Market Watch

Money Moves While Fools Dance

A degree in Behavioral Studies like many other Sociology programs is often times tailored toward addiction, family dynamics, and general mental health. Surprisingly to some, I found it most fascinating the relevance social behavior has in economics.  It may just be the most important of all studies with which to dissect markets, trends, and exchange. It is after all supposedly the willing  interaction between two or more entities to exchange goods and services (in a real free market).  Demand is a funny thing though. It’s relevance is in the eye of the beholder which is subject to whims and social trends. More importantly, the question “What has Value?” has social inputs. Those inputs can be influenced and controlled. A good article on hedge talks some about this…

Game theory is a bridge between hot-blooded social languages like dancing and cold-blooded formal languages like mathematics. Game theory is an abstraction of dynamic social interactions. Because it’s an abstraction, game theory usefully adopts some of the formal grammar of mathematics, which remains the most efficient way to represent theory regardless of what the theory is about. But game theory has no meaning or usefulness outside of a social setting. Like the tango, game theory takes two. Also like the tango, game theory is all about movement, the fluid movement of separate individuals who are bound up with each other in a system of mutual expectations and individual goals. Put it all together and game theory uses some basic mathematical concepts to organize our thinking about dynamic and strategic behaviors that have their origins in our social animal brains and Murdock’s List. It’s a powerful tool kit.

Some people have an intuitive ability to “speak” game theory fluently. These are geniuses like Dick Clark who can translate between the language of the social animal and the language of the self-aware brain effortlessly, and make an enormous fortune in the process. Clark recognized the trends, nuances, and idioms of popular culture just as surely as he recognized the economic formulas behind radio and television syndication. Was he a brilliant artist? Nope. Couldn’t dance, sing, or act. But he spoke the language of performers and somehow figured out how to communicate that primal grammar to Middle America in a way that felt “safe”. It seems weird today, as we are immersed in a popular culture of youth, but “youth culture” (a phrase coined by Paul Anka in reference to Dick Clark) didn’t exist before American Bandstand. As much as anyone over the past 50 years, from the Beatles to Elvis Presley to any performer you want to name … Dick Clark was responsible for the modern landscape of how the languages of music and dance are communicated in a commercially lucrative fashion. His secret (other than a bizarrely youthful face)? Clark understood the Common  Knowledge Game.

Clark didn’t poll America to determine their taste in music. He told them their taste in music … not directly, but by creating common knowledge — ideas that a crowd believes that the crowd believes. With the American Bandstand group dance staging and scripted questions, Clark allowed the TV audience to see a crowd of attractive young people act as if the music were popular. This is all it takes.Clark didn’t have to force his preferred choice of popular culture on his audience like some centrally-planned Ministry of Culture. The TV audience chose it all on their own, thinking all along it was their choice! This is the power of the Emperor’s New Clothes. This is the power of the sitcom laugh track and the live studio audience. This is the power of public coronations and executions. This is the power of Tahrir Square and Tiananmen Square. This is the power of the crowd seeing the crowd, and it is the most potent force in the social world.

It’s certainly the most potent force in the social world of markets, and every Central Banker today is playing the Common Knowledge Game just as hard as Dick Clark ever did.

How? How is this relevant to markets and central banks? If you have even remotely taken a look at the Federal Reserve’s attempt to be more “transparent” you will see what really is transpiring here. Is it openness or another social input?

How is this the Common Knowledge Game? Since August 2012 we have watched the markets dance to Draghi’s tune. If you don’t know by now that Draghi’s words move the market crowd, then you’re an idiot. But you’re not an idiot. And neither is any one of the hundreds of thousands of people reading the WSJ headline. And neither is Draghi. We are told by the WSJ that Draghi’s words today have a good beat and you can dance to it. So we do. We dance, just like we’ve been trained to do by watching this show 30 times before.

As a result, Italy and Spain’s equity and credit markets outperformed Germany’s by a mile after Draghi’s signal … which was exactly the intended effect(Spain is now borrowing money at the cheapest rate in the euro era!) and exactly why it is so difficult to be a macro Value investor today. All of your fundamental indicators that show (correctly) that Italy and Spain are ridiculously overvalued at current prices relative to, say, Germany don’t matter in the least. Or rather, they matter, but they evaporate like dew when the Draghi sun shines at a press conference.

