Pragmatic Capitalism

Practical Views on Money, Finance & Life

Q&A…The Answers

Thanks for another round of good questions.  I’ll do my best to answer them all…

Leftcoast:  I’ve seen you comment in the past that when you were managing money you were a master hedger and still beat the S&P 500. I find so many times hedging techniques are expensive and while they may create a low volatility portfolio, they usually do little more than ruin your chances of outperforming.

I was wondering if you could provide some resources that helped you learn that particular area of your craft.

CR:  I had a good run (and will probably get back into asset management again), but I was managing a small amount of money and implementing some pretty unusual strategies (which made my job substantially easier than someone running hundreds of millions or billions).  My approach has really changed over the last 10 years away from a really active stock picking approach to a more multi-strategy active/passive macro approach.  I found the stock picking to be overly onerous and not scalable to a huge asset base.  Plus, the environment changed.  I evolved.  I’m a lot smarter now and I utilize my time investing in a much more efficient manner.

I view the markets like a river.  If you can find the direction of the river just about anyone can look like a great swimmer.  You don’t need to find the pockets of faster moving water (individual stocks) though you do need to avoid the rocks (manage risks).

I “hedge” primarily through portfolio design and what Ray Dalio would refer to as “alpha generator” (my active management approaches).  I think successful portfolio construction is mostly about understanding how different assets and strategies fit together to achieve one overall goal.  A simple example is the equity/bond relationship.  To me, equities are a key component in portfolio construction.  After all, they represent the key asset related to our productive output.

To a corporation, its outstanding debt issuance (our fixed income holdings) are often its lowest cost access to capital.  To the holder of these assets (the corporation’s liabilities) we’re holding an asset that is safer (it pays a fixed income, matures at par and has a higher standing in the liquidation process), but largely in-line with the same endgame – helping the corporation achieve profits.  Just like the corporation, you don’t want all your eggs in one basket.  That’s exposes you to risks.  So, you design your business in such a manner that reduces those risks, but leverages your potential strengths.

To the corporation, debt issuance is a means of achieving this.  To the fixed income holder in a portfolio, you’re able to diversify exposure to the equity structure through the holding of a slightly safer asset.  The fixed income component is essentially a hedge.  But its gains are not achieved by offsetting the equity component.  Its gains are complimentary and achieved in a differing structure.

I really need to write something more detailed about all of this because that only scratches the surface on what I believe proper portfolio design should look like….I’ll get around to it one of these days.

Britonomist:  What are your views on bank regulation? Do you support higher capital requirements? What about regulations designed to separate investment banking from retail banking?

CR: Banks are extended an extraordinary privilege in our society.  Monetary Realism refers to bank money as “inside money” because it is created inside the private sector.  This is the dominant form of money in our economy.  Outside money (cash, notes and bank reserves) all serve to facilitate or support inside money.  So banks are the key issuers of money.  In other words, our money supply is privatized to an oligopoly of entities competing for demand for loans.  Ultimately, money is a social construct.  The govt has essentially outsourced the money supply to these banks in order to try to achieve a capitalist market based money system.  But these entities cannot and will not regulate themselves.  That’s where the govt comes in.  I think, in return for this privilege, banks should be strictly regulated.  Banks compete for profits.  They are driven by private purpose, not public purpose.  So there’s an inherent conflict in these banks being able to issue our social construct.  In order to avoid having the banks corrupt the system, we must place safeguards in the system to ensure they cannot take excessive risks.  Because, in the process of profit seeking it’s natural for banks to reach out on the risk spectrum at times.  We should not allow this to reach extremes that it has in recent years.  This will result in inevitable instability.

Stephen:  Do you buy in to the notion that over the long-term, the price of gold is correlated to global money supply levels as measured by M2? Please see chart in link below and let me know what you think. If you do believe that there is some correlation, I think this topic would make for a great article and interesting debate.

CR:  My research concludes that the key driver of gold prices is negative real interest rates.  Here’s a good paper on this.

Armo:  Are free-floating currencies a modern-day thing? In this post ( you talk about how fixed exchange rate currencies & gold standards have always failed.  How long have free-floating currencies been around for?

CR:  Good question.  The modern system of truly free floating currency regimes has been in place since 1971 when the USA broke the USD’s relationship with gold.

JM:  If the goverment runs a deficit in a given year, and part of that money spent is ‘created out of thin air’ as opposed to being (a) ‘borrowed’ in the form of bond sales to non-Fed entities or (b) raised via tax revenue, what is the most effective way to remove that excess money from the system to avoid future inflation?

