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On The Game-Theoretic Market Crash 'Solution' To The Fiscal Cliff

Tyler Durden's picture




 

Via Michael Naso of FBN Securities,

I expect a return to a skittish environment as soon as today especially in light of the selloff overnight.  Thus, traders should disregard Monday’s tape and focus on how upcoming events and the looming fiscal cliff will drive the price action. I am confident in my prediction for the course of the economy by leveraging simple game theory in handling the upcoming crisis as Congress returns for its lame duck session.  Consider the following payoff matrix:

 

“Compromise” reflects a decision from either side that each find unpalatable.  For example, this would include Republicans’ agreeing to a tax hike on portions of the population or the Democrats’ extending current marginal rates.  The numbers inside each of the quadrants indicate the level of utility, or satisfaction for the corresponding state.  For instance, if the government assigns a higher levy on those with over $250K in per annum income, then the Democrats would enjoy 10 units of utility while the Republicans, disappointed they could have negotiated a better deal, would lose 10 units.

Curiously, I injected a bit of algebra into the analysis by representing the scenario of going over the cliff as a two dimensional function using time and the dislocation of the capital markets, most notably equities, as inputs.  This loosely approximates the “theta” in the risk premium that I previously have alluded to when describing the potential shock.  Modeling the actual results using these two factors is more art than science; however, I will assume that the closer we get to the deadline and the further stocks decline, the more painful the choice of not compromising becomes.

For example, with seven weeks left until the sequester along with the S&P 500 trading only 7% below its multiyear highs, both President Obama and Speaker Boehner would rather shove two sticks in their eyes than move from their hardened stance despite some of the recent rhetoric in favor of bargaining in good faith.  As long as the loss of utility from both sides’ digging in their heels is more favorable than conceding to the preferences from those across the aisle***, then the game arrives at a Prisoner’s Dilemma.  In short and holding America hostage notwithstanding, the two parties would rather drag this fight out to the very end assuming the market does not collapse in the meantime.

More poignantly, the above matrix concludes that the fiscal cliff virtually guarantees an aggressive selloff for equities until the stop loss for the Democrats and Republicans has been triggered.  For example, if the clock hits midnight on New Year’s Eve with the blue chip index at or near its September peak, each faction would feel comfortable standing up to the other well into January.  On the other hand, both corporate CEOs and Main Street would scream for compromise in response to stocks in freefall.  At such time, the game gets more complicated albeit President Obama would have a scintilla of an advantage given his majority in the Senate and the reelection challenge every two years for those in the House.

This extreme likelihood of future investor suffering does not preclude an intermediate term modest snapback rally, for managers may have the perception that Washington has ample time to address the crisis appropriately such that institutions subsequently could find valuations attractive enough to put money to work.  An incremental, yet necessary, drop of my sentiment indicators would project a deeply oversold landscape that would incubate such a move.  However, any reversal would be short in duration and small in magnitude until the pain inflicted on stocks within the context of the time to expiration is far too great for politicians to ignore the cries of their constituencies.

***In the above matrix, this would reflect any value < -10

 

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Tue, 11/13/2012 - 10:02 | 2975756 venturen
venturen's picture

I aunk your battleship!

Tue, 11/13/2012 - 10:03 | 2975758 cossack55
cossack55's picture

Beware Pac-man

Tue, 11/13/2012 - 10:06 | 2975765 Quaderratic Probing
Quaderratic Probing's picture

Buy the F------ crater

Tue, 11/13/2012 - 10:06 | 2975766 buzzsaw99
buzzsaw99's picture

Naso again. ugh.

Tue, 11/13/2012 - 10:07 | 2975768 SheepDog-One
SheepDog-One's picture

'Govt compromise' = 'bend over, america'

Tue, 11/13/2012 - 10:08 | 2975769 holdbuysell
holdbuysell's picture

Of course this analysis assumes the game doesn't shift to a new state as described by the systemic collapse paper presented here before.
Wouldn't surprise me that the finest 535 unknowingly push this to a point of no return.

