Is Saudi Arabia's Grand Strategy Shifting?

Even in this era of global paradigmatic changes, Saudi Arabia's shifting grand strategy is perhaps one of the most surprising developments to occur thus far, but the fast-moving Russian-Saudi rapprochement is likely to provoke an Iranian "zero- sum" reaction which could complicate Moscow's multipolar efforts in managing the "New Middle East".

Vladimir Putin with King Salman bin Abdulaziz Al Saud at the official greeting ceremony, Moscow, October 5, 2017 (Photo: kremlin.ru)

Most observers were taken aback by what to many seemed to be the inexplicable visit of Saudi King Salman to Moscow this week, wondering how and why the two long-standing Great Power rivals were able to get so close to one another in such a short period of time – and apparently without much public fanfare, too – in making this historic event possible. The usual Alt- Media demagogues decried this as a sellout of Russia's fundamental national interests, with the most extreme pundit-provocateurs even ranting that it amounts to President Putin siding with "terrorists" such as Daesh and Al Qaeda, especially in light of Moscow's decision to sell the much-vaunted S-400 anti-air missile systems to Riyadh and even set up a Kalashnikov production plant in the Kingdom.

Had the Saudi Arabia of 2017 been the same country as it was half a decade ago, or even last year for that matter as some could argue, then there might be some rhetorical substance to this outlandish claim no matter how false it would still be, but what most people don't realize is that Saudi Arabia is in the process of comprehensive changes to its foreign and domestic policies, and that there's a very high likelihood that it will moderate its traditional behavior in becoming a more responsible actor in international (and especially regional) affairs. A lot of this has happened away from the public eye, at least in the sense that the developments weren't "sexy" enough to draw widespread attention from most media outlets and commentators, but these piecemeal changes have altogether contributed to the formation of what looks to be a totally new grand strategy.

Russia's Rationale

Before getting into the details of the drastic policy changes that Saudi Arabia has been up to lately, it's important to comment a bit on why Russia is embracing its erstwhile nemesis. For starters, Russia's foreign policy is driven nowadays by the "progressive" faction of the Ministry of Foreign Affairs, which believes that

their country's 21st-century grand strategic ambition should be to become the supreme balancing force in the Eurasian supercontinent. To this end, they're diligently employing "military diplomacy" and "nuclear diplomacy"; the first in selling arms to rival states in order to preserve the status quo between them and prevent a hot war from transpiring (which is the opposite of the US selling weapons in order to tip the balance in favor of its preferred partner and spark the said conflict that Russia wants to avoid), and the second in utilizing its global leadership in nuclear energy technology to make important strategic inroads with non-traditional partners.

Multipolarity In Action

Concerning Saudi Arabia, this has seen Russia sign deals with it for the S-400 anti-air missile system and Kalashnikov production plant ("military diplomacy"), and Rosatom's proposal to build Riyadh's first-ever nuclear power plant ("nuclear diplomacy"). Of course, there's also traditional and energy diplomacy at play here as well, the former as it relates to cooperation in uniting the Syrian "opposition" as a prerequisite to resolving the War on Syria, and the latter when it comes to both sides' participation in the historic OPEC+ output deal from last year and subsequent renewal earlier in 2017. Moreover, none of this is occurring in a multipolar vacuum either, as Russia's premier Chinese partner has been making great strides with Saudi Arabia in the same timeframe, including by inking two sets of deals totaling than $130 billion in the past six months alone.

Riyadh's Reforms

Most of the Chinese-Saudi agreements were signed in the framework of Crown Prince Mohammed Bin Salman's ambitious Vision 2030 project for diversifying away from his Kingdom's present oil-exporting dependency and towards a more "real-sector" economy. This can't happen unless crucial socio-cultural reforms are made in Saudi Arabia, and the young prince – who's far from a fundamentalist Wahhabi in real life and therefore something like a "rock star" among his country's majority "moderate-prone" youth population (over half of which is under 25 years old) – recently undertook the pivotal decision to allow women to drive in the future, understanding that this a necessary step to increasing their future participation in the economy. It can be expected that more such reforms might follow in the future, such as the possible reopening of movie theaters and maybe even one day lessening the patriarchal legal restrictions placed on women's freedom of movement.

Unipolar Pushback

Mohammed Bin Salman's reforms aren't without controversy, however, as they've produced a lot of resistance among the country's ultra-fundamental clerical class, as was explained in the author's recent analysis about "Why Allowing Saudi Women To Drive Is Very Dangerous". The fact of the matter is that Saudi Arabia isn't a pure "monarchical dictatorship" in the structural-political sense, but a "dual dictatorship" between the monarchy and the clergy, but the Crown Prince's socio-culturally modernizing reforms are being perceived of as an unprecedented "power grab" which de-facto constitutes a "soft coup" by the monarchy against the clergy. In turn, the most extreme clerics could become a pressing national security risk if they rally their followers against the monarchy in fomenting unrest, whether manifested through street protests, a royal coup, or terrorism. It's the fear of this happening which explains the Kingdom's recent crackdown and the author's subsequent investigation into "Who's Really Trying To Overthrow Mohammed Bin Salman?"

As the aforementioned article concludes, the only serious player with the clandestine competencies to pull this off is the US, which is considering the "Balkanization" of the Kingdom into a collection of emirates aided by the duplicitous connivance of its regional UAE ally. This was elaborated on more in depth by the author in his work a couple of months ago explaining "The Machiavellian Plot to Provoke Saudi Arabia and Qatar into a 'Blood Border' War", but the overriding idea is that the US has had an interest in betraying its decades-long ally ever since the 2015 Iranian nuclear deal was agreed to, which the author predicted in his summer 2015 piece about a "Polar Reorientation In The Mideast" that also described the strategic contours that would eventually lead to the present-day Russian-Saudi rapprochement. It's this Great Power convergence between Moscow and Riyadh, as well as the latter and Beijing, which is driving the US to wage an incipient but increasingly multifaceted Hybrid War on Saudi Arabia.

Stopping The Saudi "Deep State" Conspiracy

Mohammed Bin Salman must masterfully manage to tame both the radical clerics and domestic terrorists if he's to have a chance at avoiding a US-backed royalist coup against him. He already has the support of the majority-youthful masses who could come out to the streets to support him in the event of a sudden coup, just like they did for Turkish President Erdogan during last year's failed pro-US coup attempt, so this infers that he needs to win the backing of the military- security services in order to preemptively suppress clerical-terrorist destabilizations before countering the royalist conspiracy that's taking form. However, Saudi forces are embroiled in the bloody War on Yemen, which was one of the first decisions that he made as Defense Minister and is therefore attributed entirely to him, but would have probably happened regardless of whoever was in power at the time due to the geopolitical dynamics involved.

In fact, the author forecast that a forceful Saudi response could be expected to developments in Yemen as early as September 2014 in his article about "Syria's Yemeni Opportunity and the Rise of the Shia Circle", which deliberately analyzed events from Riyadh's sectarian perspective in an attempt to better understand the Kingdom's future response. Likewise, the follow-up piece in January 2015 about "Yemen: The Saudi Coup That Totally Backfired" presciently concluded that "the Saudis are expected to hit back

as hard as they can against the phantom 'Iranian menace' that they're attributing their Yemeni failings to", and that "no matter which form it takes, it's not going to be pretty." In any case, the only way for Mohammed Bin Salman to be confident in the support of his military-security services is to downscale the disastrous War on Yemen and eventually follow the Syrian peace format in resolving the conflict there in as much of a "face-saving" way as possible.

That, however, won't necessarily endear him to any of the conspiratorial royals who are plotting his ouster, many of whom are reportedly irreconcilably opposed to him for his high-profile foreign policy failings in the aforementioned War on Yemen and Qatar Crisis, which is why the young prince so urgently needed to make up for them with a dramatic success elsewhere, ergo the reason why he decided to commence his country's now-successful rapprochement with Russia. Conversely, it's precisely because of his pivotal role in carrying out this game-changing foreign policy rebalancing that the US wants him out, and Washington sent a very clear message to Riyadh of its displeasure just the other day when it announced that it will be halting some of its military exercises with "Gulf countries" until the Qatar Crisis is resolved. Reading between the lines, this is the Pentagon voicing its strong opposition to King Salman's visit to Moscow and Saudi Arabia's S-400 deal with Russia, thereby signaling to its in-country proxies that it's time to commence their planned regime change operation.

Moderating The Monarchy

All in all, Mohammed Bin Salman is trying to compensate for his earlier errors of judgement in "moderating" his country's foreign policy to the most realistic extent possible under the present circumstances, which in an historical comparison amounts to an unprecedented pivot of sorts towards the Multipolar World Order. This doesn't just have geopolitical implications, however, as there's the very real possibility that Saudi Arabia might de-dollarize new Vision 2030 and energy contracts with its new non-Western partners, which would in effect equate to the death of the "petrodollar". The author predicted this in a late-September forecast after it became abundantly clear that the country was no longer as solidly in the American camp as most observers had considered it, especially following its fast-moving rapprochement with Russia and the $130 billion's worth of deals that the Kingdom signed with China.

