What happens when an upheaval so massive forces financial markets, governments, and society to rethink how our systems work? Michael Krieger, author of the Liberty Blitzkrieg, joins Real Vision to explain what coronavirus and the response to the outbreak has revealed about the condition of American systems – from financial markets to the health care system. Tracing the story of financial markets and societal trends over the past two decades, Krieger outlines how our systems have been pushed to the brink – focusing on emergency policy responses and the everything bubble. He also provides viewers with potential solutions to the systemic decay that has been brought to the forefront by the coronavirus outbreak.
The Interview · Featuring Michael Gayed and Michael Venuto
With coronavirus wreaking havoc worldwide, it’s a perilous time to be in the market. Businesses around the world are shutting down. Equities are plummeting as investors flee to safety, and central banks, desperate to contain the financial contagion, are reaching into their arsenal to do whatever it takes. Today, Michael Gayed, portfolio manager at the ATAC Rotation Fund, sits down with Michael Venuto, chief investment officer of Toroso Investments, and explores the question that’s on everyone’s mind: Is this a fleeting moment of panic, or are we seeing the conditions for a true doomsday scenario? The pair place the massive sell-off in context, explore whether ETFs are making the violent price swings worse, and take a deep dive into the plumbing of the markets. Filmed on March 10, 2020, in New York.
Transcript00:02CHRIS COLE: Hello, everyone.00:03My name is Christopher Cole.00:04I’m here with Real Vision today in our offices of Artemis Capital, and it is my pleasure00:08and honor to be interviewing an old friend of mine, Toby Carlisle, who is the founder00:14and principal of the Acquirer’s Funds.00:18Toby is an expert on value investing, and has written four books on the topic, which00:24are really new classics in the field, and should be read by any serious value investor.00:30I’d like to introduce Real Vision to Toby Carlisle.00:32TOBIAS CARLISLE: Thanks for the very kind introduction, Chris.00:34I’m very happy to be here.00:36I’m so happy to be doing it with you.00:37CHRIS COLE: Well, Toby, tell us about how did you get into value investing.00:41TOBIAS CARLISLE: I was a mergers and acquisitions lawyer in Australia initially and then in00:46San Francisco, went back to Australia to be a general counsel of a public company that00:53was a telecommunications company.00:57I started working 2000 right at the very top of the dot-com boom, saw the collapse, and01:03then saw the emergence of this new breed of investors that new to me.01:09Nobody had really heard from these guys since the ’80s, but they were the guys who’ve been01:15doing the takeovers in the ’80s had returned.01:18They weren’t known as activists at that stage.01:21We didn’t really have a name for them.01:22They’re looking to get control of these busted dot-com businesses that had raised a whole01:27lot of cash, had an enormous amount of cash burn.01:30It was hard to figure out what they saw in these businesses, because I had read security01:35analysis, the Graham and Dodd book, and I’d read Warren Buffett’s letters, and he talks01:41about looking for a wonderful company at a fair price.01:44These weren’t wonderful companies at all.01:45They’re terrible companies, terrible businesses, but because they had raised so much cash,01:49they traded down the discount to their cash, these guys were looking to get control, looking01:53to get control of the cash then to either liquidate the company or use it to buy other02:00companies.02:02That period from early 2003 to about 2007 was a golden age for value.02:09Deep value guys coming through activists, private equity firms taking company.02:14I just thought if that ever happens again that the market gets cheap enough that that02:19strategy of buying sub-liquidation value companies, if that opportunity presents itself again,02:24I’ll take advantage of that and try and buy those companies.02:28When the 2007-2009 collapse occurred, I stopped working as a lawyer, set up a little fund,02:36set up a blog talking about buying the subliquidation value companies.02:40I just fell in love with the strategy and the process.02:44I continue to research, write some books and that’s how I get to here.02:48CHRIS COLE: I think one of the most interesting things about your research is that you have,02:54there’s so many individuals that follow the value investing framework, and I think everyone’s02:59knowledgeable with a canon of material out there, securities analysis, Benjamin Graham,03:04but you’ve added some new twist to that through quantitative research, and I wanted you to03:09talk about that and how that plays into the concept of the Acquirer’s Fund?03:14TOBIAS CARLISLE: Well, I think rather than adding too much of a new twist, what we’ve03:18done is just revived some of the old ideas.03:22Because Warren Buffett has been so successful, and he’s the avatar of value, and he preaches03:28this wonderful company at a fair price philosophy.03:32Many of today’s value investors have similarly embraced that philosophy and so they look03:37for particular things, high returns on invested capital, moats, compounding type businesses03:42that grow very rapidly.03:44Then they’re trying to buy at a fair price which might be saying a market multiple for03:49a company that is better than that.03:51That’s one very small part of value investing.03:54There’s a much broader universe out there.03:56The idea is simply that you’re buying something for less than it’s worth.04:02Typically that’s hard to do, because most companies don’t really trade at a big discount04:06to what they’re worth.04:07The places where you find those big discounts is in financial distress where an industry04:15might be going through a down cycle.04:18That is what I described as deep value, where what we’re trying to do is we might be trying04:22to buy at a discount to balance sheet value, we might be trying to buy a cyclical company04:26at the bottom of its cycle, and then trying to buy at a further discount to that.04:30Then we’re hoping that there’s an uplift in the way that the business performs and then04:35you will still get the discount between the intrinsic value and the price at closing.04:39You have two ways to make money.04:42We did some research, I did some research with [indiscernible] PhD at but haven’t found04:47every