Global Macro Podcast Series | featuring Michael Green · Global Macro Podcast Series | featuring...

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GlobalMacroPodcastSeries|featuringMichaelGreen

IfI’mrunningadiscretionaryprogramandthat’sgoingintosomeformofastructuredproduct(andthisdoesn’thappenforpreciselythisreason),ifIchoosetodosomethingthatisdifferentthanIwouldhavedonehistorically,thentheresultsofthatproductcouldbeverydifferentthanIhaveadvertisedthemforandI’dbecomeliable.So,I’mforcedintoaquantitativesystem.That'sactuallypartofthereasonwhyIpartneredwithWayneisthatIrealizedthatuntiltheruleschangethereis,actually,nosubstitutetoadocumentedquantitativeprocess.

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Introduction

Forme,thebestpartofmypodcastingjourneyhasbeenachancetorefinemyowninvestmentframeworkthroughaseriesofconversationswithextraordinaryinvestorsineverycorneroftheworld.Inthisseries,Ialongwithmyco-hosts,RobertCarverandMoritzSeibert,wanttocontinueoureducationbydiggingdeeperintothemindsofsomeofthethoughtleaderswhenitcomestohowtheworldeconomyandglobalmarketsreallyworktotryandlearnhowtheythink.

Wewanttounderstandtheexperiencesthathaveshapedthem,theprocessestheyfollow,andthehistoricaleventsthathaveinfluencedthem.Wealsowanttoaskquestionsoutsideournormalrules-basedplayground.We'renotlookingfortradeideasorrandomguessesaboutanunknownfuturebutratherknowledgeaccumulatedoverthecourseofdecadesinthemarketstotrytomakeusbetter-informedinvestorsandwewanttosharethoseconversationswithyou.

OurGuesttodayisoneoffewrealindependentthinkersandastudentofmarketsandmarketstructureand,perhaps,theleadingmindwhenitcomestohowthegrowthofpassiveinvestingischangingmarketsinawaythatfewpeoplerealize.So,I'mabsolutelyconvincedthatyouwillhaveyoureyesopenedfromourconversationtodaywithMichaelGreen,ofLogicaCapitalAdvisers.

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Niels:Mike,thankssomuchforjoiningustodayforaconversationaspartofourminiseriesintotheworldofGlobalMacrowherewerelaxourusualsystematic,orrules-basedframework,toprovideyou,withabroadercontextastowhereweareinaglobalandhistoricalframeworkand,perhaps,discoversomeofthetrendsthatmayoccurintheglobalmarketsinthenextfewmonthsorevenyearsand,ultimately,howthiswillimpactallofusasinvestorsandhowweshouldbestprepareourportfolios.

So,we'resuperexcitedtodiveintomanydifferenttopicsinthenexthourorso,notleastbecauseyouhavedonealotofworkonsomeofthestructuralchangesinthemarketsduetohighlevelsofpassiveinvestingthatI'msurewe'llbespendingsomeofthetimeon.Letmejustkickitoffwithakindof30,000-footquestion,Mike.Wheredoyouthinkweareinabigglobalmacropicture?

AsIhavesaidbeforeinthisseries,itfeelstomethatit'sablendofthingswe'veseenbefore,inthepast.Alotofpeoplecomparethistothe'30sand'40s;theJapanesebubbleinthelate'80s;ofcourse,theTechBubble;GreatFinancialCrisis;then,ofcourse,wehaveaddedsomethingbrandnew,namelyaglobalpandemicwhichmakesitprettyunique.Howdoyouseeitrightnow?

Mike:So,Ithinkthosecomparisonsareoftendrawnintermsofwherewearerelativetohistory.Ithinkoneofthethingsthatishardestisthatweallknowthephrase,"Historydoesn'trepeatbutitrhymes."So,we'reconstantlylookingforthosepatterns.Ihavehadtheviewforawhilethatit'sverylazytocomparethetimeperiodthatwehavegonethroughtothe1930s-thisideathatwe'reinthisgreatglobaldepressionfollowingtheglobalfinancialcrisis.

TheprimarypushbackthatI'dhaveagainstthatisthecontinuinggrowthofwealthdisparity.Inequalityhascontinuedtoexpandandthe1930swereverymuchaninequalityequalizationtimeperiod,particularlyafterthe1929to1932timeperiod.IfanythingIthinkwe'restillinthe1920sand,potentially,haven'tseenourglobalfinancialcrisisyet.

Niels:I'msureyoufollowalotofthepeoplewefollowaswellbutitkindoftiesin,alittlebit,totheFourthTurningfromNeilHowewhere...

Mike:Yeah,he'safriendofmine,yeah.

Niels:Wherehesays,"Youknow,thefirstcrisisthatyouthinkisthebigonemayactuallynotturnouttobethebigone.Thatcomes,usually,attheendoftheFourthTurning."Weknow

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thathepredictsthattobethisdecade,so,that'sprettyinteresting.Ofcourse,yourfriendatRealVision,RaoulPal,hetalksaboutthethreephasesthathe'sseeing:theunraveling;nowwe'reinthehopephaseofthecurrentmarket;thencomestheinsolvencyphase.Doyouthinkinthesametermsor..?

Mike:Idothinktherearealotofsimilaritiesinthelineofthought.So,thebiggestconcernthatIhave,andIdidaninterviewwithRaoul(IthinkitwasApril8th,sofairlysoonafterthe"bottom"),andmyobjectioncontinuestobethatitfeelslikeweareprojectinghistoryontothefuture.So,we'resaying,"Thishastohappen."Thechallengeincomparingthe1920sandtodayisthatinthe1920swehadaconvertiblecurrency.Itcouldbeconvertible,anditwasconvertibleintogold.So,thelevelofdefaults,thelevelofuncertaintyintermsofpeople'sabilitytosourcedollarstoservicethedebtwasmuchmoreconstrainedinanenvironmentofthegoldclause.Wedon'thavethattoday.

So,toexpectthesameoutcomes;toexpectpolicymakerstositbyandsay,"Ourhandsaretied,"astheywatchthepotentialunravelingofthesystem,Ithink,ishard.So,Ithinkwe'llcontinuetogetlotsofsignalsfromthemarketthateffectivelysaytheequivalentof,"Hey,payattentiontous.Youhavetorespond.Wehavetodosomethingorthatwillhappenagain."Ithinkwewillcontinuetoencounterthosetypesofcrises,buttoexpectthesameoutcomeswhenyouhavearadicallydifferentcurrencystructurethanyoudidinthe1920sandthe1930s,Ithink,feelsstrange.

Niels:Hmmm,sure.

Rob:Ireallylikethepointthatyoumadeaboutinequalityincurrenciesbecausenormallyyou'reright.Assetpricesgetsmashedincrises,dividendsgetsmashedandthewealthierpeoplewhoownthoseassetstendtoseetheirincomereducing.So,that'sreallyinteresting.Itdoessuggestthateitherwe'renotthereyetorthiscrisismaybetrulydifferent.IwanttoleadthatintoasubjectthatIknowyouhavetalkedaboutalotbeforewhichispassiveinvesting.

Mike:Itwillbewhatmytombstonewillsay.(Laughter).

Moritz:Welldeserved.

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Rob:So,Ithinkonethingaboutcrisesliketheseisthattheymaycausethesebigseculartrendsthatweseeandthingssortofreversepartlyorcompletely.Obviously,therehasbeenabigriseinpassiveinvestingoverthelasttwentyyears,Iguess,possiblygoingbackfurther.Doesthisfeelliketheremightbeachangehere?

So,there'salittlebitofanecdotalstuffgoingon.There'sthisinvestmentasentertainmentthesis.ItdoesseemliketherearemoreindividualinvestorspilingintoRobinhoodandbuyingindividualstocks.

Ifyou'reinvestingforentertainmentyou'renotgoingtogoandbuyakindofboring,marketcapweightedETF,you'regoingtowanttobuyindividualstocks,storystocks,namestocksandhavesomeexcitement.So,that'sonethingthat'sgoingon.ButIdowonderwhetherthiscrisis,generally,couldcausethattrend,potentially,tostoporevenreverse.Maybethereareotherexplanationsofwhatcouldbegoingonthere.

