When Does the Story Break?

Tyler Durden's picture

Submitted by Ben Hunt of Salient Partners' Epsilon Theory blog,

Until an hour before the Devil fell, God thought him beautiful in Heaven.
Arthur Miller, “The Crucible”

It’s always about timing. If it’s too soon, no one understands. If it’s too late, everyone’s forgotten.
Anna Wintour

Saint Laurent has excellent taste. The more he copies me, the better taste he displays.
Coco Chanel

Beauty, to me, is about being comfortable in your own skin. That, or a kick-ass red lipstick.
Gwyneth Paltrow

For, dear me, why abandon a belief Merely because it ceases to be true? Cling to it long enough, and not a doubt It will turn true again, for so it goes. Most of the change we think we see in life Is due to truths being in and out of favor.
Robert Frost, “The Black Cottage”

Lord I am so tired How long can this go on?
Devo, “Working in a Coal Mine”

He can’t think without his hat.
Samuel Beckett, “Waiting for Godot”

Perhaps the most irrational fashion act of all was the male habit for 150 years of wearing wigs. Samuel Pepys, as with so many things, was in the vanguard, noting with some apprehension the purchase of a wig in 1663 when wigs were not yet common. It was such a novelty that he feared people would laugh at him in church; he was greatly relieved, and a little proud, to find that they did not. He also worried, not unreasonably, that the hair of wigs might come from plague victims. Perhaps nothing says more about the power of fashion than that Pepys continued wearing wigs even while wondering if they might kill him.
Bill Bryson, “At Home: A Short History of Private Life”

The most common question I get from Epsilon Theory readers is when. When does the market break? When will the Narrative of Central Bank Omnipotence fail? To quote the immortal words of Devo, how long can this go on? Implicit (and sometimes explicit) in these questions is the belief that this – whatever this is – simply can’t go on much longer, that there is some natural law being violated in today’s markets that in the not-so-distant future will visit some terrible retribution on those who continue to flout it. There has never been a more unloved bull market or a more mistrusted stock market high.

It’s a lack of love and a lack of trust that I share. I believe that public markets today are essentially hollow, as what passes for volume and liquidity is primarily machines talking to other machines for portfolio “positioning” or ephemeral arbitrage rather than the human expression of a desire to own a fractional ownership share of a real-world company. I believe that today’s public market price levels primarily reflect the greatest monetary policy accommodation in human history rather than the real-world prospects of real-world companies. I believe that the political risks to both capital market structure and international trade (which are the twin engines of global growth, period, end of story) have not been this great since the 1930’s. Simply put, I believe we are being played like fiddles. That does NOT mean, however, that I think anything has to change next week … or next month … or next year … or next decade. The human animal is a social animal in the biological sense, and as such we are cognitively evolved to maintain our beliefs and behaviors far beyond what is “true” in an objective sense. This is, in fact, the core argument of Epsilon Theory, that there is no such thing as Truth with a capital T when it comes to the institutions and the social organizations that we create. There’s nothing more “natural” about our market behaviors than there is around, say, our fashion behaviors … the way we wear our clothes or the way we cut our hair. For 150 years everyone knew that everyone knew that gentlemen wore wigs. This was the dominant common knowledge of its day in the fashion world, absolutely no different in any way, shape or form than the dominant common knowledge of today in the investing world … everyone knows that everyone knows that it’s central bank policy that determines market outcomes. And this market common knowledge could last for 150 years, too.

I’m not saying that a precipitous change in market beliefs and behaviors is impossible. I’m saying that it’s not inevitable. I’m saying that it’s NOT just a matter of when. I’m saying that understanding the timing of change in market behaviors is very similar to understanding the timing of change in fashion behaviors, because both are social constructions based on the Common Knowledge Game. It’s no accident that the most popular way to relate that game is the story of the Emperor’s New Clothes.

Here’s a photograph Margaret Bourke-White took of the Garment District in 1930. Every single person on the street is wearing a hat. How did THAT behavior change over time? How did the common knowledge that All Men Wear Hats, or wigs or whatever, change? Does it happen all at once? Smoothly over time? In fits and starts? Who or what sparks this sort of change and how do we know? To use a five dollar phrase, what is the dynamic process that underpins the timing of change in socially-constructed behaviors, whether that behavior is in the investing world or the fashion world?