bit of industry and academic research that we could find that had been published04:51from Graham onwards, from the 30s onwards, and we tested that in a system to see what04:57works, what continues to work, what stopped working, what never worked.05:02There are many things that were perhaps a product of data mining.05:06We looked at how do you identify a good credit?05:10How do you find something that’s financially strong?05:13How do you Identify earnings manipulation?05:15How do you find statistical fraud?05:17How do you find businesses that are very cheap and can grow and buy back stock and the product05:24of that research was a book called Quantitative Value.05:27I noticed this unusual phenomenon while we were doing it, that very undervalued companies05:31behave in an unusual way that sometimes the things that the less attractive the business,05:39the better the performance of the stock, because they just get too cheap and so nobody in their05:45right mind would go and buy these things unless you can find some of these other indicia of05:49value or quality in there.05:52That was a book called Deep Value that came out 2014 discussing the mechanics of mean05:57reversion.05:59Those mechanics are simply they’re private equity funds, there are activists who will06:03come in and turn these companies around.06:05There’s also management in there, not liking the performance of the company.06:09They might be beholden to the industry cycle and as other participants in the industry06:17leave, the ones that remain can ask for higher prices for their services or for their goods06:23and so they then get a period of very good performance.06:25I just found that a fascinating approach and it’s not one that is discussed much outside06:32of Buffett.06:34Buffett’s wonderful companies at fair price.06:37My research is focused more on those type of businesses and that’s what the fund does.06:42The fund to buy– we like balance sheet strength is great, and we can find it so we will have06:49a strong healthy balance sheet, lots of cashflow coming into the business as well, lots of06:53free cash flow.06:55This is on the long side because we did run long/short.06:57We like the company to be buying back stock.07:00I think that’s a very powerful signal which shows that there is that free cashflow there,07:04it’s genuine free cash flow, management’s thinking like you would want management to07:10think taking advantage of that undervalued stock price.07:13I think when you see a material buyback, that also indicates that the stock is undervalued07:17because you see lots of buybacks through the cycle, buybacks tend to peak at the top of07:21the cycle.07:22There might be mopping up option issuance or just trying to goose the stock price at07:26the very top of the cycle.07:28That’s not the buyback that you want.07:29You want material buybacks.07:31Those things together on the long side, that’s a pretty traditional– we’re going to find,07:37we will own cyclical companies, we’ll buy companies that it might be difficult to understand07:43the reasons why we’re buying them because it might look like the business is in a particularly07:47good one, that we think that the combination of balance sheet strength at the bottom of07:51the cycle, it’ll look like a healthier business going forward.07:54On the short side, we’re looking for somewhat of the reverse of that, something that’s extremely08:00overvalued to the extent that you can identify a value to some of these companies.08:03It’s very hard, there may not be any value there at all, but more importantly, they’re08:10in financial distress.08:11There’s some statistical earnings manipulations, statistical fraud, they have negative free08:16cashflows so the way they’re financing the businesses by raising equity or selling debt.08:24That’s a game that can go on until it stops, until the market no longer lets you do that.08:31We also look for broken momentum because many of these companies will finance themselves08:35by telling a great story, even though the financial statements don’t reflect the narrative.08:42The narrative is wildly diverged from the financial reality of the company.08:47That’s what we like to find on the short side, really compelling narrative but none of that08:52is being reflected in the financial statements.08:55When the market starts seeing that too, and that momentum has gone from– or the momentum09:00is broken, we’ll take a short position.09:03In the ordinary course, we hope to make a little bit of money on the short side, but09:07the real function of the short so when the market collapses, they should provide more09:11protection than their weight in the portfolio.09:15You hope through a 2000 or 2007 and 2009 type scenario that it would perhaps prevent you09:21from drawing down as much as the market.09:23CHRIS COLE: You found that there are certain quantitative metrics that are highly indicative09:29of a quality value play.09:32Maybe to talk a little bit about that, and how that differs from some of the other viewpoints09:39out there on that.09:40TOBIAS CARLISLE: It’s become much more popular, it’s voguish now to largely to ignore balance09:48sheet quality.09:50For a company to grow very rapidly, it helps it for it to be asset wide and they might09:56run with very substantial amount of debt on the balance sheet which when they’re running10:01up, that means they run very fast, and they’ll go year after year, performing very well.10:08The problem is that it doesn’t allay so much in the way of– there’s very little balance10:13when you go the other way.10:14What I like is balance sheet strength.10:17To the extent that we’re using these statistical measures, it’s not necessarily a new invention.10:22I don’t regard it necessarily as, it’s not like a NASA level analysis of the companies.10:26It’s just we’re trying to find a– it’s a sensible approach of doing it.10:30The reason we do it that way rather than trying to be more discretionary and more ad hoc in10:35our approaches that we think that there are good behavior reasons, and there’s lots of10:41research that indicates that a more systematic, disciplined, quantitative, replicable approach10:48to doing it means that through the bad times, you’re able to keep on functioning and doing10:55what you should be doing, buying the right stuff, you don’t swing for the fences, keep10:58sizes of positions fairly small, consistently apply the approach, because every strategy11:04has good times and bad times and value has gone through a very rough time.11:09Since