America’s energy independence was an illusion created by cheap debt. All that’s left to tally is the damage.
Ever since the oil shocks of the 1970s, the idea of energy independence, which in its grandest incarnation meant freedom from the world’s oil-rich trouble spots, has been a dream for Democrats and Republicans alike. It once seemed utterly unattainable — until the advent of fracking, which unleashed a torrent of oil. By early 2019, America was the world’s largest producer of crude oil, surpassing both Saudi Arabia and Russia. And President Trump reveled in the rhetoric: We hadn’t merely achieved independence, his administration said, but rather “energy dominance.”
Then came Covid-19, and, on March 8, the sudden and vicious end to the truce between Saudi Arabia and Russia, under which both countries limited production to prop up prices. On March 9, the price of oil plunged by almost a third, its steepest one-day drop in almost 30 years.
As a result, the stocks that make up the S.&P. 500 energy sector fell 20 percent, marking the sector’s largest drop on record. There were rumblings that shale companies would seek a federal lifeline. Whiting Petroleum, whose stock once traded for $150 a share, filed for bankruptcy. Tens of thousands of Texans are being laid off in the Permian Basin and other parts of the state, and the whole industry is bracing for worse.
On the surface, it appears that two unforeseeable and random shocks are threatening our dream.
In reality, the dream was always an illusion, and its collapse was already underway. That’s because oil fracking has never been financially viable. America’s energy independence was built on an industry that is the very definition of dependent — dependent on investors to keeping pouring billions upon billions in capital into money-losing companies to fund their drilling. Investors were willing to do this only as long as oil prices, which are not under America’s control, were high — and when they believed that one day, profits would materialize.
Even before the coronavirus crisis, the spigot was drying up. Now, it has been shut off.
The industry’s lack of profits wasn’t exactly a secret. In early 2015, the hedge fund manager David Einhorn announced at an investment conference that he had looked at the financial statements of 16 publicly traded shale producers and found that from 2006 to 2014, they spent $80 billion more than they received from selling oil. The basic reason is that the amount of oil coming out of a fracked well declines steeply after the first year — more than 50 percent in year two. To keep growing, companies have to keep plowing billions back into the ground.
The industry’s boosters argue that technological gains, such as drilling ever bigger wells, and clustering wells more tightly together to reduce the cost of moving equipment, eventually would lead to a gusher of profits. Fracking, they said, was just manufacturing, in which process and human intelligence could reduce costs and conquer geology.
Actually, no. The key issue is the “parent child problem.” When wells are clustered tightly together, with so-called child wells drilled around the parent, the wells interfere with one another, resulting in less oil, not more. (This may not surprise anyone who is attempting to be productive while working in close quarters with their children.)
The promised profits haven’t materialized. In the first half of 2019, when oil was around $55 a barrel, only a few top-tier companies were profitable. “By now, it should be abundantly clear that the current shale oil business model does not work — even for the very best companies in the industry,” the investment firm SailingStone Capital Partners explained in a recent note.
Policymakers who wanted to tout energy independence disregarded all this, even as investors were starting to lose patience. As early as 2018, some investors had begun to tell companies that they wanted to see free cash flow, and that they were tired of compensation models that rewarded executives with rich paydays for increasing production, but failed to take profits into account. As a result, fracking stocks badly underperformed the market.
But with super-low interest rates, investors in search of yield were still willing to buy debt. Over the past 10 years, the entire energy industry has issued over $400 billion in high-yield debt. “They subprimed the American energy ecosystem,” says a longtime energy market observer.
Even as the public equity and debt markets grew cautious, drilling continued. That’s because one big source of funding didn’t dry up: private equity. And why not? Private equity financiers typically get a 2 percent management fee on funds they can raise, so they are incentivized to take all the money that pension funds, desperate for returns to shore up their promises to retirees, have been willing to give them.
In the Haynesville and the Utica Shales, two major natural gas plays, over half of the drilling is being done by private equity-backed companies; in the oil-rich Permian Basin, it’s about a quarter of the drilling. From 2015 through 2019, private equity firms raised almost $80 billion in funds focused mostly on shale production, according to Barclays.
Until the capital markets began to get suspicious, private equity investors could flip companies they had funded to larger, public companies, making a profitable exit regardless of whether or not the underlying business was making money.
That, too, is ending, as investors in such funds have become disillusioned.
You can see how all of this is playing out by looking at Occidental Petroleum. In 2019, Oxy, as it’s known, topped a competing bid from Chevron and paid $38 billion to take over Anadarko Petroleum, which is one of the major shale companies. Since that time, Oxy’s stock has plummeted almost 80 percent in part due to fears that the Anadarko acquisition is going to prove so wildly unprofitable that it sinks the company.
On March 10, the company announced that it would slash its dividend for the first time since the early 1990s, when Saddam Hussein’s invasion of Kuwait sent oil prices plummeting.
Occidental is just one piece of the puzzle. In April, the Energy Information Administration cut its forecast for U.S. oil production, estimating that it will fall both this year and next — suggesting that the days of huge growth in production from shale are over.
On March 10, Scott Sheffield, the chief executive of Pioneer Natural Resources, a major driller in the Permian Basin, told Bloomberg that U.S. oil output could fall by more than two million barrels per day by next year if prices remain where they are today.
“This is late ’80s bad,” a close observer of the industry says.
After the United States engaged in a high-stakes negotiation with Russia and Saudi Arabia to curtail production, a tentative deal was struck on Thursday. Certainly, President Trump, who has staked so much on the American shale industry, wants to save it. “We really need Trump to do something or he’s going to lose all the energy states in this election,” Mr. Sheffield told CNBC in late March.
A deal, and higher oil prices, might help the industry. But they won’t fix its fundamental problem with profitability. Energy independence was a fever dream, fed by cheap debt and frothy capital markets.
All that’s left to tally is the environmental and financial damage. In the five years ending in April, there were 215 bankruptcies for oil and gas companies, involving $130 billion in debt, according to the law firm Haynes and Boone. Moody’s, the rating agency, said that in the third quarter of 2019, 91 percent of defaulted U.S. corporate debt was due to oil and gas companies. And North American oil and gas drillers have almost $100 billion of debt that is set to mature in the next four years.
