There are these two young fish swimming along and they happen to meet an older fish swimming the other way, who nods at them and says “Morning, boys. How’s the water?” And the two young fish swim on for a bit, and then eventually one of them looks over at the other and goes “What the hell is water?”David Foster Wallace, in 2005 Commencement Address to Kenyon College
There is a funny thing I’ve noticed about telling that David Foster Wallace story: I am convinced at this point that everyone who hears it imagines themselves as the older fish.
Especially investment professionals who hear the story.
Don’t get me wrong. If there is one thing more ironic than believing you are the older fish in the David Foster Wallace story, it is telling the story in the first place (since the moral of the story is that humans are all wired to be the two younger fish). And if there is one thing more ironic than telling the story in the first place, it is doing so and then immediately teasing others for not understanding the moral of the story. As chief among us sinners, therefore, I will tell you what I think and what I think I know.
Like Ben, I think the water is changing. I think several ‘immutable’, ‘inherent’ features of financial markets are being recognized as stories subject to revision. I think missionaries with a vested interest in those stories are actively working to promote their preferred narrative as something the crowd believes the crowd believes. I think such a change in any one of five such stories is important enough alone to change the way we allocate capital, develop investment strategies, structure markets and conduct business as investment professionals.
I think these are those five stories. I know that there are certainly more that don’t occur to me because, well, that’s the nature of the water in which we swim.
- We live in a deflationary world.
- We live in a flat world.
- We live in a world in which the Fed has your back.
- We live in a world in which doing anything other than maximizing top-line growth is value–destructive.
- We live in a world of easy credit, abundant leverage, inexhaustible liquidity and limited regulatory scrutiny.
Now let me tell you what I don’t know.
I don’t know how to predict how and when the old narrative will die. I don’t know how to predict when the new narrative that replaces it will be born.
Oh, I have some ideas.
But first you deserve to know why someone willing to tell you he thinks the water is changing went all soggy when it came to giving you any details about how we will know that it has changed.
I’m not expecting it. I’m observing it.George Soros
Yeah, yeah, we use this Soros quote a lot. Why are you booing? He’s right.
Still, there are limits to how far observation can get us. It is true that if we were content with perfunctory, nearly tautological answers to how zeitgeist-defining narratives like the five I mentioned above are born and how they die, well, that would be no problem at all. They are born when enough people believe that everyone else believes in them. They die when the opposite happens. Not when enough “facts” about “reality” accumulate, except to the extent the crowd believes those are the things that will change everyone’s mind. And certainly not when an older fish comes along to let everyone know the “truth” about them, which never changes anyone’s mind.
On its face, however, that explanation isn’t very useful. We can just sit here agreeing with each other until we are blue in the face that it feels like COVID killed collective belief in “The World is Flat!” stone dead, but it doesn’t get us any closer to being able to measure something as abstract as ‘what the crowd believes the crowd believes’. What we call the Narrative Machine, our research effort here at Epsilon Theory, is an attempt to represent that abstract concept – something game theory calls common knowledge – through a model. Since we can’t measure what the crowd believes directly, we instead observe the behavior by influential individuals and institutions (e.g. politicians, executives, celebrities, core cultural institutions, Wall Street, Madison Avenue and the media). More specifically, we observe their missionary behavior, by which we mean linguistic evidence of attempts to shape, create and sustain those narratives.
Oceania had always been at war with Eastasia, that kind of thing.
And then we measure it.
Now, the Narrative Machine is not a model for what the crowd actually believes about some topic. For reasons we have written about at length previously, we don’t think that would be very useful anyway. Instead, ours is a model which seeks to represent what the crowd believes the crowd believes, which as we see it is a lot closer to the transmission mechanism for a market populated by real, thinking people – and the machines they code to exploit the same. It is based on the idea that sufficiently widespread and shared use of distinctive phrases closely related to a topic (e.g. Auto stocks), framing (e.g. “Auto stocks are really a bet for or against EVs”) or premise (e.g. “investors are bullish about Tesla’s capacity growth”) is strongly indicative of the presence of common knowledge. In other words, we believe there are important publications and people that the crowd will assume others will have heard. You don’t trade above-the-fold of the Journal, but before you sit down at your terminal, you’re pretty sure everyone you will talk to that morning has at least glanced at the headlines. You don’t build political strategy around the, uh, thoughtful arguments put forth on the opinion page of the Washington Post, but you damn sure operate knowing that the staffers across the hall have read it.
