental rules of markets and government shift drastically. I’m not looking forward to either.
What does this mean for investors? It means that at some point in the next year or two, I think we are all going to have a Henry Hill “Goodfellas” moment, where we think that we understand the conversation going on around us, where we think that we’re engaged with our social system in the usual way … and then everything will go sideways in a split second, and we will suddenly and with extreme clarity realize that we don’t understand anything at all except that we’re sitting at a table with a maniac. Or if you want a more light-hearted metaphor, we will all have a George Costanza moment where we come to the realization that all of our instincts are wrong. Most of us, of course, have already endured more than a few of these George Costanza moments here in the Golden Age of the Central Banker. I think you ain’t seen nothing yet. It’s not the Minsky Moment I’m worried about, where some credit bubble internal to markets wreaks havoc as it pops. No, it’s the Sideways Moment that I’m worried about, where a political accident external to markets wreaks structural havoc on the entire market system.
Do I understand why Draghi is doing what he’s doing? Do I understand why the Fed is getting colder and colder feet about raising rates? Sure. They’re watching inflation expectations continue to collapse. Here’s the latest chart for the primary metric for US inflation expectations, 5-year forward rates, courtesy of the St. Louis Fed.
Inflation expectations are THE most important data point in the Fed and ECB models that drive monetary policy decision making. And those models, driven by this chart, say that you’re a fool if you raise rates now. Or if not a fool, then at the very least you’re taking on significant post-Fed career risk. Hard to see some big hedge fund shelling out the big bucks for another ex-Fed Chair if this is what makes everything go sideways.
What Draghi and Yellen are doing is exactly what happens when you abdicate social policy to models, when you pretend that you’re just a technocratic financial regulator, and I suppose that’s what makes me angriest of all. I can see where this is going politically. Everyone can see where this is going politically. And maybe we’re already too far gone to change the politically polarized course we’re on. But we have to try. We have to speak honestly about the political dimensions of extraordinarily accommodative monetary policy in its maintenance of massive debt and its creation of massive wealth. Because if we don’t speak, then others will speak for us. And we won’t like what they have to say.
The Gross-out: the sight of a severed head tumbling down a flight of stairs. It’s when the lights go out and something green and slimy splatters against your arm.
The Horror: the unnatural, spiders the size of bears, the dead waking up and walking around. It’s when the lights go out and something with claws grabs you by the arm.
And the last and worst one: Terror, when you come home and notice everything you own has been taken away and replaced by an exact substitute. It’s when the lights go out and you feel something behind you, you hear it, you feel its breath against your ear, but when you turn around, there’s nothing there.
– Stephen King
You’re gonna need a bigger boat.
– “Jaws” (1975)
Back in my portfolio manager days, I was a really good short seller. I say that as a factual observation, not a brag, as it’s not a skill set that’s driven by some great intellectual or character virtue. On the contrary, most short sellers are, like me, highly suspicious of all received wisdom (even when it is, in fact, wise) and have weirdly over-developed egos that feed on the notion of “I’m right even though the world says I’m wrong”. But what set me apart as a short seller were two accidents of experience. First, I didn’t come out of Wall Street, so I wasn’t infected with the long-bias required of those business models. Second, my professional career prior to investing was all about studying mass behaviors and the informational flows that drive those behaviors.
Here’s why that’s important. The biggest difference between shorting and going long is that shorts tend to work in a punctuated fashion. One day I’ll write a full note on the Information Theory basis for this market fact, but the intuition is pretty simple. There’s a constant flow of positive information around both individual stocks (driven by corporate management) and the market as a whole (driven by the sell-side), and as a result the natural tendency of prices is a slow grind up. But occasionally you’ll receive an informational shock, which is almost always a negative, and the price of a stock or the overall market will take a sharp, punctuated decline. The hardest decision for a short seller is what to do when you get this punctuated decline. Do you cover the short, pocket a modest gain, and look to re-establish the position once it grinds higher, as it typically does? Or do you press the short on this informational validation for your original negative thesis? It’s an entirely different mindset than that of most long-only investors, who – because they have the luxury of both time and informational flow on their side – not only tend to add to their positions when the stock is working (my thesis is right, and I’m raising my target price!) but also tend to add when it’s not working (my thesis is right, and this stock is on sale!).