Tue, 11/13/2012 - 10:09 | 2975777 knukles
knukles's picture

Beware skittishness?
Hows about skittishness be here, we be goin' to full bore panic type screaming, yelling, wringing of hands, high blood pressure, massive bursts in refills of benzodiazopine medications  and of course, the Never Let a Good Panic Go To Waste Routine to raise taxes, increase spending. borrow more, cry, weep and claim the problems all fixed until the following manufactured problem is left unaddressed and the symptoms treated.

Tue, 11/13/2012 - 10:09 | 2975778 Urban Redneck
Urban Redneck's picture

a quantitative approach the the financial risk associated with a political event, aka a circle jerk

Tue, 11/13/2012 - 10:11 | 2975784 SheepDog-One
SheepDog-One's picture

OH NOEZ! Stawks are droppin! QUICK throw some more peasants overboard!!

Tue, 11/13/2012 - 10:57 | 2975964 Legolas
Legolas's picture

Hold on, we has to get past the 10 am rally first.

Tue, 11/13/2012 - 10:11 | 2975785 Ljoot
Ljoot's picture

Maths scare me.

 

Tue, 11/13/2012 - 10:19 | 2975807 Azannoth
Azannoth's picture

Any mathematical calculation on "what the government might do" is fundamentaly flawed because Math assumes rational actors that play with a given and known set of rules, neither is the case here

Tue, 11/13/2012 - 10:15 | 2975792 Sean7k
Sean7k's picture

The problem with this particular analysis is it ASSUMES that the two parties are opponents. It neglects to recognize the possibility that the parties, working together, may be finding a way to game the people into a preferred result.

For example, the opportunity to move stocks, bond and metal prices are infinite. Having pre-knowledge of policy changes would be a boon to bankers and people in the know.

The solution is already apparent, what has the US, Japan and the EU done in every similar situation up to the present? Why, they have kicked the can down the road and added stimulus. This will be the result once again, as there will be a continuance to protect the economy from the fiscal cliff. 

Thank goodness someone is paying these idiots to conduct exercises in futility to keep the base population interested in the game. 

Tue, 11/13/2012 - 10:16 | 2975803 dcj98gst
dcj98gst's picture

"""President Obama would have a scintilla of an advantage given his majority in the Senate and the reelection challenge every two years for those in the House."""

My prediction:

This is a big advantage, especially because BO does not need to get reelected.  I say the hard line is drawn by BO, and taxes are going up on people over $250k with sequestration to boot. This final deal is constructed in January to reduce the taxes on people making less than $250k.

A new fiscal cliff is set for next year for us to dismantle just as we approach the precipice.  Assuming we dont have a currency crises before.

Tue, 11/13/2012 - 10:17 | 2975805 SheepDog-One
SheepDog-One's picture

Hey maybe its NOT just 'all about the fiscal cliff' rubbish, maybe its 'OK we've been living in fantasy and suspension of disbelief 'cuz its an election year' and reality has just shown back up to collect. We're in a collapsed economy....shaving the edge of a few coins is not going to save us.

Tue, 11/13/2012 - 10:20 | 2975812 kito
kito's picture

lets take some over under bets here on when the next u.s downgrade occurs by one of the 3 clown ratings agencies...............i say december 15th...............

Tue, 11/13/2012 - 14:43 | 2976879 Quazi Mohammad ...
Quazi Mohammad Rezwanul Ahsan Nafis's picture

Sandwich now, downgrade later.

Tue, 11/13/2012 - 10:23 | 2975820 spanish inquisition
spanish inquisition's picture

Throw out any idea of money and redo on the what is important, politics.