The combined effect of these two multipolar realignments, as well as the likely downscaling of the War on Yemen and the "Damocles' Sword" potential that Saudi Arabia has for dealing a deathblow to the dollar, are increasingly turning Mohammed Bin Salman into the "Saudi Saddam", in that he's now being targeted for elimination by the US because this one-time American subordinate was brave enough to chart his country's own sovereign path in the world. If he can successfully withstand the US-encouraged "deep state" coup against him being waged through the Hybrid War mechanisms of a rebelling clergy, a possible domestic terrorist insurgency (as partial blowback from Saudi Arabia's support for such groups abroad), and a royalist plot, among whatever other means might soon make themselves available, then it's expected that the end result will be a considerable moderation of the Kingdom's destabilizing activities in the region.

Irate Iranians

Background Concepts:

While the welcoming of Saudi Arabia into the multipolar fold as a responsible member of the international community would be celebrated by many because of the far-reaching consequences that it could have in altering the entire course of the New Cold War, there's one multipolar party which would actually be incredibly irate at this happening, and that's Iran. The Islamic Republic is caught in an intense security dilemma with the Kingdom, inspired partly by the centuries-old but previously long-dormant Sunni-Shiite split, and also the US' efforts since the 1979 Revolution and especially after 9/11 to exacerbate this into taking on geopolitical dimensions all across the international Muslim community ("Ummah"). Iran and Saudi Arabia both conceive of international affairs as being a "zero-sum" game between them, and it's very likely that Riyadh and its media surrogates will intentionally misportray King Salman's visit to Russia as being against Tehran instead of epitomizing Moscow's skillful geopolitical balancing act.

It's understandable if Iran feels uncomfortable with these optics, though it should recognize that Russia's overall intent is truly apolitical and driven by neutral Great Power considerations, not anything directed against it personally no matter what the forthcoming Saudi psy-ops might infer.

That being said, it's very tempting to perceive of events through the aforementioned "zero-sum" prism in seeing any betterment of Russian-Saudi relations as being to the overall detriment of Russian-Iranian ones, which in turn might prompt an asymmetrical response or set thereof from Tehran in countering what some of its leadership might truly believe is Russia's "unfriendly" and "humiliating" gesture by hosting the Saudi King, selling him S-400 anti-air missiles and state-of-the-art Kalashnikovs, and bidding to produce the Kingdom's first-ever nuclear power plant. This isn't speculation either, as Iran already isn't happy with the de-facto alliance that Russia has struck with "Israel" in Syria, which is explained in detail in the author's earlier work rhetorically questioning whether "Anyone Still Seriously Thinks That Russia And Israel Aren't Allies?"

Phase 1: Syria

Moreover, Iran doesn't like how Saudi Arabia is the main reason why it hasn't been invited to join BRICS, and while the other four members are in a technical sense equally responsible for this too, it's only Russia which is courting Saudi Arabia in a way which could make Iran uneasy given how impactful the latest rapprochement will be for Syria. Therefore, even though Iran's official media has been largely silent on the implications of the Russian-Saudi rapprochement, it can't be ruled out that the millennia-experienced Iranian diplomats are preparing one of their stereotypically asymmetrical responses to what's happening, and that it could most immediately have consequences for Syria. For example, Iran could make the Astana talks more difficult by siding more closely with Damascus in attempting to rebuff the joint Russian-Turkish efforts to get the Syrian government to enter into certain political-administrative concessions (e.g. a "phased leadership transition" and "federalization") as part of a comprehensive peace plan that would meet the interests of most external parties to the conflict and therefore maximize Moscow's geopolitical "balancing" capabilities.

Phase 2: Caucasus

Apart from that and stepping its response up a notch, there's also the possibility that Iran could work with India to redirect the North-South Transport Corridor (NSTC) from Azerbaijan and Russia to Armenia and Georgia instead, the latter route of which was predicted in the Mideast chapter of the author's book-length analytical series about "The Chinese-Indian New Cold War" and would allow both on-the-fence Great Powers to pioneer a trade route to the EU. This would be a geopolitically troubling development for Russia and contribute to its perception that Armenia has become an "obstructionist" actor vis-à-vis Moscow-led Eurasian integration processes and has probably been totally taken over by the powerful American-based diaspora lobby, though China's latest inroads in building its second-largest embassy in the post-Soviet space in Yerevan might help to "balance" everything out in preventing this potential move from being completely disastrous for multipolarity. Nevertheless, if Iran takes this step in rerouting some or all of the NSTC to Armenia, Georgia, and the EU, then it would probably mean that it's also seriously considering expanding its asymmetrical response to the third phase of operations in the Balkans.

Phase 3: Balkans

The third and final escalatory phase of Iran's most realistic responses to any perceived "security dilemma" with Russia after Moscow's rapprochement with Riyadh would be if Tehran seeks to broaden its asymmetrical measures to include energy and geopolitical dimensions in the Balkans. The author wrote about the future role that post-sanctions Iranian energy exports to Europe could have in challenging Russia's present market dominance in certain regions, and while this might not happen if the EU reimposes sanctions against the Islamic Republic in compliance with American pressure, it still can't be entirely discounted that Iranian LNG exports to Croatia, Ukraine, Lithuania, and even Poland could be in the cards, as well as its exit from the OPEC+ output agreement. However, the most destabilizing consequence of Iran's irritability with Russia could be if it decides to return to its post- Yugoslav role in breaking up Bosnia, using the Serbs as stand-ins for the Russians in a new proxy war. That's the most extreme step that Iran could take and there's nothing right now which indicates that it will happen, but it should nevertheless be included as the worst- case "dark scenario" forecast.

Concluding Thoughts

Royal Pivot:

Saudi Arabia's grand strategy is shifting away from its former Western-/unipolar-centric focus to a more diversified one of "multi-alignment' with multipolar leaders such as Russia and China, motivated in part by the US' hostile energy and geopolitical actions against it. On the domestic front, Crown Prince Mohammed Bin Salman is modernizing his country's socio-cultural situation by enacting belated reforms that will complement his ambitious Vision 2030 project of multisectoral economic diversification away from its present dependency on oil exports. Taken together, the international and domestic dimensions of Saudi Arabia's grand strategic shifts are expected to have game-changing implications in altering the global dynamics of the New Cold War, to say nothing of what would happen if the Kingdom de-dollarizes its future Vision 2030 and energy deals with its new non-Western partners, hence why the initiator of all of this, Mohammed Bin Salman, is now the "Saudi Saddam" in the sense of being targeted for elimination.

Iranian Reaction:

That's not all that there is to it, however, since even in the event that the young prince is successful in thwarting his myriad Hybrid War adversaries and the wide variety of weaponized threats that they're poised to utilize against him, it's unlikely that this will result in multipolar stability in the Mideast, owing mostly to the fact that Iran is expected to be incredibly irate at its hated rival being feted as a privileged partner by Russia and China. The difference between the two Eurasian Great Powers, however, is that Moscow's outreaches to Riyadh are having direct consequences for Syria, particularly as it relates to possibly "counterbalancing" or even "rolling back" Iran's intended post-Daesh influence in the Arab Republic, or so it may seem, which is why Tehran looks much more suspiciously at Moscow than it does at Beijing. The problem, though, is that Russia isn't doing any of this "against Iran", but in the "larger multipolar interests" of becoming the supreme "balancing" force in the Eurasian supercontinent, which in and of itself necessitate having excellent relations with Saudi Arabia.

Scenario Forecasts:

If the Iranian leadership is misled into viewing Russia's ties with Saudi Arabia as part of a "zero-sum" game and not the "win-win" strategy that it's actually intended (key word) to be, then it's very likely that the Islamic Republic will resort to one of its stereotypically asymmetrical responses honed by millennia of diplomatic experience in making its silent disagreements well known. This would be an unfortunate development because it would mean that Russia's sincere efforts to balance and then mediate the Saudi-Iranian/Sunni-Shiite rivalry would be for naught, and that the US' unstated goal of redirecting Iranian attention away from Saudi Arabia and towards Russia would have been partially successful. Nevertheless, should this happen, then it's expected that the three- phase tier of escalatory responses could see Iran create "complications" in the Astana peace process; redirect the North-South Transport Corridor away from Azerbaijan and Russia and towards Armenia, Georgia, and the EU; and begin actively competing with Russia for part of the European energy market. At the worst, it might even try to restore its destabilizing influence in Bosnia and spark a proxy war against Russia's Serbian partners there.

