The "Pecking Order" In A World Of Hollow Freedoms

Authored by Ben Hunt via Epsilon Theory blog,

"If we can agree that trickle down is just a ruse invented to trick the gullible, we should also agree that any and all QE is robbery in plain daylight."

Out of all the animals we keep on our “farm”, chickens are the only ones that bring me no joy. Chickens are, by nature, brutal and cruel. They will torture the weak to death with their pecks, not because they have to, but because they can. It’s the way their brains are hard-wired, and it works for them, as a species. So I pretend that chickens aren’t evil and I’m not complicit. Because I really like the eggs.

We are trained and told that the pecking order is not a real and brutal thing in the human species. This is a lie. It is an intentional lie, one that we pretend isn’t evil and where we are not complicit.

Because we really like the eggs.

And that’s the news from Lake Wobegon, where all the women are strong, all the men are good-looking, and all the children are above average.

 

- Garrison Keillor

We can’t all be rich.

We can’t all be famous.

We can’t all be Someone Who Matters to the World.

[Team Elite Narrator: OR CAN WE?]

Blake:    Put. That coffee. Down. Coffee’s for closers only. You think I’m f**king with you? I am not f**king with you. I’m here from downtown. I’m here from Mitch and Murray. And I’m here on a mission of mercy. Your name’s Levine? You call yourself a salesman, you son of a bitch?

 

Moss:    I don’t gotta sit here and listen to this s**t.

 

Blake:    You certainly don’t, pal, ’cause the good news is — you’re fired. The bad news is — you’ve got, all of you’ve got just one week to regain your jobs starting with tonight. Starting with tonight’s sit. Oh? Have I got your attention now? Good. ‘Cause we’re adding a little something to this month’s sales contest. As you all know, first prize is a Cadillac Eldorado. Anyone wanna see second prize? Second prize is a set of steak knives. Third prize is you’re fired. Get the picture? You laughing now? You got leads. Mitch and Murray paid good money for their names. You can’t close the leads you’re given, you can’t close s**t. You ARE s**t! Hit the bricks, pal, and beat it ’cause you are going OUT!

 

? Glengarry Glen Ross (1992)

The truth is that unless you are really rich, you work for Mitch & Murray. Yes, that includes you, Vox writer changing the world one smarter-than-thou opinion at a time. Yes, that includes you, tech start-up developer kicking back in your flair-bedecked WeWork cubicle.

We don’t feel the crushing power of the Mitch & Murray pecking order as palpably as the salesmen berated by Alec Baldwin feel it, because the language of David Mamet has been replaced by the language of Dick Thaler and Cass Sunstein. The modern Mitch & Murrays don’t browbeat us. They nudge us. They convince us that a set of steak knives is a darn good outcome, that it’s a promise kept rather than a threat delivered. Coffee’s not just for closers. No, no … coffee is for EVERYONE. In fact, let’s put some caffeine into everything you drink. Something nice and caffeinated to wash down that big slice of office birthday cake.

Most importantly, today’s Mitch & Murray writ large — the system of Mitch & Murrays — provides credit to the non-rich, essentially limitless credit for anything that’s intangible or depreciates quickly, anything that lets the non-rich FEEL rich. How about a nice dinner out? New smartphone? You deserve it! How about a couple of years of graduate school? More than a couple of years, shooting for a tenure track position? [Heh, heh] I mean … why certainly, even better!

Go on, try the eggs. They’re delicious.

And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

 

- Ben Bernanke (2010)

Step One in the Pecking Order Lie is to promote a narrative of trickle-down economics - that making the rich even richer is a good thing for the non-rich.

This is exactly what Ben Bernanke is saying here, that the Fed’s extraordinary efforts to prop up the stock market aren’t just good for the rich, but will be good for everyone once the “wealth effect” kicks in and the rich start spending their money.

Whenever someone uses the phrase “wealth effect”, they are promoting a trickle-down narrative.  

How does trickle-down monetary policy work? By spending TRILLIONS of dollars to buy financial assets, the world’s central banks have inflated the prices of ALL financial assets, EVERYWHERE in the world.

This is not a secret plan. This is not a hidden agenda. This is the avowed purpose of what central bankers call Large Scale Asset Purchases (LSAPs). The goal is to force us to “reach for yield”. The goal is to force us to buy more and more risky assets (stocks) at higher and higher prices. The Fed is trying to make the stock market go up. And they’re succeeding.

Here’s a great chart from TCW showing how this works. The orange line is the growth rate of the US economy. The blue line is the growth rate of how rich we are. By tripling the stock market, the Fed has made us much richer than our economy has grown … SOOO much richer than our economy has grown.

But the goodies of a trebled stock market aren’t evenly distributed. Who owns stocks? If we’re talking about households, leaving aside pension funds and endowments and other institutional investors, it’s the rich, mostly. And that household share of the Central Bankers’ Bubble doesn’t increase linearly with wealth, but exponentially, meaning that the really rich own a lot more stocks than the merely rich, so the really rich have gotten a lot richer than the merely rich.

Here’s a chart from Deutsche Bank showing the impact (it’s a year old, so the effect is even more pronounced today with the stock market 20% higher). Thirty years ago, the non-rich (the bottom 90% of American households by income) owned 35% of American household wealth. Today they own about 22%. Forty years ago, the really rich (the top 1/10^th of 1% of American households by income) owned about 7% of American household wealth. Today they, too, own about 22%. Moreover, the gains of the really rich have mirrored the losses of the non-rich, which means that the well-off and merely rich (the remaining 9.9% of American households) haven’t seen much of a change one way or another.

Now this shift in relative wealth of the non-rich and the really rich didn’t start with the Central Bankers’ Bubble and its narrative of trickle-down wealth effects from monetary policy. It started roughly in 1980 with the Reagan narrative of trickle-down wealth effects from fiscal policy. And before we make overly facile comparisons with the 1920s and 1930s, this chart isn’t taking into account pensions and social security and other safety net features of the modern semi-sorta-welfare state. So I don’t know how historically abnormal today’s level of significant wealth inequality might be, whether it’s Louis XVI level inequality or simply robber baron level inequality.

But I know that it IS.

I know that inequality is growing. I know that the pecking order has been getting stronger for a couple of decades now, and that it’s been driven by the Central Bankers’ Bubble over the past decade. I suspect that this is probably a good thing for global egg production. I also suspect that this is a bad thing if you care about liberty and justice for all.

The narrative around trickle-down fiscal policy has become highly politicized, as the good Democrat soldiers at the usual Team Elite bastions never tire of telling us how those Republican tax policies will increase wealth inequality. And they’re right.

But these same tireless foes of trickle-down fiscal policy trip over themselves praising and promoting the narrative of trickle-down monetary policy under Bernanke and Yellen, which has been FAR more effective at delivering windfall gains to the really rich than Ronald Reagan or Paul Ryan could ever dream of achieving through tax “reform”.

Lenin called communist sympathizers in the West “useful idiots”. The Nudging State and the Nudging Oligarchy have their own willing crew of stooges, drawn primarily from children of privilege (well off or merely rich, not really rich) who want to “make a difference”, who want to be Someone Who Matters to the World.

[Team Elite Narrator: But you DESERVE to be Someone Who Matters to the World, my young friend. You’re good enough, you’re smart enough, and doggone it, people like you. Why, here as a WaPo staffer you’ll be making the world a more succulent host for Jeff Bezos better place for all!]

The picture on the left is Jeff Bezos, age 40, worth a billion dollars or so. The picture on the right is Jeff Bezos, age 52, worth 100 billion dollars or so. HGH looks good on you, Jeff.

I think that at some point in the next decade, it’s inevitable that oligarchs like Bezos will gain access to life extension technologies unavailable to ordinary mortals. At that point, the pecking order will take on an entirely new dimension. At that point, we have a war. Which the non-rich will lose.

You’ll be pleased to know that Janet Yellen, with a reported net worth of about $15 million, is “greatly concerned” about growing inequality, but regrets that the Fed has no purview on this terrible problem. Perhaps Congress should do something, she suggests, like “making college more affordable” — by which she means extending even more debt financing — or “supporting early childhood education” — by which she means publicly funded daycare so that both parents can work in support of the Nudging State and the Nudging Oligarchy.

This is Step Two of the Pecking Order Lie — the provision of massive debt financing to the non-rich, preferably for non-appreciating experiences like going to college or quickly depreciating things like cars and smartphones.

Why? So that the non-rich will FEEL RICH even as they BECOME POORER.

Student debt (and every other form of consumer debt) is the functional equivalent of an office birthday cake. Debt provision and a pleasant narrative to go with it is a highly cost-effective behavioral tool for maintaining worker morale in the face of objectively deteriorating labor conditions.