Solving the short seller’s dilemma requires answering one simple question: is the story broken?Is the informational shock sufficient to force long-only investors to doubt not just their facts, but – much more crucially – their beliefs, thus turning them into sellers, too? The facts of the informational shock are almost immaterial in resolving the short seller’s dilemma. Your personal beliefs about those facts are certainly immaterial. The only thing that matters is whether or not the river of information coming out of the sell-side has shifted course in a way that swamps the old belief structures and establishes new Common Knowledge.
In the meantime, what we’ve been experiencing in markets is the plain and simple fear that always accompanies a broken story. The human reaction to a broken story is an emotional response akin to a sudden loss of faith. It’s a muted form of what Stephen King defined as Terror … the sudden realization that the helpful moorings you took for granted are actually not supporting you at all, but are at best absent and at worst have been replaced by invisible forces with ill intent. The antidote to Terror? Call the boogeyman by his proper name. It’s the end of the China growth story, one of the most powerful investment Narratives of the past 20 years. And that’s very painful, as the end of something big and powerful always is. It will require investors to adapt and adjust if they want to thrive. But it’s not MORE than that. It’s not a sign of the investment apocalypse. It’s the end of one investable story, soon to be replaced with another investable story. Because that’s what we humans do.
Here’s a great illustration of what fear looks like in markets, courtesy of Salient’s Deputy CIO and all-around brilliant guy, Rusty Guinn.
These are the cumulative pro forma (i.e., purely hypothetical) returns generated by selling (shorting) the high volatility S&P 500 stocks and buying an off-setting amount of the low volatility stocks (0% net exposure, 200% gross exposure). The factor is up 10% YTD and 15% from the lows in May. Now just to be clear, this is not an actual investment strategy, but is simply a tool we use to identify what factors are working in the market at any point in time. There are any number of ways to construct this indicator, but they all show the same thing – investors have been embracing low volatility (low risk) stocks ever since Greece started to break the European stability story this summer, and that dynamic has continued with the complete breakdown of the China growth story. This is what a flight to safety looks like when you don’t trust bonds because you think the Fed is poised for “lift-off”. This is the fear factor.
Three final Narrative-related points…
First, while the breakdown in the China growth story has reached a tipping point over the past week, this is just the culmination in what has been a two year deterioration of the entire Emerging Market growth story. The belief system around EM’s has been crumbling ever since the Taper Tantrum in the summer of 2013, and it’s the subject of one of the most popular Epsilon Theory notes, “It Was Barzini All Along”. Everything I wrote then is even more applicable today.
Second, I see very little weakness in either the US growth story (best house in a bad neighborhood, mediocre growth but zero chance of recession) or the Narrative of Central Bank Omnipotence. Do I think that the Fed is being stymied in its desire to raise short rates in order to reload its monetary policy gun with conventional ammo? Yes, absolutely. Do I see a significant diminution in the overwhelming investor belief that the Fed and the ECB control market outcomes? No, I don’t. Trust me, I’m keeping my eyes peeled (see “When Does the Story Break?”), because in many respects this is the only question that matters. If this story breaks, then in the immortal words of Chief Brody when he first saw the shark, “You’re gonna need a bigger boat.”
Third, while I’m relatively sanguine about the China growth story breaking down, as I’m confident that there’s a value story waiting in the wings here, I’ll be much more nervous if the China political competence story continues to deteriorate. This is a completely different Narrative than the growth story, and it’s the story that one-party States rely on to prevent even the thought of a viable political opposition. In highly authoritarian one-party nations – like Saddam’s Iraq or the Shah’s Iran – you’ll typically see the competence Narrative focused on the omnipresent secret police apparatus. In less authoritarian one-party nations – like Lee Kuan Yew’s Singapore or Deng Xiaoping’s China – the competence Narrative is more often based on delivering positive economic outcomes to a wide swath of citizens (not that these regimes are a slouch in the secret police department, of course).From a political perspective, this competence Narrative is THE source of legitimacy and stability for a one-party State. In a multi-party system, you can vote the incompetents (or far more likely, the perceived incompetents) out of office and replace them peacefully with another regime. That’s not an option in a one-party State, and if the competency story breaks the result is always a very dicey and usually a violent power transition. I am seeing more and more trial balloons being floated in the Western media (usually with some sort of Murdoch provenance) that indicate “dissatisfaction” with this or that cadre. And it’s not just a markets story any more, as grumblings over the Tianjin fire disaster appear to me to have grown louder over the past week. I haven’t seen this sort of signaling coming out of China in 20 years, and it certainly bears close watching.