American Backup Plan:

None of Iran's forecasted responses are certain, or even that it will negatively appraise the fast-moving Russian- Saudi rapprochement in the first place, but in the possible event that it does, then it would inadvertently be playing into the US' intended strategy of indirectly using Iran as a backup plan for replacing Saudi Arabia in countering Russian interests in the Mideast, Caucasus, and the Balkans. In addition, Riyadh's reversal from the unipolar camp to the multipolar one would leave the US without a regular source of jihadi recruits, thereby necessitating that it scout elsewhere in such countries as Sudan, India, Bangladesh, and Indonesia. The most likely scenario to happen in the near future is that Iran's suspicions of the Russian- Saudi rapprochement manifest themselves subtly in Syria, at least at first, while the US begins looking to non-Mideast "Global South" countries for mercenaries while concurrently commencing its regime change operation in Saudi Arabia.

The best outcome would be if Russia's multidimensional diplomatic efforts could bring Saudi Arabia and Iran together in a "New Détente" like how Iraq's Muqtada al-Sadr unsuccessfully tried to do, all the while assisting both of them in warding off the US' Hybrid War threats, but the most likely result is that this wishful thinking eventuality is still a far way's off, if it ever happens at all, since the US is well known for flexibly adapting its unipolar grand strategy to accommodate for any multipolar contingency such as this one.

A Rising (Central Bank) Tide Turns Everyone Into A Genius

Until the system implodes--you're a genius.

So you've ridden the markets higher--stocks, housing, commercial real estate, bat guano, quatloos, you name it--everything you touch turns to gold. What can we say, bucko, other than you're a genius!

It's a market truism that rising tides lift all boats. But that's not the really important effect; what really matters is rising tides turn everyone into a genius--at least in their own minds.

Those of us who have been seduced by the Sirens' songs of hubris know from bitter experience how easy it is to confuse a rising tide with speculative genius. When everything you touch keeps going higher, the only possible cause is.... your hot hand, of course!

Stocks--I'm a genius! Housing--I'm a genius! Commercial real estate--yes, well, I suppose the evidence is overwhelming--it does seem I'm a genius.

The only thing better than buy and hold is buy the dips and hold--and use margin or whatever leverage you have to buy more before the price goes even higher.

What can we say other than: this is the strategy of geniuses. The proof is in the charts:

The S&P 500: margin to the hilt and buy every dip: genius!

Housing in Sweden, Toronto, Brooklyn, West L.A., San Francisco, Seattle, Portland, Shanghai and every other blazing-hot market: borrow more from the shadow banking system, mortgage your house to the hilt, do whatever you have to do to get the down payment and buy another flat: pure genius!

The source of our collective genius isn't an act of Nature--it's that good old pump inflating every asset bubble on the planet, central banks creating credit-money out of thin air and buying assets hand over fist: stocks, ETFs, bonds, mortgages, and so on.

Central banks have collectively purchased $1 trillion in assets year to date.

The Federal Reserve and the other central banks are playing the role of financial gods, intervening in the interactions of mere mortals to create the illusion of stability.

To this end, the Fed has created trillions of dollars and used this money to prop up delusional asset values (high) and destabilizing interest rates (low).

If we look at a decentralized financial system as a self-organizing ecosystem, we find that the strength of the system lies in the adaptability of the myriad organisms in its many micro-climates. The key strength of a decentralized financial ecosystem, i.e. one not organized as a top-down command economy, is the "genetic diversity" of its many participants. There is not just one dominant species in the ecosystem, but many interdependent species.

In a financial ecosystem, there is not one lender and one class of borrowers, but a huge diversity of lenders, borrowers, creditors and savers, and a wealth of interacting, inter-dependent enterprises.

A centrally planned financial ecosystem is a doomed system. The Fed is the equivalent of an ignorant, hubris-infused agency that seeks to "restore" an ecosystem by flooding it with water and unleashing a single predatory species raised in an unnatural, contrived "factory."

The Fed is wiping out diversity and thus the adaptability of the enterprises that survive its crude flooding and replication of a single predatory species.

The Fed is creating a sickly, vulnerable mono-culture of an economy, one dominated by financial predators which are themselves lacking in genetic diversity.

Just as agencies playing god further degrade the natural systems they claim to be "restoring" with ever-grander interventions, so too is the Fed destroying the U.S. economy with equivalent god-like meddling and ever-more grandiose, ever-more delusional interventions in what were once decentralized, self-organizing systems that naturally sought harmony and stability through the low-level churn of bad bets being written off and over-leveraged speculators going bankrupt.

Put another way: the Fed has taken the risks generated by predatory institutions and policies, and distributed it throughout the entire financial system. This distribution of risk in service of maintaining asset bubbles creates the illusion of stability, low risk and "sure thing" speculation.

Rather than let over-leveraged speculators and institutions reap the consequences of their excesses, the Fed (and other central banks) have loaded the entire system with risk.

Until the system implodes--you're a genius.

One Of The World's Biggest Sovereign Wealth Funds Is About To Become A Seller

As readers may recall, one of the alleged reasons for the market swoon at the end of 2015 and early 2016 was what Deutsche Bank first dubbed "quantitative tightening" but not by central banks (that would come later), but by sovereign wealth funds in general - with an emphasis on petrodollar nations who were struggling to balance their budgets at a time of plunging oil prices and were forced to sell assets - and China in particular, which faced with a tumbling Yuan was forced to sell billions in US-denominated securities to halt the sharp devaluation of the Yuan.

Now, after a period of relative stability for sovereign wealth funds, in which the indiscriminate SWF/China selling of 2015 faded into a distant memory, one of the world's biggest buyers of trophy assets is about to become a seller again. According to Bloomberg, following the ongoing isolation by its powerful Arab neighbors, Qatar's sovereign wealth fund is reversing a decade-long run in high-profile foreign investments to buttress its own economy.

The Qatar Investment Authority, or QIA, which has already reduced its holdings in Credit Suisse, Rosneft and Tiffany in recent months, is considering unleashing what could be a liquidation tsunami in this illiquid market, selling more of its $320 billion of assets, which includes stakes in Glencore and Barclays, and using the proceeds to bolster the domestic economy, according to Bloomberg sources.

The selling, which we previewed back in June amid an overview of Qatar's deteriorating financial system, will probably not come as a surprise: "Sovereign wealth funds, such as the Qatar Investment Authority, are always national buffers against adverse risk events, " said Sven Behrendt, managing director of GeoEconomica in Geneva. "Since the boycott is such a risk event for Qatar, the assets stored within QIA will need to serve as such a buffer."

Created over a decade ago, in 2005, to handle Qatar's vast windfall from sales of LNG of which it is the world's biggest exporter, the QIA and other Qatari investors have amassed holdings in Hollywood, New York office space, London residential property, luxury Italian fashion and even a soccer team. The QIA ranks as the ninth largest globally, according to the Sovereign Wealth Fund Institute.

Meanwhile, Qatar's banks have already sensed the change in the wind direction, and having pitched acquisition targets to the QIA for years "are now proposing asset sales, and have been told not to expect any major investments by the fund in the near term." The fund hasn't formally hired financial advisers to dispose of any assets but is considering which stakes are best positioned to be offloaded, they said. The QIA declined to comment.

Quoted by Bloomberg, Rachel Pether, a senior adviser at the Sovereign Wealth Fund Institute said that "the QIA is being fiscally prudent by not actively pursuing new investments." She added that "the QIA has approximately 57 percent of its portfolio in publicly listed securities, which means there is reasonable liquidity in its portfolio if further support is required."

The QIA last year saw its biggest overhaul since 2014, grouping $100 billion of investments in local companies into a new unit and abandoning the Qatar Holding name synonymous with its highest-profile deals, people with knowledge of the matter said at the time.

After a dip in transactions in 2015 and 2016 as oil prices slumped, the fund regained its appetite for deals late last year, investing in Turkey's biggest poultry producer, Rosneft, and U.K. gas company National Grid Plc, all within a couple of months.

All that, however ended after a Saudi-led standoff that started in June has put the small but rich (with the world's highest GDP/capita ratio in the world) in a vice.

Confirming the start of the upcoming liquidation phase, CEO Sheikh Abdullah Bin Mohammed Bin Saud Al Thani said last month that the QIA plans to spend most of what remains of its $45 billion investment target on U.S. assets as it seeks diversification. As Bloomberg adds, the fund is also considering selling some of its extensive property portfolio, especially in the U.K. where it owns stakes in London's Savoy Hotel, the Shard skyscraper and the Olympic Village. The QIA also wants to sell an office building in London's Canary Wharf financial district that is leased to Credit Suisse, people familiar with the matter said last month.

In other words, already reeling from the withdrawal of Ultra high net worth buyers, the London real estate market is about to get hit by a double whammy of selling from the very top.

The QIA has injected billions of dollars into local banks to shore up liquidity after Saudi Arabia, the United Arab Emirates and Bahrain cut diplomatic ties on June 5 amid accusations of funding terrorism, prompting their lenders to withdraw funds from Qatar, people familiar with the matter said at the time. Qatar has repeatedly denied the charges.