Milton:   The ratio of people to cake is too big!

 

- Office Space (1999)

Unless, like Milton, you don’t get your slice of cake. Then you burn the office down. Or vote for Trump. Same thing.

It is a sin to believe evil of others, but it is seldom a mistake.

 

- Garrison Keillor

The pecking order is real. It is beautifully masked in modern human society, but no less brutal and no less cruel than in the chicken coop.

How do you escape the pecking order? How do you quit Mitch & Murray? Well, you can make a lot of money. That’s the tried and true method. Enough money to build a walled garden around you and yours, expanding it as you can to take in others. F-you money. Somewhere between merely rich and really rich should do the trick, depending on how many generations you want to protect within those walls. Unfortunately, that’s a big gulf these days, that distance between merely rich and really rich, and it’s getting wider every day.

But there’s another way.

No matter how much money we have or don’t have, we can reject the idea that we can be Someone Who Matters to the World and instead embrace the idea that we must be Someone Who Matters to the Pack. Now maybe your pack IS the world. Probably not, but maybe. If it is, then be bold and matter to the world. But more likely it’s your family. More likely it’s your friends. More likely it’s your partners and employees. More likely it’s your church. More likely it’s your school. More likely it’s your country. It’s damn sure not your political party. It’s damn sure not an oligarch.

Why should we reject this notion of being Someone Who Matters to the World? Because that’s the shiny lure that the Nudging State and the Nudging Oligarchy dangle in front of bright young things. And bright not-so-young people, too. The shiny lure of mattering is how they set the hook — which is debt — and that’s how they reel you in. Because once you’ve got that hook in your mouth … once you’re up to your eyeballs in debt … it’s soooo hard to ever get free. I know of which I speak. So do a lot of people reading this note, I bet.

The simple truth is that we can’t escape the pecking order. We can’t escape economic inequality and the hard-wired impulses to brutality and cruelty used to support inequality. Not for long, anyway. Walled gardens never last.

But we can do better. We can reject the lies used to justify inequality even as we accept the reality of inequality. We can be IN the pecking order world without being OF the pecking order world.

There is an autonomy inherent in rejecting the lure of the Nudging State and the Nudging Oligarchy, an autonomy that can power a life well lived. It doesn’t mean rejecting the world as it is. It doesn’t mean leaving the grid for Alaska homesteading. No, that’s a prison of quite another sort. It doesn’t mean mattering to nothing. It means mattering to other humans who see YOU as an autonomous end-in-itself and not as a means to an end. THAT’S your pack. Make a difference for THEM.

In January 1941, eleven months before Pearl Harbor brought the United States into World War II, Franklin Roosevelt gave his Four Freedoms speech — Freedom of Speech, Freedom of Worship, Freedom from Want, Freedom from Fear — memorialized over the next few years by Norman Rockwell in these famous paintings.

What is autonomy? It’s freedom.

What freedoms? These.

If you get nothing else from Epsilon Theory, get this: these freedoms are not granted to us by the State or the Oligarchs. They are not theirs to give. They are not rewards for good behavior or allocations from a central pot. They are ours. They have always been ours. They cannot be taken away.

But we can give them away. We can sell our birthright for a mess of pottage in the form of student debt and a tasty slice of office birthday cake. We can allow ourselves to be beguiled by the glamour of mattering for a Mighty Cause, giving away our allegiance to those who would use us as fodder or feed. We can embrace the pecking order lie and exchange our True Freedoms for Hollow Freedoms, for a freedom of socially acceptable speech and a freedom of socially acceptable worship and a freedom from socially manufactured wants and a freedom from socially manufactured fears.

We can’t escape from a world dominated by the Hollow Freedoms any more than we can escape from a market dominated by Hollow Liquidity and Hollow Volatility. But in markets and in politics we can call things by their proper names. We can maintain our autonomy of mind. We can find our pack and matter to them. We can recognize that a politics without shame is a politics without honor, just as a market without risk is a market without reward. We can take a loss in the short term, knowing that we’re playing the long game. We can do this handshake by handshake, investment by investment, candidate by candidate, good deed by good deed.

And watch how our world starts to change. Watch how we Make America Good Again.

Sheep Logic - This Is The Age Of The High-Functioning Sociopath

These are baby-doll Southdowns, and yes, they’re exactly as cute as they look in this picture. We only have four today on our “farm”, as sheep have a knack for killing themselves in what would almost be comical fashion if it weren’t so sad. We keep them for their so-so wool, which we clean and card and spin and knit. It’s so-so wool because the Southdowns were bred for their meat, not their fleece, and I can’t bring myself to raise an animal for its meat. Well, I could definitely raise birds for meat. Or fish. But not a charismatic mammal like a baby-doll Southdown.

Here’s the thing I’ve learned about sheep over the years. They are never out of sight of each other, and their decision making is entirely driven by what they see happening to others, not to themselves. They are extremely intelligent in this other-regarding way. My sheep roam freely on the farm, and I never worry about them so long as they stay together, which they always do. But if I only count three in the flock, then I immediately go see what’s wrong. Because something is definitely wrong.

That’s the difference between a flock and a pack. A flock is a social structure designed to promote other-awareness. It has no goals, no coordinating purpose other than communication. A flock simply IS. A pack, on the other hand, is a social structure designed to harness self-aware animals in service to some goal requiring joint action — the raising of cubs, the hunting of meat, etc. Both the flock and the pack are extremely effective social structures, but they operate by entirely different logics.

We think we are wolves, living by the logic of the pack.

In truth we are sheep, living by the logic of the flock.

*  *  *

There’s no domesticated animal species that has had more of a reputational fall from grace than the sheep. To call someone a sheep today is just about the worst insult there is. To call someone a sheep is to call them stupid and — more pointedly — stupidly obedient and in thrall to some bad shepherd.

It wasn’t always this way. Jesus isn’t insulting you when He calls you a sheep. The point of all those Biblical allegories isn’t that sheep are stupidly obedient or easily led, but that the healthy life of a willful sheep requires a good shepherd.

Ask anyone who actually keeps sheep. Sheep are weird. Sheep are evolved to have a very different intelligence than humans. But sheep are not stupid. Sheep are not obedient. And sheep are definitely not easily led.

Of course, no one except a dilettante farmer like me keeps sheep today, so all of the Old Stories about sheep and shepherds have lost their punch. They’ve all been diminished through the modern lens of sheep-as-idiot-followers.

Today most people dismiss the notion that good shepherds - i.e., individuals with expertise and wise counsel in some difficult to navigate field like … I dunno … investing — exist at all. And they utterly reject the idea that it’s actually okay not to have a fully formed and forcefully held opinion on anything and everything, that it’s not a sign of personal failure to say “I don’t know” and follow another’s lead.

It’s not just the media careers and media business models that are built on the notion of the Constant Hot Take — an unending stream of contrarian opinions expressed in the most incendiary way possible, solely for the entertainment value of contrarian opinions expressed in the most incendiary way possible — it’s the millions of hours that so many non-media civilians will spend engaged on Twitter or Facebook or whatever to construct their own steady stream of Hot Takes and bon mot responses. All tossed out there like bottles into the vast social media ocean, never to wash up on any inhabited shore, lost in some great Sargasso Sea of impotent and forgotten texts.

Why? Why does @RandoBlueStateLawyer with 45 followers spend the better part of every afternoon thinking about his next brilliant riposte to the latest Republican Hot Take on Obamacare reform? Why does @RandoRedStateRetiree spend every evening working himself into a MAGA apoplexy that can only be sated by retweeting his 19,001^st Hannity blurb?

To answer that question, I want to go back to the Old Stories. I want to share with you what sheep are really like.

Sheep are evolved to have a specific type of intelligence which has the following hallmarks.

1. Enormous capacity for other-regarding behaviors. Sheep are unbelievably sensitive to what other sheep are doing and their emotional states. If another sheep is happy — i.e., it’s found a good source of food, which is the only thing that makes a sheep happy — then every other sheep in the flock is filled with jealousy (there’s really no other word for it) and will move in on that good thing. If another sheep is alarmed — which can be from almost anything, as bravery is not exactly a trait that tends to be naturally selected in a prey species — then every other sheep in the flock is immediately aware of what’s going on. Sometimes that means that they get alarmed, too. As often, though, it’s just an opportunity to keep going with your own grazing without worrying about the alarmed sheep bumping into your happy place.


2. Zero altruism and overwhelming selfishness. The most popular misconception about sheep is that they are obedient followers. It’s true that they’re not leaders. It’s true that they are incredibly sensitive to other sheep. But it’s also true that they are the most selfish mammal I’ve ever encountered. They don’t lead other sheep or form leadership structures like a pack because they don’t care about other sheep. Every sheep lives in a universe of One, which makes them just about the most non-obedient creature around.


