Casino capitalism is the winning and losing of fortunes in the stock market. So wrote (and we paraphrase) John Maynard Keynes in his famous General Theory of Employment, Interest, and Money in the midst of the Great Depression (1936). He went on to warn about extremes:

Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.

In short, bubbles growing alongside an economy might be benign. When bubbles begin to direct the economy, particularly physical investment, the situation has become dire. That is casino capitalism. Traditional standards of investment discernment and conduct are deemed passé. Overvalued assets become foundational for speculative behavior when the dynamics of price appreciation become the basis for “investment” rather than cash flows. Chasing price becomes a cycle of excess that feeds on itself. Speculators, taking their cues from price movements, drive the market higher. Valuation loses its authority as a governor of extremes, and the chasm between the moment and reality deepens, seeding a frenzy that will reap only tears.

Roots of the Casino

Keynes could not have imagined that it would be the once staid and estimable U.S. central bank that would both build and license the great American casino. Its perpetually lower interest-rate policy since the dot-com bubble has enabled and encouraged speculation while capital development languishes. Moreover, as tales of instantaneous riches abound, day traders on a shoestring and modern-day titans like Elon Musk have flocked to the wagering tables where they stand elbow to elbow as they roll the dice.

The narrative that breathed life into Bitcoin, SPACS (special purpose acquisition companies), and ubiquitous day trading—to name just a few of the telltale signs that casino capitalism has metastasized to capture the retail investor’s fancy—has its roots buried deeply in the soil of low-cost money. With the discount rate so shockingly low that the present value of future cash flows is both gargantuan and so exceptionally volatile as to be rendered unreliable, today’s speculators are left knowing the price of everything and the value of nothing.

Casino capitalism is a magnet for gamblers: those who accept the notion that an expectation of high returns comes at the expense of high risks. “Double or nothing” wagering, a notion anathema to rational commercial transactions, is a mainstay in the world of big gains and losses.

To be sure, many speculators are temperamentally inclined toward the get-rich-quick allure of glitzy houses built on chance and hope. But many became speculators because they’ve concluded there is no alternative (TINA). The one-year U.S. Treasury note yields 0.18% and the 10-year, 1.54%. The 10-year U.S. Treasury note, which inherently carries price risk, cannot produce a return greater than the aforementioned 1.54% for a 2031 maturity unless the buyer is merely trading it. Every non-speculative asset derives its price from applying a discount rate based on the yield of an appropriate-maturity U.S. Treasury note or bond, plus a premium for the additional risk perceived. In today’s managed-interest-rate world, low risk virtually guarantees low return.

Managing Risk

The visible dynamics of the TINA phenomenon almost certainly suggest a corollary sub-surface structure that is innately and worrisomely unstable. Like an iceberg, it is typically only a portion of a situation that is available for analysis. Markets, if nothing else, are profoundly complex systems of which we see only the tip. Such complexity is inclined toward disequilibrium. Once in a critical state, a seemingly insignificant shifting of variables in a complex system gives birth to a veritable tsunami. Given such catastrophic risk, diversification—the bread and butter of modern portfolio theory (MPT)—fails as a risk-mitigation strategy. Other strategies that include negative-risk correlations or market timing are likely to fall woefully short of expectations as well. Despite the risks of a lights-out scenario, or perhaps because of it, managers rarely present their “risk-adjusted returns” or even “tail-risk-adjusted returns.” The Thanksgiving turkey metaphor comes home to roost.[1]

There are those of us, though unfashionable in the extreme for too many years, who believe that the high-risk/high-return gambling paradigm can and should be turned on its head by tell-it-as-it-is fiduciaries. We are so bold as to argue that the lower the risks assumed, the higher the prospective returns. Of course, our conviction is predicated on the repetitious nature of certain historical forces that have reappeared with the reliability of the seasons. The first is the easiest understood: regression to the mean. Examine the valuation of the S&P 500. Over the last 21 years the Shiller CAPE (cyclically adjusted price earnings ratio) has mean-reverted through down-and-up cycles: After peaking at 44.2 x in 2000, it fell to 13.2x in 2009, only to rebound as we write (39.8). Its historic mean is 16x. We will provide data and narrative on the seven preceding secular cycles in our 2021 annual report, due out in January 2022.

Even in our definition of risk, we likely differ from the majority. For example, we see price volatility as our ally and accomplice, making it possible for us to buy cheaper or sell dearer. Risk of permanent loss of capital, we contend, is the thoughtful investor’s nemesis. It is most often the result of overpaying for an asset. We are aware that in the everyday investment world, where emotions often hold sway, a paper loss easily becomes a real one when a client’s tolerance for price volatility is underestimated and the urgent and unequivocal GMO (get me out) call is received. To avoid subjecting any client to such emotional torture, we are committed to be absolute-, not relative-return, investors. Further, we have the mathematics of long-term compounded returns on our side.

In the absence of sufficient, absolute-return, investment opportunities, we are content to hold most assets in short-term U.S. Treasuries, effectively limiting the portfolio downside. Minimal equity positions provide exposure to modest intermediate gains. A final commitment of capital is made to asymmetrical derivatives that benefit greatly from a reversion to the mean.

When casino capitalism reigns, invariably in the terminal phases of a speculative bubble, such unorthodox portfolios are one of the few options for prudent investors. The derivatives, like any insurance premium, are a constant and irritating reminder of possibilities left behind. That is, until the reason for the insurance becomes obvious. The ultimate opportunity for the iconoclasts is a regression to … reality. Flush with the confidence of having avoided the debacle, the temperament to embrace equities at bargain-basement prices is compelling. Then, as our friend likes to say, all’s swell that ends swell.

[1] “A turkey is fed for a thousand days by a butcher; every day confirms to its staff of analysts that butchers love turkeys ‘with increased statistical confidence.’ The butcher will keep feeding the turkey until a few days before Thanksgiving. Then comes that day when it is really not a very good idea to be a turkey. So with the butcher surprising it, the turkey will have a revision of belief—right when it’s confidence in the statement that the butcher loves turkeys is maximal…” From both the turkey’s and the butcher’s perspective, the turkey story is the mother of all harmful mistakes: mistaking absence of evidence (of harm) for evidence of absence. To avoid becoming a turkey starts with figuring out the difference between true and manufactured stability. It doesn’t take much imagination to figure out what happens when constrained, volatility-choked systems explode…

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