Markets have not been this dominated by political uncertainty and divorced from economic fundamentals since the 1930s. Ben Hunt – Harvard Ph.D., the author of the Epsilon Theory Newsletter, and Chief Risk Officer at Salient Partners, an asset manager based in Houston, TX – provides useful lessons from game theory for thriving in what he calls “the age of central bankers.”
In a recent meeting of the Boston Security Analysts Society (BSAS), Hunt gave an impassioned overview of the application of game theory to markets to evaluate investment decisions under uncertainty.
Game theory in Poker and the Game of Thrones
Hunt introduced game theory in the context of poker. To be successful, one needs to play the player and not the cards. Having been dealt the same cards, an intelligent player will make different decisions playing against a table of off-duty Las Vegas card dealers than he would against a table of “half-inebriated dentists,” Hunt said. Thinking about the cards as the fundamentals of investments, the player should focus on the other market participants along with their strategies and incentives. Hunt offered the old adage, “If you have been playing cards for 30 minutes and you don’t know who the sucker is, it is you.” Hunt said this is true in markets as well. An understanding of game theory, along with an understanding of the players and games that are played in the markets, will help investors avoid being that sucker.
The central concept of game theory is strategic interaction while making decisions under uncertainty, Hunt said. Decisions are not made in a vacuum, but in the context of other players also making decisions to advance. To illustrate the spectrum of risk, Hunt quoted former Secretary of Defense Donald Rumsfeld’s infamous statement regarding the lack of evidence linking the Iraqi government with the supply of weapons of mass destruction to terrorist groups in 2002:
“There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns. There are things we don't know we don't know.”
In the spectrum of risk, certainty includes the “known knowns,” risk includes the “known unknowns,” and uncertainty includes the “unknown unknowns.” All modern economic theory is based on decision-making under risk where potential outcomes can be identified with probabilities assigned. With regard to investment decisions in the current environment characterized by central bank interventions, Hunt said that the use of “econometrics is not wrong, but is less useful in an environment of uncertainty than it is in an environment of risk.” Given the high degree of uncertainty, the lessons learned from game theory and history provide additional insights for success in today’s markets.
Proudly admitting his charter membership in the “Khaleesi, Mother of Dragons” fan club, Hunt tied his passion for George R.R. Martin’s books and the HBO series "The Game of Thrones" to his passion for game theory as it applies to financial markets. The series is set in the fictional Seven Kingdoms of Westeros and chronicles the violent dynastic struggles among the realm's noble families for control of the Iron Throne. Hunt described how the story shifted from one character to the next, depicting each character’s point of view as a participant in the game. Every character is being strategic but knows that every other character is being strategic too. He concluded that “the notion of getting one step ahead of the other characters has to be in the context of knowing that they are trying to get one step ahead of you.”
Game theory in history
Highly successful businessmen like Andrew Carnegie, Jay Gould and Cornelius Vanderbilt did not succeed in their investments by applying analytical techniques such as free-cash flow models, but through their awareness and focus on the other players in their markets, according to Hunt. Their understanding of the “story” around their markets and their ability to corner their markets were critical, he said. Hunt stressed that these investors did not ignore the fundamentals of their investments but successfully balanced the importance of playing the player along with playing the cards. He discussed how historical patterns of too much global debt followed by deleveraging have always created uncertainty in markets. He cited the 1494 collapse of the Medici Bank which over-extended loans to Edward IV along with the 1870s and 1930s as periods of high market uncertainty rooted in debt and deleveraging. In all cases, the source of the uncertainty was magnified by politics and political fragmentation.
Following the 2008 financial crisis, Hunt conceded that the massive injection of liquidity provided by quantitative easing successfully “restarted the stopped heart of the global economy.” But, he notes, it is problematic because an emergency government policy has become a permanent government program where there is now a “constant IV drip.” This creates technical uncertainty in uncharted territory and he believes no one really knows whether we can wean ourselves from this policy.
The common knowledge game and missionaries
Hunt outlined how the “common knowledge game” influences decision-making. In game theory an item of information is common knowledge if all of the players know it, and all of the players know that all other players know it, and all other players know that all other players know that all other players know it, and so on.1 Dr. Hunt illustrated how this game works using the example of the Island of the Green- Eyed Tribe. On this island it is taboo to have blue eyes, and you have to get in your canoe and leave the island the next morning you discover you do. However, there are no mirrors on the island, so no one knows the color of their own eyes. It is also taboo to discuss or communicate eye color to any other person. Thus, although it is taboo to have blue eyes, no one ever leaves the island, and all knowledge about blue-eyed people remains private.