3. The determination to pursue any behavior that meets Hallmark #1 and #2 to absurd ends, even unto death. My worst sheep suicide story? The first year we kept sheep, we thought it would make sense to set up a hay net in their pen, which keeps the hay off the ground and lets the sheep feed themselves by pulling hay through the very loose loops of the net. Turned out, though, that the loops were so loose that a determined sheep could put her entire head inside the net, and if one sheep could do that, then two sheep could do that. And given how the hay net was hung and how these sheep were sensing each other, they started to move clockwise in unison, each trying to get an advantage over the other, still with their heads stuck in the net. At which point the net starts to tighten. And tighten. And tighten. My daughter found them the next morning, having strangled each other to death, unable to stop gorging themselves or seeking an advantage from the behavior of others. The other sheep were crowded around, stepping around the dead bodies, pulling hay for themselves out of the net. That was a bad day.

In both markets and in politics, our human intelligences are being trained to be sheep intelligences.

That doesn’t make us sheep in the modern vernacular. We are not becoming docile, stupid, and blindly obedient. On the contrary, we are becoming sheep as the Old Stories understood sheep … intensely selfish, intensely intelligent (but only in an other-regarding way) and intensely dogmatic, willing to pursue a myopic behavior even unto death.

Why are we being trained to think like sheep? Because sheep are wonderful prey animals. They pay the rent with their fleece, and when push comes to shove you can eat them, too. Plus they’re not helpless prey animals. Sheep are quite competent and rather self-sufficient prey animals, which from a smart owner’s perspective is really what you want. If sheep were truly docile and stupid, then they’d be way too much trouble to keep. Nope, with sheep you can let them wander around all day and do their thing. Just keep them from killing themselves in some really stupid accident and you can harvest them for years and years and years.

How are we trained to think like sheep? By the rewards we receive from our modern social institutions for other-regarding flock behaviors like jealousy (feeling sad when others are glad) and schadenfreude (feeling glad when others are sad), and by the penalties we receive for self-regarding pack behaviors like honor and shame. If you’ve ever kept a pack animal like a dog, you know how clearly they can experience a sense of shame, that feeling when you believe you’ve let the pack down through your personal failure. Sheep have no shame. Not a bit. Shame requires self-evaluation and self-judgment against some standard of obligation to the pack, concepts which would make sheep laugh if they could. Sheep are enormously other-aware, but never other-obliged. They’re high-functioning sociopaths, shameless creatures of jealousy and schadenfreude, which is exactly the type of human most purely designed to succeed in the modern age.

The mechanism for all this sheep training, particularly in our investment lives, is what game theory calls the Common Knowledge Game. Once you start noticing it, you will see it everywhere.

I’ve written about the Common Knowledge Game a lot in Epsilon Theory, starting in the original “Manifesto” and continuing with notes like “A Game of Sentiment” and “When Does the Story Break”. But let’s review this core game of sheep logic one more time, with feeling. So here’s the classic thought experiment of the Common Knowledge Game — The Island of the Green-Eyed Tribe.

On the Island of the Green-Eyed Tribe, blue eyes are taboo. If you have blue eyes you must get in your canoe and leave the island the next morning. But there are no mirrors or reflective surfaces on the island, so you don’t know the color of your own eyes. It is also taboo to talk with each other about eye color, so when you see a fellow tribesman with blue eyes, you say nothing. As a result, even though everyone knows there are blue-eyed tribesmen, no one has ever left the island for this taboo. A Missionary comes to the island and announces to everyone, “At least one of you has blue eyes.”

What happens?

Let’s take the trivial case of only one tribesman having blue eyes. He has seen everyone else’s eyes, and he knows that everyone else has green eyes. Immediately after the Missionary’s statement, this poor fellow realizes, “Oh, no! I must be the one with blue eyes.” So the next morning he gets in his canoe and leaves the island.

But now let’s take the case of two tribesmen having blue eyes. The two blue-eyed tribesmen have seen each other, so each thinks, “Whew! That guy has blue eyes, so he must be the one that the Missionary is talking about.” But because neither blue-eyed tribesman believes that he has blue eyes himself, neither gets in his canoe the next morning and leaves the island. The next day, then, each is very surprised to see the other fellow still on the island, at which point each thinks, “Wait a second … if he didn’t leave the island, it must mean that he saw someone else with blue eyes. And since I know that everyone else has green eyes, that means … oh, no! I must have blue eyes, too.” So on the morning of the second day, both blue-eyed tribesmen get in their canoes and leave the island.

The generalized answer to the question of “what happens?” is that for any n tribesmen with blue eyes, they all leave simultaneously on the n^th morning after the Missionary’s statement. Note that no one forces the blue-eyed tribesmen to leave the island. They leave voluntarily once public knowledge is inserted into the informational structure of the tribal taboo system, which is the hallmark of an equilibrium shift in any game. Given the tribal taboo system (the rules of the game) and its pre-Missionary informational structure, new information from the Missionary causes the players to update their assessments of where they stand within the informational structure and choose to move to a new equilibrium outcome.

Before the Missionary arrives, the island is a pristine example of perfect private information. Everyone knows the eye color of everyone else, but that knowledge is locked up inside each tribesman’s own head, never to be made public. The Missionary does NOT turn private information into public information. He does not say, for example, that Tribesman Jones and Tribesman Smith have blue eyes. But he nonetheless transforms everyone’s private information into common knowledge. Common knowledge is not the same thing as public information. Common knowledge is information, public or private, that everyone believes is shared by everyone else. It’s the crowd of tribesmen looking around and seeing that the entire crowd heard the Missionary that unlocks the private information in their heads and turns it into common knowledge.

The important thing is not that everyone hears the Missionary’s words. The important thing is that everyone believes that everyone else heard the Missionary’s words, because that’s how you update your estimation of everyone else’s estimations (why didn’t that blue-eyed guy leave the island? I know he heard the news, too … hmm … but that must mean that he, too, saw a blue-eyed guy … hmm … oh, snap.). The power source of the Common Knowledge Game is the crowd seeing the crowd, and the dynamic structure of the Common Knowledge Game is the dynamic structure of the flock. There’s no purposeful objective that animates a flock the way it does a pack, which is why you famously have people describing the “madness of crowds.” But it’s not madness, and it’s not chaos, either. A crowd is the communication mechanism for the Common Knowledge Game, with clear rules and strategies for playing and winning.

Understanding the Common Knowledge Game has been the secret of successful shepherds since time immemorial, in business, politics, religion … any aspect of our lives as social animals. The only difference today is that technological innovation provides a media toolkit for modern shepherds that the shepherds of the Old Stories could only dream of.

This is why sitcom laugh tracks exist. This is why performances, whether it’s an NFL game or Dancing with the Stars, are filmed in front of a live audience. This is why the Chinese government still bans any internet pictures of the Tiananmen Square protests, with their massive crowds, more than 20 years after they occurred. This is what John Maynard Keynes called the Newspaper Beauty Contest, which he believed (and demonstrated) was the secret to successful investing through the 1930s. This is how Dick Clark built a massive fortune with American Bandstand. He didn’t tell Middle America what music to like; he got a crowd of attractive young people to announce what music they liked (“it’s got a good beat and you can dance to it, I give it a 94, Dick!”), and Middle America took its cues from that. Not only is that all you need to motivate sheep, it’s far more effective than any efforts at direct influence.

This is why executions used to be held in public and why inaugurations still are. This is why Donald Trump cared so much about the size of his inauguration crowd. This is why he’s always talking about the viewership and ratings of his televised appearances. Trump gets it. He understands what makes the Common Knowledge Game work. It’s not what the crowd believes. It’s what the crowd believes that the crowd believes. The power of a crowd seeing a crowd is one of the most awesome forces in human society. It topples governments. It launches Crusades. It builds cathedrals. And it darn sure moves markets.

How do we “see” a crowd in financial markets? Through the financial media outlets that are ubiquitous throughout every professional investment operation in the world — the Wall Street Journal, the Financial Times, CNBC, and Bloomberg. That’s it. These are the only four signal transmission and mediation channels that matter from a financial market Common Knowledge Game perspective because “everyone knows” that we all subscribe to these four channels. If a signal appears prominently in any one of these media outlets (and if it appears prominently in one, it becomes “news” and will appear in all), then every professional investor in the world automatically assumes that every other professional investor in the world heard the signal. So if Famous Investor X appears on CNBC and says that the latest Fed announcement is a great and wonderful thing for equity markets, then the market will go up. It won’t go up because investors agree with Famous Investor X’s assessment of the merits of the Fed announcement. The market will go up because every investor will believe that every other investor heard what Famous Investor X said, and every investor will be forced to update his or her estimation of what every other investor estimates the market will do. It doesn’t matter what the Truth with a capital T is about the Fed. It doesn’t matter what you think about the Fed. It doesn’t matter what everyone thinks about the Fed. What matters is what everyone thinks that everyone thinks about the Fed. That’s how sheep logic, aka the Common Knowledge Game, works in markets.

