Practical Lessons from Andy Constan | Bridgewater, Macro Pillars and Navigating Deleveragings

[00:00:00] Find a portfolio you can live with, manage it passively through time and don't think you have an edge because you probably don't.

[00:00:09] He said, yeah, but then that would be over and we wouldn't have anything more than the money we made.

[00:00:16] And that was, that struck me as bizarre.

[00:00:19] But he explained it to say that what they do and what I did once I learned this lesson was what they're trying to do is capture a alpha stream that'll last, you know, a generation ideally.

[00:00:33] Welcome to Two Quants and a Financial Planner, where we bridge the worlds of investing and financial planning to help investors achieve their long-term goals.

[00:00:38] Join Matt Zeigler, Jack Forehand and me, Justin Carbonneau, as we cover a wide range of investing and planning topics that impact all of us and discuss how we can apply them in the real world to achieve the best outcomes in our financial life.

[00:00:47] Jack Forehand is a principal at Validia Capital Management.

[00:00:50] Matt Zeigler is managing director at Sunpoint Investments.

[00:00:53] The opinions expressed in this podcast do not necessarily reflect the opinions of Validia Capital or Sunpoint Investments.

[00:00:58] No information on this podcast should be construed as investment advice.

[00:01:01] Securities discussed in the podcast may be holdings of clients of Validia Capital or Sunpoint Investments.

[00:01:05] So Matt, today we're going to talk about one of my favorite macro thinkers.

[00:01:09] Tell us, tell us, tell us and make me relive the moment where I'm pretty sure I paired him when we did our playlists to islands in the stream.

[00:01:17] That is what we are.

[00:01:18] I think that was my song for him because I just kept thinking about it.

[00:01:21] It's been stuck in my head ever since then.

[00:01:23] Did we just get a YouTube comment about Islands in the Stream or about Kenny Rogers or something?

[00:01:26] It just comes up over and over again because it's a great song.

[00:01:30] But I know that's not what we're here to talk about today.

[00:01:32] We're talking about Bridges Over Troubled.

[00:01:34] Well, maybe it was a Bridge Over Troubled Water reference.

[00:01:36] Who are we talking about today, Jack?

[00:01:38] Yeah, so we're going to talk about Andy Constant.

[00:01:39] And we've been lucky.

[00:01:40] Andy's been on the podcast like five times now.

[00:01:42] And every time he comes on, I learn something because he's really great at developing these simple frameworks to understand what's going on in the macro world.

[00:01:51] And we're going to go through a couple of them today.

[00:01:53] But I love that idea because it can be very confusing for someone like me, like what's going on in macro.

[00:01:58] There's so many moving parts.

[00:01:59] There's so much complication.

[00:02:01] There's all these pieces going left and right.

[00:02:02] And like to break it down to simple frameworks is great.

[00:02:06] And so today we're going to go through some of Andy's.

[00:02:07] And we're also going to talk about things like, you know, he worked at Bridgewater for a while.

[00:02:10] And we've only had maybe a couple of people on the podcast who work at Bridgewater.

[00:02:13] So we're going to talk about some of the things you learn there.

[00:02:15] Andy is a source of not just education for people who are trying to learn more and do this stuff themselves, but anybody out there who's a professional in doing this.

[00:02:24] He just frames stuff up in such like a quick, tight.

[00:02:27] Here's the four things you need to understand when you're thinking about macro.

[00:02:30] You can steal so much.

[00:02:32] Which I am stealing, stolen so much from his communication style about this stuff.

[00:02:37] It's just, it's phenomenal.

[00:02:38] I love working through these clips.

[00:02:40] I can't wait to share these with everybody because copy, borrow, steal, whatever.

[00:02:45] Andy's a great thinker.

[00:02:46] We're going to show you why.

[00:02:48] And so for the first one, I've got a little button here and I'm going to rate you as we go here from like one to five, because we're going to be talking about Bridgewater.

[00:02:53] And from my understanding, that's what goes on there.

[00:02:55] So for the rest of the podcast, maybe we'll get a little thing on the screen for the viewers to see how I'm judging you.

[00:03:01] But I'll just be judging you from here on out.

[00:03:02] Okay.

[00:03:03] But just know that goes both ways.

[00:03:04] That's the whole Bridgewater thing.

[00:03:06] As I told you before, I'm getting over some sickness here.

[00:03:08] So my rating might be quite low today.

[00:03:10] But anyway, this is, so one of the things that I wanted to ask Andy when we first had him on, this is our first interview with him a couple of years back, is like anytime someone's been inside Bridgewater, like what do they learn there?

[00:03:20] It just seems like such a cool place.

[00:03:22] And it seems like there's so much you can learn there.

[00:03:23] So we asked him, what is his biggest lesson from Bridgewater?

[00:03:26] Before I joined Bridgewater, I thought about investing as a series of trades.

[00:03:33] You know, I would have a strategy and trades would come from that strategy.

[00:03:38] But each trade was separate.

[00:03:41] And after the trade, though that intelligence about what may happen in the trade, the learning from that trade, work wasn't really kept except in someone's brain.

[00:03:56] And so for me, and I said, this is when I sat down with Bob Prince and told, and we were discussing what I thought was, you know, very early in my career, what I thought was the best trade I've ever seen.

[00:04:08] And to be honest, it's still the best trade I've ever seen, which was selling 10 year S&P volatility at 38%, which at the time was very unusual and still is and realized much, much less.

[00:04:27] So Bob said, you know, Andy, I think that's a great trade, but it doesn't give us anything.

[00:04:33] It doesn't make any value.

[00:04:35] It doesn't give us any value.

[00:04:37] And I was like, well, you know, we probably at the size Bridgewater could do this.

[00:04:41] We probably make, you know, $20 billion for our investors.

[00:04:47] And he said, yeah, but then that would be over and we wouldn't have anything more than the money we made.

[00:04:54] And that was that struck me as bizarre.

[00:04:56] But he explained it to say that what they do and what I did once I learned this lesson was what they're trying to do is capture a alpha stream that'll last, you know, a generation ideally, but, you know, at least 10 or 15 years.

[00:05:14] And something that can be repeated again and again in a systematic way.

[00:05:20] And the learning on that is far more important to them than the learning about a, you know, the amount of time one would have to take to learn about a particular unique circumstance that is unlikely to ever repeat itself.

[00:05:36] Yeah, like I love this idea.

[00:05:38] Obviously, I'm a quant guy, so I like this idea.

[00:05:40] But that story he told is crazy.

[00:05:43] Like that idea that Bridgewater, like you've got this huge trade you could make.

[00:05:47] That trade could make you a ton of money.

[00:05:49] But you know what?

[00:05:50] We're not going to do it because it's not repeatable.

[00:05:52] It's not going to add to what we do.

[00:05:54] And he said something like 20 billion.

[00:05:55] Like if you've got a trade for me, Matt, that I can make 20 billion, please let me know.

[00:05:59] I'll go ahead and do it.

[00:05:59] I don't care if it's part of my system or not.

[00:06:01] But I thought that was really cool that they're so rigid in what they're doing.

[00:06:04] Like if it's not part of making our system better, we're not going to do it.

[00:06:08] If you dive into the cesspool of the YouTube comments below this video, I am quite certain somebody will be insisting they have a wonderful crypto scheme to make you 20 billion dollars.

[00:06:18] I think about this with clients a lot.

[00:06:21] And I think about it in terms of what I call line item logic.

[00:06:24] When people stop thinking about it in the context of the greater portfolio or in the context of a greater life, you get so obsessed with a line item.

[00:06:33] And even your best idea is a single line item.

[00:06:36] You get divorced from the reality of what it means in the greater context.

[00:06:41] Understanding that Bridgewater from the top down is so intensely aware of this that they'll say, we're going to pass on this great idea because it's not repeatable and it doesn't fit into the greater structure.

[00:06:53] That's both intimidating and beautiful all at once.

[00:06:58] Yeah, I love the quote from Bob Prince.

[00:06:59] The quote was, if it doesn't give us anything, we're not going to do it or something along those lines.

[00:07:04] And like that, that's just a great way to look at it.

