The Case for a Continued Rally with Warren Pies

[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 speak with 314 Research founder Warren Pies. Warren has a unique systematic way of looking at the macro world and we use it to examine the economy, inflation, the labor market and a lot more.

[00:00:34] We also dig into his market outlook for the second half of 2024 and the quality-driven strategy behind his newly launched ETF. We don't come across too many people doing truly unique research, but Warren is able to think outside the box and look at markets in

[00:00:46] ways many others don't to identify insights others have missed. Thank you for listening. Please enjoy this discussion with 314 Research's Warren Pies. Hi Warren. Thank you very much for joining us today. Thanks for having me.

[00:00:59] Good to have you back on. This is going to be a pretty wide-ranging discussion talking about some of the research you guys are putting out over at 314 Research, your take on different aspects or parts of the economy. I guess get your view on what you think the

[00:01:12] second half looks like and then hopefully if we have time we can talk about the new ETF that you guys recently launched which I know you're excited about. So yeah, so this is going to be a fun and I think very highly educational conversation for our audience.

[00:01:29] Thanks so much. Yeah, no I'm looking forward to it. Always enjoy listening to all your conversations that you have some of the good people on and so hopefully I can add to that. Appreciate that. One of the ideas over at 314 is that the 6040 stock bond portfolio,

[00:01:48] you know the future returns might not be as strong as they were maybe in the last 40 years. You know I think 2022 was kind of a wake-up call for the 6040 investors, giving that stocks and bonds both went down but you know it's kind of come back

[00:02:02] since then pretty strongly so but generally what are you thinking as you kind of look out when you think about 6040? Yeah I mean I would say that the 6040 portfolio is bad. No it's one

[00:02:15] those phrases that I think it's a little overused so it's not really dead. I've heard you talk about that. It's just I think we went through this perfect regime for 6040 where we you know from a

[00:02:28] very high level there was structurally disinflation or no inflation to worry about. So when there's no inflation to worry about in the like just basically a two variable economy where you have inflation and growth as a concerns for your portfolio you take inflation out on the picture

[00:02:45] then every single drawdown in the equity side is going to be growth related and growth-related drawdown is ultimately good for bonds. And so you had this great environment one way to see that

[00:02:58] we've done a lot of work just might sneak up on it from a different angle but I haven't talked about before so it's kind of interesting. As we've done a study where we broke down every pullback that the markets had since 1950 anything from 5% 10% 15% and beyond. And what you

[00:03:16] notice we've pulled a bunch of statistics out of that and what's a viable dip and what should you do whenever the market pulls back 5% or 10% and your probabilities. I think there's a lot of

[00:03:26] interesting stuff in that but one of the things we noticed is that that 2009 to 2020 period we called that the golden age of dip buying. So I think it was historically I don't remember

[00:03:36] no if my number is correct exactly but every 5% dip I think it was something close to 75% of all 5% dips were buying opportunities in that 2009 to 2020 period and if you go from like 1950 to 2008 the number was much just barely above 50% like 55% of those 5% dips were buying opportunities.

[00:03:59] And when you break it apart one of the major factors that determines if a dip is going to be just a 5% shallow dip or something bigger is the direction of interest rates during that

[00:04:09] that market stress. And so what we found during that 2009 to 2020 period to go to that regime analysis is almost every one of those 5% dips were met with bond rallies so you had lower yields

[00:04:21] cushioning your equity portfolio and so obviously that was good for risk assets it was good for your 6040 portfolio in general and now what we've seen we don't have a whole lot of a big timeline to

[00:04:33] look at yet but post 2020 post pandemic it hasn't been buying the 5% dips hasn't been as good of a proposition that's because yields have been underneath as a causative agent for a lot of the

[00:04:46] stress you see in your equity markets and so these 5% dips there's no yield cushion if yields are causing it and they're going say the 10 years going to 4.5 and then 4.75 and then 5% you have less of a cushion from yields and what this all feeds into is more volatility

[00:05:03] on the equity side and a lot more volatility in a very basic stock bond portfolio like a 6040 portfolio so and that comes down to ultimately inflation just back as a concern for investors

[00:05:14] so yeah that's our I'd say the big picture view and why we've spent so much time trying to come up with allocation models that insert alternatives and can work in our view on this new regime.

[00:05:28] I just want to make one comment on that which is you know a lot of times as investors we kind of only know what we see so like in my professional career you know it's been mostly

[00:05:38] a declining interest rate environment and so you think that that is how it is but what I appreciate about that is you know you guys go back look at the data and I think you know as investors we

[00:05:50] always need to understand it it's never the same nothing's ever stays the same and this idea about where rates are and how stocks and bonds sort of move together you know it's not like we can be

[00:06:01] grounded in last 15 years and think well prior to 2022 and think that that's that's how history always is so that's a very good comment and I'd be interested in seeing some of that that research

[00:06:11] at the points. Well you see a lot of people who are expecting the yield environment we probably didn't talk about this as we get through the second half outlook and stuff I think there are a lot

[00:06:22] of people or a big mass of investors who still expect us to return to the interest rate regime and the inflation regime that we saw over the last 15 years and I think that's a highly

[00:06:32] questionable assumption and so if you're wrong about that even a little bit I think your 6040 returns are less attractive going forward. Can you just flush out the inflation piece a little bit more like where where are you following on where inflation might ultimately end up here?

