Understanding the Changing Macro Landscape with Warren Pies and Fernando Vidal

[00:00:00] Welcome to excess returns where we focus on what works over the long term in the markets.

[00:00:05] Join us as we talk about the strategies and tactics that can help you become a better

[00:00:09] long-term investor. Justin Carboneau and Jack Forehand are principals at Validia Capital

[00:00:13] Management. The opinions expressed in this podcast do not necessarily reflect the opinions of

[00:00:17] Validia Capital. No information on this podcast should be construed as investment advice.

[00:00:21] Securities discussed in the podcast may be holdings of clients of Validia Capital.

[00:00:24] Hey guys, in this episode of excess returns, we're going to have all those links at the end. You want to check this out because my God, your charts and everything else are some of the best that anybody's putting out right now. And I say that looking at a lot of frigging charts. So first off,

[00:01:41] let me just say thank you and let me follow crossed past with Fernando and worked with him. We became good friends first and really

[00:04:04] how we present arguments. So definitely an important factor.

[00:04:10] Warren's got the legal background, Fernando. What background did you have if you say photography or arts? What are the charts?

[00:04:12] No, I did a finance degree and then a degree in machine learning. So I'm very technical-minded.

[00:05:21] and tied to everything. And I get the sense that the macro research,

[00:05:24] it's like it's always there and rooted in what you're doing.

[00:05:27] Can you speak a little bit about commodities

[00:05:28] and then maybe the macro process?

[00:05:30] Yeah, I mean, commodities,

[00:05:34] if you're gonna have a view on commodities, as you said,

[00:05:36] it's really a top-down asset class.

[00:05:39] I covered commodities and before that,

[00:05:41] the energy sector and material sector at Ned Davis.

[00:05:45] And these really are sectors that,

[00:05:47] if you're talking about oil, which is the commodity where I really cut my teeth. And so, um, these things go hand in hand. So for many years at NDR, I really stuck to the oil world, but you know, we were building out our macro process in the background and that's been one of the most fun parts of three 14 is we kind of spread our wings and sure, sure.

[00:07:02] The way we look at the world, uh, to replicate those things so that when somebody comes to you with an argument, you can say like, well, did they explore that? Well, how come they're not showing me this? And basically getting at this kind of data-driven quantitative approach

[00:08:22] means that you have to go and recreate that back, you could say, a hundred years. Some people have charts going back to the Roman times. You've seen those charts of interest rates or whatever. But really, we don't have good, high quality data for very long. And if you want to talk about recessions or business cycles,

[00:10:47] quote, I quote, go to bad, or you study funding announcements and QFON issuance versus bill issuance and these things.

[00:10:50] There's really nothing in the history that would suggest the moves we've seen here in

[00:10:54] the last few quarters.

[00:10:55] So kind of to your point, what we need to do is you need to understand the data, but

[00:10:59] understand the limitations and then apply that logic in that current kind of reasoning

[00:11:04] and thinking to the situation at hand and why it's like where do you start? You could just think of the way the stock market has evolved and from trading off of digital trading and high frequency trading and just the way even stocks are quoted has changed just within the last few decades.

[00:12:21] This is a rapidly changing world. And I technicians really like that. That's a great signal, but we've had the new advent of zero DPE options and a lot of a different, I'd say underlying market dynamics.

[00:13:40] And we've seen many more breadth thrusts over the last year.

[00:13:43] We had a 20-year period where we didn't get as wide breadth thrust, and now we've had

[00:13:46] multiple within one year. some earlier this year that ended up being good signals, it looks like. And we had some last year, for instance, that ended up being kind of bad signals. I think it's more about understanding the world changes, like you said, that you have to contextualize these things. There's no silver bullet, mom, unfortunately. I want to get back to that issue and she mentioned because that's been

[00:15:00] probably one of my biggest lessons of this year's.

[00:15:02] I was always paying attention to what the Fed is doing, but and I didn't

[00:15:05] realize that sort of what the Treasury refuses to issue duration, they issue short term debt instead, than people thought, and the market has done very poorly since then. And then the realist recent announcement was the opposite, going the other direction and other markets rallying. So there definitely seems to be, this seems to be very important for the market. Yeah, I'd say July 31st was they announced Q4 issuance, coupon issuance.

[00:17:44] And just to be clear how we, again, positive for markets and positive for rates, which I think is driving everything at the moment. But over the long term, I think there'll be consequences that we have to deal with. Is there possible knucklehead question on this, but I want to ask you about this.