Qatar should also look at other assets that could be used as alternative buffers to reduce some of the heat on QIA, said GeoEconomica's Behrendt.

"The diplomatic boycott and economic blockade of Qatar sees basically two strategies employed by the parties: the Saudi-led coalition employs a 'wearing down' approach, Qatar a 'holding out' strategy," he said. "In the end it will be about who will have the longer staying power."

And while the QIA liquidation was telegraphed months in advance, a bigger question is if now that SWFs are once again selling assets to shore up the domestic economy, will others follow, and specifically, will Saudi Arabia be next. As Bloomberg's Javier Blas showed few days ago morning, Saudi FX reserves tumbled $6.9 billion in August, and are down a whopping $48bn YTD, effectively in line with the drop over the same period in 2016, when Saudi Arabia saw $54bn in reserves flow out, on lower oil output and prices. If and when Saudi Arabia joins the QIA as a motivated seller (at any price), and as central banks withdraw as buyers of first, last or any resort, the sudden risk asset air pocket of 2015/2016 may seem like a walk in the park in retrospect.

China's Shadow-Lending Ecosystem Could Be As Large As $40 Trillion, PBOC Guesses

Today, I'd like to take some time to revisit a couple of topics discussed in the past. I am, of course, referring to the burgeoning increases in China's Debt levels, Shadow Bank Assets (loans) and M2, along with a high-level analysis of the most recent PBOC Financial Stability Report and FSB Global Shadow Bank Monitoring Report. (No!....please don't click this page closed....I promise this will eventually get interesting...)
As a starting point, let's begin by reviewing the February, 2015 McKinsey report Debt and (not much) Deleveraging . I first referenced the report in this blog in March of 2015. The report focused on the world's, and particularly China's, rapidly building debt/leverage phenomenon (2014 Year End Data). I encourage you to re-read the entire report, but for those of you who are pressed for time, I'll give you the executive summary bullet-points right here:
- Debt continues to grow
- Reducing government debt will require a wider range of solutions
- Shadow banking has retreated, but non?bank credit remains important
- Households borrow more
- China's debt is rising rapidly

I'm hoping that the McKinsey authors will consider updating the report, bringing the figures current, as I believe these observations, figures and analysis are even more pertinent today than they were back in 2015.

China's Debt
So now, using McKinsey as a reference point, let's take a look at where we are today, via the FRED (St. Louis FED)data below.
The FRED (Federal Reserve Economic Data - Citations below) Chart below represents US Core Debt (as defined and provided by the BIS - Bureau of International Settlements) compared to China Core Debt, as a percentage of GDP. The third (bold Red) line represents China's debt levels adjusted for a "what-if" constant I'll explain shortly.
Lets dig into the numbers. We see from 2006 thru 2016 US Core Debt increased modestly from roughly 220% of GDP to 250% of GDP. However, China's Core Debt, relative to GDP nearly doubled during the same period, to roughly 260% of GDP.
Before we discus the above, let's talk about what GDP is (and isn't). GDP is:

C+I+G+(NX) or: (Consumption + Investment + Government Spending + (Exports-Imports)).

First, it's important to understand that increased GDP does not necessarily increase wealth or improve quality of life. A GDP calculation is measuring-stick for economic activity....nothing more. A GDP figure makes no representations as to the quality, efficiency or economic utility of the activity producing the GDP. i.e.) When my Dad was in the Army (WWII....the "big one") he talked about "practicing" digging fox holes. He and thousands of other soldiers would be told/ordered to dig holes and fill them in.....for no apparent reason other than to keep them busy. This activity, since he was being paid to do it, would increase GDP, even though it accomplished nothing more than wear them out and keep them out of the English pubs.
That said, here are a few examples of things that would significantly increase GDP.

Building a Superhighway, Bridge or Bullet Train connecting two uninhabited deserts or islands. (I+G)

Building a Ghost City. (I+G)

A military build up. (I+G)

Producing millions of tons of steel and cement held in a developer's CIP inventory. (I+G+C)

Creating even more manufacturing capacity (factories and mines) for steel, cement, etc.(I)

Building infrastructure. i.e.) Public works, water, power plants, tunnels, wells, utilities etc. (I+G)

Manufacturing phones, computers, clothing and consumer goods for export. (C+NX)

Buying tons of eCommerce stuff. (C)

Tearing down an abandoned building/high rise. (C+G)

Here are a few more you might not think about.....again, these are events/activities that increase GDP but don't necessarily increase wealth or quality of life.

A hurricane....all of the destruction has to be financed and rebuilt. (C+I+G)

Public Welfare and Housing Assistance Checks (C+G)

Single Payer Health Care (C+G)

Paying 10x as much for a medical procedure as you might pay in other countries (C)

So you get the point.....although it looks good on paper, incurring debt to build/finance things that aren't economically viable, produce little (or no) economic utility or fail to generate earnings and cash flow doesn't work too well over the long haul. At some point, the lenders won't be paid back.....or, as should happen in a free-floating world, if they are eventually paid back, they'll be paid back with a currency having a fraction of the purchasing power of the currency they initially loaned out to finance the activity.
China's "Productive GDP"
Now, let's get back to the bold Red line on the chart above and take some time to coin a phrase. We'll call it "Productive GDP" or PGDP. As any economist will tell you, desperate times call for desperate measures.....and new terminology! Let's say that China's "Productive" GDP, for lack of a better term, is defined as GDP excluding all of the over-building, non-productive excess capacity and accounting games created simply to hit the arbitrary 7%, etched in stone, silly, CCP mandated GDP growth target.
So let's further say that rather than the published, rock solid, 7%, annual NBS GDP growth rate, the "Productive", un-fudged, non-incentivized, PGDP growth rate is only 4.6%, (2/3rds of the published/reported rate), but still a remarkable number for an economy the size of
China's. Extrapolating the bold Red Line above, if GDP is "overstated" by a third, we illustrate/conclude that the ratio of Core Debt to "Productive" PGDP explodes to nearly 400%, much higher than the current G20 average of 240%.
Author's Note: You math aficionados out there might be observing that the bold red line doesn't consider the compounding impact (i.e. reducing the GDP growth rate in a prior year impacts the current year starting point). So the method illustrated (multiplying GDP by a constant) actually overstates GDP. That's absolutely correct. However, since I have no actual data to base my adjustment on, it's a guess, an arbitrary adjustment, so the compounding doesn't matter. Besides using a constant was just simply easier than trying to program the FRED model to compound the change. In any case, I'm just illustrating a point.
So far so good?