Mike:So,theonethingthatIalwayshighlightforpeoplewithpassiveisthatthegrowthofpassiveisnowbasicallybuiltintothesystem.Fromaregulatoryframework,allthenewmoneythatcomesintotheU.SSavingsandInvestmentaccounts(primarilyintheformof401KsandIRAs),arecominginpassivevehicles.

So,thisisactually,bylaw(ornotquitelawbutcertainlybyregulatoryfiat),intothe401Kspace,wherecorporations,becauseoftheDOL'sfiduciaryrolethatdidn'tfullygointoeffectbutwentintoeffectenoughthatitcausedthechangesthathavereinforcedthis.Ifyouareacorporationandyouoffera401Kplantoyouremployeesandyouofferthemaplanthatdoesnothavethecheapestandlowestcostindexfundsinit,thenyouactuallybecomeliable.Youbecomeliablenotjustfortheaccessfeesbutyouactuallybecomeliablefortheunderperformancethatcouldpotentiallyaccrue.

Nobodysignsupforthat.That'snotwhatcorporationsdo.Thatisactuallywhytheywantedtogetawayfromdefinedbenefitplans.Theydidn’twanttoberesponsiblefortheoutcomes,theywantedtoberesponsibleforthecontributions.So,theentiresystemhasaggressivelyshiftedtoconvertingthoseinflowstocominginthroughpassivevehicles,primarilythroughthingsliketarget-datefunds.Atthispoint,we’relookingatwellover100%ofthenetflowsthatcomeinto,particularly,theequityspaceandincreasinglyinthefixedincomespacearecomingintheformofpassivevehicles.Untilthatchanges,untilweactuallychangetheregulatorystructureIhaveahardtimeseeingitreverse.

Moritz:So,inessence,thismeansthattheHRrepresentativeisthenewCIO.

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Mike:That’sexactlywhatitmeans.

Moritz:Thoseguysmakethecalls.Theysay,“We’redoingthis,we’rebuyingtheS&P500,orwe’redoingwhateverthecasemaybe.

IliveinGermany,andit’sthesamething.Longgonearethedayswhereretirementmoneywasallocatedtoamutualfundmanagerandtheywerediscretionarilytradingstocks,buyingvalue,whateverthecasemaybe.Rightnowallofthoseproductsarelinkedtoanindex,beittheDAXindexortheEUROSTOXX50andtheymayhaveaguarantee.So,there’salongputoptionorsomesortofaguaranteeforretirementattachedtothataswell,butitisanindexproduct.Andalloftheflowshappenataboutthesamepointintimewhichistheendofthemonthforthebeginningofthenextmonth.Thatisthesweetspotwhereallthemoneyflows.

Ithinkwhatonecansee,anditamazesme,isthat...Well,firstoff(thishasbeenlongreported),theaveragecorrelationandtheaverageco-movementbetweenstocksincreases.Butwhatyoualsoseeisthatthebreadthofthemarketchanges.AllofasuddenallofthestocksintheDAX,forinstance(whichhas30stocks),areabovethefiftydaymovingaverage.Ithappensmoreregularly.Whereas,previously,tenyearsback,itwasa50/50typeofthing.Nowit’sno,no,no,that’snota50/50typeofthingthat’sa95%oddsthatifonestockisabovethefiftydaymovingaveragealltheothertwenty-nineareabovethefiftydaymovingaveragetoo.

Mike:Well,that’soneofthebiglegaciescomingoutoftheglobalfinancialcrisis.So,thereasonwhyallthoseproducts(inoneformoranother)arereferredtoasindexproducts,isbecause,again,youdon’twanttoattachanyformofliability.

IfI’mrunningadiscretionaryprogramandthat’sgoingintosomeformofastructuredproduct(andthisdoesn’thappenforpreciselythisreason),ifIchoosetodosomethingthatisdifferentthanIwouldhavedonehistorically,thentheresultsofthatproductcouldbeverydifferentthanwhatIhaveadvertisedthemforandI’dbecomeliable.So,I’mforcedintoaquantitativesystem.That'sactuallypartofthereasonwhyIpartneredwithWayneisthatIrealizedthatuntiltheruleschangethereis,actually,nosubstitutetoadocumentedquantitativeprocess.

Youjustcan'trunonadiscretionarybasis.Youcanshowabacktestifyouhaveaquantitativeprocess.Aninstitutionalinvestorcandisregardthat,butthosebacktestscanbeusedforthingslikesellingavariableannuity.Thosebacktestscanbeusedforfixedincomeannuities.Thosebacktestscanbeusedforstructuredproductsintermsofthemarketingofthoseproducts.Theonlyrequirementisthatyouhavetostickbythem.

WehavesostackedthedeckagainstdiscretionaryactivemanagersthatI'mnotreallyevensureit'sagameworthplayingunlessyouchoosetoactuallychangeyourprocesstotake

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advantageofthefuturesinthemarketandvery,veryfewpeoplearedoingthat.It'shard.Youhavetobendyourmindandchangeeverythingthatyouhavebeentaughtforthepasttwenty-fiveyears.

Niels:I'msurewe'regoingtotalkmoreabouttheeffectsofpassivegrowingintermsoftheequityspace,butjustoutofcuriosity,areweseeingexactlythesametrendsonfixedincome?Ispassivealsodominatingtothesameextentorisit,infact,maybebecauseyieldsaresolowpeoplearesaying,"Wow,IneedtofindanactivemanagerbecauseIcan'tlivewithzero."

Mike:Thefixedincomespaceisabouttenyearsbehindtheequityspaceintermsofthegrowthofpassive.Intermsofindividualdiscreetallocations,therehasbeenatremendousamountofgrowthintheETFsandthefixedincomespace.Inparticular,theyhavebeenwidelyadoptedbyfixedincomemanagers.Theyusethemtoaccesssomeformsofliquidity.Again,ifIlookattheinvestmentpublicintheUnitedStates,byfar,thelargestsourceofgrowthinthefixedincomespaceisthroughthetarget-datefundsthemselves.

So,theVanguardandBlackrockandCapitalGroupvehiclesthatdominatethatspace,betweenthethreeofthemtheyholdwellover50%ofthetarget-datefunduniverse,thosearereallytheprimarysourcesofgrowth.Thosehavetheirownindexconstructionproblemsthat(inmyopinion)actuallyexacerbatemanyoftheproblemsthatwe'reseeing.So,fixedincome,Iwouldactuallysay,isanalogoustotheindexingoftheU.S.equitymarketspriortothedot-comchanges.Thereisjustastructuralmistakeinthewaytheindicesareconstructed.

Moritz:Andinadditiontothat,Iwouldsay,wehave,intheU.S.,thefixedindexannuitiesandtheVAtypeorproducts,essentially,allofwhichareindexedlinked.Ifthey'renotindexedlinkedtoindicessuchastheS&P500,theyarelinkedtocustomindicesproducedbyQAStypeofbankstrategieswhich,themselves,probablymakereferencetoanindexagain.

So,it'sself-referencinginsidetheproductbacktoanindex.Thoseproducts,bytheway,arealsostrongly,stronglygrowinginAsia,Singapore,HongKong,Taiwan,toacertainextentstillJapan.So,thistrainseemstohaveleftthestationandgainedspeedthatmoreandmoreofthemoneyisgoingpassive.

Onewonders,what'stheendgamewiththat?Howlongwillthatgoon?Priceinsensitivebuyingandsellingatsettlementorclose,linkedtoanindex,withoutanyconsiderationof(let'sjustcallit)valueorfairprice,whendoesitstop?Whenwillitbreak?

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Mike:Well,that'sofcoursethesixty-fourtrilliondollarquestion.

Moritz:Yeah,so,pleasetellme.Don'ttellanybodyelse,justme.(Laughter)

Mike:PartofthewaythatIalwaystrytosolvetheseproblemsisthatItakethemtothereductioadabsurdumconclusion.So,oneofthekeydifferencesbetweenadiscretionarymanagerandanindexmanagerishowtheyholdcashorhowtheytreatcash.

