Passive Investing, Inflation and the Bifurcated Economy with Mike Green

[00:00:00] Welcome to Excess Returns, where we focus on what works over the long term in the markets. Join us as we talk about the strategies and tactics that can help you become a better long-term investor. Jack Forehand is a principal at Validia Capital Management.

[00:00:11] The opinions expressed in this podcast do not necessarily reflect the opinions of Validia Capital. No information on this podcast should be construed as investment advice. Securities discussed in the podcast may be holdings of clients of Validia Capital.

[00:00:22] Hey guys, this is Justin. In this episode of Excess Returns, we welcome back to Mike Green. We build on our discussion in previous episodes with Mike about the impact of passive investing and discuss the academic research supporting his thesis,

[00:00:35] and how he sees the situation playing out going forward. We also get Mike's opinion on inflation, the Fed, the risk of the rising use of options, and the short volatility trade, and a lot more. Mike always has thoughtful takes on a wide variety of investing topics,

[00:00:48] and that shines through in this interview. Thank you for listening. Please enjoy this discussion with Simplifies Mike Green. All right, Mike. Hello. Thank you for coming back on Excess Returns. It's always a pleasure to have you here. Oh, it's a pleasure to be here, Justin.

[00:01:03] Thank you very much. Appreciate you and Jack for taking the interest. Yeah, you're very welcome. We've had you on a few times where we've talked about a lot of things with you, but we're going to start in an area that we

[00:01:16] have spoken to you about. But I think there are some interesting developments, and that's the update on the influence of passive in the markets and your views on that. I think a lot of our audience, and a lot of our audience follows you and knows about what those

[00:01:35] views are. But one of the things recently is you've been highlighting some recent work in the academics field on the impact of passive. We wanted to maybe give you an opportunity to talk about that. And then what are the most important papers out there that you've

[00:01:55] come across? What are the highlights of those? What are they showing? So this is one of the things I try to do for people when I give my full presentation. So if you're ever forced to suffer through that, one of the few benefits you get is my academic

[00:02:10] appendix that says these are the things you should be looking at. If I were to start in terms of the process of how I arrived there and kind of the way I would encourage people to start, first paper is Lasse Peterson sharpening the arithmetic of active

[00:02:25] management 2016. Second paper that is really critical to understand is probably the work of Gabbay and Coyjian Zambia Gabbay and Ralph Coyjian, the inelastic market hypothesis. I would supplement that with one of two papers from Bouchaud on this topic. JP Bouchaud is a

[00:02:46] head fund manager out of Paris. His work on market impact was extended into Gabbay and Coyjian by himself and a couple of other co-authors in a paper called the inelastic market hypothesis in microstructural interpretation. Valentin Haddad, how competitive is the stock market,

[00:03:09] introduces multipliers with insecurities and highlights this dynamic that I've been emphasizing recently. That's really the paper you've probably seen me refer to which is the one that's talking about the least elastic stocks being the largest stocks which feels paradoxical to most people

[00:03:26] that the impact seems like it would be larger on small stocks but it actually turns out that the impact of index buying is significantly greater on the largest stocks which contributes to the dynamics we've seen of large outperforming small not just in the form of technology

[00:03:43] when it crops every sector of the market right so literally you can go into every single sector and you will see that the largest stocks continue to outperform. A couple of other papers that I think are really worth highlighting, Jonathan Parker,

[00:04:00] financial innovation in the case of target date funds is one of the first to very clearly and simply lay out the impact of systematic allocation strategies that automatically rebalance between stocks and bonds and his rather straightforward and easy work was then

[00:04:15] extended in a much more complex way by a professor I think who's now at Washington, Julu, she worked under Hannah Lustig at Stanford and her work on the portfolio rebalance channel is the same thing just highlighting it in a slightly different

[00:04:32] way in a much more mathematical construct. Those papers largely explain what we've been seeing right that what we're seeing is not the byproduct of thoughtful investors whether they're skilled or unskilled who are theoretically taking the discounted cash flow

[00:04:48] analysis projection on an individual stock and trying to value each security but instead an increase in the growth of systematic strategies in which allocation is following a very simple rule something like market cap waiting and the implications of both that and then the

[00:05:07] second component is a portfolios that systematically rebalance. One of the really interesting components about that last part is actually an area where we remove systematic rebalance and so you guys are old enough to remember when we used to

[00:05:22] construct portfolios and we'd say something like I'm going to put a 10% allocation in the small kind of value because 10 French and Eugene Favre tell me that outperforms over time right the studies are pretty clear on that. That largely was dispensed that I would actually be surprised

[00:05:39] that this wasn't the case in many of the portfolios you managed that's not picking on you it's just a standard practice in the industry we've moved away from the idea of allocating a fixed percentage to things like small cap to choosing to allocate to a total market portfolio

[00:05:53] and so when you actually do that there is no limit to how small those small lift stocks can actually become right if they fall to 3% of the market portfolio well that's where they should be allocated they fall to 1% well that's where they should be allocated at some coin

[00:06:09] the private sector bid would emerge but that's really hard to actually do in an environment of higher interest rates and what I would argue is near peak profitability so all of those kind of play

[00:06:22] into what I think of the mechanical behaviors that we've seen where prices seem to increasingly deviate from underlying fundamentals. Are there any areas that you think you'd see more like to see more work being done in the academic field at least on this topic like do you

[00:06:43] have anything in mind that if you were to if you were to like commission you know a research paper out there is there anything that you think you would like them to look at that they're not

[00:06:53] looking at well I mean the the area where I had differed from most of the academic studies was actually addressed by a paper that I encouraged the writing of in 2022 by Marco Sammin

