Market Narratives, Fact versus Fiction, and the End of Central Bank Stories

by Jeffrey Miller, Partner, Eight Bridges Capital Management

January 23rd, 2017
We are all susceptible to the pull of viral ideas. Like mass hysteria. Or a tune that gets into your head that you keep on humming all day until you spread it to someone else. Jokes. Urban legends. Crackpot religions. Marxism. No matter how smart we get, there is always this deep irrational part that makes us potential hosts for self-replicating information.

Neil Stephenson, Snow Crash, 1992, Chapter 56.

Markets go through phases, shifting from one regime to another. Its participants succumb to an idea about the “right” way to invest.  In the early 1970s it was go-go growth stocks.  For a while in the 1990s it was all about Buffett and value.  There are times, like the late 1990s, when it’s all about momentum.  But these are all just ideas that the market is telling itself are true at any given time, instead of viewing the markets as systems that move and evolve over time. Investors like the story of being a value investor or growth investor, because everyone needs an origin story – people like to have something to anchor them. Value versus growth versus momentum were the stories investors told themselves from about 1935 through 2009.  And then something changed.  The stories stopped being told by investors, and started being told by government entities.  Central Banks, Presidents and Prime Ministers became more important to markets than the underlying fundamentals of markets themselves, particularly in fixed income. But many investors are having a hard time adjusting to this new reality.

It’s uncomfortable to admit that what you do for a living can be driven for years, maybe decades, by a collective story over which you have no control.  But that may well be the only true reality we’re left with these days.  I think we’re going to look back with fondness to when the market’s origin story was told by investors arguing about growth versus value instead of central bankers and politicians. Morningstar and Lipper will be viewed with nostalgia as a quaint way of categorizing the players in a game that became unplayable.

“Y’know, watching government regulators trying to keep up with the world is my favorite sport.”

Neil Stephenson, Snow Crash, 1992.  L. Bob Rife, television interview, Chapter 14.

I think we’re nearing the time when regulators finally realize that their storytelling won’t save the world.  For the past seven years we have been on the receiving end of a constant stream of fairy tales from the Federal Reserve, European Central Bank, China, and Europe’s political leaders. The Fed’s “strategic communications policy” that involved “forward guidance” to “manage market expectations” about the course of future Fed policy became a self-reinforcing narrative that drove a globally connected economic system to push interest rates into negative territory and equity market valuations to levels not seen except at the market peaks in 1929 and 2000.  Merkel and Draghi continually talk about the importance of “unity” while also initiating massive ECB bond buying programs and simultaneously leaving Greece and Italy to suffer massive unemployment and stagnation without fiscal stimulus. Abe has the BOJ pegging Japan’s 10 year yield at zero.  And China just fakes its economic data while trying everything it can think of to cushion the fall in the Yuan.  And yet…everything is great!

But the problem is this narrative relies on all the market participants believing it despite the fact that the narrative makes no objective sense – that at the same time “everything is fine” yet, “we need rates at zero to stimulate growth” – they both can’t be true at the same time.  And yet…the best investment decision you could have made in the past seven years was to believe them both and not fight the central banks. In policy driven markets, you need to play a “common knowledge game.” The key to exiting safely from a policy driven market, like the one we are in now, is knowing when the government regulators are no longer able to keep up with the world.

Hiro: “Wait a minute, Juanita. Make up your mind. This Snow Crash thing—is it a virus, a drug, or a religion?”

Juanita shrugs. “What’s the difference?”

Neil Stephenson, Snow Crash, 1992.  Hiro and Juanita, Chapter 26.

If you’re able to play along with the new religion, and then, when it cracks, immediately liquidate and go to cash or short, then ride along. But this is tricky. It requires you to, all at once, both be acutely aware of the narrative you are being told, how it is being perceived by other market participants, and when it suddenly isn’t being heard in the way that the storytellers meant it to be. At some point, the narrative cracks, people realize they are being played, and all hell breaks loose. We may well be seeing the start of it now. You can’t tell from financial markets, but I think we’re seeing the dawning realization that the stories we’ve been told just aren’t true, that the ECB and Fed can’t magically create a world of never ending prosperity and zero volatility. Sometimes a new narrative can take over: the recent Trump Trade was one of those times. It was investor driven not CB driven. But it was built on top of the false narrative that Europe is stable and functional, so it’s a temporary, albeit powerful, move. And once a critical mass realizes that the narrative is false, we’ll have a Snow Crash – a systemwide shutdown.  And that’s when you’ll want to step back in and buy.

When we can watch something on TV, and then be told right afterwards that what we saw was something else (and yes, I’m referring to the surreal press conference (is it a press conference when the press isn’t allowed to ask questions, or just a speech? But I digress…) held on Saturday by the new Trump Administration)), we’ve stepped across the line from where we knew we were being lied to by central banks and their accomplices in government but at least they pretended to be telling the truth, into a world in which the alteration of truth is upfront.  And you can choose to go along with it, or not – but it’s now hyper clear what they want you to hear.

