#writing ![[Pasted image 20230320111706.png]] We are witnessing a textbook example of the fallacy of composition in the markets. The fallacy occurs when individuals assume something is true of the whole just because it is true of some part of the whole. A great example of this is when one person stands up at a game to see better but obstructs the view of those behind them and before you know it, the whole stadium is standing. This is how bank runs start and is clearly what is going on in the markets as the initial failed capital raise by SIVB led to its failure, the failure of Signature Bank, a crisis at First Republic, and now the sale of long-embattled CSFB to UBS. Less erudite market observers call the fallacy of composition throwing out the baby with the bathwater. This fallacy is often used to argue against the assumed rationality of economic agents that is assumed by economists to support their theories such as the Efficient Market Hypothesis. I am naturally drawn to this argument but what originally got me thinking about the fallacy of composition was this definition from Charles Kindleberger: >Rational action in economics does not imply that all actors have the same information, the same intelligence, the same experience and purposes. Moreover, the fallacy of composition brings it about from time to time that individual actors all act rationally but in combination produce an irrational result, such as standing to get a better view as spectators of sport, or, more dramatically, running for the exit in a theater fire. >-Manias, Panics, and Crashes p.217 The irrationality of individuals and how it manifests in the markets and life is the overarching topic that we explore constantly in this space. The cause of this irrationality is often individual self-interest, which is very rational for the individual but when manifested in crowds and mobs can demonstrate some of the more terrifying behavior that humankind has been known to exhibit. Daniel Kahneman talks about "availability entrepreneurs" who pop up during availability cascades like we are seeing now: >This emotional reaction becomes a story in itself, prompting additional coverage in the media, which in turn produces greater concern and involvement. The cycle is sometimes sped along deliberately by "availability entrepreneurs," individuals or organizations who work to ensure a continuous flow of worrying news. The danger is increasingly exaggerated as the media compete for attention-grabbing headlines. Scientists and other who try to dampen the increasing fear and revulsion attract little attention, most of it hostile: anyone who claims that the danger is overstated is suspected of association with a "heinous cover-up." The issue becomes politically important because it is on everyone's mind, and ***the response of the political system is guided by the intensity of public sentiment.*** The availability cascade has now reset priorities. >- Thinking, Fast and Slow p.142 You can divine a model for how these panics play out in that quote which is certainly applicable to our situation today. This week's FOMC meeting has been taken over by the run on the banking system we are in the midst of and puts the Fed in a real difficult position as it has tightened enough to break a lot of stuff at this point, but inflation is still uncomfortably high. The intensity of public sentiment now is focused on uninsured deposits, and it seems likely that the markets will continue to push until the authorities explicitly grant what they have tried to only implicitly grant. To end an availability cascade such as this you need to change the narrative. The risk of the banking system has not changed overnight (in fact it got much healthier with the BTFP), it is just that investors have been reminded of the riskiness of banks and now that is all they hear about so they will do what is rational for themselves but irrational in the whole and the bank run will continue until the narrative changes and the focus of attention shifts away from the riskiness of banks. In 2008, it eventually took overwhelming action by the authorities to change the narrative and allow the cascade to reverse, but back then that overwhelming action was necessitated by the massive and permanent losses the banks had suffered in the housing market. This time is a bit different in that the losses are not necessarily permanent (if you trust the full faith and credit of the US) but the availability cascade has put pressure on the liquidity of the banking system so the authorities are a bit less motivated to take overwhelming action and risk moral hazard. This is a tough pickle to be in. While we continue to not see signs of real money panicking, we also haven't seen them stepping in to buy at lower prices. The price action in gold and rates last week was representative of the unwind of some large, short rate and short gold trades and sure enough we got news that Adam Levinson's Graticule Asia Macro hedge fund is closing after his bets on short-term rates "imploded and erased years of gains." This is not surprising as we have been observing the market-generated information (MGI) that said it was the global macro community who was short bonds, short gold, and long the dollar. It would be unusual if Graticule was the only body bag to be carried out after the move we have seen in the two-year over the past two weeks. While we have spent most of this letter talking about the irrationality of the markets, it would be incorrect to say that markets are irrational. While the actions of any individual or group of investors may be irrational and lead to irrational outcomes, the whole market communicates the collective wisdom of the rational and irrational actors. Keynes said: "Markets can remain irrational longer than you can remain solvent", and this is true for most investors and the fast money investors, which include huge hedge funds and money managers, have been the ones setting prices over the past two-weeks. The real money investors, the ones that have the capacity to take large amounts of risk out of the market and hold it through a prolonged period of irrationality have not come back into the markets. This is very valuable MGI, if we really are in a systemic banking crisis, stocks would be much lower as real money investors would be liquidating their holdings, but that is not what we have been seeing. That is not to say that we won't see it, but it is notable that we haven't seen it yet. What we have seen is the liquidation from highly leveraged and weaker investors which are always the first to go. Whether we see more than that or not likely depends on the ability to change the narrative around the banks.