[00:19:03] Is there, so like with issuance and pushing, debt. And when you look at it during periods of QT, the most price sensitive buyer is leveraged hedge funds, unsurprisingly. And so you need to have yields go high enough, get that group come in here and fill the gap,

[00:20:20] if that's what you mean.

[00:20:21] Because really, when you look across the other buyers, they're kind of tapped out at this

[00:20:25] point.

[00:20:26] Banks aren't buying, foreigners are stepping away. that's fed 10-year rates going down 50 basis points and small caps rally large and stocks and general rally. Do you have anything that I missed anything, Fernando, from our work on that? No, I think that's a good summary. Like up until last week, I think, you know, when the new announcement came out, like the market, you know, we got up that's what was going to happen. If you model things out, staying below 20% would take a lot of coupon issuance, and once that's off the table, you can get some relief there. Do you use the word temporary there? Are we really just kicking the can down the road? I mean, obviously the debt problem is not going away because they're

[00:23:01] issuing more short-term debt.

[00:23:02] I mean, is this just kind of a temporary reprieve and then this

[00:23:04] becomes a more major problem down the road?

[00:24:05] maybe the Fed stops QT, so that immediately takes 720 off the table. And then the Treasury could continue with their steady state issuance, which let's say it's between 1.2 and 1.4 trillion of coupon debt every year.

[00:24:14] And that would immediately begin exerting force on that bill's outstanding number to come back to like that 20% level.

[00:24:21] So if you take a really long-term perspective, like three's no evidence that supply matters, that the market is so deep, it's gonna take this debt down and it's all fundamentals. And there was a big debate coming into this TVAC. Like one side basically said, look, yields have shot higher

[00:25:42] after the July 31st to August 2nd announcement

[00:25:46] of more issuance. traditional buyer pools. And another way of saying that is that there's increased uncertainty for future demand. And that's in Bond-Lingo, a higher term premium that we're seeing in long-term debt. And so when you listen to the government itself, they're saying that the rise

[00:27:00] in yields has been more attributed to the supply demand factors that you mentioned versus your of GDP. So let's say another trillion dollars of deficit financing in the event of a recession. So we're at a $2.5 trillion hole that could easily become $3.5 or $4 trillion in a recession scenario. And generally, this builds outstanding question. This build outstanding

[00:28:23] jumps during a recession because it's like you've got the guys in the camp to think inflation's coming back. That's going to be our biggest problem.

[00:29:40] You've got people who think a recession is coming very soon.

[00:29:42] And then you've got your soft landing people who think we're going to thread

[00:29:45] the needle. I'm just wondering if note you sent us in preparation for this about this idea that stocks and bonds have been negatively correlated for a really long time. And we might be shifting to another really long time where maybe that's not true anymore. So I don't know, Fernando, if you may take this one. What are your guys' thoughts on that? Do you think we're entering

[00:31:03] a period here where maybe we're going to see positive correlation from stocks and bonds are moving together, stocks are just far too volatile compared to bonds, and I need to step down my allocation to stocks just because of this correlation change. So it leads to a lot of changes in the way people construct portfolios.

[00:32:20] You have to rethink a lot of strategies about using leverage to exploit this negative correlation allocation model, because our idea was that the next 25 years aren't going to look like the last 25 years and you need alternatives and you need a better mousetrap. Because quite honestly, the 6040s kicked butt from 1998 to 2021. And if that's going to be the next 25 years, then we should all kind of pack it up and go home and just let the 6040 continue to do its magic, work its magic, honestly.

[00:33:46] But I don't see that happening. you're by definition getting a rally where docs and bonds are correlated. So your volatility on 60-40 in this regime is gonna be like Fernando said, our study suggests it's a 2.5% annual increase based on current correlations

[00:35:00] versus the past 25 year correlations.

[00:35:03] You should expect your max drawdown to increase

[00:35:05] by like 10%, all else equal on your 60-40 portfolio. thing. So it matters tremendously, you know, that even a risk of the correlations turning positive. And you know, we've written a lot about the reasons for that. You know, the specter of inflation is one of them. Warren can talk about the energy side. But it's definitely something that changes, changes things significantly.

[00:37:23] Is that does that ring a bell for Nando? Is that what what the numbers were?

[00:37:26] Yeah, that sounds that sounds right

[00:37:33] No, another way to look at it is like if you wanted the volatility of the historical 6040

[00:37:35] in the positive correlation regime you would need

[00:37:39] Like a 50-50 portfolio split to achieve that same amount of volatility in the new regime

[00:37:45] So I mean that's one is if you look at household allocations and pension allocations, households and pensions are historically

[00:39:02] way overweight equities.

