Billionaire investor Stanley Druckenmiller discusses the outlook for the U.S. economy, his investment strategy for stocks and bonds, President Donald Trump’s attempts to sway Federal Reserve policy and the prospects for a solution to the U.S.-China trade dispute. He talks with Bloomberg’s Erik Schatzker. (This interview was from December 17, 2018)
The Most Important Competitive Advantage is Trust
Why is it that equity returns are at record-highs – and yet beating the market is harder than ever? Josh Wolfe, co-founder and managing partner at Lux Capital, sits down with Mike Green, chief strategist and portfolio manager at Logica Capital Advisers, to explore this question. After Wolfe discusses a few of his recent successful venture exits, the pair discusses how excessive liquidity is making it harder to deploy capital, a process Green calls “alpha-degradation.” Other topics include Tesla, Bloomberg, and the “first-mover disadvantage.” Filmed on January 23, 2020, in New York.
Transcript
00:01MIKE GREEN: Well, you can tell by the smile on my face, I’m happy to be here.00:04I’m sitting down with one of my best friends, Josh Wolfe, so excited to be back here in00:08New York and chatting with you.00:09Welcome back to Real Vision.00:10JOSH WOLFE: Symmetrical happiness.00:12Always thrilled to be with you.00:13MIKE GREEN: Every time you come on the show, we get to talk about a new success.00:18Last time, we talked about the magic.00:19You were so excited about CTRL-labs, and pushed you on the idea that maybe you were falling00:23in love with something and where’s my sales commission?00:26JOSH WOLFE: Man, we got to do these interviews more often.00:29It’s been a streak of good luck.00:31MIKE GREEN: With CTRL-labs, now, you sold it to Facebook.00:34Remind people what CTRL-labs is, remind me why you’re begrudging in the sale.00:40What do you think Facebook wants to do with something like this?00:42JOSH WOLFE: The thesis behind CTRL-labs which led to three nights of sleepless nights in00:47pursuit of this entrepreneur, Thomas Reardon and Patrick Kaifosh, his co-founder, was premised00:53with this intercepting phenomenon that I call these two arrows, one of inevitability, and00:59one of the perception of the impossibility.01:01Inevitability is this directional arrow of progress where it doesn’t necessarily tell01:04you who the entrepreneur is or what the company is but there’s this inevitable high probability01:09that this is the way that technology is trending.01:12The impossibility is when everybody else in the field, peer VCs, just don’t see it.01:16They think, oh, that’ll never work.01:18It’s impossible.01:19Impossibility ends up dictating low prices or less competition and inevitability raises01:23our confidence and conviction.01:25In this case, the arrow of progress, the inevitable, was the idea that something we call the half-life01:31of technology intimacy.01:33This buzzword that we coined but basically 50 years ago, you had a giant ENIAC computer,01:37you physically went up and pulled some plugs and buttons.01:39First half-life, 25 years ago, you have a personal computer and you’re tickling the01:43keys, you’re touching the monitor, you’re flipping the power switch on the back.01:4612 and a quarter years ago, the next half-life, you have a laptop, physically touching your01:51thighs, becoming a little bit more intimate with you, you trade the mouse for a trackpad.01:54Six and a quarter years ago, now you’ve got your phone cradled in your hand.01:57First thing you touch in the morning, last thing you touch tonight, separated from your02:00body only by a thin film of fabric.02:01Three and a half years ago, your iWatch.02:0324 hours a day on your hand or 18 hours a day.02:06A year and a half ago, AirPods with a computer inside for voice recognition.02:09That directional arrow of progress, the inevitability was computability was becoming more and more02:14intimate and close to you.02:15We shared that thesis with a lot of people and then we ended up meeting this researcher02:18at one of our other companies, Charles Zucker, who’s a PhD neuroscientist.02:21He said you got to meet this guy, Reardon.02:23Reardon was the inventor of this technology that we use called Internet Explorer when02:27he was at Microsoft as a young guy.02:30He was one of 17 kids, 10 biological, seven adopted.02:34Just insane family situation.02:35Bill Gates taps him, he goes and works at Microsoft for a decade from ’90 to 2000.02:40He’s also Bill’s right hand guy during the monopoly DOJ trial.02:43Then after making a lot of money and being technologically renowned and reasonably wealthy,02:49he does what anybody would do in his shoes, he starts another company, Openwave, which02:52ends up creating a mobile browser that we all use and then goes back to college and02:57gets a degree in Classics in Latin.02:58Then spends the next near decade getting a PhD in Neuroscience, where the thesis he was03:03working on is this myoelectric response.03:05The idea that you could detect from the surface of your skin, the roughly 15,000 neurons,03:12that innervate roughly 14 muscles in your hand, which is important because if I’m typing,03:16my brain is telling my fingers to do something.03:18If I am turning a knob or switch or a lever or doing anything, my brain is subconsciously03:24telling my hand to move.03:25He figured out how you could take that signal, detect it and map it to the technological03:30devices we use.03:32Instead of having to type on a keyboard, instead of having to type a switch, instead of having03:35to turn a thermostat, I could effectively either do that motion in free space, or, and03:40this was the crazy part, think about making that motion and I can control the devices.03:44MIKE GREEN: We talked about this last time.03:46You highlighted that even if we go back and look at the Tom Cruise film, Minority Report,03:51where he has this dynamic and he’s moving this, he’s wearing gloves, he’s making the03:55gestures, et cetera, what Thomas Reardon figured out was that that subconscious thought was04:00actually sending a signal that they are then restricting and so the process of learning04:04how to type on Mavis Beacon is actually just your brain sending those signals to your fingers,04:09your fingers then figuring out how to do it, and you’re training that interface back and04:12forth.04:13CTRL-labs basically shortcuts that process.04:15JOSH WOLFE: In fact, they had a maddening demo, which we may have talked about, where04:19you try to hit the button before the device knows that you intend to hit the button and04:25you can’t do it.04:26MIKE GREEN: That’s amazing.04:27JOSH WOLFE: It can detect your intention to fire your muscle and move it before you actually04:31move it, which makes that, because if you have 1000 neurons that are activating a single04:35muscle, if there’s 100 of them, and if you were to do this now and you think about just04:38moving a finger, you get the sensation, this feeling of that finger, and it can detect04:43that.04:44I became obsessed with the entrepreneur, I lost sleep in pursuit of the deal for three04:48nights.04:49My wife, when she finally met Reardon was like you, you’re responsible for this household04:53duress.04:55It was an amazing experience, but it was too short.04:57It was too short.04:58It was about a year and a half, almost two years and Facebook made an entry on the company,05:01which we rejected.05:02Zuckerberg came back and made a more persuasive entry.05:05These founders, some of whom, unlike Reardon, had never made money before.05:09It was very compelling, the amount of capital that Facebook was going to invest into the05:14company on an ongoing basis, as well as the liquidity that people were going to get now.05:19I wish we would have held it longer.05:20I truly think this would have been a $10 billion business instead of something a little under05:22a billion dollars, but it was a great outcome for our investors and a thrill to be part05:26of what I think is going to be a historic technology that we will all be using.05:29MIKE GREEN: Now, I want to come back to this but this also brings up another topic that05:33you and I’ve discussed before, which is basically the concentration of capability inside companies.05:38What we have very clearly seen are companies like Google and Facebook, Apple, Microsoft,05:44have become very acquisitive.05:45They have an extraordinarily low cost of capital and have been able to buy these.05:50Do you think for Thomas Reardon as he thinks about going inside Facebook, that that creates05:56a limitation or that that changes the trajectory of the technology versus its original vision?06:00JOSH WOLFE: I’ll give you two answers because I tried the no answer.06:04I tried the moral suasion.06:06I tried– and this was at a time when Zuck was in front of Congress being lambasted as06:11a poster child of technological excess and election meddling.06:14I’m trying to make the case, my God, you are going to take a technology that can capture06:17your neural intention and give it to Facebook?06:20You’re going to spend the next two years in front of Congressional committees yourself.06:23I tried emotional suasion with my kids, saying don’t sell, sending videos to the board.06:28We don’t trust Facebook.06:29I tried financial suasion to do a secondary in capitalized business.06:33In the end, I think Reardon actually had a very rational view of this.06:36Again, he worked for Bill Gates at Microsoft when Microsoft was arguably the evil empire.06:42His view was back then, Bill Gates was a lot more powerful, and Microsoft was a lot more06:45powerful than Facebook is today.06:48Bill today is considered a president of the world in many ways.06:51He’s curing malaria, he’s taking on poverty, he’s doing big global things in a way that06:55many of our other elected leaders are not and there’s no reason that you couldn’t imagine06:59a decade hence, as hard as it is, that XOC because of Chan Zuckerberg Initiative might07:04find a cure to Alzheimer’s or something and suddenly be in that same position.07:08I think the idea that there’s going to be the monopolistic power concentrated, he felt07:13was overblown.07:14The thing that I think was really appealing to him, when you get bit by the bug of taking07:19Internet Explorer from one person to a billion users, the idea that you could take this technology07:26and its ability to let humans express themselves and control the world around them, from one07:31person or in our case, a few dozen people to 8 billion people, which is his goal, you07:37want a platform like a Facebook.07:41I think that the world will be better off with this scaling and I think it will unleash07:46many technologies in almost this moral imperative case to invent so that genius can get unleashed07:51and unlocked, that a lot of genius will get unlocked as people start to use this and discover07:56what they can create with it.07:57Again, I just wish it was still in my hands for a few more years at a much higher multiple.08:02MIKE GREEN: I wish it was to actually, but you didn’t try the physical violence approach,08:06which might have been my return.08:10Last time we got together, we had a similar discussion.08:12This time, it was John– that time, it was Johnson and Johnson acquiring the robotic08:17surgical company– JOSH WOLFE: Auris for just under 6 billion.08:22MIKE GREEN: Yes.08:23Exactly.08:24I haven’t had a robot operate on me yet.08:27Do you keep tabs on how that progress is developing, how that technology is developing and what08:32the next stages are when you exit these vehicles or just the bandwidth that that would consume?08:37JOSH WOLFE: No, we continue to track that because again, the thesis is sound and the08:40idea that the skill of a human in the operating room is the rate limiting factor to be able08:46to scale surgeries, particularly if you are a highly skilled surgeon.08:49The ones that make the most money, they’re the most sought after for the most sophisticated08:53procedures.08:54I think that that’s going to start to go away and the sophistication of the surgeon will08:57be embedded in the machine.08:59We see that across the history of technology where somebody that has manual dexterity,09:04that has precision replicability, rather than that being the implicit knowledge of the surgeon09:10through many experiences, why should they not be able to effectively download that into09:15a machine so that that can scale and reach many?09:17MIKE GREEN: It’s interesting.09:19Every time you and I talk, occasionally I get shivers down my back.09:21I’m reminded of a paper by Mark Koyama describing the innovations that actually led to the creation09:27of the Industrial Revolution.09:29One of those innovations was actually the transition from needlepoint in designs and09:34fabric to printed fabric can go.09:37What they did was they introduced variety into the consumption basket of young women09:41being courted by young men and that the young men had to enter into the labor force to obtain09:45dollars so that they could actually go buy stuff dramatically changed the work habits09:49of the world.09:51When you say something like that, and you highlight that type of technological development,09:55I can only see the number of opportunities that it expands in terms of the capability10:00to lower the costs, increase the ability of people to have the surgeries that they might10:04otherwise not have in the United States, the developing world, et cetera.10:09Really excited to