When we observe those publications and people telling the crowd what the crowd thinks, and when we observe other publications and people begin to use that same language to describe what the crowd thinks about a topic, framing or premise, we think those observations are generally really good models for what we would observe and measure if we could observe and measure common knowledge itself.
As it happens, we think there are good and reasonable behavioral grounds for this approach, too. Humans tend to be optimistic about their own ability to resist being told how to think and very pessimistic about the capacity for other humans to do the same. If a publication or celebrity begins telling us how to think, we certainly wouldn’t let that affect us, but we are more than happy to believe that it shapes the beliefs of others. More importantly, we think civilizations are built on foundations of memes – images, stories and connotations that have repeatedly demonstrated the ability to survive and reproduce when attached to contemporary events. Manipulation of the masses through media is Lindy, I suppose. All of which increases our confidence that measurable missionary behaviors are a reasonable model for what the crowd believes the crowd believes.
But a reasonable model isn’t a perfect one.
The biggest problem with this model presents itself when we aren’t talking about bull case narratives for Tesla or a “time to rotate to cyclicals!” narrative being pushed by some sell side house with an axe. That kind of thing we can observe in all of its useless, cringeworthy glory, for all the good it does us. The problem is the zeitgeist-defining narrative that is so fundamental to our understanding of what stocks and markets and companies and capitalism ARE that it isn’t even discussed.
After all, fish don’t swim around talking about the water.
What I mean is that it isn’t as if moral missionaries host urgent press conferences to shout from the lectern, “Most Americans think that murder is wrong!” Neither does the Wall Street Journal daily voice things like, “institutional investors don’t seriously consider inflation” nor Barron’s that “everyone still believes in a Fed put” nor the CIOs of the ten largest institutional asset owners in America that “free and fair trade is still the path to collective global prosperity.”
The Narrative Machine, whether we mean Epsilon Theory’s models or the brains that you and I have tried to train to consume information more judiciously, is good at measuring missionary activity and narrative adherence. That is, we can see when efforts are being devoted toward telling us what to think. Once we spot those, we can see when people or outlets are staying very on-message or going off-script. Think of missionary activity and narrative adherence as the currents and temperature, if you’re not sick of nautical analogies yet.
The five stories I mentioned above, and a hundred others to which we rarely give a second thought – THOSE are the water in which we swim as investors. They reflect our implicit belief in collective stories that no longer require observable missionary behavior because they are already fully integrated into our institutions, laws and conventions. We don’t have to talk about them very much any more. We don’t need missionary nudges to believe that the crowd believes in them. And changing them is like trying to free a 220,000 gross tonnage container ship that has wedged itself in the silty sides of a canal.
Last tortured nautical analogy, I swear.
Because it is so hard and because it is assumed to be impossible, the implications of a true change in the water, of a shift in a zeitgeist-defining narrative, are monumental. If the common knowledge about something like inflation or globalization changes, it changes everything. And yet, missionaries on Wall Street telling us that it is time to consider acting on ‘active tactical and opportunistic fixed income products with a flexible mandate’ isn’t evidence of a change in common knowledge about inflation. Neither is table-pounding from a key politician about a ‘balanced budget’, if such a thing is even conceivable in 2021. Nor is a data point or two dozen data points indicative of reflation, deflation or anything else. Not even an Epsilon Theory note or two about the topic.
Which leads us to a simple, if unsatisfying truth:
A model which uses missionary behaviors as a proxy for common knowledge isn’t enough to observe what is happening to the water in which we swim, much less to reliably predict when it is changing.
There is hope.
We have a lot of data we can work with. But data isn’t information. Information is what causes someone to change their mind. And if we want to know what will cause the crowd to change its mind about the water in which it swims, I think that we also must get in the habit of asking a different question – a question that is at once a fundamental query of both information theory and game theory.
What do we need to be true?
Imagine that you are a famous and wealthy financier. Let’s say that your name is, oh I don’t know, Schlex Schreensill. Now let us say that you are being investigated for fraud. You’re in an interrogation room, and you know that a politician involved in facilitating your maybe-not-entirely-above-board financial scheme is in the next interrogation room over. He knows enough to be dangerous, and his hands are dirty, too. He might even be a bigger target.