[00:07:06] And like I would have never thought, you know, in a hedge fund world, I mean, everybody's trying to make a buck any way they possibly can.

[00:07:11] Like, and I assume most hedge funds will do these one-off things.

[00:07:15] But like it just, that really is where it hit home for me.

[00:07:18] Yeah, I, this ties into so many other things.

[00:07:22] It ties into the idea of Cinalittle.

[00:07:24] It ties into the idea of just having a process inside of yourself that you can repeat and know why you do that and why what you're doing is aligned with it.

[00:07:32] It's such a life philosophy approach to how you want to build and run a portfolio.

[00:07:37] And again, just really impressive to see it from the top down.

[00:07:41] So the second one is also about Bridgewater.

[00:07:43] And another thing we want to ask him is what's the biggest misconception?

[00:07:46] Because all of us look at Bridgewater from the outside and we have all these ideas about what's going on there.

[00:07:51] We asked Andy what we get wrong.

[00:07:53] Well, let me say that I don't know.

[00:07:57] But because I don't know what the outside impressions are by people.

[00:08:04] To me, the experience of being there was the biggest growth opportunity of my career.

[00:08:10] I learned more about investing and myself than I could have ever imagined in those three, three and a half years I was there.

[00:08:18] And I think it was the most rewarding experience I've ever had.

[00:08:21] It wasn't perfect, but it was as close.

[00:08:23] It is the highlight of my life.

[00:08:27] I was there.

[00:08:28] So I fit in that organization for three and a half years, which is, you know, a long time for an outsider to most people that come there come from undergraduate, straight from college.

[00:08:41] And as an experienced hire, it's a bit more complex to fit in.

[00:08:47] But I think from a culture fit, it was a good match for me.

[00:08:52] But as it relates to the investing, I definitely know that people don't understand how Bridgewater invests in the large.

[00:09:03] And that's because there is some perception that the CIOs pull levers on the portfolio to express views.

[00:09:13] And the answer to that is they don't.

[00:09:14] I have the unique role of being right at the point where all of the ideas are then turned into a portfolio and then executed.

[00:09:28] And I will say from that vantage point, I know exactly how much discretion or lack of discretion the CIOs have.

[00:09:36] And I would say the amount of capital out of 100 cents on the dollar, one cent at most is discretionary.

[00:09:47] And 99 cents are simply the models doing what they're programmed to do.

[00:09:52] And I think that is broadly misunderstood.

[00:09:55] And this kind of goes back to the systematizing thing, like this idea.

[00:09:58] And this is probably something I thought to some extent, like if Bridgewater has a view that a certain thing is going to happen in the economy,

[00:10:04] like I would think Bob Prince or whoever, whoever the CIO is at any given time is sitting there and saying, all right, you know,

[00:10:10] here's the trade we're going to put on to express that view.

[00:10:12] And he was talking about like it's more of it's a systematized thing.

[00:10:15] It's not that the CIOs are not sitting there like making discretionary trades on Bridgewater's portfolio.

[00:10:21] So my first question, and I'm going to get into this clip, the beard.

[00:10:25] When does the beard come along?

[00:10:27] Because there's pictures of him without the beard.

[00:10:29] I think in all the interviews, he's got the beard.

[00:10:32] The strategic decision for the beard.

[00:10:33] I really like the beard.

[00:10:35] Do you know?

[00:10:36] I mean, my dad, my dad would always do it in the winter.

[00:10:38] So is that the kind of thing?

[00:10:39] Like it's a kind of a warmth thing around the winter.

[00:10:41] Now we've got five different interviews with Andy and I put, I think at least three of them are represented here.

[00:10:45] So you're probably going to see some different looks from some different seasons, depending on when we did it.

[00:10:49] Okay.

[00:10:50] The seasonal beard adjustment.

[00:10:51] And I think he's all bearded in all these clips, but all right.

[00:10:54] That's a question for another day.

[00:10:54] I don't even know if he is today.

[00:10:55] I haven't seen an interview with him in a little bit, but.

[00:10:57] All right.

[00:10:57] Oh, we're going to phone him up later.

[00:10:59] If he is, there might be a winter thing because we're getting into winter right now.

[00:11:02] Well, respect the beard.

[00:11:04] First and foremost, if he ever decides to make it non-seasonal and goes full ZZ top, I'm here for that too.

[00:11:09] Also, what I would just like from my personal perspective is to actually be able to grow the beard, which is just not possible for me.

[00:11:14] You can't grow a beard either?

[00:11:16] You're also in this case?

[00:11:16] I mean, first of all, it would look horrible.

[00:11:18] The second of all, it's just not, it's not even possible.

[00:11:19] Like it's, unfortunately I haven't been gifted with that ability.

[00:11:23] This is, this is a common bond we share.

[00:11:26] We can, uh, if we went seasonal, we'd both look like patchy middle schoolers.

[00:11:30] It'd be, uh, it'd be great.

[00:11:33] So this whole 99% of system less than 1% or less discretionary approach.

[00:11:40] I always, always go back to Dalio as the inventor of the chicken McNugget, or at least in my heart and mind, that's how I choose to remember the invention of the chicken McNugget.

[00:11:49] And then it's Ray Dalio is doing, but inside of this, when he explains it this way, the chicken McNugget just exists in the greater processes process of McDonald's manufacturing of a meal for people in the drive-thru line to feed their kids.

[00:12:03] This idea that you have, you are so focused on the basic things you do, the basic product and service you provide that all tasks align with that thing.

[00:12:12] If that means there's a smarter way to create and fund and, uh, hedge, whatever crazy futures of pink goo were involved in the making of the chicken nugget.

[00:12:21] Like just, just brilliant.

[00:12:23] 99% system.

[00:12:24] Get it almost all the way to the very, very end, right?

[00:12:28] Leave a little tiny amount of wiggle room for a new idea when it can get in and get adopted.

[00:12:32] So it's not just burgers anymore.

[00:12:33] You're doing, doing chicken McNuggets too.

[00:12:36] It just wild to think.

[00:12:38] And again, maybe it's not a miskin, maybe it's a, it's a known conception of other people, but that systematic approach just pretty, pretty inspiring.

[00:12:47] I bet you as a quant, you must look at this and be like a glorious church of quant investing.

[00:12:52] It's what I believe in too, but it's funny.

[00:12:53] Like all of us are inclined to want to believe the other way is the better way to do it.

[00:12:56] Right.

[00:12:57] So we, we love like the macro, like Stanley Druckenmiller is out on CNBC making his call.

[00:13:01] Or like in my world of quant, like the stock picker who just is a better, you know, could just find the right stocks all the time.

[00:13:06] Like, I think we were more attracted to that approach, but I think clearly this systematized approach in most cases is better.

[00:13:13] Yeah.

[00:13:13] Yeah.

[00:13:14] And like, this is why I love the story of Dalio inventing the chicken McNugget or inventing the way that they could, you know, put the, they could basically secure the input costs for the chicken McNugget in a repeatable way to do it the same way they could do it for a hamburger.

[00:13:28] Or it's this idea of that's the sexy, not so sexy, interesting story of how you get to that, uh, amazing end product.

[00:13:37] But that, that's not really the story.

[00:13:39] The story is we've got this incredible thing that can just mint money over and over and over again through the basic delivery of this thing.

[00:13:45] Once we understand why it's valuable, pretty brilliant insight.

[00:13:50] So this next one is probably the shortest tip we'll ever do, uh, on this.

[00:13:53] And it's funny when we did this episode with Andy, I was like, I was going to put, I usually put some clips on Twitter and I was going to put this, but I'm like, can I put a four second clip on Twitter?

[00:14:00] I'm like, I probably can't.

[00:14:01] But the funniest thing is this is probably like the most important insight people need.

[00:14:05] So this is our standard quality question, which is if you could teach one lesson to the average investor, what would it be?

[00:14:08] Here's Andy's answer.

[00:14:09] So I think the, the answer is, um, find a portfolio you can live with, manage it passively through time and, um, don't think you have an edge because you probably don't.

[00:14:24] I think this is basically, you know, what, what everybody should be doing and particularly the alpha part.

[00:14:29] Like, and we, we did a portfolio episode with him where we asked him the same question and he got more into this alpha part.

