The Risk Trilogy

Tyler Durden's picture

Submitted by Ben Hunt of Salient Partners' Epsilon Theory,

A trilogy is a pretty abstract notion. You can apply it to almost any three things.
Jonathan Demme


So then you like it? You really like it, Your Majesty?

Emperor Joseph II:

Of course I do. It’s very good. Of course now and then – just now and then – it gets a touch elaborate.


What do you mean, Sire?

Emperor Joseph II:

Well, I mean occasionally it seems to have, how shall one say? How shall one say, Director?


Too many notes, Your Majesty?

Emperor Joseph II:

Exactly. Very well put. Too many notes.


I don’t understand. There are just as many notes, Majesty, as are required. Neither more nor less.

Emperor Joseph II:

My dear fellow, there are in fact only so many notes the ear can hear in the course of an evening. I think I’m right in saying that, aren’t I, Court Composer?


Yes! Yes! Er, on the whole, yes, Majesty.


But this is absurd!

Emperor Joseph II:

My dear young man, don't take it too hard. Your work is ingenious. It's quality work. And there are simply too many notes, that's all. Just cut a few and it will be perfect.


Which few did you have in mind, Majesty?

Peter Shaffer, “Amadeus” (1984)

The most dangerous thing about an academic education is that it enables my tendency to over-intellectualize stuff, to get lost in abstract thinking instead of simply paying attention to what’s going on in front of me.
David Foster Wallace, “This is Water: Some Thoughts, Delivered on a Significant Occasion, about Living a Compassionate Life” (2009)

TLDR (Too Long Didn’t Read)
most common acronym I see on Zerohedge to describe an Epsilon Theory note

Gregg Greenberg at was kind enough the other week to give me a few minutes (2:30 to be exact) in a video interview to enumerate the three biggest risks I saw facing markets today.

At first I rolled my eyes at the request and the format. 150 seconds? Really? I mean, have you heard my Alabama drawl? It can take me 150 seconds just to order a cup of coffee. Then this past week Alex Coppola of the Wall Street Journal was similarly kind enough to give me a platform to talk about the Epsilon Theory perspective on markets for a forthcoming Voices column, again with a focus on the three biggest risks facing markets, again with a pretty strict format to prevent verbosity. How could I possibly communicate what I wanted to say in 400 words?

But you know what? I did. And my message was the better for it. Like David Foster Wallace, I have a tendency to over-intellectualize my work, and this was a healthy corrective. Is there an element of Short Attention Span Theatre in what Gregg and Alex do? Is there still a place in the world for a 25,000 word article in The New Yorker on the history of grain? Yes and yes. But there’s also a place for busy people to get a Classics comic book version of a long-form saga. Not a dumbing down, but rather a condensation to essential elements and an invitation to dig deeper if desired.

And yes, I realize that I’ve spent the better part of a page describing how I intend to write a pithy note. So here’s the drill. Three downside risks for markets, each summarized in a single page and linked to Epsilon Theory notes if you want to read more.

1) China has shifted from a monetary policy of choice to a monetary policy of necessity.

Just to be clear, I’m not one of those guys who sees China as on the brink of some enormous economic collapse. But I do believe that Chinese political legitimacy depends on the government delivering real economic growth … not the pleasant veneer of asset price inflation as in the US or the simple avoidance of abject deflation as in Europe. As that real economic growth becomes more difficult to achieve (three reasons: cheaper yen and greater Japanese competition in advanced export markets, more or less permanently depressed demand in primary European export markets, disappointingly slow growth in domestic consumer-led demand), the Chinese government increasingly faces the existential threat of a hard landing. Because it’s an existential threat, it ain’t happening. The Chinese government will seek to reverse economic growth uncertainty by any means necessary, including massive shifts in decades-long trends in monetary policy.