And why’d you go and tell her I was selling you weed?
Because somehow it seemed preferable to admitting that I cook crystal meth and killed a man.
– “Breaking Bad” (2008)
Are you in the Mafia?
Am I in the what?
Whatever you want to call it. Organized crime.
Who told you that?
Dad, I’ve lived in the house all my life. I’ve seen the police come with warrants. I’ve seen you going out at three in the morning.
So you never seen Doc Cusamano going out at three in the morning on a call?
Did the Cusamano kids ever find $50,000 in Krugerrands and a .45 automatic while they were hunting for Easter eggs?
I’m in the waste business. Everybody immediately assumes you’re mobbed up. It’s a stereotype. And it’s offensive. And you’re the last person I would want to perpetuate it. There is no mafia.
[pause] Alright…look, Mead, you’re a grown woman, almost. Some of my money…comes from illegal gambling and whatnot. How does that make you feel?
At least you don’t keep denying it, like Mom.
– “The Sopranos” (1999)
You’re lying! Now I know why Ed’s been calling every half hour. You’ve been back on the case, haven’t you?
No! I swear it’s another woman!
– “Naked Gun 33 1/3: The Final Insult” (1994)
Always confess to a small crime if you want to hide the big stuff. I remember reading this in a Robert Heinlein sci-fi novel when I was a kid, and it’s stuck with me ever since. Once you start looking for this trope you see it everywhere, and even if it goes a little over the top at times in scripted media (anyone remember the “24” season where Jack Bauer tortures his own brother, who gives up a partial truth to hide their father’s role as an arch-villain of treason?), I’m always on the look-out for it in the Narrative construction of our unscripted investment news media.
The problem in mass Narrative construction is not (or at least is very rarely) an issue of intentional misdirection through selective confession. But you don’t need intentionality for this dynamic to take root and misdirect all the same. Much more commonly, it’s the spreading of an easy to understand revelation of old fashioned greed that generates such a sense of outrage among all of us that regulators and policy makers mobilize to “crack down” on a few obvious bad guys while leaving the underlying flawed system intact. The result is that the flawed system often gets a new lease on life, as both the popular and regulatory attitude becomes “Oh … well, I guess so long as you’re not doing THAT, then I suppose we’ve got nothing to worry about.”
Case in point: the record $20 million fine levied by the SEC last week on ITG for its egregious wrongdoing in management of its trading dark pool. I can say that this was egregious wrongdoing without any fear of contradiction because – in sharp contrast to almost every settlement you’ve ever seen with the SEC, where the defendant “neither admits nor denies” anything – ITG was forced to confess as part of the settlement. You can read the SEC press release here, you can read the Bloomberg take here, and you can read the Wall Street Journal take here and here. As with most things market structure-related, I’ve learned a ton about this case from Sal Arnuk and Joe Saluzzi at Themis Trading, who put out a daily note on market structure that I think is very useful.
What did ITG do? They blatantly traded against the interests of their own clients, by peeking into their order book to buy and sell stock in other venues for their own account a few milliseconds ahead of their client orders. It’s pretty much a textbook case of front running, only in a modern context of dark pools and multiple electronic trading venues. This predatory HFT program traded 1.3 billion shares and (per Arnuk and Saluzzi’s calculations) impacted the pricing and execution of about 130 billion shares by a few pennies per share. That’s billion with a B. My favorite factoid from the SEC docs: ITG ranked their clients by how easy they were to trade against, and – surprise! – tried to do more business with the suckers. Oh, and here’s another shocker – the suckers were always the sell-side; ITG would turn off the program when it faced its buy-side clients. To be clear, this wasn’t a “rogue” operation at ITG, but something that was explicitly approved by their Board … twice.
My concern is NOT that what ITG did is rampant in the trading world. I doubt that any other dark pool operator or independent execution trader is cheating their clients in such an overt, really almost caricaturish fashion. My concern is in the grey area between cheating and edge. My concern is that our market structure is fundamentally flawed – or at least contains unanticipated and uncompensated risks – and that an honest discussion of those flaws will be shunted to the side in favor of easy regulatory posturing against those darn evil-doers. My strong hunch is that a regulatory and media focus on obvious front running will lock in the current market structure, although equally bad for investors would be some sort of witch hunt against all dark pools and all electronic trading venues.