see how that moves forward.10:12My next bet for the one though, that’s going to be acquired, is one you just started talking10:15about, which is the Variant Pharma.10:17JOSH WOLFE: Yeah, this is early.10:20It’s consistent with the theme which we follow, which is the decreasing gap between science10:23fiction and science fact.10:25In this case, the inspiration really came from X-Men and Professor X puts on this helmet10:31called Cerebro and is able, from a call crowd of mutants ridiculously, to spot the one in10:35a million person who can shoot lasers out of their eyes and conjure fire from their10:38fingers.10:39He got us thinking, okay, if there’s a one in a billion chance of some super rare phenotype,10:43a trait, which has [indiscernible], seven people walking around that have extreme high10:48oxygen saturation at high altitudes, they get into an accident, their bones don’t break,10:53they have extremely high metabolism, lots of interesting traits, and you just have to10:57go and find them.10:58Now, the other interesting thing, and here’s where there’s this arbitrage is the vast majority11:02of money and effort and research and talent has gone into sequencing, pale, male, stale11:07white Europeans, people like us.11:09Maybe not the stale part, but very few people have gone to the outer regions of the world11:15because those people don’t have money to find these outlier traits in these outlier regions.11:20I think that there is an absolute genetic goldmine of these people who are quite literally11:29mutants whose traits, and it’s really important because the team here, the fourth or fifth11:36person that they hired was a computational geneticist but the second and third was a11:39cultural anthropologist and an ethicist because they want to get benefit sharing and have11:44these people participate in both the economic profits but also the scientific progress that11:50comes from finding these unique individuals.11:52You will take a minority mutant population and end up helping find cures for the masses.11:58I think it’s an area of medicine in genetics that has never been explored.12:01We started the company, filled a team, they have now gone and it’s interesting we call12:05them at the moment Treks.12:07There’s a lot of thought– T-R-E-K, like a trek.12:13Which even they don’t really love that, they killed the idea of a mission, because that12:17has a connotation of expertise of your [indiscernible].12:20Lots of consideration about that even just like how do we approach these populations12:24who are rightly skeptical from having been exploited in the past by big companies or12:28explorers, or whatever.12:29We don’t call them explorations, we don’t call expedition.12:32There’s a lot of thought into the etymology of what we call these– MIKE GREEN: Extreme12:35wokeness.12:36JOSH WOLFE: Yeah.12:38They’ve done a handful of different partnerships, the ones that have been publicly announced,12:42I’ve been with them, our recent New Zealand who have really interesting metabolic traits.12:46Pakistan, which is a genetic island population and that Pakistan is not an island geographically,12:51but there’s a lot of interrelated marriages and cousins marrying cousins.12:55Because of that, you get interesting traits, which are likely or more likely to have a13:00monogenic condition, a similar gene that goes [indiscernible] and does something.13:04Then they just went to Nepal and were with the Sherpas and it was absolutely stunning.13:09They brought back some video.13:10They have a Nat Geo documentary person that’s going around with them filming their treks.13:15These Sherpas are going up with hundred pounds on their back and they’re completely not out13:20of breath and our team is dying and there is a genetic predisposition for that.13:25MIKE GREEN: You skipped one that actually caught my attention, was just the Samoan populations.13:30Very quickly, like from reading about the Varian Pharma website, resistance to diabetes13:36in the Samoan population run something like 30%.13:42As a result, the statistics was to replicate a Variant Pharma study that required only13:4810,000 people in Samoa, would require roughly 10 million, if I got those numbers correct,13:54in Europe?13:55JOSH WOLFE: Yes.13:56Because you already have the traits manifest in the people.13:57You’re not searching for all this needle in haystack, you have all the needles.14:01MIKE GREEN: It’s just absolutely incredible.14:03I don’t think people can fully appreciate the revolution that’s in front of us from14:08this standpoint.14:09I have a number of friends that are in the biotech space.14:12One who is going to join us tonight to drink after this event.14:17They are highlighting that there’s just this extraordinary advances coming in the biotech14:22space as people approach things from a standpoint of how do we change the way we study it, not14:27necessarily how do we change the tools?14:29The ’80s and the ’90s were largely about innovations in terms of what are the tools?14:35JOSH WOLFE: Sequencing.14:36MIKE GREEN: Right, exactly.14:37Now, you’re talking about the redesign of the actual process of how do you think about14:41the problem?14:42JOSH WOLFE: Exactly.14:43In fact, the way that we think about it is search is really, arguably the first competitive14:46advantage because you’re trying to find and identify these populations, some of which14:48they’re not publicly disclosing.14:49I’ll share one with you, not where it is but what the traits are.14:53Sequence, which is relatively as you point out, because the technological curves in this14:56are commodity, then you want to go and basically develop and you’re either going to partner15:01with Big Pharma, or in some cases, develop your own clinical trials, and that’s a lotmore money.It’s really the search of how do you partner and develop a competitive advantage.Arguably, the most important competitive advantage is trust, with the reputation that you have, how you’re contracting with local researchers, how you’re treating the local population,15:19how you’re prioritizing them, how you’re deprioritizing them, if that might be the case and what legacy15:24you leave.15:25One of the populations, South America, nine people were mean.15:29This is like a tiny group of people who have extremely high metabolic rate that spikes15:35at night.15:36Adaptation to the environment, temperature precipitously drops, they almost have like15:39a Heat Shock Protein that raises their body temperature.15:42Now, if you think about this, if that proved and I don’t know if it is, but if it proved15:45to be a monogenic condition, the gene makes the protein that raises the body temperature15:48at night and that was a targetable drug, you’re talking about a pill that you take a night–?15:53MIKE GREEN: Makes you skinny.15:54JOSH WOLFE: I don’t know if it makes you skinny, but you’re definitely burning fat while you’re15:56sleeping and with the obesity epidemic in the US, it would be pretty interesting.15:59MIKE GREEN: That really is just fascinating, fascinating.16:03It is my bet for the next one by the way.16:05I don’t know everything in your portfolio, but that is one that strikes me as just an16:08instantaneous.16:09JOSH WOLFE: Well, if we keep this pattern going, then the next time we sit down– MIKE16:12GREEN: I know, who wants to talk about the sale of Variant Pharma?16:14You have been begging them not to sell.16:16One of the other companies you talked about that got away from you, and I think you actually16:18became involved, Zoox.16:20This is in the self-driving space.16:22There was big announcement from General Motors or Drive more accurately in the past– JOSH16:26WOLFE: Cruise.16:27MIKE GREEN: Cruise, absolutely.16:28Correct.16:29Can you talk a little about what’s going on in that space?16:30JOSH WOLFE: Cruise was actually the one that got away from us.16:31We had offered Kyle $20 million at a 40 million pre-money so 60 million post and somebody16:40else did it, another great VC, at 80 million.16:43We thought that was double the price that we were in.16:45We were being priced disciplined on this.16:46Then we introduced Kyle to GM.16:49GM bought them nominally $4 billion, a little bit less.16:53Yeah, so that would have been 11x in nine months or something.16:58That was a big error of omission in hindsight, and that is an amazing team.17:03I think that they are serious.17:04I think that Aurora, which is another competitor, is serious.17:07I think that Zoox is the most serious, obviously biased, we’re invested but we only full stack17:13autonomous vehicle driving highway city in San Francisco, in Nevada, elsewhere, actually17:20doing robo taxi rides in Vegas.17:22Tesla, as you know, if you follow me on Twitter at all, that is mostly BS when it comes to17:28autopilot.17:29It’s actually dangerous that this is even on the road but the level of sophistication17:33that you have on everything from solid state LiDAR to the software simulation to being17:37able to navigate double parked cars, pedestrians, right hand turn, left hand turns, multi-coordination,17:43intersections, it’s really complex.17:45It’s still going to take a very long time for all of these things to see the light of17:48day, billions of dollars will be invested.17:50My hand to my heart, I actually think that the first real application of this, which17:54is another interesting phenomenon and trend that I think is going to play into cities17:58in a big way and it’s going to touch everything from Amazon to the smart home, I think you18:03will see self-driving cars first manifest in right hand turn lanes in certain city districts18:08where just like bike lanes, you are making multiple rights and doing a traveling salesman18:14problem trying to figure out how you navigate from neighborhood to neighborhood, 24 hours18:18a day delivering things, not people but things.18:21Even Zoox is focused on people and Cruise is focused on people.18:25There are some others that I think are thinking about commerce and goods.18:28Now, if you think about just the trend, again in a directional arrow progress, we are used18:32to our phone as a remote control where you press a button, you get your stuff.18:36Amazon Prime has primed us for one-hour delivery or two-hour delivery.18:40You press your button, something comes from a warehouse in New Jersey, using New York18:43as an example.18:44There is an autonomous vehicle that runs a route, gets to New York, has a human in there18:49to do the last mile delivery, which eventually might see robots that are people that are18:52trying to do that but I think it’s too many variables situations coming out of a vehicle18:56into apartment buildings and others that you’ll see that but human will come out like a FedEx19:00Delivery person.19:01Then the next thing that they will need in this value chain is access control.19:05I actually think that you’re going to see a whole suite of industrial blocks and cameras,19:09some of which you’re seeing early incarnations of, we have one called Latch Access, Amazon19:13bought a camera company called Ring.19:16There’s going to be many others in the space, but the ability to give trusted access tocomplete strangers to enter your home and treat your cupboard, your medicine cabinet,your fridge or closets in the same way you might give somebody trusted access to accessor deposit a file into a box or Dropbox or Google Drive.This idea of access control, I think it’s this next phase.19:38From pressing a button on your remote control for the thing you want, to an autonomous vehicle19:42delivering at 24 hours a day, to a human entering your home, because you’ve given the trusted19:46access.19:47Again, this is almost like if I would say 10 years ago, you’re going to get in cars19:51with strangers, you’d be like, no way.19:53Today, because you mostly trust the brand, and the accountability and the choke point19:57of an Uber or Lyft, you get into stranger’s cars.20:00I think you’re going to be letting strangers into your home to do this last quarter mileof cars.MIKE GREEN: I actually very much agree with that vision, that we are ultimately movingto an environment in which trust becomes the underlying dynamic.We’ve talked about this occasionally in the dynamic of crypto or various other thingsthat trust is becoming a feature that is embedded into the application layer.JOSH WOLFE: It’s actually the one feature that I’ve joked with Facebook Portal, is totallyabsent.I always said that.Facebook Portal just got this great design, but it’s missing the one feature which istrust.MIKE GREEN: Also my pushback on companies like Uber and Lyft actually has been the daysare going to suffer from a first mover disadvantage.They have had to address the issue of how do I transport people by “hiring” millionsof people?The process of shedding those employees is actually going to be far more difficult than20:49they think.20:50That actually sets up a dynamic in which a company like Zoox or and others who has built20:55themselves purposely, not to establish an app and get the app installed on the phone,20:59which is actually remarkably easy, although the trust layer becomes an important component21:02of it.21:04They’ve cut out the labor component that the separation there was going to create a bunch21:08of social anxiety and potentially lead to far more enforced regulations.21:12We’re already seeing this in California, where they’re being forced to treat them as employees21:16as compared to contractors.21:17JOSH WOLFE: They’re trying to