Trump and the pris­oner’s dilemma

Financial Mirror (Cyprus) - - FRONT PAGE -

Let us as­sume that Mervyn King is right and the week-toweek strat­egy of ma­jor cen­tral banks has be­come to stop eq­uity mar­kets within their ju­ris­dic­tion from go­ing down. And let us fur­ther as­sume that mar­kets are fully con­vinced of cen­tral bankers’ re­solve to achieve this end.

In the case of US eq­ui­ties, which sit at the cen­tre of the global sys­tem, such a propo­si­tion log­i­cally means that their price has two com­po­nents: (i) the “in­trin­sic value” of the un­der­ly­ing shares, and (ii) the im­plicit prom­ise of sup­port in the shape of the Fed­eral Re­serve’s “put”. Ac­cord­ing to my val­u­a­tion model-based “guessti­mate”, the value of such a put rep­re­sents 15%-25% of the value of the S&P 500. The im­pli­ca­tion is that the US eq­uity mar­ket is over­val­ued, if not yet in an out­right bub­ble.

As I have been writ­ing for at least five years, ab­nor­mally low in­ter­est rates rep­re­sent noth­ing but a tax on the poor and a sub­sidy for as­set own­ers, or “the rich”. This ob­ser­va­tion is rel­e­vant to a cer­tain na­tional elec­tion cam­paign which some read­ers may have no­ticed is now crank­ing up in the United States.

In a re­mark­able his­tor­i­cal role re­ver­sal, it is now clear that Hil­lary Clin­ton is the can­di­date for those who have ben­e­fited most in re­cent times from ab­nor­mally low in­ter­est rates. Hence, if mar­kets be­come con­vinced of a Demo­cratic vic­tory in Novem­ber, lit­tle should change and the value of the “put” in sup­port­ing as­set mar­kets will not be ad­versely af­fected.

On the Repub­li­can side, Don­ald Trump’s pri­maries cam­paign was based on the premise that he was rich enough not to be cap­tured by the in­ter­ests of “the rich”, and in an­other ex­tra­or­di­nary shift in the US po­lit­i­cal fir­ma­ment, this mes­sage was suf­fi­ciently well re­ceived for him to last week be con­firmed as the Repub­li­can’s pres­i­den­tial can­di­date.

In ad­di­tion to this po­lit­i­cal calculus, let us as­sume fur­ther that the Fed’s price keep­ing op­er­a­tion has been done with the help of a few pow­er­ful fi­nan­cial houses in the US and some help­ful for­eign cen­tral banks, which have con­se­quently found them­selves rather long the US stock mar­ket.

Such a group­ing must be wor­ried that a Trump pres­i­dency will mark a dis­ap­pear­ance of the Fed’s “put” since he has ex­pressed sup­port for the “au­dit-the-Fed” ini­tia­tive, and so would likely seek new rules reg­u­lat­ing the ties be­tween the cen­tral bank and fi­nan­cial mar­kets. It fol­lows that such a group­ing will face a temptation to liq­ui­date po­si­tions (taken to help the Fed in its PKO) should opin­ion polls be­gin to favour Trump. I have no par­tic­u­lar in­sight into po­lit­i­cal mat­ters, but while last week’s Repub­li­can con­ven­tion was hardly glitch free, this is an unusual year as shown by this week­end’s news over hacked emails and ap­par­ently in­ap­pro­pri­ate be­hav­iour in the Demo­cratic Na­tional Com­mit­tee.

Such a be­havioural re­sponse from those ac­tors as­sist­ing the Fed in its grand project would in­evitably push the stock mar­ket lower, and if this were to hap­pen in a big way, the elec­tion of Trump would it­self be­come more likely. For such a group, any in­di­ca­tion of grow­ing Trump elec­toral strength would point to a “heads I lose, tails I also lose” propo­si­tion. As such, this amounts to a clas­sic pris­oner’s dilemma: so long as the big play­ers do not break rank, the deal should hold but any sug­ges­tion that one of them was seek­ing a jump on the rest and start­ing to sell could re­sult in all hell break­ing lose, and very quickly.

The prob­lem with such pacts is that as soon as one party loses con­fi­dence in the abil­ity of all par­ties to stay to­gether, then the ra­tio­nal re­sponse is to be the first one to break rank as such ac­tion min­imises even­tual losses

It will be in­ter­est­ing to watch how the PhDs at the Fed ex­tract them­selves from the hole they have dug in re­cent years. Ma­nip­u­lat­ing mar­kets can work for a while, un­til one day it stops work­ing and usu­ally the door is too nar­row for ev­ery­body to get out in time.

I am no spec­u­la­tor, but buy­ing call op­tions on the VIX may be a good hedge against Trump be­ing elected, which may not be the near im­pos­si­ble out­come that se­ri­ous opin­ion seems to think. An­other ap­proach may be to buy out-of-the­money put op­tions on the S&P 500 which have an ex­piry in December. Af­ter all, the smart money did not see the re­volt of the Bri­tish peo­ple com­ing in last month’s ref­er­en­dum on Euro­pean Union mem­ber­ship. We are in­deed liv­ing in very strange times.

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