The Narrative is Reality

The Narrative is Reality
February 12, 2015

“I have come to believe that the whole world is an enigma, a harmless enigma that is made terrible by our own mad attempt to interpret it as though it had an underlying truth.”
― Umberto Eco, Foucault’s Pendulum

Back in the days when I still thought markets were driven by fundamentals I used to be a big fan of Don Coxe’s monthly commentaries. Don was at the epicenter of the commodity / BRIC narrative, and his commentaries were dense with historical context, pithy quotes, and compelling analysis. He was the progenitor of the concept of a ‘triple waterfall crash’, of which the prolonged bear market in Japanese equities was the prototype. He also coined the rule that investors should focus on areas of the market where, “those who know it best, love it least, because they’ve been disappointed most”. For him, this was the dominant driver of the commodity trade, as long-time CEOs of major mining and energy companies would be slow to bring on new production in the face of high current prices, because they would be terrified that the next secular bear market for those commodities would be just around the corner.

For me in the mid-naughts, Don was the “Guardian of the Trend”. And I was a full-on, card carrying member of this cult.

Secular Cults

In secular (that is, non-religious) cults, confidence in the narrative is fuelled primarily by “Confirmation Bias” and the “Illusion of Knowledge”. In other words, people search out as many facts as possible to support their narrative, and believe that more information increases the accuracy of their forecasts. To wit, I became an expert in fields that supported my world view.

I could quote all the relevant stats on Saudi’s oil fields and why we shouldn’t believe them. I knew the NPV of the major Canadian oil-sands companies based on reserves in the ground at a range of long-term oil price forecasts. I tracked the relative cost curve for on-shore vs. deep water drilling, as well as the lease prices for different classes of exploration and production platforms. I watched the crack spread and the term structure of crude futures. I watched Saudi CDS as a leading indicator of oil price movements. I read Dennis Gartman.

In addition, I knew the relative global reserves of potassium and phosphorus and the largest and lowest cost producers. I could cite all manner of statistics on global demographics, and the likely increase in meat consumption due to the rise of the emerging middle class, and implications for corn and oat prices. I watched Caterpillar, Joy Global, and Manitowoc stocks and listened to management calls about the state of construction and mine development in emerging economies. I understood the difference between laterite and magmatic sulphide nickel deposits, and their relative cost structure.

But those are just facts, and facts only serve to support the narrative; they have no power in themselves. The narrative is based on faith, and all new information is filtered through the prism of that faith. Faith in peak oil. Faith in China’s emerging middle class need for meat and infrastructure. Faith in scarcity. Faith in monetary profligacy and the inevitability of inflation. Faith, faith, faith!

Ghosts of Bubbles Past and Present

In each cycle, there are a handful of pied pipers diligently manning required posts as “Guardians of the Trend”, assuring us that the narrative is reality. In the “Greed is Good” era of the 1980s, the narrative was fed by such characters as Martin Zweig,  Michael Milken, and Ivan Boesky, with the fictional “Gordon Gekko” as the archetype.

In the technology bubble the ‘animal spirits’ were lifted by such characters as Henry Blodgett, Mary Meeker, Jack Grumman, and Frank Quattrone. During the emerging markets / commodity bubble the narrative was led by Jim O’Neil (who coined the term BRICs), Jim Rogers, Marc Faber, Peter Schiff, T. Boone Pickens, and Eric Sprott. The coincident housing bubble narrative was fostered by Louis Cavalier, Abby Joseph Cohen, and others.

The new new new narrative of central bank omnipotence has its own cast of “Guardians”. The leading cast members are Paul Krugman, Ben Bernanke, Janet Yellen, Shinzo Abe, Mario Draghi, and perhaps Mark Carney. David Tepper and his ilk are zealous acolytes. The members of the ‘passive posse’ (you know who you are) also play supporting roles by overwhelming protests of ‘asset inflation’, ‘expensive markets’ or ‘low future returns’ with chants of ‘efficient markets, efficient markets, efficient markets’. Paul Samuelson, who stated that markets are “micro efficient” but “macro inefficient” is rolling over in his grave.

Or maybe the current narrative really is ‘the truth’, and the market’s tree really can grow to the sky. I no longer care either way.

Breaking the Spell

“One might be led to suspect that there were all sorts of things going on in the Universe which he or she did not thoroughly understand.”
― Kurt Vonnegut, Slaughterhouse-Five

The collapse of the emerging markets / commodity bubble was an intensely traumatic experience, and left a gaping vacuum in my understanding about how the world works. If I knew as much as I did about the markets I was involved with, and the gurus I followed knew as much as they knew, and everyone got the trade completely wrong in the end, what did that mean? I can now empathize (abstractly) with members of doomsday cults who forecast a ‘rapture’ which never arrives.