say, look, we are just layered to match a driver and rider21:21and we don’t want to employ or be responsible, but you’re right.21:24The regulatory aspect of this is going to apply pressure to labor.21:26MIKE GREEN: Yeah, I think that’s ultimately right.21:28Now, you mentioned this idea that we’re going to take things, so I understand what you’re21:32saying.21:33I wonder if the challenge there is the person who has to be there to take the delivery.21:38JOSH WOLFE: I think that there will be a designated– and I’ve actually seen privately some of the21:45apps that some of these companies have, that are almost like an augmented reality thing21:49that when, let’s say a UPS delivery person, or if it was an Amazon Prime delivery person,21:54they look at their phone, they’re given a provision code to enter the apartment.21:59It takes a picture so it knows who’s there, knows what they’ve entered with.22:03They enter and they see this augmented reality thing of where they should– it might literally22:07be X marks the spot that they’re looking on the phone, put this here, or might be when22:12they go over the fridge, put this here.22:14They literally use that as a layer, which itself is another interesting thing I want22:18to talk about but the simulation layer to place things in certain places.22:22It may not be that you’re trusting them to come into your bedroom yet, for your bathroom22:25yet.22:26People will trust an Amazon Prime to come in and load their fridge and put away all22:30their groceries.22:31We get fresh, direct delivered on a weekly basis, and what do they do?22:34They come into our home, and they lay down all the bags.22:37Then my wife and I and the kids put everything away.22:40There’s no reason that I wouldn’t pay another $5 during that delivery fee to have them put22:44everything away for us in a consistent predictable way.22:46MIKE GREEN: Yeah, that consistent predictable way is actually a great distinction.22:50We have people who help maintain our home and when they unload the dishwasher, I’m constantly22:55saying, where the hell did they put this?22:58The ability to actually have that enforced in a consistent manner, I completely agree23:01with you, and I actually share your– JOSH WOLFE: We’ve read your head style, everything23:03in its right place.23:04MIKE GREEN: Everything in its right place, which sounds terrible in a lot of ways.23:08We all see those homes with the– I think the condo stuff is what it’s called, Marie23:13Kondo, where everything’s labeled and it’s got its own specific place.23:16I think you and I look at that, like, oh my God.23:18JOSH WOLFE: That stresses me out.23:19MIKE GREEN: That would drive me insane.23:21There is a component of predictability that you want to life hack, expend the minimal23:26amount of energy saying, hey, where’s the rolling pin today?23:29Where is the measuring cup?23:31When I think about that question that we started to address in terms of this self-driving capability23:38and you referred to the Tesla solution as being dangerous, which I share your concerns.23:46The challenge of self-driving, as I understand it, there’s certainly as it is presented is23:51this idea of miles on the ground.23:53How many miles do you have to travel to solve every possible permutation?23:59That seems like such a flawed model to me it, what’s your reaction to that?24:04JOSH WOLFE: I think it’s going to be a combination.24:05It’s going to be a combination of simulation where you’re trying to predict every scenario24:08from a human walking out, three humans walking out, old person, young person, ball coming24:12across, horse, dogs, different weather situations, potholes.24:16Why?24:17Because in any model, including what I would argue in human consciousness, you have this24:20prediction, memory prediction framework.24:22The computer basically has a memory based on either simulation or reality of what the24:26thing ought to be.24:28Then it experiences in real time what that reality is and maps it.24:31If it confirms to what the memory is, then the prediction, there’s no surprise.24:35This is the same thing I think that we experience in human consciousness.24:38I see you, I see if you see my funky shoes, you predict, hey, that’s Josh.24:43If you were looking at somebody else, and you saw this funky shoes and you– hey, that’s24:47Josh, but then it was Steve, you’d be like, oh, surprised.24:49Then you have this emotional salience that updates your prior, updates your model.24:53Computers are the same way.24:54These simulations in the self-driving cars and robots are the same way.24:57There’s a prior, whether that is through experience for programming, and the programming could25:02be from simulation.25:03Then there’s the actual experience.25:05Then when those map and conform, there’s no surprise, you don’t have to update the model.25:09If you think about all of the permutations that occur in reality, it’s infinitely complex.25:14You’re going to need a mix of models that are mapping onto the real world, and then25:18the ability to quickly discern.25:20In Zoox’s case, when you watch some of these videos online of the situations that they’re25:25able to navigate, in many of the cases, there’s no programming of those situations.25:29Having a double parked car, followed by a biker coming out of nowhere and a pedestrian,25:34every one of those things has to be almost consciously recognizing objects, and then25:38classifying those objects as humans, as bikes, as cars, as static objects.25:43Then intuiting what an intention might be and making a prediction about that.25:47It’s super complex, it’s going to be years of iteration.25:50I do think that these things are still very dangerous.25:53The idea of putting cars out on the road and calling them autopilot and giving people this25:57false sense of confidence is super dangerous.26:00It’s irresponsible.26:01It’s an accounting trick being used to book revenue and pull it forward, but this will26:09happen.26:10We will be in autonomous vehicles.26:11MIKE GREEN: It’s interesting, actually, because what you described as a very complex system26:18has features that I think are actually that overlay with some of the work that I’m doing26:22and I think you know this but I’m involved in some– my first machine learning projects26:25and there’s this issue of tractability, what can actually program.26:30Ironically, the transition to self-driving is the most difficult.26:35Because you have the unpredictability of human beings that may or may not conform to the26:39laws, that may or may not conform to these components.26:41Balls will always be there, children are always run out into the street.26:46The car driving itself, somebody double parking and behaving in a manner that’s not consistent,26:50having no mechanism to communicate that to you other than the very rudimentary signals26:54that come from brake lights, hazard signals, turn signals, et cetera, that’s ultimately26:59going to give way to a much more tractable problem as you have more and more machine-driven27:05vehicles on the road.27:06JOSH WOLFE: Well, especially as vehicle to vehicle protocols start to communicate the27:10intentions with each other.27:12Humans have this where if you and I are walking on the sidewalk in New York, and we come into27:15each other, you have that awkward Larry David like moment where you’re going left, I’m going27:19right then we make a mistake and the coordination problem.27:23Coordination is a function of both prediction and communication.27:25I do agree with you that you will have all kinds of layers of protocols where self-driving27:30cars and other robot systems, autonomous systems will have this coordination communication27:35protocol.27:36MIKE GREEN: Well, and we tend to take for granted the human’s capability to do that.27:42We all have the experience of making eye contact with a pedestrian crossing the crosswalk and–27:47JOSH WOLFE: You do a little dance and– MIKE GREEN: Well, even a car driver.27:50It’s just all it requires is that eye contact that allows people to be aware that you’ve27:53actually seen them then you can proceed under conditions.27:57It would be the rare assumption that you would make eye contact with the driver, enter the28:01crosswalk, and they would run you over.28:04We are very much programmed.28:06It’s built into our capabilities to understand when somebody has actually seen us.28:10That flash of recognition of this is a human being like it’s very much built in there.28:14We tend to take that for granted.28:16Machines don’t have that capability yet, or they’re developing it, as you’re highlighting28:20the Zoox, but once they have, then they’ll have their own native protocol as well that28:24makes this problem so much easier.28:26JOSH WOLFE: That, by the way, is one of the hallmarks just generally of human intelligence28:29and relevant entirely markets, which is I know that you know that I know.28:33Then it’s how many layers is that?28:36One of my kids I think, is very savvy.28:38She knows that I know that she knows that she’s like four layers whereas one of my other28:41kids is like, I know.28:43MIKE GREEN: Well, since we’re now crossing over to the virtual world, you introduce your28:46Twitter handle.28:48My character is the Vizzini from The Princess Bride.28:51I always focus on that– JOSH WOLFE: Inconceivable.28:54MIKE GREEN: Inconceivable, but the most important part for me of that character is actually28:57the iocane powder, where it’s a game being played but people are actually not aware with29:01it.29:02He believes he’s outsmarting somebody, but he doesn’t actually know the game that’s being29:05played involves poison in both cups.29:07It’s like immunity condition.29:09Which brings us to actually a discussion of a game that I’ve had with a number of people,29:12and one of our mutual friends, Mike Mobizen.29:16We’re going to transition into discussing public markets for a second here and Mike29:19has written several books and he’s talked often about the dynamic of skill development29:24in markets and how markets are becoming more challenging.29:27The alpha degradation that we’re seeing in public markets he attributes to an increase29:32in skill that is being accumulated in the market.29:35I think Michael actually misunderstands the game that’s being played.29:39He uses the poker analogy.29:41He says, we saw this online, there was a game of poker.29:45As poker moved online, there’s an explosion of players.29:48Initially, they were a bunch of Patsy’s that decided that they had been good at their local29:52games, got online and the pros were able to basically fleece these players and take their29:56money away.29:57Eventually, you’re left to the game in which only pros are playing pros.30:00JOSH WOLFE: Skill level has leveled up and a lot of the variance is more attributed to30:06luck.30:07MIKE GREEN: Correct.30:08The stock market is the extension of that analogy for him.30:12I think it’s a flawed analogy, and I wanted to get your reaction to that.30:16The way I look at it is poker is a fixed game.30:20It’s ergodic in nature.30:21We know at every point that the number of cards is going to be unchanged, there’s the30:24probability of a hand is going to be unchanged.30:26The configuration of the river or what you have in your hand can influence your perception30:30of those probabilities, but the odds really don’t change.30:34Stock markets or any form of market for that matter, is nonergodic.30:40We have no knowledge about what the distribution of the possible configurations are in the30:43future.30:45I actually think that he’s improperly framing the question, I think he’s using an ergodic30:49game to make an analogy to a non-ergodic game, in which the idea of skill development really30:55can’t exist.30:56JOSH WOLFE: I think Michael would agree that markets are complex adaptive systems.31:01There’s punctuated periods where there is a game, there’s a recognition of how that31:05game is played, then people level up to that game.31:08Then at some point, they may not be aware that the game is changing, but I think during31:11the period where people understand what the game is, the skill level is rising and so31:17the variation between investors is increasingly attributed to luck, but then, like you say,31:22the undulating landscape changes and suddenly the game that you thought you were playing,31:26you’re no longer playing.31:27You see this all the time.31:29Hedge fund guys before ’07 didn’t care about macro at all.31:33They were just bottoms up stock pickers, long short equity, short always overvalued, be31:38long, it was undervalued.31:39All of a sudden, everybody came, all the quarter letters, while the top value guys were suddenly31:44talking about macro.31:45They were pledging, oh, well, we didn’t because the game changed, macro mattered.31:50I think that at any given point in time, now you could argue it’s people that are getting31:53smart to the structure of the market as you are about passive indexation and inflows and31:58incremental flows and how that is changing the game.32:03I think Michael’s point is markets are complex adaptive systems, people can get wise to what32:09the game is.32:11They may not realize that the game has changed, but as long as there’s a general agreement32:14about the game, skill level rises and variance is more attributed to luck.32:17MIKE GREEN: That’s fascinating insight in terms of the way I’ve been thinking about32:21it, because it resonates with me, a discussion I had recently with a