So,ifyouthinkaboutthemathematicsofwhathappens,adiscretionarymanager(andwe'vegotourownproprietaryresearchthatwe'vedoneonthis)willtypicallyholdabout5%cash.Now,inordertokeepupwithanindextheymaytakethatdown,andwedothingsliketrackthecashbalanceasapercentageofmarketcaptogiveusanindicationofthissortofstuff.

MichaelHardnetthasagoodpiecehecallsTheFlowShowthattracksthelevelofcashallocationsasaconsistentnegativecorrelationwiththereturnprofile.OneofthethingsthatIpointouttoMichaelallthetimeisthattheonlypeoplethatrespondtohissurveysareactivediscretionarymanagers.NobodyatVanguardisresponding.So,whenhesaysthatthemarketis5%cash,or4.7%cash,whathe'stalkingaboutisthediscretionarymanagers.

TheVanguardsoftheworldrunwithnocash.Mypersonalfavoriteexample,again,Igobacktothingsliketarget-datefunds,theycarrynocash.Thevehiclestheyinvestincarrynocash.Theonlywaythattheyaccommodaterebalancingisbecausetheyhaveaconstantflowofnewcapitalcomingin.

So,youhavethesesortsofcrazydynamics.Ifyoujustwalkthroughtheimplicationsofamarketthathas5%cashtoamarketthathas0%cash,theonlywaythatcanbeaccomplishedisbyinflatingtheassetsthemselves.Becausewhatyouarereallydoingisyouaresaying,"Ineedtoreducethecashtozero."Well,thecashisneithercreatednordestroyedatanypointinthisprocess.Ibuy,yousell,cashisunchanged.So,theonlywaytoaccommodatelowerlevelsofcashisbydrivingtheassetpricesthemselvesup.

So,howdoesthisconclude?Ithinkitconcludeswiththeworld'smostridiculousmelt-up.Whenwedothemathandwalkthroughtheimplicationsofgoingfroma5%cashworldto,effectively,a10basispointcashworld,whichisroughlytheaverageacrosstheindexspace,themarkethastogoup50X-50X,not50%,not5%,oranythingelse,fiftytimes.We'retalkingShillerPEsinthe500,600sortofrange.

DoIthinkwe'llgetthere?No,becausebeforewegettherethevolatilityhasexplodedtosuchanextremethatacatastrophiceventthatjustwipeseverybodyoutandtheysay,"Well,we'renotgoingtodothatagain,orwe'regoingtofreezethemarket,wehavetostopthemarketinsomeway,shapeorform."I'mconvincedthatishowthisends.

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Rob:So,you'retheschoolthatETFs,makethemarketmoreunstableIguessthen.

Mike:Well,theydoboth.So,that'stheirony.Whenyouintroduceanalternativeapproachtomanagingmoney,it(atleastinitially)hasadiversifyingeffect.IfIhavemanagerswhowillonlybuywhenstocksarebelowtentimesearnings,wellthen,ifstocksgototwentytimesearningsbecauseofsomeexternalforce,thenextbuyeris10X.So,themarkethastofall50%.That'swhatthedot-comcyclewas,bytheway.

IfItakeascenarioinwhichthemarginalbuyerisalwayssomebodywhosaysIcan'tholdthiscash.IfyougivemecashI'mgoingtouseittobuy.Pricesaregoingtoinflate.

Ifyoucombinethosetwoyougetadiverseecosystem.So,stockscangoupanddowninrelativelysmallranges.There'sactuallyvoldampeninguptoaboutapoint.Onourmath,itsuggestsaround30%passivepenetrationwasthetroughintermsofwhatyouwouldexpect,intermsofrealizedvolatility,becauseyouhadpeoplewhowantedtosellandpeoplewhowouldbuywithoutthinkingaboutit.Itwasadiverseecosystem.

Now,aswe'repushingoutofthat,we'removingintoahighervolatilityregimeand,ofcourse,it'sreallytoughtodiagnosethis.Ihaveahypothesis,Ihavegotmodelsthatshowthatthisiswhathappensandsofartheyhavebeenlargelyaccurate,butman,it'sawfullyhardtoarguethataglobalpandemicisactuallylinkedtopassiveinvestingperse.Ifeelit'sverymuchlinkedtotheresponsesthatwehaveseen-thereactionsinthemarket.

Likemostsocialsciencesit'saone-offexperiment.Ican'trepeatitandbe,"OK,everybodylet'sgobacktoFebruaryandwe'lldothiswholethingwithoutpassive,orwithoutthepandemic."Youjustcan'trecreatetheexperiments.So,youhavetohaveahypothesisanduntilyou'reprovenwrongyoukeepoperatingonit.

Rob:So,it'snotlike'87whereyoucouldarguethatthefeatureofmarketstructure,whichwasportfolioinsurance.Alotofpeopleprobablythinkthatwasthecauseofthecrash.

So,ifwegobackto,say,1929.Maybeit'sabitsillycomparing1929tonowbecauseitwassuchalongtimeago.I'veseenthefiguresthatstockownershipwaslowerinthesensethatonlyabout10%ofU.S.householdsownedstocksandnowit's50%.Thedifferencebeing,ofcourse,backthenIthinkmostpeopleprobablyownedthemasindividualnamesandwereactivelytradingthemoneythemselvesratherthanitbeingpassivelyinvested.Althoughtherewereafewthingscalledinvestmenttruststhatwereabitstrange.

Doyouthink,wouldthemarketbemoreorlessstableifweweresomewherebetweenthosetwoextremes?It'shardformetogetmyheadaroundthefactthatindividualretailinvestors

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who,generallyspeaking,canbeprettywildintheirbehaviormakethissystemlessstablethanthismentalimageIhaveofariverofmoneykindofflowingconsistentlythroughthesystem?

Mike:So,Ithinkwehavetobeverycareful,right,becauseone,IdothinkthatyoureferredtotheUnitInvestmentTrust.Iactuallythinkthattheyareverysimilartomuchofthefinancialinnovationthatwe'retalkingaboutwithpassive.Theylargelyweredesignedtodeploycapital.Therewasfarlessconsiderationofwhatactuallysatinsidethem.Inmanycasestheywereblindintermsorthattheydidn'tdiscloseeithertheamountofleveragethattheyused,etc.

Ithinkanothercomponentthatpeoplegenerallyunder-appreciateisthatwhileweallcomplainaboutleverageandwecomplainaboutthehighlevelsofdebt,theflavor-de-jourofhowwesolvethisissomethinglikeriskparodywhichsays,"OK,let'sleverourportfolio10Xinthefixedincomespace,andlet'sadd..."Whatyou'reactuallydoingisaddingdebt.You'readdingrecoursedebttoyourportfolioandsaying,“That'sthesolutiontohowwetradeaworldthathastoomuchdebt.Let'sradicallyincreasethequantityofdebt.”

Well,bydefinition,ifyouchoosealeveredapproach,you'retalkingaboutincreasingthedemandforfinancialassetsinaggregate.So,Ithinkthereisalotofsimilarities.Again,thisisoneofthereasonswhyIdrawtheanalogtothe1920sbecauseIthinkwehavefinancialinnovationwithoutaverythoughtfulapplicationofwhatwe'reactuallydoing.

Then,justintermsofwouldthemarketbemoreorlessvolatile?Ijustthinkit'sreallyhardtosay.Thebid/askspreadsinthe1920s,inaworldthatwasdominatedbyhighcommissions,byrestrictedaccess,it'sjustreallyhardtoactuallydrawadirectanalog.

Moritz:Hardifnotimpossible.Allofthosetimeperiodsaredifferent.

Mike:TherewasaperiodduringtheSumerian...I'mjoking.Thatwasajoke.(Laughter)

Wehavenoidea,wereallydon't.So,theonlythingwecandoisbuildamodelandifthatmodelbroadlyfitsthedatathenyoucontinuetofollowit.