When you’re having debates about facts, you’ve stepped fully into what Ben Hunt has termed the narrative machine (his writings are excellent).  Below is a chart from Hunt’s August 17, 2016 report of how news stories on Bloomberg coalesced around a common account of Brexit after it happened.  The charts show what words and phrases the stories have in common before an event (on the left) and what they share after the event.  It’s a visual way to show the self-reinforcing echo chamber in which the modern media operates.

Why are we letting this narrative happen?  Because there really isn’t anything an investor can do about it anyway. Fighting it doesn’t work. You just lose money.  And capital.  So you play along, aware that you’re in a metaverse but unable to extricate yourself.   Smart investors – and who’s to say what one really is until after the reversal – will play along too. But smart investors will also spend lots of time obsessing over alternative universes in which things do not work out so well.  They play one game while learning another.  Others…well they just barely figure out the first game before it changes.  Then they blow up.

When it gets down to it — talking trade balances here — once we’ve brain-drained all our technology into other countries, once things have evened out, they’re making cars in Bolivia and microwave ovens in Tadzhikistan and selling them here — once our edge in natural resources has been made irrelevant by giant Hong Kong ships and dirigibles that can ship North Dakota all the way to New Zealand for a nickel — once the Invisible Hand has taken away all those historical inequities and smeared them out into a broad global layer of what a Pakistani brickmaker would consider to be prosperity — y’know what? There’s only four things we do better than anyone else:
microcode (software)
high-speed pizza delivery

Neil Stephenson, Snow Crash, 1992.  Introduction to Hiro Protagonist, Chapter 1.

This was written 25 years ago. And it manifested itself in our reality this past November.  The hollowing out of our middle class was not only completely forseeable, but it was written about in a popular book.  And yet, here we are, with the political establishment acting surprised it happened and not knowing what to do next.  Well, I don’t know what’s going to happen in politics, but in terms of markets, if we were just sitting here at 8 or 9 or 10 times earnings, getting a 10-12% earnings yield and a little bit of growth to boot, would I really care?  No.  Because it wouldn’t matter.  Yes, maybe the market would get worse, and stocks would go to 5 or 6 times earnings, and I’d be down 35% and wanting to puke, but then my earnings would accrete into book and I’d earn my way out of it in 3 or 4 years.  At a median S&P 500 P/E of 22.9x earnings at 12/31/16, earning your way out of it will take nearly a decade.  That’s not good.  Plan accordingly.

“You don’t respect those people very much, Y.T., because you’re young and arrogant. But I don’t respect them much either, because I’m old and wise.”

Neil Stephenson, Snow Crash, 1992.  Uncle Enzo, Chapter 21.

Not respecting the markets can be a dangerous game.  But there’s a difference between not respecting their correctness, because they’ve been manipulated globally by central banks for the past 7 years, and not respecting their power.  Many smart investors have been run over in the past 2 years by not respecting the power of the markets to do irrational things for longer than they “should.”  That’s what makes this market so difficult, and I think, will make it so dangerous to the passive, indexed, long-only investor in coming years.  After the Snow Crash, we’ll invent new stories and narratives to tell ourselves, and the cycle will repeat, only with new narrators and new characters.

Right now I’m market neutral, with fairly large bets via options on a SPX decline. I am still short international sovereign debt, along with small shorts on the Italian and Chinese stock markets.  I’m leaning long in some tech companies, consumer discretionary stocks, and defense in the U.S., with a number of shorts in other sectors offsetting that. And I’m still waiting for the time when market participants realize they’re part of a story that doesn’t end well.

I was quoted in Barron’s The Trader column, written by Ben Levisohn a few weeks ago. You can find a link to the PDF here if you don’t get Barron’s (but you should).

If you would like more specific ideas on how to navigate these markets, just reply and let me know and I will sign you up for a free trial of my newsletter.  By the way, we changed the name to Miller’s Market Matrix.  Stockpicker was too similar to some others out there.
This week’s Trading Rules: (all from Neil Stephenson, Snow Crash, 1992)

  • The world is full of power and energy and a person can go far by just skimming off a tiny bit of it.
  • When you are wrestling for possession of a sword, the man with the handle always wins.

SPY Trading Levels: Our levels have been about spot on.  The S&P 500 has gone 99 days without a decline of more than 1%.  That’s very rare.  It can lead to higher VAR positions than normal.  Be prepared.

This week’s levels:

Resistance: Same as before, there is a lot between 226 and 228.  Not a lot above that.

Support: A little at 221/222, then 218/219, then a lot at 213/215.  After that it’s a little at 209.

Positions: Net neutral stocks (both long and short stocks). Short FXI, SPY, and BWX. Long put options on SPY, KRE, HYG and FXI.