THINK LIKE A CHESS PLAYER
Great chess players think many moves ahead of their opponent. The only way to get an edge in chess is to break down the many possible future scenarios and always remain one step ahead of where your opponent is planning to move next. The market is no different, but most people don’t think like a chess player. They think like a Twitter user (what have you done for me lately). But the market isn’t a 140 character snippet of the here and now. The market is a chess board whose players are always thinking dozens of moves ahead of you. To succeed in the markets (regardless of your approach, long-term or short-term) you have to be able to think like a chess player.
A good example of this is the current market. Greece seems to be the only headline out there. All anyone can think of is how Greece is going to be the next Lehman Brothers. And the market has positioned for this event with a 8% decline in recent weeks. But the key to winning this game is in understanding the potential future outcomes of a worst case scenario like Greece. Most investors are just assuming it will be a disaster. Which it will be if there is no policy response. But if there’s one thing we can rely on from politicians who hate seeing their net worth decline it’s that they’ll respond. So the key to this market is gauging the political response in case of a Greek default. What will European leaders do? As I said on Twitter earlier today, the thing to fear is not a Greek default, but the response. Will politicians respond with a bazooka like Eurobonds? Or will they respond with nothing? Obviously, nothing would be a total disaster. But my guess is they’re assessing precisely how this sort of event will unfold and spread and they’re looking to ring fence and contain the effects. Will they succeed? Who knows.
What I do know is that over the last 4 years the investors who didn’t understand the next big policy and its effects were the players who got steamrolled by the Fed, ECB and other entities parading down Wall Street firing their various tools into the hearts of traders. This environment is no different. Personally, I’d be shocked if they let Greece default and defect without unveiling a bazooka. So to me, the key isn’t obsessing over the Greek default. The key is obsessing over the response. Thinking beyond today’s headlines to what the NEXT headline will be. Will it be:
“European leaders let Greece default, no policy response leads to market collapse”?
Or will it be:
“Greece defaults, European leaders unveil deposit guarantee, ECB credit facility, Eurobonds as markets soar in response”?
I guess you need to place your bet. If you’re on the wrong side of that headline it’ll be checkmate for you. 
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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44 Comments
Great post cullen. I wish you’d write about market psychology more often.
Yes, this late-day rally was due to some Merkel ranting about “Eurowide bank deposits guarantees”. You mention it here. It is not serious from a thinker like you. They need it soon (“Euro FDIC?”), besides, the key question- with what money they will guarantee it? Just more ECB printing? What is the size of Eurozone banking system? 46 trillion euros. Good luck with that. And with market rally.
Cullen,
Even Basil Moore mentions this – in “Shaking The Invisible Hand” …
Economic life may be viewed as analogous to a game of chess. There are about 10^120 [raised to] possible moves in chess. This is such a large number that it is impossible for any conceivable computer to examine all possible moves. As a result for human beings chess is effectively an open game. In interactive systems there exists no unique “best” move, since what is “best” depends on the behavior of one’s opponents. Even so there are many poor moves, and chess masters can develop many heuristic relationships. Like chess, economies are “open” interactive systems. Given our limited analytical capabilities most interactive systems are effectively “open.” Since we never have “complete” information, we are never able to “rationally” calculate optima or maxima positions.
Good stuff. Thanks Ramanan. I don’t totally agree there (it sounds a bit efficient marketish). To me, the possible moves are not quite as complex as Moore states. In the markets, it’s really just up, down or sideways. And the player who can consistently calculate the timeframe and the direction with some level of higher (than 50%) probability will win more often than he loses. I ran a strategy for my old fund doing this that generated 17% a year just repeating similar bets over and over again. It was robotic work, but it was all probabilities. All I did was formulate a strategy that generated a 55-60% win rate and run the trade over and over again several thousand times a year between 2005 and 2011.
Btw, I owe you an email on some stuff. Will be in touch.
Sure Cullen.
About the Moore quote, I guess in the paras before and after he does sound “not efficient marketish”.
Casanova is looking good with his short euro and oil.
Casanova does not see the two options of Cullen (break up or fiscal union) playing out.
Europe is a complex thing. I expect we will be in crisis mode all the way until the Euro reaches parity or goes below the USD.
When that happens, and it will, economic growth will start coming back to the old continent and we will be back to the old politics.
Expect crisis mode cruising for the next 3 to 5 years with no significant change other than the euro going down.
Any tinkering with fiscal union or full break up is just sensationalist propaganda.
Cullen,
Any chance we could connect on e-mail as well? I have some career questions. I’m sure you know me by know as I have been posting a while.
Thanks.
Of course. email is tpc at pragcap.com. If I’m slow to respond then apologies. I always get around to all emails within a few days.