Moritz:Yeah,we'reseeing...Iwasreallysurprised,IsawitonTwitter(Ithink)lastweek.“U.S.pensionfundsconsideringtoleverup.”Totheextentthatthey'redoing60/40,orriskparity,orwhateveritisthattheydowiththeirlong-termassetallocation,butthey'regoingtogo(I

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don'twanttosay'allin'),they'reshiftinguponegearbecausetheyneedtodeliver,Idon'tknowwhatitis,7%?Theycannotdeliver7%inthecurrentinterestrateenvironment.So,whatdoyoudo?Youleverup.This,tome,soundslikearecipefordisaster.

Mike:Ihavetoagreewithyou.Ithinkthatpartoftheironyisthatmostleveragetothispointhasbeenheldwithinalimitedliabilityformat.So,CalPERS,forexample,whoiswheretheheadlineswereforthelastweek,theycanabsolutelybuy,asalimitedpartner,intoafundthatisleveredtwentytoone.That'sawayoftappingleveragebutit'snonrecourse.

Whatthey'retalkingaboutdoingisactuallyborrowingmoneythatisfullyrecoursedtothepensionsandthendeployingthat.Fromariskcontrolstandpoint,somebodyneedstobeslappedupsidethehead.That'sjuststupid.Itreallyis.Itonlyhappensinanenvironmentinwhichpeoplearejustsoarrogantthattheyhonestlycan'tthinkabouttheliabilitythattheyarecreatingforthetaxpayer.

Niels:Therearesomanythings,really,tounpackwithyou,Mike.Now,sincewearetalkingaboutpensionsI'mcuriousaboutacoupleofthings.Oneis,ofcourse,alotofpeopletalkabouttheloomingpensioncrisis.Ithink,actually,onRealVision,youranawholeseriesonitsoI'mkindofinterestedinyourviewonthat.ButI'malsointerestedindemographics.Howdoesthatallplayin?Iimaginethattheyoungergenerations,obviously(mostlikely),arepassivetypeinvestors,Robo-investors,orwhatever;Iimaginethattheoldergeneration,myageplus,maybenotsomuch;thenthereisthewholedemographicshift,theboomersretiringandneedingmoneyback,wheredoesthisallfitin?

Mike:Yeah,Iknow.Ithinkyou'rehittingon,obviously,thecriticalissues.Again,wedon'thaveamodel.Wecanrunthingsforwardbutwehavetodosowithuncertaintyabouttheassetreturnframework.So,oneofthebrilliantthingsabout,atleast,thewayitseemstobestructuredisthatifIthinkthemarketisgoingtogoup50X,ormoreaccurately20Xfromtheselevels,wellthenwe'vesolvedtheproblem.It'sallfixed.Let’sjustgoleveredlongandeverythingisgoingtobefantastic.

Theproblemis,though,thatwhatthat'sdoingisthat'spumpinguptheclaimsthattheboomershaveonthesystemandthat,inturnthen,needstobesold.So,youhavethisperverseimpactwherethemoneythatiscomingoutisafunctionoftheleveloftheassetprice.Butthemoneythatisgoingisafunctionofthelevelofincomes.

So,whenIstarttalkingaboutincomes,I'mobviouslytalkingaboutearningsandthosecanbebothonthecorporatesideandonthepersonalside.They'relinearintheirconstruction.They

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basicallyhavetobeone-to-oneagainstanincomestream.Thereareonlysomanypiecesofthepiethatcanbesplitup.Ifwedecidewe'regoingtopayalotmoreforthatandwebuildthatonthebacksofyoungpeoplewhoaredecidingthroughnofaultoftheirown,it'ssimplythesystemthatwehavesetup,that6.5%oftheirpaycheck,everytwoweeks,goesintotryingtobuystocksathigherandhighervaluationswhilethey’regettinglessandlessownershipforeachdollarthatcomesin.Themoneythatiscomingoutisultimatelygoingtoswampthat.

So,tome,that'stherealpensioncrisisisthat,attheendoftheday,thecashflowsdon'tmatch.So,theonlysolutiontothatissomebodyelsehastostepinandeithersuspendthepricesontheassetssothattheycan'tbedrivendownwards,whichiswhatIwouldarguewehavedoneforthepasttwentyyears.IthinkthisislargelythephenomenonthatweseewiththeFedsreactionfunction.Orwecoulddecidethatwe'regoingtoreplacetheactualcashincomethat'slostatsomelevel.

Theproblemisthatpoliticallywheredoyoupinthat?DoyoupinthatatS&P15Xearnings?Doyoupinitat30Xearnings?Doyoupinitat100Xearnings?Theproblemisthatwekeepsettingthatlevelhigherandhigher.TheFed'sreactionfunctionisgettingquickerandquickerandquickerbecausethisproblemisjustgrowing.

Rob:WhenI'mtalkingtopeoplewhoarequiteabitolderthanmyselfaboutpensionsandIsaid,"Youknow,pensionsdon'treallyexistthey'rejust,essentially,acontractbetweenyouandtheyoungergenerationsastohowyou'regoingtotransfermoneytoeachother."Ultimatelythathastohappeninthroughsomemechanism,right?So,inthiscountry,Iguess,wehaveabiggerstatepensiongovernment-fundedpensionandanyshortfallinprivatepensioningincomewill,mostlikely,comethroughhigherstatepensions.Ofcourse,whereisthatcomingfrom?Well,it'sgoingtocomefromgeneraltaxation.Who'spayingthetax?It'stheyoungergenerations.

Thedistributionofhowthatkindofreallocationofwealthfromoldtoyounghappens,maybe,differently,dependingonthemechanismbutultimately,iftheboomershavegotthesehugeclaims,thenthey'reeithergoingtohavetobereducedsomehow,orrepudiatedeffectively,orthere'sgoingtohavetobeanothermechanismofgettingthemoneyoutoftheyoungergenerationtoultimatelypayit.

Mike:Well,Ithinkthereareacoupleofdifferentwaysitcanhappen.Oneisthat,asyousaid,wecouldexplicitlyreduceit.That'sdifficulttodoinaDemocraticsystem.It'sfascinatingtowatch,andthisisobviouslyoneoftheimplicationsofsomethinglikeNeilHowe'sgenerationalview,thatultimatelythereisawarbetweentheyoungerandoldergenerations,anddowechoosetoactuallystickbythat?

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Well,theoldergenerationscontroltheinfrastructure.Theycontrolthepoliticalsystems.Atleastfornow,theycertainlycontroltheaccesstothepowerintheformofpoliceandeverythingelse.Ithinkwe'restartingtoseethesesystemsbangagainsteachother.Historicallywehavenothadproblemstothislevelwiththeexceptiontherearejustaveryfewempireswhereyouhaveanythingremotelyclosetothis.

TheRomanEmpirehadachievedalevelofrelativeaffluenceandithadtodealwithstufflikethis.So,thetransitionoverthefirstcenturyB.C.,fromtheRomanRepublictotheRomanEmpire,isonethatIcontinuallyemphasizeforpeoplethatwearelookingatasystemwherewhateverybodyiscryingis,"Weneedasingle,strongindividualwhocantakecontrolofthesystemandforcepeopletomakethechangesthattheyarerefusingtomakeasaDemocraticpolitic,asthevoiceofthepeople.Wearerefusingtodothatsoweneedtohaveastrongand..."Well,that'sadictator.That'swhatadictatorliterallyis.

So,I'mveryconcernedthatwe'remeaningfullystressingtheDemocraticinstitutions.IwouldhighlightintheUnitedStates,andIthinkthisisalsoverytrueinEurope,thatyou'reseeingthediscussionrightnowwithGermanyandtherestofEuropeultimatelydecidinghowwe'regoingtochoosetoallocatethoseresourcesisreallyhard.

Californiaisbroke,totallybroke.IfIlookatitfromastandpoint,IhadaTwitterresponsetheotherdaythatinthisversionoftheEuropeandebtcrisistheroleofGreecewillbeplayedbyCalifornia,andItalywillbeNewYork.WeneedsomebodytobailoutCalifornia.WeneedtobailoutIllinoisorweneedtodecidewe'renotgoingtodothat.Ifwechoosenottodothatthentherearegoingtobehugeimplications.Therearegoingtobehugeimplicationsifwechoosetobailthemout.Wedon'thavegoodchoicesinfrontofusandwedon'thavegoodsystemsfordealingwithit.

