Heads I Win, Tails You Lose

I was searching for images associated with stochastic processes, the ten-dollarest of ten-dollar terms, and amazingly enough, I wasn't finding much to work with. But then I somehow came across this picture of Donald Trump "flipping" the coin for the Army-Navy game ...

Leave aside the weirdness of a grown man not knowing how to flip a coin. Leave aside the weirdness of his clearly not caring that he doesn't know how to flip a coin, that there is no actual flipping involved in his process, and yet he proceeds with full confidence that this is a perfectly great way to flip a coin. And everyone just goes along with the show.

No, no ... just leave all that aside.

The point today is that there’s no way that a normal distribution accurately describes the role of chance in a series of coin tosses, when that coin is flipped by Donald Trump.

Ditto with your portfolio.

There's no way that a normal distribution accurately describes the role of chance in a series of portfolio return outcomes, when those portfolio returns are "flipped" by Donald Trump and Barack Obama and Jay Powell and Mario Draghi and all the other Team Elite Missionaries. Sure, I'm making fun of Trump in the headline picture here, but if you think there's a smidgen of difference between Trump and Obama and every future resident of 1600 Pennsylvania Avenue in their overwhelming desire to transform capital markets into a political utility ... you are sadly mistaken.

When I say that capital markets have been transformed into a political utility since 2009, what I'm saying in geek terms is that the normal distribution of variation in portfolio returns no longer exists.

Everyone thinks it does. Everyone thinks that a normal distribution of some sort still describes the role of chance in market outcomes, that of course there's a policy impact on skew or heteroskedasticity or the mean or volatility or whatever, but over the long term (or my favorite, "over a credit cycle") there's by and large a normal distribution of variance in portfolio outcomes around some mean expected return.

I'm saying this is wrong.

I'm saying that the distribution of variation in portfolio returns in a regulated utility like capital markets is whatever the State ALLOWS the distribution to be.

Some regulated utilities - like airlines - used to have a very tightly controlled distribution of economic outcomes, but over time were "deregulated" to allow a more-or-less normal distribution of return variance. Other regulated utilities - like power generation and transmission companies - have had a non-normal distribution of portfolio returns imposed throughout their existence. Large losses and large gains for these existentially important utilities are illegal. They are simply NOT ALLOWED. It's not that they have a compressed normal distribution of return variance ... it's not a normal distribution at all.

Before the near-death experience of 2008, the State was happy to allow a more-or-less normal distribution of variation in returns for capital markets. Sure, occasionally we needed to call out the Plunge Protection Team. Sure, political discretion was often the better part of monetary policy valor. But by and large, capital markets were ALLOWED to have chance play a large role in their outcomes. Some years will be good. Some years will be bad. A few years will be very good! Sorry, a few years will be very bad.

But since the near-death experience of 2008, capital markets have been seen - quite rightly, I'd say - as existentially important to the State. Capital markets produce asset prices in exactly the same way that power plants produce electricity, and I'm not sure which is more important to modern society. Honestly, we wouldn't last a week without either on a nationwide basis before things would get downright post-apocalyptic. Until 2008, the State didn't think it was possible for a deflationary shock to bring down the entire asset price production utility. Now they know. And they won't make THAT mistake again.

Is this a forever thing? No, it's not a forever thing. No Zeitgeist is permanent in a three-body system. One day, large market gains and losses WILL BE ALLOWED again.

But a lot has to happen between today and that day. Debts must be monetized. Debts must be inflated away. Bread must be distributed and circuses must be maintained. Wars must be won. Wars must be lost.

Look, I don't enjoy writing this. I know this isn't what people want to hear, and I know that a lot of smart people who I really respect have put their chips down on other sides of these views.

But when I look at the core research questions of investing with Clear Eyes and a Full Heart,

• What are the Narratives (story arcs) I am being told?
• What are the Abstractions (categorizations) presented to me?
• What are the Metagames (big picture games) I am playing?
• What are the Estimations (the roles of chance) shaping outcomes here?

these are the answers that I find ...

• Everything that has shifted in the relationship between State and Market has shifted to prevent a systemic-ending deflationary shock like 2008 from ever happening again. So it won't. If you have prepared your portfolio to protect you from a nasty deflationary shock like a Euro crisis or a China crisis or a Fed crisis - what I call the Three Horsemen of the Investment Semi-Apocalypse - you are building a Maginot Line. You are fighting the last war. You should prepare for the next war. You should prepare for the Fourth Horseman - Inflation - because this horseman is riding in as a response to a deflationary shock or in the absence of a deflationary shock. Either way, fast-motion or slow-motion, THIS is the vector of the next system-redefining process.

• While political scorecards passive large-cap equity indices may not fluctuate so much over this new Zeitgeist, at least not in real terms ... your portfolio (particularly an institutional or ultra high net worth portfolio) almost certainly will, especially in real terms. Why? Because the bond market ain't a political scorecard. Because everything you think you know about portfolio diversification will fail when the Fourth Horseman rides into town. Because emerging markets are going to be crushed before this is over. Because every professional investor's inflation-investing muscles have atrophied to the point of helplessness. Because you think long-vol and crisis-alpha are things.

It's never the same gag twice. It's always the next gag.

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