Control Theory -- or "Proof of a System Is What It Does" (POSIWID)

Yes, the Fed is at the heart of the Trumper. But not for the reasons you think.

Top Comment:

TChampion (Tennis Champion? T-ball Champion?) lobs a valid question:

Thank you for thoughtful analysis as always. Love your work, but find it of little value in figuring out what I should do for myself. Don't mean it as a criticism, but a statement of fact. Govt could pump more or even accelerate fiscal stimulus. Lot of macro shops f*ed this one up last year and said we were sure heading off the cliff, how would I have known biden add on more leverage to spend even more. Not enough demand for treasuries? No problem, Fed could double its balance sheet and leave treasury trading with no pulse (a la Japan). Many states are now coming out with auto-IRAs - programs which automatically subscribe small business employees into IRAs. Just one more area driving more QDIA-driven funds into the market. Asset bubble could keep blowing for a long time and prices could hockey stick from here so that even if they were to lose 50% of their value from the peak, I would still come out way behind by staying in cash. You can probably poke holes or rip to shreds any of these arguments, but my point is the array of outcomes from here is so large, what the hell do I do?

MWG responds:

There are two quick observations. One, nothing in YIGAF should be construed as investment advice for obvious compliance reasons. I simply cannot share individual financial advice. And (2) candidly, not sure you’d want me to. The objective of YIGAF is a forum for thinking out loud. I try to share data-driven insights on market structure and economics to encourage YOU to think about your world while I think about mine.

With that said, my advice remains the same as I’ve often spoken publicly — as long as flows into passive continue, US equities via index funds will offer anomalously high returns driven by flows, not fundamentals. We’ve never been here before and I can’t offer a guarantee of the future, and certainly the knowledge that the “man behind the curtain” is a fraud can lead to overly-cautious investment frameworks as your neighbor “gets rich.” I’ve spoken publicly on this tension and continue to re-emphasize it. The mechanics of the system speak to a violent unwind. For me, that emphasizes preserving wealth rather than chasing it. For others, a different conclusion may be reached. I LOVED this Twitter post last week on this topic:

It’s absolutely worth the read and you have to decide if you want to embrace the nihilism or fear it. As a father with three young adults, I try to do both. You must decide on your own.

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The Main Event

While my background in finance is well-known to readers, my second major in college was “Operations Research,” now contemporarily renamed “Decision Science.” Decision Science is the field of study of complex systems through modeling with the objective of understanding how complex systems can be “controlled” or optimized.

Back then, the relatively rudimentary tools at our disposal largely boiled down to multi-variable regressions run in Minitab. A multi-variable regression sits at the heart of last week’s discussion of “The Omitted Variable” in inflation modeling, where a misspecification of labor vs inflation sits at the heart of discussions of Fed policy.

Since I’m feeling very 21st century today, I decided to ask ChatGPT to consider a recent whitepaper on the subject of “populism” in the context of government policy:

My ChatGPT prompt:

I asked ChatGPT to consider the Taylor Rule, the ostensible “optimal” interest rate policy derived from inflation versus target and GDP vs Potential GDP. Since potential GDP is defined as “the level of GDP at full employment,” most models substitute unemployment versus NAIRU. This model is so well accepted that Bloomberg has a built-in Taylor Rule model:

Note that this model suggests a Fed Funds rate of 5.9% — the Fed is clearly not restrictive.

But that was the subject of last week’s essay. The point of this week’s essay is to consider the implications of a misspecified policy variable. So back to ChatGPT:

Hmmm…. so simple a 5th grader could understand it.