It’s still unclear where most of this debt is held. Some of it has been packaged into so-called collateralized loan obligations, pieces of which are held by hedge funds. Some of it may be on bank balance sheets. Investors in the equity of these companies have already seen the value of their holdings decimated. Pension funds that have poured money into private equity firms may take a hit soon, too. All we know for sure is that fracking company executives and private equity financiers have made a fortune by touting the myth of energy independence — and they won’t be the ones who have to pick up the pieces.
Imagine being furnished with generational wealth under one condition – you must choose only one asset allocation for your portfolio and stick with it for 100 years. Where would you even start? Chris Cole, CIO and founder of Artemis Capital Management, returns to Real Vision to answer that very question. He sits down with Danielle DiMartino Booth of Quill Intelligence to discuss the optimal portfolio construction for the long run, regardless of market condition. With uncertainty everywhere despite all-highs in the market, Cole discusses how to navigate Charlie Munger’s “death of the efficient frontier.” He explains the allegory of the Hawk and Serpent and breaks down the construction of his 100-year portfolio. Cole and Booth provide viewers with the tools to traverse the “incremental death of alpha,” and markets that are increasingly subject to the amplified volatility of increasingly passive investments. This piece is a much-watch for the pension fund or endowment that has no long-volatility exposure in their portfolio. Filmed on February 7, 2020 in Austin, Texas.
DANIELLE DIMARTINO BOOTH: Well, hello.
This is Danielle DiMartino Booth with Real Vision, and today we’ve got a real treat.
We are bringing your Christopher Cole with Artemis Capital.
We’ve been waiting for over two years for a follow-up to his seminal paper.
It’s out there.
You have to read it.
Share it with people– maybe not people under 18.
They wouldn’t understand it.
But everybody needs to get a copy of this and read it.
We’re going to discuss what it’s all about today.
CHRISTOPHER COLE: Thank you.
It’s a pleasure to be here and back on Real Vision again.
DANIELLE DIMARTINO BOOTH: So I’m going to start with an anecdote.
Years ago, I was in Omaha, and I visited with Charlie Munger.
And he made the comment to me that the entire pension fund advisory business one day would
go out of business.
It would go the way of the dodo bird because of the group think that surrounded the industry
because of the way that the portfolios were being designed in a world where central banks
were effectively running the show.
And he made the comment to me that he saw in the future, he said, I might not live to
see, but you will, the death of the efficient frontier.
So I’m curious about your thoughts on portfolio construction, how it’s done, and how it that
evolution has changed basically the way this entire generation approaches investing.
CHRISTOPHER COLE: Well, beginning with that and looking at what Munger has said, as a
follow-up to my last letter, the Ouroboros letter that talked about the cycle of risk
and how volatility has been used as both a proxy for risk and also as a source of return.
I thought, how can I– what will disrupt that– what will disrupt that cycle?
I posed a question to myself saying, well, if we’re going to see what happens in the
future, we have to look to the past, and the distant past, not just the recent past, not
the last 10 years, not the last 40 years.
We need to look back 100, 200 years to understand the cycle of capital creation and destruction.
And I posed this question to myself.
I said, imagine that someone gives you generational wealth, enough money that you can live and
your children’s children can live at a high level.
But it’s subject to one question, one dynamic.
You have to choose an asset allocation and stick with that allocation over 100 years.
What allocation do you choose so that your children’s children will have prosperity?
And taking that cue, I went back and looked at 90 years of historical data, backtested
a wide range of popular financial engineering strategies, everything from risk parity, the
traditional pension portfolio, short volatility, long volatility strategies, commodity trending
strategies, and looked and how do these perform?
And what asset allocation is the allocation that’s going to provide wealth, not only consistently
over 90 years, but through every generational cycle, through both periods of secular growth
and secular decline?
And what I found surprised me, that echoing Munger’s statement, the allocation that the
majority of US pension systems and retirees are following, which approximately today is
about 70% equity-linked products- – that could be everything from stocks to private equity,
things that are the profit from secular growth– and about 20% bonds.
That portfolio has done incredibly well over the last 40 years.
But when you look at that portfolio over 90 years, you see a very, very different reality.
And that has a wide range of social, economic, and social ramifications that become quite
But looking at that, I say, what asset allocation can I find that will actually provide protection
over that 90 years consistently?
And that answer came not from a macro view.
It doesn’t come from me having an opinion about whether or not we’re going to go into
a recession or whether or not there’s going to be some continued economic prosperity.
It comes simply by looking at data, using mathematics, looking at data, and looking
at empirical data over a lifetime to come to that determination.
And I think the results are quite shocking.
And I think they run somewhat counter to the consensus knowledge as to what optimal portfolio
allocation should be.
DANIELLE DIMARTINO BOOTH: So Charlie Munger was right.
CHRISTOPHER COLE: I think he’s right.
DANIELLE DIMARTINO BOOTH: Take a step back to the October 2017 paper, if you will.
Back then, you drew the scope of the financialization of the markets of the economy.
You talked about risk parity, and share buybacks, and the massive effect that they had had on
the crowding in to certain asset classes.
So talk about what effect this herding instinct has had on the way this generation views investing.
CHRISTOPHER COLE: You and I have a very similar writing style.
I love metaphors.
I think visually.
I think I think you do too.
DANIELLE DIMARTINO BOOTH: Yours are better.
CHRISTOPHER COLE: Yours are– they’re very good.
But in that 2017 paper, I think I wanted to use the idea of an Ouroboros, this concept
of a snake devouring its own tail.
And what this was a metaphor for– what is now about $3 trillion in equity markets alone.
This is just equity markets, US equity markets.
The number is much larger if you expand that across asset classes.
But of strategies that use volatility as an input for taking risk, but also seek to generate
excess yield, either through selling volatility or through the assumption of stability.
So in this number, you have implicit and explicit short volatility strategies.
And I think there’s a lot of confusion as to what this means.
Explicit short volatility strategies are strategies that they will sell derivatives, so they’ll
DANIELLE DIMARTINO BOOTH: So the easiest would be selling the VIX.