legendary investor from32:25the 2000s who I’m not going to name, said to me, Mike, I was meant to invest in the32:302000s.32:31The game that is being played today, I don’t understand.32:35I’m at this point too old and too rich to try to figure it out entirely.32:39It’s really interesting to think about it in that context.32:42Because it becomes a question of are those who have been so successful and accumulated32:46the– JOSH WOLFE: Half listening and half thinking about who I think it is, and I think32:48I know who I think it is.32:50MIKE GREEN: Do you think you know what I think I know?32:53JOSH WOLFE: Inconceivable.32:55MIKE GREEN: Exactly.32:56That actually becomes a really interesting question, though, because it then raises the33:01issue of have we allowed that concentration of wealth, have we allowed that to blind ourselves33:05to the potential that the game has completely changed, which certainly what my research33:08would lead, that the market is no longer the market as people think about it?33:12There are exploitable phenomenon, but it requires a complete rethinking of how you approach33:16the problems.33:18As phrased in those terms, I completely agree.33:21I think that will still lead me to say that it’s actually not skill development.33:25That would be a cyclical phenomenon that would show up slightly differently, the tools that33:30were developed for how we manage markets, how we think about them were largely created33:34in that time period.33:36The assumptions that we make in the use of those tools, things like alpha, beta, Sharpe,33:41et cetera, I think are actually improperly suited for the current environment but that33:45brings us then into the general discussion of public markets, which is, let’s talk about33:49how you see the world of public market’s valuations, and how you think about how that is either33:54influencing or being influenced by the private markets as you primarily participate in.33:58JOSH WOLFE: I just had a dinner with also a very prominent and maybe the most prominent34:02CIO in the endowment world.34:04I asked him, do you see risks about liquidity and illiquidity in both public markets and34:11private markets?34:12In the public markets, is it a function of passive indexation and inflows and whether34:17it’s Fed, algos, momentum, whatever it is, dollar and by everything rising, what happens34:22if there are withdrawals and everything comes down?34:25His view on that was with passive roughly 20% of market structure today?34:31MIKE GREEN: It’s about 35%.34:32JOSH WOLFE: Okay with but I think you’ve made the point that something like 80% or 90% of34:36the incremental dollars are going into passive?34:37MIKE GREEN: Far more than 100%.34:39JOSH WOLFE: Okay.34:40His view was when it got to like 90%, he would be worried and I recalled and actually raised34:45you as an example, I said, I have a smart friend who mathematically has shown actually34:48when it gets around where we are now, 35%, I thought it was for, that’s when you get34:52the structural runaway risk on liquidity side of passive indexation.34:57That was on the public side.34:58On the private side, he has done something interesting, which was, he never wants his35:04illiquid portfolio to be more than 50% of the endowment.35:06What he’s done because of who he is, has gone to the underlying GPs and said, give me your35:10hand to the heart mark of what you think this is worth, not the fast 157 mark based on accounting35:17basis.35:18Historically, when he did this, in 2000 and in 2007, or ’08, both saving them from substantial35:25drawdowns during the crisis.35:27It was somewhere between 25% and 30% discount to what any given company that ended up exiting35:32in that year, proved to exit at.35:35There was a level of conservatism that the managers expressed because they valued the35:39relationship with this particular CIO.35:41They said they were going to be super honest and ethical about what their hand to the heart35:44was because they wanted to continue to be hired as a manager.35:48Today, he says it’s between zero and 10%, so elevated valuations on the private equity35:54side.35:55If you look at the total amount of PE money today– MIKE GREEN: Well, just to be clear35:57what you’re saying.35:58What they are saying is they see no discount to where they’ve marked it in the event that36:02they would have to sell under distress type conditions?36:04JOSH WOLFE: Correct.36:05MIKE GREEN: That’s astonishing.36:06JOSH WOLFE: $1.5 trillion of PE assets are sitting on the sidelines right now, so there’s36:10an enormous amount of dry powder.36:12Now if you’re a public market investor, maybe that’s a positive thing.36:14MIKE GREEN: Well, wait a second.36:15Again, I want to be clear, when you say PE assets are sitting on the sideline, this is36:19the cash that has been raised but not yet deployed?36:22JOSH WOLFE: Correct, by buyout funds and venture funds.36:24Venture is a mouse to the elephant here, but 1.5 trillion globally, 800 billion of that36:30is North America.36:31That’s about two times the level of what it was 10, 11 years ago going into even then36:36a PE crisis 2007, ’08, ’09.36:38VC itself has raised about 50 billion across 250 funds in each of the last two years, which36:44is four times what it was 10 years ago.36:46Again, we’ve talked about this in the past, but the number one thing that is predictive36:49of returns is not the BCG McKinsey, whatever.36:53It’s the amount of capital that’s flooding in.36:54The amount of capital that’s flooding in is undeniably high.36:57You look at some of the surveys for LPs, they will say 80% of them feel unequipped in a37:02downturn that they’re well-positioned, yet two thirds of them are continuing to increase37:06their allocation to PE notwithstanding the numbers that I just gave you.37:11When there was a downturn, and you had this denominator effect, again, 10 years ago, two37:16thirds of those LPs were not making any new commitments to new funds on a private equity37:22side.37:23They anticipate that they’re not quite there, but they can’t help but continue to allocate37:26and I think that’s setting up a problem.37:28You had public markets to your point up 32%, 33%?37:31MIKE GREEN: 31% last year.37:33JOSH WOLFE: Denominator effect.37:35If that were to continue, great, everybody’s portfolio looks good.37:37You got high marks on these private equity for the other people that are not doing this37:40more conservatively.37:41If the public markets were to decline, you have a denominator effect, what are people37:45going to do with this PE portfolio?37:48There’s going to be a race for secondaries and liquidity.37:50I think the secondary guys in the next few years are going to be really well-poised,37:53they might be sitting on cash for longer than people expect.37:57On the public market side, there’s really interesting thing that Jim Grant had recently38:04shown, PE on the S&P; is 21, 22.38:07The PE is of course market cap weighted on the S&P; 500, but if you market cap weight38:14the E part, instead of just aggregating and averaging as it is, you actually have a 3238:18times multiple.38:20MIKE GREEN: Is the difference– the way it’s calculated on the public indices is what’s38:23called the harmonic median.38:24Effectively, you are going through and it’s almost like ignoring the outliers.38:29JOSH WOLFE: Because each of the cases aren’t you’re taking a multiple where you’re taking38:33the PE of Apple times the weighting of Apple and the PE of GE and the weighting of GE and38:37just basically aggregating that.38:39MIKE GREEN: Not quite.38:40The details, we can walk through another point, so it’s the calculation is actually what’s38:46called the harmonic median.38:47If actually, you’re going through the 50th percentile type dynamic.38:50You’re 100% right.38:53The other point that I would raise is that we’ve never seen a larger gap between GAAP,38:58G-A-A-P, and the “operating earnings” that make up that 21, 22 PE that you’re referring39:03to.39:04JOSH WOLFE: Well, and on top of this, you have something like 95% of companies that39:05are now reporting non-GAAP earnings.They’re making up funny metrics.39:10Now, we saw this in WeWork on the private side, when you had community adjusted EBITDA.39:14Tesla is like ground zero of like ridiculous terms like, what are delivery sales?39:19What does that actually mean?39:21There’s a lot of companies that are just using funny language because in a bull market, people39:23are less scrutinizing.39:25I think that that’s really a ripe situation where you have lots of non-GAAP accountingterms that are signifiers of risk.You have S&P; growing revenue 3%, 4%, 2%, 3%, 4%?MIKE GREEN: Somewhere in that range, yeah.39:36On per share basis, slightly higher, but yeah.39:40JOSH WOLFE: Most of the 31%, 32% return over the past year was mostly for multiple expansion39:44because I’ve had– MIKE GREEN: More than 100% actually flat to slightly negative earnings.39:47JOSH WOLFE: For the past four quarters.39:49People are paying higher multiples for lower or negative growth.39:52One interesting thing and this is a forming hypothesis that is a little bit more wishful39:56thinking from the venture side.39:59If we are at peak earnings, and people have been talking about peak earnings forever,40:02but if we’re at peak earnings, and corporates are looking and saying, okay, how do I actually40:06maintain margins at a time where 60% of COGS is labor, I think that there will be an increasing40:12turn to technology.40:14Now, I don’t know the timeframe.40:15That’s not going to be like, okay, let’s quickly implement the system and lay off a bunch of40:18people and maintain our margins again.40:20I do think that some of the things that we’re investing in, whether it’s metal 3D printing40:23or certain technological systems for efficiency, you have the opportunity for at least margin40:30stability against a situation where revenues are declining, prices are coming down.40:36There’s another question about what happens to input costs?40:39Well, a lot of smart people are– and I don’t know if you agree with this or not, but weak40:44dollar, long commodities, long gold, higher input prices, smaller margins.40:49MIKE GREEN: Not on that account.40:50JOSH WOLFE: You’re in the higher dollar camp?40:52MIKE GREEN: I tend to think that we’re going to have a higher dollar simply because the40:56global system is ultimately set up on a collateral basis and everything we’re describing in terms41:02of high valuations and increasing risk is actually touching that collateral dynamic.41:07We’re concerned about the risks that the collateral contracts.41:10If the collateral contracts and the debt actually becomes increasingly due, which means the41:13dollar is under demand.41:16I fall into the higher dollar camp, but– JOSH WOLFE: Do you have a view on margin pressure?41:21MIKE GREEN: I think the margin pressure is likely to come actually from a couple of different41:25areas.41:26We’ve seen unequivocally the margin pressure.41:29We’re allowing the system to increasingly run with tight labor, whether that shows up41:35in wages or not is heavily influenced by the composition.41:40When you have lots of old people, wages don’t go up all that much because they tend not41:45to ask for raises and that tends to conceal the relatively rapid wage gains that we’re41:50seeing in the younger generation.41:51There’s a couple of good reports that I could send you on that stuff.41:54JOSH WOLFE: I do wonder if the wage gains are happening taking into account the amount41:58of new company formation.42:00When you have a flood of capital into any sector, if there’s a lot of company formation,42:04those companies are competing with each other for talent and so wages are rising.42:08I do wonder if some of that capital inflow starts to abate, that you would actually see42:13more people consolidating, more supply of talent going into fewer companies, and wage42:17suppression.42:18MIKE GREEN: What we’re seeing is actually more on the opposite side.42:20The rates cut– while you’re very active in the process of business formation, I actually42:24would suggest that many of the statistics that we receive from the Bureau of Labor Statistics,42:28the BLS, are inflated by the assumptions around business formation.42:33Actually, the data suggests that business formation has fallen dramatically, not your42:37type of business– JOSH WOLFE: The mom and pop shops and independent contractors.42:42MIKE GREEN: That type of business formation has taken an extraordinary hit.42:46That, in turn, actually weirdly increases the potential for this to behave in a convex42:54fashion because what you’re beginning to see, and you’re seeing this very clearly in the42:58data is as the economy has slowed in this last cycle, we have seen overtime hours decline,43:03we have seen weekly hours decline, which has pressured some of the headline numbers in43:07terms of the average weekly compensation that people are receiving, you’re beginning to43:10see this show up and stress in terms of credit cards, et cetera.43:13The early signs of some weakness are there.43:16The primary dynamic that we’re actually seeing is this issue of hoarding of labor.43:22Companies are seeing decreased utilization of their labor but because of the headline,43:27finding new employees is so hard, they’re resisting with every fiber of their being43:32letting go employees that they currently have.43:34We haven’t yet seen that turn and we may not.43:37It’s very hard to know how that plays, but