[00:07:09] who's a professor at Harvard he had written a paper evaluating the impact of passive similar to some of the work of Hidaldo and others and he scaled this the impact by assuming a level of passive

[00:07:25] share right and so actually Hidaldo does the same thing they both assumed that the very obvious share that they could glean from Black Rock, Vanguard and State Street was effectively the sum total of

[00:07:38] passive share at about 15 percent of the market cap in 2020 my work suggested that it's actually a multiple of that and I pushed Marco to evaluate that he came up with a methodology where they looked at the fraction of shares that are actually changing hands on index rebalance

[00:07:58] as a strong indicator of what the actual share was and as I expected it turns out that that number is somewhere around 38 to 40 percent so we're and that's back in 2020-2021 so we're at

[00:08:11] a level of passive penetration that's far greater and if you read the balancing Hidaldo paper again how competitive it's a stock market and you understand how they've scaled the impact you understand how important that assumption of 15 percent was it's a much bigger problem than

[00:08:27] Hidaldo's paper would actually suggest due to the much higher share of passive investing so is the academic work finding what you've talked about basically which is the idea that liquidity doesn't scale with size and that's why the biggest companies are more

[00:08:39] effective at this that's the easiest way to think about it but it's also a function of inability to replace right so if I'm building a if I'm deciding to to construct a passive index

[00:08:53] replicate the S&P 500 there's two approaches I can take I can buy every security or I can statistically sample right and if I think about something like United Airlines versus Delta Airlines

[00:09:04] do I actually care if I get Delta and United in there combined between the two of them I'm going to make a guess and say there's 0.3 percent of the S&P 500 they're functionally exchangeable

[00:09:17] it's not going to have a meaningful impact on my portfolio behavior if I get one versus the other but I can't exclude Apple can't exclude Nvidia I can't exclude Microsoft and as a result it actually turns out that even within passive there are degrees of inelasticity in terms

[00:09:34] of demand for individual securities yeah it's interesting like we know some we run some direct indexing strategies and we know some people who do as well and that's an interesting problem

[00:09:43] they face which is the idea that you know if I have to replace if I'm selling Nvidia or if I'm selling Apple like what to replace it with to continue to track the index is a very challenging

[00:09:51] thing because these companies have gotten so big and there's not really any great proxies for exactly you know for that the idiosyncratic risk of those individual companies yeah I mean at the scale of the the weights in the S&P 500 or even the total market index which again

[00:10:06] remember that the S&P 500 is I think 94% of the weight of the total market index at this point you know it the small companies just don't matter essentially it seems way to put it right and you

[00:10:19] actually hear this commentary on Twitter for example which I think is fascinating right people are like I don't care what's happening to the smaller companies I don't care what's happening in small private companies because it doesn't affect the index which is what I trade

[00:10:31] the real problem associated with that is actually sociological it creates exactly the type of fragility that Nassim Taleb has highlighted over and over and over again there were actually studies on this done in the 1990s looking at the impact of bankruptcy dynamics around large

[00:10:49] companies versus small companies it's easiest to think about a factory town right if you work in a local furniture mill in you know North Carolina and the sole provider of employment

[00:11:02] in the town shuts down the town's dead right but if the local you know grocery store shuts down somebody else is going to open up another grocery store the same thing is true when we

[00:11:11] start talking about these giant companies the Microsoft's apples etc I am in no way suggesting that Apple or Microsoft are going to fail in fact I've got that in the opposite direction but the simple reality is that we're making our economy and our markets more and

[00:11:26] more dependent upon the idiosyncratic risk to steal Jack's term of very large companies and the associated fortune something I want to ask we're going to ask more about the risks but first I want to ask about you've been tweeting a little bit about this recently and

[00:11:40] one of the things you keep saying is I wonder what might be happening you know people are showing something that's going on in the market and then you'll reply with some charts and say I wonder what might be happening and one of the charts you replied with was

[00:11:49] the academic research in terms of I don't know if it was the performance or the multiples of the big companies against all other companies it's sort of in the academic research it goes up for a

[00:11:59] little bit which is what we've been seeing but then eventually it seems like it accelerates a lot in the academic chart you included I'm just wondering like is that what we would expect

[00:12:06] to happen here is that these companies are getting a little bit a little bit and a little bit more expensive and eventually that's really going to accelerate well it's ultimately the dynamic of two things right one is as you scale that market cap again it goes back

[00:12:19] to this issue of the inelasticity component one of those clear dynamics is that liquidity does not scale with market cap scales with volume and effectively volatility not exactly volatility but close enough as a proxy the largest companies are actually in many ways more volatile today

[00:12:40] than the smallest companies because of that inelasticity dynamic right we've seen Tesla and Apple and Nvidia the obvious one have these unbelievable moves and expansion in terms of multiples it's really just a function of people trying to push money into these names when the volume

[00:12:58] does an appropriately scale right the liquidity doesn't appropriately scale it is an exponential function because if you allow Microsoft to grow to be 10 percent or 20 percent of the index you actually are creating conditions in which that becomes even more true the next dollar into a

[00:13:15] vanguard index fund if Microsoft were 20 percent of the index would totally overwhelm the actual liquidity that's being provided in the market you'd see a huge market impact associated with that buying activity and to be very clear like that's really what it is we all we have seen

[00:13:33] from passive on a continuous basis is an underlying bit right because passive has gained share because more and more money is flowing into passive the point out repeatedly there's really only five days in history that I can point to where there was a net selling of passive

[00:13:51] none of those were particularly attractive days so that that was actually one of the questions I was going to ask you so that there really is not much experience in the past with what happens when passive goes in that negative great because it really just doesn't happen