[00:14:34] But the idea that you don't have alpha, um, or you probably, I think he said you probably don't have alpha is like such an important thing for people to understand because all of us think we do.

[00:14:44] Like all of us, anybody who's building a portfolio of individual stocks, at least if you're doing it discretionarily and to some extent, if you're doing it quantitatively as well, like you believe you have some sort of alpha.

[00:14:53] If you're timing the market in some way, you're getting in and out, you believe you have some sort of alpha.

[00:14:58] And like the data would just suggest you don't, the data would suggest I don't.

[00:15:01] I mean, obviously Matt, you're a macro trader, so you probably do, but the vast majority of us don't.

[00:15:06] So I think that's one of the most important lessons you can take because the pursuit of alpha leads to so many problems for people.

[00:15:12] It leads to so many, you know, such a reduction in their return over time that everybody could get that lesson in their head.

[00:15:17] We'd all be better.

[00:15:18] Your edge is whatever keeps you from going over the edge.

[00:15:23] Full stop.

[00:15:24] Simple as that.

[00:15:24] Your edge, your only edge that you can ever hope for is a thing that keeps you from ever doing something colossally stupid.

[00:15:29] One of my favorite ways that I very, very rarely use for obvious reasons is talking to people, especially planning clients.

[00:15:37] And at the end of the day, you're hiring somebody like me to stand in between you and stupid.

[00:15:42] That's pretty much the whole job.

[00:15:44] You're going to try to do something.

[00:15:45] I'm going to try to say like, no, no, no, no.

[00:15:47] Here's why this is a bad idea.

[00:15:48] And you're actually paying almost insurance for somebody to say like, oh, well, careful now, kids.

[00:15:53] Like, here we go.

[00:15:54] It's bumper bowling all the way down.

[00:15:56] It's not exciting.

[00:15:57] It's nothing else.

[00:15:57] Your only edge in so much of investing is just, again, here's the edge.

[00:16:03] I could jump over into chaos and stupidity, or I could stay here and keep focused on the things that actually work, are repeatable, and compound over time.

[00:16:12] That's all you can hope for.

[00:16:13] He's this succinct about this because he clearly gets it this deeply.

[00:16:18] Do you think you could have an investment advisory firm and have your slogan view we sit between you and stupid?

[00:16:23] I wonder how that would work for Kim.

[00:16:25] I will say this.

[00:16:26] I very, very rarely pull that quote out.

[00:16:29] Very, very much.

[00:16:31] On occasion, though, it gets to the point where I just have to say it that bluntly.

[00:16:35] And I don't like to do it because it feels almost arrogant in some way.

[00:16:38] And who knows?

[00:16:39] Like, whatever people do is whatever people do.

[00:16:41] We're trying to help align and enable that pathway and keep it constructive.

[00:16:46] But sometimes somebody will be asking about something.

[00:16:49] This goes back to that line item risk point.

[00:16:51] And you're obsessing over some minor detail.

[00:16:54] And it's just reminding them that.

[00:16:56] Yeah, you've hired me to stand in between you and stupid.

[00:16:58] And I am warning you that, you know, not this Hawk Tua, you know, coin or whatever is the thing.

[00:17:05] Luckily, nobody asked me to do that.

[00:17:06] If you have to hire someone to stand between you and that coin, you've probably got bigger problems than that.

[00:17:09] But how many of those people should have had somebody that they hired to stand in between them and that thing?

[00:17:15] Did that thing go to zero, by the way?

[00:17:16] Is that over?

[00:17:16] Or I didn't even.

[00:17:17] I'm cursory aware from the influencers and our peers, the finfluencers, as you might remember.

[00:17:26] When I saw some of them, like, who were freaking out about they couldn't believe they lost money on it.

[00:17:30] And, you know, you're sitting back going, I can't believe you thought you were going to make money on it.

[00:17:34] How does this work?

[00:17:36] Yeah, I don't know.

[00:17:37] It might be zeroed by now.

[00:17:38] And if not, is this your macro hedge fund call?

[00:17:42] Are you short the coin yet, Jack?

[00:17:44] Not yet.

[00:17:45] I don't think I would short it.

[00:17:47] I probably won't start now.

[00:17:49] Why not start with crypto?

[00:17:50] Why not start with tokens?

[00:17:52] Yeah, why not start with something that's supply and demand based and could go up to 100x, like, at any point, even though it has no value.

[00:17:59] Yeah, it's funny.

[00:17:59] Like, somebody was talking about, like, do you, I guess the idea was because microstrategy is trading at such a premium to Bitcoin.

[00:18:06] It's like, do you short microstrategy and buy Bitcoin?

[00:18:08] And, like, people are like, absolutely not.

[00:18:10] It makes a ton of sense, but, like, things can go so south on you before that thing works out that, like, you just can't do it.

[00:18:16] I don't know.

[00:18:16] If you can figure out a way how to, I don't want to call the top in the AI art versions of scenes from the movie Gladiator.

[00:18:27] But I think I've seen more of those than I've ever seen in the history of humanity and not just, you know, we've moved from just posting, like, the memes of Gladiator to people imposing themselves in scenes of Gladiator.

[00:18:38] And I don't know if we can get a higher level of hubris than that.

[00:18:42] So this next one, I think, is really great because I'm not one to try to call what's going to happen in the macro world.

[00:18:47] But I think it's great to have a framework where you understand what's going on in the macro world because there's so much bad advice that's going out there and so many bad takes on macro that I think it's great to say, like, here are four things I can look at to maybe judge what's going on.

[00:18:59] So here's Andy's four pillars of macro.

[00:19:01] So there are four pillars.

[00:19:03] The first pillar is in terms of picking assets, you have to know what growth expectations are going to be.

[00:19:10] So if I have two choices, lend money to a new business like a lemonade stand or own the lemonade stand, I'm choosing between bonds in the first case and stocks in the second case.

[00:19:27] And, you know, a lemonade stand does well when, you know, people start buying a lot of lemonade.

[00:19:32] And so that's growth.

[00:19:33] And so if you can expect growth in the economy, you'd prefer stocks over bonds.

[00:19:40] And so that's one pillar.

[00:19:41] What's growth doing?

[00:19:43] The next one is inflation.

[00:19:45] Inflation is interesting in that for nominal bonds, for fixed income, when inflation is higher, you're only receiving the same fixed income.

[00:19:57] And so by lending to buying a bond, lending to somebody who pays you back 10 years from now, your purchasing power when you make that loan is higher than when you give it when you get your money back.

[00:20:09] And so inflation is bad for bonds.

[00:20:12] It's a little more complicated for equities, but it's actually quite easy for things like commodities.

[00:20:18] And so the second pillar is how are inflation expectations laying out?

[00:20:24] The fourth pillar, I'll come back to the one you want to talk about as my third pillar.

[00:20:28] But the fourth pillar depends on a lot of the things we just spoke about, which is how are investors positioned and what might they likely do?

[00:20:36] And I call that flow in positioning.

[00:20:39] And it's something you can monitor across a wide range of investors.

[00:20:43] But the third pillar is the one that's been dominant for since 2020.

[00:20:49] And that is what I call risk premium.

[00:20:54] And risk premium is the following thing.

[00:20:58] If you have cash and you give it to somebody, either somebody who wants to sell you a bond or a stop, you're going to take on risk.

[00:21:09] Because cash isn't going to change tomorrow.

[00:21:11] But one of those two investments is going to change tomorrow.

[00:21:17] And you may want your cash back.

[00:21:18] And the only way you can do it is to sell your investment to somebody else.

[00:21:25] And you can suffer a drawdown.

[00:21:29] And you could have less money.

[00:21:30] And so for that, you need to be compensated.

[00:21:34] And that's the benefit of holding assets.

[00:21:39] People will compensate you for taking risk.

[00:21:43] Sometimes they compensate you very little.

[00:21:45] Sometimes they compensate you a lot.

[00:21:47] But in all cases, the compensation for taking on risk is positive.

[00:21:54] And so owning assets, by and large, is a good deal.

[00:21:58] But what's important is that periodically, the demand for assets, meaning the savers, and the supply of assets, meaning issuers like the government, corporations, banks, anything that creates an asset, get out of whack.

