Practical uses for the Makian Distribution

Who cares if risk and leverage are related? 

Well, let’s look at a practical application of the theory.  Let’s look at silver.

The fundamentals for silver look shockingly good.  With all the liquidity sloshing around the world, it’s going to end up somewhere.  Currently it’s ending up in US bonds, oil and gold.  With some left over going into propping up shares with ridiculous P/Es and insanely low dividend yields (at least in the US).  So some markets are undoubtedly subject to “bubble-like” dynamics due to “excessive” liquidity from the Fed searching out diminished investment opportunities.

The question is not whether there will be bubbles (that’s guaranteed given the Fed’s “please use me as a carry trade” policies).  The question is where the next bubble will form, getting on that train before the others and riding it for everything it’s worth.

Silver has an interesting combination of (1) limited supply (2) historically low prices (both in absolute terms and relative to gold) and (3) having been the subject of a bubble in the past – but not in the recent past.  So it’s a prime candidate in my view for a tsunami of money to wash over it, with dynamics similar to what we saw in the 1970s.

If the Makian distribution is useful during bubbles, then silver will be unlikely to return its long term average of a couple of percent, and will probably go ballastic, only to face severe volatility and extreme negative returns in a couple of years’ time.   Between then and now, it’s likely to be a wild ride.

Similarly, bank shares appear vulnerable to bubble-like dynamics.  Just look at US and Aust and UK bank shares over the last 12 months!  Drops of over 80% in some cases, only to see rises of equal magnitude in the second half of 2009.  If you used the normal distribution to model bank share movements these extreme movements would have been considered “insane”. 

Use the Makian Distribution on the other hand and you would have predicted that the least likely outcome this year would have been the steady long-term mean average return on bank shares.  You would have expected extreme volatility, switching from extreme negative to extreme positive.  Just like what happened!

One way of making money out of the Makian Distibution when most market participants are using the normal distribution is simple:  If the theory is correct, put options would be ridiculously, insanely underpriced in markets subject to extreme leverage.  So if you buy bank shares and also buy put options for those shares exercisable in 12 months time at a 10% – 15% discount to today’s prices (to protect you from likely – not unlikely – Black Swan volatility) then you should come out ahead.  Why?  Because Black-Scholes is used to price options, Black-Scholes uses the normal distribution and the normal distribution underestimates extreme volatility in highly leveraged markets.  And banks shares are nothing if not highly leveraged.  So returns during these times will likely be highly positive or highly negative – but unlikely to follow their long-term mean return.

Bank shares have already skyrocketed since March 09, but unlike some I still think they have a little way to go on the upside, before collapsing on the downside.  Why, given that so many respected, experienced commentators are warning against buying the banks?

Well, given the obviously close connection between governments and the major banks (and I’m only talking about the two or three biggest banks in each country here) then I am confident central banks will continue to pour money down the throats of the major banks to keep re-capitalizing them.  The markets are so distorted that I believe any method will be found to re-capitalize and “re-profitize” the big banks.

For example, anyone betting against Goldmans, or hoping Goldmans execs will be prosecuted for insider trading or fraud, is deluding themselves.  Goldman is the US government right now.  In other words, it’s hardly going to prosecute itself.  It decides its own profitability, regardless of market conditions.   It will only go down if the US government goes down.  That may happen, but there’s a lot of upside between then and now.  Why not climb aboard the gravy train?

Of course, I’m obviously not your financial advisor and I’m not recommending you go out and invest on this basis.  I’m merely saying that if the Makian Distribution is a better reflection of the “real” distribution of returns in highly leveraged markets, then it necessarily follows that there are opportunities for “arbitrage” profits when everyone else is stupid enough to price using the normal distribution.  This is just one example of how this misperception by “mainstream” market participants could be used against them.

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