CHRISTOPHER COLE: Selling the VIX, that’s right.
So this paper came out prior to the XIV blow up, and it talked about how the VIX ETPs were
likely to have significant problems.
But that’s a very small component of that short volatility trade.
A much larger component of the short vol trade are strategies that replicate the risk parameters
of short volatility trades but may not actually be shorting volatility.
So strategies like this might be things like volatility targeting funds or some elements
of risk parity, for example.
DANIELLE DIMARTINO BOOTH: Risk parity is still something we don’t hear a lot about, even
though it’s massive.
CHRISTOPHER COLE: Yes, yeah.
And indeed, the framework there is– this could be anything between literally shorting
vol– literally shorting volatility, what I’ll call short gamma or being short trend–
and we could talk a little bit more about that– short correlations, short interest
These are risk factors of a portfolio of short options that various financial engineering
strategies will replicate, maybe not all of them, but certain aspects of them.
That doesn’t mean all these strategies are bad.
It just means that they are formulated to a world where interest rates are dropping,
assets are mean reverting, and that volatility is quite low.
And guess what has happened the last 40 years?
We are at generational lows in volatility across asset classes.
Asset trending– I think this is something most people don’t realize that, actually,
assets, equity for example, used to trend higher and lower.
You can measure that through something called autocorrelation.
All that means is that if today was down, it is likely that tomorrow will be up and
DANIELLE DIMARTINO BOOTH: Buy the dip.
CHRISTOPHER COLE: Buy the dip, that’s right.
So the assets for the greater part of a lifetime were autocorrelated in the sense that higher
prices resulted in higher prices, and lower prices resulted in lower prices.
That autocorrelation peaked right when Nixon delinked the dollar versus gold, or the US
dollar versus gold.
And we have underwent a multi-decade decrease in autocorrelations.
And now, we’re at really peak mean reversion markets.
So a lot of strategies make the assumption that mean reversion is implicit to asset price
That’s definitely not always the case.
So to that point, one of the strategies we actually tested was buy the dip.
How would buy the dip perform going back 90 years?
This is very interesting.
Buying the dip, you don’t think of it as a short volatility, strategy but it is short
gamma, what’s short that autocorrelation effect.
Well, buy the dip has performed incredibly well over the last 10 years, and really over
the last 20 years, as central banks have been very reactive to market stress.
DANIELLE DIMARTINO BOOTH: That’s an understatement.
CHRISTOPHER COLE: Right?
Well, it’s very interesting.
If you go back and you test buy the dip over 90 years, that strategy goes bankrupt three
DANIELLE DIMARTINO BOOTH: Bankrupt’s a big word.
CHRISTOPHER COLE: Flat out loses all of its money three times over a 90 year history.
It is only really in the last 10 years where it’s compounded at about 10% a year where
we’ve seen that outperformance.
DANIELLE DIMARTINO BOOTH: I think that might– let’s see.
Is that the quantitative easing era?
CHRISTOPHER COLE: I think so.
It’s not a coincidence.
Yes, not a coincidence at all.
DANIELLE DIMARTINO BOOTH: So you tweeted out something a few days ago about long-term deflationary
CHRISTOPHER COLE: Yeah.
DANIELLE DIMARTINO BOOTH: It feels like we keep going there.
What in your mind could possibly ignite inflation?
Because it’s the one thing that nobody is expecting.
We’re all expecting wash, rinse, repeat.
More deflation next time there’s a disruption of any kind, and again, every central bank
comes riding into the rescue with more stimulus.
CHRISTOPHER COLE: More stimulus– so look at looking back at– there have been other
cycles across history that are like an Ouroboros eating its own tail.
If we take this beyond just short volatility, we can think of it as part of the entire debt
So this idea that you start out with something good, you start out with real economic growth,
technology, and demographics, and that leads to growth.
And fantastic– you’re growing.
The economy is growing.
It’s fundamental growth.
At a certain point in time, the fundamentals get stretched and we become reliant on fiat
devaluation and debt expansion.
DANIELLE DIMARTINO BOOTH: So think of the baby boomer generation generating genuine
economic growth, and then they’re starting to move to spending less.
And how do you fill that gap?
CHRISTOPHER COLE: Exactly.
So to this point, we start out in this framework.
It’s in the period of 1984 to 2007– one of the most incredible periods of asset price
growth and asset appreciation growth in not just American history, in history period.
90% of the returns of a 60-40 stock-bond portfolio came from the 22 years between ’84 and 2007.
Just 22 years drove 90% of the gains of that portfolio over 90 years.
DANIELLE DIMARTINO BOOTH: I probably couldn’t count on one hand the number of investors
who have been around since before 1984.
CHRISTOPHER COLE: Exactly.
The average investment advisor is 52 years old.
They were a kindergartener during the stagflationary period of the 1970s.
So you have all these baby boomers, 76 million baby boomers– largest generation in American
They’re teenagers right into the devaluation of gold in the 1971.
That is driving a tremendous amount of inflation at that point in time.
Interest rates go up to 19%, and then these baby boomers, 76 million of them, enter the
workforce in the early ’80s.
And they start making money.
They start making money, and they start spending.
They start investing.
So you have baby boomers coming on in.
Then you have a trend towards globalization, so we’re able to export our inflation overseas.
You have a technology boom as well.
And then, interest rates begin dropping.
DANIELLE DIMARTINO BOOTH: Oh, yes.
CHRISTOPHER COLE: So and– DANIELLE DIMARTINO BOOTH: May he rest in peace, Paul Volcker.
CHRISTOPHER COLE: Exactly.
And as if that’s not enough, taxes start coming down.
So you have this once-in-a-generation, once-in-several-hundred-years economic boom, asset price boom that occurs,
driven as baby boomers come into the workforce, begin savings, enter into their prime earning
But now, those boomers are going to be retiring.
They are going to be drawing $20 trillion dollars out of markets instead of putting
that into markets.
This, obviously presents a tremendous deflationary force.
So I’d like to think about this as a snake.
If we take the snake metaphor and we pull it out, it’s not just short volatility.
It is almost like a snake devouring its own tail as part of a business cycle.