[00:22:24] And when they get out of whack, the supply of demand gets out of whack.

[00:22:28] And when they get out of whack, that affects their price.

[00:22:32] So in the QE example, which started in 2020, I'm just talking about the post-COVID QE, the Fed was buying assets from the market.

[00:22:46] And that money squeezed the price of assets higher because there was an imbalance between the supply of assets and the demand for assets.

[00:22:58] And that caused risk premiums to fall, which is inverse to the multiple of a stock expanding and caused an extensive rally in assets.

[00:23:15] In QT, the opposite is happening.

[00:23:17] The private sector is being asked to take on more assets than they'd prefer.

[00:23:23] And so savers that may have a fixed demand for assets, now we're seeing a greater supply of assets that results in their price falling to increase the demand that they have to make the market settle.

[00:23:37] And so that back and forth is my third pillar.

[00:23:41] So I'll just read these off because I think they're really good.

[00:23:42] Like, so what are growth expectations?

[00:23:45] What are inflation expectations?

[00:23:47] Flows and positioning and supply and demand.

[00:23:50] Like if you look at those four things, you could probably have a pretty good framework for looking at what's going on in the macro grid.

[00:23:58] Anybody who sits in a position where they, even if your investment strategy or philosophy is not exclusively macro driven.

[00:24:07] If you just need a framework to talk about macro to, I don't know, your dog when you're walking them or your client across the desk from you.

[00:24:16] You should jot these four things down because this is really great.

[00:24:20] And also quick shout out.

[00:24:21] Did you ever read that accounting book?

[00:24:22] I read this years ago and just of all the things, it was like an accounting for dummies type thing, but it was accounting and it was all in terms of running a lemonade stand.

[00:24:31] Did you ever run into this book?

[00:24:33] It was just like teaching you accounting via a lemonade stand?

[00:24:36] I think I basically learned how an income statement, a cash flow statement and a balance sheet work, thanks to a book that explained all this in terms of running a lemonade stand.

[00:24:45] And it was effectively written for children, but also written for adults.

[00:24:50] And it was, I still think of it as one of the most profoundly useful things I've ever read.

[00:24:54] But we'll see if I can find the link.

[00:24:55] I'll share it somewhere if I can find it.

[00:24:57] I have a physical copy of it somewhere.

[00:24:58] The lemonade stand example was great as a way to like simplify this whole thing.

[00:25:01] It's really great.

[00:25:02] And I assume kids still do lemonade stands out there.

[00:25:05] So just the idea of if you have to talk macro with the rest of the world, even if you're not investing with a macro overlay or a very deliberate or heavy handed one, just this idea of like you're, you're picking your assets to pick your assumptions with your vehicles.

[00:25:18] You have some view on inflation because that's going to change your input costs.

[00:25:23] You have some idea of risk premium because as soon as you don't have cash, you should be earning something for it.

[00:25:28] By the way, best explanation of risk premium.

[00:25:30] I think I've ever heard inside of that.

[00:25:32] And then the positioning flow thing, which is what everybody always leaves out.

[00:25:36] I'd actually tag even sentiment into that too, where you have to look at around you and say, how are other people?

[00:25:42] How are my peers thinking about this stuff?

[00:25:44] Maybe my favorite macro framework ever.

[00:25:47] I don't know.

[00:25:47] Do you have any that rank up this high with you?

[00:25:50] No, this is good because, you know, as you know, like I'm a list type of guy from dealing with me behind the scenes.

[00:25:54] So like anything with a list I really like.

[00:25:57] And the other thing I really like about this is in the first two I read, the word expectations was in there.

[00:26:01] And I think that's so important because everybody wants to say, oh, inflation's high or whatever.

[00:26:05] This is what matters is what you think relative to expectations.

[00:26:09] And so when you're trying to set up a framework, like the important thing is not like what is inflation right now?

[00:26:15] Well, the important thing is what are the expectations for inflation?

[00:26:18] What are the expectations for growth?

[00:26:19] And if you're somebody who wants to forecast the macro environment, you have to have different you have to have a different opinion, those expectations.

[00:26:25] And you've got to be right.

[00:26:26] I love and we're so we're recording this coming into the end of, you know, we're recording this on the 12th.

[00:26:32] They'll be out sometime next week, I think it's the end of 2024.

[00:26:34] We are basically in what's your S&P target for 2025 season and all that those type of shenanigans.

[00:26:40] The more important question is what are your assumptions and my my professional work doing all the planning stuff.

[00:26:48] We spend more time on just thinking about the capital market assumptions and where we are against those long term expectations now.

[00:26:56] So, yes, what's the inflation rate today?

[00:26:59] What's the inflation rate in the rearview mirror?

[00:27:02] But then we look forward.

[00:27:03] How far away from it are we right now?

[00:27:05] And what's the expectation for next year?

[00:27:07] You put whatever target you want on the S&P 500.

[00:27:10] The reality is we've just had two years of massive above average returns for the S&P.

[00:27:16] You should be checking that against your assumptions and thinking about how does this net out over a time horizon?

[00:27:21] I actually care about expectations and assumptions, putting those things together and how you communicate.

[00:27:28] That's 95 percent of the battle as far as I'm concerned.

[00:27:31] Have you seen his islands framework on this?

[00:27:33] Oh, yeah.

[00:27:34] The islands Andy uses.

[00:27:35] This is my islands in the stream reference right here.

[00:27:38] This is the.

[00:27:38] Yeah, this is a great.

[00:27:39] It's a great way to think about it.

[00:27:40] Because he talks about you have kind of higher for longer island.

[00:27:42] You have recession island.

[00:27:44] Then you have soft landing island.

[00:27:45] And he talks about like which one he's on.

[00:27:47] But he also talks about which one's crowded.

[00:27:49] And that's a great way to think about expectations.

[00:27:51] Like if, you know, recession island at one point was really, really crowded.

[00:27:55] Like everybody thought we were going to.

[00:27:56] Andy wasn't on there.

[00:27:57] But everybody thought we were going to have a recession.

[00:27:59] So what was important is thinking about how I deviate from that.

[00:28:02] If everybody's on this island and I can be at a different island and I can be right, then I might be able to make a profit.

[00:28:07] So I just thought that was a good way.

[00:28:08] Like thinking about these islands and what's crowded was a good way to think about expectations in that context.

[00:28:13] It's a great way.

[00:28:13] And it gives you that framework because you can start to think about those islands and how many people are on it.

[00:28:18] It's kind of the idea of like how many people are abandoning it.

[00:28:21] We just had the Rosenberg moment.

[00:28:24] And I know Ben Hunt was talking to us about this, what, like a year or maybe two years ago where he was saying the bull market isn't over until we get to the point where David Rosenberg throws in the talent says fundamentals don't matter anymore.

[00:28:37] And I know he was saying that tongue in cheek and in jest.

[00:28:40] But we just had David Rosenberg basically put it out there that maybe the fundamentals don't matter anymore.

[00:28:46] And these are the kinds of things where you're like, oh, my God, he's always on that island.

[00:28:50] He's over on that island now.

[00:28:52] You got to pay attention to this stuff.

[00:28:55] Yeah, I would think the majority of people now are on Soft Landing Island, right?

[00:28:57] I would guess.

[00:28:58] I mean, I'm not hearing too much worry about inflation anymore.

[00:29:01] I'm not hearing, you know, the recession stuff is kind of gone by the wayside.

[00:29:03] So and again, that doesn't I don't I don't know what my divergent view would be because I don't know anything about this stuff.

[00:29:08] But I would assume Soft Landing Island is probably quite crowded right now.

[00:29:10] Soft Landing Island seems to be crowded.

[00:29:12] And we just saw I feel like in the last week or two, I just saw the first countertakes start to show up.

[00:29:18] I saw Colin Roach had some great countertakes on the inflation.

[00:29:21] What if this is deflationary, not inflationary?

[00:29:24] I saw Jared Dillian making some really smart comments on what if people misunderstand what some of Trump's policies can mean for markets.

[00:29:31] And we're just we're starting to get some flavors of that.

[00:29:34] Peter Atwater is over there losing his mind over sentiment with some of the stuff he's seeing.