The investigators have enough to issue you a nominal fine for “failure to supervise” or something already, and to smear the politician in the court of public opinion. You’re both almost certainly going to get a slap on the wrist, but then again, maybe you can convince them it was the other guy all along and skate on all charges. To throw either one of you in jail, however, they need one or both of you to talk. So begins a process of Good Cop / Bad Cop, of carrots offered to get you to rat out the politician and of sticks threatened if you don’t. And remember, he’s a politician, so of course he’s going to take any opportunity to rat you out, which the agents are very happy to remind you.
A good, old fashioned Prisoner’s Dilemma.
Now, in the classic case of this game theory problem, the equilibrium outcome – the outcome that it’s impossible to reason your way out of once you’ve really thought through what the other guy must be thinking – is that both you and the politician rat each other out. In the end, the cost of being made the sucker is just too high to believe the politician will be willing to risk it. Besides, a reduced sentence for cooperation is still prison, but it’s better than the alternative.
As Ben wrote about some years ago in a now-classic Epsilon Theory piece, it is both possible and useful to think about this in information theory terms as well. The idea of the illustration below is to represent the depth and symmetry of the equilibrium state of the game. It represents the amount of informational content that would be necessary to change the conditional payoffs of the game and for the “ball” to roll to a new equilibrium.
Ben’s example asks the reader to consider how this “information surface” would change if one of the payoffs changed. In this case, that change is a material reduction in the cost to Schlex of keeping mum.
To be sure, mutual defection is still this game’s equilibrium. The politician grinds his teeth, but just can’t bring himself to believe that you’d be willing to risk even one extra year in prison if he plays ball with the cops and you don’t. But he is grinding his teeth. This equilibrium is NOT as strong as the equilibrium of the classic game. Only a small amount of information about payoffs, about predispositions of the other player, the conditions which might cause a change in those payoffs, the expectation of repeated play and/or the uncertainty attached to all of the above would be necessary to move the ball out of that equilibrium.
What does that have to do with narrative structure?
In the case of most narratives and missionary activity we track, we generally observe an information surface with pretty short walls. In other words, when the WSJ writes about how analysts perceived an earnings update, or when ESPN writes about how baseball fans are responding to a decision to move the All-Star Game in response to a new voting rights law in Georgia, it immediately changes common knowledge. The amount of information that it takes to change what the crowd believes the crowd believes is pretty small. If you can observe that language repeating itself and attaching itself to a widening set of topics and sources, you are observing a change in the equilibrium.
In the case of zeitgeist-defining narratives, the water in which we swim, the walls of the information surface are often insurmountably steep. What I mean is that it doesn’t matter how many missionaries tell you that everyone thinks that globalization should reverse or will reverse, or which person or publication said so. It doesn’t matter how many missionaries inform you that the 40-year bond rally is finally over and inflation is finally arriving as a risk, or which person or publication said so. Or at least, it doesn’t matter very much.
The walls which protect the equilibrium of the water in which we swim from new information are high.
And those walls are built out of the things we need to be true.
So what do we mean by the things we need to be true?
Let us start from the anecdotal and specific, and then pull back to something more general. Consider, first, the zeitgeist-defining narrative that “We live in a deflationary world.” Now consider a range of social structures or social structure-defining conventions that have been assembled around that narrative:
- Practically every institutional asset pool of any size in the United States has a formal investment policy statement which requires a 20-40% allocation to nominal bonds;
- Perhaps half of the fees charged to individual investors by the financial services industry are functionally paid only for professional advice about how much of an allocation to nominal bonds should be added to a portfolio of equities;
- Retail investment products with access to inflation-sensitive assets are sparse, hypothetical, poorly constructed, and largely focused on asset classes with equity-like and growth characteristics that could still be sold to clients during a deflationary period;
- Benchmarks, indices and conventions for reporting and measurement are built around a balanced allocation to stocks and nominal bonds;
- Securities exams, university curricula, textbooks, personal finance books, internet guides and encyclopedias explicitly frame nominal bonds as a (1) risk-free or low risk asset and (2) an equity-diversifying asset; and
- US companies and their executives have been rewarded for four decades for creating (1) asset portfolios, (2) business models, (3) capital structures, (4) human capital, (5) product lineups, (6) brand and marketing profiles and (7) cost structures which emphasized the generation of top-line earnings growth in an environment in which cost inflation and pricing power were tertiary considerations, at best.