The months immediately following the Global Financial Crisis were some of the most challenging of my life. I had linked my value as an investment professional to my ability to predict markets based on superior knowledge and understanding. But  my superior knowledge and understanding had not translated into better forecasting ability or investment performance. Therefore I had no value as an investment professional. Should I seek out a different career?

But no one I followed – in fact, no one I’d heard of – had been able to do any better. Sure, there were a few ‘gurus’ who nailed the bear market, and a much smaller number that nailed both the bear and the bounce. But their narratives and methods were inscrutable and unconvincing. And as the bull market matured, even these gurus quickly lost their prescience. Which way do you move when you have no direction?

Tetlock’s Gift

It was during this period of existential crisis in 2009 that I stumbled upon Philip Tetlock. Of course, this was only partly by accident. At any other previous point in my life I would have tripped over Tetlock, picked myself up and walked on as if nothing had happened. But at that particular time I was an empty vessel, waiting to be filled with a new understanding of the world. I was ready to receive.

For those who haven’t heard of Philip Tetlock, and who may be ready to embrace the terrifying (but liberating!) reality that he has validated with his decades long research, I encourage you to read this article, and watch this video.

In 1985 Tetlock, fascinated by his previous experience serving on political intelligence committees in the early 1980s, set out to discover just how accurate expert forecasters were in their predictions of future events. Over a span of almost 20 years, he interviewed 284 experts about their level of confidence that a certain outcome would come to pass. Forecasts were solicited across a wide variety of domains, including economics, politics, climate, military strategy, financial markets, legal opinions, and other complex domains with uncertain outcomes. In all, Tetlock accumulated an astounding 82,000 forecasts.

This represents an incredible body of evidence about expert judgment, and Tetlock’s analysis rendered several astounding conclusions:

  • Expert forecasts were less well calibrated than one would expect from random guesses
  • Aggregated forecasts were better than any individual forecasts, but were still worse than random guesses
  • Experts who appeared in the media most regularly were the least accurate
  • Experts with the most extreme views were also the least accurate
  • Experts exhibited higher forecast calibration outside of their field of expertise
  • Among all 284 experts, not one demonstrated forecast accuracy beyond random guesses
In short, experts would have delivered better forecasts by flipping coins. But there was a silver lining.
Tetlock also tracked some simple, rules based statistical models alongside the experts to see if these models would be competitive in terms of forecast calibration. He found that many simple models performed with substantially better calibration than the experts, and delivered accuracy well beyond random chance. For example, models that forecast that the next period would continue the recent trend worked well. Models that forecast a return to a long-term mean also performed well. Chock one up for systematic momentum and value investors.
In any event, you may not be in a cognitive/emotional state where the facts presented above can be assimilated into your worldview. If you are a research analyst that is paid to make predictions about whether to buy or sell a stock at the current price, or an economist who is paid to forecast interest rates or oil prices, then these facts undermine your ability to make a living. Few people can operate for long with this level of cognitive dissonance, so you will necessarily ignore these conclusions.
Many readers are in a self congratulatory mood since their ‘long and strong’ equity bets have paid off so handsomely over the past five years or so. Self attribution bias prevents these readers from understanding that their success is due to luck, not skill. As such, they probably are not ready to receive Tetlock’s wisdom either. These readers may regret their hubris in the depths of the next crisis, when they are 25% to 50% poorer. C’est la vie.
If however, like me in 2009, you are disenfranchised with the analysts on TV, and in the newspaper, and at your firm, opining ad nauseum on topics they can’t possibly forecast, and with no accountability, then Tetlock’s wisdom might just be the right medicine at the right time. Who knows, perhaps five or six years down the road, you may find that you’ve reconstructed yourself in many delightfully unexpected ways, and produced some pretty neat new ideas based on concepts that actually work.
Of course, the market narrative exists whether you pay attention to it or not. But when you embrace the great unknown, you’re able to disengage and observe the mania for what it is: the Jungian collective unconscious acting to manifest its own destiny. It’s a movie playing out in real time in front of your eyes, with all the humour and drama and, eventually, tragedy that makes any great movie worth watching. And just as any faith requires sacrifice, most of these participants sacrifice a meaningful slice of their savings in order to avoid the physical pain of social exclusion.  As such this drama, which is no more or less than the moment to moment expressions of faith by millions of market participants, fed by oscillating tantrums of greed and fear filtered through a grimy prism of amorphous identity and values, presents incredible opportunities for the enlightened few.
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