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“When Does the Story Break?”JOHN MAULDIN | May 28, 2014

Te behavior o markets (and o entire societies) depends on what everyone knows that everyone knows.Make sense? It didn’t to me, either, until Ben Hunt walked me through an example or two o the CommonKnowledge Game in the piece you’re about to read.

Ben says the question he is asked most is “When?” When will this market break? When – to use Ben’sterm – will the “Narrative o Central Bank Omnipotence” ail? He doesn’t so much answer the question asexplain why he can’t answer it. But he doesn’t leave us empty-handed. In act, Ben’s explanations o marketbehavior in terms o the narratives in which we all participate and the games we all play, are among themost use ul tools I have or surviving and thriving out here in unexplored and increasingly treacherousterritory.

In other words, it may not be so important to know exactly when a major market narrative will ail (thoughI wouldn’t mind having a working crystal ball) as it is to know how and why it might ail. Tat way, wehave some chance o detecting incipient signs o ailure.

I nd it ascinating that so much o market behavior happens silently, right inside our skulls – billions obrains, each working overtime to suss out what the rest might be thinking o doing. Te “power o thecrowd watching the crowd” is the “most potent behavioral orce in human society,” says Ben – but thepower wielded by those who can watch the crowd watching the crowd is more potent yet, because theirperspective on the Common Knowledge Game lets them ask how the game may be about to change.

But what does it take or “what everyone knows that everyone knows” to shif, or even to ip, and or newcommon knowledge to assert itsel and become entrenched? “Fortunately or us,” says Ben, “game theory

provides exactly the right tool kit to unpack socially driven dynamic processes.” So let’s get to unpacking!Ben con esses that there is “a y in this glorious ointment” o gamesmanship, and that is the potential ormajor political shocks. Where, he asks, should we look or “a political shock that would be big enough tochallenge the common knowledge that Central Banks are large and in charge, capable o bailing us out nomatter what?”

I won’t tell you his answer (hint: it’s not Ukraine), I’ll make you dig or it; but on the way you’re going tounearth some real treasure.

Li e is busy. We are getting ready to y to Italy and then nd a train to uscany and cars to requanda. Ihave dinner with Steve Cucchiara in Rome Friday night, then get up and meet George Gilder, who willbe ying in rom Boston and spending a week or so with us. We will both spend our days working on new

books (although I might take a day to visit Sienna again). Other riends will be dropping by or periods otime. Dylan Grice will show up at some point next week, as will David ice [o Prudent Bear ame] andCliff Draughn rom Excelsia in Savannah). And others! It will make or un dinners.

I do somewhat pay attention to the markets and just shake my head in amazement. Who would haveguessed an all-time S&P high o 1905 and 2.5% on the ten-year bond? REALLY? And as Doug Kasspointed out this morning, the VIX is back down to 2007 levels! But this next chart, sent to me by MebFaber, is not so much ominous as just head-shaking unny. Dear gods, we humans have such short termmemories. We always seem to believe it’s different this time.

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Sell in May and go away? Not so ar this May! Maybe we see a swoon in June? I this market action doesnot make you nervous, then you’re a better man than I am, Gunga Din.

Tis weekend’s Toughts from the Frontline will come to you rom Rome, but it will take us to China, aplace that is even harder to gure than Italy! Have a great rest o the week.

Your wondering how I can lose weight in Italy analyst,

John Mauldin, EditorOutside the Box






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“When Does the Story Break?”

By Ben Hunt, Ph.D.Epsilon TeoryMay 25, 2014

Until an hour be ore the Devil ell, God thought him beauti ul in Heaven.– Arthur Miller, “Te Crucible”

It’s always about timing. I it’s too soon, no one understands. I it’s too late, everyone’s orgotten.– Anna Wintour

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

Beauty, to me, is about being com ortable in your own skin. Tat, or a kick-ass red lipstick.– Gwyneth Paltrow

For, dear me, why abandon a belie Merely because it ceases to be true? Clingto it long enough, and not a doubt It will turn true again, or so it goes. Mosto the change we think we see in li e Is due to truths being in and out o avor.

– Robert Frost, “Te Black Cottage”

Lord I am so tiredHow 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 ashion act o all was the male habit or150 years o wearing wigs. Samuel Pepys, as with so many things, wasin the vanguard, noting with some apprehension the purchase o a wigin 1663 when wigs were not yet common. It was such a novelty that heeared people would laugh at him in church; he was greatly relieved,and a little proud, to nd that they did not. He also worried, notunreasonably, that the hair o wigs might come rom plague victims.Perhaps nothing says more about the power o ashion than that Pepyscontinued wearing wigs even while wondering i they might kill him.

– Bill Bryson, “At Home: A Short History of Private Life”






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Here’s a photograph Margaret Bourke-White took o the Garment District in 1930. Every single person onthe street is wearing a hat. How did HA behavior change over time? How did the common knowledgethat All Men Wear Hats, or wigs or whatever, change? Does it happen all at once? Smoothly over time? Ints and starts? Who or what sparks this sort o change and how do we know? o use a ve dollar phrase,what is the dynamic process that underpins the timing o change in socially-constructed behaviors, whetherthat behavior is in the investing world or the ashion world?

Fortunately or us, game theory provides exactly the right tool kit to unpack socially driven dynamicprocesses. o start this exploration, we need to return to the classic thought experiment o the CommonKnowledge Game – Te Island o the Green-Eyed ribe.