Fortunately for us, game theory provides exactly the right tool kit to unpack socially driven dynamic processes. To start this exploration, we need to return to 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 or otherwise communicate with each other about blue eyes, 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 nth 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 simply 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. This is the power of the crowd watching the crowd, and for my money it’s the most potent behavioral force in human society.

Prior Epsilon Theory notes have focused on the role of the Missionary, and I’ll return to that aspect of the game in a moment. But today my primary focus is on the role of time in this game, and here’s the key: no one thinks he’s on the wrong side of common knowledge at the outset of the game. It takes time for individual tribesmen to observe other tribesmen and process the fact that the other tribesmen have not changed their behavior. I know this sounds really weird, that it’s the LACK of behavioral change in other tribesmen who you believe should be changing their behavior that eventually gets you to realize that they are wondering the same thing about you and your lack of behavioral change, which ultimately gets ALL of you blue-eyed tribesmen to change your behavior in a sudden flurry of activity. But that’s exactly the dynamic here. Even though there is zero behavioral change by any individual tribesman for perhaps a long period of time, such that an external observer might think that the Missionary’s statement had no impact at all, the truth is that an enormous amount of mental calculations and changes are taking place within each and every tribesman’s head as soon as the common knowledge is created.

I’ve written at length about the portfolio construction corollary to phenotype, or the physical expression of a genetic code, and genotype, or the genetic code itself. The former gets all of the attention because it’s visible, even though the latter is where all the action really is, and that’s a problem. In modern society it means that we place an enormous emphasis on skin color as a signifier of otherness or differentiation, when really it deserves almost no attention at all. In portfolio management it means that we place an enormous emphasis on style boxes and asset classes as a signifier of diversification, when really there are far more telling manifestations. The dynamic of the Common Knowledge Game is another variation on this theme. For almost the entire duration of the game, the activity is internal and invisible, not external and visible, but it’s there all the same, bubbling beneath the behavioral surface until it finally erupts. The more tribesmen with blue eyes, the longer the game simmers. And the longer the game simmers the more everyone – blue-eyed or not – questions whether or not he has blue eyes. It’s a horribly draining game to play from a mental or emotional perspective, even if nothing much is happening externally and regardless of which side of the common knowledge you are “truly” on.

If you haven’t observed exactly this sort of dynamic taking place in markets over the past five years, with nothing, nothing, nothing despite what seems like lots of relevant news, and then – boom! – a big move up or down as if out of nowhere – I just don’t know what to say. And I don’t know a single market participant, no matter how successful, who’s not bone-tired from all the mental anguish involved with trying to navigate these unfamiliar waters. These punctuated moves don’t come out of nowhere. They are part and parcel of the Common Knowledge Game, no more and no less, and understandable as such.

What starts the clock ticking on the “simmering stage” of the Common Knowledge Game? The Missionary’s public statement that everyone hears, creating the new common knowledge that everyone believes that everyone believes. How long does the simmering stage last? That depends on a couple of factors. First, as described above, the more game players who are on the wrong side of the new common knowledge, the longer the game simmers. Second, the dynamic depends critically on the fame or public acclaim of the Missionary, as well as the power of his or her microphone. A system with a few dominant Missionaries and only a few big microphones will create a clearer common knowledge more quickly, reducing the simmering time. Whether it’s Anna Wintour and Vogue or Janet Yellen and the Wall Street Journal, the scope and pace of game-playing depends directly on who is creating the common knowledge and how that message is amplified by mass media. Fashion changes much more quickly today than in, say, the 1930’s, because the “arbiters of taste” – what I’m calling Missionaries – are fewer, more famous, and have stronger media microphones at their disposal. Ditto with the investment world.