[00:14:05] remember the course of my career which is basically forever the you know underlying dynamic is passive has gone from about 1 percent market share when I entered the markets to today it's someone that wrote a 40 percent that continuous share gain which really accelerated after the pension

[00:14:22] protection act in 2006 and then took another leg up in an even more rigid form with the introduction or the transition to target date fund this is what are called qualified default investment alternatives that happened in 2012 right and at that point if I remember correctly

[00:14:38] passive was only 15 16 percent in 2012 today we roughly tripled that share when you think about how passive could go negative I mean off the top of my head I think of probably two different scenarios one is more acute we see like a 2008 type scenario

[00:14:55] you know where there's just big flows out of passive or people reduce their flows or some sort of market crisis that leads to that and the other would be I guess as the boomers retire

[00:15:03] you could argue that they may become negative eventually even though they're probably a lot less passive than the people that are contributing you could have more of a slow type thing where eventually it goes negative that way are those both reasonable so I think there's a couple of

[00:15:17] components right so people have probably heard me use the expression contributions are a function of income and withdrawals are a function of asset levels and just very quickly like imagine a 401k or

[00:15:27] a pension plan that has a requirement to spend about 4% of the assets and as you guys are financial planners you know the underlying dynamic of an IRA or a 401k requires you to take larger and

[00:15:39] larger distributions as you age right as a fraction of the underlying that means that evaluations are really high right so stock price to income or market cap to GDP right which was the

[00:15:53] classic method indicator since GDP is really just a measure of domestic income you can flip that on its head and effectively think of that almost like a PE ratio what are we paying for the financial

[00:16:03] assets of our country the equity financial asset publicly traded equity assets of our country as that multiple gets higher and higher it becomes harder and harder to replace the withdrawals with the contributions so whether it's actually the baby boomer is going negative or whether it's a function

[00:16:22] of you know even institutions that might be forced to withdraw over and above their contributions these are all contributors to that underlying dynamic like just mathematically at some point it breaks down did this happen did passo go net negative in 2008 at all or not at all

[00:16:40] so actually it's one of the fascinating things there was some net negative components particularly around the futures markets in 2008 around Lehman but actually if you look at 2008 in every single month manguard had positive inflows so maybe i was wrong about that i mean maybe a crisis is not

[00:16:57] enough you know to turn at least right where we are right now to turn the flow is negative we actually know that a crisis is not enough right because covid for example vanguard you know

[00:17:05] very politely announced that less than one percent of their clients even attempted to change their allocations to sell right and that stuff congratulatory my reaction to that is oh my god what should have been two because we actually did see net passive redemption over some of that time

[00:17:22] period some part of that was a function of reallocation to more aggressive passive like strategies ie the naztac 100 etc but this is exactly the model that you would expect when passive tries to sell markets correct sharply so when you think about the probabilities and

[00:17:45] the way this might play out in the future as passive continues to grow like how do you think about the different possibilities there and what's most likely well what feels to me to be the most likely output is that you'll ultimately have a combination of those two components

[00:17:59] right so it'll have waterfall type characteristics where it starts to roll over and then the discretionary joins in as well right there's nothing that causes anyone to buy you've effectively created a situation in which the short interest in the market is at the lowest levels in history

[00:18:16] that means there's very few forced buyers there's a very high probability that type of condition and you would actually not so much see forced selling as much as you would see people moving very rapidly to change their portfolio allocation to something that is far more suitable

[00:18:32] for somebody at for a great status in life we've seen a higher and higher fraction of assets allocated to equities or part of that has been a function of portfolio design and people reacting to the realized profit a bit of the realized performance in these assets

[00:18:47] but is that starts to change as you start to see the volatility increase which it absolutely will as passive continues to gain share uh you ultimately are setting yourself up for a situation

[00:19:00] that can't be avoided now the timing of it there's a number of things that can influence that right if it's tied to job loss an aggressive job loss like we saw in 2020 or if it's tied to

[00:19:12] a credit event like the Lehman Brothers in which suddenly a significant fraction of cash becomes non-cash in its underlying characteristic your claims on Lehman Brothers is a hedge fund for example converted from an actual pool of cash that you could spend to buy additional shares

[00:19:28] to an unspecified claim literally a uh uh you know general claim on the equity of Lehman Brothers at that point right you became an unsecured creditor of Lehman Brothers with uncertainty as to where you would actually generate in whether you are going to get that

[00:19:46] cash back or not so that type of dynamic can create forced selling or cause people to react in an adverse way again I think the most likely outcome is simply that we tip negative because

[00:20:00] of the withdrawal versus contribution dynamics and that then suddenly starts to change all the narrative right in the same way that the market is levitating upwards around these dynamics it could very quickly reverse and start basically moving in a manner downward that makes no sense

[00:20:18] whatsoever in terms of the underlying fundamentals they always talk about the stairs up in the elevator down and it sounds like that's what you're talking about here but I'm wondering is there any possibility of the stairs down here like just the reverse of what we've been seeing

[00:20:29] like if this boomer thing plays out slowly over time that these big companies would just kind of slowly work their way back down is that is there any reasonable case that that would happen

[00:20:38] so I think you're actually seeing elements of that within the smaller cap stocks right so if I look at the large cap stocks there's a second feature that is playing in which is that despite record valuations companies are aggressively repurchasing shares under the very simple argument

[00:20:53] that you know it's better for them to return cash on a tax basis through share repurchases than it is through dividends that's certainly true but it also means that they're buying back their

[00:21:04] their own stock at extraordinarily high valuations at the same time by the way that the insiders the company employees are selling their shares aggressively right so like this is kind of nonsense

[00:21:17] if you really think about it so in terms of like the conclusion from this and it sounds like the timing part of this is very very difficult right you're it's it's hard to