Of course, this sort of challenge to the Narrative of Central Bank Omnipotence could not go unaddressed, and sure enough by 7 pm last Friday you had a WSJ article by none other than Jon Hilsenrath, the Common Knowledge spokesman for the Fed, titled “Fed Unlikely to Alter Course After Jobs Report.” Over the weekend and on Monday you had at least three Fed Governors come out with similar statements, that there was no confusion or complication imposed by the jobs report. Nothing to see here folks, move along. None of these Powers That Be are taking issue with whether or not the Friday jobs report was bad news … the only thing that matters is how this news impacts the common knowledge structure that generates their power to control market outcomes. That’s the threat that must be squelched. This is what Bernanke meant when he talked about using communications as a policy tool, and this is what Yellen (and Draghi and Abe and everyone else in the club) will continue to do … use public statements to play the Common Knowledge Game and drive market outcomes by proxy.

I can sleep well at night if you get nothing else out of Epsilon Theory beyond the recognition that a) you are being played, and b) there are rules and logic to how you are being played. But I’d also like to demonstrate that c) it’s entirely rational to play along (to a point), and d) you can be a player, too.

It can be entirely rational to act as if the Emperor is wearing a beautiful set of clothes. In fact, when you’re caught in a Common Knowledge Game others will look at you askance if you act publicly according to the evidence of your own eyes rather than the evidence of the crowd watching the crowd. But you need to recognize that’s what you’re doing. It’s critically important to avoid internalizing your behavior, falling into what Kant called a “dogmatic slumber”, believing in your heart of hearts that the Emperor truly looks marvelous.

The moment you give yourself over to the Dick Clarks of the world who create common knowledge, the moment you abdicate your keenly evolved human abilities of self-awareness and other-evaluation … that’s the moment you put yourself at the most risk. Because the game will change. Even if the external conditions of the world today are exactly the same as the external conditions of the world yesterday, a change in the internal conditions of the other game-players, whether it’s a queen bee like Draghi or a set of worker bees like us, can change your best move.

Game theory is all about playing the player, not the cards. That’s not a replacement for understanding the fundamentals and the math of drawing this card or that, but it sure is a complementary skill set. If you want to win.

You see demand is perception. With enough inputs and  influence perception can change and be controlled. So let the rest of the muppets dance while you watch the “real” market. Focus on fundamentals and let markets play their games. Follow the money. You may not have the resources but you can probably guess who does. What are they doing with their money? Our parents were wrong, don’t do as they say do as they do. Here, lets see if the big wigs think the market is bullish. Remember its not what they tell their customers but what they do for themselves…..

But Dimon’s pay day is even more outrageous than first considered. That’s because Dimon wasn’t awarded stock options or a riskier stock bonus called stock appreciation rights, or SARs. Instead, he was granted nothing but restricted stock. It was the first time in 10 years J.P. Morgan JPM -1.44%   didn’t award stock options or SARs.

By their nature, stock options and SARs require a company’s stock performance to eitherincrease or hold value for the bonuses to be worth significant amounts. The downside, however, is much greater too. Restricted stock is less likely to lose value. It’s a less-risky bet.

So, why does this matter? The decision to pay Dimon entirely in restricted stock suggests that expectations at the bank are that the stock’s best days could be behind it, according to John Olagues, who not only brought this to my attention, but did some analysis on just how significant this switch in stock grants is.

By way of example, a top executive could receive either employee stock options worth $6 million on 400,000 shares (the ESOs are worth 30% of stock price at the time of the grant using a Black-Scholes model, according to Olagues) or $6 million via 125,000 in restricted stock. The stock is trading at $50 at the time of the grant. Three years later, here are Olagues’ scenarios:

Assume the stock price is unchanged: This makes the ESOs worth about $4.5 million and the restricted stock worth about $6 million. Assume the stock is down 10% and trading at $45. This makes the ESOs worth about $3.2 million with the restricted stock equal to about $5.4 million. Assume that the stock is down 25% and trading at $37.50. This makes the ESOs worth about $1.7 million with the restricted stock worth about $4.5 million.

And while we’ve singled out Dimon, he’s not the only executive to suddenly shift strategies. As Olagues notes, Morgan Stanley MS -0.43%   announced Jan. 23 that CEO James Gorman received 155,207 restricted shares worth about $5 million at grant. Last year Gorman was granted about 440,000 stock options valued at $3.3 million.

Nor is this shift limited to Wall Street. Again, Olagues found that Target Corp. TGT +0.37% handed out stock options to top executives on the second Wednesday of January for the last 10 years. This year the company didn’t hand out any on Jan. 8, just small amounts of restricted stock.

Likewise, Intel Corp. INTC +0.02%  handed out restricted stock according to a filing made yesterday.

Full article HERE . Its seems the big chiefs don’t think to highly about the next few quarters. Doesn’t matter, they have made their dollars anyways.