Submitted by Ben Hunt via Salient Partners' Epsilon Theory
blog,
I was at a conference, on deck for a presentation, and I had
the chance to listen to the Q&A for the speaker ahead of
me.
“Assuming no external shock, how much longer can this bull
market run?”
The speaker, not exactly the most sparkling of raconteurs
under the best of circumstances, first replied with the obligatory,
“well, that’s a very good question”, and then proceeded to give a
detailed, bone-dry explication of exactly how long he thought this
market would run, the likely level of the S&P 500 top, and a
few winning sectors and stock picks for good measure. It all
sounded very smart, and I’m sure he was … smart, that is. But boy
oh boy, if there were ever a living embodiment of von Neumann’s
dictum that being precise is all too often a waste of time, this
was it.
Because this wasn’t “a very good question”.It was,
in fact,
a pretty useless question,the functional
equivalent of asking a botanist how big a tree can grow in the
absence of storms, droughts, fires, blights, lightning, insects, or
whatever. Answer: pretty darn big. Better answer: who cares? You
don't need my help with an investment strategy for a paradise
scenario, any more than you need my help with an investment
strategy for a doomsday scenario. But where we could all use some
help is with an investment strategy for the Real World in-between
paradise and doomsday. What we all need is a good perspective or
vantage point for differentiating between this potential shock and
that potential shock, for evaluating what signals to press and what
signals to fade. It’s not a matter of predicting shocks, but rather
a matter of reacting to incipient shocks smartly
and strategically, of knowing, in the immortal words of Kenny
Rogers, when to hold ‘em and when to fold ‘em. Now
that’sa good question, and it’s one that Epsilon Theory is
well suited to take on.
There’s a specific sort of instability in the world today – a
game theoretic instability – which means that it has an
identifiable pattern and rhythm you can understand in order to
improve your investment strategy.
It’s the instability of the game of Chicken, and once you
start looking for it, you will see it
everywherehere in the Golden Age of the Central
Banker.
Greece vs. the Troika? Chicken. Western sanctions on Russia
over the Ukraine? Chicken. OPEC vs. US energy producers? Chicken.
ECB vs. the Swiss National Bank? Chicken. Fed monetary policy
communications to markets? Chicken. Abenomics? Chicken. US policy
towards China? Chicken. ISIS vs. the world? Chicken.
Let me take a minute to describe why a game of Chicken is
particularly and peculiarly unstable, because understanding the
game’s dynamics is crucial for understanding how and why Chicken
has become the defining strategic interaction of nations and
institutions today, just as it was in the 1930s, the 1910s, and the
1870s.To make that description, I’ll be drawing on the
concept of the
Nash equilibrium, the most influential insight of
mathematician John Nash, whose early career and lifelong struggle
with mental illness was portrayed in the great movie “A Beautiful
Mind”, and who was killed last month in a car accident at the age
of 87 (I’d like to think that his not wearing a seatbelt while
traveling on the New Jersey Turnpike was a game theoretic exercise,
but that’s the Keats-ian Romantic in me talking).
The central idea of the Nash equilibrium is that a
non-cooperative strategic interaction between players (for
simplicity’s sake we’ll just talk about two player games, although
the concept is applicable for any number of independent players) is
in balance, i.e. in equilibrium, if neither player prefers to
“move” from the current game position after consideration of both
his preferences and potential moves AND his opponent’s preferences
and potential moves AND the knowledge that both of you are thinking
about the other in this manner. The Nash equilibrium takes
seriously the notion that the other player is just as smart as you
are and, as importantly, just as strategic as you are – meaning
that both of you can look several moves ahead, and both of you are
making moves that are contingent on the other player’s moves. Like
all great ideas the Nash equilibrium seems simple at first blush,
but it’s a deceptive simplicity, one that when applied rigorously
can shed light on a raft of social interactions that otherwise seem
irrational or unpredictable.
I’ll start with a common game that has a straightforward Nash
equilibrium, the Prisoner’s Dilemma. I’ve
written about this game in several prior notes,
so I won’t go into detail here about its meaning. It’s just an
example to explain the nomenclature. Below is the standard way of
depicting a game between two players – in this case you and Al
Capone – with each player having two behavioral choices – in this
case Silence or Rat – and with the game payoffs in red for you and
green for Al. The infamous Prisoner’s Dilemma outcome, where both
you and Al rat on each other even though you both suffer more than
you have to, is marked with the light blue oval and is the stable
Nash equilibrium.