Shadow Banking
Now lets revisit the 2015 McKinsey Report (2014 data) bullet points above. Specifically:
Shadow banking has retreated, but non?bank credit remains important
Unfortunately, per the People's Bank of China (PBOC), Shadow Bank lending has reversed course abruptly and skyrocketed since the 2015 McKinsey report. Nobody really knows how big China's Shadow Bank ecosystem is, but the PBOC recently offered a rather shocking guess in their 2017 Financial Stability Report (pg.48). China's Off-Balance-Sheet, un-regulated, "Shadow" loans have grown to nearly US $37 Trillion (RMB 252.3 Trillion) and have surpassed China's US$34 Trillion, "On-Balance Sheet" bank assets as of the close of 2016. They also restated the 2015 numbers, increasing the 2015 figures to US$ 28 Trillion (RMB 189 Trillion), roughly doubling the 2015 figure.
Keep in mind, the PBOC estimating Non-Bank Shadow loans is a bit like the local Sheriff estimating "unreported financial crime". He doesn't have authority over the mechanics of the activity, lacks enforcement resources and therefore can't do much about preventing the crime(s). Even if he had authority and resource, he'd have a hard time zeroing in on the metric....criminals generally don't respond to surveys or self-report their schemes. Moreover, the Sheriff would have an incentive to under-estimate the problem and hope everything works out, since, at some point, someone is going to be held accountable. As history shows, and Chinese Bankers are well aware of this, financial scoundrels are normally exiled to horrific disgrace on a private tropical island with access to boatloads of Cayman Islands money.....so it goes.
Again, based solely on the usual, limited transparency inherent in PBOC reporting (good things are trumpeted and bad things are swept under the rug), a disclosure like this would indicate that the problem is potentially much larger than they are letting on. In the 2017 Financial Stability Report (an oxymoron if I've ever heard one) the PBOC restates the Shadow Bank Assets for 2014 and 2015 (as shown by the dotted line in the chart below). To my knowledge, no other major economy has ever experienced an acceleration anywhere near these levels of Non-Bank, Shadow debt relative to GDP, much less restated it in a gigantic "ooppps....our bad" buried in a couple of paragraphs in the bowels of a report. In China....they do things big. The bigger the better. The two Charts below, prepared by Capital Economics illustrate that we've apparently entered uncharted waters.
Although the fiercely independent citizens, politicians and bankers of Hong Kong and Singapore might disagree, we can generalize that the leverage in those economies (tall bars on the left of the chart) is inextricably linked to the Chinese financial system. If there were ever a potential "ground-zero" for a default- induced financial contagion Shang-Hong-apore would be it.
Shadow/Non-Bank Credit has become an absolutely essential tool for keeping all of the financial balls in the air. As reported by Ambrose Evans-Pritchard in a piece for the Telegraph:
Jahangir Aziz and Haibin Zhu from JP Morgan said the debts of the state-owned entities (SOEs) have alone reached 90pc of GDP or $13.3 trillion.
Nearly 60pc of new credit this year is being used to repay old loans. It takes four times as much new credit to generate a given amount of extra of GDP as it did a decade ago. "China's rising indebtedness has come to represent all that is disconcerting about their economy," they said in a report entitled "The Sum of All Fears".
Hmmmm....."The Sum of All Fears"....catchy little title for a financial/policy report! Tom Clancy would be proud....
Viewed another way, when we add the current, 2016 BIS figure, roughly US$28 Trillion of China's Core Debt plus the estimated US$37 Trillion +/- of Shadow debt (RMB 253.5 Trillion), we have a Debt/PGDP ratio approaching 900% of "Productive" PGDP. The Comparable, relatively constant, US ratio (250% +/-) is shown in blue below.
"Total Social Financing" (TSF)
Total Social Financing (TSF), a term of art the Chinese government introduced a few years ago to track the leverage in their economy, grew to RMB 155.99 trillion RMB (US$ 23 Trillion), up 12.8 percent from 2015, per the PBOC Report. (Pg. 28) The intent of this statistic is to track the "total financing" required by households and businesses. The process goes awry when we try to decipher exactly what's included in this metric and how the data is collected. There are numerous articles written on this topic and I've listed a few of them in the citations below. Suffice it to say that the consensus is, that a significant amount of Non-Bank Shadow financing is excluded from TSF. Interestingly, this metric, intended to show changes in the composition of how economic growth is financed, is actually misleading, since significant Shadow risk is omitted from the calculations.
Some Verifiable Numbers.....Bonds
As difficult as it is to measure China's fragmented Shadow Financial System, there are a few reported metrics which are presumably more reliable than others. China's bond markets are one such example. In the last two years (2015 & 2016) the value of new "Major" Chinese Bond issues (below) has actually exceeded the total amount outstanding of America's Corporate Bond market (about US$ 8.6 Trillion). Why is all of this new debt necessary? Again, most (60%?) of the new issues are used to roll over other bonds/debts/financing coming due.
Continuing the theme, Non-Performing Loans (NPL's) have somehow remained relatively constant, hovering just under 2% since 2011 as shown below. (pg. 44 of the PBOC Report)
How can this be? Perhaps it's just little old skeptical me, but usually, when borrowing skyrockets like this, underwriting is lax and bad loans go bad much
quicker. The universally accepted game bankers play to keep a bad loan from being reported as non- performing is to refinance it and change the terms....and (drum roll please....) ....like magic, it's a performing loan again! In all likelihood, that's what's happening with this fake NPL statistic. It's hard to believe that China's financial system hasn't already broken its economic foot as a consequence of kicking all of these NPL cans down the road, but somehow it just keeps chugging merrily along. As my favorite Irish pub drinking song goes...."Roll me over in the clover.....roll me over lay me down and do it again...this is number one....we've only just begun.....".

Protecting Your Blind Side - Hedging & Spitznagel's Tail Strategy

"The price of protecting quarterbacks was driven by the same forces that drove the price of other kinds of insurance: it rose with the value of the asset insured, with the risk posed to that asset." -

The Blind Side
Counter-intuitively, that is often not the case in the capital markets. The more asset valuations and risk rise, the more implied volatility tends to drop and therefore the cost of insuring financial assets typically fall. As the S&P 500 index nears the sumptuously round number of 2500 and valuations surpass levels preceding the Great Depression, the price of options to protect investors is deeply discounted. Provide valuable insight
The lead quote from Michael Lewis is in reference to NFL Hall of Famer Lawrence Taylor, otherwise known as LT, a defensive end for the New York Giants. LT was an exceptional player who not only threatened an opposing teamʼs offensive prowess but more importantly, the health of their quarterback. The Blind Side, by Michael Lewis, documented how teams were forced to pay dearly for insurance against this threat. The insurance came in the form of soaring salaries for strong left tackles who protect right handed quarterbacks from the so called "blind side" from which players like LT were attacking. The sacrifices teams made to shield their most valuable asset, the quarterback, limited the salaries that could be spent on players to boost their offensive fire power. LT taught general managers an important lesson - protecting your most important asset is vital in the quest for success.
Growing your wealth through good times and preserving it in bad times are the key objectives of wealth management. At times when the markets present "LT"-like threats, prudence argues for both a conservative posture and protection of assets.
While many investors continue to ignore the lopsided risk/return proposition offered by the equity markets, we cannot. Sitting on oneʼs hands and avoiding the equity market is certainly an option and one which we believe might look better over time than most analysts think. That said, it is not always a viable option for many professional and individual investors. Some investors have a mandate to remain invested in various asset classes to minimum required levels. In other cases, investors need to earn acceptable returns to help themselves or their clients adhere to their financial goals. Accordingly, the question we address in this article is how an investor can run with the bulls and take measures to avoid the horns of a major correction.
Risk vs. Reward
There are two divergent facts that make investing in todayʼs market extremely difficult.
1. The market trend by every measure is clearly any novice technician with a ruler projected at 45 degrees can see the trend and extrapolate ad infinitum.
2. Markets are extremely overvalued. Intellectually honest market analysts know that returns produced in valuation circumstances like those observed today have always been short-lived when the inevitable correction finally arrives.
In The Deck is Stacked we presented a graph that showed expected five-year average returns and the maximum drawdowns corresponding with varying levels of Cyclically-Adjusted Price-to- Earnings (CAPE) ratios since 1958. We alter the aforementioned graph, as shown below, to incorporate the odds of a 20% drawdown occurring within the next five years.
Over the next five years we should expect the following:
1. Annualizedreturnsof-.34%(green line)
2. Adrawdownof27.10%fromcurrent levels (red line)
3. 76%oddsofa20%orgreater correction (yellow bars)
In a recent article, 13D Research raised an excellent point quoting Steve Bregman of Horizon Kinetics:
"There is no factor in the algorithm for valuation. No analyst at the ETF organizer—or at the Pension Fund that might be investing—is concerned about it; itʼs not in the job description. There is, really, no price discovery. And if thereʼs no price discovery, is there really a market?"
If, as Bregman states, the market is awash with investors, traders and algorithmic robots that do not care about fundamentals or value, is there any reason to think the market cannot continue to ignore fundamentals and run higher? While such a condition can easily endure and propel prices to even loftier valuations, the precedent of prior bubbles dictates this does not end well. At some point, the reality of economic fundamentals which underlie prices reassert themselves. Accordingly, in the following section, we present a few hedging strategies that allow one to profit if the market keeps charging ahead and at the same time limit losses and/or profit if financial gravity reasserts itself.
Options
There are an infinite number of options strategies that one can deploy to serve all kinds of purposes. Even when narrowing down the list to purely hedging strategies one is left with an enormous number of possibilities. In this section, we discuss three strategies that involve hedging exposure to the S&P 500. The purpose is to give you a sense of the financial cost, opportunity cost, and loss mitigation benefits that can be attained via options.
Option details in the examples below are based on pricing as of July 24, 2017.
Elementary Put Hedge
This first option strategy is the simplest option hedge one can employ. A put provides its holder a right to sell a security at a given price. For instance, if you own the S&P 500 ETF (SPY) at a price of 100 and want to limit your downside to -10% you can buy a put with a strike price of 90. If SPY drops below 90, the value of the put will rise in line, dollar-for-dollar with the loss on SPY, thus nullifying net losses beyond 10%. Devising a similar strategy to manage a basket of stocks, ETFʼs or mutual funds is more complicated but similar.
To help visualize what a return spectrum might look like on a portfolio hedged in this manner consider a simple scenario in which one owns the S&P 500 (SPY) and hedges with SPY options. The following assumptions are used:
Own 400 shares of SPY at a price of $246.80 per share at the cost of $98,720.
The holding period is 1
Purchase SPY put options with a strike price of $230, expiration of 9/21/2018 and a cost of $9.15 per share and total cost of $915 per option. (Each option is equal to 100 shares)
The graph below provides the return profile of the long SPY position (black) and three hedged portfolios for a given range of SPY prices. The example provides three different hedging options to show what under-hedged (2 options), perfectly-hedged (4 options) and over- hedged (8 options) outcomes might look like.
Note the breakeven point (yellow circle) on the hedged portfolios occurs if SPY were to decline 10% to $221 per share. The cost of the options in percentage terms is shown on the right side of the breakeven point. It is the difference in returns between the black line and the dotted lines. Conversely, the benefit of the options strategies appears in the percentage return differentials to the left of the breakeven point. (Additional cost/benefit analysis of these strategies is shown further in the article) In this example, we assume the options are held to the expiration date. Changes in other factors such as time to expiration, rising or falling volatility, and intrinsic value will produce results that do not correspond perfectly with the results above at any point in time other than at the expiration date.
Collar
The elementary option strategy was straightforward as it only involved buying a one-year put option. Like the first strategy, a collar entails holding a security and buying a put to hedge the downside risk. However, to reduce the cost of the put option a collar trade requires one to also sell (write) a call option. A call option entitles the buyer/owner to purchase the security at the agreed upon strike price and the seller/writer of the option to sell it to them at the agreed upon strike price. Because the investor is selling/writing an option, he is receiving payment for selling the option. Incorporating the call option sale in a collar strategy reduces the net cost of the hedge but at the expense of upside returns.
To help visualize what the return spectrum might look like with a collared portfolio that owns the S&P 500 (SPY) and hedges with SPY options, consider the following assumptions:
Own 400 shares of SPY at a price of $246.80 per share at the cost of $98,720.
The holding period is 1
Purchase SPY put options with a strike price of $230, expiration of 9/21/2018 at the cost of $9.15 per share and total cost of $3,660. (Each option is equal to 100 shares) Sell/write SPY call options with a strike price of $270, expiration of 9/21/2018 at the cost of $3.75 per share and total benefit of $1,550.
As diagramed below, a collar strategy literally puts a collar or limit around gains and losses.
Writing the call option reduces the net hedging cost by $1,550, limits losses to 9% but caps the ability to profit if the market increases at 7.21%.
Bloomberg created an index that replicates a collar strategy. Bloombergʼs collar index (CLL) assumes that an investor holds the stocks in the S&P 500 index and concurrently buys 3-month S&P 500 put options to protect against market declines and sells 1-month S&P 500 call options to help finance the cost of the puts. As options expire new options are purchased.