The snake is eating prey and naturally compressing inwards through secular growth.
And that’s healthy.
But towards the end of the secular growth cycle, that snake relies on financial engineering,
excess leverage, and begins eating its own tail.
And that is where we’re at, I would say, in the cycle right now.
And you’ve written beautifully on this about some of the debt problems out there.
Currently, we’re at 48% debt to GDP, highest corporate debt to GDP, highest level in American
DANIELLE DIMARTINO BOOTH: You tack on– you aggregate non-financial, we’re at 74%.
CHRISTOPHER COLE: 74%.
DANIELLE DIMARTINO BOOTH: Unheard of numbers.
CHRISTOPHER COLE: And what are we doing with this?
What are corporations doing with this debt?
They’re issuing debt to buy back their own shares at a trillion dollars a year.
And then institutions are funneling that in in order to– they need to find ways to generate
yield absent any fundamental growth.
So we had a year like last year, where there’s no actual earnings growth, but it’s all multiple
expansion driven by share buybacks and speculation.
So this is– we’re at this end of the cycle, where the snake is devouring its own tail.
Now, this can go on for a long time.
DANIELLE DIMARTINO BOOTH: Clearly.
CHRISTOPHER COLE: Well, what breaks that cycle?
And this comes to the image in the paper of the allegory of the hawk and serpent.
And I was thinking about this.
Outside our offices here, we have a peregrine falcon that flies around.
DANIELLE DIMARTINO BOOTH: I saw that on Twitter.
You need to tweet more often, by the way.
Got on “Real Vision” thumbs up on that?
CHRISTOPHER COLE: I do a lot of research and work, but I’ll try.
I’ll try a little bit more.
I’m still getting used to it, by the way.
The whole retweet thing– DANIELLE DIMARTINO BOOTH: It gets tricky.
CHRISTOPHER COLE: It gets tricky a little bit.
But that hawk– I noticed the idea of hawk.
And there is an old symbol of a hawk fighting a serpent.
And this symbol has deep roots.
It’s actually on the great seal of the US.
It’s on the coat of arms of Mexico.
It has important ramifications across different traditions ranging from Aztec to Egyptian
But this idea to me, what it represented is the serpent represents the secular growth
cycle that becomes corrupted at a certain point in time, where the serpent begins devouring
its own tail.
It is unable to generate growth naturally and has to self-cannibalize.
And the hawk comes down and represents the disruption of that cycle.
But the hawk has two wings, which also work with the probability distribution.
On the left wing– DANIELLE DIMARTINO BOOTH: Wow, that’s deep.
CHRISTOPHER COLE: So the metaphor goes deeper.
On the left wing, we have debt deflation.
This is what Japan has experienced.
That’s one way you get out of this decaying growth cycle.
DANIELLE DIMARTINO BOOTH: Slowly.
CHRISTOPHER COLE: Slowly.
That’s what the US experienced in the ’30s.
But on the other end of it, you have fiat devaluation and reflation.
That is where you simply devalue your currency.
And that could be helicopter money, devaluation currency, money printing.
That is another way that you get out of that crisis.
This is as old as money itself.
And one wing can occur before the other.
You can have a deflationary crisis before you have a reflationary crisis.
So to get back to your original question, what will cause– what I see causing inflation.
You have a scenario today where the two largest blocks of the US population are baby boomers,
at about 22% of the population right now.
They have a lot of money.
They’ve lived through one of the most incredible periods of asset price growth in history.
And they want to protect that money.
So they are going to– they’re going to support policies or are incentivized to, I should
They don’t need to, but they’re incentivized to support policies that protect their retirement
and their entitlement benefits.
Now you have millennials, which are now the largest generation at 26% of the population,
and Gen Z following, are likely to be the first generation in American history to be
poorer than their parents.
DANIELLE DIMARTINO BOOTH: Remarkable.
CHRISTOPHER COLE: Remarkable, yeah.
Lower household creation rates– they have– the average millennial has substantial student
DANIELLE DIMARTINO BOOTH: Low savings.
CHRISTOPHER COLE: No savings, that’s right.
So the incentive of the average millennial, they’re incentivized in essence to pursue
policies that represent redistribution of wealth and seek to tax, redistribute, and
So I think the time to look, and maybe what could cause inflation is the political sea
change towards– DANIELLE DIMARTINO BOOTH: At some point– we’re at $23 trillion now.
But to your point, at some point, you’re going to hit a level of debt if truly all of these
social spending initiatives are financed by printing money.
Theoretically, at some point, you will hit a limit.
I agree with you.
You talk about passive investing.
It’s a hot button.
90% of flows go into passive strategies.
Even pensions are in passive strategies.
Talk about the perfect– perfect liquidity of passive investing.
CHRISTOPHER COLE: The concept of passive– and now, we are at a point where passive investments
have eclipsed active for the first time in history.
And my friend Mike Green who’s a friend of “Real Vision” has a lot of fantastic research
DANIELLE DIMARTINO BOOTH: Yes, he has.
CHRISTOPHER COLE: And I’ve done some work, in essence, trying to replicate his assumptions
using some toy models and was able to do that.
His theory, at the end of the day, is that at a certain point, if the market is dominated
by passive actors, it not only amplifies volatility, which I completely agree with– if there is
no other incremental seller against a buyer or buyer against a seller, each incremental
buy or sell will result in massive movement in the underlying.
DANIELLE DIMARTINO BOOTH: It’s an amplifier.
CHRISTOPHER COLE: It’s an amplifier.
Because if you look at active investors, active investors are a volatility dampener.
Value investors will come into the market, and they will buy when there is a big collapse
in asset prices.
So they will in essence put a floor underneath asset prices.
And they’ll sell when asset prices go to high.
Well, you remove all the active investors, and that will amplify volatility.
The other factor that comes into play a lot of the time is this idea that it actually
reduces the alpha available to active participants.
DANIELLE DIMARTINO BOOTH: Clearly.
We’re watching one asset manager after another, one hedge fund after another go away.
CHRISTOPHER COLE: Because, in essence, passive is in its own right a systematic strategy.
It has elements of– it is a basic systematic strategy.
So it goes back to the soul of investing.