Well, rumor about Pan-europe bank desposits guarantees originated in London, nothing to do with German Chancellor.
But, if you are akin to game of chess, let’s dissect all possible moves:
1) Eurobonds – they are illegal by EU Maastricht Treaty. For that Treaty to be changed, it would take months, if not a full year. Europe does not have that time.
2) ECB Credit Facility – Mean ECB ballooning its already bloated balance sheet? Possible, but it only comes with money presses.
3) Bank deposits guarantees – same as 2), only with multi-trillion (like at least 10-trillion) facility. Euro-FDIC? Again, that takes time. And money.
4) Contagion. What about other peripheral countries and their bond markets? Bond vigilantes? Impact to global economy as Eurozone sinks to more severe recession? How in the world will they (peripheral countries) become more competitive with harsh austerity measures that don’t foster growth?
Sorry, Cullen, but your game of chess looks very simplified.
If the market craters then you can come back and say “checkmate”. I shake your hand, say well played and we play again. That’s how this works.
Btw, the laws binding these countries by the Maastricht were thrown out the window years ago.
First, thanks for the reply. Second, maybe you would like to read Maastricht Treaty first, which explicitly forbids joint debt liabilities, before you fire claim like this?
Third, I never told I was shorting the market, that is your free assumption (so far, you lost a bishop at least). Fourth, I see you did not respond to any of my comments made in good faith, just stating “well, this is game of chess”. Well, Schoeveningen Sicillian Opening, and after 5 moves you are already lost. That is the quantum of quality informations you provided to your readers here.
1. I am not quite sure why your tone is so defensive or hostile. If you didn’t like my post or you found no value in it then fine, but is there any need for the hostile tone in doing this? You could just say, “your story wasn’t very informative. Here’s why.” That’s totally fine. I write A LOT of stuff here. Some of it is bound to be useless and/or wrong.
2. You’ve made it clear that you’re not sitting down at the table with me so you shouldn’t claim to be taking pieces.
3. The Maastricht was broken as soon as countries broke their debt limits and the ECB agreed to fund them nonetheless. So you’re a little behind the curve there.
I do apologize if you found my tone defensive or hostile, it was not meant to be that way. Bit I am not sure which pieces do you like, white or black? By your first reply I freely assume that you favour massive intervention to stop hemorrhaging, but you don’t reply to my comments; Yes, I am taking the pieces, just please tell me what side of the game you favour.
I am afraid that you pronounce Maastricht Treaty dead even if it is still well alive; German Chancellor, Swedish and Dutch PM’s made clear references to it while speaking of Eurobonds, so I don’t understand why it should be “dead” just because you want it to be dead. After all, you have this evening Euro Summit Statement about Greece: is there anything new in it? Not a single word about a single backstop.
Just to be clear – I am looking for a debate here, and not all games of chess end with a checkmate: in fact, very few do. One opponent usually resigns when sees a lost position.
Debate is good! I believe you’re foreign so maybe I am reading into your writing style too much. Sorry.
My position is that Europe only has two options. The Euro, as is, is unworkable. The single currency with no federal govt (no treasury) and no floating exchanges means that the trade imbalances are INHERENT and destructive. It can be no other way. So there are two options. You must bring back the old currencies to create floating FX. OR, you must do what the USA has and create a federal union with a Treasury which can eliminate the funding risk at the state level.
So it’s full steam ahead towards fiscal union or bust. Anything inbetween will just prolong the inevitable. My vote is for fiscal union since I think Europe can work and will only become more unified as time goes on. Going backwards makes no sense to me. But I am an American and I have no say in what Europeans believe is in their best interest. But as someone who understands a thing or two about monetary systems that’s where I stand….
Thank you! Yes, I am a foreigner. Now I agree with you completely, that the Fiscal Union (and a full political Union) is a real solution for this crisis. Unfortunately, German Chancellor stated this morning that Fiscal Union “is away in years from us”. Perhaps we will agree that after two years of political circus Europe is on the verge of collapse, meaning it simply has not much time for political posturing. After all, what if anti-austerity parties win Greek elections again? It is a game of chicken without precedent. But, I agree with you completely. Full Fiscal and Political Union or bust.
Thank you.
Thanks Danny. I think it has to be done in baby steps. It can’t be done overnight. But if the ECB agreed to some form of deposit guarantee, a permanent credit facility and a form of Eurobonds then I think they can piece this together until the full political and fiscal union is formed. For now it’s all about eliminating the risk of default at the sovereign level and that requires some form of unifying fiscal creation. Eurobonds are a good start. But just a start. Whether they can pull that together is another question….
That’s unlikely to happen with Germany in the EZ. They’d have to change their constitution.