So who owns us market sheep? The controllers of any Common Knowledge Game are the Missionaries, and the eternal Missionaries are the political executive and the market sell-side. Politicians and brokers have understood the power of this game for thousands of years, which makes the Street and the White House the constants as you examine the history of American sheepification. But they’re not the most powerful Missionaries of the modern age. No, that honor goes to our central bankers, relative newcomers to the Game, but quick studies all the same.

In his last Jackson Hole address, Ben Bernanke extols the virtues of their “communication tools”, carefully constructed media messages designed to alter investor behavior, messages that he says have been their most effective policy tools to date. Interest rates may hit a lower bound of zero, and asset purchases may lose their punch, but investors can ALWAYS be “guided”. The architect of this new and powerful toolkit? Vice Chair Janet Yellen, natch. Forward guidance and what the Fed calls communication policy are the very definition of Missionary statements, and our utter absorption in what everyone believes that everyone believes about the Fed’s impact on markets IS sheep logic.

Think that the Fed will go back to their old taciturn ways, content to let their actions speak louder than their words? Think again. Here’s Ben Bernanke again, this time in his final speech as Fed Chair:

The crisis has passed, but I think the Fed’s need to educate and explain will only grow. When Paul Volcker first sat in the Chairman’s office in 1979, there were no financial news channel on cable TV, no Bloomberg screens, no blogs, no Twitter. Today, news, ideas, and rumors circulate almost instantaneously. The Fed must continue to find ways to navigate this changing environment while providing clear, objective, and reliable information to the public.

Active central bank Narrative construction in the service of their policy goals is a permanent change in our market dynamics. The introduction of such a powerful new weapon in the Fed’s policy arsenal can no more be removed than mustard gas or tanks could be removed from national arsenals after World War I. Market prices may be mean-reverting, but “innovation” in the service of social control never is.

What do the Missionaries get out of this? What’s our equivalent of wool and mutton? It’s low volatility. It’s the transformation of capital markets into a political utility, which is just about the greatest gift that status quo political interests can imagine. When Donald Trump and Steve Mnuchin talk about the stock market being their “report card”, they’re just saying out loud what every other Administration has known for years. Forget about markets, our entire political system relies on stocks going up. If stocks don’t go up, our public pension funds and social insurance programs are busted, driving our current levels of wealth inequality from ridiculously unbalanced to Louis XVI unbalanced. If stocks don’t go up, we don’t have new collateral for our new debt, and if we can’t keep borrowing and borrowing to fuel today’s consumption with tomorrow’s growth … well, that’s no fun, now is it?

The flip side to all this, of course, is that so long as stocks DO go up, nothing big is ever going to change, You say you want a revolution? You’re a MAGA guy and you want someone to drain the Swamp? You’re a Bernie Bro and you want the rich to “pay their fair share”? Well, good luck with any of that so long as stocks go up. It’s a very stable political equilibrium we have today, full of Sturm und Drang to provide a bit of amusement and distraction, but very stable for the Haves.

And that brings us back to @RandoBlueStateLawyer and @RandoRedStateRetiree, fighting the good fight on Twitter or Facebook or wherever, speaking their Truth to their audience of dozens. They’re smart guys. Politically engaged guys. They’re angry about the mendacity of the Other Side. In another day and age they’d slam the newspaper down on the table and tell the dog what a fool that darn Truman was. Maybe write a strongly worded letter to the editor. But today they are consumed by this modern equivalent of writing a letter to the editor. They are immersed in the world of the Constant Hot Take, morning, noon and night. Why? Because Common Knowledge Game. Because they see a crowd responding to a crowd, and they are hard-wired to join in. Because it makes them feel good about themselves. Because they’ve been turned into other-regarding sheep even as they think they’re being self-regarding wolves.

In the same way that the modern story of what it means to be a sheep — docile, obedient, stupid — is totally wrong, so is the modern story of what it means to be a wolf. We think of a wolf as the epitome of rapacious independence, but wolves, like all pack animals, are far less independent (and far less greedy) than your average sheep. Unlike sheep, wolves can act outside of their group because they’re not consumed by other-regarding behavior, but those actions are ultimately in service to the pack. A sheep always acts within its group, but it’s never in service to the flock, only to its own needs.

Look, I’ll admit that I’m talking to myself as I write these words. I spend WAY too much time on Twitter, justifying it to myself in any number of ways, when in truth it’s the functional equivalent of a meth habit. At least it’s not as tough on the teeth. My wife is hooked on Facebook, my kids on god knows what social media platforms …. I’m not so naïve as to think that the answer to our collective sheepification is just to put the devices down. No, we’ve got to shift the way we use this stuff, not quit it cold turkey.

So what do we do? We stop pretending to be fake wolves and we start acting like real ones. We stop acting like animals of the flock and we start acting like animals of the pack. We reject the other-regarding emotions of jealousy and schadenfreude. Yes, even in our tweets (gulp!). We embrace self-regarding emotions like honor and — here’s where I’m going to lose everyone — shame.

Yes, we need a lot more shame in the world. The loss of our sense of shame is, I think, the greatest loss of our modern world, where — to retweet myself — scale and mass distribution are ends in themselves, where the supercilious State knows what’s best for you and your family, where communication policy and fiat news shout down authenticity, where rapacious, know-nothing narcissism is celebrated as leadership even as civility, expertise, and service are mocked as cuckery. Or to put it in sheep logic terms: the tragedy of the flock is that everything is instrumental, including our relationship to others. Including our relationship to ourselves.

Why do we need shame? Because with no sense of shame there is no sense of honor. There is no mercy. There is no charity. There is no forgiveness. There is no loyalty. There is no courage. There is no service. There is no Code. There are no ties that bind us as citizens, as fellow pack members seeking to achieve something bigger and more important than our ability to graze on as much grass as we can. Something like, you know, liberty and justice for all.

Any coin worth having has two sides. A shameless politics has no honor. A riskless market has no reward. Oh, the Missionaries will tell you that there’s honor in the shameless politics and reward in the riskless markets, and for all the high-functioning sociopaths out there I’m sure that’s true, But if you’re not totally sheepified yet, if your goal is still honorable service to your clients or your partners or your family or your nation or your species — whatever your pack may be — then you know that this is NOT true. You know that shame and risk can be deferred or displaced but never wiped clean, no matter how many Supreme Court Justices you appoint and no matter how many all-time highs the stock market hits. You know that a reputation is like a tea cup; once broken you can glue it back together, but it will always be a broken tea cup. You know that the only game worth playing is the long game.

This is the Age of the High-Functioning Sociopath. This is the Age of Sheep Logic. We have to survive it, but we don’t have to succumb to it. How do we Resist? Not by switching out blue Missionaries for red Missionaries or red Missionaries for blue Missionaries. Not by switching out one bad shepherd for another bad shepherd. We don’t have to play that game! We resist by changing the System from below, by carving out local spheres of action where we are relentlessly honorable and charitable, relentlessly un-sheeplike. We resist by Making America Good Again, one pack at a time, which is a hell of a lot harder than making America great ever was. We resist by doing right by our clients, even if that means getting slapped around by supposedly riskless markets and shameless politics. Even if that means losing clients. Even if that means losing our jobs.

A good shepherd once said that whoever shall smite thee on thy right cheek, turn to him the other also. Of course, I also knew a good Dungeonmaster who said that being lawful good didn’t mean being lawful stupid, and turning the other cheek always seemed to be kinda stupid to me. Kinda sheeplike. But then I started keeping sheep, and my perspective changed. Sheep would never turn the other cheek. But a wolf would. A wolf would take a hit for the pack. It’s the smart play for the long game. As wise as serpents, you might say.

It’s time to be wolves. Not as devourers, but as animals that know honor and shame. It’s time to be wise as serpents and harmless as doves. It’s time to remember the Old Stories. It’s time to find your pack.

Doing This In College Will Boost Your Income By 36% - But It Will Also Make You Dumber

Years ago, we reported on the shockingly effective college-to-Wall Street pipeline established by Sigma Chi Epsilon, a fraternity whose members made it a goal to build a “little fraternity on Wall Street.” By offering insider tips, as well as offers to intervene on candidates’ behalf, members of the fraternity have helped populate banks like J.P. Morgan, BofA and Wells Fargo with fellow alumni – helping them beat odds three times steeper than the Princeton admissions rate.