The Rat-Rat outcome is a Nash equilibrium because you don’t
want to change from Rat behavior to Silence behavior (moving from
the bottom right quadrant to the upper right quadrant) because your
red payoff declines from -5 to -10. Ditto for Al Capone. He’s not
changing his behavior from Rat to Silence (moving from the bottom
right quadrant to the bottom left quadrant), as his green payoff
would be worse for making the move.
More interestingly, the Rat-Rat outcome is a highly
predictable Nash equilibrium because no matter what quadrant or
combination of behaviors you and Al start with, the game always
ends up in the bottom right quadrant.Why? Because this is
a non-cooperative game. Even if you and Al start in the happy upper
left quadrant of Silence-Silence, where there is a +10 total
utility to the shared outcome, there’s no way for Al to prevent you
from choosing Rat behavior and boosting your personal payoff from
+5 to +10. That wouldn’t be so bad in and of itself, but your
choice to move from Silence to Rat is accompanied by Al’s payoff
changing from +5 to -10, and that’s intolerable for him. So he
decides to switch his behavior from Silence to Rat, to get out of
what’s called the “sucker payoff” of the bottom left quadrant if
that’s where you were planning to put him, or to put the sucker
payoff of the upper right quadrant onto you if you were keeping
your mouth shut after all. Of course, you are thinking about Al
Capone in exactly the same way, and both of you know that both of
you are thinking in this manner. All this combines to make the
Rat-Rat outcome a very speedy equilibrium solution to the
Prisoner’s Dilemma.
Now here’s the layout for the game of Chicken.
You and James Dean are each driving your car towards the
cliff’s edge, but unfortunately for both you and James there isn’t
a single Nash equilibrium for this game. Obviously it’s disastrous
for both of you to stay in the lower right quadrant where you’re
both dead and leaving behind pretty corpses. But why should you
stop your car and enter the stable but embarrassing Nash
equilibrium of the upper right quadrant (-10 for you, +10 for him)
when it would be just as easy for James Dean to stop his car and
move both of you into the far more enjoyable and just as stable
Nash equilibrium of the lower left quadrant? A game of Chicken has
two Nash equilibria, each just as likely as the other, each just as
“natural” an outcome as the other.
This is the inherent vice of the game of Chicken – it is
impossibleto predict the outcome of the game by looking at
the fundamentals of the game.It is inherently
unpredictable – not because we don’t know enough facts about the
situation or because we’re not smart enough to analyze the
situation – but because it is the mathematical nature of this
particular beast.
I’m often asked what I think the outcome of the negotiations
between Greece and the Troika will turn out to be. Will Greece
leave the Euro and default on its debt? Will Germany blink? And
when I answer the question by saying that I don’t know, I can feel
the disappointment. Don’t you even have an opinion, Ben? You seem
to know a lot of the facts here, or at least you talk a good game
about domestic Greek politics and multi-level game-playing. What
good is game theory and all your knowledge if you can’t even
handicap the odds of a Greek default?
Game theory is useful precisely because it tells me that
there is no fundamentals-based or structural methodology to
handicap the odds of a Greek default!Sometimes the answer
to a mathematical question is the same as the answer to a prayer or
the answer to a Magic 8 Ball: NO. There is no greater understanding
possible here through the use of science and mathematics. To
paraphrase Von Neumann again, get used to it.
In my stump speech about investing in the Golden Age of the
Central Banker, I always start by making
the distinction between decisions under risk and
decisions under uncertainty. In a decision under risk, you know
the possible outcomes of a decision and you have a rough sense of
the probabilities to associate with those outcomes. In a decision
under uncertainty, you either don’t know the possible outcomes or
it’s impossible to assign meaningful probability distributions to
those outcomes. What’s at stake in the distinction between the two?