What is the primary instrument of Chinese monetary policy? It’s not control over short rates or QE balance sheet expansion as in the West, both of which are powerful but indirect economic levers. It’s direct control over credit availability and direct control over currency exchange rates. I’m particularly concerned about the latter. Recent forced declines in the value of the yuan are not simply efforts to “increase volatility” or “punish speculators”, as the Party line and Western apologists would have you believe. No, the goal is to invigorate growth by making exports cheaper, and when that goal is a political necessity it will be pursued regardless of the tensions it creates with both Japan and the US. My concern is that this is what a modern-day trade war looks like ... conflict over exchange rates, not tariffs and quotas.

If you want a deeper analysis, the core Epsilon Theory note here is “Rosebud”. Relevant shorter notes include “The Power of Why” and “Two Shifting Narratives”.

2) The Narrative of Fed Omnipotence continues to reign supreme, but now in a tightening monetary policy environment.

A narrative is a set of widely held beliefs about what everyone thinks that everyone thinks (in game theoretic terms, "common knowledge") created by very public statements by very public people … Janet Yellen, Mario Draghi, even the WSJ's own Jon Hilsenrath. Over the past five years an extremely powerful narrative has been created, what I call the Narrative of Fed Omnipotence – whatever happens in the market, for good or for bad, happened because of what the Fed did, not because of what happened in the "real" economy. And for the past five years that's been great for the market (US market, anyway, EM's not so much) as the Fed did very market-supportive things. But now the Fed is starting to tighten, which is definitely not market-supportive. If the Narrative holds true, then the market will go down even if the real economy picks up. In fact, so long as the Narrative holds true, bad real world news is good market news because it keeps the Fed in play, and vice versa.

Is a declining market a foregone conclusion as the Fed continues to tighten? No, but for the market to go up from here will require the development of an alternative narrative that supplants the dominant Narrative of Fed Omnipotence. This is what I’m watching for, and movement on this front (or lack thereof) is what I’ll try to alert you to through Epsilon Theory. The leading challenger? Same as it ever was – American exceptionalism and self-sustaining growth. The two variants on this theme? Technology-led growth (mightily damaged over past few months) and Energy-led growth (still going strong). But for now, at least, the Fed narrative still trumps all.

If you’ve read anything from Epsilon Theory, you’re familiar with my arguments around Narrative and Common Knowledge. This is the heart of a game theoretic perspective on markets, and it’s by far the most prevalent subject of Epsilon Theory notes. I’ll highlight three: “It Was Barzini All Along”, “How Gold Lost Its Luster”, and “A World of Guarantees”. Relevant shorter notes of late include: “The King is Dead. Long Live the King.”, “Goldilocks and the Dog That Didn’t Bark”, and “Oh Stewardess, I Speak Jive”.

3) The Hollow Market is cracked open by well-intentioned but destructive regulators.

The Hollow Market is my phrase for a market structure where humans trading to express an interest in the fractional ownership of a real world company account for less than 30% of market activity. Whether it’s “liquidity provision” or algorithm-driven arbitrage, machine-to-machine trading dominates modern markets against a backdrop of increasingly concentrated holdings of securities, and that’s a very unstable recipe. My concern with the Hollow Market is not only that it exists in such a Flash Crash-prone fashion, but that it’s terribly misunderstood. The Big Data technology that created the Hollow Market cannot be un-invented, but government regulators are apt to really screw things up as they try to do just that. As always, market infrastructure is created in the intersection of human greed, technology, and regulation. As always, technological breakthroughs upend the market structure apple cart, allowing upstart players to bypass regulatory barriers and steal rents from incumbents. As always, the incumbents muster the support of their political allies to recapture their rents, absorbing or crushing the upstarts in the process.

What’s different this time is that this brewing regulatory crusade is part and parcel of a larger regime effort to turn markets into social utilities, where private information is criminalized and broad market price inflation is effectively enshrined as a permanent government policy objective. As Clemenceau famously said about World War I, “War is too important to be left to the generals.” Political leaders today, across the globe and regardless of political stripe, are saying of the Great Recession, “Markets are too important to be left to private investors.” I have to admit, it’s an ingenious political response to maintain social order in the face of a global deleveraging cycle, even as the small-l liberal in me weeps. Bottom line: I have no idea what market structure will look like in 5 to 10 years, but my strong suspicion is that alpha will be an even rarer commodity than it is today.