the start of the year, if you track the factors that have done well, it’s the11:15factors that have done well for the last few years, momentum is done very well, growth11:18has done very well.11:20Value has done very badly.11:22Quality has done very badly, which is historical.11:25Typically, what happens is there’s a value premium, you get a little bit more performance11:30for buying these companies that are trading at a discount to intrinsic value, and that’s11:35not been the case.11:36CHRIS COLE: Let’s talk about that a little bit.11:37It’s really, really interesting, because, I’m a volatility guy.11:41You’re a value guy.11:44Years ago, we bonded back in Santa Monica, two completely different disciplines but we11:51share some things in common in the sense that value can perform during periods of market11:56crisis.11:57I’m curious for you to talk a little bit about the history of value over the last 20, 3012:05years, how it performs in different market cycles, its defensive properties, and to answer12:10this question, value has underperformed for 10 years, is value investing dead?12:16Is it dead?12:19To get your take on that, not that I believe that, but.12:22TOBIAS CARLISLE: That’s a question I get a lot.12:24Is value dead?12:25Can value come again?12:27I don’t know but I can go back to that– we have pretty good data on value back to 1951,12:36point in time data to 1973.12:39There are very distinct cycles through that entire period.12:45Over the full period, the outperformance for just a simple price to a fundamental whether12:51it be price to book or price to cashflow, enterprise value of cashflow, enterprise value12:55to EBITDA, even price to earnings, very simple metrics.12:59The outperformance to the low price to a fundamental which is a reasonable proxy for a value stock13:06has been massive.13:09The growth side of that equation where you’re paying a higher price for that fundamental13:14has been pretty weak.13:15Behaviorally, you might say, well, why would you pay that higher price?13:19Because the very best performers have always been expensive.13:23Walmart, for most of the time it was listed was always very expensive.13:28Microsoft’s mostly always been pretty expensive.13:31The companies that you buy that have these low prices to a fundamental tend to be junkier13:36companies, cyclical companies, but you get paid to hold those companies.13:43You don’t get paid all the time.13:44You get paid over the full data series and the full cycle as well because value performs13:50various different ways through the cycle.13:53From the bottom of a crash, value does spectacularly well, value should provide some protection13:58through a crash.At the tail end of a bull market, value looks terrible because the bid from value guys goes away.14:05The people who are feelers and who are prepared to pay increasingly higher prices will do14:10very well through that tail end, but then there is some justice for those guys.14:13There’s a typically very significant crash to the momentum growth side through the cycle.14:19There have been about six periods where value has underperformed materially.They’re all were very well known bull peaks.The last one was 2000, in the run up to the dot-com, value performed very badly.They’re all the covers has Warren Buffett lost his magic.14:37CHRIS COLE: The barons won.14:39TOBIAS CARLISLE: Then value did then go on to perform pretty well for that for the early14:452000s.14:46Then it’s been week again, so it depends on how you measure value.14:50Price to book value, that’s the value factor.That’s the academic definition of value.No practitioner uses price to book value, but that’s the one that everybody points to,because that’s the one that the academics prefer, because it’s very simple to calculate15:02and there are some good reasons, it’s less volatile, the fundamental is less volatile15:06where earnings is moving around, book value is reasonably static from quarter to quarter.15:11It’s a reasonable proxy.15:13It really hasn’t outperformed for 14 or 15 years.15:18There are many reasons for that.15:20Partially, it’s the composition of balance sheets has changed over time.15:25There are companies out there that have bought back so much stock that actually got a negativebook value.15:32It’s very difficult for book value to categorize them as a value stock, even though if we wouldlook at them on another measure, like a price to earnings, we would regard them as valuestocks.15:43Book value hasn’t worked, but there’s no practitioner who actually uses it.15:46If you use an ensemble of measures that might be cash flow and earnings, and sales, even,15:53that would have helped you keep up for the market for longer but it’s still failed sometime15:57over the last five years.15:59If you have some craftsmanship, which is what the more quantitative value guys describe16:04as their own mix that they use, where you might look at other things besides simple16:12values, you might look at the quality of the balance sheet, the quality of the earnings,do the cashflows match the reported earnings, because that’s important.You can have wild deviations where companies are reporting good earnings, but it’s notreflected in cash flow generation.16:28If you use all of those measures, which is what most practitioners are doing, that keptup with the market, and that outperformed pretty well until about the start of 2018.Since 2018, that hasn’t worked very well.16:42That’s a shorter period of time.16:43That’s probably what most practitioners have seen.16:46It’s been a period of weakness for value.16:50There are pockets like that through the data series where that happens and then immediately16:55afterwards, there is some very good performance for value.16:57The thing that would make me nervous is if value was underperforming but the portfolios17:05as they reformed at each rebalance that aren’t reflecting the discount that we’re seeing,17:10but what has been happening is the value portfolios have been getting cheaper so that the price17:16ratios are wider.17:18What has happened now is that the most overvalued stocks are extremely overvalued, more overvaluedthan perhaps may have been ever.The undervalued stocks, maybe at their long run mean, maybe a little bit rich to the long17:32run mean.17:33I think at some stage, we don’t necessarily have to have a crash, the cycle can just go17:40back to value, but most likely what happens is that there’s some crash that resets the17:45market.17:46In the crash, what has happened when momentum