Now, a new study by researchers at Union College in Schenectady has confirmed what that story appeared to suggest. That despite the constant distraction from academics that fraternity membership represents, students who join reap the benefits of the associated professional network for years to come, MarketWatch reports.

Of course, these benefits come with a tradeoff: The study showed that being a member of a fraternity also makes you dumber.

“Being a member of a fraternity in college lowers a student"s GPA by approximately 0.25 points on the traditional four-point scale, but raises future income by around 36%, according to a paper, “Social Animal House: The Economic and Academic Consequences of Fraternity Membership,” published by two economists from Union College in Schenectady, New York. “For this reason, joining a fraternity may be a rational decision that improves the long-term prospects of an individual student despite its damaging effects on a student’s grades,” the paper concluded.”

These results suggest that fraternity membership causally produces large gains in social capital, which more than outweigh its negative effects on human capital for potential members,” they concluded. “These findings suggest that college administrators face significant trade-offs when crafting policies related to Greek life on campus.” They surveyed 3,762 alumni from a liberal Northeastern college who work full-time and also adjusted for the statistical impact of age, gender and ethnicity on a person’s income.”

While fraternities have frequently been the subject of unflattering press coverage in recent years – the Penn State hazing-death case being one example - about the culture of rape and dangerous risk-taking that fraternities perpetuate, the study’s results offer a strong argument for universities to keep Greek life programs: namely, that the organizations offer at least some long-term benefits to members.

“Despite the partying and troubling headlines that fraternity life involving hazing and sexual assault in recent years, supporters of fraternities say there’s another side to Greek life. Among them, they provide academic support for students and social connections that can last a lifetime. Studies at the American University in Washington, D.C. and other colleges have found that Greek life results in higher GPAs. Fraternity alumni programs, LinkedIn groups, online communities all help foster strong social ties that are designed to last a lifetime across different generations of members of the same fraternity.”

The study’s authors explained that they controlled specifically for the impact of social connections by correcting the data to factor out other behavioral tendencies of fraternity life – like excessive alcohol consumption.

“Alcohol-related behavior did not explain much of the effects of fraternity membership, the latest study found. Fraternity membership lowers grades by 0.18 to 0.42 points. Controlling for alcohol-related behavior reduces this estimate only slightly - by about 0.03 to 0.05 points.

“This suggests that, despite its visibility, alcohol consumption plays a relatively minor role,” the paper concluded. Because the data was collected from workers from ages 25 to 65, it incorporates the effect of Greek membership on lifetime earnings - not just on earnings in the first job after college.

As MarketWatch explains, other studies have also proven that alcohol consumption has myriad negative repercussions for individuals, most notably by lowering the odds of attaining full-time employment after graduation.

“However, heavy drinking just six times a month reduces the probability that a new college graduate will land a job by 10%, according to researchers at Tel Aviv University and Cornell University published in the peer-reviewed academic journal “Journal of Applied Psychology.” Alcohol is a depressant that impacts motor functions and brain activity. The authors suggest that each individual episode of student binge-drinking during a month-long period lowers the odds of attaining full-time employment upon graduation by 1.4%.”

In summary, the study effectively proves the old saying: “It’s not what you know, it’s who you know.” But then again, we imagine readers – particularly, American readers - have long suspected this to be accurate.

Mark Hanson: Housing Bubble 2.0 - The End Is Nigh?

Authored by Mark Hanson via MHanson.com,

The incredible essay below is reproduced here with permission by Dr. Hunt for Epsilon Theory. If Dr. Hunt is even moderately accurate, which I believe he is, the housing market headwind on deck could be every bit as powerful as what hit at the end of Bubble 1.0.

Bottom line: The Fed, during Obama, did everything in its power to surge all asset prices — stocks, bonds, real estate, collectables, et al — with no regard for its own guidance, as to when it would take its lead-foot off the accelerator.  Now, under Trump, they are doing the exact opposite;  looking “through” all the obvious coincident and near/mid term, economic weakening trends in an effort to raise rates as quickly as possible.  If, the past 8-years of a Fed in Armageddon-mode created the “everything bubble” (hat-tip Wolf Richter), what will shifting monetary policy into reverse do to said asset price levels?

Back in Bubble 1.0, the helium came out of house prices when the “unorthodox credit and liquidity” was forced out of the markets all at once precipitated by the mortgage credit market implosion.  Quickly, house prices “reattached” to end-user, shelter-buyer employment, income, and credit fundamentals…or, to what end-user, shelter-buyers could really buy using a traditional, 30-year fixed rate mortgage, and a truthful loan application, which was about 30% less.

What’s really the difference between the “unorthodox credit and liquidity” coming out back then and coming out now from a Fed in reverse?  House prices didn’t surpass their 2007 peaks because everybody is working, making more money (with the exception of those in the footprint of tech bubble 2.0).  They have been goosed for years by unorthodox demand using unorthodox credit and liquidity (i.e., investors, speculators, flippers, floppers, foreigners, money launderers, options, etc etc) just like in Bubble 1.0.

One thing is for sure…house prices are as diverged, or more, from end-user, shelter-buyer employment and income fundamentals as they were back in 2006.

Just because there are no NINJA loans that turned every ma and pa into a millionaire for the purposes of qualifying for a mortgage to buy a house, which pushed prices through the roof, doesn’t mean the housing market hasn’t been similarly, artificially goosed over the past five-years beginning when millions of legacy mortgage were “modified”.

“Loan Mods” — used to fight the very de-leveraging that would have once and for all “fixed” the excesses in the housing market — were so exotic (DTI’s of 70%+, credit scores below 600, LTV of 150%+, payments of 2% interest only) they made Angelo Mozillo blush.  Loan mods made WaMu’s 2005 vintage Pay Option ARMs look safe and sane!

As Bubble 2.0 was forming and unorthodox demand increased, pushing  house prices beyond the reach of most end-user, shelter-buyers in any given region, volume remained relatively weak…sales volume has never been a feature of Housing Bubble 2.0. In fact, after 7-years of ZIRP, $10 Trillion in new .Gov debt, and $5 Trillion in Fed money printing, builder new home sales are sitting at around 60% of the volume of the past Bubble. Resales are about 20% lower (resales rose more because that’s where the unorthodox demand lives…it doesn’t go to Pulte developments for flips and rentals).  Most blame a “lack of supply”. As if house supply doubled, so would sales. But, the problem has always been about true, fundamental demand, which is a key feature missing from this housing “faux-covery”.

Remember, a “house-price recovery” and “housing market recovery” are two vastly different things.

In closing, this housing Bubble always needs constantly lower mortgage rates; stable to increased flows of unorthodox demand, credit and liquidity; and/or increased leverage-in-finance vis-a’-vis easing of mortgage credit to keep house prices detached from end-user, shelter-buyer fundamentals.  All three of these engines of house price inflation have been running at max RPM’s for years. 

But, if a Fed in reverse takes shuts down two of the three engines, there simply isn’t a way for the GSE’s — who do 90% of all mortgages — and the banks to ease mortgage credit quickly, or dramatically, enough to prevent house prices from once again re-attaching to end-user, shelter-buyer fundamentals, which could be 30% less than where they stand today.  AND, if during this de-leveraging cycle the economy dramatically weakens, then end-uer, shelter-buyer fundamentals weaken and house prices could even fall further.

*  *  *

Subject: Epsilon Theory: post-Fed follow up

Date: June 16, 2017 at 11:35:45 AM PDT

Ben Hunt, Ph.D.

Chief Investment Strategist, SALIENT

I sat on the porch

Listened to the rain

Smoked a cigarette

And counted to ten

Oh no, here it comes again

That funny feeling

– Camper Van Beethoven, “Oh No!” (1985)

A quick post-Fed follow-up to my email on Monday and the publication of “Tell My Horse”, the best-received Epsilon Theory note to date (thank you!). I’ll jump right into what I’ve got to say, without the usual 20 pages of movie quotes and the like. Well, I’ve got one quote above, because I can’t help myself. They’re the lyrics to the best break-up song ever, and they’re what Janet Yellen was singing to the market on Wednesday.

Let’s review, shall we? Last fall, the Fed floated the trial balloon that they were thinking about ways to shrink their balance sheet. All very preliminary, of course, maybe years in the future. Then they started talking about doing this in 2018. Then they started talking about doing this maybe at the end of 2017. Two days ago Yellen announced exactly how they intended to roll off trillions of dollars from the portfolio, and said that they would be starting “relatively soon”, which the market is taking to be September but could be as early as July.