[00:21:25] figure out when this might happen even within like a period of years right it's just very difficult to think about how this might play out is that right well I think it's less difficult than people

[00:21:35] think right so one of the other charts that I've sent around is we're now actually starting to see things like the Vanguard total market index flows turn negative right that's a big change now I think what's actually happened is that allocations have shifted towards more

[00:21:50] growth oriented components we've seen a significant influx of capital there is obviously like technology and AI but that in turn is actually setting up conditions that are not dissimilar to what transpired from 1998 until 2000 when the market similarly

[00:22:08] narrowed as people said aha I get the joke right 1998 I put this tweet out earlier you know I think it was earlier today you know Coca Cola was trading at 60 times earnings Johnson and Johnson was trading I think at 42 43 times earnings and people you know operated in the

[00:22:26] framework of you know okay stock should be significantly higher right this is the era of Dow 36000 by Kevin Hassett and I can't remember who the other author was um the you know from that period from 1998 2000 the market narrowed significantly as people

[00:22:49] basically said okay this is all about technology right I think we're seeing something very similar with the AI characteristics today which is also one of the reasons why it's so hysterical is

[00:23:00] the wrong term but it is how it kind of feels to me where people are piling into AI related stuff you know basically saying well this is the only thing that could explain what we're seeing

[00:23:12] right the the economy must be transitioning to this unbelievable productivity boom associated with the AI it's a very hard call for me to swallow and in terms of the magnitude of this I mean I

[00:23:24] guess that it's also very hard to predict but you're not thinking like a 10 correction you know when this whole thing reverses right you're thinking this could be like a significant market event well what we don't so the quick answer is we don't know right but the dynamics of

[00:23:38] volmageddon for example are actually quite instructive if you looked at the characteristics of volmageddon you'd gotten to the point where the inverse mix etus the passive exposure to a rebalancing of the ux futures had gotten to the point where it was consuming about 70 percent of

[00:23:55] the liquidity on any given day right that meant that when an excess of liquidity needed to be pushed through the system was incapable of absorbing it and prices collapsed this is not that similar

[00:24:10] right I mean you guys occasionally talk to active managers when you look at their portfolio construction one of the questions you ask is how much cash are you parent and the reason you ask that is not necessarily because you're worried about the drag but more because you're

[00:24:23] raising the question of how thoughtful are they about the optionality associated with cash and the neat redemptions without being forced to sell could they opportunistically buy things if prices were to retreat a very typical level of cash historically for an active manager was

[00:24:38] around five percent in today's interest rate environment I would expect it to have risen to something close to that but because passive vehicles carry no cash and because the market cap weighted indices have performed so well active managers are being forced to chase the

[00:24:54] passive managers who carry no cash whatsoever right so if I were to look right now I actually have not done this this month so far so we'll see where it shows up but if I were to look at

[00:25:08] the holdings of the vanguard total market index the current cash balance on a 1.6 trillion dollar fund complex is 21 million bucks so the only way that you meet a redemption in the vanguard total market index is by selling shares one of the conclusions a lot of people have made

[00:25:32] from this including david einhorn who has used your work and had a great podcast with very riddles where we're talking about this is the idea that fundamentals really don't matter anymore and I'm wondering do you and I know back in the day you know if the fundamental when

[00:25:41] fundamentals did matter you were a small cab doll you guy you know you have this bunch of experience as a fundamental manager like do you think we ever get back to that do you think I mean is it would

[00:25:49] it require a meltdown of the market for that to happen do you see a future where fundamentals might matter more well so I don't think either david or I would say fundamentals truly don't matter right clearly fundamentals matter for a variety of reasons one of the most obvious

[00:26:05] being things like what we saw with Hertz for example over the the period that the meme stock craze or the dynamics of game stop or others you know you saw those prices move to extraordinary levels on the back of short squeezes and then the fundamentals reassert

[00:26:22] themselves to an extent right they ultimately companies that need to tap capital markets to raise cash and to refinance their debt are uniquely exposed to companies that don't need to do that and that's you know that's a really big deal because if I'm issuing shares

[00:26:39] into the market I've got to find somebody to buy it and if you know this is one of these crazy things when you really think about it like keep gill on game stop helped game stop raised $4

[00:26:50] billion three billion of which came in a two week period before the company announced that their earnings were going to be a disaster right like and he made somewhere in the neighborhood of $200 million that's just about what the underwriting fees would have been for that

[00:27:04] type of capital raise from Goldman Sachs so this is the perverse world that we live in where keep gill has effectively become a you know uh uh you know underwriter for the issuance

[00:27:18] of game stop shares by creating a short squeeze yeah you can probably exactly like an underwriter you can argue game stop might not exist but i'll keep gill I mean they've done great so much money

[00:27:29] I think I think there's an extraordinarily high prospect of that right this is a company that many people who were shorted thought was going to go to zero now there is no prospect of

[00:27:39] that company being wiped out over any reasonable period of time for the very simple reason that it's got a ton of cash now are they going to invest that productively and does that cash justify their existing market I don't think so but you know we're left explaining nonsense

[00:27:55] in markets right now where you see things like micro strategy trading yet huge premiums to the only value protocol value that's there and something like its bitcoin there is no rational

[00:28:07] explanation for that just two more things I want to ask you about before we shift to macro on the first is options you know if you look at any chart of the amount of use of options in the market

[00:28:15] it's gone up dramatically since 2020 I mean the the rate of increase has slowed but it's still way higher than it was do you think there's any risk to that um in terms of the overall

[00:28:24] market the fact that options are being used a lot more than they were before well I think I think it creates a leveraging mechanism and I think that there's a risk in a couple of different