and growth have run like this is that thedowndraft has been massive for them.It’s been to the tune of 80% or 90%.17:58I think value could pull back a little bit.18:00I think that you want to be long short as a value guy going into the next crash to really18:06see the performance and maybe capture some outperformance on the way down and then to18:12be fully invested when the market finally does not turn and I think it will be a verygood period for value from the bottom.18:17CHRIS COLE: This is a powerful idea that in a late cycle, if we’re entering into some18:22late cycle secular change or some recession, value will drop like momentum stocks, but18:31will drop less in a market correction and that a long/short, something that is short18:38the momentum stocks, the hot stocks, the highflyers that are making money and long the inexpensive18:45value stocks, that long/short positioning will outperform and deliver alpha.18:52It’s interesting too, because even if you’re just a macro guy and you don’t pick stocks,18:58I’m a volatility trigger so I don’t pick any individual stocks, but I paid very close attention19:04to the value momentum relationship.19:07Any good macro investor should because it is an interesting forward indicator to volatility.19:13I think it’s very interesting that this last October, we saw one of the most violent reversals,19:22at least when I was looking at the data, it was multiple days, there’s one day I think19:26was a six standard deviation move and other day, there was a three standard deviation19:29move.19:31Truly wild moves where value dramatically rebounded against momentum stocks.Can you talk about how good that is as a signal to the macro investor community?19:43Is that something that we should pay attention to?19:46What’s your take on that recent reversal that has occurred over the last couple months?19:52TOBIAS CARLISLE: The thing that you’re describing, the spread got very, very wide, as wide as19:58it has ever been through August 27th was the bottom of that spread and then it did start20:04closing fractionally from August 27th through to September 9 th, which was then the biggest20:10one-day move in value’s favor since the early 2000s, sometime in the early 2000s, that’s20:16the five or six sigma move that you’re referring to which any quant note will tell you that20:23it’s not a normal distribution.20:27The point remains that it’s still was a very big move in value’s favor and it was a very20:32bad day for momentum.20:33Then it was followed up the next day by that three sigma move in value’s favor, and away20:38from momentum.20:39Then it was a very good September, October, November, December for value.20:44Value outperformed the market through all of those months.20:46It’s softened up through January, it wasn’t a great January, it wasn’t a great January20:51for value, was a very good January for momentum, one of the best months for momentum in 2020:58years or something like that.21:00It’s good to see those guys win once in a while.21:03I think that that’s what you would expect to see when there’s a regime change, very21:07high volatility in the turn, because I think that that’s the way regimes change.21:12You get that move and that frightens folks who are in the momentum strategy.21:16They realize there is some downside to that strategy, because they haven’t seen a lot21:19of it.21:21I see that particularly in low volatility strategies.21:24Low volatility wasn’t something that I think folks had heard much about until a few years21:29ago, two or three years ago.21:31I think it became very voguish a few years ago, and the reason why is pretty clear, when21:36you look at the data, low volatility strategies typically do what they say they do.21:41They don’t go up as much as the market does when it goes up, but they don’t get down as21:44much as the market does when it goes down.21:47Over the last five years, that’s not been the case.21:49It’s materially outperformed.21:50CHRIS COLE: The low volatility, just for the viewers, low volatility described strategies21:55that effectively are hurting into stocks that are low vol stocks, low beta stocks, in essence22:02trying to use stocks as a replacement for maybe bonds.22:05TOBIAS CARLISLE: I think that’s right.22:06Well, there’s the joke doing the rounds now that you buy bonds for the growth and you22:15buy equities for the yield, whereas that’s not traditionally been the case.22:19Low volatility is beneficiary of that, particularly because for that reason that you identified,22:24I think that it regarded potentially as a bond replacement to the extent that equities22:29further down the capital structure can do that.22:31I’ve looked at low volatility in relation to value, I just ran this progression over22:36the weekend because I was interested to see what does it look like?22:40The notable times when low volatility has outperformed value, much 2009 was the peak22:46for low volatility relative to value in the last say, decade or so.22:52Reasons for that are very easy to understand.22:54That was the bottom of the crash and we performed very well at the other side of that.23:01Then June 2, 2012, there was a little echo crash around that period of time.23:08I don’t know if folks remember that but it looked like we might be going back into another23:13crash, and I think that that’s when some of the QEs started again.23:17CHRIS COLE: In 2012?23:18TOBIAS CARLISLE: 2012.23:19CHRIS COLE: It looked like we began to see outperformance of value during that period23:24of time and then they put on QE, they did QE3 at that point.23:31TOBIAS CARLISLE: In 2013, the market had a very, very good year.23:34I remember discussing it with you at the time because it was a very good return for the23:37market but also a very low volatility year.23:40It was one of the best risk adjusted returns on record, 2013.23:44Now, been replaced by some of the more recent years, but at the time, that was a significant23:48move.23:49CHRIS COLE: I’ll even say one of the best risk adjusted years and one of the best risk23:53adjusted three-year period starting that year in 200 years’ worth of equity data for passive23:58investing over that period of time, truly amazing.24:00TOBIAS CARLISLE: That was a good year, 2013 was a good year for the market.24:03It was about a 50% year for the market, but it was a 60% year for value, so very good24:08year for value, too.24:10It was really the last time that value did anything material.24:14Value’s had– 2016 was a good year for value, but 2015 was a very weak