Whichever way it goes, though, the ultimate result will be the same – an accelerated victory of the big bank trading groups over the high-tech trading firms for control of market flow data. HFT liquidity providers and quant-oriented execution shops are technology companies disguised as financial intermediaries. They hijacked the market infrastructure in the aftermath of the Great Recession, stealing it away from under the noses of the big financial firms who had come to see control over market structure as their birthright, and they had a good run. But now the big boys want their market infrastructure back, and they’re going to get it.
A lot of HFT critics are crowing over the ITG confession. You see! HFT is front running, plain and simple! Told you! And HFT defenders are largely silent because … well, you can’t defend the indefensible. I’m in the anti-HFT camp (see “The Adaptive Genius of Rigged Markets”), but I’m not crowing. If history is any guide at all, the existence of a clearly identifiable small-v villain will forestall the unmasking of what I believe is a Big Bad … the subterranean influence, bordering on control, of human investment behaviors by firms controlling advanced inference machines (see “Troy Will Burn – the Big Deal about Big Data”). Market infrastructure is only the first battleground in this war, but it’s a critical one. If even more advanced non-human intelligences owned by even more powerful institutions are allowed even more unmonitored and unregulated access to even more massive order books, this first battle is even more lost than it already is. But that’s exactly where I think we’re headed.
Everything under heaven is in chaos; the situation is excellent.
― Mao Zedong (1893 – 1976)
A quick email on China’s currency devaluation last night. The news itself is big enough, but it’s the Narrative that’s developing around the devaluation that has my risk antennae quivering like crazy. What do I mean? I mean that initial media efforts to portray the devaluation as a one-time “adjustment” that’s in-line with prior policy have been overrun by stories of “shock” and disjuncture. This is true even within Rupert Murdoch’s various media microphones, which tend strongly to toe the Beijing party line. Moreover, the devaluation is not being described in Western media as Chinese “stimulus”, which it surely is and would send markets higher if portrayed in this light, but as Chinese “currency competition” and as a sign that the growth problems in China are more severe than Western central bankers would like to believe. Or more precisely, would like to have YOU believe.
What’s the Truth with a capital T about Chinese growth, Fed intentions, and the future price of growth-sensitive assets like oil? I have no idea and neither does anyone else. Seriously. But what I do know is that the Common Knowledge about Chinese growth – what everyone thinks that everyone thinks about Chinese growth – is dramatically changed for the worse today, and it’s a change that will accelerate unless the Narrative shifts. That could happen. I still have nightmares about how the Narrative around the ECB’s OMT program shifted from “Draghi’s Blunder” to “Draghi’s Bold Move” within a single day in the pages of the Financial Times in the summer of 2012. But unless and until that Narrative shifts, the path forward for the Fed just got much more perilous. And that’s why the 10-year US Treasury is at 2.12% as I write this note. Unless and until that Narrative shifts, the path forward for oil and any other global growth-sensitive asset or security just got much more perilous. And that’s why oil is at $43 as I write this note.
One last point, focused on what’s next for China. As with everything else here in the Golden Age of the Central Banker, my crystal ball is broken. But I think that I’ve got the right lens for viewing China and its political dynamics, and you can read about it in two Epsilon Theory notes: “The Dude Abides: China in the Golden Age of the Central Banker” and “Rosebud”.
War is too important to be left to the generals. – Georges Clemenceau (1841 -1929)
Competition has been shown to be useful up to a certain point and no further, but cooperation, which is the thing we must strive for today, begins where competition leaves off. … If we call the method regulation, people will hold up their hands in horror and say ‘un-American’ or ‘dangerous.’ But if we call the same process cooperation these same old fogeys will cry out ‘well done.’ – Franklin Roosevelt (1882 – 1945)
The New Yorker magazine’s cartoons of the plump, terrified Wall Streeter were accurate; business was terrified of the president. But the cartoons did not depict the consequences of that intimidation: that businesses decided to wait Roosevelt out, hold on to their cash, and invest in future years.
– Amity Shlaes, “The Forgotten Man” (2007)
Quite possibly the TVA idea is the greatest single American invention of this century, the biggest contribution the United States has yet made to society in the modern world. – John Gunther, “Inside USA” (1947)
This is the greatest advertising opportunity since the invention of cereal. We have six identical companies making six identical products. We can say anything we want. How do you make your cigarettes?
Lee Garner, Jr.:
I don’t know.
Lee Garner, Sr.:
Shame on you. We breed insect repellant tobacco seeds, plant them in the North Carolina sunshine, grow it, cut it, cure it, toast it…
There you go. There you go.
