Wondering why your Thanksgiving groceries cost more this year? It’s because greedy corporations are charging Americans extra just to keep their stock prices high. This is outrageous. businessinsider.com/big-companies-…
Inflation and the Common Knowledge Game
Epsilon Theory
December 8, 2021·Money
At whatever point in time you think inflation will start to fade, you are being too optimistic.
US corporations are raising prices, sometimes [gasp!] at a faster rate than their costs are increasing.
As a result, ruling party politicians are losing their minds.
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The highlight for me (or lowlight, I guess) was this Nov. 17 letter from the Biden White House to the Federal Trade Commission, calling for federal regulators to investigate whether oil and gas companies are engaging in "illegal conduct" by increasing their gross profit margin. I am not making this up.
Usually, prices at the pump correspond to movements in the price of unfinished gasoline, which is the main ingredient in the gas people buy at the gas station. But in the last month, the price of unfinished gasoline is down more than 5 percent while gas prices at the pump are up 3 percent in that same period. This unexplained large gap between the price of unfinished gasoline and the average price at the pump is well above the pre-pandemic average. Meanwhile, the largest oil and gas companies in America are generating significant profits off higher energy prices. The two largest oil and gas companies in the United States, as measured by market capitalization, are on track to nearly double their net income over 2019 – the last full year before the pandemic. They have announced plans to engage in billions of dollars of stock buybacks and dividends this year or next.
I do not accept hard-working Americans paying more for gas because of anti-competitive or otherwise potentially illegal conduct.
White House letter to Federal Trade Commission, Nov. 17, 2021
I, for one, welcome MiniPlenty's forthcoming diktat on acceptable crack spreads. LOL.
So look, this is ridiculous stuff, almost as ridiculous as "temporarily" releasing 50 million barrels of oil from the Strategic Petroleum Reserves. But I get it. If I were an incumbent ruling party politician I'd be pretty miffed, too.
The US government has not just allowed but directed a dozen years of the most accommodating monetary policy conditions in literally the history of mankind, with a cost of capital that is effectively zero for large corporations.
The US government has not just allowed but directed the creation of a multi-trillion dollar infinity-pool of liquidity to prop up any hiccup in asset prices.
The US government has not just allowed but directed one of the largest transfers of wealth - again, literally in the history of mankind - to the managerial class.
One day we will recognize all of this as the defining Zeitgeist of the Obama/Trump years. One day. But not today.
And now you guys are raising prices more than your costs are going up? After all we've done for you? Seriously?
Like I say, I'd be miffed, too. Something, something, face-ripping leopards.
But this isn't collusion or price fixing or "anti-competitive conduct" or any of the usual high-functioning sociopathic behaviors we've come to know and love from our titans of financialization industry. I mean, yes of course the vast majority of Chairman/CEOs (and ruling party politicians) are high-functioning sociopaths, but that's not the determining factor here.
Why are US companies raising prices in unison?
Because it's rational behavior in the Common Knowledge Game.
We’ve written about the Common Knowledge Game a lot, starting in the original “Manifesto”. Honestly, once you start looking for the Common Knowledge Game, you will see it everywhere.
Common knowledge is something that we all believe everyone else believes.
The classic example of the Common Knowledge Game is the fable of The Emperor’s New Clothes. Everyone in the crowd possesses the same private information — the Emperor is walking around as naked as a jaybird. But no one’s behavior changes just because the private information is ubiquitous. Nor would behavior change just because a couple of people whisper their doubts to each other, creating pockets of public knowledge that the Emperor is naked. No, the only thing that changes behavior is when the little girl (what game theory would call a Missionary) announces the Emperor’s nudity loudly enough so that the entire crowd believes that everyone else in the crowd heard the news. That’s when behavior changes. That's when behavior changes FAST.
For months now, Missionaries large and small have been saying that inflation is here and inflation is well-embedded. But when the most powerful Missionary in the world, Jay Powell, says that inflation is no longer “transitory” … well, now everyone knows that everyone knows that inflation is here to stay.
And when everyone knows that everyone knows that inflation is here to stay, ALL businesses can raise prices to maintain margins without fear of competitive pressure or customer pushback.