These conventions can change, of course. If the world truly enters a sustained reflationary / inflationary period, they will change. But until that happens, these will continue to act as high walls against a change in common knowledge, as container ships stuck in sludge.
Because, for example, if you are a major asset owner, law, policy and sticky investment policy statements will make it nearly impossible for your behavior to reflect a belief in a change in the inflationary / deflationary regime. And because you know that about yourself (and likely think your institution the more sophisticated), these embedded conventions will create a strong belief that the crowd doesn’t really believe in a change in the zeitgeist enough to change their behaviors. Add in the effect of legal conventions that create a positive obligation not to veer too far from common knowledge about ‘what is prudent’, and the threshold restricting expressions of a true belief in inflation that goes beyond the lip service of some floppy 2% allocation to a new ‘opportunistic real assets’ bucket is practically insurmountable.
Those who cannot change need the status quo narrative to be true.
The same goes for companies and executives, who have succeeded in a decades-long crusade to have options and restricted stock grants considered ‘aligned incentives’, a veritable coup that permits them to seek out short-term price appreciation over long-term value creation and have it, too, called ‘prudence’. Having been trained for more than a decade that cost of capital doesn’t matter, that cost structure doesn’t matter and that top-line growth is the only thing that does, an executive who pivots too quickly to restructuring to prepare for costs and pricing that matter will believe they are leaving money on the table. More importantly, they believe others will come to the same conclusion.
Those who have built their compensation models around a narrative need it to be true.
That old Upton Sinclair quotation about a man and his salary is true at a scale a lot greater than a single man. To be fair, the things we need to be true are not always so tangible. For example, ‘the world is flat‘ as a narrative is deeply entangled with the norm-enforcing memes that underpin all sorts of policy. A shift away from globalization would reflect implicit racism. A shift away from globalization would be a rejection of capitalism and free markets. A shift away from globalization is an expression of opposition to the democracy, freedom and peace that inevitably comes with open commercial relations. You may believe all or none of those memes – they’re not all meant for you or me, after all – but that doesn’t matter.
Those who have engineered permanent political polarization from a narrative need it to be true.
So how do we make this less specific and more general? How do we use it to help us consume information more effectively? I think that asking ‘what do we need to be true’ means asking at least these questions about any zeitgeist-defining narrative that we think may be in flux:
- High-friction Conventions: Has swimming in the water of this zeitgeist-defining narrative caused the emergence or creation of conventions, laws or ‘best practices’ which have significant frictional / switching costs – more importantly, is the crowd mutually aware of these high frictional costs?
- Gatekeepers and Offloaded Risks: Are there industries, lobbies, parties or special interests which have emerged because of and which are ultimately dependent on this zeitgeist-defining narrative? Are they powerful enough to make us skeptical that the crowd will change its mind?
- Entangled Memes: Are there powerful cultural or moral entanglements that make it difficult for the crowd to believe that the crowd will change its mind?
We think a model that explores common knowledge through the analysis of missionary statements – people telling us what the crowd believes – remains extremely useful. But only when there are not structural barriers to the crowd changing its mind. If we want to have any hope of knowing with any measure of certainty when the water has changed, much less predicting its outcomes, we must also observe what the crowd believes the crowd needs to be true.
We are already beginning our efforts to model this for our Epsilon Theory Professional and consulting clients. A lot of what we discover will make its way (and has made its way) into our regular publishing as well.
But for all of us, subscriber or not, wondering whether the water that has defined our investing, business and political careers is changing, it is time to get in the habit of asking a new question any time we consume information:
Well done, Rusty, really well done!
So much of who we think we are - who we want, nay, need to be - is wrapped up in the stories we tell ourselves about what needs to be true.
I am reminded of a line in the Falcon and the Winter Soldier where Bucky and Sam are talking. Sam is questioning whether Cap was right in believing in him. Bucky tells Sam that he can’t think that way. Because if Cap was wrong about Sam, then he was wrong about Bucky and that is something that Bucky can not live with. So he needs Cap to be right about Sam. Incredibly powerful moment.
Water indeed. Well done.
I’ll pile on one last nautical analogy that I think helps me to frame what you’re talking about.
This isn’t looking at descrbing the water in which we swim. It’s looking at how the water can change such that we have to adapt a new form of swimming. Quickly. Before we drown in the changing waters. How long can you swim the same way before you have to alter course because what you’re doing just isn’t working.