All of modern portfolio theory and all of mainstream
macroeconomic theory and all of econometric modeling – ALL of it –
is based on the assumption that everyone in the world is making
decisions under risk.Violate that assumption – an
assumption that is as deeply buried and indecipherably written
within the edifice of academic economics today as the assumption
that “a nationwide decline in home prices is impossible” was deeply
buried and indecipherably written within the edifice of $10
trillion worth of residential mortgage-backed securities in 2008 –
and your portfolio risk analysis suddenly has a hole big enough to
drive a truck through.
Game theory provides a perspective and a toolkit to
distinguish between decisions under risk and decisions under
uncertainty.It can’t work miracles by predicting the
outcome of something that’s inherently unpredictable, but it can
identify the situations that are unpredictable and suggest coping
mechanisms for dealing with them. And that’s a lot. It can also
highlight the situations
where you have made a category error, where you
have a misplaced confidence in your existing risk management
toolkit or perspective. And that’s a lot, too.
So what does determine the outcome of a game of Chicken? Surely
it’s not just a random outcome? Well, no, it’s not random, but
you’re not going to like the answer I have for you any better.
The game of Chicken is not a test of power and
capabilities. It is a test of will. It is governed by constructed
signals of resolve, control, and – occasionally – lack of control.
It is governed by Narratives, particularly by political Narratives
when the game is played on an international stage.Cooler
heads rarely prevail in a game of Chicken, even if they’re
objectively the stronger player. Because we’re all smart enough to
know how to play the game, and because we know that the other
players are going around and around in their heads trying to figure
it out just like we are, the game of Chicken breeds insecurity,
doubt, and miscalculation like no other. Play the game enough times
and it will break you. It’s un-insurable, plagued by inherent vice,
and that means that it’s un-investable, too.
I promised that game theory could provide some coping mechanisms
for dealing with technically uncertain (as opposed to merely risky)
investment or policy environments, and I’ll write briefly about
three in this note. The first two are methods for gauging which
equilibrium the game of Chicken is moving towards by evaluating the
relative strength of the competing player Narratives. The third is
a more general observation about gameplay and timing.
First, watch for acceleration and deceleration in
behaviors, not absolute levels of speed.
Technically speaking, second derivatives are always more
influential than first derivatives as signaling devices because
they contain more information (data that makes you change your
mind; see “
Sometimes A Cigar is Just a Cigar” for a primer
on Information Theory), and third derivatives are even more
powerful. More colloquially, it’s not whether your car is going
faster than James Dean’s, it’s whether you are accelerating your
speed more than James is accelerating his speed. Better yet, it’s
whether you start to accelerate at a faster rate than you were a
second ago. Remember, the game of Chicken is all about intentions
and willpower, not capabilities and structure, and pressing down on
the gas pedal is the only structural (or to use a $10 word,
endogenous) method of communicating those intentions.
Three quick examples of the primacy of change (and change of
change) in determining market outcomes in Chicken environments:
What was the Fed Narrative that brought markets back from the
abyss in the spring and summer of 2009? Answer: “green shoots” –
the notion that even though the US and global economy were still
declining, they were getting worse at a decelerating rate.
What was the market reaction to Bernanke’s summer of 2013
Narrative that the Fed was not going to put on the brakes, but they
were going to “ease off the accelerator” a bit? Answer: Taper
Tantrum – a sharp decline in almost all asset classes in almost
every market around the world, as investors reacted to the change
in intentions signaled by the Fed (for more on this, see one of my
first Epsilon Theory notes, “
2 Fast 2 Furious”).
Now fast forward to today and ask yourself why we are NOT
seeing a similar sell-off in global markets as the Fed very
publicly goes about its business of preparing to raise short rates.
Answer: because from a second derivative perspective putting on the
brakes is the same thing as taking your foot off the accelerator.
Deceleration is deceleration; you’re just crossing the zero-line
when you put your foot on the brake. There is no essential
change in intentionsfrom the Taper Tantrum to today, and
that’s why this Narrative-dominated market continues to set new
highs.
Second, watch for self-binding behaviors, particularly
suicidal self-binding behaviors.
These are very powerful Narratives for signaling intentions,
and they are variations of the classic Chicken-winning strategies
of ripping your brakes or steering wheel out of the car, or acting
so crazy that your opponent believes that you prefer death to
defeat.