[00:29:39] These are important contrarian signals that are now starting to crop up where people are pointing out which islands are too crowded.

[00:29:46] And the other thing before we before we go is like a lot of times the islands that are crowded are right.

[00:29:51] And that's one of the challenging things in investing is the consensus is right a lot of the time.

[00:29:54] And so the challenge is you want to have a divergent opinion and you want to be right.

[00:29:58] Right. That's hard to do when the consensus is right a lot of the time.

[00:30:01] Like you've got to be pretty smart and he's done a good job of doing this.

[00:30:04] But like that is the challenge of the whole thing.

[00:30:06] Yeah, it's an unpopular opinion.

[00:30:07] But vanilla ice cream is really fantastic for a lot of things.

[00:30:11] I am very pro vanilla ice cream usually as a compliment in lots of desserts.

[00:30:15] And I love my ice cream.

[00:30:16] I will go way down the rabbit hole on some Ben and Jerry's or other crazy stuff.

[00:30:21] Shout out to ice cream if you would ever come back to life.

[00:30:23] I don't know how I could personally fund you, but you're my favorite ice cream ever.

[00:30:26] You're dearly missed.

[00:30:27] But vanilla ice cream is really awesome.

[00:30:29] And man, you know, you could pair it with lots of things.

[00:30:32] It works really great.

[00:30:33] And sometimes the crowd is right.

[00:30:34] Sometimes the most basic thing is just the greatest thing in the world for an extended period of time.

[00:30:39] You can't overlook that.

[00:30:40] By the way, that ice cream was good.

[00:30:42] The concept behind that, if I remember, was basically we're going to go completely the other direction.

[00:30:45] Like everybody's like healthy and make this better.

[00:30:47] They're like, we're going to make the most unhealthy ice cream we can conceivably make for you.

[00:30:50] Wasn't that the idea?

[00:30:51] This is not a tangent you want to take me down because I cared way too much about this.

[00:30:57] It was, why are people trying to make ice cream healthy?

[00:30:59] What if we made it unhealthy?

[00:31:01] And I remember showing it to a chef buddy and a food chemist and chef buddy and saying like, I think they made crack in a pint.

[00:31:09] And this is my favorite thing ever.

[00:31:11] And I remember both of them looking at the ingredients and they're like, I didn't know you could have this much more fat content than like Ben and Jerry's or whatever.

[00:31:19] But oh my God, was that the most delicious ice cream I've ever tasted in my life.

[00:31:24] So this one, man, I'm not going to talk a lot on this one because this is like right in your sweet spot.

[00:31:28] But we asked Andy, he came on a show with your portfolio series and we asked him how he thinks at a high level about his personal portfolio.

[00:31:35] I hope to describe, so everyone makes mistakes in their investing, in their personal investing.

[00:31:41] I hope to just give you a sense of what I think the right way to do it is.

[00:31:45] And I've made mistakes a lot of times in doing it this way.

[00:31:48] But how I think the right way to do it is and how I'm doing it now.

[00:31:52] And so goals are very important.

[00:31:55] So, you know, when I think about personal finance, the first thing I think about is that I always want to have enough cash available to meet any type of sort of immediate cash need.

[00:32:08] And that could be very from, you know, my daughters will expect a wedding one day.

[00:32:14] That'll be a lump sum.

[00:32:16] And, you know, I've just I'm on the last month of last quarter of semester, I guess, of college payment for my fourth kid.

[00:32:26] So, you know, that took some planning.

[00:32:27] So when you look back, it's all about planning for large expenditures with the right assets to have at the right time to fund those.

[00:32:37] As I look forward, you know, then it is into things like retirement and what, you know, having a lasting retirement.

[00:32:47] And then you have to think about once your retirement is funded, you have to think about if you what your view is on providing for your family after you've passed your estate.

[00:33:03] And things like, you know, what you'd like to give away from for charity, a portion of that estate.

[00:33:10] And that gets into some interesting individual personal dynamics.

[00:33:14] So, yeah, I'll just throw this one over to you, because this was basically I think a lot of the stuff you've been talking about since we've been doing this podcast is pretty much encompassed in this quote.

[00:33:22] And again, going back to what we've talked about before on the podcast, like people expect when we have these really sophisticated investors on, they're going to talk about their advanced macro frameworks and all that other stuff.

[00:33:32] And Andy really got to the core.

[00:33:34] None of that was in there.

[00:33:35] And he got to the core of what is important when you build a personal portfolio.

[00:33:39] One thing that I'm consistently amazed other people are amazed by is I don't care if you have a billion dollars or if you have five dollars.

[00:33:48] These basic tenants are just there.

[00:33:50] They're just there.

[00:33:51] Every single person, no matter how much money you have, you're only going to be alive so long.

[00:33:55] We've got a calendar in front of you of here are the things that matter to and why.

[00:33:59] Andy's big, like have goals, just have goals, state the goals, know when they're happening.

[00:34:04] So you can have a calendar of the things in your life that are happening that you care about.

[00:34:08] You're going to have some understanding of how your cash flows map over the calendar because you're going to have surpluses and deficits along the way.

[00:34:15] When you have a surplus, you got to ask that question.

[00:34:17] Third category, balance sheet.

[00:34:18] If I have a surplus, what am I saving money into?

[00:34:21] Why am I saving money into this thing?

[00:34:23] And if I have a deficit or if I ever need to tap that balance sheet, I have to know how am I pulling this out?

[00:34:29] What am I selling?

[00:34:30] Why and when?

[00:34:30] He was talking about money for his kids in school.

[00:34:33] He saved money at work, surplus in the cash flow, moves out of the balance sheet, goes into a place.

[00:34:38] Hey, I know this tuition bill is coming due.

[00:34:40] Now it can come off the balance sheet, back into the cash flows, satisfy the thing, check the box off on the calendar.

[00:34:46] It's that simple.

[00:34:47] We're all moving through a version of this in our life, in our times and extra bonus points.

[00:34:53] He started to land on it at the end of that clip.

[00:34:56] Everything you make or save that ends up on that balance sheet, you're either going to consume it, meaning pull it back in to spend it, or you're going to gift it.

[00:35:03] It's going to go somewhere else.

[00:35:05] Nothing more than that.

[00:35:06] Go listen to the Peter Mladina interview we did a year or so ago.

[00:35:10] Still one of my favorite interviews we ever had because all the academic research, no matter what, no matter how much money you have,

[00:35:15] you're either going to gift or consume those assets.

[00:35:18] You can have a plan and a goal for each.

[00:35:20] Bravo, Andy Constance.

[00:35:22] Love this personal approach.

[00:35:23] It's so simple because it deserves to be this simple.

[00:35:26] And it's amazing how many even sophisticated investors miss this.

[00:35:30] A lot of sophisticated investors will focus on all these complex strategies in their portfolio, and they'll never thought about it.

[00:35:35] They won't have thought about it.

[00:35:36] Like, oh, I need this amount of money for college at this point, or I need this.

[00:35:39] They really don't do the basic financial planning.

[00:35:41] They really focus on the investment side.

[00:35:43] They focus on generating alpha or generating the best returns, and it lacks this framework, which is why you'll see a lot of smart, sophisticated investors will eventually use a financial planner.

[00:35:52] Even though you think, why would they ever use a financial planner?

[00:35:54] They're so smart about investing.

[00:35:55] But the reality is getting all this other stuff right is way more important than all that outside and all that other stuff, unless you're renaissance or something like that.

[00:36:02] And then it doesn't even matter because you're making such a big return.

[00:36:04] You don't have to play it for anything.

[00:36:05] No, but even then, we work with so many finance professionals, and it's like, oh, you're an executive at a giant asset manager, and you're in private equity, you know, running these funds.

[00:36:15] And those people still need help because you need a framework around this stuff.

[00:36:21] It's really hard to do it yourself, and all of us are busy.

[00:36:24] I use somebody else for our finances.

[00:36:26] Other people in my firm, like we use each other for different things that we do.

[00:36:29] Because you just need a sounding board.

[00:36:31] You need a third body.

[00:36:32] You need a place to keep you in check and make sure you're doing this activity so you don't, you know, so you don't get into trouble.