[00:06:49] Well I mean I think you guys had Bob Elliott on I know you'd reference some of the things he said that you want to talk about um and he talks about income driven cycle uh my take on that

[00:07:01] I'm not sure I think sometimes it's all about semantics and how you define things I'd say this has been a fiscal fuel cycle so the deficit the 7% GDP I think we might have been the first to

[00:07:14] start calling these pro-cyclical massive pro-cyclical deficits at 314 and we were there was a chart that we put out a long time ago showing the unemployment rate scatter plot versus the deficits and just haven't ever seen an environment where we've got basically full employment in 7% 6% 7% of GDP

[00:07:32] fiscal deficits and so to me that's been the defining feature in this what's powered the economy over these years and why it's been so resilient and I also think it's good has been the ultimate

[00:07:46] proximate cause of inflation more or less. I know there's been a big debate supply and demand and there of course were supply chain factors that contributed inflation in early days

[00:07:54] but it's hard to argue when you look at just like say the CPI index not a year over year just the base index versus like a trend line pre-covid in the way we've divorced from that and we're not coming back

[00:08:06] and everyone knows that intuitively that you know if you're you live in a neighborhood and the houses around you have gone up 50% and they're not coming back it's not like this is a bubble

[00:08:15] that's going to revert it's this is the new state of affairs and I see I take that back to deficits and I look at it on a cumulative basis and say yeah that explains a lot of inflation

[00:08:25] if that's where we're at then in my opinion inflation is not going to go back to the pre-covid era unless we address the fiscal side in some way and I don't I don't I don't know how to forecast

[00:08:36] that but that to me is going to be the thing you need to pay attention to it. I don't see the political will because ultimately if you address that fiscal side without something else going on

[00:08:45] you're probably gonna have a pretty nasty recession and so it's hard to see that happening in the next election cycle. So do you think in the intermediate term we're going to see a lot of

[00:08:56] this like three to four percent inflation you know not crazy high inflation but also not the two percent target? Yeah I mean I think that's probably a good base case but it's a little bit

[00:09:05] of a nuanced thing because I do think inflation set to fall measured inflation is set to fall or at least soften enough to give the Fed the leeway to start cutting in the second half of the

[00:09:16] year and so you know everything's not all one way I mean it's not all just gonna you know just not just gonna stay at three percent and stick there I think there's gonna be ebbs and

[00:09:27] flows. So that's what I see is that we're gonna have this air pocket here there is some you could call it residual seasonality or whatever I think in the back half of the year

[00:09:38] just like we saw pretty disinflationary prints in the last six months of last year I think you could get some more this year obviously we've said we think shelter is going to stay sticky but it

[00:09:47] was sticky last year and we managed some you know sub two tenths month over month PCE prints through the second half of last year so that's kind of what I see happening and then rolling

[00:09:56] forward though I don't think this is just this episode of inflation is just over and done with and now we're going back to the the way it was in 2019 and before. You mentioned sticky

[00:10:09] shelter and I want to ask you about that because I've learned a lot from you on this you know a lot of people have this idea that you know shelter kind of lagged on the way up and basically they're

[00:10:16] thinking it's about to turn here it's gonna lag on the way down too it's about to turn it's about to pull down inflation but you have some data that suggests that's probably not

[00:10:23] what's gonna happen so can you talk about like what you're seeing in shelter? Sure yeah the it all comes down to really how it's calculated and I mean this kind of gets into it can be a

[00:10:32] philosophic debate like how do you measure inflation? I personally think they actually do a pretty good job of measuring shelter inflation in reality and so when you really dig into the papers there's conspiracy theories on how the government's measuring inflation and things

[00:10:48] like that but what I find is that the BLS is doing the best they can with a really difficult problem and so what's going on with shelter why is it unlikely to come down is because I've said

[00:10:59] this a lot and Powell's talked about this in his press conferences and he's talked about it for years is you just had new rents skyrocket and the existing rents have lagged and they've just

[00:11:10] there's still a big lag where those existing rents need to catch up and the way to think about this is if you're a landlord and you have an apartment building and you've got all your

[00:11:19] tenants locked in it like let's say a thousand dollars a month and you've got a new unit and that new unit goes up 50% so rents are up in the new rental market is up 50% you can rent that out for

[00:11:31] $1,500 a month and then as the years go by these or the months go by you're you have to boost your existing tenants up to that market rent so you're going to slowly raise their rents and that's

[00:11:45] the new rental market setting the edge of the market in the existing rental market coming up to meet it that's if you think about that it's going on throughout the economy and that's the reality

[00:11:55] of how apartments and rental units work and so the Fed accounts for that they have a survey they have new rents that are about 13 to 25% of the survey and then the rest is existing rents

[00:12:08] and so over time it to the extent new rents have eclipsed the existing rental market that that difference almost like a big accumulated change that in level change that difference is

[00:12:21] going to dictate how long the quote unquote lag is and so you know you really need the new rental market to chill out for a sustained period of time in order for the existing

[00:12:31] market to catch up and we thought that might happen at the end of last year but instead what we've seen is this nascent kind of pickup in the new rental market so we've had like a two three

[00:12:41] percent say three and a half percent in some markets rise in new rents and given the nature of that separation in the accumulated change between the two new and existing rents it's even a three

[00:12:52] percent rise or four percent rise in new rents just pushes out that conversion state so far and so when we run all the numbers we use different indexes and and measure it in different ways and what we find is that that convergence is unlikely to take place

[00:13:09] really anytime before mid the middle of next year and it's all path dependent on what happens at the rental market and some would argue that that's dependent on what happens with interest rates long-term interest rates. What do you think about the attempts to do like real-time measures

[00:13:20] of inflation you know true inflation is the most popular one I was listening to you with Jeremy Schwartz they've done something where they kind of tried to do something more real time housing and they're showing a lot lower inflation numbers than the official stuff

[00:13:30] what do you think about the idea of trying to do that versus what the Fed's doing or what BLS is doing? I think it's a cool thing and a cool project and I mean like uh try and remember

[00:13:39] what was the uh there was a uh there was a project the some other million price project or whatever they were that we I heard about for years before all this ever started like

[00:13:50] Jim Grant used to talk about it a lot and people like that they were kind of like over debasing the currency and causing inflation. I think it's a cool project but you just have to state what