Moritz:That'sessentiallythepicturethatwe'relookingathereinEurope.Wedon'thavethefiscalunion,wehaveacommoncurrency,andacommoncentralbankbutnofiscalunion,nocentralizedtaxes,noneofthatstuff.So,thesystemisunderpermanenttensionofbreakingbecauseoftheimbalancesthatitcreates.

Mike:Yes.

Moritz:WhatIwanttocomebacktois,whatyoualwaysreadis,"Duringtheseuncertaintimes,ifyouneedanyguidance,lookatme..."Butinmarkets,it'salwaysuncertain.Eventheeasypeasybullmarkettradingisnevereasy.Thereisalwaysuncertainty.WhatIwanttosayisthatwe'regettingtomoreandmorelevelsofextremes.Thatisatleastmyfeeling.

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WhenIlookbackoverthepast,say,twenty-fiveyearswe'vehadmanycrisesandallofthatandtherehasalwaysbeenuncertainty.Butwhat'shappeningnow;everycrisisthatwe'regettingintoseemstobealittlebitworsethantheonethatwehadbeforeintermsofmoneyprinting,intermsofcentralbankreactionfunctions,whateverthecasemaybe.

So,itfeelslike,atsomepoint,wewillgettothisendgameandsomethingwillbreak.Democracywillbreak,whateverthecasemaybe,therewillbesomethingweirdgoingon.Myquestionis,howwouldyoubest,fromanassetallocation,trading,investingtradingpointofview,howwouldyoubestprepareforthat?

Mike:So,that'sactuallywhyIjoinedupwithWayneandwechosetolaunchtheLogicaAbsoluteReturnproduct.Wehaveactuallytriedtodesignittobeaproductthattakesadvantageofthefuturesthatwethinkarelikely.So,risingvolatility;amarketthatisincreasinglyextremeinbothdirections,thoseareoutcomesthatlendthemselvestostrategiesthatusederivatives.So,that'swhatwe'vetriedtodo.We'veactuallytriedtobuildaproductthatiscapableofexploitingthisphenomenon.

It'schallenging,though,becauseasvolatilityrisesthepriceofthatnon-recourseleverage(whichiswhatwethinkofasoptions…)thepriceofthosebeginstoriseandotherpeoplebegintopursuethesestrategies.So,wehavetobethoughtfulabouthowweadaptateverystepintheprocess.

Wehavegone,intheperiodof(giveortakefivemonthsthattheLogicaAbsoluteReturnproducthasbeenlive),we'vebeenthroughalmosteverypossiblenodeintermsofourallocationschema,andasaresult,we'reactivelyinvolvedindevelopingmoretechnologies,moreapproachestowhatcouldhappennext.HowwouldwebepreparedifXhappened?Howwouldwebepreparedifvolatilityrosefromanalreadyelevatedlevel?There'sadifferentanswertothatthanvolatilityrisingfromaverydepressedlevel.

So,wejusthavetobeverythoughtfulabouthowthat'sdone.Idon'tthinkthatthereisanyonesystemthatyoucansetandforgetandsay,"Here'sapermanentportfolio.”Alotofpeoplehavespentalotoftimetryingtodothatandtheyhaveusedthepasthundredyearsofdatabutwe'vebeentalkingfortwentyminutesandIhavealreadyintroducedtheRomanEmpire.So,nowweneedtwothousandyearsofdata;andImentionedSumeria,let'sgetfivethousandyearsofdata;andthenlet'sconsiderthefactthatwehappentobetheonlyinhabitedplanetthatweknowof.Somewhereoutthereisprobablyatenthousandortenmillionyearhistoryofaninvestablesociety,maybethereisn't.

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Moritz:Passiveinvesting.

Mike:Passiveinvesting,whoknows.It'sintergalactic,whocares.That'spartofthepoint.Youusethephrase'non-argotic'.Itisanon-argoticsystem.Ourparticipationinthissystemchangesit.Allofthemodelsthatwehaveadopted,overthepastsevenyears,especiallypassiveinvesting,assumecomponentsofanargoticsystem.Weusethephrase'MonteCarlosimulations'.BydefinitionMonteCarlosimulationsassumeargodicity.Theyassumethatthedistributionsarestableandunchangingandthat'sjustwrong.It'sjustwrong.

So,webuildthisgiantedificethatnowmanagesroughlyhalftheassetsontheplanetundertheassumptionoftheearthbeingflat.It'snotflat.That'sgoingtocauseaccidents.Themoreresourcesweallocatetoasystembuiltontheideathattheearthisflat,themorepeoplewe'regoinghavetoburnatthestaketopreventthetruthfromgettingout.So,we'vebuiltanedificethatIthinkisabsurd.

Moritz:Iagree.YouhavepeoplelikeNassimTalebtalkingaboutthemassiveimpactofthetailsandhehasabigfollowing,butthisisonlyonepartofit.Weknowtherearetails.Weknowtailsarefatteronbothsidesofthedistribution,actually,butwhatyou'retalkingaboutisthatthedistributionthatwe'relookingatmayactuallybecompletelywrong.

Mike:Right.Ithinkthatisabsolutelycorrect.Ithinktheironyisthattheprocessofbuildingtheperceptionthatthesystemisunderstandable,undersomeformoflognormalityorsomeformofBrownianmotionwhichsitsattheheartofallsortsofWallRaousianequilibriummodels,theprocessofassumingthatandputtingcapitaltoworkunderthatframework(thisiswhatIwasreferringtoearlier)perversely,actually,imposesthatframework.

IfIhavecapitalandeverytimesomethingmovestwostandarddeviationsdown,andIbuyit,wellthen,guesswhat?Attwostandarddeviations,thetailsaregoingtoincreasinglybelessfat.It'sgoingtolookmorenormal.Actually,it'sgoingtoexperienceincreasedkurtosis.

Thecenterisgoingtobehigherbecausetherearemorepeopleengagedintheprocessofmeanreversion.Now,allofasudden,whatcausesittobreakiswhenforcesthatwecouldn'thaveforeseenoverwhelmthosemeanreversionarycharacteristics,andthenthemarketisforcedtounwindinanextraordinaryfashion.

So,thisisverymuchtheMinskitypeframework.Stabilitybegetsfragilityorinstability.So,wehavebuiltupthisgiantedificethatisjustpredicatedonassumptionsthatweremadebecauseitwaseasy.Themathisreallyeasywithlognormality.Themathisreallyeasyifwehavemean

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reversionarybehavior.Therearelotsofassumptionsandthingsthatwecanpointtoandthefactthatmarkets,largely,behavethatwaybecauseindividualsdiscountedhistorically.

So,ifindividualsdiscount,ifthemarketparticipantsdiscount,thenthemarketwillexhibitmeanreversionarybehavior.Ifthesystemsarebuilttoreinforcethemomentumcharacteristics;ifthesystemisbuilttosay,"Hey,let'sreinforcethesedynamics"(becauseweassumethateverybodyelsehasalreadydonethiswork),andweputallthecapitalthere;thenwedestroythemeanreversionarycharacteristicsofmarkets.That'sexactlywhatwe'reseeing.

Niels:Youmentionedhistoryand,Iguessweallstudyhistory,weallusehistoricaldatatobuildourmodelsand,asyousay,wetryanddrawsomeanalogsbackintime.Butoneofthethingsis(andI'mcurioustoseewhetherIcanmakethisfitintothediscussion),whenwegobackintime,onethingthatweobserveisthatcountriesweremuchmoreindividualbecausewedidn'thavethetechnology.