A missionary comes to the island one day and announces, “At least one of you has blue eyes”. This creates public knowledge that influences the islanders’ decisions. The short answer to what happens on the island after the missionary’s announcement is that if there are N people on the island with blue eyes, they will leave on the morning of the Nth day. (You can find the full solution with its inductive argument here.) Hunt emphasized how the common knowledge introduced by the missionary changed the behavior of blued eyed people on the island. He connected the role of this missionary to our modern missionaries – politicians, central bankers and influential pundits – and emphasized the influence those missionaries’ public statements have on the markets.
The missionary is the creator of common knowledge that we all know that everyone else knows. This public information drives the game. Hunt ranked Angela Merkel as the most influential missionary because what she says is highly likely to be counter to the common knowledge about the European economic system. The next most influential missionaries, but by “by an order of magnitude” lower than Merkel, are U.S. Federal Reserve Chairwoman Janet Yellen and ECB president Mario Draghi. Other missionaries include Warren Buffet and the Wall Street Journal author Jon Hilsenrath.
Over the last five years the fundamentals have mattered less and markets have been more influenced by the common knowledge game. Investors are not making decisions based on fundamentals or on consensus. Since we all perceive that we are smart enough to look at the consensus of the crowd, the consensus no longer matters. Instead, it is the power of the crowd seeing the crowd responding to the missionary’s common knowledge statements that influences the decisions and movements of markets.
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The role of the missionaries is to tell us, the “crowd”, how we should think about something while communicating their message in a way that makes us think that everyone has heard this news. Hunt said “there are only four media microphones that matter:” The Wall Street Journal, Financial Times, CNBC and Bloomberg. If one of these missionaries says anything through any of these four microphones, we all assume that everyone has heard what was said, and it creates new common knowledge.
Hunt illustrated the influence of common knowledge and modern missionaries with the following example. The Fed comes out with an announcement. Your first level of decision-making is your personal response to what the Fed said, but then you realize that your opinion is not significant with regard to how you should react to this information with your investments. The second level of decision-making is the consensus step, which lasts around 30 minutes. During this period the market will move either up or down slightly depending on whether the Fed statement met the consensus of what economists predicted it would say. After 30 minutes Jon Hilsenrath publishes his thoughts in the Wall Street Journal telling you how you should think about what the Fed announced. Hunt said his reaction to Hilsenrath’s responses is usually, “Are you kidding me? This guy is nuts,” but his professional reaction is to make a trade based on what Hilsenrath said we should think. After the Hilsenrath announcement, the markets will either “accentuate the consensus move or go violently against it in the opposite direction.” This is a way to get ahead of the game, and Hunt said that you can use these common knowledge-changing missionary statements to help guide decisions in your tactical portfolio.
Missionary statements can also influence and move the price of individual stocks, according to Hunt. He explained this with the history of Salesforce.com (CRM). Over the last four years CRM is up and all of the gain came on the 16 trading days after earnings announcements. CRM’s earnings are announced after close by its CEO Marc Benioff. They consistently beat their earnings estimates by one cent on a pro-forma basis. Benioff goes on CNBC with Jim Cramer who says to buy the stock while Benioff uses his three minutes to tell the story. Benioff, Cramer and a handful of sell-side analysts are the missionaries. The new common knowledge from this announcement causes a short-term gain in the stock and, because you know that everyone else knows this information, you can get ahead of the game by acting in advance of this new common knowledge. Hunt said that this strategy works because we are social animals and “suckers for a good story.”
Central bankers have taken on this narrative, storytelling approach, Hunt said, as a policy tool to support, influence and inflate the markets when “the avowed goal of quantitative easing is to force us as investors to take on more risk than we would otherwise be comfortable with.” Hunt did not recommend that investors go against what the missionaries say, but recognize that you are playing the game.
What to do when the crystal ball is broken
Hunt stressed the importance of recognizing our weakness for a good story and discerning whether the narrative behind your decision is useful to your goals or the missionaries’ goals. The proper place for game theory and being a better game player is for tactical investment decisions, Hunt said. He recommended avoiding game playing for long-term, strategic investments. Hunt said that alpha has never been more difficult to achieve than it is today “because of the illegality of acquiring private information on public companies.” Although we have had five years of “unprecedented monetary policy coordination,” we are now in a period where differing domestic political priorities will ultimately determine the positions of all central bank leaders. Hunt warned that the next five years of central bank divergence “will absolutely have unexpected and huge impacts on the markets”.
Justin Kermond is the vice president of business development for Advisor Perspectives.
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