While fundamental value—an inexorable tide that pulls on the price of markets and currencies over longer-term time horizons—is still necessary as an investment tool, it’s no longer sufficient.
What we need, in addition, is an understanding of the macro developments that can drive price either toward or away from fundamental value in the short to medium term.
The challenge is that the complexity of macro developments in a global context typically exceeds what the human mind can process. To understand these developments, an analytical paradigm is necessary—and the one we use is game theory.
Game theory is a set of principles for scrutinizing the sequential, strategic interactions of multiple agents—the parties at the bargaining table in the conflict in the Middle East, the U.S. debt-ceiling negotiations, and the eurozone crisis, for example. These parties act in their best interests and respond to other parties’ actions via cooperation and conflict.
Consider the eurozone crisis that has evolved over the past couple of years. Coming into 2015, each of the 17 eurozone countries had individual objectives, some overlapping with other countries’ objectives, as the chart below illustrates. These objectives evolve as the situation progresses and the players’ interests change, because every move undertaken changes the payoff and influences other players’ actions.
Brian Singer is head of dynamic allocation strategies team and portfolio manager at William Blair.