[00:13:58] you're measuring and what you're trying to accomplish and understand the drawbacks there's always a drawback and so to me if you're if you just use the new rental market and you change the game like the Fed obviously was using the same the same methodology back in 2021 which made

[00:14:14] them late to raising uh rates if you switch the game here at this point in time you basically are um you're you're basically uh going to have a policy asymmetrical and in favor of allowing for

[00:14:28] inf- inflation so if you're if you're in an apartment building where the rents you're getting renewals and the rents going up six percent that's your reality you know just because the guy walks in off the street and uh the off the street new rental is only up three

[00:14:43] percent your reality is that your rents up six percent on a renewal basis so I'm I like how they measure it personally I've my first I think default assumption was that this is a government you know gerrymandered kind of thing and there are some weird things but

[00:14:59] they're trying to measure actual inflation in in shelter costs what are your thoughts on what's going on in the labor market you know one of the things you mentioned I'm going to

[00:15:08] be with Bob Elliott one of the things I've learned from him is you know if you have four to five percent wage growth it's going to be very very hard to have two percent inflation

[00:15:15] um so it's important to pay attention to what's going on in the labor market like what do you see in there are you seeing any signs of weakness yet yeah i think it's softening I don't

[00:15:22] think that's any kind of um major issue yet our view as I've said before is we we look at the housing and construction markets employment markets to tell us where the overall labor market is going

[00:15:35] um I keep at first I go back to first principles on this like if we're trying to guesstimate when a recession is coming the big defining feature of a recession is job losses

[00:15:48] so when you think about wherever those job losses come in the average recession going back in modern american history 20 to 30 percent of all jobs lost in a recession are construction jobs that's the

[00:16:00] swing that's a big swing factor and you can see it in the non-farm payroll reports we're getting like 75 percent of all jobs added are in highly non-cyclical places government education health

[00:16:12] care things like that so if we're going to have a recession we need job losses if we're going to have job losses you got to focus on construction in cyclical areas of the economy and construction

[00:16:21] might only account for it might account for 20 or 30 percent of jobs lost but it's only five percent of jobs in the economy so it's kind of a narrow focus but I think it's an important

[00:16:29] way of looking at the jobs market and so when I look at the residential construction labor market I'm seeing for the first time uh weakness I think and for the first time in years

[00:16:44] our models are saying there's going to be some slack emerging so as of right now payrolls are making cycle highs but we like to back into what do we expect payrolls to be

[00:16:54] and we use units under construction a mix of multifamily single family and then we project out where that's going to be based off of uh starts and time to complete and things like that and uh

[00:17:05] what we see is that you know maybe through the current payrolls are say three to three and a half percent overstated um and that's that's new for us our models have been showing tightness in that

[00:17:16] market for years so do you think like this week this this week and it'll be very slow moving that's what I would expect like our view in the second half outlook was you know that we would

[00:17:26] avoid a recession and part of that is I think construction has been a secularly tight labor environment and so I just think that these builders are going to be pretty pretty slow to do layoffs and so they I think employee retention is going to be important and so

[00:17:46] I think we'll have some softening those numbers but not enough to push this into recession the big the big rule of thumb I use is that the residential construction employment usually falls uh peak to

[00:17:57] trough like 8 prior to modern american recessions and so you know like I said our model shows like 3 slack I doubt we even get that much unless we get more deterioration in the underlying

[00:18:10] housing data I doubt we even get that kind of um that kind of collapse so right now it's pretty premature it's very preliminary to say but we see it we see the slack emerging I think it's

[00:18:22] important to recognize it and has asset allocation and in positioning implications do you think this this slow moving this which is not a word but I'll go with it of this ties back to what

[00:18:32] you mentioned earlier about this being driven by income and not by debt you know we're always used to like a 2008 swear you know things kind of blow up very quickly in the way things are

[00:18:40] right now we're likely to see more of a slow moving type situation where we're all waiting for this explosion and it just doesn't come yeah I don't think there's a big explosion coming

[00:18:49] yeah I think it's going to be more of like a slow grinding slowness that comes into the economy I mean balance sheets across the board have been recapitalized basically uh so there isn't a lot of debt excess to deflate and so I don't like I do think that

[00:19:06] on that's on that front I agree with Bob and I and I you know the only way if you say that the deficit the cumulative deficits have been fueling this economy for the last few years then

[00:19:16] the you know logical corollary to that is that shrinking the deficits would be the thing that would be we'd be most exposed to economically now and I don't see anything you know a significant shrinking of the deficit they kind of grow automatically you know if the

[00:19:33] GDP is growing you're measuring deficits a percentage of GDP the deficit's growing every year so um I think you're right I think Bob's right in that front that there's not a big collapse coming

[00:19:42] and we don't really have the right mix in the economy for a big collapse in my opinion we're going to talk about your second half outlook but first I want to look back at the

[00:19:50] first half because I had read your first half outlook way back and it was actually very very right um you had this pretty right and I was wondering when you look back was there anything

[00:19:58] that surprised you about the first half relative to what you thought or did it play out pretty much the way you thought it would um we thought the Fed was going to cut earlier than they

[00:20:06] actually are going to end up cutting and so uh that's number one the reason they didn't end up cutting in my opinion is really the shelter re-acceleration that we saw I think that financial conditions so there was this debate going on would financial conditions

[00:20:24] loosen and cause inflation and there was a group that took all the inflation we saw in like January and February and they they tied it all to you know the fallen yields basically in the rally

[00:20:36] and asset markets at the end of last year and I was always skeptical that because it was like insurance and things like that that were going up on it and then measured inflation so

[00:20:44] I thought that the logic was was a little weak there but then we did see shelter inflation the new rents like I said were ticking up and that's extending the time that we're going to get

[00:20:53] this elevated shelter so I did see that as being a a real impact from the the loosening financial conditions earlier in the year so we were a little bit too gung-ho on the disinflation