[00:28:33] frameworks right if you want to assist it just remember from a leveraging standpoint if I were to buy an at the money call on a stock that's typically going to be there obviously some characteristics

[00:28:43] rather depend but that's typically going to be a 50 delta position as compared to the 100 delta position if I were to be long the underlying security I'm able to use far less capital

[00:28:54] to gain a very similar exposure so there's been no question in my mind that we've seen an element of leveraging positions associated with the growth of that the second thing is to remember that all more than 100 percent of the growth has actually happened at very short expiry options

[00:29:12] so that means that the characteristic of the distribution of options has changed and we see this in their behave price behavior of the VIGS where skew has taken a significant you know a significant retreat or has retreated to levels that are among the lowest in history

[00:29:27] and in many ways we actually see positive skew associated with single names for top side exposure people want to have a number of exposure to Nvidia great example of that would actually be the

[00:29:39] levered Nvidia funds which have been among the fastest growing funds in history if I were looking something like the Nvidia 2x or the Nvidia 3x I think there's a 3x in there let's just see here there's billions of dollars in those in there there's billions of dollars in

[00:29:58] them right it's not totally dissimilar to the dynamics around what we saw with Bitcoin I wonder how much of that is like institutional people who are using it in an intelligent way and how much of that is retail people who are just making huge bets on Nvidia

[00:30:13] the quick answer is it's very hard to know right if you know let's look at the Nvidia you know granted shares too long here let's see if we can look at the holders list

[00:30:28] this is this is awesome actually thinking about it right so Citadel and Jane Street are the largest holders followed by Millennium, Jump Financial, Korea Investment Management, Morgan Stanley, Wolverine Trading etc that tells you that effectively it's being used by professional traders

[00:30:48] to either scalp option premium or to delta hedge other positions that they have in a more effective manner the one other thing I want to ask you about before we switch to macro is the short

[00:30:59] vol stuff because you've seen that stuff volatility has been pretty muted you've seen that stuff growing again I know you were way out ahead of the XIV thing when it happened all those the very different dynamic now is there anything that concerns you there

[00:31:11] well I there is no way around the fact of being very concerned when you see implied correlation at the levels that we're seeing so for an out-of-the-money call for example implied correlation is currently I think around 5% we've never seen anything like that in history and what that

[00:31:27] tells you remember the correlation is not a liquid tradeable market the spread between correlation trades is typically 15 to 20% right so if I'm quoting you at 5 that actually means that I could probably buy it at 20 and I could sell it at 2 when you have that type of dynamic

[00:31:50] it means the correlation which is theoretically an input into the model actually becomes an output there's no way to arbitrage it into anything close to a stable price level and so what we're seeing is simply the mechanical dynamic associated with a significant quantity of particularly call

[00:32:13] selling on the F&P 500 against a significant amount of buying of calls on single names like NVIDIA so that just mathematically tells you the correlation has to be lower the other reason why that's you know so interesting is that you would think with the increase in weights associated

[00:32:33] with individual companies that you would see a rise in correlation but paradoxically again this feeds back into a much lower implied correlation than you would expect because the way that correlation is actually calculated square is the weights and so the square of a 5% weight is 25

[00:32:54] the square of a 0.5% weight is 2.5 that means that there's just a much bigger impact as companies get larger and larger if their volatility persists because of the demand for single name options you're going to see the implied correlation for the index fall to extraordinarily low levels

[00:33:15] what that means is that many types of hedging are actually quite cheap it also tells you that the market is not actually telling you information this is simply the output a portion of the market in which there's really not an arbitrageable trade

[00:33:34] people are trying to chase after this with dispersion trades but remember that dispersion is all about realized volatility as compared to implied volatility that certainly helps set the price level when you talk about implied volatility but it doesn't again it's just not

[00:33:53] an input into the system right nobody is actually doing the calculus to say well here's what I think the fundamental correlation between apple and invidia is and therefore I'm going to make this bet

[00:34:05] yeah to your point on correlations I mean it has been for people who are just looking at the index they're seeing a pretty you know quiet market people who are looking behind the

[00:34:12] scenes are seeing a lot more going on in terms of the relative costumers of all the components yeah I think that's right and and you know that's one of the reasons why you're actually seeing me

[00:34:22] put those charts out there saying you know let's tweet that they're saying whatever could it be right because we're just seeing more and more people who are increasingly aware that something

[00:34:33] is different something is happening now it's really easy to turn around and say well it's the feds fault or to turn around and say it's just rank speculation by you know millennials who are no

[00:34:44] longer chasing after bitcoin and by the way I don't want to get involved in a bitcoin conversation but when you have that type of argument it's not actually what's happening it's an explanation

[00:34:55] for the phenomenon that we're seeing you know and it's one of the real challenges that we're encountering because the information content that is actually being sent to policymakers is everything's great even as bankruptcies are surging delinquencies and defaults are starting

[00:35:11] to rise rapidly in consumer areas businesses themselves commercial real estate that are all these areas are wilting and dying on the vine even as we're told by many people because there's speculation in various forms of crypto or because there's speculation in AI

[00:35:30] that somehow or another the right answer is the fed should be hiking raids yet again right I mean it's just it's it's so absurd in its underlying construction to think sign of restriction of the fed is a function of what the price level is for SMCR right

[00:35:48] it has no relationship zero relationship in fact and it in many ways I would actually argue and this is part of the discussion I've also been having with guys like Warren Mosler around things like MMT the simple reality is the fed has set interest rate to the level

[00:36:02] that reward 20% of the population and meaningfully penalized 40% of the population and the remaining 40% is kind of sitting there going I'm not sure which one's telling me the truth