By suicidal self-binding behaviors I mean politically suicidal,
like John Boehner’s go-to move in negotiations with the White
House, where he “has no choice” but to take a hard line or else
face a revolt from the Republican caucus, but I also mean
physically suicidal. And before you say that this is only something
that ISIS jihadists would do, consider that last week the US
Defense Department floated a trial balloon in
The New York Times
saying that they were considering moving up to 5,000 US troops
into Baltic and Eastern European countries. Now the press articles
emphasized all the tanks and equipment that would be pre-positioned
there, making it seem as if this would be a very potent fighting
force, ready to take on a new Evil Empire if one materialized from
Moscow. Please. These soldiers would be in Eastern Europe for
exactly the same reason we stationed US soldiers in West Berlin
during the Cold War: they are there to die. In the event of a
Russian attack, their job is to be killed so that the resulting hue
and cry would guarantee an all-out NATO military response. Sorry,
but it’s true. It’s a classic “tripwire” strategy, and the thing
about tripwires is that they have to be broken in order to work. Of
course, the Russians know exactly what the moves are here, which
makes them less likely to engage in full-frontal military actions
in the first place, which is exactly the Pentagon’s goal. It’s an
effective way of playing the game of deterrence, which is a form of
Chicken,
but less effective and more risky the deeper you
place the tripwire into Russia’s sphere of influence. Color me
nervous. Really, I don’t see how the game is worth the candle
here.
On the flip side of the self-binding spectrum, intentional
ambiguity can also be a very effective strategy for playing
Chicken, particularly if you’re starting from a structurally
stronger position than your opponent.
What is not effective at all, however, is to switch
back and forth between ambiguity and self-binding, as we have
seen from time to time with the Fed (data dependence versus strong
forward guidance) and
constantlywith this White House, particularly in its
foreign policy.
Third, there is one redeeming quality about the game of
Chicken – it takes a long time to play.
Unlike the Prisoner’s Dilemma, where you typically get to the
single Nash equilibrium so fast it makes your head spin (and
usually too quickly to react effectively in your portfolio),
Chicken players tend to have a mutual interest in pushing back the
day of reckoning as much as they can. That’s because no matter how
confident you are that you’re “winning” with your clever signals
and Narratives, neither your true will nor your opponent’s true
will are knowable or observable directly. Chicken is a game played
through a glass, darkly. It’s ultimately as unpredictable for the
players as it is for investors, and if there’s one group that hates
unpredictability even more than professional investors it’s
professional politicians.
The upshot of all this for investors is two-fold:
Take your time in dis-engaging from the game. Yes, a game of
Chicken is inherently unpredictable and hence inherently
un-investable, but you have plenty of time to exit. Moreover, the
passage of time can often make the ultimate car crash much less
painful. For example, while a Greek default and Euro exit will
spark trouble no matter when it occurs, it’s absolutely less
destabilizing today with most of the debt in the hands of the
Troika than three years ago when that debt was spread all over the
private banking sector.
Don’t freak out on any individual signal or
Missionary statement, but don’t ring the
all-clear bell, either. Because Chicken is a game of
constructedsignals and Narratives signifying hidden will
and intentions, there’s almost always “room” for players to volley
market-moving statements back and forth, regardless of the
objective or structural characteristics at hand. In other words, it
is virtually impossible for a single signal to push the outcome
into either Nash equilibrium. When does time run out in a game of
Chicken? When you see
competingNarratives of “we have no choice” you’ve entered
the death spiral phase of the game. That’s when it’s time to head
for the hills, and quickly.
I’ll close this note with the same line that I find myself
using over and over again.
The Golden Age of the Central Banker is a time for
investment survivors, not investment heroes, and the ubiquity of
inherently unstable games of Chicken is a big reason for that
advice. There’s no shame in picking your battles, in recognizing
what’s investable and what’s not. There’s also no reason to panic.
But it’s not easy to make that differentiation if you’re looking at
an uncertain world through risk-colored glasses. Time for a new set
of lenses, one that takes seriously the patterns of strategic
interaction and behavioral dynamics that rocked the world in the
1870s, the 1910s, the 1930s, and … I suspect … the years
immediately ahead of us.