year for value and24:19then ’17, ’18, and ’19 have been disasters for value guys.24:26When I look at the data now, there’s a very significant peak in the outperformance of24:31low volatility strategies over value strategies.24:34What that has typically indicated in the past is that we’re about to have a very good period24:39for value in the near term, and a weaker period for some of those strategies.24:44Volatility will almost certainly be a beneficiary of that, too.24:47CHRIS COLE: That’s interesting.24:48Also maybe that a lot of these institutions that are crowding into low vol stocks, maybe24:55that low vol stock might underperform value based– and might underperform people’s expectations25:00based on some of your analysis in that department.25:02TOBIAS CARLISLE: Well, that would be my expectation that value will materially outperform and25:05low volatility will have a more difficult period.25:08I would say that if you look at low volatility, they tend to be extremely expensive stocks25:12at the moment, and the rebuttal to that is always that low volatility is not a strategy25:17that depends on those stocks being cheap.25:21We’ve been through this very unusual period for this performance of volatility, low volatility,25:26and so I think that there’s been quite a lot of crowding into low volatility strategies,25:30either consciously or unconsciously.25:33I think it’s some of these stocks that have those very smooth returns do attract folks25:37who perhaps are looking more at the price trajectory than the fundamentals of the business.25:42You can see that, you can pull up any chart, pull up the Microsoft chart has that fit like25:48the ski jump path to it, Apple’s chart has the same ski jump up to it.25:54Tesla’s chart, after doing nothing for years and years has had that fivefold increase in26:00the last six months.26:02Who knows what the cause of that is?26:03There are lots of theories about it at the moment, maybe there are more shorts out there26:09than we know about.26:10It’s one possibility.26:12This delta hedging in the– now that there’s a lot of action in the options, maybe the26:17delta hedging into the equity that keeps on pushing it up.26:19The Tesla, I think is a very good example.26:21It’s a weaker balance sheet, financial statements aren’t great for Tesla.26:28There’s no growth but its 2% year on year revenue growth, they’re selling more cars,26:33but they’re not selling them.26:34They’re not making as much money as they have in the past.26:36It’s a metal bender, it still has to create a factory to make these cars.26:41It’s not like software as a service where each marginal sales virtually costs and yet26:46it moves like a software as a service stock.26:48CHRIS COLE: To this point, this is interesting.26:49It goes back to something you and I were talking about maybe a couple weeks ago, where I think26:54I was telling you the story of how I was in Switzerland.26:57We were going to a meeting, leaving Zurich to go to [indiscernible].27:03My marketing guy is like, well, let’s take an Uber.27:08I’m like, no, it’s going to be really expensive.27:10Let’s take the train.27:11Switzerland has one of the best train systems in the world.27:14He said, no, the Uber is cheaper.27:16I’m like, that’s impossible.27:18How is Uber cheaper than taking a train in Switzerland?27:21It was.27:22This is to go an hour and a half outside of Zurich.27:25The only rationale I have on that is that you have– I actually wanted to thank SoftBank27:31for subsidizing my business trip but, effectively, what’s your take on this where you have–27:37they always say, never go into business with a non-economic actor.27:41That’s probably why you and I don’t own nightclubs.27:44In this mindset, if you have cheap money from central banks, they’ve lowered interest rates27:49down to zero and the big institutions of the world are throwing money at VC funds that27:56are throwing money into these companies and they don’t care if they ever make a profit.28:01They’re just looking for growth, in a frenzy for growth.28:07There’s no assessment of value, then other brick and mortar companies that are seeking28:13return of profit and have to pay people and are actually looking to a long term survival28:20have to compete against these new disruptive technologies, that are actually being subsidized28:25by inexpensive money.28:27To what point are central banks crowding out value investors?28:30TOBIAS CARLISLE: That’s a great question.28:32I think it’s been a great time for consumers.28:35There’s been enormous consumer surplus subsidized by the VCs on Sand Hill Road.28:40That’s been great for everybody to get cheaper taxi rides, among other things.28:47What drives that?28:50Potentially that’s too low interest rates making marginal business ventures look better28:55than they would otherwise look.28:56If your cost of money is virtually zero, then you can get a return anywhere that will be29:01better than virtually zero cost of money, then that’s a project that you should probably29:05be investing in.29:06That’s one of the problems that interest rates being set to flooding the market with money29:12creates that better businesses aren’t rewarded for being better businesses.29:18Being a careful husband of the cash on your balance sheet, that’s not rewarded at all.29:25Spending it to grow is rewarded.29:28The way that that is reflected is in that duration trade where the 30-year, when interest29:36rates move, the 30-year moves a lot more than the 10-year.29:39The 10-year is more like a value stock or value stocks are shorter duration, because29:44their cash flow as a front end load.29:47You buy cheap cash flows now, perhaps expecting that there’s not going to be as much growth29:51or there might be a little decline in the cashflows of the value stocks.29:55Whereas the growth stocks, they’re not earning any cashflows now, all of the cashflow was29:59back end loaded to the extent that they can’t make any cash for it at all, but that’s the30:03expectation.30:04When you move interest rates a little bit, you get wild moves from the growth stocks,30:08you drop interest rates, you get wild moves up from the growth stocks, value stocks don’t30:12tend to be sensitive.30:14Maybe interest rates need to go up for value to start working.30:16I’ve heard that argument.30:17I think that’s a very good argument.30:19The problem is that I think there are lots of really good arguments for why value hasn’t30:22worked and some of them are going to be right in retrospect, and some are going to be