Why Common Knowledge Changes The World

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by Adam Taggart, Peak Prosperity:

The private understanding that we’re in trouble is suddenly becoming realized by the public

For those paying attention, there have been plenty of signs indicating that financial asset prices are dangerously overvalued and that the decade-long economic expansion is reversing towards recession.

But the mainstream — until just recently — has refused to see this.

Over most of 2019, investors have remained willing to push stocks, bonds and real estate to record prices. And the Federal Reserve, the Trump administration and the media have boasted about America’s “strong economy” on a weekly basis.

But suddenly, the herd has become skittish.

It’s not panicking (yet). But a lot of the predominant investor euphoria and complacency has vanished, along with more than a $trillion in market value as stocks have slid from their July highs.

Why?

Well, it’s a matter of private knowledge becoming common knowledge. An understanding that until recently was shared only by a small percentage of people is now starting to be adopted by the masses.

This is a very powerful transformation that often leads to swift changes in the status quo. Ben Hunt of Epsilon Theory explains this phenomenon very well:

The core dynamic of the Common Knowledge Game is this: how does private knowledge become  not public knowledge  but common knowledgeCommon knowledge is something that we all believe everyone else believes. Common knowledge is usually also public knowledge, but it doesn’t have to be. It may still be private information, locked inside our own heads. But so long as we believe that everyone else believes this trapped piece of private information, that’s enough for it to become common knowledge.

The reason this dynamic — the transformation of private knowledge into common knowledge  is so important is that the social behavior of individuals does not change on the basis of private knowledge, no matter how pervasive it might be. Even if everyone in the world believes a certain piece of private information, no one will alter their behavior. Behavior changes ONLY when we believe that everyone else believes the information. THAT’S what changes behavior. And when that transition to common knowledge happens, behavior changes fast.

The classic example of this is the fable of The Emperor’s New Clothes. Everyone in the teeming crowd possesses the same private information — the Emperor is walking around as naked as a jaybird. But no one’s behavior changes just because the private information is ubiquitous. Nor would behavior change just because a couple of people whisper their doubts to each other, creating pockets of public knowledge that the Emperor is naked. No, the only thing that changes behavior is when the little girl (what game theory would call a Missionary) announces the Emperor’s nudity loudly enough so that the entire crowd believes that everyone else in the crowd heard the news. That’s when behavior changes.

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Hunt uses this private-to-common knowledge transition to explain the sudden fall of previously ‘untouchable’ power brokers such as Harvey Weinstein and Jeffrey Epstein. For decades, these abusers could get away with their crimes because the sins were only recognized by a social minitory. But once the world became aware, there was no way push them back into the shadows.

Recession Risk Suddenly Becoming ‘Common Knowledge’

In the case of today’s financial markets, few people have been willing to challenge their faith in the current expansion (now the longest in history). The ten-year ride has been easy, comfortable and dependably profitable.

They’ve been able to ignore reams of charts and data over the years warning that the lofty asset valuations weren’t supported by underlying fundamentals. What do those doomers know anyways? Just look at how well my FANG stocks keep doing!

But this week, two developments occurred that were too obvious for the complacent masses to ignore.

First, the US Treasury yield curve achieved full inversion. On Wednesday, the yield on the 10-year Treasury fell below the yield on the two-year for the first time since 2007.

Why is this a big enough deal to spook the majority of investors?

Because an inverted yield curve has preceded every US recession since 1955:

Chart - history of inverted yield curve

And this isn’t the only serious recession indicator received this week. Those thinking the US economy is too strong to succumb to slowing economic growth need look only as far as Europe, where Germany, by far the largest economy in the EU, just announced that it experienced negative growth in Q2:

Germany's economy shrinks by 0.1% in Q2 2019

If Germany and the rest of the EU slide into recession — along with other major countries like Brazil, Mexico, the UK, South Korea and Russia, which are all facing similar risk — will there be enough demand to keep the US out of one as well?

More and more folks are beginning to have serious doubts. As they should.

This newly-accepted “common knowledge” regarding recession risk goes far in explaining why the recent interest rate cut by the Federal Reserve failed to goose the financial markets higher as hoped. Finally, a critical mass of investors is beginning to realize that more cheap debt can’t solve the problems facing a global economy already drowning in debt.

With this loss of faith in the Fed’s omnipotence, the continued ability to maintain today’s near-record asset prices gets thrown seriously into question.

What Other Knowledge Is Suddenly Becoming ‘Common’?

Doubt breeds more doubts.

And there are many strings of ‘conventional’ wisdom that are unravelling fast when pulled on.

Rotten Apple?

Take Apple, as an example. For years, it has been celebrated as an engine of technological innovation. And its stock has been a bulletproof juggernaut; marching higher every year since 2009.

But Apple hasn’t released a game-changing product since the iPhone, which debuted back in 2006. And now, with global smartphone saturation and slowing economies, iPhone sales have dropped for the past 3 consecutive quarters.

The company is coasting on its bygone success. Without another truly transformative product launch (sorry, air pods and smart watches aren’t going to cut it), overall revenues will continue shrinking.

Investors, whose shares currently support Apple’s nearly $1 trillion market cap, haven’t all gotten the memo yet. But when enough of them do, expect this long-time darling stock to drop hard.

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