The core Epsilon Theory notes on this score include: “The Adaptive Genius of Rigged Markets”, “Hollow Men, Hollow Markets, Hollow World”, “The Levelers”, and “A World of Guarantees”. See also: “When E.F. Hutton Talks”, “The Wages of Fear”, and “Uttin’ on the Itz”.

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Dorelei's picture

If it wasn’t for the each Gov protecting us against trusts, the entire world would be run mostly by one giant mega corp ,fruit of the merger of all nowadays corp !


So free-markets are actually prevented from showing their true evil form by governments ???

Kind of a schizophrenic-paradoxical dilemma ….

kaiserhoff's picture

So much verbage and theory after protesting against that whole schtick.  Let's cut to the Chase.

1.  China's main problem, which it refuses to admit or confront, is corruption.

2.  When bonds go up, stocks go down.

3.  Subtle but important point.  People, institutions, and machines are buying indexes, not making decisions about individual stocks.  Short term success, long term stupid.

   On the whole a fine piece, because it makes an honest effort to look at prime movers and first principles.

CrashisOptimistic's picture

Michael Lewis just laughs at all that crap.

KennyG09's picture

Because after all...a crash is optimistic

philipat's picture

I agree to the extent that The Squid wants its front-running monopoly returned as a result of closing or restricting HFT in favor of it's own exchange. I disgaree to the extent that I don't actually see the Regulators doing much else. Wake me up when the CFTC exposes Gold and Silver price manipulation on Comex....

nofluer's picture

May I respectfully suggest -

"Risk" #1 - Eliminate 1st sentence, keep sentence #2, eliminate the rest of #1.

#2 - Save last two sentences of 1st paragraph. Cut the rest of it.

#3 - The risk is general ignorance of how the "markets" currently work. Get rid of the rest.

jcpicks's picture

'It was God that was laughing at me.'


KennyG09's picture

So what you're telling me is that the free market isn't real? My god I had no idea after the three fuckin years I've been here. Not even counting the number of fuckin years before that.  Please save the internet space for something less obvious.

Cacete de Ouro's picture

I hate having to cut my stuff down from like 6000 words to one third of that.

If you want to read it, read it, if not, then don't

Cacete de Ouro's picture

If I had the time I would have written you a shorter letter.

Who said that?

Future Jim's picture

"How could I possibly communicate what I wanted to say in 400 words? But you know what? I did. And my message was the better for it."

The Quality Amendment

I propose the following Constitutional amendment to increase the quality of legislation passed by Congress.

The Congress shall not pass any bill larger than the original Constitution. Each bill must be smaller than 4,367 words.

Higher quality legislation would thus be able to crowd out lower quality legislation.

Such an amendment would simultaneously reduce corruption and waste as well as gridlock.

AdvancingTime's picture

We are on the same page when it comes to limiting the lenght of laws. And I'm talking reasonable sized print double spaced. The paragraph below is ripped from an article I wrote about the flaw of big government

"Add to my wish list of "crazy" ideas the following. Eliminate the dreadful electoral college and the distortion it causes. Cut in half the number of members in both the House and Senate while at the same time placing term limits upon them. Limit all laws to under five pages. Last but not least, move toward more national referendums and votes, if American idol can do it, so can we. In the future elections should also be held this way as long as proper verification can be confirmed"

The remainder of the article can be read at the site below.

nofluer's picture

1. The American people are too stupid to be trusted with direct elections. (If you doubt this, look at the last several occupants of the WH and the "quality" of the members of the House & Senate.)

2. "as long as proper verifications can be confirmed." Again - many votes are properly verified - and crooked as a slow river on a flat plain. I give you Al Franken's "election" as a case in point.

The "electoral college" was intended as a "fail safe" to prevent obviously crooked elections from being successful. After the election of an individual about whom the voters knew NOTHING (TWICE!!!) I fail to see the electoral college as an efective mechanism. Perhaps something better could be created, but direct elections are not it.