So,alotofthetime,whenwehadacrisis,thesecriseswereisolated(OK,soJapanhadacrisisbuttherestoftheworldwasdoingOKandthenEuropehadacrisisbutotherpartsoftheworlddidOK),rightnowitseemslikecorrelationsbetweeneconomieshaveincreaseddramaticallyforthefirsttime.It'snothappeningjustnow,butithasbeenaroundforonlyafewyearsinabiggerpicture.So,economiesarecoordinated,and,forthefirsttime(Ithink)rightnow,wehaveG10currencies.Wehavetheinterestratesprettymuchatthesamelevel.So,whatriskdoesthatintroducethatthewholeworldseemscorrelated(forlackofabetterword)?

Mike:Ithinkyouknowtheanswertothat.Ifthereisincreasedcorrelationthenthereisdecreasedabilitytodiversifyyourrisks.Thesystembecomesmorepronetoextremebehaviors.Waynehasareallygoodillustrationthatheusesthatsays,"Look,ifyouthinkcorrelationsarelowat0%correlation,well,thatmeansthingsmoveinthesamedirection50%ofthetime.Ifthey're25%correlatedthatmeanstheymoveinthesamedirection62.5%ofthetime,andifthey're50%correlatedthentheyaregoingtomoveinthesamedirection75%ofthetime."So,themorecorrelatedtheygetthemoreextremethepeaksandvalleys.Thereisverylittlemodulationthatbecomespossible.

Again,thisgoesbacktotheunderlyingbuildingofthefragilityofthesystem.Ifthesystemispredicatedontheassumptionthattheauthoritieswilldoeverythingthattheycantokeepthesysteminplace,tomaintainthecurrentfunctioningofthesystem,thereisahugemoralhazardassociatedwiththatwhichistheexactsameonewewerejustdescribingintermsofthemeanreversionarycharacteristicsofmarkets.Whenthatbreaks,whensomeexternalforcecausesthattobechallenged,thenallhellbreaksloose.

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Iwouldsaythatthispandemichasbeeninteresting.Wehaveseensomeveryreal-worldstresseswhereoptimizedsystemsdon'tworkreallywell.TheU.S.experiencedtoiletpapershortages.That'sabsurd.Weexperiencedshortagesofverybasicthingslikepersonalprotectionequipmentfordoctors.Weweretoldmasksdon'thelp,notbecauseitwastruebutbecauseweneededtopreservethemasksforusebymedicalprofessionals.Wedidn'twanttoseehoardingactivity.Wedidn'twanttofreakpeopleout.

So,Ithinkthereisnoquestionthatthereisanextraordinaryamountoffragilitythatwehaveestablished.Breakingdownthatelementofcooperation,whetherit'sbetweentheU.S.andChinaorwhetherit'sbetweentheEuropeanStatesortheU.S.States,allofthateffectivelyexposesthegapsinthesystem.IfCaliforniadecidestohordePPEandnotshareitwithNewYork,thenbothhavetosupplymorePPEonashort-termbasisanditbecomesmoredifficultforanalreadystressedsystemtomeetthat.That'sareductionofthesurplusthatIwouldactuallycharacterize...

Peopletalkabout,andIhavespokenopenlyaboutthisbefore,peopleusethephrase,"Weliveintheageofuncertainty."Thatissuchapileofdogdoo-doo(Iguessisthetechnicalterm).Weliveinanenvironmentofabsolutecertainty.

Howareyougoingtogettoworkeveryday?Well,yougetonthisgiantconcretestructurethathasbeenbuiltbytheresourcesofsocietyandyoutransportyourselfandyourfourthousandpoundpieceofequipmenttoaparkinggaragewhereyou'regoingtotakeanelevatorthathadtobeconstructedtotakeyouuptoyouroffice.Youonlybuildthosesystemsinenvironmentsofintensecertainty.

Itellthestory,andIusetheanalog,inplaceslikeAfricawheretheystillwashtheirclothesintheriver.Theriverhascrocodiles.Well,whathappensifyouwashyourclothesinthesamespoteveryday?Thecrocodilesaregoingtobethere.They'llbewaitingforyou.There'sarulethatsays(notrulebutit'sarule-of-thumb),youcanswimacrosstheriveratapointofentryonce;ifyoudoittwicethecrocodilesaregoingtostartpayingattention;bythethirdtime,they'rewaitingforyou.Imagineif,everythreedays,youhadtochangeyourroutetotheofficebecausetherewerecrocodileswaitingforyou.That'suncertainty.It'sonlywhenwehaveextremesurplusthatwecreatethecertaintythatwecanthenturnaroundandgo"GoshI'msouncertain.WhatamIgoingtohavefordinnertonight?"Not,"AmIgoingtoeatdinner?”or,“Issomethinggoingtoeatmefordinner?"It's,"DoIwantVietnameseorChineseorTai?"That'snotuncertainty.

Moritz:It'sstillaverydifficultdecision.(Laughter)

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Mike:It'salwaysgoingtobeThai,butyes.(Laughter).

Rob:Iguessoneeffectofcertainty,I'mnotsureaboutgoingbacktoRomantimes,buttheBankofEnglanddiddoapaper,relativelyrecently,withinterestratesdatabackaboutsevenhundredyearsandthatshowedaslowseculardeclineinrealinterestrates,globally,fromabout15%towherewearenow,whichisprettyclosetozero.Iguesslowerrealinterestratesareabyproductofcertaintybecauseyoudon'tneedasmuchofapremiumforlendingmoney.

Wetalkedalittlebitaboutthekindofhuntforyieldandthehuntforusingleveragetodothat.That'sanobviousbyproductofhavingthislow-interest-rateenvironment.Whatelseisoutthere?Whataretheotherkindsofcarrytradesthatyousee,potentially,peoplegoingintoorthatarealreadyinandthatwillbecomeoverblownasaresultofthebackendofsevenhundredyearsoffallinginterestratesthatdon'tlookasiftheyaregoingupanytimesoon?

Mike:So,Ithinkthat'saninterestingpaperforacoupleofreasons.I'mactuallydoingsomeworkcollaboratingwithaBrown[University]professor.HisnameisMarkBlyth,onapaperthattalksaboutsomeofthesecomponents.One(againremember),anytimeyoulookatalonghistoryofdata,anythingthatispredicatedonuncertainty,likeinterestrates,ifyouarelookingatalonghistoryofit,italmost,bydefinitionisgoingtofallbecauseifithasrisenyou'reinthedarkagesandyoudon'thavetheabilitytoaccesslongreamsofhistory.So,youjusthavetobesomewhatcarefulaboutthepointintime.That'sthereasonwedon'thaveafivethousandyearhistoryofinterestrates.

ThesecondcomponentthatIwouldsayisthatabigchunkofwhatdrivesrealinterestrates,andtherewasareallygoodpaperoutofU.C.Davistalkingaboutthedynamicsofpandemicsbackthroughtheagesandcomparingittowars.So,realinterestratesareactuallydriveninalargepartbytheavailabilityofcompetingusesofcapital.So,ifIdon'thavearoadbetweentwomajorcities,orIdon'thaveatrainbetweentwomajorcities,there'sahighROIassociatedwiththat.AnythingelseIwanttousethemoneyfor,ratherthanexpandingthetradebetweenthosetwoplaces,isgoingtohavetocompetewiththatunderlyingdynamic.

So,Ithinkpartofwhatyou'reactuallyseeingwiththelowlevelofrealinterestratesisacombinationoflowtonegativepopulationgrowthratesparticularlyadjustedfordemographicsinthedevelopedworld.What'sthereturntowideningthehighwaybetweenNewYorkCityandBoston?It'sprettylow.Thereisnotalotofvaluethere.Ifanything,thedisruptionassociatedwiththatconstructionisfarmorethanthevaluethatcouldbecreated.Weseethiswiththedynamicsofhigh-speedrail.So,thosefactors,Ithink,largelyareresponsibleforthelowlevelofinterestrates,thelowlevelofrealinterestratesthatwe'reexperiencing.

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Thehuntforyield,thesearchforyieldisaseconddynamicwhichisthatwehave,by-and-large,chosen(throughpolicy)tolowerinterestratesandraisethevalueofexistingcapitalandlowertheopportunitiestoinvestnewcapital.Yet,peoplearelivinglongerandfacinganeedtodrawdownassetsinawaythatforcesthemtoseekoutformsofyieldthatallowthemtoliveoffoftheirassets.