[00:21:05] uh story at the beginning of the year and the other thing that we missed you know if we I do think we had a pretty good outlook but the thing we missed is we did not we thought there'd be more

[00:21:14] of a broadening already in the market than there's been and this has been like a second year in a row of extraordinarily narrow leadership in the S&P 500 and so it's frustrating environment for most

[00:21:25] people who aren't indexing um but that's the those are the two things I'd say we got wrong in our in our outlook but uh for the most part I mean we we did expect a big equity rally

[00:21:36] in the first half and we've been or we we thought that the 10 year would average 4-2 this year I stick by that we thought gold would hit 2500 an ounce I thought oil would hit you know 90 plus

[00:21:48] in the first into the first quarter and then have a bad second half we'll see how the second half goes for oil but those are the the big sweeping predictions that we had at least

[00:21:57] do you have any thoughts on why it hasn't broadened out and one of the things if you look back at the first half like almost any fundamental type approach or many of them didn't work out very well um you

[00:22:06] know because these huge companies were driving so much of the returns like do you have any idea any ideas on why the rally didn't broaden out as much you know we were playing with this

[00:22:15] like what is the what's going on with that broadening and what could be the fundamental driver of it and our view is that there's just been a real bifurcated economy and anything credit

[00:22:27] sensitive has just been left for dead and so you you know you hear a lot of people say the economy is great you know we're GDPs growing this much and whatever statistics you want to cite but I

[00:22:39] could cite some other things don't look so good like existing home sales are at the depths of where they were back in 2009 and so existing home sales sales are on the floor and there's so much tied to that furniture and durable goods that go along with the

[00:22:54] new home buying cycle and things like that uh new car sales are below the levels that they were in 2018 and 2019 uh and so in the average age of the car on the road is like 14 years which

[00:23:06] I think is an all-time high so we've had a there's this school of thought that the fed raising rates hasn't done anything to the real economy and I don't think that's correct you're missing a

[00:23:19] big thing you're there are credit constrained areas of the economy it usually for the most part it goes into the goods side of the economy and so existing home sales new cars durable goods those

[00:23:31] things have that require financing at that five to 30 year level that's those things are dead the Fed has effectively killed those markets and I you know I don't think it's perfectly scientific

[00:23:42] but I think a lot of those areas are areas that are uh lagging in the market those are some of those those some of the areas that you would need to see reawaken in the economy to bring

[00:23:53] up that that other however many stocks 493 stocks but it's well really actually less than that but on every metric we look at this is the narrowest bull market ever you know equal-weighted up only

[00:24:05] 27% at this point in time uh every other rally's like double that if not more uh historically so that's my best guess you know credit creation has just been so lackluster uh in this in

[00:24:19] this uh cycle so so Jack I just want to make sure you saw Warren's year on price target in the S&P right right yes okay I know we're going with that but we're very bad market forecasters um but we

[00:24:33] always do like to show that we can't do it we always do an episode at the beginning of the year where we come up with our our forecast which are not nearly as well informed as yours

[00:24:41] and I think yours and Justin's are the same if i'm correct right yeah I had 58 but I'm just it's just confirmation bias I was like anytime I see the 5800 I'm like yep I got it right

[00:24:55] bring your skepticism like I write a thing every year whenever I do an outlook and you have to say a target because it's like part of like the I don't know self-immolation that you have to do in

[00:25:06] this it's like you I say this is gonna this is gonna be awful don't you know don't tie me to this so I mean I don't I'm not a believer in the targeting or forecast I mean in my career started in the

[00:25:18] oil space and that's an even weirder market to say I'm in forecast the price way out in the future there's so many path dependencies and stuff like that I used to think you know the sell side shops

[00:25:28] that would do the oh here's like my econometric model on demand and I built us a bottoms up supply model and that there's gonna be a half a million barrel a day deficit which we have

[00:25:38] to solve with an 87 dollar break that's that's insanity and you can't do it um it's a little bit worse than the s&p 500 but it's all forecasters just you know dime a dozen I even said it I mean

[00:25:50] we said 52 100 on the s&p by may at the beginning of the year so I'm I'm glad we got one right it's like but it's it's hardly uh it's hardly a science or anything like that and I think I said it

[00:25:59] on tv like these projections are worth the paper they're printed on so but that's quite the challenge of you know getting the actual number there's so much great stuff in your outlooks

[00:26:08] and I would highly recommend anybody go to your website and look at it and you guys have amazing charts I know Fernando's helping behind the scenes doing great stuff like that you guys do

[00:26:15] so much stuff that I like I read these outlooks a lot and you have stuff in there every time that I've never seen anywhere else so and we're gonna get into some of that now but I just want

[00:26:23] to compliment you because they are really really good thank you I do I mean we I'd like to say it's easy but it's not there we we for every chart that makes in there and every study

[00:26:34] makes in there by 10 that don't and we we don't I don't go around reading a bunch of other stuff from other people we try to be original so I'm glad to see that that like shows up in there

[00:26:44] I think it really screws you up to get even if they're smart people if you read someone else's outlook you're just gonna buy it's gonna force you to think more like that or if especially if a smart person it's like bearish and we've been bullish

[00:26:57] it makes you feel all kinds of self-conscious and stuff like that so I try not to read other stuff so at a high level can you talk about what your outlook is for the second half

[00:27:06] yeah well I think um something should come around kind of full circle on in markets at least me I I've always been you know I see a seasonality study and I was I've always been kind of cut

[00:27:19] it down and say you know these there's no how many years are there in the you know four year cycle how many four-year cycles do you have 12 18 to study like this is you know

[00:27:30] silly but what I was with all that said I think that I'm coming around to the idea there is something to seasonality the more we've been looking at it in spin and how specifically what happens when a

[00:27:43] year starts out really well I guess you call it the January factor the January barometer from like a old stock almanac type of language but what we find is when the first half is strong