I've toyed for years with the concept of a National Lottery. The "winner" (loser?) gets to serve one 4 year term and OUT, and they can't leave office with more wealth than they entered office with (plus the value of their salary), and must return to the job they held when chosen, and would be barred from positions of influence for life.

Bazza McKenzie's picture

You have to impose some related constraint on regulation, otherwise everything ommitted from laws passed by congress is just imposed by administrative fiat of the bureaucracy, with the law being essentially a blank check for the administration to make whatever rules it likes without requiring a vote by elected representatives.

nofluer's picture

Easily done by simply limiting all bills to a single subject - with NO "riders" allowed.

Cacete de Ouro's picture

You said all that in 150 seconds? Well done!

I Write Code's picture


Just say: Risk, Risk Messiah, and Children of Risk.

g'kar's picture

I thought the sc-fi channel versions (on dvd) were very well done and closer to the books than the Kyle MacLachlan version.

I Write Code's picture

Agreed.  That David Lynch version was a fiasco.

g'kar's picture

The Alan Smithee extended release of the David Lynch version was so embarrassing that David Lynch used the pseudonym Alan Smithee to hide his shame.

buzzsaw99's picture

And for the past five years that's been great for the market (US market, anyway, EM's not so much) as the Fed did very market-supportive things. But now the Fed is starting to tighten, which is definitely not market-supportive. If the Narrative holds true, then the market will go down even if the real economy picks up. In fact, so long as the Narrative holds true, bad real world news is good market news because it keeps the Fed in play, and vice versa....


So much thought brought to mind from this. I wish I could condense it comprehensively and briefly but I will fail. The fed would like people to think they are tightening when in fact they are not. If what they are doing was in fact tightening then the long end of the curve would be going ballistic which would send shock waves through the entire bond market with disastrous ripple effects in the equities market. This time of year tax money is rolling in to d.c.. Tapering is still loosening in that environment.


The premise of the above, however, is still in essence correct. If the fed actually were to tighten, then nothing else would matter because as we all know there is no market, there is only the fed. However... What they are doing now is trying to make it appear as if they are tightening when in fact they are not. If you want to know their true intentions watch what they do after a 10% market decline. The truth is that the fed likes the market where it is and will under no circumstance tolerate anything to happen to fake market values because that in turn exposes the fraudulent bank balance sheets and bogus income statements when they themselves helped in the construction of that shoddy facade. edit - none of the above should be (mis)construed as market advice because i'm getting out while the getting is good bitchez.

Pareto's picture

+1 as always buzzz.....well said.

AdvancingTime's picture

The crux of our economic woes lay in the fact that over the last several decades we have created entitlement societies on the back of the industrial revolution, technological advantages, capital accumulated from the colonial era, and the domination of global finances. Now reality has begun to come into focus and it is becoming apparent that this is unsustainable.

Promises were made on the assumption that those advantages would continue in both Europe and US, and that ever greater prosperity and entitlements would be sustained through debt financed consumption growth.In that eerie fantasy world, debt fueled consumption was to be the catalyst to bring about ever more growth.  The entitlements and promises that have piled up have become overwhelming. I see no way we can avoid a major "readjustment" to the economies of the world. More on this subject in the article below.

viator's picture

"well-intentioned but destructive regulators."

The very definition of a regulator.

q99x2's picture

Dude has a southern drawl in his epsilon theory.

But it is interesting that people can make up so much stuff based on so little. Sort of like birds chirping.

ebworthen's picture

Odd that you include this quote, then proceed to over-intelectualize:

"The most dangerous thing about an academic education is that it enables my tendency to over-intellectualize stuff, to get lost in abstract thinking instead of simply paying attention to what’s going on in front of me."