There are two different competing thought processes, I think, that are at war with one
The one thought process is that assets should have a value, that there should be a value,
and that market participants are fighting to determine what that value is.
But there is, in theory, some intrinsic value to it.
DANIELLE DIMARTINO BOOTH: Price discovery.
CHRISTOPHER COLE: Price discovery.
There is a second school, which I think is gaining strength right now, which is forget
All that matters according to this school of thinking is the price momentum of the asset.
DANIELLE DIMARTINO BOOTH: You can burn your MBA.
You don’t need it anymore.
CHRISTOPHER COLE: That’s right.
So aspects of factor investing follow this principle, whether it’s momentum, quality,
whether it’s FANG, or whether it’s ownership of company management.
Whatever the factor is, as long as people believe in the factor, and keep buying, and
keep providing– as long there continues to be liquidity, that creates value.
I’m clearly in camp number one.
I clearly believe that there’s intrinsic value.
I believe– DANIELLE DIMARTINO BOOTH: Well, if you go back 100 years, there is.
CHRISTOPHER COLE: There is.
And I would like to quote Harley Bassman, who once had a fantastic quote.
He always says this, that pigs can fly if shot out of a large enough cannon.
They always return to earth as bacon.
He’s so right on the money with his usual wit.
With a large enough amount of central bank stimulus and enough ability to create debt,
you can create this illusion as to momentum in these factors that– so I actually think
passive investing is actually just a liquidity momentum trading.
DANIELLE DIMARTINO BOOTH: I would agree with you.
Look– well, October 2018, it was not pretty.
It acted as an amplifier, but on the downside.
But we haven’t seen a lot of that.
You put venture capital and private equity into your 70% slice of the pie.
Because I don’t think that if you went down to Texas teachers, for example, I don’t think
that they would say that– they would say it would be at the opposite end of the spectrum,
and it would be a diversification strategy against publicly traded equities.
CHRISTOPHER COLE: So one are the concepts on doing this paper is I wanted to find a
asset allocation that is a solution.
What asset allocation can work over 90 years that can protect you against the deflationary
elements of the left wing of the hawk and the reflation three elements of the right
wing of the hawk?
That led me to a very big conclusion, and it ties into the question about private equity.
Most people think that excess return– that you want to take to asset classes that both
have solid returns, and bring them together, and that you’ll get a better result from.
That they prioritize the search for yield and prioritize excess return.
And what I found is that, actually, what people should prioritize is secular diversification.
And what that means is that you should look to large asset– look to asset classes that
can perform on the left or the right tail, and boldly size them in your portfolio.
That means boldly sizing countertrend asset classes that perform when stocks and bonds
DANIELLE DIMARTINO BOOTH: So gold’s not like the little 10% just in case?
CHRISTOPHER COLE: That’s right.
Gold shouldn’t be 1% or 2%.
It should be 20%.
Volatility should be 20%.
Commodity trend should be 20%.
And then stocks and bonds can make up the other remaining 20 and 20.
Well, so private equity– DANIELLE DIMARTINO BOOTH: That stands the conventional wisdom
on its head.
CHRISTOPHER COLE: It does, where many individuals have big problems trying to even allocate
3% of their portfolio to gold.
Well, this gets back to the private equity VC question.
Now, these are relatively new asset classes.
It’s tough to see their performance going back 100 years.
But Cambridge has fantastic data going back a good 20 years, 20, 30 years.
DANIELLE DIMARTINO BOOTH: When I was at DLJ, we had a merchant bank.
Private equity was this cottage industry.
Leon Black used to walk the halls.
This was way before– what, they’ve got $4 trillion?
CHRISTOPHER COLE: Yeah, it’s massive.
DANIELLE DIMARTINO BOOTH: Massive.
CHRISTOPHER COLE: Massive.
Well, it becomes very clear from looking.
You can just look at the return data from private equity NVCs to see that these asset
classes are secular growth asset classes.
They are correlated to the business cycle.
DANIELLE DIMARTINO BOOTH: So they move in concert with publicly-traded equities.
CHRISTOPHER COLE: They move.
Sure, you might get some excess return, but they are correlated to equities.
They will lose money in the event that there’s a widescale recession.
Well, I should say, they have historically lost money when that has occurred.
I cringe when I hear leaders of very large– and I’ve heard this.
Leaders of very large pension systems, huge, huge systems that have a lot of money, and
they say that private equity and venture capital are diversifies because they’re lagged.
This doesn’t work with the data in view.
DANIELLE DIMARTINO BOOTH: I’ve been harping on this issue for years and years.
When we went into the crisis, the baby boomers were still an actuarial accounting assumption
you could fudge with.
Heading into the next downturn, they’re going to be a cash flow issue for pensions.
And when you factor in the illiquidity aspect of the alternatives, it just makes no sense.
CHRISTOPHER COLE: No, it does not.
And this is what we’ve seen.
So I put about a post on Twitter.
And I had three asset classes.
And they were just sine wave graphs.
The two asset A and asset B were highly correlated with one another, and they were slightly offset
from one another.
And asset C, the last asset, was a countertrend asset.
It was an asset that didn’t make any money, but made money when all the other assets lost
DANIELLE DIMARTINO BOOTH: Did it lose?
CHRISTOPHER COLE: It lost money, actually– lost a little bit of money.
It was flat.
DANIELLE DIMARTINO BOOTH: A little– OK, critical words.
CHRISTOPHER COLE: And I posted to Twitter.
I said, which of these would you combine.
You can choose two assets to have the optimal portfolio.
And of course, everyone says, well, we’re going to choose the high returning asset and
the countertrend asset because that’s going to result in a dramatically better risk adjusted
return as opposed to combining the two assets that have similar return profiles, which results
in bigger gains, but bigger losses.
So Twitter got that answer correct.
80% of people chose the trend and the countertrend asset.
But what’s interesting is that the big institutions around the world are doing the exact opposite.
They’re taking equity exposure, and then they’re layering on more and more private equity exposure,
and more VC exposure, and more high yield credit exposure, and short volatility exposure,
and you name it, all because they have to reach the 7.25% return target.