The CLL and SPY returns were well correlated until the latter part of 2008. At this point, when volatility spiked and the markets headed sharply lower, the benefits of the collar were visible.
(Bloomberg assumes a different collar structure than we modeled and described).

Sptiznagelʼs Tail Strategy
Mark Spitznagel is a highly successful hedge fund manager and the author of a book we highly recommend called "The Dao of Capital." Spitznagel uses Austrian school economic principles and extensive historical data to describe his unique perspectives on investing. In pages 244- 248 of the book, he presents an options strategy that served him well in periods like today when valuations foreshadowed significant changes in market risk. The goal of the strategy is not to hedge against small or even moderate losses, as in the first two examples, but to protect and profit from severe tail risk that can destroy wealth like the recent experiences of 2000 and 2008.
Sptiznagelʼs strategy hedges a market long position with put options expiring in two months. On a monthly basis, he sells the put options and buys new options expiring in two months. The strike price on his options are 30% below current prices. To replicate his strategy and compare it to the ones above we assume the following:
Own 400 shares of SPY at a price of $246.80 per share at the cost of $98,720.
The holding period is 1
Purchase 82 SPY put options (equivalent to .50% of the portfolio value) with a strike price of $175 (30% out of the money), expiration of 9/15/2017 (2 months) at a cost of $.06 per share and total cost of $492. (Each option is equal to 100 shares)
For purposes of this example, new options are purchased when the current options mature every two months (Spitznagel sells and buys new options on a monthly basis). We also assume this hedge was already in place for a year resulting in an accrued trade cost of $2,952 (6 *$492) to date.
The graph below highlights the cost benefit analysis.
The strategy graphed above looks appealing given the dazzling reward potential, but we stress that the breakeven point on the trade is approximately 30% lower than current prices. While the cost difference to the right of the breakeven point looks relatively small, the axisʼs on the graph have a wide range of prices and returns which visually minimizes the approximate 6% annual cost. Similar strategies can be developed whereby one gives up some gains in a severe drawdown in exchange for a lower cost profile.

Cost/Benefit Table
The tables below compare the strategies detailed above to give a sense of returns and a cost/benefit analysis across a wide range of SPY returns.
The option strategies in this article are designed for the initial stages of a decline. Pricing of options can rise rapidly as volatility, a key component of options prices, increases. The data shown above could be vastly different in a distressed market environment. These options strategies and many others can be customized to meet investorʼs needs.

Summary
We insure our cars, houses, health and our lives. Why is the idea of hedging ones wealth rarely considered especially considering the cost of that protection actually falls as the market becomes more vulnerable? Given current market valuations along with a 76% chance of a 20%+ drawdown, we urge clients to consider implementing a defensive strategy of insuring your portfolio. Although option strategies compress returns, they serve to "defend the perimeter" in the event of a severe market correction. These strategies and many others like them yield peace of mind and the ability to respond clinically in the event of turmoil as opposed to reacting emotionally.
The rather simple examples in this article were created to give you a sample of the costs and benefits of hedging. When devising a hedging strategy, it often helps to draw a picture of an ideal but realistic return spectrum. From that point, a spreadsheet model can be used to try to create the desired return profile using available options.
In addition to options strategies, there are other means of hedging a long portfolio such as structured notes, volatility funds, and short funds. Portfolio construction is also an important natural means of mitigating exposure to losses. While the topic for future Unseen articles, they are ideas worth exploring and comparing to options strategies. Hedging and options analysis is a complex field limited only by imagination and market liquidity.

Sheep Logic - This Is The Age Of The High-Functioning Sociopath

These are baby-doll Southdowns, and yes, they're exactly as cute as they look in this picture. We only have four today on our "farm", as sheep have a knack for killing themselves in what would almost be comical fashion if it weren't so sad. We keep them for their so-so wool, which we clean and card and spin and knit. It's so-so wool because the Southdowns were bred for their meat, not their fleece, and I can't bring myself to raise an animal for its meat. Well, I could definitely raise birds for meat. Or fish. But not a charismatic mammal like a baby-doll Southdown.

Here's the thing I've learned about sheep over the years. They are never out of sight of each other, and their decision making is entirely driven by what they see happening to others, not to themselves. They are extremely intelligent in this other-regarding way. My sheep roam freely on the farm, and I never worry about them so long as they stay together, which they always do. But if I only count three in the flock, then I immediately go see what's wrong. Because something is definitely wrong.

That's the difference between a flock and a pack. A flock is a social structure designed to promote other-awareness. It has no goals, no coordinating purpose other than communication. A flock simply IS. A pack, on the other hand, is a social structure designed to harness self-aware animals in service to some goal requiring joint action — the raising of cubs, the hunting of meat, etc. Both the flock and the pack are extremely effective social structures, but they operate by entirely different logics.

We think we are wolves, living by the logic of the pack.

In truth we are sheep, living by the logic of the flock.

* * *

There's no domesticated animal species that has had more of a reputational fall from grace than the sheep. To call someone a sheep today is just about the worst insult there is. To call someone a sheep is to call them stupid and — more pointedly — stupidly obedient and in thrall to some bad shepherd.

It wasn't always this way. Jesus isn't insulting you when He calls you a sheep. The point of all those Biblical allegories isn't that sheep are stupidly obedient or easily led, but that the healthy life of a willful sheep requires a good shepherd.

Ask anyone who actually keeps sheep. Sheep are weird. Sheep are evolved to have a very different intelligence than humans. But sheep are not stupid. Sheep are not obedient. And sheep are definitely not easily led.

Of course, no one except a dilettante farmer like me keeps sheep today, so all of the Old Stories about sheep and shepherds have lost their punch. They've all been diminished through the modern lens of sheep-as-idiot-followers.

Today most people dismiss the notion that good shepherds - i.e., individuals with expertise and wise counsel in some difficult to navigate field like … I dunno … investing — exist at all. And they utterly reject the idea that it's actually okay not to have a fully formed and forcefully held opinion on anything and everything, that it's not a sign of personal failure to say "I don't know" and follow another's lead.

It's not just the media careers and media business models that are built on the notion of the Constant Hot Take — an unending stream of contrarian opinions expressed in the most incendiary way possible, solely for the entertainment value of contrarian opinions expressed in the most incendiary way possible — it's the millions of hours that so many non-media civilians will spend engaged on Twitter or Facebook or whatever to construct their own steady stream of Hot Takes and bon mot responses. All tossed out there like bottles into the vast social media ocean, never to wash up on any inhabited shore, lost in some great Sargasso Sea of impotent and forgotten texts.

Why? Why does @RandoBlueStateLawyer with 45 followers spend the better part of every afternoon thinking about his next brilliant riposte to the latest Republican Hot Take on Obamacare reform? Why does @RandoRedStateRetiree spend every evening working himself into a MAGA apoplexy that can only be sated by retweeting his 19,001st Hannity blurb?