CR:  Money in our monetary system is borrowed into existence.  When a loan is created a new deposit is created.  This creates money.  When a loan is paid back the money is destroyed.   In the aggregate though, loans must always expand as the economy expands.  There is no other way.  So there’s really no such thing as destroying money in the aggregate.  The money supply will always expand assuming the economy is healthy, people are taking out more loans to buys goods and services, purchase homes, make investments in their businesses, etc.  That’s just a simple reality.  We need to stop worrying so much about the expanding money supply and start worrying about the productive output that results from this money creation.  A bad private equity firm goes bankrupt when it issues loans to bad companies.  A society goes bankrupt when it creates more money for increasingly useless output.

Freemarketeer: What sort of things did you do to trade earnings back in your past life?

CR:  I had one goal – beat the analysts at guessing the estimates.  I got pretty good at it.  I’d say my win rate was somewhere in the 70-75% range.  More importantly, I knew how every stock traded (I probably traded 250 each earnings season).  I knew that XYZ needed to beat and raise or it would always gap down (knowing how specific stocks trade thinly or not was crucial in risk management).  That meant you needed to hit the bids the second the report missed and the bids showed up.  The most satisfying trade was always being the first guy out the door because you knew the right response, you got the news instantly and you digested faster than just about anyone.  And then you hit some poor guy or gal with a position they’d regret taking.  I knew ABC’s management played the analysts for fools every quarter and would beat, raise and guide the year lower (and that the stock would respond favorably).  There were so many little nuances.  The trading was fun – it was a lot like playing poker.  Especially at 3AM in a thinly trade name when you can literally see a handful of other players in the market and the spreads are nice and fat.  But it was a lot of work.  A lot of conference calls.  A lot of balance sheet and income statement analysis.  The analysis (and the waking up at 3AM PST) was awful.  I don’t recommend it as a strategy for anyone unless you have a team of analysts doing it.

Joyce:  Kyle Bass is once again predicting the demise of the Yen. Even with a basic understanding of MMR the fact that the Yen continues to go on its merry way tends to baffle me. Has anyone published an essay that clearly explains what keeps the Yen from crashing with such awful debt, demographics and now a trade deficit as well.

CR:  It’s MR.  MONETARY REALISM.    :-)  The Yen is strong for several reasons.  Its a carry trade currency which bolsters demand.  Japan is enormously productive making it a very safe currency.  And inflation remains low.  What other currency can you find that trades against the Yen that has those attributes?  Not many.  Hence, its buoyancy.

Tim:  Any chance you would consider running a Black Friday shopping special for your annual Orcam Research notes currently offered at $499/year?

Thank you for the consideration!

CR:  Sorry, but I don’t think I am planning to run any specials on the research at present.  I priced the Orcam Research at $42 per month.  So I think the $499 sounds high, but it’s not as back breaking as it might sound to some people.  I hate to be a stickler on the price, but that’s already REALLY low for this kind of research.  We’re offering institutional style insights for really reasonable prices.  I wanted the research to be accessible to small investors.  Most of this kind of research costs thousands or tens of thousands a year.  Orcam is at the very low end of the spectrum.  Some of my colleagues literally can’t believe I am charging so little….

Also, if you’d bought it a few weeks or months ago you’d know that we’ve been tactically cautious through the entirety of the -8% equity declines and nailed the fiscal cliff reaction following the election.  The early subscribers paid for their research several times over with that one insight.

Gary UK:  US Govt gold holdings fell from 22,000 tonnes to 8,000 tonnes in the 50s and 60s, due to foreign governments exchanging their dollars for gold.

During this same period the US had no trade deficit.

Can you explain how the two are related, and why the US Govt felt it needed to waste money storing those remaining 8,000 tonnes?

CR:  The US govt holds gold for the same reason most other people do – as insurance against a worst case scenario in fiat.

Ely:  What is your stance on social security? What’s the best balance to allowing people to invest for retirement on their own without letting it become so large that it over-financializes the U.S. What’s a good solution to balancing out demand leakages associated with IRAs/401ks? Thanks

CR:  Sorry, I saw this in the question section and forgot to answer.  First of all, I want to be very clear that MR takes no position on political issues.  It’s a pure description of the monetary system.  You can pretty much come to any conclusion you wanted using the understanding of the system that MR teaches.

My personal position is that a nation should provide extensive healthcare for those who cannot take care of themselves (like the elderly).  But I am not an expert on the efficiency of the program.  That’s just not my area of expertise.  Sorry.