And at the end of the day, what you have is a portfolio that is tilted to secular growth.
Will perform in secular growth, but in the event that we have any regime change, any
period of secular change, either on the left wing of the hawk with deflation or the right
wing of the hawk with reflation fiat devaluation, that portfolio will struggle and struggle
DANIELLE DIMARTINO BOOTH: I wasn’t surprised about most of what you wrote.
But I was intrigued about how you view real estate as an asset class.
It’s got the highest return, but– CHRISTOPHER COLE: Yeah, so real estate is– real estate’s
quite interesting as an asset class, because I think most people don’t really think of
it as– it is a levered secular growth asset.
And your average person, I think, the average retiree– maybe not the institutions, but
the average retiree, they would never go lever their stock portfolio five times.
But you own a home, and that is a levered investment.
That’s not saying it’s a bad investment.
I’m not saying that.
But most people don’t look at it in that light.
So in the same way that you structure– that one should structure trend and countertrend
assets to balance the hawk and the serpent, the idea of including real estate in one’s
thinking about one’s personal portfolio, I think, is really important because, oftentimes,
your job is driven by the economic growth cycle.
Your home is driven by the economic growth cycle.
And then you’re Levering that exposure to the economic growth cycle.
And then you’re also adding stock exposure onto that.
So the average retiree with some– or the average working individual with a mortgage
has tremendous exposure to the secular growth cycle levered– DANIELLE DIMARTINO BOOTH:
And there’s an extraordinary percentage of baby boomers with mortgages.
CHRISTOPHER COLE: Yes, yeah.
DANIELLE DIMARTINO BOOTH: And the rest of their portfolio’s in an index fund.
CHRISTOPHER COLE: And very few people think about this.
And the concept at the end of the day that somehow that will be insulated– stocks dropped
86% in the Great Depression, and real estate dropped to the same degree.
Now, in prior cycles, when interest rates were at 19% and were able to be lowered, that
created a dynamic where real estate performed somewhat like a bond.
Every single time that rates went down, it increased the affordability for people to
buy bigger homes.
So that provided a cushion for real estate.
Well, when rates are at the zero bound, several bad things begin to happen.
First of all, your 60-40 portfolio can struggle in the sense that your bonds are not getting
as much benefit.
But on top of that, your hold price is not going to get as much benefit if rates can’t
DANIELLE DIMARTINO BOOTH: At the margin.
CHRISTOPHER COLE: At the margin, yeah.
So I don’t see people realize this.
Rates where they are today, for us to get the same benefit on a bond portfolio, on a
long-duration bond portfolio, or the same pickup in mortgages that we got after ’08,
the Fed would have to lower interest rates to negative 1.5%– DANIELLE DIMARTINO BOOTH:
Ooh, don’t say negative.
CHRISTOPHER COLE: –to get the same benefit as people got right based on where they lowered
I’ve never going to say that’s not feasible anymore, because God knows what is feasible
But I will say there are major social ramifications if they pursue a course like that.
DANIELLE DIMARTINO BOOTH: Talk about one way that you would play volatility long.
Or if there is no way, one way, how do you– you said 20% long volatility.
How do you do that?
CHRISTOPHER COLE: Now, I take a very broad definition of what long volatility is.
So let’s start out with specifics.
I actually went back and I tested using very defensible assumptions.
What different traditional explicit volatility strategies, how they would have performed
over periods like the Great Depression, over the 1970s.
So for example, it’s very popular to do covered calls.
People will own stock and they’ll sell calls against that.
Large pensions do that as well.
Some people will do tail risk catching.
They’ll buy put options– various strategies.
So I tested all of these strategies using very realistic assumptions going back to the
And those assumptions are laid held in very high detail in my paper.
So one of things I found, just to start out with– short volatility strategies, which
in equity markets, currently there’s upwards of about $200 billion of these strategies,
are very popular, have performed extremely well since the ’80s.
These mean reversion short vol strategies, pretty much every single one of them showed
complete annihilation of capital over 90 years.
And I would say that based on very defensible assumptions that people should not only avoid
these strategies, but also institutions that robotically and systematically apply them.
And I believe there is a place for these strategies if they’re used tactically.
Using human discretion, say, this asset has overpriced volatility.
We’re going to sell it as part of a trade.
That’s very different than what a lot of institutions are doing, which is they are constantly systematically
selling volatility for excess yield.
And this includes even collateralized short vol strategies.
So most people have come back and said, well what about something like a covered call strategy?
Why would that show impairment of capital.
And well, let’s take a look at that.
In the 1930s, the stock market dropped 80%.
Now, if you were selling calls on the way down, you would have done a little bit better
than someone who was just holding the stock.
But then, we had the deflationary left tail.
Then you have the right tail, where they do the 1932 Banking Act, and they devalue.
Lower rates– devalue, and also, devaluation versus gold.
At that point, you had a 70% rally that occurred over a month and a half.
So imagine that you’re selling calls, earning a little bit of money.
But you’re holding that against stock.
And you’re losing all the way down.
You lose 70% of your capital that way.
And then, you’re selling calls into a 70% rally that occurs over a month and a half.
And that wasn’t the only rally.
There was another rally that occurred in the ’30s, that over 80% over four months.
And that was the Roosevelt devaluation versus gold.
DANIELLE DIMARTINO BOOTH: Hard to pivot in that short period of time.
CHRISTOPHER COLE: That’s right.
DANIELLE DIMARTINO BOOTH: That’s your point.
CHRISTOPHER COLE: So these are political risks.
You have deflation.
And then, you all of a sudden have a political shift that causes reflation, either through
monetary or fiscal policy.
And if one thinks they can predict that, they’re wrong.
There’s just no way unless you’re psychic.
So with that same understanding how shortfall performed, we can look at how longfall has
Long volatility, truly buying a straddle, buying puts and calls, would have been positive
carry for decades.
It would have made money in giving you diversification over the 1930s all the way through the ’40s,
and also would have given you income in the 1970s.
So to this point, one of the things we’ve advised is something we call active long vol,
which is this idea that you forego the first movement in volatility.
You’re not looking to protect against exogenous risks.
But when the market moves a little bit, you catch the momentum of volatility.