[00:36:16] um you alluded to a bunch of macro stuff so I want to I want to move to that as we move to the second half of the interview here um we finally had a weak inflation print it seems like

[00:36:24] inflation you know was is coming down a little bit it still seems to be above the fed target I just wanted to get your overall take on what you're thinking about inflation right now well so my view on inflation unfortunately hasn't changed which is that the underlying feature

[00:36:38] of our economy and this is true both to the US economy and broadly speaking for the global economy is that what we're focused on is this idea that somehow or another there's inflation regimes and therefore we're destined to go back to the 1970s for example there certainly are

[00:36:55] elements of that right we have periods of surplus supply and periods of surplus demand but those periods of surplus demand tend to almost exclusively be tied to one of two things an incredible increase in the demand from the public sector for scarce and finite

[00:37:13] private sector resources not in the form of taxation but in the form of you know we need your services for the war do it for your country um that can cause significant inflation in the private sector because you're effectively creating this is Warren Mosler's work you're

[00:37:32] creating a price taker or a price maker in the form of the government saying I will be at whatever is necessary to obtain the soldiers um on the flip side of that there's actually

[00:37:45] a fascinating piece that just came out uh trap synoning in part because it largely concerns the work that I've done from the Dallas Fed addressing this issue of the increase in immigration and what they correct the point out is that many people say well the reason that we've

[00:38:00] had a weakening labor market the reason that we've had deflationary pulses is because of the increase in immigration and what I've pointed out to people over and over and over again is that population growth is really the primary driver of demand and the truly unique experience

[00:38:18] that we went through in the 1960s and 1970s was totally unprecedented population growth across the world in the form of the green revolution which supported it in emerging markets in the U.S. and the combination of baby boomers and actually the civil rights acts that made

[00:38:38] it much easier for women and minorities to participate in the formal economy and obtain access to money that they needed for significant resources. The other thing that happened over that time period and this is something I need to write about but unfortunately I have not written

[00:38:55] about in detail yet was a dramatic expansion and employment by the public sector and that public sector was compensated for that inflation right and so effectively at every step in the process from give or take 1950 until you know roughly 1980 when Reagan's reform started to shrink

[00:39:13] the absolute status of the government you saw this dramatic expansion in public employment relative to private employment that's a real source of crowding out the idea that like deficits are somehow crowding out investment in the private sector I don't have a lot of sympathy for that

[00:39:31] view what I 100% have sympathy for is the fact that the government can create a competing demand for those same resources in the form of employees in the form of soldiers etc. At that part we really haven't seen yet. You mentioned weakness in the labor market you mentioned

[00:39:50] commercial real estate are you starting to see signs now of weakness that would have you worried in terms of like the potential for recession going forward? Well to be clear I

[00:39:59] actually think we're already in a recession so I actually have a very rich of a view on that that doesn't mean I'm right I want to be very very clear but it is really important that people

[00:40:10] understand the behavior that they're seeing in the headline stock indices you know a lot of people will criticize the perspective that it's increasingly narrow under the ages that you know these are the companies that matter for the future sort of thing certainly could be true but I

[00:40:23] guarantee you that you know there's still going to be an important role for companies like UPS or for many of the participants in the Russell 2000 that actually comprise the industrial capability of this country or many privately traded companies right privately held companies that fill a similar

[00:40:45] role. The idea that they're not relevant to the economy is truly absurd about 30% of U.S. employment is now tied in one way or shape or form to a levered company and all of those

[00:40:57] have seen a radical restructuring over their cost of capital. To think that's not going to have an impact just seems very I mean it is theoretically possible but it is not backed by the empirical

[00:41:11] experience so you'll hear a lot of people running around talking about all the deficit is so high it means we can't possibly have a recession. Well then explain what's going on in terms of the earnings trends for the Russell 2000 or the market capitalization trends of the Russell

[00:41:25] 2000. If you accept my theories around passive which is I have to argue unfortunately increasingly hard for somebody to push back that hard on then you have to be able to explain why we're not seeing

[00:41:38] a broad based expansion if it's really a function of U.S. deficit striving because I know that dynamics. Yeah so this is something that's interesting and you've talked about this a lot this idea of you know whether it's inflation whether it's economic growth recession like

[00:41:52] it's so important to like think about in the eyes of each person it's so different like what someone's experience on one end of the economic spectrum right now is completely different than somebody's

[00:42:01] on the other end of the economic spectrum and I think all of us when we look at all this aggregate data have to keep that in mind. There's really different things going on underneath the hood.

[00:42:10] Yeah I think that's right. I think this is one of the great ironies is that we moved into a post-fansian world in a lot of ways but we're still using aggregates we talked about consumer

[00:42:20] spending. We don't talk about you know jack spending right we are increasingly capable of disaggregating the economy into atomistic analysis that is you know viewing groups as varied this thing

[00:42:36] but we just haven't done it yet right we really haven't done it yet and so one of the charts that you had said that you wanted to discuss is this repeated refrain that we hear that the bottom

[00:42:45] 50 percent balance sheets have improved so much right and like I'm sorry that is just a fundamental misunderstanding of what's actually trans you know transpired in that cohort what's transpired in that cohort it's that that is the cohort that has had the greatest increase in old

[00:43:04] age representation and so when you replace relatively young people with much older people by definition their incomes are lower and their balance sheets are stronger paid off the debt on their house they've accumulated retirement accounts right all of these things

[00:43:21] they're actually applying through into the data sets that we're receiving that are just deeply insulting and misleading to many segments of our society. Yeah jack spending you mentioned that would probably be a constant recession indicator because jack is so cheap that uh jack

[00:43:37] spending is always probably going down so you probably want to use that in the uh in the aggregate economic data. In the contributors though right and so you know again like I know