Man, this is like one of the two big philosophical/existential questions along with “How do you fight the monster without becoming the monster?” How shaky are the fundmental truths that you’ve built the most basic building blocks of your day on? How little has to change before those fall apart? As Rusty mentions, ther’s a ton of friction because of how much is entangled and tied up in a system that needs to work one way. But eventually, you’ve gotta go with the water.
“What do we need to be true?”
I’m pretty sure this is the driving force behind every story humanity has ever told.
Brilliant article! I will be meditating on the implications of this framing for a while.
Others have called this the “truth-shaped hole.” Unspoken assumptions that the writer/messenger/Missionary doesn’t mention encircle a gap in the picture - that itself becomes a picture once you have enough of the data around it.
Ugh, is there an “edit” button? I meant to say “leaves a gap in the picture” or “leave an outline that encircles a gap.” Either one of those makes sense.
Very thought provoking Rusty , it got me thinking ? - you know who needs the deflation narrative to exist - the U S Government, with that 30 trillion dollar anvil hanging around its neck an increase in rates that would occur if the real inflation rate was known would put it out of business. At least as we know it today.
That is why no matter how high inflation really goes I believe the CPI and other measures will be manipulated to show 1-2%. With hedonic adjustments they can basically make it say whatever they want. The bond market might balk but they will print enough to make sure that never happens for long. That lie will be protected to the end.
Very well expressed.
Because we are fish and not birds. We can’t evolve fast enough to keep up with the changes in the water.
frog in boiling water. it will be too late.
The currency (US $) would be the logical pressure relief valve to the hedonically adjusted, mis-measured CPI and the QE to handle the epic deficits. But (and I hate when Economists throw in “on the other hand”), the dollar is the reserve currency and it historically catches quite a bid when anything in the connected global financial brew turns sour. Our current account and budget deficits should change that narrative, but the narrative hasn’t tainted that water…yet. The dollar failing to rally in the next legitimate risk-off environment would be enough to flip that switch. Voila, we would have inflation that the Fed won’t stop. I didn’t say, “can’t stop”, the politics of tightening financial conditions when well below full employment will be avoided for long enough to get them way behind the curve.
I think Tony is pointing the Pack in the right direction. It will take objective data that the Narrative, and the muscle memory attached to it, did not work out as expected or forecasted to change the water. As an old school “tape reader”, how do bull and bear markets in stocks end? The Narratives are incredibly powerful when markets are trending. A bull market finally succumbs when the divergences building up in Advance/Declines, New Highs, Industry Group or Market Cap participation falter while the Index barely backs off. This hasn’t stopped the trend, but finally becomes too much objective evidence that the trend is faltering even though the Narrative hasn’t given up. Momentum in markets works until it doesn’t. Central Bank/Fiscal involvement may have strengthened the Narratives during the trending phases but they falter eventually nonetheless. Awareness of divergences and weakness that is at odds with consensus is still the signal an investor should respect.
The governments across much of the globe need financial repression to try to work through their debts, so running inflation higher than reported is the start. Then as it becomes impossible to rely solely on the central banks to buy all their bonds (this likely becomes counterproductive), there will be capital controls, trading taxes/duties etc to “encourage” fiduciaries to buy the paper that they rationally wouldn’t otherwise do.
In fact the games have begun I believe in EU and the UK, the latter of which has already put together a committee to guide investment with “dons” of the fiduciary industry that “will pay acceptable returns for driving better outcomes for the country…”.
Should sound familiar. And a lot more to come.
And a reason why we should expect the narratives to stick even harder as they are visibly contradicted.
Obviously swimming in my own soup of narratives, but seems to be their rational direction of travel, and has a jive with what seems to be quite a few of our own perceived realities.
This is my favorite ET article I have read. So many powerful players NEED the current set of beliefs and structures to be true that will be nearly impossible for them to become false. But in the next 1 to 100 years they will eventually change. How, why, and when are fascinating questions.
I am at once slightly annoyed that I did not think of this perfect example and grateful for your comments!
Absolutely, and only if we can - as Chris said below. I worry that it’ll be a bit more of the “how to run away from a bear” story. None of us will evolve quickly enough for some of these, but evolving faster than others may still be enough in some sense.