the data actually suggested it’s heading in43:41the opposite direction of the way that your hypothesis– JOSH WOLFE: That wages will continue43:44to rise.43:45MIKE GREEN: We are at an inflection point in which that could continue to tighten.43:48That’s one of the risks that the Federal Reserve may have created with reinforcing the cycle43:53with the interest rate cuts.43:55Only the future can actually tell us what actually ends up happening.43:58JOSH WOLFE: Demographics.44:00Let me ask you, because I always love your views.44:01MIKE GREEN: I’m interviewing you.44:02JOSH WOLFE: But your answers inform me.44:05MIKE GREEN: I understand that.44:07Nobody is interested in what I have to say on this topic.44:09We’ll talk offline on the demographics.44:11I want to touch though on a topic that demographics does influence that you and I both care fairly44:15passionately about, which is politics, the election that’s approaching.44:19You and I have publicly sparred, you have supported Bloomberg as a candidate, he wouldn’t44:25be among my last choices.44:28I’m interested to hear how you’re thinking about it.44:30I’m sure– JOSH WOLFE: Mine is very simple.44:32These are debates that I used to get into with Lauren, my wife, that I never really44:38thought the president matter.44:39I thought that all you needed was a good figurehead, who mostly was the better looking person that44:44conveyed all the evolutionary psychology appeals of symmetry and dominance and that stuff.44:50I think, in this case, I want the candidate and this is something that Bill Gates who44:56I serve on a board with said to my friend, Andrew Sorkin at the [indiscernible] conference45:00earlier this year, I just want the most professional person that really resonated with me, I just45:05want the most professional person.45:09The rancor that I see, the debasement of the office that I see with the current individual,45:16maybe I have this false nostalgia of pining for somebody that can set a level of behavior45:22and that is presidential, one that I want my kids to look up to and say like that is45:27the way to behave.45:28That is the way to make decisions.45:29That’s the way under pressure or criticism to react.45:33My preference for Bloomberg is really in actually thinking that unlike Trump, he’s actuallya billionaire and he can’t be bought and that the appeal that he has is more about legacythan short term gratification.45:45I find him to be the most professional and the most rational, but tell me your counter45:53thesis.45:54MIKE GREEN: My counter thesis would be almost saying exactly what you’re saying, which ishe perceives himself as the most professional but doesn’t perceive himself as a statesman.Someone who’s meant to represent.You can actually see it in what he is describing is his approach to the central office.He’s going to open it up, turn it into a bullpen, he’s going to manage it.He’s going to manage the US economy like he’s managed Bloomberg.That, unfortunately, is not the job of the president.My fear is, is that he very clearly doesn’t know that.46:23JOSH WOLFE: Do you think with the management of New York, which is a vibrant, complex,46:28diverse economy, that he did a bad job?46:31MIKE GREEN: I don’t I think that he did a bad job, but I think that he was handed a46:34gift.46:36The inflation that we saw through the 1990s created a revenue stream.46:39We, unfortunately, are going to run out of time here.46:42We didn’t get to talk about China, which you’ve also become very vocal on.46:46You and I are both involved there.46:47Let’s treat that for another time.46:49JOSH WOLFE: I will say, to your credit, this was something I was hyper bullish on in the46:53idea that there were two Chinas, an old China and a new China.46:56You would say, Josh, you’re wrong, you’re missing this.46:59I got to tell you, you changed my mind because I’ve come to see the evils and the skepticism47:04and there’s an idealistic view about what China could be and there’s a realist view47:09of what it is today, and I become much more in your camp.47:12It’s a great example of something I’ve changed my mind on because of you.47:14MIKE GREEN: To your credit, you absolutely have done that.47:17I’m very excited to see that.47:19My guess is we’ll get the same way with Bloomberg.47:20Hope we don’t actually see the need for that to happen once he’s in office.47:24Josh, as always, such an amazing time spending with you.47:27The time flies by and we’ve run out of it now.47:29Look forward to seeing you again.47:32Hopefully within a year.47:33JOSH WOLFE: Thank you, Mike.47:34Always good.47:35MIKE GREEN: Take care, Josh.
The Risk That Interest Rates Stay Low.. And We Can’t Afford an Increase (Crisis)
Transcript
00:01MIKE GREEN: Mike Green, I’m here for Real Vision at the Real Vision Studios in New York00:05City.00:06Today, we’re going to sit down with another individual who is known for his work in the00:10past of space, in particular, his work on ETFs.00:13Steven Bregman has a been on Real Vision before with an extended series called, “The Dark00:18Side of ETFs,” where he sat down with Grant several years ago.00:21We’re going to revisit that, particularly in the context of some of the stuff I’ve talked00:24about.00:25I’m really interested in how Steven thinks about the endgame of the passive strategies00:29and how to think about the influence in the market.00:32Let’s sit down and see how this goes.00:34Steven, you and I have not had the chance to talk for a couple of years, you’ve been00:40one of the other voices in the wilderness shouting about the risks associated with passive00:44investing.00:45I’d love to pick into your brain and understand the approach that you’re taking to some of00:50these challenges and some of the opportunities that are created by the growth of passive00:55investing.00:56One of the places to start is one of the areas of difference.00:59I focused primarily around the indexing component and you’ve spent a lot of time talking about01:03ETFs.01:04STEVEN BREGMAN: Well, essentially, they’re one of the same.01:07Sometimes people use the terms interchangeably because they don’t know the difference, and01:12they’re being casual about it, and I do the same actually, ideal primarily with direct01:18individual clients.01:19They’re not institutions.01:20They don’t have an institutional mindset.01:25They’re unaware of real differences.01:29They’re unaware of the fact that asset management companies, Wall Street is not really about01:36investing.01:37It’s about asset gathering.01:39They would be unaware, for instance, that how does an index come to be.01:44An index comes to be because a certain asset management specialize in this might be under01:53pressure from ever declining fees and you can’t charge a premium fee for a commodity02:00product.02:01Once upon a time, I think the fees on S&P; 500 index are like 50 basis points 60 basis02:07points, now, they’re down to zero.02:11What do you need to do to justify a higher fee?02:15Create something that seems to have, at least has the fig leaf of differentiation.02:20You can charge more for that, at least for a while.02:24You invent a new index, you do some back testing, you find some bucket of 20 or 30 or 40 companies02:32that fit some theme that back test well for the last five years.02:36By definition in this industry in modern portfolio theory, as applied nowadays, that means, some02:44positive rate of return with some relatively low comparative volatility, beta correlation,02:53what have you, and then you can float a new index, and they’re from offering ETF against03:03it.03:04You can’t even get it off the ground unless it back test well.03:08That’s how that works.03:09Indexes don’t just come about because they’re good investments, they come about because03:13it’s an opportunity for a management company to gather assets through a new ETF for which03:19at least initially, they can charge 45 or 55 or 65 basis points.03:23They can keep that fee, except if they’re lucky enough to gather enough assets, not03:2810 or 20, 30, or 40, 50 million, not even enough to break even, but if I gather some03:35hundreds of millions of dollars, well, then somebody else would come and knock them off,03:39like Vanguard and drag the fees down again.03:41People don’t even get these basic concepts and because my natural audience are individuals,03:46who really are the victims of this asset gathering business that parades as an investment business,03:56we study that.03:57MIKE GREEN: Well, you and I originally started in the same space.04:01You come up from the classic stock picker, single stock focus, run a highly concentrated04:06portfolio and by some measures, you found a few names that you think are truly extraordinary.04:11We can talk about a few of them if you’d like, but your insight into ETFs that I know you04:18from the Grants Conference discussions is largely around the dynamic of many different04:25ETFs buying the same underlying products, and this tendency to overlap.04:30You’ll see very high representation of Exxon Mobil, you’ll see very high reputation representation04:35of other stuff.04:36The dynamic that you’re talking about now, where effectively you offer a good back test04:41to try to offer something that you can actually charge fees for and the potential for if that04:48gets to scale, either you to lower your costs so that new entrants can’t come in and replicate04:52it or to be disintermediated by one of the giants in the industry.04:56STEVEN BREGMAN: They’re very disinclined to do that, they need every penny.05:00MIKE GREEN: Yeah.05:02How do you think about this dynamic of the difference between a Vanguard model and a05:08BlackRock type model where they are charging rock bottom fees and the need within the industry05:15for innovation in order to push forward how thought process is going?05:19STEVEN BREGMAN: The whole thing doesn’t even make a difference.05:22There’s no differentiation.05:24The whole thing, I’m going to say something, it sounds incendiary, I don’t mean to be incendiary,05:28but well, I shouldn’t say it’s a lie, but it’s false.05:33The whole thing is a false premise.05:34Now, we actually have the evidence.05:37The evidence is in.05:40We now have a couple things I’ll mention.05:43First of all, the great indexation passive investing ETF experiment, which took off for05:50real, more or less yearend 1999.05:53Slowly at first, but it was given a real boost in the wake of the 2007-2008 financial crisis06:00and people got really scared.06:02Now, they did everything that people do, which is act reflexively, which is not necessarily06:07helpful, which is first of all, sell your securities and memorialize a perhaps temporary06:14loss.06:15Then when they get back in after there’s confirmation that things are going up, which means they’ve06:19lost much of the recovery.06:23That’s normal.06:26What they did is they defaulted immediately to ETFs.06:29They were there.06:31They had time to become better known.06:35They’re a better mousetrap than a mutual fund and people had been really traumatized.06:43Traumatized, by the way, not just individual investors, but their brokers, financial advisors,06:49trustees of pension funds, [indiscernible] they all work.06:53They were scared of risk, all kinds of risk; manager risk, security specific risk, everything.07:02The proposition of an index made a lot of sense.07:06People had the experience, I could buy my favorite REIT.07:10Maybe that’s the one that goes to zero or I could buy an REIT sector index fund, and07:17it might not do well but it’s not going to zero.07:21That started taking off.07:22ETFs is supposed to be better, and indexations are better.07:29People like me could talk about it and analyze it and start coming up with a very amusing07:34and hopefully illuminating examples of how distorted it was becoming.07:38It was still subject to a lot of argumentation that passive investing, which is supposed07:42to benefit from the free rider principle, we just want to participate in the wave of07:48what active managers do when they contest in the open market and the set clearing prices07:53and just participate without changing anything.07:55We could argue that they’re beginning to actually alter clearing prices but those are arguable.08:02We could argue that the only reasons they were outperforming active management then08:10that came to be there are any innumerable articles about it, that active management08:14has just been proven to underperform indexes.08:19We could argue that simply because they were pushing up their own very limited number of08:25securities in which they traffic people and understand that you have to elucidate that08:29also why that is, but that was all arguable.08:33Now, we’ve got some proof because now, we’ve got a 20-year track record for ETF -based08:42index investing and history has spoken, and they all found one thing.08:48The S&P; 500 for the last 20 years has got roughly a 4.5% annualized return.08:59If you go to the MSCI All Country World Index, less than that, maybe 3.5% or 4%.09:06If you bought a 20-year Treasury note, and you’re in 1999, you could have bought about09:10a 6.3% or 4% yield.09:12MIKE GREEN: Remember it well, yes.09:13STEVEN BREGMAN: You could have done just fine.09:15They didn’t even perform as well as called a risk free Treasury but 20 years is a long09:22time.09:23Then if you take another look at what we think is the primary risk to investors, and the09:31primary responsibility of an investment advisor is not comparable