Epsilon Theory

Today’s markets require an investment approach viewed through the lenses of history, game theory and market structure, detailed in Salient chief investment strategist Dr. Ben Hunt’s acclaimed Epsilon Theory newsletter.

Author: W. Ben Hunt, Ph.D.
Date: February 7, 2017
Category: Game Theory
Tags: Axelrod, Chicken, cooperate, defect, Prisoner’s Dilemma, Team Elite, Trump

The Trump presidency is breaking us. Not because of the specifics of his policies or whether they’re right or wrong or anything like that. It’s breaking us because we now routinely talk past or yell at our friends, family, and fellow citizens, despite vast common ground on the really big ideas of what it means to be Americans or, more fundamentally still, a good human being. Game theory can’t solve this growing discordance or reverse the evolution of competition, but it can identify the issue and maybe, just maybe, show us ways to mitigate the damage.

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Fiat Money, Fiat News

Author: W. Ben Hunt, Ph.D.
Date: January 4, 2017
Category: Big Data, Narrative
Tags: Anchorman, counterfeit, cow bell, Facebook, fake news, fiat, Greshams Law, Kurosawa, Russia, wolf trap

The history of money provides instructive lessons for the dominant social issue of the past few months: fake news. There’s an important distinction to be made between politically slanted news, like when the Washington Post writes a silly article about Russians hacking the U.S. electric grid, and outright fakery. The former is fiat news, which is to “real news” what fiat currencies like dollars and euros and yen are to “real money” like a gold coin. Fake news is something different. Fake news is counterfeit news, which is to fiat news what counterfeit bank notes are to fiat currencies. The fiat news business is booming. As a result, the counterfeit news business is booming, too. And if the history of fiat money and counterfeit money is any guide, we ain’t seen nothing yet.

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The Art of the Probe

Author: W. Ben Hunt, Ph.D.
Date: December 8, 2016
Category: Adaptive Investing, Game Theory
Tags: active management, Ann-Margret, blockades, chess, Cincinnati Kid, Common Knowledge Game, ECB, General Giap, information, Khrushchev, poker, Probing Bet

epsilon-theory-the-art-of-the-probe-december-8-2016-cincinnati-kidI’ve written a lot about The Common Knowledge Game – here, here, and here – because it’s the game of markets, i.e., it’s the central contribution of game theory to understanding how markets work. I’ve also written a lot about new technologies and new perspectives – here, here, and here – that help us see The Common Knowledge Game in action. But until today I’ve never written on a basic question: how can you be a better player in the game of markets? This is my first cut at an answer, and along the way I’ll pull examples from the game of poker and the game of nations. I think it’s a fun paper and hope you find it useful.

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American Hustle

Author: W. Ben Hunt, Ph.D.
Date: November 17, 2016
Category: Big Data, Narrative, US Politics
Tags: earthquake machine, Jay Cutler, Lady Gaga, Narrative Machine, Ocean's 11, oil, Otto, political culture, Steve Bannon, the Borg, Trading Places, Trump

epsilon-theory-american-hustle-november-17-2016-the-stingThree questions to answer today: what did the Narrative Machine tell us about the market immediately before and immediately after the November 8 election, what am I preparing for now as an investor, and what am I preparing for now as a citizen? I’m giddy about the first, quietly confident about the second, and pretty darn depressed about the third. Could be worse, I suppose.

  1. The Narrative Machine gave clear, actionable, and non-consensus signals prior to the U.S. election last week.
  2. Yes, the Trump reform and infrastructure Growth Narrative is a tailwind for stocks and a headwind for bonds for the next four years. And yes, the overwhelmingly negative constraints that massive global debt places on global growth is still a headwind for stocks and a tailwind for bonds for the next four years.
  3. Trump breaks our political culture. Politics is no longer a “marketplace of ideas” when you think the other side is comprised of bad guys. Politics becomes a zero-sum Competitive Game of self-defense, which means that anything — anything! — goes.
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You Had One Job

Author: W. Ben Hunt, Ph.D.
Date: November 3, 2016
Category: Adaptive Investing
Tags: Bayesian, diversification, dogs, empathy, Faulkner, Karnak, Marsellus, portfolio, Pulp Fiction, rabbi, Schumpeter, talent

salient-epsilon-theory-ben-hunt-you-had-one-job-november-4-2016-goGood dog trainers will tell you: every dog needs a job. It’s true for the pack, and it’s true for the portfolio. Every investment should accomplish a specific job in a portfolio, such that diversification emerges from the combination. But in the same way that it’s a common mistake to get a dog for the life you wish you led rather than the life you actually lead, so is it a common mistake to make an investment for the portfolio you wish you had rather than the portfolio you actually have. This is particularly true with alternative investments, which is why they don’t FEEL satisfying to most investors, even if the performance is okay.