Now what has happened in the real world to accelerate the Fed’s tightening agenda, and more to the point, a specific form of tightening that impacts markets more directly than any sort of interest rate hike? Did some sort of inflationary or stimulative fiscal policy emerge from the Trump-cleared DC swamp <sarc>? Umm … no. Was the real economy off to the races with sharp increases in CPI, consumer spending, and other measures of inflationary pressures? Umm … no. On the contrary, in fact.

Two things and two things only have changed in the real world since last fall. First, Donald Trump – a man every Fed Governor dislikes and mistrusts – is in the White House. Second, the job market has heated up to the point where it is – Yellen’s words – close to being unstable, and is – Yellen’s words – inevitably going to heat up still further.

What has happened (and apologies for the ten dollar words) is that the Fed’s reaction function has flipped 180 degrees since the Trump election. Today the Fed is looking for excuses to tighten monetary policy, not excuses to weaken. So long as the unemployment rate is on the cusp of “instability”, that’s the only thing that really matters to the Fed (for reasons discussed below). Every other data point, including a market sell-off or a flat yield curve or a bad CPI number – data points that used to be front and center in Fed thinking – is now in the backseat.

I’m not the only one saying this about the Fed’s reaction function. Far more influential Missionaries than me, people like Jeff Gundlach and Mohamed El-Erian, are saying the same thing. If you think that this Fed still has your back, Mr. Investor, the way they had your back in 2009 and 2010 and 2011 and 2012 and 2013 and 2014 and 2015 and 2016 … well, I think you are mistaken. I think Janet Yellen broke up with you this week.

The Fed is tightening, and they’re not going to stop tightening just because the stock market goes down 5% or 10% or (maybe) even 20%. Bigger game than propping up market prices is afoot, namely consolidating a reputation as a prudent central banker before the inevitable Trump purge occurs, and consolidating that reputation means keeping the evilest of all evil genies – wage inflation – firmly stoppered inside its bottle.

Let’s be clear, not all inflation is created equal. Financial asset price inflation? Woo-hoo! Well done, Mr. or Mrs. Central Banker. That’s what we’re talkin’ about! Price inflation in goods and services? Hmm … a mixed bag, really, particularly when input price inflation can’t be passed through and crimps corporate earnings. But we can change the way we measure all this stuff and create a narrative around the remaining inflation being a sign of robust growth and all that. So no real harm done, Mr. or Mrs. Central Banker.

Wage inflation, though … ahem … surely you must be joking, Mr. or Mrs. Central Banker. How does that possibly advance economic efficiency and social utility? I mean, even a first year grad student can *prove* with mathematical certainty that wage inflation only sparks a wage-price spiral where *everyone* is worse off. What’s wrong with you, don’t you believe in math? Don’t you believe in science? Hmm, maybe you’re just not as smart as we thought you were. But I’m sure you’ll be very happy as an emeritus professor at a large Midwestern state university. No, Ken Griffin is not interested in taking a meeting.

I know I sound like a raving Marxist to be saying this, that the Federal Reserve system and all its brethren systems were established specifically to serve the interests of Capital in its age-old battle with Labor. But yeah, that’s exactly what I’m saying. Propping up financial markets? That’s a nice-to-have. Preserving Capital as the apex predator in our social ecosystem? There’s your must-have.

Whatever you think full employment might be in the modern age, 4.3% is at the finish line. And 4.1% or 3.9% or wherever the unemployment rate is going over the next few months is well past the finish line. You’re already seeing clear signs of labor shortages, particularly skilled labor shortages, in lots of geographies. Wage inflation is baked in, and modern populist politics make it impossible for corporations to play the usual well-we’re-off-to-Mexico-then card. Not that wages in Mexico or China are really that much better anymore, depending on what you’re doing, and there are inflationary wage pressures there, too.

Bottom line: I think that the Fed is going to do whatever it takes to prevent wage inflation from getting away from them, and shrinking the balance sheet is going to be a vital part of that tightening, maybe the most important part. Why? Because the Fed thinks it will push the yield curve higher as it lets its bonds and mortgage securities roll off, which will help the banks and provide an aura of “growth” and a cover story for the interest rate hikes. Otherwise you’ve got an inverted yield curve and a recession and who knows what other sources of reputational pain.

But here’s the problem, Mr. Investor. Ordinarily if the Fed was determined to take the punchbowl away by tightening monetary policy and raising interest rates, your reaction function was pretty clear. Get out of stocks and get into bonds. Wait out the inevitable bear market and garden variety business cycle recession, and then get back into stocks. Or just ride your 60/40 vanilla stock/bond allocation through the cycle, which is the whole point of the 60/40 thing (even, though, of course, you’re really running a 95/5 portfolio from a risk perspective). But now you’re going to have both stocks *and* bonds going down together as the Fed hikes rates and sells bonds, in a reversal of both stocks *and* bonds going up together over the past eight years as the Fed cut rates and bought bonds.

Hmmm. ‘Tis a dilemma. What to do when indiscriminate long-the-world doesn’t work? What to do when nothing works? Maybe, with apologies to the old Monty Python line, active management isn’t quite dead yet. And just at the point of maximum capitulation to the idea that it is. Wouldn’t be the first time. In fact, that’s kinda how maximum capitulation works.

Is everything as neat and clean in reality as I’m making it out to be? Of course not. Other central banks are still buying bonds. Maybe global growth pulls everything through. Maybe President Pence/Ryan/whoever-is-fourth-in-line pushes through all the tax cuts and regulatory rollback and infrastructure build programs that your little old capitalist heart desires. Plus this isn’t some cataclysmic event like “China floats the yuan” or “Italy has a bad election”. It’s a slow burn.

But I think that if your investment mantra is “don’t fight the Fed”, you now must have a short bias to both the US equity and bond markets, not the long bias that you’ve been so well trained and so well rewarded to maintain over the past eight years. This is a sea change in how to navigate a policy-driven market, and it’s a sea change I expect to last for years.

All the best,

Ben Hunt, Ph.D.

"The Western Status Quo Political System Is Collapsing Into &#039;Something Else&#039;"

Authored by Ben Hunt via EpsilonTheory.com,

Michael Corleone:  I saw a strange thing today. Some rebels were being arrested. One of them pulled the pin on a grenade. He took himself and the captain of the command with him. Now, soldiers are paid to fight; the rebels aren’t.

Hyman Roth:   What does that tell you?

Michael Corleone:   They could win.

Hyman Roth:  This county’s had rebels for the last fifty years— it’s in their blood, believe me, I know. I’ve been coming here since the ’20s. We were running molasses out of Havana when you were a baby — the trucks, owned by your father.

Hyman Roth:  Michael, I’d rather we talked about this when we were alone. The two million never got to the island. I wouldn’t want it to get around that you held back the money because you had second thoughts about the rebels.

? “The Godfather: Part II” (1974)

Michael Corleone is like me and every investor over the past five years who held off on an attractive investment for fear of political risk. Except he was right and I’ve been nothing but wrong.

Somehow, I think Silicon Valley got even more spun up than Manhattan. There were hedge fund people I spoke to about a week after the election.

They hadn’t supported Trump. But all of a sudden, they sort of changed their minds. The stock market went up, and they were like, ‘Yes, actually, I don’t understand why I was against him all year long.’

? Peter Thiel, in a New York Times interview (January 11, 2017)

John Wick:  People keep asking if I’m back and I haven’t really had an answer. But now, yeah, I’m thinkin’ I’m back.

? “John Wick” (2014)

Me, too. Political risk, though, not so much.

If political parties in Western democracies were stocks, we’d be talking today about the structural bear market that has gripped that sector. Show me any country that’s had an election in the past 24 months, and I’ll show you at least one formerly big-time status quo political party that has been crushed. This carnage in status quo political systems goes beyond what we’d call “realigning elections”, like Reagan in 1980 converting the formerly solid Democratic Southern states to a solid Republican bloc. It’s a rethinking of what party politics MEANS in France, Italy, and the United States (and with the UK, Spain, the Netherlands, and maybe Germany not too far behind). The last person to accomplish what Emmanuel Macron did in France? The whole “let’s start a new political party and win an election in two months” thing? That would be Charles de Gaulle in 1958 and the establishment of the Fifth Republic. The last person to accomplish what Donald Trump did in the U.S.? The whole “let’s overthrow an old political party from the inside and win an election in two months” thing? I dunno. Never? Andrew Jackson?

Now don’t get me wrong. Do I think Emmanuel Macron, a former Rothschild investment banker whose “ambition was always two steps ahead of his experience”, is the second coming of Charles de Gaulle? Do I think Donald freakin’ Trump is a modern day Andrew Jackson? Bwa-ha-ha-ha-ha-ha … good one!

