Ed. Note: we are thrilled to announce the launch of Epsilon Theory Professional Service, where financial advisors and investment professionals can tap directly into our Narrative Machine market research and analysis. For the past week we’ve been highlighting specific investment applications we’ll be offering as part of that service, as well as the Big Picture value proposition.
In our final highlight publication, we’re reprinting last week’s In Summary, our weekly market analysis as seen through the Epsilon Theory lenses of game theory, narrative and history.
For more information on all Epsilon Theory subscription services, click here. ET Pro subscriptions will be open for enrollment starting Wednesday, December 12. – Ben
ET Pro In Summary
(December 1 – December 7, 2018)
Professional investors are wrestling with four big concerns, what I call the Four Horsemen of the Investing Apocalypse:
The Four Horsemen of the Investing Apocalypse
- The Fed keeps on raising interest rates and shrinking its balance sheet, ultimately causing a nasty recession in the US and an outright depression in emerging markets.
- China drops the trade war atom bomb by letting the yuan devalue sharply, sparking a global credit freeze that makes the 1997 Asian financial crisis look like a mild autumn day.
- Italy and its populist government play hardball with Germany and the ECB in a way that Greece could not, leading to a Euro crisis that dwarfs the 2012 crisis.
- Inflation, particularly wage inflation, gets away from the Fed, as their monetary policy tightening forces corporations to increase their risk-taking.
Humans are biologically designed to pay attention to one big thing at a time, and our media stimulus machine knows it, so every week the “story” of what’s driving markets up or down will be good news or bad news on one of these concerns. Two weeks ago the story was Jay Powell finding that old-time dovish religion, which markets loved. This week the story was Trump starting the clock on a trade war game of Chicken with China, which markets hated. In truth, of course, there is “news” about all four of these concerns happening all the time, but until further notice … if you want to explain the WHY of your portfolio to your clients or your board or your CIO or whoever it is that you have to explain yourself to, you’ll need to explain it in terms of The Story of the Week. Because even if you’re not utterly focused on that Story of the Week, THEY are.
And for the next 90 days, that Story of the Week is most likely to be the China trade war story.
Why? Because it’s got a ticking clock. Again, we are biologically hardwired to respond with full attention to a countdown to disaster (the core brilliance of the TV show “24”), and again, our media stimulus machine knows it.
The easiest prediction I’ll ever make is that CNBC constructs a “Countdown to Trade War” video graphic over the next month or two, literally counting down the days until China-US relations detonate.
Talking about the China-Trump trade war game of Chicken is good business for CNBC and Bloomberg and all the rest, so talk about it they will. Even if there’s nothing to talk about. Actually … especially if there’s nothing to talk about. And when they do talk, I promise you that 95% of that airtime will be spent asking this guest or that guest (I would say “expert”, but in a world where Kevin O’Leary is treated as an expert in everything from algo construction to Sino-Japanese foreign relations, I’ll stick with “guest”), about the “chances” of a deal being struck anytime soon and the “likelihood” that the deal will favor the US or China.
Let me be really clear about this.
Anytime that anyone talks about “chances” or “odds” or “likelihood” in the context of a game of Chicken, like this trade negotiation between the US and China, they are talking nonsense.
There are no odds in a game of Chicken.
It’s one of the hardest concepts in game theory to wrap your head around, but maybe the most important. And it has enormous consequences for how to invest over the next three months.
Chicken is a game with two equilibria – two potential outcomes for the game. You can see this mathematically in the stylized 2×2 game matrix below, with the equilibrium outcomes circled in gold, or you can just think about every game of Chicken you’ve ever seen in the movies. I’ll use “Footloose” for my example, because … Kevin Bacon. I mean, c’mon.
Both Ren (Kevin Bacon) and Chuck start in the bottom right corner of the matrix. They’re both driving their tractors straight at each other. Both are faced with a decision. Do I continue to drive or do I jump off my tractor? If they both do nothing and stay in the bottom right corner, then both players have a TERRIBLE pay-off (-100 for both Ren and Chuck). This is NOT an equilibrium, because at least one player (in this case both players) can get a better pay-off by changing their strategy from Drive to Jump.
If Ren (the column player) jumps, then the column strategy changes from Drive to Jump and both players are now in the bottom left corner. That’s a better pay-off for both players, but a LOT better for Chuck (+10) than for Ren (-10). This IS an equilibrium because NO player can get a better pay-off by changing strategies from here. Obviously Chuck isn’t going to Jump now that Ren already did, so the row strategy isn’t changing, and obviously Ren isn’t going to get back on the tractor and start driving again towards mutual suicide.
But you’d also end up in an equilibrium (neither player will change his strategy) if Chuck decides to jump (changing the row strategy and moving both players to the upper right quadrant), which is a LOT better for Ren (+10) and still better than mutual destruction for Chuck (-10).
