Welcome to radical uncertainty

• We got a glimpse Monday morning, when the stock market whipsawed, moving more than 8% in half an hour on little more than a rumor about President Trump's state of mind.

The big picture: Economist Frank Knight elucidated the key distinction in his 1921 book "Risk, Uncertainty and Profit."

• Risk, Knight said, applies to situations where different outcomes can be assigned various probabilities, which can then be calculated and priced.
• Uncertainty is where those outcomes cannot be assigned numerical probabilities, but they can still be modeled and analyzed by using stress tests, history, storytelling, scenario analysis, and other tools. This is the world of educated guesses.
• Radical uncertainty, as described in the eponymous 2020 book by John Kay and Mervyn King, is closer to pure guesswork. It describes a world where we don't have a grasp of what the possible outcomes even are, let alone what kind of probability to assign to each one.

Zoom out: Trump's trade policy is unpredictable, with tariffs being set and changed constantly.

• In such a world it becomes difficult to make long-term investment decisions, since such strategies require some degree of predictability about the future.
• A world where tariffs on China can go from 10% to 104% in a matter of weeks, despite international trade treaties, is a world where shareholders much prefer stock buybacks and hiked dividends to large-scale capital investments that could end up looking extremely foolish.

Follow the money: Between 9:43am and 10:17am Monday — a period of 34 minutes — the S&P 500 rose by an astonishing 8.3%, after a murky series of events involving a social media post, erroneous headlines on CNBC and the Reuters wire, and lots of frantic confusion in the market. (Reuters withdrew its story and apologized for the error. CNBC corrected itself on air.)

• In other words, the S&P rose more in 34 minutes in one morning than it did in the first 13 years of this century.

• That kind of volatility is a defining symptom of radical uncertainty, a state of affairs where no one has any conviction about what anything might be worth, or even about what they don't know.
• In such a world, the stock market starts to behave less like a weighing machine and more like a random number generator.

Between the lines: In a world of radical uncertainty, markets change in important ways.

• Overall valuations are lower, as investors demand a risk premium for risks they can't even name, let alone model.
• Volatility becomes a permanent feature of the market, rather than a temporary aberration.
• Cash allocations rise, as investors wait for that volatility to throw up investing opportunities.

The bottom line: Trump's tariffs have humbled the world.

• So long as he remains president, it seems likely we'll be living in this state of not knowing, which we only briefly glimpsed during the depths of the pandemic.