At least the big stories, and at least in part! Thanks, Tim!
Yes, I think that is a reasonable analog! The complication comes in the transition, in which we receive missionary statements / common knowledge prods about what would ordinarily be such a truth-shaped hole.
For my part, I think most of these are long cycles. I think the advantage of so many needing the current narrative to be true is that the danger of being a little bit late to a “change” may be less than it sometimes is. I could be wrong.
I think that may well be right, Patrick, but the bigger point I might make is that the objective data itself may not be enough.
Yes, indeed. Your suggestion is, I think, among the bigger reasons why the water hasn’t changed despite years of missionary efforts signaling that it was.
That means a lot to hear, Gregg. The path these things follow is really fascinating to me, too.
It occurs to me that perhaps the simplest definition of an entrepreneur is somebody who knows they are swimming in the water. Because that knowledge means you can at least consider the possibility that it can be changed.
I agree, it will never be enough. This upcoming period will require much more independent and contrary thinking than the falling inflation and interest rate epoch of the past 40 years. Since the structures are so steep and the framework so robust, most will be carried along for a very unpleasant ride. As Ben likes to say, same as it ever was. Only after all of the damage has occurred will the substantial majority of investors reluctantly be forced to pivot.
My career started just as the disinflationary bull market got underway in the early/mid 1980’s. The portfolio managers with experience had gained it by investing in the 1960’s/1970’s. That cycle’s water informed how they invested and how risk and reward were managed. Only a handful were able to successfully navigate the transition.
The pack is here to help get us to the other side, while knowing the journey will be fraught.
Exactly right Lawrence. And this brings up an important point about two missionaries: Yellen and Powell (YaP). When you game it out, after realizing that you have two monetary missionaries in the two most powerful economic positions of Govt, you realize they have a significant, shared incentive to lie.
Knowing what YaP NEED TO BE TRUE, I ask myself the following question. Who are Yellen and Powell (YaP) willing to bankrupt? In addition to the $30 Tn in debt you refer to, the FED owns a boatload of USTs. Are they more willing to bankrupt the Govt and the FED itself by forcing rates higher to combat inflation? Or are they more willing to bankrupt the American people by allowing Inflation to run higher, virtually unaddressed? The new policy of “average inflation targeting” is a dead giveaway here. [I’m not expecting it. I’m observing it.” By George, I guess.]
Perhaps we need to separate YaP, put them in different interrogation rooms. Not sure who plays the cop tho? How the American people accomplish that, I don’t know.
Until the Chinese say no more of these useless dollars, we want Yuan, gold or Bitcoin for our goods…
I don’t know if this is good news or bad news, but I am totally laughing at myself. I started investing during the late 1970s and early 1980s and have never liked long bonds. I remember short term money market funds returning 18% while long bonds were only at 13%. Why would anyone every buy long bonds? Needless to say I never did. Now I mostly worked and hand only limited savings to invest and diversified mutual funds served me well enough until I retired recently and had way too much time to spend investing. Now I am here and wondering what can I do. I never actually learned how to invest during inflation, just developed the bad habit of avoiding bonds. Thanks for all the writing and ideas. I certainly think the water is getting mighty cloudy.
Can someone explain this "Manipulation of the masses through media is Lindy, I suppose. "
I found these:
Lookup “Taleb Lindy Effect” to get some idea. I sometimes feel like I missed a few chapters when reading on this site.
I agree, Lawrence. Though, I think they will hide in plain site similar to the numerous changes in the computation of inflation over the years. We have all seen inflation in our daily lives - not trying to be an old fish - but we have and continue to live in an inflationary world - at least for things like health care, food, and education - "Yay, College! " to quote two very insightful authors.
Such a thoughtful essay. I read it before b’fast and will read it again later today. I wonder if you have seen the Adam Curtis documentaries “Hypernormalisation” and “Can’t Get You Out Of My Head”. The latter is 6 episodes over an hour each. Curtis’ theme is that we have been manipulated into a dream state where nothing is what we think it is. He ends with the quote from David Graeber “the ultimate, hidden truth of the world is that it is something that we make, and could just as easily make differently.”
Just for fun substitute “mercenary” for “missionary”.
As a civil engineer and somebody who has ( a long, long time ago in a galaxy far, far away) dealt with public sector capital improvement projects it seems that if your model requires you to amortize your debt over 100 years then you need some things to be true.