And this is how we modeled it.
It is an attempt to model systematically what active long volatility managers seek to do,
which is provide portfolio insurance type of protection for lower cost security.
But there’s other long volatility strategies or countertrend strategies that are also really
Commodity trending is an example of a strategy that can be very effective.
Commodity trend has not been very popular in recent years, but was particularly effective
in the 1970s during that inflationary period and was effective in the 1930s.
And then finally, gold, is a long– I would say a long volatility asset because it plays
off of that fiat devaluation that occurs.
DANIELLE DIMARTINO BOOTH: Of course.
CHRISTOPHER COLE: So in this sense, by having parts of the portfolio, all of these asset
classes, all of these asset classes are countertrend to equities and are uncorrelated to bonds.
They show no correlation to equity and bonds.
So to the same point, instead of chasing excess yield, what people need to be doing, particularly
the large institutions need to be positioning portfolios boldly in asset classes that are
non-correlated to stocks and bonds, preparing for a period of secular change.
Danielle, the numbers are amazing.
The numbers are amazing.
In my portfolio, the replication portfolio going back 90 years that we show in the paper,
you’re able to achieve consistent performance above the 7.25% pension return target that
is consistent through every generational cycle.
DANIELLE DIMARTINO BOOTH: And that’s how pensions should be invested for the long haul.
CHRISTOPHER COLE: That’s right.
DANIELLE DIMARTINO BOOTH: Absolutely.
We’re going to go in the weeds, and then we’re going to pull back out.
Describe the evolution of cross-asset volatility.
There used to be an order of things– FX, rates, equity.
Has that been destroyed in this era of all– you name it– VIX, move, every gauge of volatility
is at a record low.
CHRISTOPHER COLE: That’s right.
Actually, equity vol, US equity vol is actually relatively expensive comparative to other–
comparative to like currency vol, for example, which is truly at all-time lows right now.
DANIELLE DIMARTINO BOOTH: And that’s a massive market that nobody ever talks about.
CHRISTOPHER COLE: I think one of the things that’s really– we talk about the short volatility
And I say, OK, it’s close to $3 trillion in equity markets right now.
The portfolio insurance was only 2% of US equity markets, but in 1987.
And that, now, these short volatility strategies of all of their styles are now closer to 10%
of the market.
That same trade is being replicated across multiple different asset classes.
so we’re seeing it replicated across multiple different asset classes.
And of course, you have the, which is something you’ve written quite brilliantly about, the
reaction function of central banks.
And that’s something I also talk about in a 2015 paper, where they are preemptively
getting in front of– DANIELLE DIMARTINO BOOTH: Yes, this is– I’ve tried to communicate this.
And I don’t think that the market quite understands Jay Powell and how different he is because
he does understand credit volatility, and he does understand what’s at stake.
So he’s unlike his three predecessors.
He’s actually trying to get out in front of what’s happening.
And that– it truly changes– it’s not reaction function right now.
He’s trying to proactively get out in front of this.
CHRISTOPHER COLE: That’s right.
Preemptive– very similar to the way that the Bush administration sought to do preemptive
strikes against terror.
They are doing preemptive strikes on financial stress.
And I think we saw this– we have different models that look at thousands of different
But this last– economic and technical indicators.
And a lot of the drivers of volatility were there in the fourth quarter of last year.
We saw CCC yields begin exploding higher.
DANIELLE DIMARTINO BOOTH: They still haven’t come back in, a lot of them, though.
CHRISTOPHER COLE: They still haven’t come back in, yeah.
We saw value begin to outperform momentum stocks– very interesting.
We saw, obviously, a re-steepening of the yield curve after an inversion.
That’s a bear signal.
And then, finally, the granddaddy of them all, we began to see blow outs in the repo
Of course, what that will do is, inevitably, if that continues, you have a deleveraging
of various hedge fund strategies that will impact asset markets.
All of these things were big risk-off flex.
However, I think the Fed obviously saw the same thing.
I don’t think people fathom this.
They created $400 billion worth of liquidity to inject into the repo system, the largest
expansion of the balance sheet since 2009.
DANIELLE DIMARTINO BOOTH: Well, it was only $85 billion when it was QE3.
So this is bigger.
CHRISTOPHER COLE: Bigger.
DANIELLE DIMARTINO BOOTH: It is bigger.
And I understand what J Powell is trying to do.
I get it.
Because he saw the credit volatility genie start to come out of her bottle in the fourth
quarter of 2018, and it scared the Dickens out of him.
Public pensions had the worst returns for that quarter.
It’s anarchy, and we’ll get to that in just a minute.
So he understands the gravity of the situation.
But it seems like the market has begun to play him.
For every 100 decline– 100 point decline in the Dow, you have 1 basis point of rate
cut immediately priced in.
You can follow it on your Bloomberg terminal.
It’s like clockwork.
CHRISTOPHER COLE: It’s the moral hazard of the problem.
DANIELLE DIMARTINO BOOTH: And they’re playing the Fed.
The market players are playing the Fed.
And I don’t think people– this is the last thing that Jay Powell wanted.
CHRISTOPHER COLE: Yeah.
It absolutely has become this point where it appears that they’re really between a rock
and a hard place.
Because on one aspect, you are risking a complete melt up in markets, which is already occurring.
You look at the behavior of Tesla, for example.
It’s fun to try to watch the media justify it, but there’s no justification.
I think Tesla’s vol term structure was dramatically steeper than the vol term structure of the
VIX the other day.
DANIELLE DIMARTINO BOOTH: Yeah you tweeted that out.
I was like, wow.
CHRISTOPHER COLE: It’s really– DANIELLE DIMARTINO BOOTH: There’s so many different ways to look
But the main is there.
This is like 1999 and 2007.
You walk into a bar and hook up.
Sorry, that probably wasn’t very politically correct, but you’ve got the leverage and you’ve
got the mania.
You’ve got the two of them together.
CHRISTOPHER COLE: I could not put it any better myself.
I think you’re right.
And these are the two realities.
And maybe they’re trying to keep it together until the election.
DANIELLE DIMARTINO BOOTH: We don’t have to go there.