[00:43:44] the phrase that I use all the time is why are you reading this now all of a sudden it's become dearer grower to post things saying well baby boomers are being too stingy they should be

[00:43:54] giving their kids more money etc etc etc right well who's writing that retired baby boomers or their kids right and you know the answer to that. That uh that why I'm reading this

[00:44:06] now framework is so powerful like ever since I started reading Ben Hunt like I asked myself that all the time and like when you ask yourself that all that all the time you think about a lot

[00:44:13] of things very differently. Yeah I think that's right. I was gonna ask you about what the Fed might do but I think I want to ask you a more high-level question because we're all concerned all the

[00:44:23] time about what the Fed might do and I'm wondering are we too concerned about that I mean it seems like we're always talking about what the Fed might do you know we've talked about

[00:44:30] a lot of dynamics here that may not have too much to do with what the Fed is doing like do you think we're overly concerned with what the Fed is doing? I think that there are elements

[00:44:39] of it that we are overly concerned and there's elements that we are under concerned right and again it goes back to what is the right interest rate well the right interest rate for Jack Forehand

[00:44:48] is very different than the right interest rate for Justin Parbeno and very different from the right interest rates for Mike Green. Mike Green prefers zero by the way. The you know the the dynamics associated with that are what's causing this bifurcation where after you know a

[00:45:06] 10-year period at zero interest rates in which it was presumed that the Fed could stimulate by lowering interest rates and it didn't really do all that much right Europe went even further at negative interest rates which anyone who's thoughtful about these you know the structural

[00:45:25] components of an economy would say hey wait a second this means you're taxing capital right how is that possibly stimulative? You give a government agent called a bank a hundred dollars and they

[00:45:35] give you back 99 at the end of the year that's a tax right under any construct so to think that that would be stimulative in any effect other than causing people to try to get out of cash

[00:45:49] which is a very short-term phenomenon is it my opinion somewhat absurd on the second part that again we see this unwind in the opposite direction you know today with much higher interest rates where suddenly the capital owners those who are being taxed with negative rates

[00:46:08] are suddenly being rewarded for having simply stat around right that sounds this overly pejorative I'm not actually saying that capitalists and the capital owners contribute nothing to the equation but you have to admit that it's pure luck that you've happened to go from 0% to 5%

[00:46:27] on your cash asset and nothing to do with your individual skill or performance. The second thing that I would you know emphasize about the Fed is I think they have the story totally wrong in terms of what's likely to happen when they engage in their

[00:46:43] behavior they've waited because they've tried to get inflation lower part of the dynamics are the current inflation right meaning the change in the price level has already retreated to extraordinarily low levels there's a reasonable chance that month on month inflation next month or there comes out

[00:47:01] tomorrow will end up printing negative right now you don't want to overreact to that but you also don't want to underreact to that because we have such slow moving agrid yet like owners

[00:47:12] equivalent rent which were created in 1983 to reduce the impact that the Fed itself was having on inflation metrics we used to include the mortgage rate in the calculation of the inflation rate because we shifted away from that we're now watching an incredibly slow moving train

[00:47:31] in which rents are falling in many many regions of the country and we're being told that you know rates are highly stimulative home building new housing permits new home construction etc are all turning over and beginning to fall with that will come job loss and everything else associated

[00:47:49] with it and meanwhile we're being told that like this is an inflationary environment it's not an inflationary environment. Mike what are your thoughts on how you think the election might impact the markets I'm guessing you know you're not building investment strategies focused

[00:48:07] on that but I'm curious as to what you think how the markets might react how things may play out well the only thing I can point to is behavior in the past couple of elections and again I would

[00:48:20] emphasize that the key likely holds in the active manager reallocation if we approach the election with considerable uncertainty if it doesn't become clear that Trump is going to win or that Biden or whoever replaces him on the democratic ticket is going to win

[00:48:39] then you're likely to see a risk off period and active managers reduce their position sizes just tied to that uncertainty right the risk adjusted cost of holding those positions goes up in that uncertainty you would expect them to reduce their position it particularly with passive flows

[00:48:57] having slowed you would expect that to lead to a period of under performance ahead of the election that people will create any narrative that makes sense to them right oh Trump's going

[00:49:07] to win and he's going to become an authoritarian or Biden's going to win and we're all going to be forced you know to uh to focus on caring for the elderly I don't know what the actual answer

[00:49:18] is I just know that that looks like a risk off period ahead of the election regardless of the actual outcome with that uncertainty resolved it feels like you're going to have a risk on event and likely a risk on event in the areas that active management focuses on

[00:49:34] which is you know or has an over representation to which be something like small cap value and so we actually saw this in 2016 upon the election of Trump despite the fact that you know commentators like Justin Wolffers were highlighting that they thought the market

[00:49:48] would crash in a 1987 style event on the election of Donald Trump instead it did the exact opposite we saw a massive risk on move in which there are also 2000 and the very short period of time shot basically straight up exact same thing happened in 2020 risk off

[00:50:03] into the election following an unfavorable resolution of the of the election for almost anyone focus on things like capital gains taxes etc you actually saw an incredible risk on event everybody touted is the return to value right the the Biden administration was going to shut

[00:50:20] off oil and gas production and therefore oil and gas prices were going to go to the moon and oil companies were the place to be and literally lasted about two months right before the traditional forces reasserted themselves and we started to see significant

[00:50:37] outperformance from technology and from large cap rate let's do a quick sort of flash round on some of these major asset classes as we kind of get to the end here so what are your views

[00:50:50] on bond right now so I think twos are very interesting I think it's actually quite fascinating if I look at one-year one-year inflation swaps or I look at one-year one-year rates those are actually creeping slightly higher as the fed as we start to price in additional rate cuts