A better way to think about portfolio construction? Step One: write down the macro scenarios your portfolio needs to confront successfully. Step Two: figure out the jobs your investments need to accomplish by immersing yourself in the stories of investors who confronted these scenarios in the past. Step Three: evaluate your managers for clarity in knowing their job and for a demonstrable process in achieving it.

The protection of the pack has been the human animal’s source of strength, in both fact and spirit, for a couple of hundred thousand years now. I think we’re going to need it over the next few years, too.

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Author: W. Ben Hunt, Ph.D.
Date: October 14, 2016
Category: Adaptive Investing, US Politics
Tags: Alien, Alienation, anthem, Ayn Rand, bubble, James Baldwin, Marx, Oswald, reset, Rhett Butler, Slacker, videogame

salient-epsilon-theory-ben-hunt-anthem-october-14-2016-time-thumbThere were anthems associated with the Dot-com Bubble and the Housing Bubble, anthems of a fundamental change in the real economy that brought all of us along for the ride, anthems that fit the political culture of the United States. Over the last six years, all we’ve heard is a statist, top-down, European-ish, tinny song of Central Bank Omnipotence that doesn’t fit the political culture of the United States, and that’s why the Central Banker Bubble is the most hated and mistrusted bull market in history.

It’s too late for a reset in this misbegotten election, but a reset — both in markets and in politics — is coming whether we like it or not. We can either prepare for the reset … we can shape the reset as best we can … or we can let the reset shape us.

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Virtue Signaling, or … Why Clinton is in Trouble

Author: W. Ben Hunt, Ph.D.
Date: September 29, 2016
Category: Game Theory, US Politics

salient-epsilon-theory-ben-hunt-virtue-signaling-september-30-2016-cutlerThe US election now looks to be neck-and-neck, pointing out a structural weakness in the Clinton campaign. I see virtue signaling galore among her supporters, communications to the Democratic tribe that you’re a good person because you’re against Trump, never mind whether or not that helps the campaign. The stakes are high, as Trump threatens to transform every game we play as a country – from our domestic social games to our international security games – from a Coordination Game to a Competition Game.

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Essence of Decision

Author: W. Ben Hunt, Ph.D.
Date: September 16, 2016
Category: Monetary Policy, Narrative
Tags: bureaucracy, Cuban Missile Crisis, Fed, Gatsby, Hilsenrath, missionaries, monetary policy, narrative, politics, Quid, reputation, Summers, Yellen

salient-epsilon-theory-ben-hunt-essence-of-decision-september-16-2016-great-gatsby-thumbAny big policy decision — whether it’s to order a naval blockade or an air strike on Cuba, or whether it’s to raise interest rates in September or December or not at all — is a combination of three perspectives: a high-level, rational expectations model, bureaucratic imperatives, and institutional politics. Unfortunately, we spend way too much time focused on the first of these and way too little on the other two, even though the latter two are far more influential on how real-world people make real-world decisions. Here’s my analysis of the Fed’s forthcoming decision on interest rates from a bureaucratic and an internal politics perspective. Seen through these lenses, I think they hike. Maybe I’m wrong. These things are always probabilistic shades of gray, never black and white. But what I’m certain about is that the bureaucratic and internal politics perspectives give a different, higher probability of hiking than the rational expectations/modeling perspective. So heads up.

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The forward-looking statements and other views expressed herein are as of the date of this publication. Actual future results or occurrences may differ significantly from those anticipated in any forward-looking statements, and there is no guarantee that any predictions will come to pass. The views expressed herein are subject to change at any time, due to numerous market and other factors. Salient disclaims any obligation to update publicly or revise any forward-looking statements or views expressed herein.

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