[00:36:38] Because it's really easy to get into trouble with this stuff or not plan.

[00:36:42] It's extra hard, especially with people building businesses and other stuff too, where they're building private assets.

[00:36:48] And I want to use that as the segue to transition into this next clip about strategy when he was at Lehman Brothers and the restrictions and all that stuff.

[00:36:57] What do we got in this clip?

[00:36:59] Yeah, so it's exactly what you said.

[00:37:00] And I thought this was interesting because we always talk about investing.

[00:37:04] We say, you know, don't worry about what someone says.

[00:37:06] Worry about what they do.

[00:37:07] But there's a little bit of a caveat to that.

[00:37:09] So here's Andy talking about how he managed his money when he was at Lehman Brothers.

[00:37:12] Well, I think my investing philosophy was pretty straightforward.

[00:37:19] Do as well as I could on my salary.

[00:37:22] Try to sell as much of the stock they would hand me for compensation as soon as I could.

[00:37:30] And not really trade or invest at all.

[00:37:33] It was probably dumb.

[00:37:34] But if you've worked at an investment bank, certainly over the last, you know, and the regulations got stricter and stricter and a major hedge fund, you know that you can't trade.

[00:37:53] Right.

[00:37:55] I've been at Bridgewater to codify the way I describe my investing and how I actually invest.

[00:38:01] But even still, at Bridgewater, I couldn't do it.

[00:38:03] And at Brevin, I couldn't do it.

[00:38:05] So that's what I'm saying.

[00:38:09] My personal experience is sort of irrelevant.

[00:38:13] I'm describing a philosophy that I literally could not put in place because of compliance for most of my career.

[00:38:20] Yeah, that's something I think a lot of people miss about the asset management industry is you don't realize, you know, you can't totally translate what people are doing in their personal portfolios because everyone in the asset management industry is under some degree of restrictions in terms of what they can trade and how they can trade it.

[00:38:32] And so they're probably not building the optimal portfolio they would without that, you know, inside of what they're doing.

[00:38:38] And if they worked on the sell side, they're way overconcentrated in, you know, Goldman Sachs or Morgan Stanley or, in my case, Citigroup and Solomon before that.

[00:38:48] I will say that Solomon Brothers was the, during my career, was the worst performing stock in all of the S&P 500.

[00:38:57] Wow.

[00:38:57] And I kept, they just kept giving me stock.

[00:39:00] Well, your move to get rid of it was a good move then.

[00:39:02] Well, you tried.

[00:39:03] I never got rid of enough.

[00:39:06] And certainly those who worked at Lehman and Bear Stearns never got to implement their investment strategy as their stocks went to zero.

[00:39:15] The part that I liked about this is there's always external factors.

[00:39:18] You know, we like to say, like, let's look at how people manage their portfolios and what they're actually doing with their money.

[00:39:23] And that's a bad idea probably anyway, because everybody has different, you know, life circumstances.

[00:39:28] But there's always these external factors sometimes that you don't think about when you think about that.

[00:39:32] And so he was talking about, and this is true of a lot of us in this business, you know, less so me because I'm running a small company, but people who work at Big Advisors, it's definitely true, is people in this business have to run everything they do through compliance.

[00:39:42] They have restrictions on what they can do because of compliance.

[00:39:44] So their ideal optimal investment strategy that they might be running, if they could do it unrestricted, is probably not what they're running because of those restrictions.

[00:39:52] So I thought that was a really interesting point, because when we do these show us your portfolios, we want to say, like, all right, what this guy is doing is obviously what he thinks is the best thing he could be doing.

[00:40:02] But sometimes it's not the case because sometimes they're under restrictions and then they have to adjust their strategy because of them.

[00:40:06] Yeah, it's just the operational reality of our line of work.

[00:40:10] And it's also the reality about how you get compensated.

[00:40:14] Jared Dillian, other Brent Donnelly, people, other people we've talked to at Lehman, almost all of them will tell you they would get paid in the stock options.

[00:40:21] And then even when the stock was on a rocket ship, they felt dumb about it, but they would they would be selling the stock every time as fast as they would get it.

[00:40:28] And part of the idea was I'm so concentrated on what the firm is doing.

[00:40:32] I'm so concentrated the idea of your triple net long, you know, either U.S. GDP or to your employer, where basically your job, the business you own or work for and your portfolio are aligned.

[00:40:42] That's not diversification.

[00:40:44] So if I have these ideas, just figuring out in a compliant way how I can start to have some of the capital to express these views, especially when they're diversifying, they're they're kind of everything.

[00:40:55] You got to have a plan for how you're going to approach this.

[00:40:57] It takes some outside the box thinking.

[00:40:59] And I was really thinking about the tech stocks of today when you were saying that I was thinking about, let's say let's say I worked in video right now.

[00:41:05] Like on one side, the financial planning move is I should be as I'm getting my video stock.

[00:41:10] I should have been selling it all along because I'm over concentrated video.

[00:41:13] But it was said by the same token, like it's kept going up the whole time.

[00:41:16] I would give it up massive amounts of gains by doing that.

[00:41:19] And I would have to think as someone sitting in video, like probably with millions of dollars of stock, like that's got to be a really, really tough thing to do properly.

[00:41:27] Really tough to do properly and really hard.

[00:41:29] There was a there was a financial planning article that I'm not going to be able to cite, but I'm sure you could find.

[00:41:34] And it was basically about how Kim Ruffer was in the charitable foundation or in a separate trust.

[00:41:40] But Jensen, Jensen Wang and his his spouse or whatever, basically stuff that they had funded years ago and how it's like, well, that, you know, that decision is worth, you know, eight or nine billion dollars now or some crazy amount of money.

[00:41:52] But it was just you have to have a framework and even inside a compliance where you can't sell or you can't necessarily transact in some way.

[00:42:00] How do you get the right amount of distance between you and this thing that could really decide your fate if you're not being proactive and how you're you're interacting with it?

[00:42:08] It takes work, takes asking for help, probably figuring out a intentional way around not painting yourself into a corner.

[00:42:15] Do you have any ideas like in terms of when you work with clients like that, like who have this concentrated positions, they're getting more of it.

[00:42:21] Like, how do you get them to make the right decisions?

[00:42:23] And especially when it goes, because I would think as a financial planner, if you were working with someone with an NVIDIA right now and you've told them, oh, you know, we've got to keep stuff on the stock along the way.

[00:42:30] They're probably about to kill you because it keeps doubling every year or whatever.

[00:42:34] Like, that's got to be a hard balance to strike.

[00:42:35] Yeah, I mean, it's hard enough to get people who have been buying NVIDIA along the way who aren't the owners of or employed by to do this type of stuff.

[00:42:44] Something we've seen regularly and I think this is the most powerful way it shows up.

[00:42:50] When people build any type of asset, usually through it's almost always through employment.

[00:42:55] So it's usually it's either you're getting stock options because you work for a company who's a rocket ship or you're building your own business and that business has been a rocket ship.

[00:43:05] The place that always brings it home is when we do that calendar cash flow balance sheet exercise.

[00:43:10] It's when we get to the balance sheet and we deliberately show people their balance sheet after we construct it in two ways.

[00:43:17] We show it to them as a pie chart.

[00:43:18] So everything is expressed as a percentage.

[00:43:20] And then we show them as as line items, basically as dollars, like you would read it on a financial statement as a balance sheet.

[00:43:27] And then we help them play that out through time using Monte Carlo, using some other stuff, too.

[00:43:32] And we want to say to them, whether that's a tech stock or whether it's, you know, your, you know, family chain of barn and boot stores or something crazy.

[00:43:41] Whenever that is, when they see that pie chart and they all of a sudden go, oh, I feel rich.

[00:43:46] I feel like I have money.

[00:43:47] I have these questions.

[00:43:48] But they're going and I'm 90 percent tied to this one area.

[00:43:53] That's the proverbial oh shit moment.

[00:43:56] That's when people go, I knew I had a lot in this, but I didn't really think about it in context to everything else I have going on inside of that portfolio.

[00:44:06] That pie chart is worth its weight in gold just to make for people to just visualize how much of their life is tied to this one thing.