But has the clock started ticking on new common knowledge to change the dominant investment game? Has there been a perception-changing public statement from a powerful Missionary to make us question Central Bank Omnipotence, to make us question the color of our eyes? No, there hasn’t. There are clearly new CK games being played in subsidiary common knowledge structures – what I call Narratives – but not in this core Narrative of the Fed’s control over market outcomes. So for example, the market can go down, and more than a little, as the common knowledge around the subsidiary Narrative of The Fed Has Got Your Back comes undone with a second derivative shift from easing to tightening. The Fed itself is the Missionary on this new common knowledge. But the market can’t break so long as the common knowledge of Central Bank Omnipotence remains intact. So long as everyone knows that everyone knows that market outcomes ultimately depend on Fed policy, then the Yellen put is firmly in place. If things get really bad, then the Fed can save us. We might argue about timing and reaction functions and the like, but everyone believes that everyone believes that the Fed has this ability. And because it’s such strong common knowledge, this ability will never be tested and the market will never break. A nice trick if you can pull it off, and until a Missionary with the clout of the Fed comes out and challenges this core common knowledge it’s a fait accompli within the structure of the game. Who has this sort of clout? Only two people – Mario Draghi and Angela Merkel. That’s who I watch and who I listen to for any signs of a crack in the Omnipotence Narrative, and so far … nothing. On the contrary, Draghi and Merkel have been totally on board with the program. We’re all going to be wearing hats for a long time so long as all the investment arbiters of taste stick with their story.

There is, of course, a fly in this glorious ointment, and it’s the single most important difference between the dynamic of fashion markets and financial markets: political shocks and political dislocations can trump common knowledge and precipitate an economic and market dislocation. Wars and coups and revolutions certainly influence fashion, but obviously in a far less immediate and pervasive manner than they influence financial markets. The fashion world is an almost purely self-contained Common Knowledge Game, and the investment world is not. Where am I looking for a political shock that would be big enough to challenge the common knowledge that Central Banks are large and in charge, capable of bailing us out no matter what? It’s not the Ukraine. On the contrary, events there are public enough to give Draghi an excuse to move forward with negative deposit rates or however he intends to implement greater monetary policy accommodation, but peripheral enough to any real economic impact so that the ECB’s competence to manufacture an outcome is not questioned. It’s China. If you don’t think that the territorial tussles with Vietnam and Japan matter, if you don’t think that the mutual accusations and arrests of American and Chinese citizens matter, if you don’t think that the HUGE natural gas deal between Russia and China matters, if you don’t think that the sea change in Chinese monetary policy matters … well, you’re just not paying attention. A political shock here is absolutely large enough to challenge the dominant market game, and that’s what I’ll be exploring in the next few Epsilon Theory notes.

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Doña K's picture

But... There are so many intelectually blind and so many intelectually deaf investors that it will take longer than we think.

"Monetary policy: It may seem strange to return to monetary policy as an option. After all, haven't we just seen that it is ineffective?.............. as a result, it seems to indicate that a liquidity trap is something that can last indefinitely."

Krugman 1998



THX 1178's picture

Well, the fed began tapering months ago and so it is now committed. There is no way out of this hole. If they continue to taper, the markets collapse and TBTF banks go bankrupt. If they untaper, faith in the US and its debt is lost and the dollar dies. So this is the case. The very fact that the fed decided to taper in the first place is that they were losing control.

loveyajimbo's picture

Nah, the Fed SAID they would taper... if you believe THAT... I have some 2008 BathHouse Barry Obongo campaign promises to sell ya... you might notice the strange coincidence of Belgium starting to buy massive amounts of US Bond trash at the same time the "taper" went into effect??  Just another part of the BIG CON... there can be no true taper... unless a default is part of the plan...

Doña K's picture

"The way to make monetary policy effective, then, is for the central bank to credibly promise to be irresponsible - to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs. This sounds funny as well as perverse."

Not only perverse Mr Krugman but also evil 

Also Krugman 1998




RiverRoad's picture

And in reality the Fed continues to loose control.  The American retail investor has been checking out of the equity market for quite a while now.  The volume speaks volumes. 

Millivanilli's picture

Calm down and be a good debt slave.  You can't make this shit up.