wrong.30:27I think, ultimately, as a value investor, you can overcomplicate things by trying to30:32figure out the macro driving those side effects or those phenomena.30:40I think that you can simplify, as a value investor, you can simplify it for yourself30:45by just working out if the individual company that you’re looking at is in fact, undervalued.30:50Then looking at, to your point, are there non-economic, are there irrational actors30:55who they’re competing with.30:58Sometimes that’s a good thing.30:59That’s what creates the undervaluation.31:01Then can that non-rational, non-economic actor survive, or will they be washed away eventually?31:08I think that that’s some of what we’ve seen over the last five years that there’s been31:12an expectation that at some stage, that flood of money in will– that spigot will get turned31:18off at some stage and so you’ll be rewarded for doing the analysis, looking at the balance31:24sheet, looking at the strength of the business, the quality of the cashflows that it’s generating,31:29but not yet.31:30CHRIS COLE: It has a similar dynamic to I would say volatility where you can suppress31:36volatility, but the more you suppress it– you can suppress it for a long time, but the31:41more you suppress it, the more it will realize itself in other ways and eventually come out31:46even greater than before.31:47TOBIAS CARLISLE: Well, you have the great analogy of burning back that the tinder in31:52the tall trees in the forest.31:56If you don’t burn it back, that creates these explosive wildfires.32:00I think that’s true also, that little bit of interest rate volatility or a little bit32:05of higher rates strengthens these companies.32:09It makes them better companies, better businesses, better managements.32:14When they get fat and happy because the tinder’s not being burnt back on a regular basis, that’s32:20when they set themselves up for a big crash at some stage.32:23CHRIS COLE: Same concept that the longer the period of value underperformance in essence,32:27the greater the value proposition becomes on the other end of it for those who are patient.32:32TOBIAS CARLISLE: Or those who can survive, too.32:34CHRIS COLE: The business risk.32:35TOBIAS CARLISLE: Because this is the problem with it.32:37Value has become a little bit of a laughingstock, there aren’t very many traditional value guys32:41around because it’s so hard to maintain, it’s hard to keep investors when you can get, for32:48basis points, you can get access to the index, and the index is the best performing asset32:53in the world, but that makes any other active look pretty ugly, and particularly when any32:58other active wants to charge a slightly higher fee.33:01Again, that’s historical, it’s not something that these trees don’t grow to the sky at33:08some stage, there is that reckoning.33:10I fully expect it to happen at some stage, I’m not predicting one in the short term or33:15in the medium term, I’m not predicting one at all at the market.33:18I think if I’ve learned anything over the last decade or so, it’s that the market is33:25unpredictable and humbling at every stage.33:27You never want to make a prediction about the future.33:30I would prefer to be, at this stage, in something like a value strategy than in the index or33:35in low volatility or momentum, because I think that value was really the only thing that33:39can provide returns over the next decade that are absolute or relatively better than anything33:48else out there.33:49I think everything else is going to have a very tough run over the next decade.33:52CHRIS COLE: It was almost a decade ago, I remember, when someone asked this.33:55There was a young kid who wanted to go on Wall Street and somebody asked us to give33:59him advice or something.34:00We took about breaks.34:01I remember we sat down and this poor kid, we were like, you need to go find the sector34:07that is the most depressed sector imaginable.34:11Get into that sector.34:12Everyone will hate it, and by the time you’re vice president, you’ll be the only person34:16who knows anything about it and the sector will be doing really well.34:19TOBIAS CARLISLE: That’s great advice.34:20CHRIS COLE: It’s great.34:21Now, you can’t find any more too depressed sectors than value investing or disciplines34:30than value investing and volatility, long volatility trading.34:33TOBIAS CARLISLE: Well, I think one of the things about value is that value is that moveable34:36phase, value’s always going to where the disaster is, or where nothing’s happened for a long34:41time.34:42Value, at the moment, looks like it’s pretty heavily into financials and energy, and miners34:48and heavy industry, which haven’t done much for a long period of time.34:52We have a lot of financials, and we’ve got some energy exposure, too.34:56Part of the underperformance of value has been that sector mismatch or the industry35:00mismatch.35:02If you’ve been a value investor in technology, you would have outperformed any naive market35:09capitalization, weighted implementation of that.35:12The problem if you’re investing across every sector, every industry is that you’re more35:18heavily weighted towards financials and other things that haven’t done as well.35:22The financials that– the reason for the underperformance probably, interest rates are probably hurting35:29financials, and the memories of 2007 to 2009 is still very vivid in anybody who lived through35:36that period, and so they’re wary, and rightly so of banks and insurers that could be hiding35:43some liability on their balance sheet that nobody knows about.35:46CHRIS COLE: Now, what’s your take on it’s interesting because now, everyone wants to35:51go into passive investing.35:53Big, large cap stocks, liquidity, large cap tech stocks, that’s the rage, the Fangs.36:00It is very similar or reminiscent to the Nifty 50s bubble in the 1960s, where essentially,36:08everyone crowded into these blue chip stocks, and those stocks.36:13What’s your opinion on that?36:15What’s your view on that?36:18Really, in terms of where do you see opportunity in the different market cap segments of value36:25as well?36:26TOBIAS CARLISLE: Every boom has this echo of other booms in the past.36:30I think tech is always very sexy whether it was electronics in the ’60s, dot-coms in the36:38’90s, and now it’s software as a services, railroads, that was a ticket once.36:43CHRIS COLE: South Sea bubble, that colonies were a tech stock at the time.36:49TOBIAS CARLISLE: People were worried about traveling on