[00:27:57] the second half historically is very strong so it's been 23 years were the first half since 1950s up 10% or more and the S&P 500 is higher 19 of the next 20 of those 23 years drawdowns are lower absolute returns are higher everything looks better and you know that's kind

[00:28:15] of a again it's sound the old me would have said that's a goofy stat but when you start really understanding how the industry works and you talk to people and then you consider

[00:28:24] how we came into this year we came into this year where everyone we just had that big rally in Q4 and everyone I'm not going to call names out but you go back to the January outlooks everyone even

[00:28:37] the most bullish people the permabarad bowls that pop into your mind were all calling for a week first half and a strong second half and that can be traced exactly back to the old election

[00:28:47] playbook so the election cycle playbook told them all in a presidential election your first half is weak second half is strong so everyone was off sides we saw it in strategist targets too

[00:28:57] so strategist targets were implying at the beginning of the year which is when they're the most optimistic only a 2% gain for the S&P 500 in 2024 and so we saw that and we thought we could

[00:29:10] fade all that and then that was how the first half took off and now we're in the second half and I think there's a bunch of people who've been left out of this rally and need to get

[00:29:19] in so that's the very very high level next so that's positioning we have a bunch of sentiment stuff that we track to say okay are we at a top yet and things like that which I think we can get

[00:29:30] into and then the next level down is I do think that the inflation scare we had in the first half is going to dissipate and the Fed is in the as we talked about the labor market has weakened

[00:29:41] sufficiently to reorder the way risks are balanced and the Fed's going to start cutting in September most likely and I would say they're gonna cut a couple times I do believe that that cutting the

[00:29:55] initial cutting and the forward guidance that comes from that is going to if there's gonna be a bra I mean this is a good place to start bidding up the rest of the market not the

[00:30:07] not that the mag seven is going to fall apart I think they keep continue to do their part in the rally but the rest of the market should move higher and I think it's going to go in order of quality

[00:30:16] first and then a little bit lower quality the last thing I want to be buying is still small caps and low quality stuff but I think there's still a lot of space like we have a chart that we didn't

[00:30:25] show but probably showed in our chart book that comes out this week we bracket top 10 all the stocks by market cap in the S&P 500 and it just tiles perfectly in their performance all

[00:30:38] the way down in the caps the small cap so I just think that that next group down at the very least is going to start catching up in the second half of the year and I think that credit as the

[00:30:48] Fed cuts rates and forward guidance and inflation's tamed for a little bit credit takes the baton from the deficit fuel economy that we've seen and you get some of those pockets I talked about

[00:30:58] that have been dormant waking up so that's kind of what I see at least from a narrative perspective in the second half yeah one of the really interesting things you had in this report

[00:31:06] is this idea of inverse ETF volume and what it looks like as you get towards the top that's something I haven't seen anybody else do can you just talk about what that shows you yeah that's

[00:31:14] an original thing that we came up with so you know a lot of people looked at margin debt for years to tell them when the top was coming and margin the idea being margin debt represented a lot of

[00:31:24] retail speculation and our view is that retail speculation has trans transferred over into the ETF market and primarily in these speculative ETFs we call it the speculative ETF universe and so that's

[00:31:37] levered long ETFs like 2x 3x ETFs and inverse ETFs so if you're a retail guy and you want to short stuff you're buying the inverse ETF so what we do is we take the volume of

[00:31:48] that entire universe of speculative ETFs and we calculate the percentage of that volume that's inverse and so the higher it goes it tells us that retail sentiment is pessimistic which is a contrarian bisignal and the lower it goes it's telling us that there's not a lot of pessimism

[00:32:09] in the retail space so as there's a little smaller percentage in the inverse ETFs that tells us that retail is getting optimistic and the numbers I use since it's kind of an original

[00:32:21] thing and people are like what that how do you orient yourself here a really optimistic or really pessimistic reading would be 60% inverse ETFs as a percentage of speculative volume in a very optimistic world is 20% that's where we saw the market top back in 2021 2022 was with

[00:32:42] inverse ETFs trading about 20% of total speculative volume and again we saw that 60% number hit in June of 2022 has been a great bisignal to be long since then and right now today we're at like about

[00:32:58] 30% and the thing that's funny to me is that we entered the year at 30% so even though the market's rallied 16% or so or whatever it was the first half it's not showing up in these objective indicators that tell us when the market's topping you know we're not seeing the

[00:33:15] inverse ETF volume fall break much below that 30% 29 30% level so not as if there's a lot of like extreme pessimism but we're not seeing what I would consider uh over optimistic that would

[00:33:31] to be indicative of a top I want to ask you more about using some other stuff in your report one other chart I wanted to mention that was in the report that was really great is

[00:33:39] this shocked me like the percentage of the time that the S&P tops in either December or January it's an incredibly high number like I would have never guessed that high that goes back to my that's the stuff like I convinced myself there's something to the

[00:33:51] seasonality stuff like you know if the market gets out of the year week um there's there's less of a chase that built through the year so you see a January top or December top that's

[00:34:02] where 56% of the of market peaks in a calendar basis either occur in January or December it's pretty crazy and then we have another chart we show in there we show the seasonality of each month broken into two parts so 24 periods of seasonality

[00:34:17] and it's funny to see the beginning of each quarter is where you have the strongest seasonality really in uh a strongest seasonal performance for that the stock market so to me the more I dig

[00:34:28] into it and just understand the behavioral side of it and how people get caught behind left behind in bull markets I think there's uh there is something to it and this of course assumes

[00:34:38] we're not going to have some external exogenous event that breaks the this bull market which is always a possibility uh and that's why we do all the macro stuff we do but you know without one of

[00:34:49] those exogenous events the the bull market that's in motion in the second half tends to stay in motion. Ernie's worth has been really interesting because you kind of have two sides to it

[00:34:59] and people on Twitter will point out we haven't seen the actual earnings growth but we are seeing huge earnings growth like in the estimates so the analysts are expecting a lot of earnings growth that hasn't happened yet how do you think about that and whether that might materialize?