From Experian Credit rating



Finally, you can’t assume that having no balances is always a good thing. If you stop using credit altogether you are no longer demonstrating whether or not you can manage credit. Scoring models will not score a report that has had no recent activity. The time frames vary by model, but can be as short six months with no balance updates.




WmMcK's picture

At least once during each 6 month period  I take a cash advance (2% for 15 to 18 month) and promptly

go to my LCS and trade the FRN for 90% Ag.

Credit rating has not been negatively impacted yet.

When it is, so what?

Oracle of Kypseli's picture

Why should anyone care about credit score?

WmMcK's picture

ZipIt writes: Credit is the oil that keeps the machine running.  Ever see what happens to an engine when you take away the oll?  That's why.

Oracle of Kypseli's picture

I agree that that's what the banks and .gov wants. On an individual basis credit entices you to spend on things you cannot afford. 

prains's picture

Debt is the easiest form of subjugation to enter into and the most difficult to get out of

darkpool2's picture

When you have no NEED for credit, YOU are in control, and then by definition, credit score has little to no meaning. Credit score is akin to your mark of the beast !

messymerry's picture

Alethia koritsi, an excellent observation on your part.  The 20th century model of economics and finance is broken beyoond repair.  When life support fails (...and it will...soon) a whole new paradigm will have to be developed.  The entire nature of money will be examined. 

Emai apo tn Kerkyra, apo poo esai?  To horio mou enai Pagous.

OC Sure's picture



Let's be clear on the terms we use.

Central banks do not have a monetary policy.

Central banks have a counterfeiting policy. The purpose is theft.

Henry Ford had a monetary policy. The purpose was wealth.

We are ruled by authority because of counterfeiting not money.


It is not a liquidity trap.

It is the simultaneous increase of counterfeit and decrease of money.

Imminent Collapse's picture

Devo? Working in a coal mine was written by Alan Touisant. Maybe a better song is "How Long Can at his Keep a going On" made famous by Ace.

what's that smell's picture

game theory is for suckers. 

statistically, if you play by the rules, you will not win (many losers, few winners)

if you cheat, you either win big or get killed.

game theory is for suckers and weaklings.

Intelligence_Insulter's picture

Socialism has failed, the liberals have ran out of other people's money.  Minimal government that protects property rights is what we need to get back to.

Omegaman2211's picture

Zero government is what we need to get back to.

Keyser's picture

And what will all those ex-government employees do for a living, besides suck the public's teet? 

DaddyO's picture

Isn't it high time we find out?


damicol's picture

You send them to Detroit, put an electric fence and a minefield around the city and leave them to it.


We can all watch on all the millions of street cameras they set as first order of business when they have formed the teeming committees and focus groups and  rewritten the local bylaws. I am sure they can all show us a thing or two about they get on surviving.


Gavrikon's picture

They will employ Hannibal Lector as the Secretary of Nutrition.

lunaticfringe's picture

Did you see that excellent piece on the Freedom Index where legislators are graded according to how well they hold to constitutional virtues. That is a fucking eye opener although it won't shock anyone here. The Freedom Index. http://directorblue.blogspot.com/2014/05/the-freedom-index-find-out-where-your.html

Shad_ow's picture

AS a whole, it is pathetic. Isn't it?

thamnosma's picture

And the winners are:

Sen. Elizabeth Warren (D) Massachusetts

Sen Tim Kaine (D) Virginia.

Both received a rating of ZERO.  These will be your Democrat presidential nominees in the future.

CH1's picture

Minimal government...

Is a deadly illusion. Once you give one group the power to tax and punish everyone else, slavery is inevitable.

Eyeroller's picture

Socialism is thriving.  It doesn't matter that they ran out of other people's money.  The Ponzi Munchkin just prints money out of thin air.

falak pema's picture

So Carlyle and all those Prvate Equity funds of Qatar and Saud that run western world are part of the "socialist" Oligarchy?

Printing is to feed the oligarchy matrix and starve the people, what socialisim has to do with western made NWO is beyond me. 

djsmps's picture

This reminds me of the Seinfeld episode about a coffee table book about coffee tables. http://www.latimes.com/business/la-fi-twitch-tv-20140525-story.html#page=1

Pay $5.00 to watch someone else play a video game.