[Writes on chalkboard and underlines: “IT’S TOASTED.”]
Lee Garner, Jr.:
But everybody else’s tobacco is toasted.
No. Everybody else’s tobacco is poisonous. Lucky Strikes…is toasted.
– “Mad Men: Smoke Gets inYour Eyes” (2007)
“How the Children Played at Slaughtering,” for example, stays true to its title, seeing a group of children playing at being a butcher and a pig. It ends direly: a boy cuts the throat of his little brother, only to be stabbed in the heart by his enraged mother. Unfortunately, the stabbing meant she left her other child alone in the bath, where he drowned. Unable to be cheered up by the neighbours, she hangs herself; when her husband gets home, “he became so despondent that he died soon thereafter”. – The Guardian, “Grimm Brothers’ Fairytales have Blood and Horror Restored in New Translation” November 12, 2014
The California Public Employees’ Retirement System said it missed its return target by a wide margin, hurt by a sluggish global economy and an under-performing private equity portfolio. The nation’s largest public pension fund said its investments returned just 2.4% for its fiscal year, ended June 30, far below its 7.5% investment target. – Los Angeles Times, “CalPERS Misses Its Target Return by a Wide Margin” July 13, 2015
When a market malfunctions, the government should not let market sentiment turn from bad to worse. It should use powerful measures to strengthen market confidence. – The People’s Daily (official China newspaper), July 20, 2015
My favorite scene from Mad Men is the picnic scene from Season 2. The Draper family enjoys a lovely picnic at some park, and at the conclusion of the meal Don tosses his beer cans into the bushes and Betty just flicks the blanket and leaves all the trash right there on the grass. Shocking, right? I know this is impossible for anyone under the age of 30 to believe, but this is EXACTLY what picnics were like in the 1960’s, even if a bit over the top in typical Draper fashion. There was no widespread concept of littering, much less recycling and all the other green concepts that are second nature to my kids. I mean … if I even thought about Draper-level littering at a Hunt picnic today my children would consider it to be an act of rank betrayal and sheer evil. I’d be disowned before they called the police and had me arrested.
Like many of us who were children in a Mad Men world, I can remember the moment when littering became a “thing”, with the 1971 public service commercial of an American Indian (actually an Italian actor) shedding a tear at the sight of all the trash blighting his native land. Powerful stuff, and a wonderful example of the way in which Narrative construction can change the fundamental ways our society sees the world, setting in motion behaviors that are as second nature to our children as they were unthinkable to our parents. It’s barely noticeable as it’s happening, but one day you wake up and it’s hard to remember that there was a time when you didn’t believe that littering was a crime against humanity.
This dynamic of change in meaning is rare, but it takes place more often than you might think. Dueling and smoking are easy examples. Slavery is, too. Myths and legends turned into nursery rhymes and fairy tales is one of my favorite examples, as is compulsory public education … a concept that didn’t exist until the Prussian government invented it to generate politically indoctrinated soldiers who could read a training manual. Occasionally – and only when political systems undergo the existential stress of potential collapse – this dynamic of change impacts the meaning of the Market itself, and I think that’s exactly what’s taking place today. Through the magic of Narrative construction, capital markets are being transformed into political utilities.
It’s not a unique occurrence. The last time investors lived through this sort of change in what the market means was the 1930s, and it’s useful to examine that decade’s events more closely, in a history-rhyming sort of way. What’s less useful, I think, is to spend our time arguing about whether this transformation in market meaning is a good thing or a bad thing. It is what it is, and the last thing I want to be is a modern day version of one of those grumpy old men who railed about how Roosevelt was really the Anti-Christ. What I will say, though (and I promise this will be my last indication of moral tsk-tsking, for this note anyway), is that I have a newfound appreciation for why they were grumpy old men, and I feel keenly a sense of loss for the experience of markets that I suspect my children will never enjoy as I have. I suspect they will never suffer in their experience of markets as I have, either, but there’s a loss in that, as well.
It’s totally understandable why status quo political interests would seek to transform hurly-burly capital markets into a stable inflation-generation utility, as summed up in the following two McKinsey charts.
Both of these charts can be found in the February 2015 McKinsey paper, “Debt and (not much) deleveraging”, well worth your time to peruse. Keep in mind that the data used here is from Q2 2014, back when Greece was still “fixed”, the Fed had not proclaimed its tightening bias, and China was still slowing gracefully. All of these numbers are worse today, not better.