On the Island o the Green-Eyed ribe, blue eyesare taboo. I you have blue eyes you must get inyour canoe and leave the island the next morning.

But there are no mirrors or reective sur aces on

the island, so you don’t know the color o yourown eyes. It is also taboo to talk or otherwisecommunicate with each other about blue eyes,so when you see a ellow tribesman with blueeyes, you say nothing. As a result, even thougheveryone knows there are blue-eyed tribesmen, noone has ever lef the island or this taboo.

A Missionary comes to the island and announcesto everyone, “At least one o you has blue eyes.”

What happens?

Let’s take the trivial case o only one tribesman having blue eyes. He has seen everyone else’s eyes, and heknows that everyone else has green eyes. Immediately afer the Missionary’s statement this poor ellowrealizes, “Oh, no! I must be the one with blue eyes.” So the next morning he gets in his canoe and leaves theisland.

But now let’s take the case o two tribesmen having blue eyes. Te two blue-eyed tribesmen have seeneach other, so each thinks, “Whew! Tat guy has blue eyes, so he must be the one that the Missionary istalking about.” But because neither blue-eyed tribesman believes that he has blue eyes himsel , neither getsin his canoe the next morning and leaves the island. Te next day, then, each is very surprised to see theother ellow still on the island, at which point each thinks, “Wait a second ... i he didn’t leave the island, itmust 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 o the second day, both blue-eyedtribesmen get in their canoes and leave the island.






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I you haven’t observed exactly this sort o dynamic taking place in markets over the past ve years, withnothing, nothing, nothing despite what seems like lots o relevant news, and then – boom! – a big move upor down as i out o nowhere – I just don’t know what to say. And I don’t know a single market participant,no matter how success ul, who’s not bone-tired rom all the mental anguish involved with trying tonavigate these un amiliar waters. Tese punctuated moves don’t come out o nowhere. Tey are part andparcel o the Common Knowledge Game, no more and no less, and understandable as such.

What starts the clock ticking on the “simmering stage” o the Common Knowledge Game? TeMissionary’s public statement that everyone hears, creating the new common knowledge that everyonebelieves that everyone believes. How long does the simmering stage last? Tat depends on a couple oactors. First, as described above, the more game players who are on the wrong side o the new commonknowledge, the longer the game simmers. Second, the dynamic depends critically on the ame or publicacclaim o the Missionary, as well as the power o his or her microphone. A system with a ew dominantMissionaries and only a ew 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 o game-playing depends directly on who is creating the common knowledgeand how that message is amplied by mass media. Fashion changes much more quickly today than in, say,the 1930’s, because the “arbiters o taste” – what I’m calling Missionaries – are ewer, more amous, andhave 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 rom a power ul Missionary to make us questionCentral Bank Omnipotence, to make us question the color o our eyes? No, there hasn’t. Tere are clearlynew CK games being played in subsidiary common knowledge structures – what I call Narratives – butnot in this core Narrative o the Fed’s control over market outcomes. So or example, the market can godown, and more than a little, as the common knowledge around the subsidiary Narrative o Te Fed HasGot Your Back comes undone with a second derivative shif rom easing to tightening. Te Fed itselis the Missionary on this new common knowledge. But the market can’t break so long as the commonknowledge o Central Bank Omnipotence remains intact. So long as everyone knows that everyone knowsthat market outcomes ultimately depend on Fed policy, then the Yellen put is rmly in place. I things getreally bad, then the Fed can save us. We might argue about timing and reaction unctions and the like,but everyone believes that everyone believes that the Fed has this ability. And because it’s such strongcommon knowledge, this ability will never be tested and the market will never break. A nice trick i youcan pull it off, and until a Missionary with the clout o the Fed comes out and challenges this core commonknowledge it’s a ait accompli within the structure of the game. Who has this sort o clout? Only two people– Mario Draghi and Angela Merkel. Tat’s who I watch and who I listen to or any signs o a crack in theOmnipotence Narrative, and so ar .. . nothing. On the contrary, Draghi and Merkel have been totally onboard with the program. We’re all going to be wearing hats or a long time so long as all the investmentarbiters o taste stick with their story.






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Tere is, o course, a y in this glorious ointment, and it’s the single most important difference between thedynamic o ashion markets and nancial markets: political shocks and political dislocations can trumpcommon knowledge and precipitate an economic and market dislocation. Wars and coups and revolutionscertainly inuence ashion, but obviously in a ar less immediate and pervasive manner than theyinuence nancial markets. Te ashion world is an almost purely sel -contained Common KnowledgeGame, and the investment world is not. Where am I looking or a political shock that would be big enoughto challenge the common knowledge that Central Banks are large and in charge, capable o bailing us outno matter what? It’s not the Ukraine. On the contrary, events there are public enough to give Draghi anexcuse to move orward with negative deposit rates or however he intends to implement greater monetarypolicy accommodation, but peripheral enough to any real economic impact so that the ECB’s competenceto manu acture an outcome is not questioned. It’s China. I you don’t think that the territorial tussles withVietnam and Japan matter, i you don’t think that the mutual accusations and arrests o American andChinese citizens matter, i you don’t think that the HUGE natural gas deal between Russia and Chinamatters, i you don’t think that the sea change in Chinese monetary policy matters ... well, you’re just notpaying 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 ew Epsilon Teory notes.

Copyright 2014 John Mauldin. All Rights Reserved.

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