"It's become the largest live-streaming site on the Web. During peak viewing times, it sometimes accounts for the fourth-highest traffic on the Internet, behind only Netflix, Google and Apple, according to statistics by Sandvine, a networking equipment company."

Oh regional Indian's picture

Save your country.

Bring back the hat.

Baseball caps don't cut it.

thamnosma's picture

Speaking of Devo, they helped bring hats back for awhile in the 80's.  I was wearing them then as well along with thin ties.

A Lunatic's picture

It's just like musical chairs......

nevadan's picture

Only two people – Mario Draghi and Angela Merkel. That’s who I watch and who I listen to for any signs of a crack in the Omnipotence Narrative,

My money is on a collapse in the Petrodollar and the rejection of USD in international trade settlement ala Jim Willie.

CHX's picture

When? When the Austrian (aka gold) is needed to bail out (cover) the Keyensians (debt), that's when. So when's when? I have no idea, but every day when's a day closer.

Seasmoke's picture

Unfortunately, so is death. 

thamnosma's picture

I figure gold and silver will skyrocket the day I die.

oklaboy's picture

bread and circuses usually end badly, as so will this one 

NoDebt's picture

When, when, when.  Back in '09 the Fed and Treasury stated very clearly their policies were intended to be "temporary", until the market basically could stand on it's own legs.  So, we've again got a government program touted as "temporary" that has become permanent.

At this point, I'd say it's not going to break until every federal agency has their own private police/para-military force and another 5-6 billion bullets have been bought.  Then they'll let it break because they'll be prepared for what happens next.

Seasmoke's picture

The time has allowed the monster to grow and get stronger. Stupid sheep. 

Winston Churchill's picture

I just wonder where they will get those bullets with the EPA closing the only US lead smelter last month.

DanDaley's picture

Gotta love that word temporary...remember that Nixon said closing the gold window in '71 was temporary.


As for the armed-to-the-teeth agencies, they will eventually end up killing each other, but by that time most of us will be long gone and this place will look like Germany in '45.

thamnosma's picture

Nothing more temporary in life than military coups.

knotjammin2's picture

I can't believe you quoted Gwyneth Paltrow.  

tdogg's picture

I have blue eyes. Bye bye.

Atomizer's picture

As soon as the internet is regulated, food prices increase for Federal Reserve exponential growth, and you need to reconsider pink slime as an alternative meal. The new world ideology is at wits end. They thought enough mouth breathers would flood the lemming to accept the agenda.


Quite the contrary. 

Theta_Burn's picture

What does it matter..

Hillary "Rodram" Clinton

This is a big fucking deal...

Joe "Ginbloom Biden

We have to pass it to see whats in it...

Nancy "whatwasthequestion" Pelosi

This will be the most transparent adminisration ever..

Barrack "Obscene" Obama

I'm to busy for the truth

John "on all forbes" Kerry

Imagine what will be by next yrs. Memorial day..

 I'd say the story already broke, and nobody fucking read it


lunaticfringe's picture

Nice. But the story ain't here yet. You'll know it when it hits every last mf'er like a 2x4 over the head. That crazy shit in Belgium (buying treasuries by proxy) is just the beginning. They've screwed the pooch alright, but nobody is feeling any pain. Not yet.


falak pema's picture

Cheap money printing only seems to work if it generates growth G not R. 

During the cheap oil period of the post war 30 year Keynesian ramp up of real economy where military destruction had to be replaced by the auto/home appliance boom; all fed on cheap oil/petrochemicals; Lord Keynes's legacy reigned SUPREME with a marginal tax rate >80% in USA and it NEVER stopped the word economy or world trade from growing. (remember that you tea drinkers and neo cons)

But when PEAK OIL hit USA and it became a war mongering and fiat disseminating dominant economy; aka from 1964 onwards; the Keynesian model failed as BW did not function anymore under Milton Friedman's floating rate $ protection and salary inflation. 

Today the fiat pump feeds illusory R and no real G; so whats the point of throwing cheap money at the financial oligarchy world which makes the people destitute...? 

MOAR fake R and less true G and then...the great splits!