To answer that question, I want to go back to the Old Stories. I want to share with you what sheep are really like.

Sheep are evolved to have a specific type of intelligence which has the following hallmarks. 

Enormous capacity for other-regarding behaviors. Sheep are unbelievably sensitive to what other sheep are doing and their emotional states. If another sheep is happy — i.e., it's found a good source of food, which is the only thing that makes a sheep happy — then every other sheep in the flock is filled with jealousy (there's really no other word for it) and will move in on that good thing. If another sheep is alarmed — which can be from almost anything, as bravery is not exactly a trait that tends to be naturally selected in a prey species — then every other sheep in the flock is immediately aware of what's going on. Sometimes that means that they get alarmed, too. As often, though, it's just an opportunity to keep going with your own grazing without worrying about the alarmed sheep bumping into your happy place. 

Zero altruism and overwhelming selfishness. The most popular misconception about sheep is that they are obedient followers. It's true that they're not leaders. It's true that they are incredibly sensitive to other sheep. But it's also true that they are the most selfish mammal I've ever encountered. They don't lead other sheep or form leadership structures like a pack because they don't care about other sheep. Every sheep lives in a universe of One, which makes them just about the most non-obedient creature around. 

The determination to pursue any behavior that meets Hallmark #1 and #2 to absurd ends, even unto death. My worst sheep suicide story? The first year we kept sheep, we thought it would make sense to set up a hay net in their pen, which keeps the hay off the ground and lets the sheep feed themselves by pulling hay through the very loose loops of the net. Turned out, though, that the loops were so loose that a determined sheep could put her entire head inside the net, and if one sheep could do that, then two sheep could do that. And given how the hay net was hung and how these sheep were sensing each other, they started to move clockwise in unison, each trying to get an advantage over the other, still with their heads stuck in the net. At which point the net starts to tighten. And tighten. And tighten. My daughter found them the next morning, having strangled each other to death, unable to stop gorging themselves or seeking an advantage from the behavior of others. The other sheep were crowded around, stepping around the dead bodies, pulling hay for themselves out of the net. That was a bad day. 

In both markets and in politics, our human intelligences are being trained to be sheep intelligences.

That doesn't make us sheep in the modern vernacular. We are not becoming docile, stupid, and blindly obedient. On the contrary, we are becoming sheep as the Old Stories understood sheep … intensely selfish, intensely intelligent (but only in an other-regarding way) and intensely dogmatic, willing to pursue a myopic behavior even unto death.

Why are we being trained to think like sheep? Because sheep are wonderful prey animals. They pay the rent with their fleece, and when push comes to shove you can eat them, too. Plus they're not helpless prey animals. Sheep are quite competent and rather self-sufficient prey animals, which from a smart owner's perspective is really what you want. If sheep were truly docile and stupid, then they'd be way too much trouble to keep. Nope, with sheep you can let them wander around all day and do their thing. Just keep them from killing themselves in some really stupid accident and you can harvest them for years and years and years.

How are we trained to think like sheep? By the rewards we receive from our modern social institutions for other-regarding flock behaviors like jealousy (feeling sad when others are glad) and schadenfreude (feeling glad when others are sad), and by the penalties we receive for self-regarding pack behaviors like honor and shame. If you've ever kept a pack animal like a dog, you know how clearly they can experience a sense of shame, that feeling when you believe you've let the pack down through your personal failure. Sheep have no shame. Not a bit. Shame requires self-evaluation and self-judgment against some standard of obligation to the pack, concepts which would make sheep laugh if they could. Sheep are enormously other-aware, but never other-obliged. They're high-functioning sociopaths, shameless creatures of jealousy and schadenfreude, which is exactly the type of human most purely designed to succeed in the modern age.

The mechanism for all this sheep training, particularly in our investment lives, is what game theory calls the Common Knowledge Game. Once you start noticing it, you will see it everywhere.

I've written about the Common Knowledge Game a lot in Epsilon Theory, starting in the original "Manifesto" and continuing with notes like "A Game of Sentiment" and "When Does the Story Break". But let's review this core game of sheep logic one more time, with feeling. So here's the classic thought experiment of the Common Knowledge Game — The Island of the Green-Eyed Tribe.

On the Island of the Green-Eyed Tribe, blue eyes are taboo. If you have blue eyes you must get in your canoe and leave the island the next morning. But there are no mirrors or reflective surfaces on the island, so you don't know the color of your own eyes. It is also taboo to talk with each other about eye color, so when you see a fellow tribesman with blue eyes, you say nothing. As a result, even though everyone knows there are blue-eyed tribesmen, no one has ever left the island for this taboo. A Missionary comes to the island and announces to everyone, "At least one of you has blue eyes."

What happens?

Let's take the trivial case of only one tribesman having blue eyes. He has seen everyone else's eyes, and he knows that everyone else has green eyes. Immediately after the Missionary's statement, this poor fellow realizes, "Oh, no! I must be the one with blue eyes." So the next morning he gets in his canoe and leaves the island.

But now let's take the case of two tribesmen having blue eyes. The two blue-eyed tribesmen have seen each other, so each thinks, "Whew! That guy has blue eyes, so he must be the one that the Missionary is talking about." But because neither blue-eyed tribesman believes that he has blue eyes himself, neither gets in his canoe the next morning and leaves the island. The next day, then, each is very surprised to see the other fellow still on the island, at which point each thinks, "Wait a second … if he didn't leave the island, it must mean that he saw someone else with blue eyes. And since I know that everyone else has green eyes, that means … oh, no! I must have blue eyes, too." So on the morning of the second day, both blue-eyed tribesmen get in their canoes and leave the island.

The generalized answer to the question of "what happens?" is that for any n tribesmen with blue eyes, they all leave simultaneously on the nth morning after the Missionary's statement. Note that no one forces the blue-eyed tribesmen to leave the island. They leave voluntarily once public knowledge is inserted into the informational structure of the tribal taboo system, which is the hallmark of an equilibrium shift in any game. Given the tribal taboo system (the rules of the game) and its pre-Missionary informational structure, new information from the Missionary causes the players to update their assessments of where they stand within the informational structure and choose to move to a new equilibrium outcome.

Before the Missionary arrives, the island is a pristine example of perfect private information. Everyone knows the eye color of everyone else, but that knowledge is locked up inside each tribesman's own head, never to be made public. The Missionary does NOT turn private information into public information. He does not say, for example, that Tribesman Jones and Tribesman Smith have blue eyes. But he nonetheless transforms everyone's private information into common knowledge. Common knowledge is not the same thing as public information. Common knowledge is information, public or private, that everyone believes is shared by everyone else. It's the crowd of tribesmen looking around and seeing that the entire crowd heard the Missionary that unlocks the private information in their heads and turns it into common knowledge.

The important thing is not that everyone hears the Missionary's words. The important thing is that everyone believes that everyone else heard the Missionary's words, because that's how you update your estimation of everyone else's estimations (why didn't that blue-eyed guy leave the island? I know he heard the news, too … hmm … but that must mean that he, too, saw a blue-eyed guy … hmm … oh, snap.). The power source of the Common Knowledge Game is the crowd seeing the crowd, and the dynamic structure of the Common Knowledge Game is the dynamic structure of the flock. There's no purposeful objective that animates a flock the way it does a pack, which is why you famously have people describing the "madness of crowds." But it's not madness, and it's not chaos, either. A crowd is the communication mechanism for the Common Knowledge Game, with clear rules and strategies for playing and winning.

Understanding the Common Knowledge Game has been the secret of successful shepherds since time immemorial, in business, politics, religion … any aspect of our lives as social animals. The only difference today is that technological innovation provides a media toolkit for modern shepherds that the shepherds of the Old Stories could only dream of.

This is why sitcom laugh tracks exist. This is why performances, whether it's an NFL game or Dancing with the Stars, are filmed in front of a live audience. This is why the Chinese government still bans any internet pictures of the Tiananmen Square protests, with their massive crowds, more than 20 years after they occurred. This is what John Maynard Keynes called the Newspaper Beauty Contest, which he believed (and demonstrated) was the secret to successful investing through the 1930s. This is how Dick Clark built a massive fortune with American Bandstand. He didn't tell Middle America what music to like; he got a crowd of attractive young people to announce what music they liked ("it's got a good beat and you can dance to it, I give it a 94, Dick!"), and Middle America took its cues from that. Not only is that all you need to motivate sheep, it's far more effective than any efforts at direct influence.

This is why executions used to be held in public and why inaugurations still are. This is why Donald Trump cared so much about the size of his inauguration crowd. This is why he's always talking about the viewership and ratings of his televised appearances. Trump gets it. He understands what makes the Common Knowledge Game work. It's not what the crowd believes. It's what the crowd believes that the crowd believes. The power of a crowd seeing a crowd is one of the most awesome forces in human society. It topples governments. It launches Crusades. It builds cathedrals. And it darn sure moves markets.