returns to some other manager09:38or to some set of managers or some abstract index or an index with some abstract purpose09:46or importance, but at the very least, to maintain someone’s purchasing power over time, and09:52hopefully to increase it.09:54Well, the measure of monetary debasement over these last 20 years, M2 money supply expansion,09:59has been more than 6% a year.10:01In that sense, if you owned the iShares S&P; 500 index over the last 20 years, you actually10:09lose in purchasing power.10:10MIKE GREEN: How do you disaggregate that, though, between the outcome versus the process?10:14Because if I were to point to active manager performance, almost by definition has to be10:20worse, because we’ve seen in aggregate, active managers underperform the benchmarks.10:24STEVEN BREGMAN: What are the benchmarks?10:28What if the benchmarks are rigged?10:29What are we going to be talking about here?10:31MIKE GREEN: Yes, exactly.10:33STEVEN BREGMAN: By the way, I should preface this by saying I’m willing to try to defend10:38it and I feel comfortable with that.10:41I think this is the– not just the United States but globally, we’re in the biggest10:45financial bubble ever that includes stock, include bonds.10:50Basically, it’s the entire set of financial assets worldwide.10:54It doesn’t happen in a vacuum.It happens because it’s unprecedented, but it follows on the heels of something whosecausality here, something else is unprecedented is there’s never before been a coordinatedglobal coordination by the world central banks to drive interest rates down to these artificiallylow rates.Now, people have caught on to this.I have books at home that have the evidence, the lowest interest rates in 5000 years.One of the things that’s happened is that it raises financial asset prices, makes peoplefeel good, but it’s actually very pernicious, because it transfers the risk and returnsbetween savers and borrowers.If you’ve done everything you’re supposed to as an individual, you’re a retired accountantor you’re an attorney or you’re a doctor, and you pay for your house and you’ve gota million dollars, $2 million saved up.11:52What’s $2 million times if you put it all into a 10-year US Treasury note in less than11:572% and it’s taxable, but even if it’s not taxable, what do you get?12:01You can hardly live on that.12:03If you don’t expect to spend your principal, you don’t know when you’ll die.12:07MIKE GREEN: Yeah, it’s a pretty extraordinary statistic.12:09STEVEN BREGMAN: It’s a crisis.12:11I like to differentiate, there’s a term statistic and then there’s a place for interpreting12:15for people, because it’s really a crisis, it’s a yield crisis, and people can’t get12:23yield.12:24What does that do?12:25There’s a dynamic to bubbles, they build over time and people owned a series of bonds, municipal12:36bonds or corporate bonds, or within a bond fund and little by little, their maturities12:41calls and the yield goes down because the coupon goes down, or the average coupon goes12:46down, because they replace it with lower coupon bonds and happens slowly.12:52Little by little, people realize I’ve got a problem.12:55Wall Street is a unique industry.13:00Among other respects, that is the only industry I know of, in which, if there’s sufficient13:08demand for a product, they can create effectively infinite supply almost instantaneously.13:16If someone likes a certain GM truck, they have to retool, there’s certain amount of13:22capital you got to put in, but they’ll sell you whatever you want.13:28What happens?13:30Some firms see, oh, there’s a need for yield.13:31Why don’t we create– it also helps the fee aspect.13:35Let’s create a dividend aristocrats ETF index.13:40You’ve got various kinds of companies like they collect the higher dividend yield and13:45so people, they go with their lead there.13:51You get less than 2% in the Treasury, if it’s looking good, 3.5% in this REIT index or this13:57dividend aristocrats index.13:59They put more money into bonds than they really should, been into equities than they should.14:07They’re doing what they can.14:09Then you have the dividend aristocrats fund and so forth and so on, but it’s important14:13to understand the magnitude of asset flows into index funds.14:21We’re talking about several hundred billion dollars every single year for a decade, it’s14:27actually been climbing until this past year, and what happens is when you have trillion14:33dollar asset managers, and they create a new fund, and it could be a $200 million fund,14:39a $400 million fund, a $500 million fund and there’s going to be a knockoff of one of the14:45competitors, as a pure business proposition, you’ve got some really bright people in the14:51back office, working up different packages of stocks, new indexes, and they tried to15:00make it work.15:02Let’s just say that they create a list that back test really well, that’s got a nice theme15:07to it and then they bring it to their managers, they managed it well, there’s a problem here,15:15is that you’ve got these hundred stocks, except in the nether regions of that list by market15:21weight, the ones at the bottom, they just don’t have the trading liquidity.15:25They’ve got so many shares per day of trading.15:28They’re an X percent, let’s say it’s equal weighted, and it’s X percent of your list15:34and we can’t go above certain liquidity limits that we set in place, we can only raise 10015:40million dollars for this.15:41It’s not even worth the time, barely pays for your salaries.15:46They go back to the drawing board and they fiddle with the rule set.15:49It’s a very simple rule set, and they simply drop out.15:51They find a way to drop those companies out.15:53It’s legitimate.15:55We’re only– we have this list, but only companies with above this much creativity or whatever.16:00Now, you drop those out and suddenly, you can raise $500 million.16:04That’s an example of why real practical purposes, the ETFs or their bond ETFs or stock ETFs16:13have trafficked substantially completely in large cap and mega cap stocks.16:20They really need basically industrial strength trading liquidity, which is why you find Exxon16:26Mobil everywhere they can put it and why you find technology stocks in funds where they16:35don’t belong, because Facebook’s really liquid, or Microsoft’s really liquid, to find a way16:40you can find individual stocks, like an Exxon Mobil or Microsoft or something else, and16:46you’ll find they’re in growth ETFs, they’re in value ETFs, they’re in momentum ETFs, they’re16:50in fundamental tilted ETFs, they’re in dividend ETFs, they’re everywhere.16:53If you actually look at it, it defies logic other than they need the trading liquidity.17:01There’s so many systemic risks in the market now.17:03What will happen is when something gets over done enough, when you get like a deep bear17:09market, you get a bubble, aside for the fact that they can go higher than you ever imagined,17:13more overvalued then you ever imagined, or lower, they become a variety of systemic risks.17:20One of them nowadays, systemic risk, set systemic risk meaning it’s going to affect substantially17:26most of the securities in the universe you’re talking about, a single variable and one of17:32those variables now– I know you’ve observed it and are concerned particularly, you study17:39it closely, is the concentration risk.17:43People are unaware of what the concentration risk now is.17:46They think they’re getting diversified.17:49Diversification semantically only just a name, because all the same stocks are being owned17:54by these ETFs.17:56The fund flows come in, the ETFs are– the indexes are price agnostic, there is no–18:04in their short list that makes up the rule set for inclusion or exclusion of ETF, market18:12cap, industry sector, PE, whatever it might be, those descriptive attributes, there is18:17no place for valuation.18:20It’s not on that list.18:21There are different ways to talk about the concentration risk.18:25Not too long ago, only a matter of weeks ago, I accounted up in the S&P; 500, the top 10018:33names, 20% of the names accounted, just happens that the numbers of this even 67% of the market18:40value of the index.18:43That’s real concentration.18:44Although we’ve never had concentration like that before.18:47They drive the market.18:49The asset allocation’s idea of shifting from one sector to another in terms of market capitalization,18:55it can’t happen anymore.18:57I think the figures for the Russell 2000, is it $2 billion and below?19:02MIKE GREEN: I think it’s a little higher than that actually now, but yeah, something like19:06that.19:07STEVEN BREGMAN: The sum, the complete market capitalization of all the Russell 2000 stocks,19:12it may only be several percent the value of the Russell 1000, S&P; 500.19:19Even if for the sake of argument, it were undervalued, let’s say it were undervalued19:24and people just wanted to shift some money there, they can’t.19:27You can’t have a thimble that’s a 5% or 6% size to accommodate that.19:35In one sense, people– they don’t know it, but they’re stuck.19:37They’re stuck in the dark, there’s nowhere to go.19:40They’re going to go to treasuries and earn a basically return that will [indiscernible].19:46I want to talk about that too, because the lie or the complete let’s say misapprehension19:53of indexation, talk about active managers you asked me before.19:57This is a long winded way of getting around to this response, which is that the indexes20:03have been buying automatic bid.20:07Every time money comes in, they’re required probably to buy and hold all the stocks they20:12own in precise proportions.20:14They’ve been buying their own book.20:18It’s arguable, pushing them up.20:23Therefore, this is not passive, if you’re not participating in whatever the clearing20:30price mechanism established by active managers.20:33In fact, one of the reasons why active managers have done more poorly is they have been the20:39bank of funds and you could– there are places to look and you can see on a given year, a20:45given quarter, so much money comes out of active managers, and pretty closely, that’s20:50the amount that goes into indexes.20:52They’ve been the bank providing that, therefore, like [indiscernible].20:55You might like what he does, you might not like what he does, but give him this.21:00He sticks to his knitting.21:01He hasn’t bent.21:03He’s not going to do what he doesn’t want to do in terms of his, let’s say the integrity21:07he has over the investment process.21:09He loses money every quarter, but he’s got to sell and you get redemptions.21:13He’s got to sell things that aren’t in the indexes, there really is no buying interest.21:19He owns undervalued securities, and he’s selling them, make them even less, more undervalued.21:24The system is gamed, I don’t think the conclusion on that basis that indexes have proven active21:33managers to not be able to perform as well as index is false.21:38There’s another anecdotal bit of information I like.21:43I made a list a year or so ago, of like a half a dozen really well respected value managers,21:50value managers who had 20, 30 years of ongoing investment performance over obviously, over21:56multiple cycles, superb performance, like really stellar, well respected, not anymore.22:03Why?22:04Because in the last five or 10 years, they’ve underperformed plus five years, the underperformance22:10year by year, and back to back.22:13Astounding.22:14We’re talking about not just five percentage points, 10 percentage points, 15 percentage22:18points a year.22:20If you take people like [indiscernible] and Chuck Royce and Sequoia Fund and so forth22:25and so on, even Carl Icahn, first of all, there’s information content in that.22:33How can you take, let’s say, half a dozen or 10 people like that, with proven serial22:41success, and suddenly in the last five years– and by the way, they all have different approaches.22:49They have an affinity or skill set for a different type portion of the markets, or style of investing22:56or method of doing it.22:58There’s very little overlap in their portfolios.23:01Suddenly, altogether, they got stupid or incompetent at the same time.23:07It just is quite improbable.23:09Therefore, there’s information content in that which is maybe something else is going23:12on, and I can talk about why the S&P; 500 underperform for 20 years the All Country World Index has23:21and get into that.23:22Before I give you this more specific, another more overarching observation, have you heard23:27of the or read the Bessembinder Study?23:29MIKE GREEN: No.23:30STEVEN BREGMAN: You’re going to like this.23:32I know if you’re going to read some point in the next week or month.23:35My business partner, [indiscernible], came across this and he wrote about it.23:41Let’s call it the academic invalidation of indexation as practiced.23:46This is a guy, Hendrik Bessembinder.23:48It sounds like someone from the 19th century, but– MIKE GREEN: This were in Germany but23:53yes.23:54STEVEN BREGMAN: He’s a professor at Arizona State University.23:56Two years ago, he published a study.23:59It’s a 90-year study of equity returns 1926 to 2016 but it’s entirely different than what24:07we’re used to.24:08It was called little insouciantly, do stocks outperform treasury bills?24:13I tell you, this is a seminal piece of scholarship.24:16It’s like a significant contribution to the field of study of finance, and essentially24:23it invalidates indexation.24:26What