railroads because they thought36:53if you went faster than the speed of a horse, you’d be atomized, which is terrifying.36:57That’s the stuff, that’s how tech of the day and that’s why it was so exciting for them37:04at the time.37:06The potential to be atomized, which probably there’s a lot of investors that hate it like37:10that.37:12I think that every boom has some sort– you can draw analogies, they do look like other37:18booms in the past.37:21I think that probably because they’re driven by the same thing, there’s some potential37:25there to invest in some life changing or world changing technology that seems to earn very37:32high, maybe not very high profits, but seem to generate a lot of revenue and a lot of37:36growth at least over a period of time.37:38It looks like it’s going to wash everything away that exists.37:40That was the argument of the dot-com boom.37:44These dot-coms are going to come in and they’re going to wash away everything that’s gone37:46before them.37:47Instead what happens is all the incumbents just adopt.37:50If I need to do is make a webpage or they had just adopt those business practices, then37:56the market goes back to the way that was before where everybody’s competing pretty much on37:59a level playing field and that’s a better period for value.38:03The market seems to– all the performance in the market has been those very large cap38:09tech stocks, but they have been the ones that have performed very well have been ones that38:13generate a lot of– they have actually generated some profits and some very good revenue through.38:18Amazon, Facebook, Apple, Netflix, but Netflix is still growing at a very high rate.38:25Google, if I didn’t mention Google.38:30They are very profitable.38:31They are very good businesses for the most part.38:33They’re expensive, but they’re not extremely expensive.38:36I think that some of the real overvaluation, the really egregious overvaluation is in some38:42of those out there.38:43I think Netflix has more of that egregious overvaluation.38:46Tesla, certainly very egregious overvaluation.38:48CHRIS COLE: You talked about this tech effect, this idea that people– I hear this all the38:53time among a lot of millennials where it’s different this time, the valuation’s different38:59this time.39:01We’ve had a transformative change in technology, the iPhones have changed, the smartphones39:07have changed everything.39:08This is a new era for technology, and yet value investing has survived through the ages.39:14Can you talk a little bit about is this a new era?39:19Is this different?39:20Has it changed, or will we seek a reversion of the mean in the same framework?39:24TOBIAS CARLISLE: There are some compelling arguments for why things may have changed.39:30I don’t know that this is the first time this has happened, but there may be changes in39:33the market.39:34There is some parallels between in the 1920s when cars was introduced and everybody got39:43access to a car.39:44There was a period of time where roads were built up, the infrastructure for cars had39:48to be built up.39:49It was a very bad period to be a value investor and a very good period to be a more tech growth39:55type investor with cars being the tech of the day.40:00That lasted for about 16 years.40:03Then value investing returned and did very well and has done pretty well through the40:09whole period.40:10We may be looking at something like that where it’s just a maybe there’s a little change40:14in the structure of the economy or there’s a change in the structure of the market.40:21I don’t think that it means that value will stop working.40:24I don’t think that necessarily means that that change is a permanent change to the structure40:30of the market.40:31I just think that because the logic I think of value investing is so compelling, if you’re40:35buying something for less than it’s worth, that should be recognized by the market over40:40a period of time.40:42Perhaps our definition of value has to change a little bit to keep up so profitable book40:46value, or the traditional metric for academics, particularly, some practitioners, maybe Walter40:51Schloss was more of a book value investor, but I think that he did some other things40:56on top of that, as well, but he was more maybe like an early quant where he have quite a41:01diversified portfolio of low price to book value stocks.41:06He did very well employing that strategy.41:09I still think you can do very well employing that strategy to the extent that there’s underperformance41:14now.41:15It’s pretty easily explained by the way that tech stocks are looking very sexy and they’ve41:21run very well.41:22A lot of investors look at the trajectory of the price only.41:27Something’s gone up a lot, that’s a reason to buy it, because that means that it will41:31continue to go up in the future.41:33Whereas value investors take the view that you have to look at the opportunity and buy41:36it at a discount to the opportunity.41:39All of those companies that have those ski jump price returns, they almost invariably41:46come back to Earth.41:47Not all of them have come back to Earth yet so I can’t say that they always do, but excluding41:51the ones in the current crop, that’s always been the case in the past that it get to that41:55point where they’re vertically ramped, there’s nowhere else to go, then that brings them41:59back to Earth.42:00I think that that’s likely to happen to certain stocks, and I think that often that’s the42:06precipitating event that leads to value, then having a very good period where we will come42:12back to our senses a little bit and try and buy fundamentals and cashflows and remember42:16that the function of business is to provide a service, to provide a product, to provide42:22some consumer surplus but also to reward the shareholders in those businesses for putting42:29capital at risk.42:30CHRIS COLE: We know, or we get a sense that the outperformance of value, the rebound value42:36that we’re seeing traditionally, has been a precursor to regime shift in markets.42:43That value has performed better at the end of a cycle, obviously, than growth and momentum42:49and that’s in the deflationary sense.42:52Let’s just imagine that we end up having a very progressive government, and even more42:59radical Fed than we have now.43:02There’s widespread money printing, fiat devaluation and we go into a stagflation airy crisis,43:09reminiscent of maybe the 1970s, how does value perform in that type of environment?43:13TOBIAS CARLISLE: How would