  1. China - We already have a trade war and currency exchange manipulation; all the jobs have gone to China and the dollar is being debased.  The Yuan just needs to be "X" amount lower for Apple and Samsung to sell stuff.
  2. FED - The FED is the problem; intervention, QE, ZIRP, bailouts, currency swaps, etc.- which leads to hollow markets.
  3. Hollow Markets - Regulation?  What regulation?  Social utilities?  C'mon, the markets are the fleecing mechanism.
Oldwood's picture

The whole economy is a fleecing operation. Do you know how to tell? When half the people are making a living at it. How many are actually producing anything that would have public demand without the intervention of the government?

acetinker's picture

I don't know the number, Oldwood, but if the unnecessary people suddenly found themselves unemployed, this 'economy' would just evaporate- that's how bad it is.  Same as it ever was, I guess.

Chief Wonder Bread's picture



The Hollow Market

1. This is the way the market ends

2. This is the way the market ends

3. This is the way the market ends

Not with a bang but a whimper

acetinker's picture

You were right to begin with, Mr. Hunt- tl:dr.

If it takes you that many words to describe a system that was designed to fail from the outset, you're either full of shit or have another agenda.

Either way, I'm not interested

gatorengineer's picture

china is caught in the oil trap.... Add some corruption and gross mis-management... End of story.

they need cheaper oil in Yuan to thrive.  Stronger Yuan, and exports plummet.

Weakening the yuan creates hungry peasants, as food inflation hits...

In short, they collapse(d) because they do not have a domestic middle class to consume the goods that they produce.

Competition from Japan is laughable....



Last of the Middle Class's picture

If all stocks split 2 for 1 tomorrow, how would that change the value of the fiat in your pocket? How about if they all combined 1 for 2? That is the beauty of fiat and those who insidiously control it's creation and destruction. The possibiities with all the financial isntruments available are truly endless. Au  is worth nothing when the Pb is flying. Ultimately the security we've known as a nation for generations will be rocked, or rather is being rocked. The middle class as we know it is gone with the wind. Know what metal you're gonna need when you need it, because my friend the bankers are covering their asses. 

Tall Tom's picture

One of the major "problems", if you can call it a problem, is over production. Increased supply leads to falling value (not just prices which is supposedly a reflection of value.) China has been flooding the market with inexpensive, and high quality items, with do not break down rapidly. Again the idea is growth and production.


China's businesses must do this in order to capture, maintain, if not grow, market share. They remind me of 1920's United States when we were doing the same without any thought as to the designed obsolescence inherent in American products. (If a company makes a Light Bulb which lasts 100 years and everybody gets that Light Bulb then the Light Bulb factoriy ends up bankrupt. due to a lack of sales.)


Of course the USA and other Western Nations are flooded with these products and the price declines in the hard goods are deflationary.


But the costs for raw materials, resources and commodities as food and fuel increase as the demands for the increase of the standard of living in the productive country rises unabated. Of course this is inflationary.


This is what will happen when the "irresistable" forces act upon the "unmoveable" object. (Inflationary versus deflationary forces which are acting upon the World Economy)When the break happens (NOT IF BUT WHEN) it will be as an earthquake of unprecedented scale.


I would shore up my dwelling if I were you because the power released will be absolutely devastating.


(When I bought my first Gem Refractometer 12 Years ago I paid $400 for it and the RI Oil was $40 for 10 Grams. Today I can buy one for $85 and the RI Oil is $15 because of China exports of these devices, and Oils, in large numbers. Just how much demand is there for Gem Labs in the USA and the rest of the World? I bought a "used" Gem Refractometer at Swap Meet for $5 today.)

Lynn Trainor's picture

Corruption in China?  Yes, but they have nothing on us.  Civil forfeiture laws for example.  Seems that each succeeding presidency and Congress are more corrupt.  The courts are corrupt too, the Supreme Court on down.  A very sad state of affairs.

gcjohns1971's picture

The disease is best described as "Government by the Highest Bidder".


But the government cannot create or produce, but only supress creation or production.

The highest bidder is almost invariably the biggest company.

The biggest companies grow wildly in such an environment... but they do not become more productive.


The story ends with Stagnation or Collapse.