Thanks, Rusty, for the challenging essay. The question is actually a part of being human. “What is truth?” Is truth objective (a given) or subjective (a choice), or sometimes either or sometimes both? What does it mean in all areas of my life when I NEED something to be true. Very good stuff and much to think about.
Maybe, just maybe part of being able to observe the water we swim in has to do with taking a step back and questioning what we think needs to be true and why we think that needs to be true… The more I read Epsilon, the more I question the assumptions of the strategists we work with in my practice (and yes, my assumptions). It’s interesting to see how uncomfortable or how some of them fall back on conventional wisdom when their assumptions are challenged.
That leads to one other comment. If questioning is a way to view the water, maybe that’s a practice to become competent in. The flip side to that is one could find themselves never standing on the solid ground of the moment.
Great article. Thanks for bending my thinking Rusty.
There is no way I can ever be as eloquent and erudite as Rusty or most of the commentators here, but the fact is we ARE in an inflationary world, and have been for some time. By now it’s obvious that the tide has turned from two decades of “imported deflation” and union busting (despite Amazon’s recent victory). The Trump administration and COVID drove the final nails in that coffin. But the BLS lies by using hedonic pricing models and “owners equivalent rent” (which has a 24.4% weight in the CPI) to keep the “official” inflation numbers below 2%. The FHFA home price index jumped by 15%, but the BLS tells us housing costs rose 2%.
So why are house prices inflating at 15%? The Fed. And why do “preferred bank deposits” return $300 annually on a $3 million deposit? The Fed. Why are terms like “the bubble economy” so prevalent? The Fed.
For those of us operating with client funds in the here and now, the fact that nobody can tell precisely when the narratives will change sufficiently to create a new body of common knowledge is precisely the crux of the matter. The end of the era of omnipotent central bankers was predicted nearly seven years ago, but they are still very much in charge. Is the end finally within sight?
We’ve all been living in Fedworld since 2009, and before. The longer we remain in it, the more twisted the explanations for what we are witnessing become. It seems like the only thing that matters are the narratives floating around in Jaypow’s head (how do you model that?).
What is the Fed’s current narrative? That the Funds rate will remain at zero for as far as the eye can see. What does any competent fixed income manager do in a rising inflationary environment (since said environment has historically implied rising interest rates)? Shorten duration. If inflation and interest rates rise sufficiently, the cost of shortening duration, or going to cash equivalents, might not be that great on a current yield basis as short rates rise in response, and is certainly preferable to doing nothing and watching losses mount in portfolios.
So how does that tactical shift work in Fedworld? You avoid markdowns in principal in exchange for earning a zero return on cash equivalents. And what if the bond market doesn’t sell off? What if the bond vigilantes remain on vacation (now I’m dating myself). How many years can one be content to earn nothing on cash equivalents when it’s so obvious that “checkout counter” inflation is very real? What was it Jeremy Grantham said about “career risk?”
I think the water has already changed. And maybe we are well on the way to common knowledge changing too. But who can say for sure? Maybe that’s why there is a stampede into crypto, art, real estate, collectibles, stocks (and don’t forget gold made new highs last summer though has been shunned as of late); anything to get out of fiat.
I think the reason nobody can say when these narratives will change, let alone “precisely” when, is that we are still living in Fedworld, with the captain on the bridge operating from the Eccles Building like the Wizard of Oz (speaking of tortured analogies). By the time Fedworld finally blows up and we are left with the harsh economic consequences on the other side, we will have a lot more problems than a tanker sideways in a canal. As my dear mother used to say, “I’m glad I won’t be around to see what you kids are going to have to live through” - said by a woman who went through the Great Depression and WWII.
I’m not sure what “we” need to be true, but it’s pretty easy to see what the Fed needs to be true. Maybe that’s why on any given day all seven governors are spread out coast-to-coast doing their missionary work giving speeches.
I apologize for the lack of eloquence in my post, but after being stuck in Fedworld for the last two decades, it’s difficult to maintain one’s coherence.
Love it! Great comment. Thanks.
This note was a madeleine dipped in tea for me. In a previous life I worked in the oil and gas business. At first it was in the modest corner of the market, the family owned, private-placement-backed operator who hunted and pecked and carved out a nice living. Then the water changed, and all of the sudden we were the plucky family business (that was actually a front for massive PE investment) taking on the giants of the independent E&P world. And when you think about what we needed to be true, man oh man were they very different things.