Unfortunately,thewaythatmostpeoplearechoosingtodothis(whetherit'sbecausetheydon'tunderstandtheimplicationsofwhatthey'redoingorwhetherit'sbecausetheyunderstanditandconsidertheriskoffsetbythesocializationoflosses),they'rechoosingtomonetizegreatersourcesofvolatility.So,yieldenhancementstrategiesthatinvolvethingslikesellingputsorsellingcallsisoverriding.That'sjustanotherwayofcreatinganinterestrate.

So,aninvestment-gradebondhasafunctionallyidenticalpayofftothatofadeepoutofthemoneyputontheS&P500.Youcapturealittlebitofpremiumthatyouamortizeovertimeandyougetafixedincomecomponenttoitandyourprospectoflossisquitelow.So,whatwe'redoingwhenwedecidethatwe'regoingtoleverupinvestment-gradebondsiswe'resaying,"Let'sselllotsandlotsofputs."Orifwemovetohighyield,allwe'redoingisshiftingthatstripeclosertothemoney.Ifwedecidethatwe'regoingtoleverupequitiesthen,theoretically,we'reactuallymovingtosellingatthemoneyoptions.So,youhearpeopletalkaboutitallthetime,"I’mgoingtoselloneputandbuytencalls."Well,youjustsoldaput.Youbasicallysoldanearthemoneyputthat,potentially,createsnearlyunlimitedliabilityforyou.

So,mostofthesestructures,inoneformoranother,areundoingafeatureofthe19thCenturythatdramaticallyincreasedrisk-actualrealrisk-takingactivitywhichistheintroductionofthelimitedliabilitycorporation;theintroductionofwhatweclassicallythinkofasequity.We'renowintheprocessoftryingtoconvertallthatbacktoa“Lloyd'sofLondon”.IfIwriteputsonastockIhaveaverydifferentprofileintermsofpotentiallossesthanifIactuallyowntheunderlying.Inone,themostIcanloseismyinvestment,andtheotherIcouldtheoreticallylosemany,manytimesthemarginthatIhavepostedagainstit.

So,Ithinkwe'reinaprocessofreturningriskandputtingmoreandmoreriskontothehousehold,ontotheindividualinvestorwiththepresumptionthatthestateisgoingtobetheretobailthemout.

Moritz:Iagree.Iwantto,comingbacktotheputselling,Icompletelyagree.ThevolumesofwhatIhear,fromspeakingtosomeofthedealers,onsystematicsellingofvolandsystematicsellingofoutofthemoneyputsinparticular[isthat]they'renotbacktothelevelsthatwesawinJanuary/February,buttheyaresubstantiallyupfromwheretheywere,say,twoorthreemonthsago.So,thememoriesofthosethathavebeenhurtseemtobesuper,supershort,and,eventhoughtheyhavebeenhitonthechin,itseemsthattheyjustdon'tcare.Theaddictiontogettingayieldandgeneratingalittlebitofextraincome,bethat2%or3%,iskindofblindingthemtotherisks.

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Mike:Again,Iwouldalmostflipthatandsaythatisactuallyabyproductofthememoriesgetting,"longerandlonger."So,ifIhavegotafifty-yearhistoryofvoleventsandaftereverysingleoneofthosevolevents,itwassuperprofitabletosellvolatility,whichissomewhatbydefinition,becauseifitwasn'tthenguesswhat?Theworldendedbyasomewhatterminaleventanyway.

Moritz:Yes.

Mike:Well,ifyouhavethat"certainty"associatednowwithafifty-yearhistorythatsays,"Thisiswhathappens,"andyoudon'thaveanydeepunderstandingofwhythishappenedorthefactthatyou'reobservingthatthishappenedmeans,bydefinition,thatyourdatasetisskewed,thenyoubecomemoreconfident.Thisiswhatwehavebeentaught.

Thereisanentirefieldofbehavioralfinanceandbehavioraleconomicsthattellsusthatallthecautiousbehaviorthatweengageinisfoolish.Wehaveprogrammedthemachinestointentionallyignorethis.So,bydefinition,it'sgoingtolooklikeourmemoriesaregettingshorterbutinreality,we'remorereliantonalongerdataseriesofhistory.

Moritz:Goodpoint.

Niels:Youtalkedbrieflyoninterestrates.Wetalkedaboutinterestratescomingdownandhistoricallyhavegonedown.Icouldn'thelpnoticethatJeremySiegelcameout,thisweek,onBarryRitholtz’spodcastsayingthathewantedtogoonrecord,orhehadjustgoneonrecordsayingthathethinksinterestrateshavebottomedforageneration,atleast,maybeevenforever,whichisquiteaboldclaim.Ofcourse,hecouldberight.

I'mcurioustoknowwhereyouthink,orhowyouthinkaboutapotentialregimeshift,ininterestrates.Interestrates,historically,hasgoneincycles.Thiscycleisalittlebitlongerthanusual,nevertheless,wedon'treallyknowifthecycleshavebroken.So,thereiscertainlyanargumentforhigherinterestrates(maybenotintheshortend)wherecentralbanksareincontrol.Iknowtheywanttotryandhavesomekindofyieldcurvemanipulationgoingonbuttheymaynotsucceedinthat.Howdoyouseethewholeinterestratespectrum?

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Mike:So,firstofall,Ithinkit'simpossibletomakethattypeofcallorforecast.Ithinkit'stemptingtomakethatsortofobservationwhenyouhaveanenvironmentofnegativeinterestrates.

Tobeclear,Ithinknegativeinterestratesareabsurdandthatthey'reaviewthatIarticulatedbackin2015andisnow,Ithink,increasinglyacceptedthatthey'reultimatelyharmfultothebankingsystem.Theycreateataxonthebankingsystem.

Iwouldjustphraseitdifferently.Whatwouldyoucallanythinginwhichyougivearegisteredagentofthegovernment$100andtheygiveyouback$99?Well,youcallthatatax.So,negativeinterestratesarejustaformoftaxation.Werecognizethat(foravarietyofreasons,primarilybecauseofthecollateralbasisofacreditsystem),wecanchargepeoplenegativeinterestratesforholdingthatcollateral.Wecanchargethemataxonthatcollateral.

Now,that'scaustictothebankingsystemanditultimatelyinhibitsrisk-taking,butweareabletodothat.Wecouldalsomakeitveryexplicitandsay,"Hey,ifyouwanttomaintainabankcharteryou'regoingtohavetopayamilliondollarsayear,ortenmilliondollarsayear,orsomescaledtoyourassetsframework.”Thatwouldbetheexactsamethingassaying,"Wehavenegativeinterestrates."

So,asyouwouldexpectinthattypeofframeworkweseethebankingsystemsgettinghollowedout.Weseethemconsolidating.Weseefewerlocalandsmallbanksthatareultimatelypredicatedontheideathattheycanearnareturnonthecapitalthattheyareinvestingbecausethegovernmentsarechoosingtotaxthemoutofexistence.So,thesystemsareconsolidatingand,bydefinition,arebecomingmorefragile.

So,istherealimittothat?Yeah,ultimatelywewillenterintoaregimeofcapitalscarcity.DoIthinkit'spossibletopickthatithappennowversusthatit'sgoingtohappenfiveyearsfromnow,versusit'sgoingtohappentenyearsfromnow?Ijustthinkthere'sahugeelementofhubrisassociatedwiththat.Byandlarge,IthinkJeremySiegel'slongruntypeforecastingshouldbeclear,I'mveryskepticalthatitworks.

Moritz:Yeah,nowaquestion(Iguesswe'realmostoutoftime),butanobservationthatwhenyou'reactuallyrunningmoneyortrading,yourworryingabouttrendsthataregoinghappenthree,four,fiveyearsinthefutureisalittlebitpointless.

Mike:Ithinkthereisthat,butIalsothink...So,look,theonethingthatIwillsay,andIdothinkthatthisisactuallyreallyimportant,iswhenyouthinkaboutdynamicsofthingslikeriskparity,Ithinkthemarketisalreadypricinginelementsofthat.Post1998itbecamethe

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responsefunctionofTHEcentralbank(theonlyonethatreallymatterswhichistheFed)thatanytimesomethinggoeswrongthey'regoingtocutthepriceofmoney.They'regoingtoreducetheyield.