the Fed be more radical than this interest?43:18I think that that scenario– CHRIS COLE: Well, you might be surprised.43:22Be careful what you want to tempt.43:23Don’t tempt the gods, please.43:24TOBIAS CARLISLE: I think we’re probably going to see it.43:27Whatever you think is, every year is going to be weirder than the last I think for the43:31foreseeable future.43:33I think that that scenario is probably a very good one for value.43:36Any volatility is good for value, anything that makes better balance sheets, more careful43:45managements, better businesses, perform better relatively two other companies that are out43:53there will be good for value investors.43:55I think that higher interest rates, a tougher business environment would certainly be a44:01very good environment for value guys.44:04I think that when we’re in very low interest rates, lots of liquidity, it’s hard to measure44:10what impact that has on the business because you see for a venture capital firm invests44:16in a tech company that then spends a lot of money on advertising, that money flows through44:20to Facebook and to Google, where advertising driven businesses used to be pretty cyclical,44:26pretty boom and bust, they’ve looked more secular recently, because there’s been that44:29move away from traditional television advertising to Google and Facebook.44:35The cycle hasn’t been as pronounced, it’s certainly been pronounced for the traditional44:39media, hasn’t look so good for them.44:42I think that potentially, very good for value and I would love to see it.44:47CHRIS COLE: It’s interesting as rates go up, volatility comes back in the markets, and44:52then the cost of capital is obviously much higher, and then I’m not getting a ride to44:58half [indiscernible] at half the cost of what it takes to take a train.45:03I think that that really segues in.45:06To that point, though, it’s interesting, this idea we think about this is Google, Facebook,45:11are these tech companies or are they advertising companies or in what the component that used45:17to be advertising agencies and more cyclical than we would think?45:22The one question I want to leave you on, the Fang stocks.45:25At what point will Tesla, what scenario, what point in history when do you think will Tesla,45:34Netflix, all these Fang stocks, Facebook, when will they become value stocks?45:40When would you see that happening?45:41TOBIAS CARLISLE: Well, I wouldn’t say that– almost every stock has its turn, has its regime45:47come to an end.45:49Buffett has been criticized in the past for not buying whatever is the fad of the day,45:54but if you look at his history, he has tended to buy a lot of these companies that are better45:59companies just after the crash or after they stub their toe and they look a little bit46:05less undefeatable.46:07At the moment, it looks like Netflix can’t be headed, Facebook can’t be headed, but I46:14think that the thing that created Facebook, for example, I think the kids don’t like to46:21be on the same platform as their parents or as the old and so Instagram arises, Facebook46:28sensibly buys Instagram, and so did the beneficiary of being the owner of Instagram where a lot46:34of attention moved.46:36I think attention moves away from Instagram now towards Tick Tock or something like that.46:40Those companies, the growth slows, but they’re probably still very good businesses.46:46They’re pretty low asset intensity, generate lots of free cashflow, reasonably stable,46:53growing businesses.46:54That’s exactly the thing that you would like to buy but at a price.46:57I don’t want to pay for all of that speculative growth and then I want own.47:03If anything, I don’t want to pay for the growth at all, I’m going to pay for them on their47:05current earnings power, with maybe a little growth in it because if you do a statistical47:11analysis on companies that the numbers that can sustain these very high rates of growth47:17are very low.47:19It’s one in 100, one in 200, which means that there’s probably there are 10 or 20 in the47:26Russell 2000 so there are a few of them around.47:28The problem is that everybody knows what they are.47:30They are bid to the moon.47:32You’re basically betting on the fact now that they are in fact better than everybody thinks47:37that they are.47:38I think that’s a very long vol at this point in the cycle, I think more likely, people47:44have overestimated what these things are worth, how far they can grow.47:48The they talk about the total addressable market for many of these businesses being47:53enormous, but what they forget is that the total eventual supply is going to be pretty47:56big too.47:57There’s going to be competition for those dollars.48:01When the market moves, value investors have to move along with it.48:04I think value follows along behind the wave where we’re picking up the detritus as it48:11comes back.48:12There just hasn’t been a lot around.48:13It’s been hard to find undervalued stocks.48:15I look forward to it, say it again.48:17CHRIS COLE: It’ll be like 2000, 40 Google’s regulated as– its regulated and broken up48:24AT&T as a Tesla utility, and all of a sudden, it’s trading a sub-depressed PE multiple to48:30whatever the next thing is.48:31TOBIAS CARLISLE: That’s so good to take that [indiscernible].48:33CHRIS COLE: Exactly.48:34Toby, it’s been a pleasure.48:37I know we’ve done this many times together outside, but this is a fun to do this on a48:41camera.48:44Toby Carlisle, Acquirer’s Fund.48:47Toby, where can people find you on Twitter and your website as well?48:50TOBIAS CARLISLE: I’m on Twitter @greenbackd, which is a funny spelling, it’s G-R-E-E-N-B-A-C-K-D.48:56My fund is the Acquirer’s Fund and the tick is ZIG, it’s listed on the NYC.49:02It’s a long/short net long to the tune of 80% or 100%, depending on where we are in49:09the cycle.49:10We’re about 80% exposed at the moment.49:12We have some shorts in that too, and we tend short as I said before, the junkier companies.49:17You can also find, I have a podcast and various other things on acquirersmultiple.com with49:22free screen, and I’m active on Twitter all day long, so I’m happy to engage, talk with49:27anybody on Twitter.49:29CHRIS COLE: I guess we got to show the viewers your daughter’s bracelet.49:32TOBIAS CARLISLE: Yeah, that’s from my six-year-old, made that while I’m away, I can remember.49:39CHRIS COLE: I think we can’t end on anything better than that.49:44I can’t top that.49:45Thank you.
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.