As a small operator what you need to be true is “the geology in this field is good enough to sink a few million into this year”. And if it’s not true then you’re as dead as the dinosaurs whose remnants you’re hoping to pull out of the ground. But as the Potemkin operator backed by hilarious amounts of cash from all over? You only need one thing to be true: the reckless spendthrifts at Chesapeake Energy will pay us a 5-7x multiple on every inch we get under contract. Companies like Chesapeake needed a whole lot of things to be true, from geology to pressure to proximity to pipelines. We needed only one. All of my former associates are still in business and are each individually quite well off. How are the Chesapeake shareholders from pre-chapter 11 doing?
Thought provoking article Rusty, but sometimes I really struggle with the practical implications. This one falls into the arcane category for me. It may take me a few times to read it, usually 6 months later when you’ll reference this article and I’ll read it again and suddenly I’ll get it… but it’s 6 months late.
Currently I am struggling with the definition of who is the “we” in the punchline? What I need to be true can be vastly different than what my family, community, government, etc collective needs to be true.
What me and my company needs to be true are usually basic assumptions. There will be people that show up for work tomorrow, and they will be able to do their job. There will be customers and they will be able to place orders. I will be able to fill those orders. Inventory will be delivered on time and for the price/terms that I contracted. I will be able to charge, and collect the income for those transactions. The laws/regulations/rules will not be significantly altered frequently. The bank will accept my deposits. The credit card machines will process the payments. My transactions with my customers need to be in the same currency as my transactions with my suppliers, employees, vendors, etc. I need it to be true that I’m not literally fighting for my life when I leave the house (foreign country invades violent civil unrest or civil war type thing).
I guess I’m over/under thinking this. Hopefully I’ll figure out the implications sooner than 6 months from now!
What a great analogy! There are so many parallels to PE/VC backed businesses who are counting on the same dynamic where Softbank, Google, Salesforce, Cisco, Microsoft, Amazon, etc are their Chesapeake/Goodrich/too many more to list Sugar Daddies. It was kind of easier to see that terrible economics backed by junk debt in a commodity business would go sideways. But, I remember Texas and S. Dakota being the lonely job creating states in the boom. Buying a house in Houston during that boom was like buying one in Austin now. If you were a seller in the Oil & Gas ecosystem in 2013 or early 2014 it was magic!
It is a reminder that there are usually a small handful of investors brave enough to step aside when the economics get way out of whack. The rest of the crowd craps out and feeds the vultures in the distressed debt world for a few years. The financial services myth that one must be fully invested at all times, in all asset classes, at any valuation is part of what they need to be true (to keep your assets generating a fee).
Inflation in the things we need , deflation in the things we want.
I would add housing to your list ??
“ There is Fuckery afoot”
I loved your reply no apologies needed.
https://en.wikipedia.org/wiki/Lindy_effect “The longer a period something has survived to exist or be used in the present, it is also likely to have a longer remaining life expectancy.”
Perhaps then “Manipulation of the masses through media is Lindy, I suppose. ” means that manipulation of the masses through media has been happening for a long time so we should expect it to keep happening.
Yes. In 2001 I made the mistake of trusting my stock broker who told me to get out of tech stocks; but he didn’t tell me that I needed to get out of stocks period. I watched my newly nicely diversified portfolio wilt a little more slowly that it would have without the diversification out of tech.
We all know that markets are now a managed political utility. That requires commentary to also be politically managed, ie propaganda. I don’t mean CNBC, although that has it’s place. I am talking about the fact that we all know the Fed’s commentary is politically managed propaganda, engineered for a specific end.
What if it’s all like that?
I think we all have seen enough stories to know the answer to that question (LBMA “gold fix”, Credit Rating Agencies, Jobs Report, etc). But I think we also have that Gel-Mann Amnesia problem too. I think those things are all too wonky/niche for us to not connect the dots and say it’s ALL that way.
What happens when we collectively start to look at the USDA reports the same way we look at FOMC minutes? I don’t think we’ve collectively recognized yet that all of the reports and data releases are “engineered” in the same way the Fed “jawbones” or nudges markets in a direction towards a specific politically desired outcome.
I think we need to start thinking about what happens once we do.
Continue the discussion at the Epsilon Theory Forum
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