But here’s what I do think:

1. Something old and powerful is happening in the real world to crush the status quo political systems of every Western democracy.


2. Something predictably sad is happening in the political world to replace the old guard candidates with self-absorbed plutocrats like Trump and pretty boy bankers like Macron.


3. Something new and powerful is happening in the investment world to divorce political risk and volatility from market risk and volatility.

The old force repeating itself in the real world is nicely summed up by these two charts, the most important charts I know. They’re specific to the U.S., but applicable everywhere in the West.

First, the Central Banker’s Bubble since March 2009 and the launch of QE1 has inflated U.S. household wealth far beyond what the nominal growth rate of the U.S. economy would otherwise support. This is a classic bubble in every sense of the word, with the primary difference from prior vast bubbles being its concentration and focus in financial assets — stocks and bonds — which are held primarily by the rich. Who wins the Academy Award for creation of wealth inequality in a supporting role? Ladies and gentlemen, I give you the U.S. Federal Reserve.

Source: Bloomberg LP and TCW, as of 12/31/16. For illustrative purposes only. Past performance is no guarantee of future results.

And as the second chart shows, this central bank largesse has sharply accelerated the massive shift in wealth to the Rich from the Rest, a shift which began in the 1980s with the Reagan Revolution. We are now back to where we were in the 1930s, where the household wealth of the bottom 90% of U.S. wage earners is equal to the household wealth of the top one-tenth of one percent of U.S. wage earners.

For illustrative purposes only.

So look … I’m not saying that the current level or dynamics of wealth inequality is a good thing or a bad thing. I’m just saying that it IS. And I understand that there are insurance programs today, like social security and pension funds, which are not reflected in this chart and didn’t exist in the 1930s, the last time you saw this sort of wealth inequality. I understand that there are a lot more people in the United States today than in the 1930s. I understand that there are all sorts of important differences in the nature of wealth distribution between today and the 1930s. I get all that. What I’m saying, though, is that just like in the 1930s, there is a political price to be paid for this level of wealth inequality. That price is political polarization and electoral rejection of status quo parties. I won’t give the whole history lesson here, as it’s a good excuse for readers to immerse themselves in Wikipedia for half an hour or so and read about guys like Father Coughlin, but the rhyming of political history in Western democracies between the late-1920s/early-1930s and today, particularly in the way that status quo political parties were subverted or overthrown or just plain eliminated throughout Westworld is … pretty amazing.

Western democracies, mixing a healthy dash of popular political representation with a big dose of capitalist economic structures, are extremely good at the most important driver of social stability: co-opting the more talented members of a mass society into the status quo system, bringing new blood into that top two percent socioeconomic club who might otherwise apply their talents in more subversive ways. Maybe not the top one-tenth of one percent on a purely financial wherewithal scale, but definitely the top two percent on a more broadly defined socioeconomic scale of wealth, stability, and influence. That co-opting process is the steam valve for Western societies, and it has two components, particularly in the most successful Western society, the United States — educational mobility (move to where the good intellectual jobs are) and labor mobility (move to where the good physical jobs are). Educational mobility, spurred in the U.S. by more than $1 trillion in government-backed student loans, is in high gear, and the importance of an educational pedigree to get into the 2% Club has NEVER been greater. Labor mobility, on the other hand, crushed by globalization and the housing crisis, hasn’t been this broken since … yep … the 1930s.

As a result, the composition of the 2% Club of wealth, stability, and influence is changing. Today it’s almost entirely a Club of the educationally mobile and accomplished, the people who deal with symbols for a living — words and tickers and numbers and code — and whose language and lingo is similarly abstracted. And because our status quo political institutions, like political parties, are in all nations and in all times the top-down creations of the 2% Club, our political parties themselves speak a different language today than they did even 10 or 20 years ago. No political party is immune, regardless of where it sits on the traditional left/right spectrum. This isn’t a Republican vs. Democrat thing. It’s not a rich vs. poor thing, either, because there are plenty of rich people who aren’t symbol manipulators and are feeling less and less at home in the 2% Club. It’s a who’s-dominating-the-2%-Club thing, and in Westworld that’s the educationally accomplished symbol manipulators.

Our status quo political parties speak well and clearly to the 2% Club and their educationally mobile circles, not so well to the guy who didn’t go to law school and whose kids don’t have a prayer of getting into Stanford. Not so well to the guy who, to be honest, kinda hates lawyers and the professional symbol manipulators, and definitely hates anyone who went to Stanford. Not so well to, as Amity Shlaes titled her seminal history of the 1930s and the Great Depression, the Forgotten Man, citizens who — today and in the 1930s — are well and truly stuck. Stuck because labor mobility is broken. Stuck because their wages are flat and their debt is up. Stuck because they’re getting older. Stuck because, like the sailors on the Battleship Potemkin, they are served disgusting, rotten meat but are told by the well-spoken professionals that these are dead fly larvae, not live maggots, and so they can simply be washed off with salty water. Stuck because the entire political system is rigged for the educationally mobile and the symbol manipulators. Not rigged in a cartoon evil sense, but rigged in the same way that the German system is rigged in favor of people who speak German and the Chinese system is rigged in favor of people who speak Chinese. Don’t speak Symbol Manipulation? Sorry, but the status quo Western political system is rigged against you. And you know it.

There’s no attachment to a political party that from your perspective is speaking gibberish. The attachment is to change and reversion. The attachment is to Something Else. The Something Else will not have a well-considered or coherent policy wrapper. It won’t look smart. It didn’t in the 1930s and it doesn’t today. Why not? Because if it did, it would be co-opted as part of the status quo! Words like “well-considered” and “coherent” and even “policy” are the abstracted words of the modern status quo. They are the language of the 2% Club, particularly of an educationally mobile 2% Club, and it’s a very different language than that spoken by anyone hailing from the world of physical construction and manipulation rather than symbol construction and manipulation.

So what is this other language? Importantly, as Joan Williams describes in her phenomenal article, “What So Many People Don’t Get About the U.S. Working Class,” it’s not a soak-the-rich language (in fact, it’s more disparaging of the poor than the rich). It’s a non-abstracted language of direct, physical involvement in localized social behaviors (what Nassim Taleb calls “Skin in the Game”), because that’s the language that has meaning for anyone who depends on labor mobility and physical construction to make a better life for themselves and their kids. It’s an uncomfortable language for the educationally mobile 2% Club, because it doesn’t abstract away the racist, sexist corners of real world, localized social behaviors and beliefs in a carefully constructed linguistic architecture. That doesn’t mean that the Forgotten Man is necessarily racist or sexist (doesn’t mean that he’s not, either). It means that these are not behaviorally motivating or politically meaningful words to a major sub-population. It means that our language defines and constrains our thoughts and behavior, not the other way around. It means that we ARE our grammar, at least in our lives as social animals. It means that the Confusion of Tongues is not just a quaint Old Testament story with cool Gustave Doré engravings about some apocryphal Tower of Babel.

It is THE political story of this or any other age, and it always leads to a radical restructuring of the political order, because you cannot have a stable political equilibrium where a critical mass of national sub-populations speak different social languages.

But that’s where we are in every Western nation in 2017. The politically ascendant sub-population on the educational mobility track hear the language of the Other and say “Unacceptable people. Must resist. Zero-sum game.” The politically stuck sub-population on the labor mobility track hear the language of the Other and say “Bad hombres. Must fight. Take no prisoners.” The center cannot hold. More accurately, there is no center, no cooperation. Competition is all, and that’s no way to run a country.

Unfortunately and unsurprisingly, the new political leaders who emerge from a collapse of the Tower of Babel are rarely the champions of the Forgotten Man that you might think would emerge. Both in the 1930s and today, there’s no shortage of non-status quo political entrepreneurs who speak the language of the politically stuck and are willing to put themselves out into the political arena. But to be successful in their political entrepreneurship it’s almost essential that these new candidates be card-carrying members of the 1/10^th of 1% Rich Club. Why? Because it requires an insane amount of money and sheer notoriety to replace the machinery of a status quo political party in a mass society. A political party is a media company. By joining a status quo party and toeing that party line, you communicate an enormous set of signals to potential voters for free. But by toeing that party line, you lose your Forgotten Man authenticity and any hope of being the champion of Something Else. Want to be a “change candidate”? Better make a couple of billion dollars first, or have plenty of billionaire friends, so you can afford to bypass the status quo political party.