But I don’t I think Jay Powell is probably the least political fed chair since Paul Volcker,
but he also understands credit volatility, and he talked about it in October 2012 specifically.
CHRISTOPHER COLE: And this ends up– it’s interesting how this ends up impacting so
many different things, because not only is there market expectations built on this, this
results in the enhancement of that mean reversion effect that we talked about.
I think one of the reasons why volatility worked for 70 years in all of its forms is
because there was not mean reversion in markets.
It had less to do, sometimes, about the absolute spikes or the big down days or up days in
markets and more to do with the fact that markets would trend.
Well, now, because people anticipate this reaction function, the mean reversion is so
baked into markets, and then that incentivizes people to follow financial engineering strategies
that profit from that mean reversionary expectation.
And today, there’s a whole cottage industry in the vol world about gamma hedging.
That’s something that people talk a lot about now.
And it’s a complicated issue, but effectively, when big institutions come out in short volatility,
the hedging of those volatility shorts reinforces mean reversion to markets.
It’s a little like a rubber band, the gamma hedging.
And what I mean by that is that the rubber band stretches out, and you have a down day
or an up day.
And the hedging of all the short volatility products results in it coming back in.
So people will buy the dip or do the opposite of what the market’s doing.
The dealers will do this to hedge.
But if you get a big enough shock where that rubber band stretches too far, it could snap
in either direction.
It can snap on the left tail or the right tail in either direction.
So in essence, it’s not just the human beings that are now anticipating what the Fed– anticipating
this behavior pattern from the Fed.
But now you have machines that are being attenuated– DANIELLE DIMARTINO BOOTH: That’s why it feels
CHRISTOPHER COLE: That’s right.
DANIELLE DIMARTINO BOOTH: Speaking of systemic, let’s end this– I could talk to you for hours,
by the way.
This is just fascinating.
But let’s wrap this up today with where you conclude this wonderful paper.
Richard Fisher and I met years ago when I was still inside the Fed.
We had lunch there were riots in the streets of Athens at the time.
And I said, I said, Richard, what do you make of this?
What can we draw from this?
I’d been writing about pensions for 20 years.
And he said, Danielle, I fear that we’ll have those riots in our streets one day, that the
public pensioners and the people who are paying for the public pensioners— if you’re Joe
Q with an IRA or 401(k), and you lose most of the value of your equity holdings, and
you’re told that your property taxes or your income tax, state income taxes are going to
have to go up to top off the pension that’s just lost as much– you talk about these things
in public forums, and individuals go at each other.
Talk about the societal implications of where we are today what you see potentially happening,
because you used the word systemic.
CHRISTOPHER COLE: So the way that the average institutional entitlement portfolio is structured
today- – and this is not an opinion.
I’m looking back across history.
There is a recency bias.
This is constructed for the last 40 years of unprecedented asset price growth.
But if you look beyond that 40 years and look at how that portfolio will perform, at a best
case, you’re looking at a 5% type of return.
In a worst case, given where debt levels are and where leverage is, you’re looking at something
much, much worse.
So if we just assume the best case, it makes 5% or 4% over the next 20 years, these entitlement
DANIELLE DIMARTINO BOOTH: Which is not enough.
CHRISTOPHER COLE: Not enough, because they’re targeting 7.25%.
That will cause an expansion of the unfunded liabilities in just the state systems alone
to about $3 trillion.
If we end up getting a lost decade, that could go as high as $10 trillion.
That $3 trillion number, that is the cost of four bank bailouts.
It is the entire tax revenue of the US government over the next year.
That is your base case.
These entitlement programs, which right now, based on the 7.25% assumption, will go from
70% funded to under 50% funded, and a third of them will be under 30% funded.
And this is not including corporate programs and other personal retirement programs.
This issue of asset allocation is an issue of systemic risk.
It is an issue of social stability, because we will be at a point where these entitlement
programs will go belly-up and face insolvency unless we can think differently about the
I could see a lot of different things happening.
I could see a day where the Fed prints money to buy pension obligation bonds.
DANIELLE DIMARTINO BOOTH: Chris, if I can tell you something, during the crisis, when
I was inside the Fed, it was debated.
CHRISTOPHER COLE: Wow.
DANIELLE DIMARTINO BOOTH: The idea– if you tech logic to the end game, the idea of the
Fed buying municipal bonds is perfectly feasible.
CHRISTOPHER COLE: That’s right.
And that will be a backdoor bailout of Wall Street if that happens.
You could see a radical progressive dynamic, where we shift to seize capital, and where
there’s– it causes massive inflation.
There’s numerous ways.
But the question at the end of the day is the average portfolio is only attenuated to
this last 40 year period of growth.
It’s not about being afraid.
It’s about being prepared.
So my parents, during the great financial crisis, they came out ahead because they had
allocations to volatility in gold, and that saved them and allowed them to retire on time.
I think the institutions, the large institutions and the average investors, if they can find
ways to invest large portions in countertrend assets, not only will they get a better overall
return profile and more safe return profile, but this will be a way for these institutions
to be able to prosper during a period of secular change, rather than suffer.
So I think this is a major– it is more than a financial issue.
It’s a social issue.
That these defensive assets, they’re not for a rainy day.
They’re for a rainy decade.
The problem that we face is not a problem of financial management or economics.
It’s a problem– it’s a social problem.
It’s an emotional problem.
It takes a lot of social discipline and to think differently.
Many of our leaders would rather fail conventionally with the herd than succeed unconventionally.
DANIELLE DIMARTINO BOOTH: They’re not Genghis Khan.
CHRISTOPHER COLE: That’s right.
That’s absolutely right.
DANIELLE DIMARTINO BOOTH: It was great talking to you today.
Thank you so much– CHRISTOPHER COLE: Thank you.
DANIELLE DIMARTINO BOOTH: –for being with Real Vision.
CHRISTOPHER COLE: I had a great time.
Depending on your 401 (K) or your pension is a recipe for retirement disaster! America is facing a retirement crisis and every day there are more and more victims of this corruption.
This is an episode of Off The Chain with host Anthony “Pomp” Pompliano and guest, Raoul Pal, the CEO of Real Vision Group.