Cullen, I keep hearing you talk about Eurobonds as a bazooka – I can’t quite see why. I understand that the logic is that making debt all joint and several individual countries won’t face quite the same credit risk and markets won’t pick on them as much. But the real problem – the Euro and thus the trade/competitiveness imbalances will remain. It may well be a big kick of the can, but just a kick. (They will still face solvency risk of course.)
Further, how could the Eurobond be done? Do they agree all NEW debt is joint and several? That won’t really do – they would need to make it retrospective and say ALL existing debt is now joint and several. That’s simply fanciful – there’s no way Germany will do that…
(Perhaps this topic is worthy of its own post so you can explain your views in detail – I think it would create some good discussion.)
The USA is the model I am thinking of. We have massive trade imbalances between states. But we also have a federal govt that disburses funds due to common bonds. The EMU could become very similar to this arrangement. And yes, I know all the social arguments and everything about how Germans hate Greeks and how they speak different languages and jobs aren’t mobile, etc. I don’t think any of that matters nearly as much as the solvency issue. And if Germany doesn’t like it then they should stop holding everyone hostage and just bring back the dmark, crash their economy and move on. Unfortunately, Germany wants their cake and to eat it too. They won’t leave the Euro, but they refuse to print money to help their own customers afford their bills. It’s senseless.
@Cullen
The entire project was senseless from the beginning. It was a neoliberal fantasy enforced on an entire continent. Germans will be fine regardless of what happens (they always are). Unlike the Chinese, Merkel would be able to manage a transition to a more consumption-based economy — indeed, they’ve already started, by hiking industrial workers’ wages by double the (current) inflation rate. Germans could relax a little and do some importing from the rest of Europe, and the rest of Europe would get to avoid a depression. Europeans are dedicated to the EU, but not so much that they want a repeat of the 1930′s, and living within your means is written into Germany’s constitution. The bank and bond run is likely to reach a critical point way before there’s even a chance of properly discussing a constitutional amendment.
“Ms. Merkel said Wednesday that the German Constitution and the European treaties forbade countries from assuming one another’s debts. ‘Aside from that, I don’t believe that they would make any contribution to boosting growth in the euro zone,’ she said.”
http://www.nytimes.com/2012/05/24/world/europe/euro-crisis-intensifies-as-leaders-bicker.html
She can’t really be more clear than that. Mutualized debt is illegal in the EU according to the treaties and unconstitutional in Germany. And she thinks they won’t work, probably because she knows Germany isn’t strong enough to carry the entire continent (and I suspect Spanish, French and Italian debt levels may be worse than we’ve been led to believe, hence the Left’s eagerness to involve the ECB).
I wouldn’t put much stock in what the Treaties say. The powers in Europe can do pretty much whatever they want, since no one can overrule them.
In something as complex as the Eurosystem, there are always ways of doing things that can be said to be within the letter of the law. For instance, the ECB could give every EU citizen the ability to deposit their Euros with the ECB at negative interest rates. As long as the public’s deposits are preserved in some fashion, it does not matter if some banks fail. It might even be better to let some of the worst go, so they can start fresh with new, well capitalized banks. Alternatively, the ECB could declare a blanket deposit guarantee at perhaps 90% of par value, and leave the topping up to the existing State guarantee funds.
The governors of the ECB also want to stay in power, and it is very easy to decide to print money, regardless of how loudly Merkel squeaks.
Cullen, thanks for a great posting. I am a chess player, and I try to invest like a play chess, but it doesn’t always work for me. Today I let my emotions get the best of me around the middle of the day. It is hard to remain calm and rational when your hard-earned money is going south rather quickly, as it was. We often think we need to act quickly, simply because the market sometimes moves fast. Taking the time to carefully plan your next move is usually better. And it is better to have a planned response to a quick fall like this morning’s before it happens.
I’ve read that when a chess player makes a particularly bad move, he is likely to then make another, and in fact several in a row. This is like my market experience, too.
And while it’s true that the greats can see further ahead, the truth of the board isn’t always so clear. Remember Bobby’s flawed, sacrificial rook pawn grab against Spassky? There are also “swindles” in chess, right out there in front of God and everybody, and I’ve been on the swindling end of a few.
From one chess player to another.
I really don’t like chess
Good analogy. It’s a Keynesian beauty contest (http://en.wikipedia.org/wiki/Keynesian_beauty_contest).
At times like these I always like to invoke Bob Farrell’s rule #9: when all the forecasters agree, something else is going to happen. In this case I wonder if Germany will leave (probably with a few others, e.g. Austria, the Netherlands) before the TARGET2 balances get totally out of hand, perhaps temporarily “dollarizing” by pegging their internal Euro rate at whatever they think it’s worth (say, $1.30) while they get everything redenominated. This would clear the way for the rest of Europe to put in place EZ-wide deposit guarantees etc., which would hit the EUR pretty hard, but it has to happen somehow.