he did is the differences that– I used to wonder about this, the reliance as a standard,24:35this is the way it’s supposed to be when you measure performance returns for people.24:40It’s all based on this time weighted percentage rate of return.24:45That’s because it’s designed for institutions, how to compare managers, but individuals,24:52they need to measure their performance in dollars.24:55That’s not how it’s done.24:56All the studies are done that way.25:01The difference is that his study was based on dollars of wealth creation.25:07How much did each company over that period of time contributed in terms of dollars of25:13value increase as opposed to just percentage return?25:17Because that only– I say “only” advisedly, only compounds at 12% a year for 20 years,25:23which is actually really good and creates a lot more dollars of wealth for some small25:28company, in a percentage basis, it’s a rocket ship for 10 years but doesn’t really have25:34that much impact on the total index.25:37This study encompasses over 25,000 different stocks.25:42Of those 25,000 call it 700 stocks, only 1092 by 4% of the total were responsible for all25:53of the $34.8 trillion of wealth generated from the equity market between July 1926 and26:00December 2016.26:0296%, the other portion of all equity studied performed no better than treasury bills.26:09He can draw some very quick conclusions from that or propositions.26:14Indexation as practiced is purports to be a representation of market reality, but it26:24really doesn’t mirror market reality.26:26That’s not how the market works.26:28If 96% of the securities don’t provide a higher return in treasury bills, then when you trade26:34one stock for another, you only have a 4% chance, about 25 chance that the new position26:42will outperform cash.26:44That’s the best argument I’ve heard so far for buy and hold investing.26:48As that 4%, that’s why indexes ultimately undiversified themselves.26:54We wrote exercises about this a long, long time ago, that you just buy a list of stocks.27:03This has to be large enough to encompass a normal distribution.27:06However, that’s 20 stocks or 10, or whatever it is, 30.27:09Most people say 35, statistically is a good number.27:12You just don’t touch it.27:15Then the two smart ones, now you don’t know which one is smarter then, they will outperform27:22over time.27:24Over time, the performance of the account will converge upon the performance of those27:27two stocks.27:30The account will get more and more volatile but it’ll also outperform.27:35The thing about indexation, though, is for a variety of reasons, it will never permit–27:42it can’t permit that to happen.27:43Number one, they’ve placed caps or limits on what a position size can be.27:48Number two, there are constantly new entrants, Uber comes along, IPO, they have to make shelf27:54space for it, they have to reduce so they get diluted over time just in a natural way.28:00Anyway, as practice, one can see why ultimately the indexes can do as well as for variety28:10of reasons, the historical returns suggest.28:11MIKE GREEN: Yeah, I think there’s definitely some truth to that.28:15I think the underlying dynamic of survivorship bias, the inability to fully participate,28:22the other component, of course, is that the participation of the individual is not reflective28:27of the performance of the index.28:29Particularly if you’re buying in an ETF where you’re paying bid versus ask, which can be28:33quite narrow, but accumulates over time.28:35To me, the most interesting thing that’s happened with the index space, though, is actually28:41almost the exact opposite.28:44Because we have functionally locked in a group of stocks that money gets continually piled28:52into.28:53The most popular mutual fund is the Vanguard total market index, where functionally every28:59stock, there are some that are excluded for sampling and liquidity purposes exactly as29:02you’re describing, which get excluded and then continue to underperform which naturally29:07draws the eye of astute value investors such as yourself, which locks in potentially underperformance29:13even as you’re accumulating a greater ownership of an undervalued asset relative to an index29:18that’s playing off of momentum.29:22That type of dynamic perversely actually ends up really damaging the capitalist system.29:30Because companies participate, regardless of their underlying fundamentals.29:34STEVEN BREGMAN: Yes.29:37Now, I’ve changed the way I talk to clients about the market and the bubble and so forth.29:44What I do find people can readily assess our bonds.29:50Bonds have many fewer variables.29:52You’ve got a coupon, you got a maturity date, and if it’s money good, you’re getting 10029:58cents on the dollar at the end period.30:01If you’re not sure it’s money good, that’s usually pretty determinable.30:04That’s not such a mystery usually.30:06I now can use this to talk about the falsity of the way modern portfolio theory and efficient30:18markets and blah, blah, blah, the way that portfolio management is practiced in an institutional30:25basis, which filters into these asset allocation models, which induces people or their investment30:30counselors to put them into certain asset classes and certain indexes and so forth,30:37the basic false premise of it.30:41You mentioned the most popular ETF by size, which is the Vanguard total market.30:46Well, in the bond realm, the fifth largest ETF is the iShares 20-year plus Treasury ETF,31:02TLT is the ticker.31:07Last year, actually through November, it got $7 billion of new assets which increases assets31:13by 65%.31:15Spectacular.31:16The problem is that the average investor who owns TLT probably thinks they did pretty well31:23last year, and they’re very pleased with it.31:25They think it’s a high return low risk investment.31:28Why?31:29Well, first of all, it’s up 14% last year, what they don’t look at necessarily and know31:33to look at is that the average coupon is not even 3%, 2.99%, which means that 80% of their31:41term came from appreciation and that that appreciation only happened because the government31:45lowered interest rates or interest rates were lowered, got lowered.31:49Well, what if they say, what if it keeps getting repeated?31:54Well, there’s obviously a limit to that.31:56Even so, the majority is still only 2.29%.32:00You hold that for 20 years, the same more or less, you can expect that’s what you’re32:03going to get and that is below the rate of inflation.32:10The government is telling you that you are guaranteed for 20 years to this purchasing32:15power every single year.32:17If M2 money supply, which in the last 20 years has been 6.2% or so, last year, it was more32:27like 7%, the last six months, it’s more like 9% on an annualized basis.32:35That’s monetary debasement.32:36If you’re going to lose 4% in terms of purchasing power every year, that means in 10 years,32:46the hundred thousand dollars, the million dollars you put in those 10-year treasuries,32:51those 10-year treasuries will be worth half as much in terms of purchasing power, you32:55could be in real trouble.32:56If the amount of income you’re able to get off, it was just enough for you in year one.33:00That’s an existential crisis for people and they sense it, but they don’t know how to33:05evaluate in terms of what they’re buying.33:07The other problem is how Wall Street describes risk to them.33:12If you go to the TLT website, right on the main page, I’ll tell you, it’s got this duration,33:18it’s got this convexity.33:20I don’t know what that is.33:21MIKE GREEN: You can know what it is, but yeah.33:25STEVEN BREGMAN: Investors aren’t conversant with that.33:29What they don’t know, in terms of risk is that if 20-year interest rates, just for the33:37sake of argument, next year, go from 2.29% which is what is about the [indiscernible]33:43and that is, to five, that they’re going to lose 30% of their investment.33:49They don’t know that.33:50MIKE GREEN: Perversely, though, if that happens because of the higher coupon, they’ll actually33:54end up with a higher total return over that 10-year period.33:58While the immediate impact would be negative, and I spent a bunch of time digging into exactly34:04this topic, post the global financial crisis because I was trying to understand what are34:10the real risks in bonds.34:11The real risks and bonds are exactly as you’re describing that the rates go low and staylow forever.STEVEN BREGMAN: They could stay low.Well, I’m convinced, and this is completely unscientific, this is completely non-technical.I’m a big believer in incentive systems, and basically, behavioral psychology and behavioralfinance, is that interest rates will stay very low if the government can help it fora very, very long time.If it can help it, simply because it can’t afford for them to go up.34:46MIKE GREEN: I agree with that.34:47STEVEN BREGMAN: They’ll do whatever they have to.34:49Eventually, they create a real crisis of one sort or another.34:54MIKE GREEN: I think the interesting challenge is thinking about it from the standpoint not34:57of a valuation system which most people tend to focus on the idea that low interest rates35:02translates to higher valuation, but you’ve referenced them to a couple of times in this.We live in a collateral based credit system.What happens when the government cuts interest rates?The price of the bond goes up.What does that do?It provides you with additional collateral to then go and buy stuff.It’s theoretically worth more even though it’s going to depreciate towards par.I think that is actually one of the key underlying dynamics.We’ve effectively built a system predicated on collateral.It’s not that the interest rate is really what’s driving it, it’s the bond price.35:38What do you see as the alternatives?35:39STEVEN BREGMAN: In today’s world, we have basically a bifurcated market in terms of35:45clearing prices, and how those clearing prices are developed.35:50That is either you’re in the indexation.35:52Above the ETF divide, you’re in the indexation sphere of activity as a security or you’re35:57not, and even excluded by the relatively simple rule sets of the ETF universe because you36:06don’t have the– you might be a large cap company, I’ll name a company, I’m not recommending36:12it or not.36:13AP Moller Maersk.36:14I forget the market cap, could be 30 billion.36:17It’s the largest shipping container company in the world.36:19Aside from the fact that it’s not a US based company, but even if they were, the thing36:25is the Moller family, I don’t remember, but they owned 45%, 55% of shares.36:32Therefore, the effective market cap is way, way lower, it doesn’t suit.36:37It also doesn’t have the volatility return characteristics you might want because the36:44shipping industry has been in depression for years.36:47That’s not going to be in an index.36:48What will happen is, if you’re below what I call below the ETF divide, there is no institutional–36:56for the original purposes, virtually no institutional interest in you.37:01There aren’t any analysts covering you because they can’t get paid to cover you.37:05Therefore, for the first time in my career, which only goes back to 1982, you can have37:13companies, you can get a free lunch– now, there is no free lunch, you have to figure37:17out like why it seems free, otherwise, you’re on thin ice.37:23You can get a free lunch in all sorts of ways because the excesses in the indexation centric37:30securities market has created deficits, in clearing prices and valuations in below the37:38ETF divide.37:39What will happen is that there are companies now that are undervalued not for any fundamental37:45reason, meaning fundamental adding to their balance sheet or their income statement or37:50competition or technological displacement or regulatory problems or management issues.38:00How can you find a decent company trading at a low enough price that you think you’re38:06getting some discount or margin safety?38:08Very, very difficult.38:10You really couldn’t.38:11What you needed to do traditionally is find some company with a blemish, the CEO absconded,38:17they lost a big contract, whatever it might be, stock drops.38:21Then our job is to try to evaluate that and find out whether that insult is transitory38:27or permanent.38:29Whether it’s structural or it’s superficial.38:32I say you know what, in two years or three years or four years, somewhere beyond the38:38standard institutional investment time horizon, I can’t take the time risk, I’m willing to38:41take the time risk.38:42That’s what I think my advantages is, is it’ll be fine.38:48In which case, what’s the normalized earnings on this and what’s some a normalized perfectly38:52average valuation?38:53Oh, I’ll do pretty well.38:54I’ll buy it and wait.38:56That’s what you have to do.38:58Now for the first time, you can buy companies that are deeply undervalued relative to some39:03objective measure, their assets and their assets are profitable, or their earnings or39:09their free cashflow, whatever it might be, good balance sheets, there’s no blemish on39:13them.39:14The only reason they’re cheap is that they’ve been excluded from the indexes, probably either39:22one of two reasons.39:23They don’t have sufficient trading liquidity.39:25Large companies, small or they don’t fit the shape parameters, meaning it might be a trust,39:36or it might be some odd– it might be a multi-industry company.39:42It’s not exactly– it might even be a real estate