So what do the numbers tell us? Two things. First, there’s more debt in the world today than before the Great Recession kicked off in 2008. All the deleveraging that was supposed to happen … didn’t. Sure, it’s distributed slightly differently, both by sector and by geography – and that’s critically important for the political utility thesis here – but whatever overwhelming debt levels you thought triggered a super-cyclical, structural recession then … well, you’ve got more of it now. Second, it’s impossible to grow our way out of these debt levels. Japan, France and Italy would have to more than double their current GDP growth rates (and again, these are last year’s more optimistic projections) to even start to grow their way out of debt. Right. Good luck with that. Spain needs a triple. Even the US, the best house in a bad neighborhood, needs >3% growth from here to eternity to start making a dent in its debt. Moreover, every day you don’t achieve these growth levels is a day that the debt load gets even larger. These growth targets are a receding target, soon to be well out of reach for every country on Earth.
The intractable problem with these inconvenient facts is that there are only three ways to get out from under a massive debt. You can grow your way out, you can inflate your way out, or you can shrink your way out through austerity and/or assignment of losses. Door #1 is now effectively impossible for most developed economies. Door #3 is unacceptable to any status quo regime. So that leaves Door #2. The ONLY way forward is inflation, so that’s what it’s going to be. There is no Plan B. What sort of inflation is most amenable to modern political influence? Financial asset inflation, by a wide margin. Inflation in the real economy depends on real investment decisions by real businesses, and just as in the 1930s most business decision makers are sitting this one out, thank you very much. Or just as in the 1930s they’re “investing” in stock buy-backs and earnings margin improvement, which doesn’t help real world inflation at all. What political institutions are most capable of promoting inflation? Central banks, again by a wide margin. Just as in the 1930s, almost every developed economy in the world has a highly polarized electorate and an equally polarized legislature. The executive may be willing, but the government is weak. Far better to wage the inflation wars from within the non-elected walls of the Eccles Building rather than the White House.
Now … how to wage that inflation war with the proper Narrative armament? No one wants inflation in the sense of “runaway inflation”, to use the phrasing of doomsayers everywhere. In fact, unless you’re speaking apparatchik to apparatchik, you don’t want to use the word “inflation” at all. It’s just like Roosevelt essentially banning the word “regulation” from his Cabinet’s vocabulary. Don’t call it “regulation”. Call it “cooperation”, Roosevelt said, and even the grumpy old men will applaud. So today China calls it a “market malfunction” when their stock market deflates sharply (of course, inflating sharply is just fine). Better fix that malfunctioning machine! How can you argue with that language? But at least the political mandarins in the East are more authentic with their words than the political mandarins in the West. Here we now call market deflation by the sobriquet “volatility”, as in “major market indices suffered from volatility today, down almost one-half of one percent”, where a down day is treated as something akin to the common cold, a temporary illness with symptoms that we can shrug off with an aspirin or two. You can’t be in favor of volatility, surely. It’s a bad thing, almost on a par with littering. No, we want good things and good words, like “wealth effect” and “accommodation” and “stability” and “price appreciation”. As President Snow says in reference to The Hunger Games version of a political utility, “may the odds be always in your favor”. Who doesn’t want that?
There are two problems with the odds being always in your favor.
First, the casino-fication of markets ratchets up to an entirely new level of pervasiveness and permanence. By casino-fication I mean the transformation of the meaning of market securities from a partial ownership interest in the real-life cash flows of real-life companies to a disembodied symbol of participation in a disembodied game. Securities become chips, pure and simple. Now there’s nothing new in this gaming-centric vision of what markets mean; it’s been around since the dawn of time. My point is that with the “innovation” of ETF’s and the regulatory and technological shifts that allow HFTs and other liquidity game-players to dominate the day-to-day price action in markets, this vision is now dominant. There’s so little investing today. It’s all positioning. And in a capital-markets-as-political-utility world, the State is now actively cementing that view. After World War I, French Prime Minister Georges Clemenceau famously said that war was too important to be left to the generals, meaning that politicians would now take charge. Today, the pervasive belief in every capital in the world is that markets are too important to be left to the investors. These things don’t change back. Sorry.
