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