company, but it’s not a REIT, they39:47want REITs, they don’t lend to development companies.39:50What’s happening now is that if you’re willing to look– if you have the license as an investment39:57advisor, to look below the ETF divide, you can find everything you want.40:02It’s possible.40:03It’s really possible.40:05You can create for somebody, you can create a portfolio with bonds and other income securities40:11or equity series that’s got, let’s say, I’ll give an example, let’s say a 4% gross yield,40:19dividend and interest, some of which is tax exempt, that has strategic, important strategic40:27flexibility, let’s say 20% in cash reserves, that also has both bonds and equities in there40:34that have plenty of optionality of a high order continued to force or modest but steady40:45state internally generated growth in shareholders equity overtime and therefore income production.40:56You can get a yield that’s twice the 10-year Treasury rate.40:59You can have a purchasing power protection.41:04You can get everything you’re supposed to have.41:07Now, is it going to track what’s happening in the marketplace?41:10No, but that’s not my goal.41:11I have a different objective.41:13You can do that, but you can’t find it in the– same with bonds, I heard you discussing41:21this is that you find a bond that’s sure valuation, perfectly good.41:28It’s money good for the next four or five years till it matures but it’s not an index.41:33It might not be a large enough issue, you can buy a 7% yield and it’s not a junk bond.41:40MIKE GREEN: Interesting.41:42Well, I think that’s going to be the interesting question.41:46A lot of the dynamics that you’re discussing, we both experienced in ’99 to 2000.41:51Similar components I’ve talked about, homebuilders right before the big housing bubble being41:55priced at half bulk value.41:57The challenge in my mind, and we referenced it a little bit before in the discussion,42:02it says that we have actually created such a fundamental flaw in the structure of how42:07assets are collected and how money comes into the system.42:10It’s not clear to me that we’re going to be able to capture those means reverting characteristics42:15that you’re highlighting.42:17If 95% of the money that comes in, if millennials who are going to be the millennials, and those42:22who come after them are fundamentally forced into passive investing styles because of regulatory42:30systems, and gain no experience whatsoever, are we setting up the conditions in which42:37we destroy those mean reverting characteristics?42:39I would highlight is a good example, the travails of FedEx relative to Amazon.42:44Amazon functionally has a zero cost of capital because of the dynamics of inclusion that42:52you’re highlighting.42:54They’re able to make investments that would be uneconomic for almost any company to make42:59certainly a large scale logistics company like a FedEx, they’ve been able to build a43:04second FedEx, something we would have thought of was having a giant significant moat for43:09an extended period of time.43:11They’ve been able to replicate it in the period of roughly three years.43:14The real fear that I have is that we’ve broken that characteristic and I think it’s going43:18to be fascinating to see if it reverses itself.43:22STEVEN BREGMAN: You bring up two points which I think spark some responses.43:27One is you’re pointing to something that people forget generationally.43:31Every generation, there are some companies that for 20 years, 30 years, grow and grow43:39and grow and they become recognized.43:42In the course of someone’s life, their personal experience, they’ve been there forever.43:46They’re stable.43:47That’s not how business works.43:50They’re not stable.43:51What’ll happen is that’s another reason why indexes have trouble doing well, which is43:58that one of the reasons why– another reason why they get this 4.5% annualized return since44:03’99 in the S&P; 500, is because if you look at the largest 10 companies in the S&P; 50044:06at the end of 1999, most of them have suffered displacement by competitors.44:14IBM was displaced by cloud computing.44:20Dell was displaced by the emergence of the iPad, and so forth and so on.44:29That’s natural, because the largest companies represent the easiest largest targets for44:36a national competitor to secure customers and revenues, and people think that an Amazon44:46or a Facebook or a Google are somehow impervious to technological displacement.44:54If you take a look, there are a whole variety of companies and technologies or just plain45:01old competition that is beginning to make inroads.45:06We don’t know which will work or not, but to give you a nontechnological form of what45:13can happen, the margins, the returns on equity of the modern Information Technology slash45:21technology companies like Facebook, Google, Twitter, are simply enormous.45:27The stated ROEs might be 30%, or something like that, depending on, but really, it takes45:33all the cash and marketable securities and the market securities in the balance sheet,45:37which are nonproductive, they don’t need them to do the business.45:39You take that away, the returns in equity could be 50%, 60%, 100%.45:44It’s simply like unheard of.45:46It’s not really sustainable.45:48Someone’s going to come after that.45:49Now, how can they come after it?45:51Well, Dell, which displaced all sorts of other companies in manufacturing PCs by doing a46:01direct to consumer approach, and they were willing to sustain a lower profit margin to46:07get there.46:10Dell is now getting into cloud computing.46:16What does that mean?46:18It sets you off up a warehouse, and you buy all the equipment and you do it.46:26Now they’re going to compete.46:28By the way, there’s a food fight going on now.46:32Amazon and IBM, IBM needs to succeed in cloud computing to protect itself now.46:39Dell’s getting involved.46:41Amazon at some point, there’s going to be margin compression.46:47One of those players is going to be willing to take a lower margin just like in ETFs.46:53Here’s why I don’t think it can keep going on.46:58We talked earlier, the bank of funds for suctioning out of active management into the passive47:11management, that’s finite.47:13As of a year ago, I think there’s a Fortune magazine article, they did a study.47:20They thought that we passed the 50% dividing line, very significant one, of all passive47:30assets as a percentage of all investment assets in public markets.47:39That has all sorts of implications.47:40You’ve looked into them yourself.47:42There’s a law of large numbers.47:44Now, there’s 50% float available to them.47:48Now, it’s less, now it’s 49.47:49If that was a correct number, 48.47:52Every year, in order to maintain the same constant pressure on the automatic bid on47:59all the stocks owned by old ETFs and bonds, they need larger inflows each year, like it48:06was $350 billion last year, whatever the number was, now it’s going to be more but the pool48:12from which they’re drawing is getting smaller.48:16That can start to accelerate real fast.48:19When the flow of funds into indexation slows, or stops, or turns negative, there’s no more48:27automatic bid and the marginal trade which is effectively indexation has been for the48:33last 10 years and increasingly in recent years.48:37The marginal trade, like the baton is handed over to the active manager and the active48:43manager, I just referred [indiscernible] because it occurs to me.48:48He’s not buying a blue chip.48:50He’s not into technology, but he’s not buying a day now mature trending into cyclical blue48:57chip, like Coca Cola, or McDonald’s or Procter and Gamble, which actually had sales declines49:04in recent years, at 25 times earnings, just not doing it.49:07Where’s the bid going to be?49:08This is before we get to other dynamics.49:10MIKE GREEN: The pushback that I would make to that is that the old people, for lack of49:16a more descriptive term, are the ones who own active managers.49:20The young people who continue to have inflows are those who own passive vehicles.49:24There’s nothing that actually says that active manager ever gets to bid again, there’s no49:29rule of the universe, there’s no law that says that has to happen.49:32It’s unfortunately catastrophic, but there is no law that requires that.49:38That I think is going to be the really interesting question is, if the system can’t find itself49:43self-regulatory.49:44Sure.49:45STEVEN BREGMAN: The rules again, when you get extremes, you get other possibilities.49:51Since it’s fully disclosed, the precise percentage positions in every single ETF, you know exactly50:01what they own, you know how many total dollars of assets are every in single ETF.50:06At a certain point, if the inflows get small enough, even with a lower age demographic50:18making contributions, it’s going to start to peter out.50:22We don’t know, I’ve never worked with these kinds of numbers the way you have but at a50:27certain point, if it looks like it’s tipping, you can have short sellers who know if there50:33are going to be any redemptions, net redemptions.50:36They’ll know exactly how much is being sold of every single security.50:42They have almost unlimited quantities of assets that they can front run.50:49That’s a different scenario.50:50MIKE GREEN: Yeah.50:51I worked through the numbers, and I think it’s going to be interesting to see how it50:54plays out.50:55I don’t think– STEVEN BREGMAN: It’s more dynamic than that.50:56MIKE GREEN: It’s more dynamic than that.50:58I think the real risk is that we’ve seen short sellers already eviscerated by the inflation51:03that I think is caused by the passive investment process.51:05STEVEN BREGMAN: But the passive investment process has still– that’s why those short51:09sellers are missing an important element.51:15Money’s flowing in, to the tune of hundreds of billions of dollars a year.51:18You can’t get in front of that.51:19MIKE GREEN: Well, to your point, though, that money is coming out of the active managers,51:23are flowing into the passive, ironically, if you have that inflation, the supply of51:28assets that’s available to the active managers goes on much longer.51:32We’ve probably seen this, there’s very few stocks, you highlight it yourself, unless51:36they’re outside of the indices, which Vanguard total market index had very few stocks that51:42actually are outside of that unless they fail to meet float dynamics or ownership dynamics.51:46STEVEN BREGMAN: Yeah, but if they’re, 100th of 1%, they’re in de facto in a de facto sense,51:53but it’s meaningless, statistically meaningless.51:55MIKE GREEN: Yeah.51:56No, I think that’s right, but that’s exactly the point that I’m making, which is the assets52:00that are owned by the active managers who by and large, buy stuff with similar characteristics52:05to the passive indices, you being one of the notable exceptions, they can experience that52:10same inflation and so one of the big push backs I have is the idea that value stocks52:13are cheap as they were ’99.52:15I don’t see that at all.52:16I think there’s elements exactly as you’re describing.52:19I think we’re going to run out of time, but one of the things that I think is going to52:23be so interesting, and I’d love to come back and sit down with you in another year is thisunderlying question of, is there a selflimiting feature?Can this actually wrap back around?STEVEN BREGMAN: I think what’s going to happen is there are going to be some serious socialproblems.MIKE GREEN: I agree.STEVEN BREGMAN: When you see serious tumult in nations, social tumult, it really oftenfollows when there’s been currency debasement, loss of purchasing power, inability to liveon your investments or your income, people get desperate, then things change, desperation,and we’re heading that direction just a lot more slowly than Greece or Venezuela.MIKE GREEN: I share those sentiments exactly.STEVEN BREGMAN: As I mentioned one term, it’s necessary for anybody I talked to, to hearwhether they are willing to let me work with them on it or not, is the ultimate hedge againstcurrency debasement.It might never work, it might never be necessary, but it can save your financial future andit can be done in such a small amount that will never harm you if it doesn’t work, whichis a fixed issuance meaning nondebasable cryptocurrency.If the time ever comes that people in various parts of the world feel they need a non-debasablecurrency, the returns can be on the order of hundreds of times your money.MIKE GREEN: I share those sentiments.54:06Historically, it would be gold.54:08We don’t know if going forward, it’s going to be a crypto asset but I agree with you54:12that those types of nonlinear properties will become an important part of any asset allocation54:17framework.54:18I really look forward to sitting down with you again and sharing these thoughts.54:23STEVEN BREGMAN: I actually enjoyed listening to you more than talk with you.54:27Thank you.
The Biggest GeoPolitical Fat Tail Risks for 2020
Maziar Minovi, CEO of Eurasia Group, joins Real Vision to discuss the biggest geopolitical threats to global stability that he sees on the horizon. He analyzes the ongoing decoupling of the US-China trade relationship and argues that the severing of technological protocols could inflict the most lasting damage. Minovi explains why he believes the rising cynicism of the American voter to be the greatest risk to global stability. Filmed on January 22, 2020, in New York.