Second, if you’re raising the floor on what you might suffer in the way of asset price deflation, you are also lowering the ceiling on what you might enjoy in the way of asset price inflation. That’s what investing in a utility means – you’re probably not going to lose money, but you’re not going to make a lot of money, either. So to all of those public pension funds who are wringing their hands at this fiscal year’s meager returns, well below what they need to stay afloat without raising contributions, I say get used to it. All of your capital market assumptions are now at risk, subject to the tsunami force of status quo politicians with their backs up against the debt wall. Their market-as-utility solution isn’t likely to go bust in a paroxysm of global chaos, any more than it’s likely to spark a glorious age of reinvigorated global growth. Neither the doomsday scenario nor the happy ending is likely here, I think. Instead, it’s what I’ve called the Entropic Ending, a long gray slog where a recession is as unthinkable as a 4% growth rate. It’s a very stable political equilibrium. Sorry.
As the title of this note suggests, we’ve been down this road before in the 1930s. But the historical rhyming I see is not so much in the New Deal policies that directly impacted the stock market as it is in the policies that established a real-life utility, the Tennessee Valley Authority (TVA). That’s because the nature of the existential threat posed by overwhelming debt to the US political system was different in the 1930s than it is today. When FDR took office, the flash point of that systemic threat was the labor market, not the capital market. Sure, the stock market took its hits in the Great Depression, but the relevance of the stock market to either the overall economic health of the country or – more importantly to FDR – his ability to remain in office was dwarfed by the relevance of the labor market. It’s another one of those changes in meaning that seems bizarre to the modern eye or ear. What, you mean there wasn’t 24/7 coverage of financial markets in 1932? You mean that most Americans didn’t really know what a stock certificate was, much less own one? To succeed politically, Roosevelt had to change the meaning of the labor market, not the capital market, and that’s exactly what he did with the creation of the TVA.
The TVA was only one effort in an alphabet soup of New Deal policies that FDR rammed through in his first Administration to change the popular conception of what the labor market meant to Americans. Other famous initiatives included the National Recovery administration (NRA) and the Civilian Conservation Corps (CCC), and the common thread in all of these efforts was a VERY active Narrative management embedded in their process from the outset, with photographers and journalists hired by the White House to document the “success” of the programs. Everything I write in Epsilon Theory about today’s pervasive Narrative construction also took place in the 1930s, in amazingly similar venues and formats, down to the specific words used.
The Narrative effort worked. Not necessarily in the permanence of the institutions FDR established (the Supreme Court declared the NRA unconstitutional in 1935, and the CCC faded into obscurity with the outbreak of World War II), but in the complete reshaping of what the labor market meant to Americans and what government’s proper role within the labor market should be. Yes, there were important things lost in FDR’s political achievements (and plenty of grumpy old men to complain about that), but let’s not forget that he was re-elected THREE times on the back of these labor market policies. If that’s not winning, I don’t know what is. And if you don’t think that lesson from history hasn’t been absorbed by both Clinton™ and Bush™, you’re living in a different world than I am.
One last point on the TVA. It’s still around today as a very powerful and oddly beloved institution, and I think its lasting political success is due in large part to the fact that it – unlike the other alphabet soup institutions – was explicitly a utility. Who doesn’t like the stability of a utility in the midst of vast inequality? Who doesn’t like the odds being ever in their favor? The more that I see today’s policy impact on markets described in utility-like terms – words like “stability” and notions like “volatility is bad and a thing to be fixed” – the more confident I am that the TVA political experience of the 1930s is coming soon to the capital markets of today. Scratch that. It’s already here.
So, Ben, let’s assume you’re right and that current events are rhyming with the historical events of the last time the world wrestled with an overwhelming debt load. Let’s assume that a politically popular shift in the meaning of markets to cement its public utility function is taking shape and won’t reverse itself without a political shock of enormous proportions. What’s an investor or allocator to do, other than become a grumpy old man? Look, the hardest thing in the world is to recognize structural change when you’re embedded in the structure. If reading Epsilon Theory has given you a new set of lenses to see the relationship between State and Market, then you’ve already done the heavy lifting. From here, it’s a matter of applying that open-eyed perspective to your portfolio, not of buying this or selling that! Everyone will be different in their particular application, but I think everyone should have three basic goals:
re-evaluate your capital market assumptions for a further transformation of those markets into state-run casinos and political utilities, understanding that whatever crystal ball you’ve used in the past is almost certainly broken today;
adopt an investment process or find investment strategies that can adapt to the structural changes that are already underway in capital markets, understanding that the patterns of belief and meaning we think are “natural” today can change in the blink of a central banker’s eye.