Just a crazy notion. But remember that Merkel could barely squeeze the ESM and EFSF past the federal court; they’d have her head if she agreed to debt mutualization or deposit guarantees without public consultation. I just don’t see her even attempting it, as she’s said over and over again this week.
Germany already passed a law specifying exactly how Germany would leave the Euro. A GerExit is not as farfetched as it sounds.
The politicians best interest is not stock, is their political career.
Sometimes the only winning move is not to play.
I agree withe Cullen. The European countries are like swimmers strung together by a rope. And Greece has stones around it’s neck. If the other swimmers let Greece sink and die, they’ll end up having to drag a corpse with stones around his neck–which is far worse then dragging a fellow swimmer,however weak, with stones around his neck. So there’s only one course they could follow. Help the guy with stones around his neck even if it slows everyone down drastically. That’s better than everyone drowning.
If the weights around his neck are growing, it might be better to cut the rope and allow that swimmer to drown quickly.
I have been thinking through the EU’s options too much, but as I see this right now Eurobonds is their only solution. Now, if they implement that then what happens to their currency? Do we see the Euro race to parity with the dollar and see US interest rates plummet further? I would think that the market would rally pretty hard which would probably beat up bonds a little bit, I guess with Eurobonds it would give us another liquid place to park reserves?
Just thinking here.
I’m expecting a giant rally in Europe once they announce Eurobonds, but a lot of chaos has to happen before that point is reached. It’s impossible to know where USD/EUR is headed for sure, but in my eyes the USD is pretty much the only strong currency remaining in the world right now.
I have questions:
1. Who will sell the Eurobonds?
2. Who will buy the Eurobonds?
3. What is the production value that backs the Eurobonds?
4. Will Eurobonds solve ALL the funding crises of sovereign counties, or is this just another stop-gap measure in trying to cover up the enormous debt accrued over the past 30 years?
1. The EC? The ECB? No-one knows at this point, as far as I’m aware
2. Lots of people
3. The full faith and credit of the yet-to-be-realized United States of Europe
4. Eurobonds will definitely lower interest rates for countries that are in danger, but by how much depends on which countries remain in the EZ when the bonds are instituted. They’ll allow borrowing for bank recaps, deposit insurance, etc., and would be eligible for collateral with the ECB. They won’t fix the internal imbalances between EZ countries, but again that depends which countries remain and how much effort is put into rebalancing the various economies.
In theory the bonds could be purchased by the ECB directly, thereby funding govts directly (over Merkel’s dead body, I suspect). This won’t be good for the value of the currency, but it seems widely accepted now that Europe is facing a depression if they don’t devalue.
How about the existing EU Treasury issuing the EuroBonds? The EU Treasury is tiny, and is funded by assessments onto member states, but it does exist. To make the Eurobonds credible though, they also need a EuroTax.
…countries, of course….
“I guess you need to place your bet. If you’re on the wrong side of that headline it’ll be checkmate for you. ”
What if we assume that, either way, there will be a big price move, and do a straddle? Do you think that would be a good strategy here?
You’d be better consulting an options expert on that one. I don’t trade options and don’t know the timeframe on the contracts or the value of such a trade.
Right, so balls deep on IBEX..got it.
-rufus
It’s a little off topic, but my understanding is that great chess players do not think many moves ahead – certainly not dozens. In fact, a Grandmaster does not think any further ahead than an International Master. Rather, a Grandmaster knows more good board positions than others. That’s different.
Cullen,
Want a real black swan that would make the Eurozone look like an irrelevant distraction? Take a look at this:
http://enenews.com/former-fukushima-daiichi-worker-i-believe-the-country-will-be-evacuated-if-the-no-4-spent-fuel-pool-collapses-should-be-hundreds-or-thousands-of-people-working-furiously-every-day
At first I dismissed it out of hand, but maybe it isn’t as crazy as it seems. If Japan had to be evacuated, where would the 110 million people go? How long would it take? It seems that the USA, Canada and Australia are the only real resettlement options. What would an emergency migration of that scale do to the economy and markets? That is not clear, but the impact would be HUGE. There might be enormous profits to be made.
‘Will politicians respond with a bazooka like Eurobonds? Or will they respond with nothing? Obviously, nothing would be a total disaster.’
As usual, you omit to mention that the options above have different implications for savers and debtors. You think like a government I suspect.
To issue Eurobonds will devalue the currency, hurting savers. To do nothing will preserve the currency’s value, hurting debtors.
I know what the US-led IMF wants, seems you want the same?
It’s quite sad that you never acknowledge that, but is a sure sign you don’t see the paradign change that is happening before your very eyes. A currency/central bank separated from a nation state, with free floating gold reserves, ready for the events ahead……