[00:35:12] Yeah it's been a little bit of a debate um I mean my natural instinct I'm a pessimistic person my natural instinct is to be skeptical and then I have to work off I've just like a bias

[00:35:23] of mine that I just have to always fight against it's not a good bias to have and so I remind myself of that um what I've seen is that the estimates if you've tracked the estimates

[00:35:34] over the last 18 months or so there has been this tendency of analysts to constantly assume that a big inflection is just around the bend uh you just have another six eight nine months and then

[00:35:47] you can see it in the estimates like a big move and then as you go forward and you go through one quarter or two quarters of earnings the companies guide down and the analysts mark their

[00:35:57] estimates down and then they would move that that big bulge of an inflection out and that's that's been the pattern through 2023 and we're now seeing we came through Q1 earning season

[00:36:11] and the estimates stayed intact and historically what you see is it seems like a high bar and I know that's what bob thinks we talked to that talked about his episode and he's been kind on the other

[00:36:22] side of this but those numbers come from the companies the companies are guiding analysts to those numbers and we just came through Q1 and that big inflection did not get marked down at all

[00:36:35] and so to me what that tells me historically is the companies are going to meet hit those numbers unless you get sideswiped by an exogenous macro event those companies are likely those

[00:36:47] earnings estimates that seem out of reach are likely to be hit in my opinion in the back half of the year so that goes along with this broadening story because a lot of it is the

[00:36:59] you're going to get still some growth the the mag seven are going to keep growing but it's the bottom half that have been lagging you know with negative growth in many of these calendar years that this is the this is their moment to start growing earnings

[00:37:11] I just wanted to ask you one other thing you touched on in the outlook with this idea and you know most of us think AI is going to produce you know going to boost productivity

[00:37:19] but we're not sure the magnitude of it and we're not sure when it's going to hit and so I was wondering what your thoughts on that are when like we'll see significant

[00:37:26] impact on the economy from AI yeah and the one point I would just tie up the earnings thing is this path for earnings that we're on it's actually very close to the path that we travel

[00:37:37] in all historic bull markets or the average historic bull market going back again to 1950 so as much as it feels crazy we've had a flat period of earnings in the face of an economy that's been growing quite aggressively on the nominal GDP basis so I don't know that

[00:37:52] it's when you zoom out at that it's all that anomalous to expect an inflection earnings coming in the back half of the year as far as AI I mean I just think you have to give a big

[00:38:02] air band around what's about to happen I don't know and Fernando's got his thoughts on AI we're seeing in our company anecdotally especially on his end we're seeing major productivity increases

[00:38:14] from the use of AI I mean his coding has gotten so much more efficient like he you know if we have a new a new chart idea or something like that he's he's interacting with AI to help him

[00:38:26] understand how to best do a data visualization that we've never done before and it can happen really quickly another story I've told is like we have a client who we're redoing

[00:38:35] some of their models in the background for them and they wanted um so part of this is delivering charts that in a certain way for them this kind of goes to this point they wanted their um

[00:38:46] they wanted to the ability to on-the-fly change date ranges in a chart and it's not I know from my time at my previous shop that it took them years to do this project and they

[00:38:58] spent millions of dollars and I mean again Fernando's a brilliant guy so the big part of his ability to utilize this but he was able to take him combined with the AI um applications

[00:39:13] he was able to solve that problem in like a week just on his own for this client so my feeling is that I don't know where this all goes I have no idea I'm not like an uber

[00:39:23] optimist or someone who thinks it's all BS either but what I can say is if little 314 research is squeezing that much productivity out of these applications I would think the top 500 companies

[00:39:34] in the world are going to figure out how to create efficiencies from it as well so I think it's going to be a real productivity enhancement tool it's just a matter of timing when does that

[00:39:44] happen and things like that even on a less advanced level than you guys are operating on like what we do I mean I'm always asking myself the question now can AI do this when I try

[00:39:52] to do something and you know the the description of this podcast that time stamps for this podcast like most of that will be 90% done by AI um you know we had a legal document we had to do recently

[00:40:03] like the first draft that it was AI did an incredible job writing it I mean I would think paralegals are in a lot of trouble based on how good it was like so there's just so many

[00:40:11] things I get like to your point it's very hard to figure out what all this means but we know there's going to be significant productivity votes from this yeah we had a Chinese hedge fund

[00:40:20] come on our service they wanted to agreement and Chinese and AI wrote it for us and uh it's been pretty incredible I mean like there's a lot of anecdotes like that that I could rattle off so

[00:40:31] I don't know I see a lot of skepticism on Twitter and I mean I'm sympathetic to skepticism like it's that's kind of how I'm wired but I mean you have to be like a little blind not to see that

[00:40:42] it's really there are some real benefits whether the all the money being spent is actually a good you're gonna return on that I have no idea but you're certainly gonna get a productivity increase

[00:40:52] from the technology I think the last time you were on cdc maybe the last time or maybe the time before um you were talking about and this is in the report sort of the importance of

[00:41:01] the equal weighted s&p 500 sort of confirming her not confirming the rally and I just think that's a very uh interesting and maybe an important thing to sort of discuss here so

[00:41:12] can you talk about that yeah so uh the history of these broadening events and this has been I mean I think we've all kind of become experts on market breadth over the last year and a half because

[00:41:23] that's been the constant push and pull in the market as you get these mega cap stocks that run and then the rest of the market has is either it's either looks very shaky because now we have

[00:41:33] an hat we have this negative narrow breadth or it broadens out into big rally ensues and that's really the tail of breadth that I found is that you either you you can have big mega cap

[00:41:44] leadership and then a broadening out and that's positive for the overall market or index um but that needs to that process needs to happen in about a 90 day window and so what we found is

