beauty in ramdomness

By coincidence, I began to appreciate Jackson Pollock’s art at the same time I was reading about fractals and deterministic chaos. Scientists have subsequently linked his beautiful work to fractal geometry It is essentially the discovery that seemingly random events (how could Pollock gauge in advance where each drop would fall on the canvas?) are an expression of nature and can coalesce into harmony and beauty.

Like drip paintings, returns in financial markets have been shown to have fractal dimensions and they can sometimes be almost as exhilarating as looking at a Pollock. Other times not so much. It all depends from how far away you look at them.

What to do with this information when we are constructing a portfolio? If some form of randomness is pervading market returns, especially in the short-term, how is one to advise needy humans what to do with their accumulated savings today?

In a conversation with a friend I tried to make the distinction between investment ‘logic’ and the fractal beauty of high random returns (in truth, I didn’t know I was doing that until afterwards). Why don’t we buy more high-yield debt and increase our equity allocation today given where short- and long-term interest rates appear to be headed? Can’t you just Pollockize a portfolio and generate beauty in someone’s personal accounting ledger?

I proceeded to lay out my – and many other analysts’ – reasoning that current prices in equity-like investments are out of line with historical values. This means that to increase high yield debt or equities exposure today we must believe at least one of these five statements:

[1] The long-term underlying cash flows of those investments will grow faster than forecast, and faster than in the past;
[2] We’re happy with returns which are substantially below historical long-term averages (implied: for the same amount of risk);
[3] Historic norms no longer apply;
[4] We will be able to spot the moment before the ‘correction’ and sell on time; and/or
[5] We don’t really ever need the money.

The last point is a budgeting exercise (as we have seen); if that is the case, we should probably have no other assets but equities. The data have so discredited point 4 that it does not deserve further serious consideration and point 3 requires we come up with an alternative universe. Only 1 and 2 are realistically workable solutions, though the first one is very difficult to justify within current economic frameworks – even tossing in Modern Monetary Theory in the mix.

If we want to produce the Pollock version of a portfolio’s performance record, we must build our strategy and investment program on multi-cycle analysis and historical research, not on forecasts of yearly returns and daily news flows. Just like we shouldn’t stare at his paintings from one or two inches away counting the individual drips, we shouldn’t focus on too short a time frame and look instead at the farther horizons of our objectives.

That’s how Pollock would want you to do it.