Narrative dynamics rule our world. Not fundamentals, whatever that means, but narrative dynamics. One on top of another. Endlessly. Recursively. It's narrative dynamics all the way down. And the number one engine of narrative dynamics is the Common Knowledge Game. Understand that and you'll understand the game of markets and politics and every other social interaction of crowds.
I wrote this almost exactly three years ago.
You don’t have to change your investment playbook for a Fed-created recession, a China-created credit freeze, or an Italy-created Euro crisis. You already know the deflationary playbook. It’s what you’ve been doing (or should have been doing) for the past ten years. Just keep doing THAT.
But if we enter an inflationary world, something that very few investors alive today have EVER experienced … well, everything you’ve been doing for the past ten years will be a mess. Your prayers to the great god of diversification, at least as that god is manifested today as the Holy Long Bond, will go unanswered. Your embrace of the cult of Vanguard, at least as that cult is expressed today as the worship of passive index funds, will give you pain rather than comfort. The very language that you use today to speak with other investors about core abstractions like Value and Growth will turn into gobbledygook.
Today’s common knowledge rejects this Fourth Horseman of inflationary regime change. But, but … demographics!, you hear. Don’t you understand that Demographics is Destiny™, that we are getting older and having fewer children, dooming us to the long gray slog? But, but … technology!, you hear. Don’t you understand that robots and AI are going to replace all us mere humans, creating a world where our bread and circuses just get cheaper and cheaper? Yeah, I understand. I hear these narratives and memes, too.
But that’s my point. We believe that we are in a deflationary world because we are TOLD that we are in a deflationary world. That’s the common knowledge. Everyone knows that everyone knows that inflation is dead and gone, that it’s a long gray slog going forward, forever and ever amen.
It’s hard to imagine when you’re immersed in it, but common knowledge can change.
That includes common knowledge of the fundamental inflationary/deflationary nature of our world.
I think it’s happening. I could be wrong. But that’s what I’m trying to imagine.
The common knowledge of whether we are in an inflationary or deflationary world has now shifted. It will not shift back for years and years, because common knowledge is a stable, self-reinforcing phenomenon. Common knowledge is a barge, not a speed boat. Common knowledge is incredibly difficult to stop, much less turn around, but once it starts going the other way it will keep going.
At whatever point in time you think inflation will start to fade, you are being too optimistic.
Why? Because common knowledge. And here's the kicker:
An inflationary world will cause enormous political and economic pain, but that pain will be different from the pain of a deflationary world.
This is the challenge of our economic lives for the next decade or more. How do we make sense of the differentness of an inflationary world? Will we have the imagination to conceive of the repercussions of that differentness and come up with the personal actions and social policies to address that differentness?
And will we have the courage to act.
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“the only thing that changes behavior is when the little girl (what game theory would call a Missionary) announces the Emperor’s nudity loudly enough so that the entire crowd believes that everyone else in the crowd heard the news. That’s when behavior changes. That’s when behavior changes FAST.”
Smacked me right between the eyes.
Thanks, Ben.
I’ll repost this from elsewhere but I’ll tweak it for this topic.
Here’s how this works, and it’s pretty obvious to anyone paying attention:
The playbook is pretty standard and frankly it bores me that nobody has come up with anything more clever than this.
I was born in the early 80s, so as Ben implies I have no experience with inflation. Does anyone have a good read on exactly what the inflation playbook or common knowledge to protect oneself from inflation was the last time it happened in the 1970s?
I did read John T Reed’s Protect Your Life Savings From Hyperinflation and Depression. Reed was a real estate investor in the 1970s and has done a lot of research on other inflationary periods throughout history. Reed has obvious political biases and he needs a good editor, but I basically learned 2 things about inflationary times from this book:
The value of bonds will usually decrease. The value of stocks, surprisingly to me, will be variable. Sometimes they go up in inflationary times, sometimes down.
The best way to protect myself and my family from ruin during inflation (and depression!) is to own everything we will ever need, today, or the means to produce it, as much as possible. Of course, this can be a very expensive strategy. Reed writes about how his father’s family owned a farm in West Virginia during the Great Depression and their life pretty much went on as usual since they were self-sufficient. But it was a hard life and Reed’s father hated it, moving to the city and eventually becoming an alcoholic.