Compromise/Comprimise means going against your base and would harm your reelectability, this position includes freshmen who did not vote for the original cliff. The only way to get to a Comp/No Comp or a No Comp/Comp is through better information that will be revealed later or someone blinking as it naturally gets pushed into No Comp/No Comp land. Gonna go to a Boehner/ Obama standoff which will benefit the rank and file because they can blame it on leadership later on (this includes Biden). It will boil down to this, Obama does not need to get elected any more and Boehner will soften his stance because he does need to get reelected.

A meaningless document slightly favoring Dems will be written and all the actual problems will be stuffed into the accounting shift can and kicked down the road.

Tue, 11/13/2012 - 17:26 | 2977588 blunderdog
blunderdog's picture

    Compromise/Comprimise means going against your base

The problem is, "the base" that elected the Republican house-members aren't actually opposed to maintaining lower taxes on everyone except the folks making over $250,000 a year.  They wouldn't be "going against" their VOTERS by passing the existing bill--just their campaign financiers.

It's a much smaller group, and not a "base" of voters.  There just aren't enough folks making decent wages to be worth raising EVERYONE'S taxes to placate them.  Even if everyone making good money turns out and votes for the folks who insisted on raising everyone's taxes, they'll lose, because they're so badly outnumbered by all the folks who'll see nothing but downside to that strategy.

Tue, 11/13/2012 - 10:33 | 2975843 Dr. Engali
Dr. Engali's picture

You are assuming that the majority of people even give a shit about stocks any longer.

Tue, 11/13/2012 - 10:53 | 2975947 odatruf
odatruf's picture

Dr. - that was exactly my thought. 

And thinking on it further, let's consider that these days corporate CEO compensation has nothing to do with stock price or other performance indicators, so it won't matter to them on that score.  Plus, if markets fall more or less across the board, it doesn't provide any competitive advantage to one firm over another.  And finally, what it will provide is an opportunity for companies (and insiders) to BTFD on share buybacks as a way to deter unwanted M&A activity and also park idle cash.

From my vantage point, I'd say every corporate CEO out there would vastly prefer to have an external reason for equity price drops that they can wash their hands of and profit from. As such, I don't see them calling Congress clammoring for any grand workout.

Tue, 11/13/2012 - 10:41 | 2975884 zorba THE GREEK
zorba THE GREEK's picture

If it plays out as Naso predicts, another number will come into play;

congressional approval rates will drop like lead balloons. This may

also have some effect on willingness to compromise as that number

is already historically low. 

Tue, 11/13/2012 - 10:42 | 2975892 Matt
Matt's picture

You know something is odd when the writer of a paper finds his own writing to be curious.

Tue, 11/13/2012 - 11:25 | 2976052 illyia
illyia's picture

I think he was referring to the conclusions he was compelled to draw from his algebraic observations.

But I could be wrong... he could just be curious.

Tue, 11/13/2012 - 10:43 | 2975894 masterinchancery
masterinchancery's picture

Your analysis fails to reflect that the Republicans actually win, not lose small, by refusing any of Obama's poisoned tax apples.

Tue, 11/13/2012 - 10:45 | 2975903 Jim B
Jim B's picture

You assume these negotiations matter, this a political wrestling match for partisan advantage. 

 The only real solution is radical cuts and tax increases across the board, the chances of this happening are ZERO! 

 

 I'll gladly pay you Tuesday for a hamburger today

http://www.youtube.com/watch?v=NJ6xBaZ92uA

Tue, 11/13/2012 - 10:58 | 2975965 odatruf
odatruf's picture

I'd normally agree with you, Jim, but since this time the Congressional inertia of doing nothing works in our favor, I'd say there is a chance of the sequester cuts and the expiration of the 2001 and 2003 tax cuts and the 2010 SS payroll tax holiday going into effect.  All of this, plus letting the countless UI extensions expire are baked into the cake.  Action that get through the system morass is required to get off this path.

And, we will have another bite at the apple with the leverage provided by the debt ceiling increase that will be needed come early next year. There again, inaction would yield the best result.