Little wonder, then, that Donald Trump, a billionaire TV star, succeeds in overthrowing the Republican Party. Little wonder that Emmanuel Macron taps a vast banker network from across Europe to fund his campaign. Little wonder that zillionaire Mark Zuckerberg has embarked on a nationwide “listening tour”, complete with equal zillions of photo ops — none of which are with educationally mobile symbol manipulators — as he prepares for a political life. Good old-fashioned mustachioed fascism may work in Turkey, but here in the U.S. you need a smiley-face with your Panopticon. Sharing is caring!

So that’s my political take: the old and powerful Tower of Babel process is starting up again, and status quo political institutions are not long for this world. As we move to the Something Else to come, we’ll have to endure a parade of billionaires wielding political power in unprecedented ways, aided by unprecedented technologies of social control. That’s the Big Risk for everyone reading this note, regardless of your politics, regardless of your social language, regardless of your vision of the life well lived. That’s the Big Risk we have to manage, as investors and as citizens.

So how do we do THAT?

For today’s note, I’m focusing on the investor side of that question, and that means focusing on the one Big Question: as the Western status quo political system collapses into Something Else, how is it possible that our capital markets are not similarly gripped by volatility and stress? What is responsible for breaking the transmission mechanism from political risk to market risk?

I’ve got a macro answer and I’ve got a micro answer.

The macro answer is that you need status quo political parties to govern a country effectively. Thankfully, there are only enough billionaire candidates of Something Else to fill the top of the ticket, and even if there were more, a party of independently wealthy and independently popular mavericks isn’t a coherent party at all. There’s not less gridlock with an essentially party-less American president or an essentially party-less French president, there’s MORE gridlock. And that means that any sort of fiscal policy — whether it’s a clear-the-decks debt assignment or a classic stimulus program or whatever — is more difficult under this sort of independent political regime than in a status quo regime.

Sure, there’s a lot of excitement when the Stranger comes to town. Take a look at what happened to the U.S. 10-year bond after Trump was elected.

Source: Bloomberg LP, as of 04/10/17. For illustrative purposes only. Past performance is no guarantee of future results.

But excitement fades as fiscal policy promise fades to fiscal policy deadlock. When I look at Washington today, or London or Paris or Rome or wherever, it sure looks for all the world like a return to our regularly scheduled entertainment. Nature abhors a vacuum, and politics is no exception. In the absence of an active and effective fiscal policy authority, global monetary policy authorities will fill the policy void. And what is their policy? Refer to chart 1 at the start of the note, please. Low growth. Financial asset inflation. Low volatility. Wash, rinse, repeat. The new Goldilocks, now eight years old. Could go for another eight years, easy. Wheeee!

Yes, there’s enormous political risk associated with the collapse of status quo political institutions and the rise of the Trumps and the Macrons of the world. But …

1. for financial markets, these new leaders are familiar, encouraging faces. They’re members of the 1/10^th of 1% Rich Club, because they had to be to sidestep status quo political parties. Moreover,


2. there’s going to be a hope and a promise of fiscal policy initiatives, and that’s a tailwind for markets, too. And finally,


3. don’t worry, Mr. Market, when that hope and promise of pro-growth policy fades into the realization of anti-growth gridlock, our old friends Janet and Mario will be there to pick up the slack with more liquidity.

That’s my macro story for the divorce of political risk from market risk, and I’m sticking to it. Where does it break down? Not with a funky German or Italian election, but with Janet and Mario declaring victory and taking away the punchbowl. That’s what will bring political risk back to markets.

On the micro side, it’s the triumph of Communication Policy, just as far as the eye can see. I’ve written a lot about Communication Policy in the past, here, here, here, and here. It’s what the Fed calls their use of words and public statements for effect, as a specific policy tool designed to influence investor behavior rather than to communicate truthful information. You know … what we would call lying in other circumstances. As Ben Bernanke said in one of his last speeches as Fed Chair, Communication Policy (“enhanced forward guidance”) has been the star of the show since quantitative easing lost its mojo with the QE2 program. Making up narratives and telling them convincingly has worked for politicians for, oh, several thousand years. I suppose the only surprising thing is that it took central bankers so long to get in on the act. Today it’s their primary shtick.

But now that politicians and central bankers have demonstrated the incredible efficacy of what game theory calls Missionary Statements — the intentional construction of common knowledge through highly mediated statements — everyone wants in on the act. Everyone wants to be a Missionary for their own institutional ends. And that Everyone definitely includes Wall Street.

Here’s what I’ve noticed in the past two major political risk events in Western markets — the Italian referendum on December 5 and the French first round election on April 23. In both cases, the most political risk-impacted equity markets began to rally sharply three or four days BEFORE the vote.

Source: Bloomberg LP, as of 05/03/17. For illustrative purposes only. Past performance is not indicative of how the index will perform in the future.

The index reflects the reinvestment of dividends and income and does not reflect deductions for fees, expenses or taxes. The indices are unmanaged and are not available for direct investment.

The top chart is the European bank equity index before and after the French vote. Below is the price chart of the broad Italian equity index before and after their referendum.

Source: Bloomberg LP, as of 05/03/17. For illustrative purposes only. Past performance is not indicative of how the index will perform in the future. The index reflects the reinvestment of dividends and income and does not reflect deductions for fees, expenses or taxes. The indices are unmanaged and are not available for direct investment.

In both cases the bottom was reached well before the actual event. Why? Because in both cases the sell-side research machine — all the chief economists and chief strategists and acolytes of all the big Wall Street firms — began churning out a flood of Missionary Statements designed to create a positive narrative around a potentially very negative (for markets) political risk event. Ditto with the U.S. election, where the positive narrative around Trump began a full week before the election (see “American Hustle” for the full Narrative Machine description).

I mean, the effort to create a positive narrative out of whole cloth would be comical if it weren’t so seriously impactful. My personal fave on the Wednesday before the French vote was a bulge bracket strategist who shall go nameless, writing to say that a Le Pen victory wouldn’t really be that bad of a thing for markets in general and the banks in particular, because if she won there could well be a massive run on the French banks, which means that Le Pen would have to backtrack on her anti-euro stance to prevent a complete economic collapse. So buy now!

My first reaction to this avalanche of positive Narrative construction was indignation, tinged with a little anger. Give me a break! Markets are getting a little squirrelly going into the vote, and so you’re going to start pumping out this drivel? My reaction was what John Maynard Keynes, who was at least as good a game theorist and investor as he was a macroeconomist, would have called a first level response to a Missionary statement — I’m right and the Missionary is wrong! This is the human, natural response. It’s also a losing response if you want to play the game of markets successfully.

As Keynes explained so smartly with his parable of the Newspaper Beauty Contest, you don’t make money by holding firm to your personal opinion of who’s the prettiest girl or what’s the most attractive stock. You don’t even make money by identifying the consensus view of who’s the prettiest or what’s the right answer to a market question, because all of us are smart enough to be looking for the consensus view. No, you make money by getting ahead of the formation of the consensus view through Missionary statements, even if your personal view is that the Missionary is dead wrong in their assessment of pretty girls or attractive stocks or market outcomes. Would you rather be right or would you rather make money? Back in my younger days I didn’t think there was a conflict between the two. Now I know better. Once the Wall Street Missionaries started their Narrative blitz, it didn’t matter that I believed (and still believe!) that an anti-status quo Italian referendum creates a systemic risk for the European banking system. I wasn’t going to get paid for that view, even if the anti-status quo vote won (it did) and even if I’m objectively correct about the risk (we’ll see). Frustrating? Sure. But in the immortal words of Hyman Roth, this is the business we have chosen.

It’s this micro explanation of the divorce between political risk and market risk that I think will prove to have the most long-lasting impact on investor behavior. You know, I started writing Epsilon Theory because Mario Draghi kicked me in the teeth in the summer of 2012 with the pretty words of his mythical OMT program. I couldn’t believe that mere narrative could be so powerful. But it is. It’s the most powerful thing in the world. Bad enough that politicians have wielded this power for centuries. Worse that Central Bankers have recently proven to be such adepts. Now that Wall Street and the global banking synod have fully embraced the dark narrative arts? Katy bar the door. Even when the androids of Westworld knew it was just a story, they were hard-wired to respond. So are we.

So put it all together and what do we have? As a citizen I’m on high alert. Political volatility is only going to get worse in Westworld. But as an investor my systemic risk antennae are pretty quiet. Is there stuff to do, long and short? Sure, particularly away from Westworld. But until and unless Draghi starts to taper and Yellen looks to hang a recession around the Donald’s neck with beyond-tapering balance sheet reduction, I don’t see how political risk translates into market risk. And even then you’ve got a powerful volatility reducer in the self-interested Narrative creation of every Wall Street Missionary. Will it last forever? Of course not. The Missionaries, both on Wall Street and in Central Banks, are only human. Inevitably they will disappoint us. Let’s just try not to have a gun pointed at our heads when they do.