Econometric Modeling vs The Central Tendency – I Know It Was You, Fredo by Ben Hunt, Salient Partners

Sen. Geary: Hey, Freddie, where did you find this place?
Fredo Corleone: Johnny Ola told me about this place. He brought me here. I didn’t believe it, but seeing’s believing, huh? Old man Roth would never come here, but Johnny knows these places like the back of his hand.

“The Godfather, Part II” (1974)

Econometric Modeling vs The Central Tendency - I Know It Was You, Fredo

Michael Corleone: C’mon, Frankie… my father did business with Hyman Roth, he respected Hyman Roth.
Frank Pentangeli: Your father did business with Hyman Roth, he respected Hyman Roth… but he never *trusted* Hyman Roth!

“The Godfather, Part II” (1974)

There’s no more dramatic moment in all of movies than the Havana club scene in Godfather, Part II, where Michael overhears Fredo blurting out that he’s partied with Johnny Ola, Hyman Roth’s lieutenant, and lied to Michael about knowing him. The look on Michael’s face as he realizes that Fredo has betrayed the family is, for my money, Al Pacino’s finest scene as an actor, and it helped him gain a 1975 Oscar nomination for Best Leading Actor. Unfortunately for Pacino, it was a good year for strong leading man performances, as Jack Nicholson was also nominated that year for his role in “Chinatown”. The winner, of course, was Art Carney from the immortal film “Harry and Tonto”. Thank you, Academy.
But this isn’t going to be a note focused on Michael or Fredo, or even my favorite Godfather character of all time, Hyman Roth. No, this is a note focused on the polite and respected henchman, Johnny Ola.  Johnny Ola is the transmission mechanism, the disease vector, the crucial connection between the schemes of Hyman Roth and the survival of the Corleone family. Without Johnny Ola there is no Fredo betrayal, no path for a misplaced trust in Hyman Roth to infect the Corleone family. Without Johnny Ola there is no movie.

Now bear with me for a moment. There is a Fredo inside all of us. We are, each and every one of us, often betrayed in our actions and decision making by aspects of our own psyches, and our investment actions and decision making are no exception. The Epsilon Theory Fredo is the little voice inside our heads that convinces us to act in what we think is our own self-interest when actually we are acting in the interests of others. The internal Fredo that we all must seek to identify and root out is, like the movie Fredo, not an inherently bad or evil sort, but weak-willed and easily misled by the Johnny Olas of the world.

The Johnny Olas of the world are not so much flesh and blood people as they are idea or concepts. They are the transmission mechanism by which powerful institutions and even more powerful ideas and concepts – the Hyman Roths of the world – wield their most potent influence: the internalized influence of trust. It’s necessary and smart to do business with the Hyman Roths of the world. It’s necessary and smart to respect the Hyman Roths of the world. But as Frankie Pentangeli reminds Michael, you can never trust the Hyman Roths of the world, and that’s what Johnny Ola does … he convinces our internal Fredo to trust Roth and betray our self-interest.

I could write a long note about how the Fed is Hyman Roth and “communication policy” is Johnny Ola. Too easy. Too true, but too easy.

No, this note is about the Hyman Roth that works above even the Fed. It’s a note about the Johnny Ola that sweet talks all of our internal Fredos, even the Fredo inside Janet Yellen.

The Epsilon Theory Hyman Roth is Econometric Modeling.
The Epsilon Theory Johnny Ola is The Central Tendency.

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:

 

Econometric Modeling vs The Central Tendency

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.

These are the two big Epsilon Theory topics of the past year – polarized politics and structurally hollow markets – and I’ll give a few paragraphs on each. Then I’ll tell you what I think you should do about it.

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

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