Do we agree that this was the common knowledge of the 1970s? Or is Reed’s perspective an outlier?
I am also curious for Ben or someone else to unpack this quote specifically in the context of inflationary times:
I am no longer a big fan of index funds (“but compared to what?”). But naively, I would think that owning index funds is riskier in deflationary times than inflationary. Since in deflationary times you know everything is correlated to move down together, no?
I’ve read Powell’s speech from last week 3 or 4 times. Partly, because of the change in the way he talked about pandemic now contributing to inflation vs. deflationary in the past. Conveniently, now everyone this week believes omicron is weaker and the pandemic is effectively over, so supply chains will normalize in 2022.
That has and continues to seem “too easy”, but I guess the next pivot point is trying to predict when everyone figures out we “are being too optimistic”.
For some reason, all I can think about is Goldman reiterating Dalio for 2022, saying “Cash is trash”.
Don’t have a view on John T Reed, @jrs , but I’ll try to unpack that quote about passive index funds.
The basic idea here is that a) there’s not a Fed-supplied liquidity tide lifting all equity boats in a tightening cycle, and b) as we’re seeing in the tech sector today, there are a lot of losers and not just all-winners when the narrative barge changes course and starts moving in the other direction. Specifically, I think we’re looking at a prolonged period of multiple contraction for “story stocks”, which will hit the largest S&P 500 sector weighting - tech - the hardest.
Bottom line - I think that there’s ‘space’ for stock-picking to work again as these tectonic plate narrative regimes shift, which is (relatively) bad for passive index funds and particularly bad as you’ll see real assets (as opposed to financial assets like an index fund) go up more sharply and with a big drum-beating narrative.
I think I understand. So your quote is contingent on (a) the Fed raising rates (etc) rather than letting the party continue. And your (b) boils down to that old quote about swimming naked when the tide goes out. So you’re not speaking of inflation in isolation, but rather as coupled to the government’s likely response to it.
The Boglehead narrative is that active stock-picking does not work and has never worked. And to the extent that it does work, it is ultimately due to insider information in one way or another. The narrative is that multiple papers have been published showing eventual reversion to the mean for most or all active strategies studied, meaning the pickers just got lucky.
That part of the narrative still rings true to me, although maybe it’s just a crutch for my own financial ignorance and laziness. (And if so, then I am one of millions of doctors and other non-financial professionals who are so fooled. And our Missionaries like Jim Dahle and William Bernstein are similarly fooled.)
So, to perhaps unfairly frame this in the Boglehead way: Are you aware of any study or other evidence showing that any active strategy consistently made money, +/- before our current water became a thing?
(Now that I write it out like this, I see that this question may be impossible to answer rigorously, as it seems common knowledge among active investors that soft insider information was much easier to get before the 1990s or so.)
Can I suggest a different avenue of inquisition to arrive at an understanding of how the Water may be changing?
Personally, I am very interested in the idea that the game is not shifting between “active” and “passive” but between content and system. In other words, that what is happening is not really about the content in the system (the securities themselves) and strategies on how to play them, but about structural changes to the system itself; changes that are redefining the game.
For example, Bogle argues that above a certain level of indexing the system equilibrium breaks down. I’ve seen estimates that it happens around 80% active. We are currently around 40% or so which suggests we are halfway there. If this view is correct, at what point in the run from 0-80% does the disequilibrium start to make itself felt? Is it linear decay? Exponential decay? Etc?
And more interestingly, if the disequilibrium in the system pushes the market into a one-sided NGU regime - I wonder what happens to “reversion to the mean”? And if that breaks down - what happens to most of our conventional financial theory?
Anyway - hopefully this helps you think differently about markets in a constructive way.
Great book to read as an investor. Not being a polyanna here btw, just being a shrewd clear eyes full hearts guy.
It appears the “common knowledge” regarding inflation, has also made it to the White House. In my opinion, really stupid to try and get in front of this number with a presidential speech.
LOL. Completely agree, @Carl_Richards . I guess the print tomorrow is REALLY bad!
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