[00:44:14] And it's a great way for to introduce the estate planning conversation.

[00:44:17] It's a great way to introduce some of the tax planning conversation.

[00:44:20] And just to say, like, congratulations, this little thing grew into this giant thing.

[00:44:24] Do you want to keep it that way?

[00:44:27] Which, oh, OK, if you do, let's see how we can remove the risk.

[00:44:31] But if you don't, we have to contend with you have a massive amount of concentrated risk in the portfolio.

[00:44:37] And it kind of goes back to that earlier idea when he was talking about it, too.

[00:44:41] You know, be 99 percent systematic if you can.

[00:44:43] And even Bridgewater saying that 20 billion dollar idea, not for us because it's not long term repeatable.

[00:44:50] And it's great to see both sides of the coin with this.

[00:44:52] And that's kind of what Andy's clip did, because you're in video right now.

[00:44:54] You're working in video right now.

[00:44:55] You're like, why am I selling the stock?

[00:44:56] This is the worst decision ever.

[00:44:58] If you're at Lehman, you're like, how why didn't I sell more stock?

[00:45:00] Like, I should have gotten as much out as I possibly could.

[00:45:03] So it's good to see that there are there are both examples on both sides of this.

[00:45:06] And maybe for somebody who's concentrated in a certain stock, like understanding that there is another side of the coin and this can go south is probably a good thing.

[00:45:12] One of one of my favorite lessons, I'm pretty sure I told it here before, is at working at Bank of America Merrill Lynch.

[00:45:19] So working at Merrill in the financial crisis era.

[00:45:21] And there was this guy, a little bit pompous, whatever else, but he was highfalutin guy with, you know, all of his stock and everything else.

[00:45:29] And he gets divorced in like 2007, let's say.

[00:45:33] And so he gets divorced in 2007, pissing and moaning all the way about like how much stock his wife got and all the other things and how dumb the ex-wife was because she got all this money and got the house and her half that she was entitled to.

[00:45:49] And how dumb is she that she sold everything?

[00:45:52] She cached out.

[00:45:53] And what a joke she was.

[00:45:55] And I watched that guy in the years that followed, knowing that he was all in on one company and that it was all gone.

[00:46:05] It was all gone, all in.

[00:46:07] And he thought she was the dumbest person ever.

[00:46:09] And man, all the times that he would just, I would overhear him talking about this thing and then thinking about it.

[00:46:15] You need to see some of that hubris, I think, in person to experience just what that risk looks like.

[00:46:20] I'll never forget that lesson.

[00:46:22] So this last one is another framework.

[00:46:24] And this is a good one for me because we just had that yen carry trade blow up thing.

[00:46:28] And that obviously ended up being a very, very small thing.

[00:46:31] But that's part of like a bigger group of things, which are these deleveragings.

[00:46:34] And these deleveragings can be small yen carry trade.

[00:46:38] They can be massive 2008.

[00:46:40] And it's interesting for me to think about like looking at it from the outside.

[00:46:43] How can I judge these things?

[00:46:44] What kind of framework can I have?

[00:46:46] So here's Andy on the four things he looks at when he evaluates deleveragings.

[00:46:49] So I'll give you the high level framework, which is who's selling?

[00:46:54] That's an important piece of the information.

[00:46:58] Is it one guy like in 1997 where a, you know, 15% drawdown occurred because one guy was forced out of his puts because he was exposed to tie bot stocks?

[00:47:12] It doesn't seem like that here.

[00:47:15] Is it systemic?

[00:47:17] That's the other extreme in which dealers, banks, insurance schemes are being forced to unwind in large quantities.

[00:47:32] There's no sign of that as far as I can tell.

[00:47:35] And so it falls somewhere in the middle.

[00:47:37] And I would describe the sell-off as broad across many assets and impacting many different types of investors.

[00:47:46] And when I step back and say, what is the, prior to the deleveraging, what did I think the environment looked like?

[00:47:53] I would say the following, which is assets were very well bid up.

[00:47:57] There was an expectation that the central banks were on an easing path.

[00:48:02] That, you know, even still earnings expectations were extremely high for the next two years.

[00:48:09] Multiples were very high.

[00:48:11] Fixed income risk premium was very low.

[00:48:15] BAL was very low.

[00:48:17] And all of those things are consistent with investors at a fairly high level of leverage.

[00:48:24] And you can look at other forms of leverage.

[00:48:29] How much repo is being done?

[00:48:32] What is the cost of repo that's seen in swap spreads?

[00:48:36] So how much demand for leverage is there?

[00:48:39] Margin loans, existing margin loans.

[00:48:42] And what I would have described, and what I have been describing, is that the system's pretty leveraged and asset prices are not very attractive.

[00:48:51] And so that's a good circumstance for a broad deleveraging.

[00:48:55] And I'm not talking about a stock market crash.

[00:48:56] I'm just talking about, you know, let's get some of the leverage out.

[00:49:01] And it's important to note that it's not like when the system is leveraged, say the overall system is leveraged two to one.

[00:49:15] And there's a deleveraging.

[00:49:22] A new investor that is buying the positions that are being sold needs to lever.

[00:49:30] And they're not going to lever two to one.

[00:49:32] If so, the market price isn't going to change.

[00:49:35] They're going to want to lever, I don't know, one and a half to one.

[00:49:38] And the only way to get that, meaning the leverage gets paid back by one and new leverage is created by another.

[00:49:46] The only way to deal with that is a price decline.

[00:49:49] And so I'm just talking about a classic deleveraging correction.

[00:49:54] We saw it in 2018 when the Fed was too tight.

[00:49:58] We saw it in 2022 in the midst of the market sell-off when the UK LDI scheme unwound.

[00:50:07] We saw it in the SVB situation.

[00:50:10] So those are recent cases.

[00:50:12] And obviously we saw versions of that throughout history.

[00:50:17] And so that's what's happening.

[00:50:20] The next bit of – so that's who's selling and why.

[00:50:24] And the answer is broad and asset prices are not particularly attractive.

[00:50:30] And there's a high amount of leverage in the system.

[00:50:33] So that's who's selling.

[00:50:34] That tends to mean that it lasts longer than if one or a few people are being delevered like Bill Wang or Victor Niederhofer or some of these other cases where it was very narrow deleveraging.

[00:50:49] So it's broad and that's the first part of the framework.

[00:50:53] The second part is, you know, how are financial institutions doing?

[00:50:57] Because there's only been one major situation where the financial system had all of the same positions as the private sector.

[00:51:08] And they were forced to delever and they were unable to offer credit.

[00:51:15] In fact, they had to take away credit from their existing clients.

[00:51:18] And that was the GFC.

[00:51:22] Now, there have been other times where, for whatever reason, these banks are either in the same position – 1998 is a fairly good example of that – or are constrained in some way in terms of how much leverage they can have, but they're not contributing.

[00:51:39] So that's a metric.

[00:51:40] How are financial institutions?

[00:51:42] And the better shape they are and the least exposed they are to the deleveraging, the shorter it's going – the shallower it's going to be and the shorter it's going to last.

[00:51:52] And right now, they're in great shape.

[00:51:54] So that would be a signal that – that would be a circumstance where one would expect a deleveraging to be shallower and quicker.

[00:52:07] And then you have said the impact on the economy.

[00:52:11] And, you know, when you look at deleveragings, whether it's 2000 or 1998 or COVID or the ones that didn't have impact on the economy, some of these deleveragings can be causal to an economic slowdown.

[00:52:35] And, you know, that has an impact on the – when there is an economic slowdown that is caused by the deleveraging, it takes a long time for the bottom to get to be in a deleveraging.

[00:52:50] And then the last thing is, what do the central banks do?

[00:52:54] What do policymakers do?

[00:52:56] And, you know, now we're in a world in which part of the policymaking can be fiscal spending, which we saw in COVID, and to a little – a medium extent what we saw in the SVB crisis.

[00:53:11] The – whether the central bank or fiscal does anything is an important criteria in terms of whether there's going to be a bounce.

[00:53:22] The strength of their response will obviously have a meaningful impact on those things.

[00:53:29] You know, if you look at the COVID crisis, which, you know, is exogenous, the market corrected in one month, made its low in one month.