[00:51:08] associated with some economic weakness that we've seen we've seen a meaningful deceleration and nominal growth and we've seen the shed come out slightly less hawkish and the last couple of speeches particularly Powell is indicating that there is a likelihood of cuts

[00:51:22] this year others have said the same thing at this point that to me makes things like two-year bonds quite interesting further out the curve because of the inversion of the curve itself right it is

[00:51:35] less extreme than it was but because of the inversion of the curve it becomes harder to see that extraordinary move again I think this is one of these situations where I think the fed is trapped

[00:51:46] they just don't understand why they're trapped right so they think they're trapped by inflation I would actually argue they're trapped because they're providing support to one element of the economy one segment of the economy and they're creating restrictions on the second set of the

[00:52:01] economy if they don't move fast the restrictions on the second set of the economy are going to turn into a credit crisis the credit deterioration the rating deterioration associated with that would cause credit availability to plummet as institutions that are allocated to these types

[00:52:20] and borrowers are forced to reevaluate the overall riskiness of their portfolio that means credit availability falls that's a contractionary event and then they start cutting rates removing the income support to the other part of the economy that could get really ugly really fast

[00:52:38] well that's one thing I wanted to ask you about is how you develop a strategy that actually hedges against sort of credit what spreads blowing out I know you guys have an ETF that sort of hedges

[00:52:52] that risk out can you just talk about that sure so part of what we're doing with that and this is actually build around some of the components or the passive strategies that I talk about fund you're referring to is the simple by highly old credit fund with

[00:53:06] credit protection or credit hedging we have three primary sources of protection that we can use there one is just simply puts all right so we get my puts on the S&P they're also we can buy it

[00:53:17] against HYG etc we also have a full is done that so it's true hedge fund in terms of its capabilities in the ability to access hedges like credit default swaps we're currently using a fraction about 20% of our hedging is coming through credit default swaps because we view

[00:53:34] credit spreads as far too tight we think that there's actually a positive expected return associated with CDS at these levels but the primary source protection that we're using there is actually tapping on features that we just talked about this dynamic of companies

[00:53:48] that need to access capital markets versus companies that don't and so we are long a basket of companies that are self-sustaining high profit margins stable profit margins don't have to hit the capital markets for either credit or equity issuance

[00:54:05] and we're short a basket on a beta adjusted basis of the exact opposite companies that are serial issuers of equity and credit companies that have poor operations require them to continually refinance themselves if you think about what you're actually doing there you're going

[00:54:21] along companies that don't need access to credit short companies that need access to credit and so when credit stress emerges the shorts meaningfully underperform the longs it's been one of the nicer constructions that I built over the course of my career where and others have

[00:54:39] done similar stuff right sock Jen has a product that is not totally dissimilar in terms of its construction um but you know that type of product that type of construction in the portfolio behaves exactly like credit spreads with one notable exception because the higher earning

[00:54:59] companies tend to have a higher dividend yield they tend to be much more stable in their underlying construction they're serially buying back shares as compared to issuing shares that portfolio while it has a lower beta than the junk portfolio this is cliff as this is betting against beta

[00:55:19] type framework that portfolio dramatically outperforms during periods of credit stress while also offering a slightly positive return over normal periods of time only time that portfolio underperforms is in the aftermath of a credit event as the stimulus comes in and as you see

[00:55:38] credit spreads contract dramatically and so you have rules around how to construct that portfolio reduce those hedge exposures in the event that credit spreads have widened out dramatically and then begin to contract I think the diversification of the three different like

[00:55:53] sleeves in there is interesting you're sort of trying to get at this protection through you know these three unique aspects of the portfolio yeah I think I think that's right I mean it's also just a recognition that there can be relative value trades within those

[00:56:09] right so one of my concerns is candidly the quality factor that high quality company can be overrepresented by things that are leading the current rally in equity markets now we've built the product so that it's not actually buying apple or buying nvidia and attempting

[00:56:30] to outperform we're using a purely quantitative metric the portfolios are equally weighted so you're not seeing that dynamic of a single stock performing extraordinarily well and pulling the second thing we do within those portfolios is we actually try to move away from the pure

[00:56:47] quality rating which would skew you towards things like technology stocks which have very little correlation actually with high yield stocks other companies that are these serial issuers and so we actually try to balance the portfolio construction so we're matching sector exposure

[00:57:04] and industry exposure as much as we possibly can it can't be perfectly replicated but it's pretty darn close and so we're just we're really at every step in the process trying to be thoughtful about that index construction we also have to recognize though there's basis

[00:57:18] risk in everything other than cvs right so i could buy puts on the s&p i can buy quotes on the rousal i would expect those to perform well in the event of a credit risk particularly from this

[00:57:29] pricing but it can't be 100 percent certain likewise i would expect my quality portfolio which it is doing today for example to outperform but sometimes it gets you know it can pick up exposures in other ways and so diversifying across that using things like cds when they get cheap

[00:57:49] enough there within kind of that 20th percentile of cheapness that actually created diversified source of hedges we actually have all three types in the portfolio currently we've got s&p quotes we've got cds on high yield index and we have the quality junk over there

[00:58:10] mike thank you very much for coming on what we know is a busy and hectic day for you we always appreciate your time please come back again thank you i appreciate it thanks for having

[00:58:20] you guys thanks mike this is justin again thanks so much for tuning into this episode of xs returns you can follow jack on twitter at at practical quant and follow me on twitter at at jj carboneo

[00:58:33] if you found this discussion interesting and valuable please subscribe in either itunes or on youtube or leave a review or a comment we appreciate you