[00:39:03] So, you know, there is a bit of a discrete pool

[00:39:06] of capital, it's

[00:40:23] just up and to the right, more5% and 5%, even if that's just where we top out. Robert Leonard Can you guys talk a little bit about what you think the Fed's going to do going

[00:41:41] forward here? It seems like they're sort of trying to play both sides of it right now. They've

[00:41:44] paused a little bit, but they're. Now, if the data deteriorates,

[00:43:01] the Fed cuts, but I don't, the number one thing is on a Fed pause as well. So usually, if you go by the historic playbook, and we go back to 1978 with our analysis on these, because really Fed policy was pretty different if you go too much beyond that. But that's the traditional playbook. Now, you mentioned housing before, housing has probably been the most surprising thing for me. Like if you told me 8% mortgage rates, I would have told you 2008 or something in the housing market. And I totally missed the supply thing. I totally missed the idea that if I've got a 3% mortgage, I'm just going to sit in my house, there's going to be no supply, but it also doesn't seem like that's sustainable going forward. So I'm just wondering, like, could you talk a little bit about your outlook for housing, given all the dynamics we're dealing with?

[00:45:42] Yeah. Um, Fernando, you wanted to,. Like housing starts in multifamily or holding in okay. Single families way off of its peak. So on net, it's kind of muddling along. But without that going higher, pay rolls should fall. And what we've seen is that pay rolls

[00:47:01] are actually holding in okay.

[00:47:03] And the time to build a house

[00:47:04] is not really significantly falling.

[00:48:04] With rates where we're at right now though, and I'd say the real reason we've been locked up at this point in time is because the national builders, the publicly traded builders control

[00:48:09] 50% of houses.

[00:48:11] They build 50% of new houses in the United States of America.

[00:48:14] And so those builders are still in great shape.

[00:48:17] You've seen their stock prices rally this year, and they're able to come in there and

[00:48:21] buy down mortgage rates, which basically gives them a competitive advantage over everybody

[00:48:26] else in the market. get us into a real housing slowdown. Well, that's certainly something we're all watching. Let's transition a little bit to, because points like that are what you're doing when you're writing this stuff and sharing it with clients. Another thing that comes from your website, from your research is you've

[00:49:40] got this tool for the likelihood of 10% declines, and you've written

[00:49:43] about this quite a bit in the month ahead.

[00:50:52] So it's done a pretty good job since we put it out in identifying, you know, kind of periods where we've had subsequent breakdowns in the market. But it's a good example of like how we use machine learning to synthesize a bunch of underlying indicators that we have an intuitive understanding for.

[00:51:01] So it's not really a black box.

[00:52:06] And anyone who's just been in markets understands that when volatility expands, upside potential expands alongside downside potential.

[00:52:09] So the model is really only focused on that downside.

[00:52:13] You have to keep that in mind, number one.

[00:52:16] And then it goes kind of to each individual client's own mandate and how they would potentially

[00:52:22] implement it.

[00:52:23] I mean, a lot of clients can in anything below 20%, we'd say, stay fully invested. You go above 20%, enter that into a cash position in the model. So those are a couple examples. But honestly, it would come down to that individual client's mandate, just in making sure first and foremost, they understand the limitations just of any model

[00:53:41] and that one in particular. I think it's are really unrealistic. So it's really not our target market. So I want to give you guys our standard closing question here.

[00:55:00] And Fernando, I'm going to ask you first.

[00:55:03] If you could impart one piece of wisdom,

[00:55:06] if you could teach one want to live, right? Yeah, a good one. Warren, what about you? You can impart one piece of wisdom. What would it be?

[00:57:27] expectations were to beat the market by like the hurdle rate was 15% above the S&P 500 every year or something like that and he had just started out and I

[00:57:34] had a pretty serious conversation with him that this is an unrealistic goal and

[00:57:38] why and so that's kind of the the thing I see more most often with I'd say the

[00:57:43] average investor is just a lack of an appreciation for how hard this game is fit for our work. If you don't want to go that far, you can always call me at Warren Pies on Twitter or your company is at 3F underscore research. Fernando, what's your Twitter handle? Fernivit, that's E-R-N-A-V-I. Excellent. And are you guys are both posting stuff on LinkedIn now or the firm is too,

[00:59:03] I think I've seen. I put stuff on LinkedIn every once in a while. I try not to let that