[00:53:39] And I think it was 120 days later was back to its all-time high.

[00:53:47] That's because of the strength of the response.

[00:53:50] And so it's super important to judge whether this will elicit – whether it will affect the economy and whether it will elicit a Fed reaction.

[00:54:03] And, you know, Jeremy Siegel called for 75 basis points, cuts it on Monday.

[00:54:07] You know, that was an incredibly stupid thing to say, emergency cuts.

[00:54:11] He since retracted that as the market stopped panicking.

[00:54:16] But there isn't – it's interesting to note that in 1987 and in the long-term capital crisis,

[00:54:24] the entire cuts that occurred in the greatest stock market crash in history and the biggest hedge fund unwind in history in which equities fell 20% in two months,

[00:54:36] the Fed cut 75 basis points in total.

[00:54:41] So you have to judge whether there's going to be a bazooka-like response.

[00:54:48] I would look at the SVB crisis and it was short and sweet because the response was over the top.

[00:54:57] Whereas I'd look at the – but it was a meaningful event.

[00:55:04] I'd look at the LDI crisis and say, you know, the BOE had a rifle shot right to where it was needed.

[00:55:13] They bought some bonds back.

[00:55:16] They redid QE.

[00:55:18] But immediately after – and that solved the problem.

[00:55:21] Now, of course, trust being kicked out really was the problem.

[00:55:27] But from a financial standpoint, that problem was solved very quickly.

[00:55:30] And then the stimulus was removed, whereas in the SVB crisis, we're still living with the $106 billion worth of BTFP that doesn't expire for another year.

[00:55:45] And so that's easier than – and probably disproportionate to what was happening back then.

[00:55:52] So anyway, that's the overall framework.

[00:55:55] Four colors.

[00:55:56] Who's selling?

[00:55:57] How are the banks doing?

[00:55:58] What's the economy going to do?

[00:56:00] And what are the central bankers going to do?

[00:56:03] And you have to judge for yourself where we are in that framework and what the likely outcome will be.

[00:56:08] So again, just to reiterate these, like number one, who's selling?

[00:56:12] Number two, how are the financial institutions doing?

[00:56:15] Number three, what is the impact on the economy?

[00:56:17] Will it cause a slowdown?

[00:56:18] And number four, how will policymakers react?

[00:56:21] So that is a really good thing to look at.

[00:56:24] Like those four things will probably tell you a lot about – if you are confronted with another deleveraging in the future, which we certainly will be,

[00:56:31] like they'll probably tell you a lot about how it's going to play out.

[00:56:34] I know it's a long clip.

[00:56:36] I encourage everybody to play it once, play it twice, play it back, slow it down if you have to, and take notes.

[00:56:42] Because when you start to map this against the islands framework or those four pillars of macro,

[00:56:48] you really start to understand the questions you want to ask about how systemic, how big could this situation be, and how concerned should I be with it?

[00:56:56] Because understanding who is selling and what the response is, how forced is it, how just is of a singular one-off, one-liner this is.

[00:57:06] Because this is such a useful framework for giving context to what historically have been the biggest market-moving events in the history of the world.

[00:57:15] They've all been massive deleveragings when they turn into this stuff.

[00:57:18] I'm not saying this will make you predict the next one or put you in a position where you're able to predict the next one,

[00:57:23] but it certainly helps you ask the questions around the margin of what could this mean when not just the first domino has fallen,

[00:57:29] but several of them have fallen right behind it.

[00:57:32] Yeah, and this was like, going back to the yen carry trade thing,

[00:57:35] this was maybe a framework that has helped you understand this was not 2008.

[00:57:39] Exactly.

[00:57:39] The financial institutions are doing okay.

[00:57:41] It's not a huge problem.

[00:57:42] This is probably not something that's going to have a major impact on the economy.

[00:57:46] The policymakers are not going crazy.

[00:57:48] Like, it's just, there's all kinds of things that would have told you, you know,

[00:57:52] maybe this is not that big of a deal if you would use this framework.

[00:57:56] And I think, I know he doesn't get too deeply into this in the clip, but it's an interesting,

[00:58:01] the point you just made.

[00:58:03] You start to see the dominoes fall, and then you can understand if it fizzles out.

[00:58:07] It's kind of in Looney Tunes when Wile E. Coyote lights the fuse,

[00:58:10] and like it goes halfway down, and then it stops, and he has to do it again,

[00:58:13] in whatever the sequence is.

[00:58:15] Sometimes, like the yen carry trade, you go like,

[00:58:17] oh, this looks really scary.

[00:58:19] Somebody lit the fuse.

[00:58:21] I see this giant reserve currency disaster on the other end.

[00:58:25] But sometimes that fuse just fizzles out.

[00:58:27] How many times have we almost been in a commercial real estate crisis

[00:58:30] in the last, what, four years since COVID?

[00:58:34] Like how many almost commercial real estate crises have we had?

[00:58:39] Yeah, a lot.

[00:58:40] And there's always going to be these doom and gloomers that are predicting this thing.

[00:58:43] Remember that YouTube channel I sent you the other day?

[00:58:45] Like I sent you all the covers.

[00:58:45] So good.

[00:58:46] They were all, they were off the just horrific, like the world is coming to an end,

[00:58:50] catastrophe type covers, and like this channel was just making a killing.

[00:58:53] But you just have to know that's out there.

[00:58:55] Like people are always calling for these things.

[00:58:57] And so it might be good to have a framework to say, all right, you know,

[00:59:01] commercial real estate is about to collapse.

[00:59:02] All right, let's look at a framework and how that might affect the market,

[00:59:06] the economy as a whole.

[00:59:07] Let's maybe apply this framework.

[00:59:08] I think with all these things where you see these doom and gloom things,

[00:59:10] this can probably help you to have maybe the proper context around it.

[00:59:14] 100%.

[00:59:15] All of Andy's stuff, it's all about giving you a context, a way to think about this stuff,

[00:59:19] a way to communicate this stuff.

[00:59:20] And I don't know if I can sell my gram this one.

[00:59:23] Maybe I can texture this clip next time, you know, some banks are blowing out.

[00:59:26] But this is really useful just, again, to think through.

[00:59:32] If this is going to turn into something major,

[00:59:35] here's all the phases it has to pass through.

[00:59:37] Here's how you want to think about it.

[00:59:38] If it's going to fizzle out into something more minor,

[00:59:41] here's how you also want to think about it.

[00:59:43] And hey, opportunistically in the middle,

[00:59:45] especially when these things fizzle out.

[00:59:47] I'm thinking about the Silicon Valley bank collapse just a year and change ago now

[00:59:51] where it made a pretty big opportunity on the back end

[00:59:54] if you realized that wasn't going to keep spreading.

[00:59:57] And as I've said before, I'm going to throw all these out.

[00:59:59] I'm just going to worry about if Matt Ziegler is selling.

[01:00:01] That's my one-step framework.

[01:00:02] If you're selling, I'm going to follow my newsletter.

[01:00:05] The whole system is about to break down.

[01:00:07] Follow my newsletter.

[01:00:07] You'll be able to tell by the YouTube clips, by the title cards,

[01:00:12] how much fire and explosion you see behind me.

[01:00:14] That's how you'll know.

[01:00:16] That's probably a good note to wrap up on.

[01:00:18] We'll see everyone next time.

[01:00:19] Thank you for joining us.

[01:00:19] Hi, guys.

[01:00:20] This is Justin again.

[01:00:21] Thanks so much for tuning into this episode.

[01:00:24] You can follow Jack on Twitter at practicalquant.

[01:00:27] You can follow me on Twitter at JJCarbono.

[01:00:30] And follow Matt on Twitter at cultishcreative.

[01:00:33] If you found this discussion interesting and valuable,

[01:00:36] please subscribe in either iTunes or on YouTube

[01:00:38] or leave a review or a comment.

[01:00:40] Also, if you have any ideas for topics you'd like us to cover in the future,

[01:00:44] please email us at excessreturnspod at gmail.com.

[01:00:48] We would like this to be a listener-driven podcast

[01:00:50] and would appreciate any suggestions.

[01:00:52] Thank you.