[00:41:55] that whenever the s&p 500 makes a new high and it's not confirmed by the equal weight within 90 days that's a negative for the overall market and so that's something we're watching

[00:42:07] it's like as we you know kind of sound pretty bullish about the second half um the I do think that you need to see that broadening take start to take hold within the next say month or 45 days so

[00:42:19] to be really exact in the the framework of that study we made a new high it was the way we classified it as a new high after 21 days of not making a new high in s&p 500 we made that new

[00:42:29] high after the sell-off on May 15th so that's when the clock starts and we've been since May 15 equal weight is basically flat it's just it can't get out of its own way and so by August 15th that

[00:42:43] 90 day window you historically you need to see the equated move higher now it's not a big that could happen in one day because we're only like I believe like two or three percent off of a new

[00:42:53] high on the equal weight the equal weight hasn't collapsed but it's just you need to see that fall through in confirmation at some point and if we're right about the Fed cuts and the Fed cuts

[00:43:02] being the impetus for broadening I think the timing all this stuff should kind of work out where somewhere in the next month you get the equal weight rallying up making a new high and then

[00:43:11] we can all exhale about this breadth divergence that we've had um but it's worth it's like you said Justin it's worth watching it's uh it's definitely a it could go the other way with breadth if the other 493 breakdown it's an inherently weaker market structure

[00:43:27] and when you talk about a broadening you're thinking more broadening within like large caps in the S&P of 100 right you're not thinking it'll go all the way down into the small cap

[00:43:33] area which is obviously struggled a lot yeah that's if I had to be my my honest feeling is that it's just not the right part of the cycle for small caps and that's um maybe that changes

[00:43:46] when the Fed starts cutting rates but I still think that the order is going to go from the uber mega caps down to maybe a few uh quintiles below that in market cap and quality and then it'll

[00:43:59] go in in that descending quality in size order this rally so I think it's going to be kind of the opposite of a market bottoming your traditional market bottoms high beta low quality leads off

[00:44:10] of a bottom I think in this mature stage of a late cycle rally the market the rally is going to broaden the other direction and the last group to get moving will probably be small caps and by

[00:44:22] the time they start moving I think very well it's very likely that um inflation's back and the feds maybe have to make another change and things like that so it's just not an area where I want to

[00:44:33] be exposed to small caps mid caps in this environment I think there's plenty of me on that broadening bone and broadening story in the S&P 490 400 whatever you want to call it

[00:44:45] and so that's how we're playing it let's pivot and talk about stock selection over a bit so you guys recently launched an ETS it's built on a stock selection model that you guys run and have

[00:44:56] been running for a few years can you just I mean walk us through the investment process what types of stocks you're holding um maybe what like the buy sell decisions look like in terms of like

[00:45:09] turnover and activeness within the because in an ETS that really doesn't matter that much that's the great thing about me to have rapper but still I think all that stuff's important to understand for people that are interested in this thing yeah so our model our stock selection

[00:45:21] model is called the full cycle trend system and uh the reason we named it that is because we're looking for stocks that can perform across uh an entire cycle and so you know my if I step

[00:45:33] back my background was in the energy space and I went through this really nasty bear market period from like 2010 to 2020 when I was really involved in energy and what it beat into my

[00:45:43] head is the importance of quality and how you basically can't really can't pay too much for a high quality company in my opinion um and so that's the basis of our system we've taken that and

[00:45:53] expanded it to the S&P 500 so we look at the S&P 500 we scan that universe of 500 stocks for the top 100 by quality and quality is a bunch of fundamental metrics um one of the things we

[00:46:05] do different I like quality because it's not totally defined either academically and uh so we can kind of put our own spin on it and for instance one of the things we look at is cash flow

[00:46:14] and earnings volatility and we only look at downside volatility for instance versus just wrapping it putting a standard deviation bracket around uh earnings which you see that a lot of

[00:46:25] places so anyways we do a number of those things we ranked the S&P on quality we grabbed the top 100 stocks there and then we come in with a trend overlay and we we ranked those 100 stocks

[00:46:37] and we're buying the top 20 every month so there's there's a fundamental basis with built on quality then there's a trend overlay and we've got a very concentrated portfolio somewhat concentrated with 20 stocks selected out of the S&P 500 and we're rebalancing monthly so I think those three

[00:46:54] steps in conjunction and it's important not to overlook the rebalance a lot of ETFs a lot of strategies are built off of this set it and forget it kind of mindset within an ETF you're

[00:47:04] not penalized for that turnover you're not you're not paying capital gains taxes so I think you need to utilize that and so that's something we're doing in there is uh rebalancing on 12 times a year we

[00:47:15] turn the portfolio over quite a bit I'd say that the portfolio turns over between three and four times a year um and really when you're in that quality universe what you're able to do is

[00:47:27] the trend analysis is a little different like we look for strong long-term and intermediate term trends we do this all a little differently and then we look for sell-offs uh we but we sell

[00:47:40] rips on very short term and we buy dips and the idea being the same trend strategy would not work in a broad market environment where you're dealing with high and low quality a lot a big mix of

[00:47:50] fundamental stocks but when you narrow your universe to just quality on a fundamental basis you can confidently buy dips and that's where we really generate a lot of return so you go back over the last three years our strategy's up like 40% on a three-year rolling basis so that's

[00:48:09] beating the S&P 500 by 12% is beating like the QAL ETF by 12% it's equal weighted and so you really want to benchmark to the equal weight it's beating equal weighted S&P by like 32% over that time

[00:48:22] and a lot of that is just being in the right neighborhood quality and then being tactical and taking advantage of those sell-offs and selling rips too because of the monthly rebalance this might not be a completely relevant question I'm just curious

[00:48:36] though is has there been times where the portfolio has been like heavily concentrated in one sector or are there some constraints around the sector exposures there or do you just let it roll

