What Polarized Politics Teaches Us About Stock Market Uncertainty

Excerpted from Ben Hunt's Epsilon Theory blog, [9]

It’s important to respect the power of econometric models. It’s important to work with econometric models. But I don’t care who you are … whether you’re the leader of the world’s largest central bank or you’re the CIO of an enormous pension fund or you’re the world’s most successful financial advisor … it’s a terrible mistake to trust econometric models. But we all do, because we’ve been convinced by modeling’s henchman, The Central Tendency.

What is the The Central Tendency? It’s the overwhelmingly widespread and enticing idea that there’s a single-peaked probability distribution associated with everything in life, and that more often than not it looks just like this:

It’s our acceptance of The Central Tendency as The Way The World Works that transforms our healthy respect for econometric modeling into an unhealthy trust in econometric modeling. It’s what creates our unhealthy trust in projections of asset price returns. It’s what creates our unhealthy trust in projections of monetary policy impact.

It also creates an unhealthy trust in the mainstream tools we use to project risk and reward in our investment portfolios.

I’m not saying that The Central Tendency is wrong. I’m saying that it is (much) less useful in a world that is polarized by massive debt and the political efforts required to maintain that debt. I’m saying that it is (much) less useful in a market system where exchanges have been transformed into for-profit data centers and liquidity is provided by machines programmed to turn off when profit margins are uncertain.

Polarized Politics

The world is awash in debt, with debt/GDP levels back to 1930 levels and far higher than 2007 levels prior to the Great Recession. What’s different today in 2015 as compared to the beginning of the Great Recession, however, is that governments rather than banks are now the largest owners (and creators!) of that debt.

Governments have more tools and time than corporations, households, or financial institutions when it comes to managing debt loads, but the tools they use to kick the can down the road always result in a more polarized electorate. Why? Because the tools of status quo debt maintenance, particularly as they inflate financial asset prices and perpetuate financial leverage, always exacerbate income and wealth inequality. I’m not saying that’s a good thing or a bad thing. I’m not saying that some alternative debt resolution path like austerity or loss assignment would be more or less injurious to income and wealth equality. I’m just observing that whether you’re talking about the 1930s or the 2010s, whether you’re talking about the US, Europe, or China, greater income and wealth inequality driven by government debt maintenance policy simply IS.

Greater income and wealth inequality reverberates throughout a society in every possible way, but most obviously in polarization of electorate preferences and party structure. Below is a visual representation of increased polarization in the US electorate, courtesy of the Pew Research Center. Other Western nations are worse, many much worse, and no nation is immune.

There’s one inevitable consequence of significant political polarization: the center does not hold. Our expectation that The Central Tendency carries the day will fail, and this failure will occur at all levels of political organization, from your local school board to a congressional caucus to a national political party to the overall electorate. Political outcomes will always surprise in a polarized world, either surprisingly to the left or surprisingly to the right. And all too often, I might add, it’s a surprising outcome pushed by the illiberal left or the illiberal right.

The failure of The Central Tendency occurs in markets, as well.

Below is a chart of 3-month forward VIX expectations in December 2012, as the Fiscal Cliff crisis reared its ugly head, as calculated by Credit Suisse based on open option positions. If you calculated the average expectations of the market (the go-to move of all econometric models based on The Central Tendency), you’d predict a future VIX price of 19 or so.

But that’s actually the least likely price outcome! The Fiscal Cliff outcome might be a policy surprise of government shutdown, resulting in a market bearish equilibrium (high VIX). Or it might be a policy surprise of government cooperation, resulting in a market bullish equilibrium (low VIX).

But I can promise you that there was no possible outcome of the political game of Chicken between the White House and the Republican congressional caucus that would have resulted in a market “meh” equilibrium and a VIX of 19.

If you want to read more about the Epsilon Theory perspective on polarized politics and the use of game theory to understand this dynamic, read “Inherent Vice [10]”, “1914 Is the New Black [11]”, and “The New TVA [12]”.