So,whatdoesthatactuallydo?Thatmeansthatbonds,whichgoupinprice(risk-freebondswhichgoupinprice)whentheinterestrateiscutnowhaveanegativecorrelationwithriskbutapositiveexpectedreturnaslongastheymaintainapositiveyield.ModernPortfolioTheorytellsyouthattheoptimalportfolio,inwhichthereissomethingthathasnegativecorrelationwithriskyetofferspositivereturn,shiftsfromabackpackproblem(a60/40allocation),toaleveredportfolio.

Now,whathappens(andIwouldarguethatthisisactuallythecoreofthereasonwhyweseenegativetermpremiumintheUnitedStates)ispeopleareincreasinglypayingforthatput.It'sanexplicitacknowledgmentthatthereisvaluetothatten-yearbondbecauseofthedurationandtheresponsethatithasinyourportfolio.Ifwemovethoseinterestratesnegative,thenguesswhat,allyouhaveisputs.Asanegativeexpectedreturnandanegativecorrelationtorisk,allofasuddenwehavetoswitchbacktothe60/40portfolio,awayfromtheleveredportfolio.Thatcreatesanetdecreaseinthedemandforfinancialassets.

So,Ithinktheendgameisrelativelyclosetothisnonsenseof,"Hey,we'regoingtocutinterestrateseverytimesomethinggoeswrong."ButIthinktheirony,ofcourse,isthatalmostnobodythinksaboutitinthoseterms.Wetendtothinkaboutitashowmuchyieldisleft?Howmuchyieldcanweget?That'snotthevalueofthatasset.Thevalueofthatassetisthatyou'vegotapositiveexpectedput,andwe'reclosetotheend.Ihopeso.

Moritz:Yeah,maybeintheU.S.interestratesaregoingtostayabovezero,oraboutthere.ThentheothermeasuresmaybeyieldcurvecontrolorsomeformofMMT.We'llseewhatthatbrings.

Mike:Iknowwe'realmostoutoftime,butyoujustbroughtsomethingupthatIthinkisreallyimportant.IdothinkitisimportanttodistinguishMMTbetweenadescriptionofthefinancialsystemandthemonetarysystem(whichiswhatitreallyis),andprescriptionsaroundwhatwecandowiththat.So,IhearpeopleusethephraseMMTallthetimewhentalkingabout,"Wellthisiswherewe'regoing."No,that'swhereweare.WeareinanMMTsystem.Thereisnoconvertibility.Theonlywaythatdollarsarecreatedisbecausethegovernmentdecidestospendthemandputthemintoexistence.Taxesarethenameansofmoppingthemup.Interestrates,inthatenvironment,arejustanotherformoffiscalpolicy.

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IfwechoosetoactuallybelieveMMT,PeterThiel,whenIwasworkingforhim,hadagreatlineonthiswhichis(Ithinkthismightaccuratelydescribeit),ifanybodyactuallytriedtorunagovernmentthiswayitwouldbetheendofthesystem.

Ithinkthat'sreallycriticalthatwehavemaintainedtheseconvenientfictionstopreventgovernmentsfromspendingmoneyinthewaythattheywant,inanywaythattheywant.Wecreatedrestrictions,initially.Wehadthegoldstandardtolimittheabilitytoincreasethequantityofmoney.So,thegovernmentshadrestraint.Wethendecidedthatdebtprovidedthattool.Well,noneofthosewereactuallytrue.

Itreallyisjustaquestionofwhat'stheproductivecapacity.So,theMMTisrightbutitoffersalmostnoprescriptionsforhowthatmoneyshouldbespent.So,byhandingitovertothepoliticians,we'reatleastinasituationwhereyoucouldseeoutcomesofhowthatmoneygetsspentthatwehaveneverpredicted.

Moritz:Yeah,itseemsthatthoserestrictionsthatyouwerereferringto,theybecomeweakerandweakerandlessandless.Thereismoreleewayinthewaythemoneygetsspent.IntheU.S.you'vereceivedyour,I'mnotsurewhatthenameofthosecheckswere,signedbyDonaldTrump,it'saformofhelicoptermoney.

Mike:Yeah,paycheckprotectionalso.

Moritz:Right.Aformofhelicoptermoneyessentially.So,thesameseemstobehappeninghereinEurope.We'regoingdownthatroutewherethingsthatyouthought,previously,impossibleallofasuddenstarttobecomepossiblebecausethoserestrictionsthatweimposedonthesystem,thateverybodybelievedin,allofasuddenthere'sareasontodoawaywiththemandpeopleacknowledgeitandjustgetonwithit.

Mike:Yeah,Ithinkit'smoreperniciousthanthat.YoustartyourchildrenoffbelievinginSantaClause,notbecauseyouactuallywanttolietothembutbecauseit'saconvenientreasonforwhytheyshouldbeniceratherthannaughty."Santaiskeepingalist."BythetimetheyrealizethatSantaClausemayormaynotexistintherealworld.(I'mnotgoingtospoilthisforanyfive-year-oldsthatarewatching.)

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Niels:That'sourtargetaudience.(Laughter)

Mike:Yeah,thatworksfine.Bythetimewegettothatpoint,theyhaveactuallyalreadyestablishednormsofbehavior.So,itisaconvenientfictiontosay,“Well,governmentspendingislimitedbythequantityofdebtthatwecanissueifit'sdoneinfiatterms.”That'saconvenientfiction.Butthereisactuallyvaluetotherestraintassociatedwiththatbelief.So,myfearis,exactlyasyou'resaying,themorethatwerecognize,“Well,thereisnolimitbasedonthequantityofdebtortheneedtoservicedebtthat'swritteninUncleSam'sscript,”thebiggertherisksarethatweactuallyhaveuncontrolledgovernmentincursioninourlives.

Niels:Well,itseemslikethebigresetcomesthedaywhenweloseconfidenceinthatnotionthatyoucanjustkeepaddingandaddingdebt.Butwe'renotthereyetitwouldseem.

Mike:Iwouldflipitandsaythatmomentcomeswhenwerealizethatthereisnoreasonforustoactuallypayourtaxes.Ifthere'snoreasonforustopayourtaxes,eitherbecauseaforeignpowerhasinvadedorbecausethegovernmentisillegitimateintermsofitsclaimonforce,thenthatproblemishere.

TheconcernthatIhave,honestly,isthat,ifanything,we'reshowingtheexactopposite.Wehavebecome,intheUnitedStates,inawaythatIdon'tthinkanyonecouldhaveforecast(IthinkinEuropeyouwerefurtheralongthispathinalotofways),mykidssaidtome,goingintotheCaronaVirus,"Howdoweprotestifwe'renotallowedtogooutside;ifwe'renotallowedtosaythatweobjecttothis;ifwe'renotallowedtosaythatwecan'tgathertogetherandsay,"Hey,weshouldn'thaveschoolsshutdown,"ifthereisnomechanismforthat,howdoyouavoidpayingyourtaxes?

Niels:Well,it'sveryconvenient.Iknowthisisacompletelynewdiscussion,andwecouldspendanotherhourortwowithyou,Mike.Imean,itisanotherdiscussion,right?Thatwhatthepandemicalsodidwasitkindoftookawaysomeofourwaysofprotestingandsaying,"No,wedon'tagree."That'saninterestingconceptwhichalotofconspiracytheoristshavetheirownthoughtson.Butlet'sleaveitwiththat.

Thiswasreallygreat,Mike.Thankyousomuchforspendingsometimewithus.WereallydoappreciateitandI'msureallofourlistenersdoaswell.Bytheway,makesuretofollowMike'sworkonTwitter,RealVision,andhisnewventureatLogicaFunds.FromRob,Moritz,

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andmethankssomuchforlisteningandwelookforwardtobeingbackwithyouaswecontinueourGlobalMacroMiniseries.Inthemeantimebewell.

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