[00:48:49] we let it roll because what I've found is that the sector exposures and a factor like this is kind of part of the it's kind of part of what you're choosing you know there's a whole cyclical

[00:49:00] portion of the market so what what is a drawback of the strategy like this in my opinion the biggest drawback is you almost have no cyclical exposure which means you have no energy exposure in this

[00:49:10] now there's every once in a while an energy stock will pop in here but it's very rare and that's something we accept and are okay with but we tell our clients you need to force feed

[00:49:19] your portfolio a set amount of energy because I do think energy is as we go all the way back to the beginning of the conversation about 60 40 and diversifying energy's been the best one of the

[00:49:28] best diversifying assets in this market post COVID and so you know that's the one thing in my own you guys do that what's in your portfolio I'm owning this ETF myself but I'm flexing my energy

[00:49:40] exposure up and down at different points in the cycle based on like our crude oil model and my outlook there and to me I think that's a really good way to manage the equity side

[00:49:50] of equity exposure in a portfolio here funny how a former energy analyst your your model kind of shuns energy but you get it in other ways I guess which is good probably for diversification yeah I

[00:50:03] mean I energy is uh it's not like the other sectors especially in this environment and so to me energy is a big risk oil spikes are a big risk to this market once you start thinking

[00:50:14] the feds involved inflation is a problem a spike in oil prices just like 2022 is one of the biggest uh potential risks to the market so yeah you know energy is gonna dig when everything else zags

[00:50:26] which is an opportunity but you also you know you don't want to be I see so many people who are in love with energy they just want the market's going up I want to buy energy it's a certain

[00:50:35] mindset of investor the value investor and there's a lot of problems I think it's a whole podcast there's a lot of problems with that that default mindset one of the other things

[00:50:46] that I want to ask you about is you know a lot of people have these levels on like the 10 year where if like you know the 10 year goes above four and a half percent you know now it's

[00:50:55] competitive with stocks and so stocks are going to sell off but you know you kind of written about this that you know it's not so much the level but well it is the level it's

[00:51:06] the percentile level that you it's not a it's not a concrete number it's like there's some band where the bond yields kind of do become maybe somewhat of an issue for stock market performance

[00:51:20] yeah that's what we found it's not like you know I mean you could use four five like four five is a decent rule of thumb like we did a back it's like this is not a academic back test we did

[00:51:31] the back test looking at oil we said like any you just get out of the market when oil was above 90 bucks a barrel you've done well since 2022 and some people who you know don't understand what we're

[00:51:41] trying to do took that as like a very literal thing but the point is like there's a level where oil starts threatening your portfolio there's a level around four five where yields have have

[00:51:50] hurt your portfolio but a better way to look at yields is not on that straight level it's how quickly that move occurs so at one point in time it was four percent and four point two five percent

[00:52:00] and then four and a half now it's maybe five percent where you know that level hits and the way we quantify that is we take a trailing 63 day range and we say what you know what happens when you

[00:52:13] get up to like the 80th percentile of that trailing 63 day range and that's been a good time to step out of the equity market so as yields have been a new risk to the

[00:52:22] stock market that's how we've navigated that is through this rolling range and so right now I think that puts the that numbers at like 4.61 percent on the 10 years so somewhere around 46 if we saw

[00:52:35] yield spike in the next two three months up from 43 to 46 the equity market price start having some indigestion um and I think that's a better way than these like very static levels uh you know

[00:52:50] but um that's that's how we're doing it looking at this rolling range the one thing you have in your report here is this strategic asset allocation recommendation and you have sort of where you're

[00:53:01] at and then you have maybe the benchmark and the min and the max how do you determine you know those levels is it is there some like momentum and fundamental or what's the driver of that

[00:53:14] that is really purely discretionary and so I do think there's like two parts of our service always explain this to new clients like we have two parts of the service we we write these long form

[00:53:24] reports with all of what we can go wherever we want in these reports and talk about whether it's inflation or earnings or anything macro we can we go down those rabbit holes um my what I found

[00:53:36] when we started the company is that uh you could get pretty academic with that stuff and you need to bring it back to a fixed set of recommendations so we put in this just very

[00:53:45] basic asset allocation recommendations that we track and we track our performance and things like that and that crystallizes those views so you know you come out and you're like well I think that the

[00:53:54] credit creation could expand I think that the Fed's going to cut rates here but I think that stocks are 25 overvalued on this basis but that's really in the top seven you have all these

[00:54:04] different studies and stuff at some point you got to put pen to paper and say here's how I position a portfolio giving all this research and that's how our research flows and how we

[00:54:13] crystallize it and those asset allocation uh those that those four buckets um we have a whole second side of the service that's non-discretionary totally systematic models like our real asset allocation model the full cycle trend stock selection model I've talked about the crude

[00:54:30] oil model the gold model sector rotation model all those are set in forget it and the idea is I do think that over time between the two a discretionary and systematic a well a well-thought-out systematic approach is going to be superior to a discretionary set of discretionary

[00:54:52] recommendations and that's just to me I think something we talked about prior to the show and something I've been saying on Twitter is like the the easiest edge to obtain for most

[00:55:02] investors is a behavioral edge and the easiest way to be to obtain a behavioral edge is through systematic rules based investing and so to me that's the way we segment our service we have

[00:55:13] these models totally systematic models and then we of course we're like you know we're macro bros so we want to have our discretionary thoughts and take all this research and distill it down

[00:55:23] into our recommendations so it's kind of a left brain right brain however you want to think of it way to divide the service but those strategic a's that's discretionary that's a discretionary cult great well listen Warren thank you very much for your time we really appreciate

[00:55:38] it we wish you all the best of luck with the ETS yeah thank you for having me I appreciate the uh the good the good luck wishes appreciate you guys thanks man this is Justin again thanks so much

[00:55:50] for tuning into this episode of excess returns you can follow jack on twitter at practical quant and follow me on twitter at JJ carbono 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