How do we "see" a crowd in financial markets? Through the financial media outlets that are ubiquitous throughout every professional investment operation in the world — the Wall Street Journal, the Financial Times, CNBC, and Bloomberg. That's it. These are the only four signal transmission and mediation channels that matter from a financial market Common Knowledge Game perspective because "everyone knows" that we all subscribe to these four channels. If a signal appears prominently in any one of these media outlets (and if it appears prominently in one, it becomes "news" and will appear in all), then every professional investor in the world automatically assumes that every other professional investor in the world heard the signal. So if Famous Investor X appears on CNBC and says that the latest Fed announcement is a great and wonderful thing for equity markets, then the market will go up. It won't go up because investors agree with Famous Investor X's assessment of the merits of the Fed announcement. The market will go up because every investor will believe that every other investor heard what Famous Investor X said, and every investor will be forced to update his or her estimation of what every other investor estimates the market will do. It doesn't matter what the Truth with a capital T is about the Fed. It doesn't matter what you think about the Fed. It doesn't matter what everyone thinks about the Fed. What matters is what everyone thinks that everyone thinks about the Fed. That's how sheep logic, aka the Common Knowledge Game, works in markets.

So who owns us market sheep? The controllers of any Common Knowledge Game are the Missionaries, and the eternal Missionaries are the political executive and the market sell-side. Politicians and brokers have understood the power of this game for thousands of years, which makes the Street and the White House the constants as you examine the history of American sheepification. But they're not the most powerful Missionaries of the modern age. No, that honor goes to our central bankers, relative newcomers to the Game, but quick studies all the same.

In his last Jackson Hole address, Ben Bernanke extols the virtues of their "communication tools", carefully constructed media messages designed to alter investor behavior, messages that he says have been their most effective policy tools to date. Interest rates may hit a lower bound of zero, and asset purchases may lose their punch, but investors can ALWAYS be "guided". The architect of this new and powerful toolkit? Vice Chair Janet Yellen, natch. Forward guidance and what the Fed calls communication policy are the very definition of Missionary statements, and our utter absorption in what everyone believes that everyone believes about the Fed's impact on markets IS sheep logic.

Think that the Fed will go back to their old taciturn ways, content to let their actions speak louder than their words? Think again. Here's Ben Bernanke again, this time in his final speech as Fed Chair:

The crisis has passed, but I think the Fed's need to educate and explain will only grow. When Paul Volcker first sat in the Chairman's office in 1979, there were no financial news channel on cable TV, no Bloomberg screens, no blogs, no Twitter. Today, news, ideas, and rumors circulate almost instantaneously. The Fed must continue to find ways to navigate this changing environment while providing clear, objective, and reliable information to the public.

Active central bank Narrative construction in the service of their policy goals is a permanent change in our market dynamics. The introduction of such a powerful new weapon in the Fed's policy arsenal can no more be removed than mustard gas or tanks could be removed from national arsenals after World War I. Market prices may be mean-reverting, but "innovation" in the service of social control never is.

What do the Missionaries get out of this? What's our equivalent of wool and mutton? It's low volatility. It's the transformation of capital markets into a political utility, which is just about the greatest gift that status quo political interests can imagine. When Donald Trump and Steve Mnuchin talk about the stock market being their "report card", they're just saying out loud what every other Administration has known for years. Forget about markets, our entire political system relies on stocks going up. If stocks don't go up, our public pension funds and social insurance programs are busted, driving our current levels of wealth inequality from ridiculously unbalanced to Louis XVI unbalanced. If stocks don't go up, we don't have new collateral for our new debt, and if we can't keep borrowing and borrowing to fuel today's consumption with tomorrow's growth … well, that's no fun, now is it?

The flip side to all this, of course, is that so long as stocks DO go up, nothing big is ever going to change, You say you want a revolution? You're a MAGA guy and you want someone to drain the Swamp? You're a Bernie Bro and you want the rich to "pay their fair share"? Well, good luck with any of that so long as stocks go up. It's a very stable political equilibrium we have today, full of Sturm und Drang to provide a bit of amusement and distraction, but very stable for the Haves.

And that brings us back to @RandoBlueStateLawyer and @RandoRedStateRetiree, fighting the good fight on Twitter or Facebook or wherever, speaking their Truth to their audience of dozens. They're smart guys. Politically engaged guys. They're angry about the mendacity of the Other Side. In another day and age they'd slam the newspaper down on the table and tell the dog what a fool that darn Truman was. Maybe write a strongly worded letter to the editor. But today they are consumed by this modern equivalent of writing a letter to the editor. They are immersed in the world of the Constant Hot Take, morning, noon and night. Why? Because Common Knowledge Game. Because they see a crowd responding to a crowd, and they are hard-wired to join in. Because it makes them feel good about themselves. Because they've been turned into other-regarding sheep even as they think they're being self-regarding wolves.

In the same way that the modern story of what it means to be a sheep — docile, obedient, stupid — is totally wrong, so is the modern story of what it means to be a wolf. We think of a wolf as the epitome of rapacious independence, but wolves, like all pack animals, are far less independent (and far less greedy) than your average sheep. Unlike sheep, wolves can act outside of their group because they're not consumed by other-regarding behavior, but those actions are ultimately in service to the pack. A sheep always acts within its group, but it's never in service to the flock, only to its own needs.

Look, I'll admit that I'm talking to myself as I write these words. I spend WAY too much time on Twitter, justifying it to myself in any number of ways, when in truth it's the functional equivalent of a meth habit. At least it's not as tough on the teeth. My wife is hooked on Facebook, my kids on god knows what social media platforms …. I'm not so naïve as to think that the answer to our collective sheepification is just to put the devices down. No, we've got to shift the way we use this stuff, not quit it cold turkey.

So what do we do? We stop pretending to be fake wolves and we start acting like real ones. We stop acting like animals of the flock and we start acting like animals of the pack. We reject the other-regarding emotions of jealousy and schadenfreude. Yes, even in our tweets (gulp!). We embrace self-regarding emotions like honor and — here's where I'm going to lose everyone — shame.

Yes, we need a lot more shame in the world. The loss of our sense of shame is, I think, the greatest loss of our modern world, where scale and mass distribution are ends in themselves, where the supercilious State knows what's best for you and your family, where communication policy and fiat news shout down authenticity, where rapacious, know-nothing narcissism is celebrated as leadership even as civility, expertise, and service are mocked as cuckery. Or to put it in sheep logic terms: the tragedy of the flock is that everything is instrumental, including our relationship to others. Including our relationship to ourselves.

Why do we need shame? Because with no sense of shame there is no sense of honor. There is no mercy. There is no charity. There is no forgiveness. There is no loyalty. There is no courage. There is no service. There is no Code. There are no ties that bind us as citizens, as fellow pack members seeking to achieve something bigger and more important than our ability to graze on as much grass as we can. Something like, you know, liberty and justice for all.

Any coin worth having has two sides. A shameless politics has no honor. A riskless market has no reward. Oh, the Missionaries will tell you that there's honor in the shameless politics and reward in the riskless markets, and for all the high-functioning sociopaths out there I'm sure that's true, But if you're not totally sheepified yet, if your goal is still honorable service to your clients or your partners or your family or your nation or your species — whatever your pack may be — then you know that this is NOT true. You know that shame and risk can be deferred or displaced but never wiped clean, no matter how many Supreme Court Justices you appoint and no matter how many all-time highs the stock market hits. You know that a reputation is like a tea cup; once broken you can glue it back together, but it will always be a broken tea cup. You know that the only game worth playing is the long game.

This is the Age of the High-Functioning Sociopath. This is the Age of Sheep Logic. We have to survive it, but we don't have to succumb to it. How do we Resist? Not by switching out blue Missionaries for red Missionaries or red Missionaries for blue Missionaries. Not by switching out one bad shepherd for another bad shepherd. We don't have to play that game! We resist by changing the System from below, by carving out local spheres of action where we are relentlessly honorable and charitable, relentlessly un-sheeplike. We resist by Making America Good Again, one pack at a time, which is a hell of a lot harder than making America great ever was. We resist by doing right by our clients, even if that means getting slapped around by supposedly riskless markets and shameless politics. Even if that means losing clients. Even if that means losing our jobs.

A good shepherd once said that whoever shall smite thee on thy right cheek, turn to him the other also. Of course, I also knew a good Dungeonmaster who said that being lawful good didn't mean being lawful stupid, and turning the other cheek always seemed to be kinda stupid to me. Kinda sheeplike. But then I started keeping sheep, and my perspective changed. Sheep would never turn the other cheek. But a wolf would. A wolf would take a hit for the pack. It's the smart play for the long game. As wise as serpents, you might say.

It's time to be wolves. Not as devourers, but as animals that know honor and shame. It's time to be wise as serpents and harmless as doves. It's time to remember the Old Stories. It's time to find your pack.