Hence the delicious tension of the game of Chicken. Hence the reason our media stimulus machine looooves a good game of Chicken. Either player can win. Either player can lose. All you have to do to win is have more willpower than the other player. That’s it. You don’t have to be physically stronger. You don’t have to be mentally smarter. You just have to “want it more”, to use the clichè of every hack sports announcer ever. But in a game of Chicken that happens to be true. You just have to want it more.
There is ZERO information about willpower in the structure of this game.
Zero. None. Nada. Rien. Bupkis.
Go ahead and change some of the pay-offs. Make them asymmetrical. Make it a -50 instead of a -100 for one of the players. Make it a +30 instead of a +10 for one of the players. It doesn’t matter.
YOU CANNOT PREDICT THE WINNER OF A GAME OF CHICKEN FROM THE PAY-OFFS.
Sorry for the shouting.
But I get so frustrated with some of the “analysis” that you hear about this trade war game of Chicken, especially this gem that you’ve already heard umpteen times and will hear umpteen-squared more times over the next two months:
“The US will win because China has more to lose in a trade war.”
This is nonsense.
It’s nonsense because it’s talking about the pay-offs of the game, not about the behavioral driver of player strategy – willpower. Pay-offs cut both ways. Sure, I’ve known people where ‘having more to lose’ makes them jump from their tractor first. But I’ve also known people who have MORE willpower in a game where they ‘have more to lose’.
Bottom line: it’s a fool’s errand to impute resolve from starting game conditions and pay-offs.
The only analysis that has any predictive usefulness in determining the winner of a game of Chicken is an analysis of exogenous player resolve. That’s a ten-dollar phrase that means you peer into the psyche of the players and figure out who wants it more.
So who wants it more, Trump or Xi?
Anyone who claims to have an answer to that question is either lying to you and/or lying to themselves. Not even Trump and Xi can know the answer to this question! Again, this is the delicious tension and suspense of a game of Chicken – not even the players know who wants it more. The outcome of the game only and always emerges from the playing of the game.
It’s not that the odds of the game are unknown.
It’s that the odds of the game are unknowable.
Successful discretionary investment boils down to two things: edge and odds.
In the US-China game of Chicken, you have no edge. And you don’t know the odds.
Unknown information creates the potential for alpha, for the ability to discover valuable private information.
Unknowable information, on the other hand, creates zero potential for alpha. In fact, it’s almost always an alpha destroyer, as market participants convince themselves that they have an “edge” in predicting the equilibrium outcome. They don’t.
Unknown information lives in the world of investment RISK, where you can calculate the expected value of an investment (risk and reward) and the cost of acquiring additional information to impact that relationship. This is what professional investors DO, day in and day out.
Unknowable information lives in the world of investment UNCERTAINTY, where none of our expected value calculations work, no matter what you spend on acquiring additional information.
You can’t hedge investment uncertainty.
You can’t hedge investment uncertainty because it’s not just difficult to measure the risk to your portfolio (and please remember that risk isn’t just a loss suffered but is also a gain foregone). It’s IMPOSSIBLE.
So what do you do if you can’t calculate the risk in your portfolio?
You take down your book. You reduce gross exposure.
Look, at some point there IS a deal. Games ALWAYS end up in an equilibrium. One of the two sides will blink, a deal will be struck, everyone will declare victory, and we’ll see then what narratives emerge from that. Maybe it will be a market-positive narrative to emerge. Maybe it won’t. Regardless, whatever deal emerges is not an investment regime change, and it won’t be the end of the world or the engine of a new bull market.
You may miss a spike up if trade peace breaks out tomorrow. You may miss a week-long rally if a narrative of imminent peace takes root. So be it. I’m not saying to get short. I’m not saying to go long volatility.
I’m saying that you do not have an accurate picture of the upside and downside risks to your portfolio so long as the US-China trade war game of Chicken is the Story of the Week in markets. Not because you’re missing any crucial piece of information, but because the equilibrium outcome is unknowable.
I’m saying that when large institutional portfolios see more uncertainty in markets – not greater risk, but more technical uncertainty – they do not buy dips and they do sell rallies. They rebalance by selling winners, not by adding to losers. They take down their book.
You should, too. And you should do it first.
Taking down your book means different things to different types of investors and allocators. I’ve used the phrase “reducing gross exposure” because it’s an expression that’s most familiar to long/short hedge fund managers, who make daily decisions on gross and net exposure, and have well-established processes for moving these exposures around quickly. For investors with more static or long-only portfolios, the more familiar terms of art might be “tactical overlay” or “active risk” or “discretionary overweights and underweights”.
In all cases, though, taking down your book means one simple thing:
Get closer to your long-term strategic allocation and stop doing whatever it is that moves you away from that long-term plan.
This, too, shall pass. And relatively soon. You don’t have to dance every dance.