Many traders today focus on what game theory calls “missionaries” – the people who move markets through their words. Why did markets trade like death in December? Because Jay Powell, chair of the Federal Reserve, led people to believe he would keep hiking interest rates, regardless of how much the market fell or rah-rah guys like TV personality Jim Cramer begged him not to.
Why did markets recover so sharply in January? Because Powell recanted his apostasy and pledged his allegiance to the market world now and forevermore. And what’s going to happen to the markets next month? Well, just look out for what Powell, Trump and Xi are going to say.
Missionary statements have been one of the most influential trading signal sources ever since Ben Bernanke launched an intentional, entirely strategic effort to force central bank statements into the forefront of investor attention nearly a decade ago. Bernanke’s Fed referred to it as “communication policy”, but it often goes by the phrase “forward guidance”. Either way, it was a strategic policy adopted almost immediately by the European Central Bank under president Mario Draghi.
“Missionary statements have been one of the most influential trading signal sources.”
For the best traders, missionary statements are only one of three broad categories of signals that impact markets. The other two? Signals the world sends us (corporate earnings announcements mostly, but also macroeconomic data releases such as unemployment reports) and signals from the market (price mostly, but also volume, bid spreads and so on).
It’s that last signal source – the markets themselves – that George Soros highlighted in his 1987 book The Alchemy of Finance, and termed “reflexivity”. Put simply, reflexivity signals that a procyclical relationship between cause and effect exists, that price action impacts investor crowd behaviours and vice versa. Just a new word for momentum, really.
But with his idea of reflexivity, Soros was looking to represent more than just momentum. He meant to describe how market signals were translated into crowd behaviours. Also how a trader could visualise and internalise that translation and get one step ahead of the crowd. For Soros, this meant relating countless examples of how he had gotten in front of this translation mechanism.
While The Alchemy of Finance has had a big influence on me, it’s a little disappointing as a blueprint for being a better trader. After all, it’s obvious to Soros how a trader gets ahead of the game, because he has already internalised the genius behind his own trading methods, and it’s hard for Soros to externalise that process for a reader.
“While The Alchemy of Finance has had a big influence on me, it’s a little disappointing as a blueprint for being a better trader.”
By solely focusing on the signals that the market sends us, the book falls into the same trap as so many traders do today – thinking that his/her signal source is always going to be the dominant one, and in doing so failing to develop a generalised process for evaluating signals from different sources.
But game theory can give you that generalised process, calling it the Common Knowledge Game. It’s the mechanism where signals propagate communally through large human audiences. It’s why sitcoms have laugh tracks. It’s why American Idol is filmed in front of a live crowd. It’s why executions used to be held (and coronations are still held) in public. It’s why good traders always have their finger on the pulse of the market at large.
Common Knowledge isn’t what you know (simply your own view) or what everyone knows (that’s consensus). Common Knowledge is what everyone knows that everyone knows. It’s the crowd’s silent evaluation of what the crowd is thinking. Above all, this is what moves markets.
“It’s why good traders always have their finger on the pulse of the market at large.”
Want to be a better trader? Read and listen to the war stories of old-school trading geniuses like George Soros. They’re not to be taken as gospel or as a playbook for how you’re going to trade today, but with an eye towards generalising and externalising the specific trading anecdotes that they describe.
Also read about the Common Knowledge Game. Not as something that’s going to give you an idea for a trade, or something that’s specifically related to the markets But as something that will provide you with a tool kit to build a trading process for linking together your own trading experiences with those of old-school geniuses.
The trick to being a good trader is to learn from the experience of others without going through the hard knocks they’ve had to. Above anything else, game theory gives you the mental tools to do that.
By Ben Hunt: Chief investment strategist at Salient and the author of Epsilon Theory, a newsletter and website that examines markets through the lenses of game theory and history, read by 100,000 investors and allocators.
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