I know I am like Charlie Brown and his football, but I have some hope that while the larger issue cans will and must be kicked, that in this once instance there will be some good to come.

Tue, 11/13/2012 - 11:10 | 2975995 Jim B
Jim B's picture

Unfortunately, I think we have pulled lots of consumption forward (living for today).  I think the inevitable adjustment period is coming, but it will be postponed until the market imposes discipline or the economy/currency collapses. 

 All bets are off in the case of a world war.

 

 

Tue, 11/13/2012 - 11:38 | 2976109 odatruf
odatruf's picture

I fully agree that we've pulled forward and that this must adjust.

It's hard to see how the market can impose discipline when rates and even asset valuations can be manipulated by the Fed and other central banks. Even if the market wanted to punish those nations, how would it do it? Inflation is the only retarding agent against such fecklessness and it can't be roiled externally. At least not deliberately.

There is an old political adage that you don't pick a PR fight with an entity that buys ink by the barrel. In that case, it was mostly referring to newspapers. But the same can be said about the Fed.

I don't think the nation-state advantage gained from war is what it once was, so I discount that possibility pretty heavily.

 

Tue, 11/13/2012 - 13:49 | 2976652 Jim B
Jim B's picture

I don't expect a war, but you never know when nations get desperate....

I agree the FED can print indefinitely, but at some point people will lose confidence or inflation will be an issue.  You can’t print money forever and it doesn’t create wealth.  I don’t think anyone knows how this will play out, I watched a Marc Faber interview recently and he talks about spreading out your bets because no one knows how this is going break.  He said today on CNBC that people will be lucky to come out the other side of this with 50% of their wealth.  I am about 99% certain that the politicians will take the easy way out.

The real questions is do we get stagflation, inflation, or a deflationary collapse.  I am somewhat diversified and hoping for the best.  If a someone knew the endgame, you could make a fortune.  Interesting times…..

 

Tue, 11/13/2012 - 15:44 | 2977122 odatruf
odatruf's picture

Jim - thanks for the back and forth.  I agree that politicians will take the easy way out if they possibly can. At least until they can't.  So far, I just don't see where the hard wall is either.

I think growing inflation is the most likely crack in the dam. Interest rates can be held near zero indefinitely so long as the Fed accepts the inflation, so stagflation is unlikely. The market are both too nervous to exert true price signals on rates and the Fed can waive that away anyway. And I also lean away from deflationary collapse because, at the end of the day, there are still a lot of people in this country that produce things of value and we will want to keep exchanging them.

I think the inflation will no be even and will continue to build in food and other must having living costs in certain areas. Eventually that translates down every supply chain and with less than normal wage growth, it will pinch a lot. People will have most of the 1s and 0s in their accounts and asset values will still be fine, but it will all be worth so much less in real terms.  50% might be high, but I think a full 1/4th drop in the real wealth and living standard is possible. Which will be nice, because that is about the same ratio of benefit discount that SS will payout in about 15 years and about as much less that Uncle Sam will do for most people by then too.

 

 

 

Tue, 11/13/2012 - 17:18 | 2977544 Jim B
Jim B's picture

I am about 25% cash, 25% real estate, and 50% stocks.  I am probably weighted too much towards commodities and PM stocks, but I think inflation is likely as well.  Inflation is probably the only way the FED can keep the balls in the air.  If they let deflation take hold, the downturn will make things even worse, GDP and tax receipts dropping.

Many American workers competing against low wage countries, a lower standard of living seems inevitable for low to medium skill workers.  Most people are oblivious and the poor will be hurt the worse.  The leaders in this country both parties have made quite a mess of things.

Agree, nice conversation..  

Tue, 11/13/2012 - 10:53 | 2975952 spooz
spooz's picture

Reminds me of when the equities threw a hissy fit when TARP was up for vote. Its always a good idea to listen to the "free" markets.

Tue, 11/13/2012 - 11:45 | 2976128 risanyq
risanyq's picture

exciting!

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