Secondary markets are not necessarily “demand leakages”.  If I hold $1MM in assets in a brokerage account (let’s say all cash just for simplicity) it’s not like I can’t go out and get approved for a black American Express and spend til the cows come home.   Again, this is about understanding inside money.  A bank just wants to know you are creditworthy enough to ensure their payments will be received on time.  They don’t really care if it’s held in secondary markets.  And in fact, large holdings of assets on a secondary market are often the best form of collateral for getting a loan.  Just ask a bank who performs repos with the Fed!!!  :-)

Ted:  Any thoughts to how low the S&P can go? At what point would you find it attractive? It’s beginning to look like a good buying opportunity as fear over the fiscal cliff is weighing on the markets…

CR: If I provide specific market insights here the Orcam lawyers start sending me emails.  I am regulated at Orcam for a reason.  The only place I provide specific markets insights is through Orcam Investment Research.    Sorry, but I have to be careful about what I say in public now that I am regulated.  Blame the government.  :-)

Cowpoke:  How are comment’s monitored? How do you regulate what comments get posted, is there an approval process?

CR:  Comments aren’t really moderated for the most part.  I have a filter for certain (bad) words, but that’s about it.  There are some default settings that hold comments with multiple links and spammy looking style.  Other than that, you guys are generally pretty awesome about moderating the comments yourselves and respecting the freedom to comment here.  I think we’ve developed one of the more educational and insightful comments sections around.  So thanks.

Garibian:  I get your distinction between between investing on the primary and secondary market and the fine line between investing and speculating. So when I buy or sell a stock on the secondary market where does the money really come from? Is it really a zero sum game and am I just taking money out of Bferro or V11 ‘s pocket?):

CR:  Secondary markets are exchanges.  The NYSE is called the NY Stock EXCHANGE because people exchange securities there.  So, if you buy $100 of GE from someone else then you exchange your cash for their shares of GE.  You get the stock, they get the cash.  That’s all that happens.  The cash came from the seller.  In this sense, the stock market is a zero sum game.  What you buy comes from someone else’s cash account.  But the idea of zero sum is somewhat misleading because the US economy is not a zero sum game.  We can all become collectively wealthier at the same time through better living standards and a better quality of output.

dijssel:  Hi Cullen, If the Dems and Reps can reach some deal about the fiscal cliff, do you foresee a face ripping rally like the one you predicted at the end of last year. Btw, that time you were right on target. Or do you think that worries about the profit cliff will dominate the general sentiment. Love your work!

CR:  I’m going to have to apologize again, but I can’t just throw out investment recommendations here at Pragcap.  This site has tens of thousands of readers every day and the lawyers don’t like it when I use this platform to discuss specific market investments.  I created Orcam so I could help more retail investors directly.  I love the big picture stuff here and the educating, but the regulators view specific market commentary in a different light so I have to be careful about my commentary here.  Sorry.

whatsgoinon:  This was a comedic jab at Japanese Bonds by zerohedge recently.

I understand MR and your previous bond vigilantes blog post and understand that a country that issues its own currency can always make the holder of the bonds whole in nominal terms for the face value of the bond.

That said, if these government bonds are “risk free” in nominal temrs then are these bonds assets exempt from a Minsky moment type scenario?

CR: I wouldn’t say Japan is immune from a currency crisis.  But I have a very hard time seeing how Japan is going to experience a currency crisis given their state of affairs.  After all, Japan isn’t some corrupt South American nation with low output.  They’re a super power with huge output, a very strong currency, a sovereign govt and very stable financial markets.  I am not convinced by the Kyle Bass prediction that Japan is in for a collapse.  I think he’s misinterpreted the dynamics there and has dug a huge hold in a bad bet.  He’s doubling down with his recent commentary.  It’s not a bet I would make personally.

WGO:  I noticed from the Koo’s recent presentation that US interest rates bottomed and began to rise after the pearl harbor attack in 40s.

I suspect the reason for rates starting to rise then was the inflationary concerns from war deficit spending. I was going to ask how well the Fed could control rates if there was a war but I did notice that rates rose slightly after the gulf war and after 9/11 but continued their continued decline thereafter. And if rates rose because of inflation and war related employment growth that might be a acceptable outcome.

That said, how concerned are you that the brilliant elected officials in Washington will choose to start a war to spur the economy because that is the only are they can agree to deficit spend?

CR:   I certainly hope this is not in the cards.  Blowing things up is such a waste of time and money.  Especially if it’s in the name of things that aren’t really a threat to the USA.  But I don’t pretend to be able to predict the madness of politicians…..

WGO:  Last question. I often read the gold bug blogosphere (and now by some mainstream pndits) how we all need to be worried about how gold is moving from the west (US) to east (china). That is

– China balance sheet is improving because gold does not have a counter party liability like treasuries have
– This is evidence of wealth transfer from US to China. That is, China’s purchase of gold and diversifying from Treasuries is in some way the market’s way of reinstituting the gold window that Nixon closed by settling the large US trade deficit in gold.

Can you please destroy this myth and let me know why I should not worry?

Also why are these emerging central bankers acquiring gold?
And why doesn’t the US government dump its useless gold reserves. Does holding the largest amount of gold reserves serve any purpose for the US?

CR:  The USA is transferring wealth to China.  In our trade with China, we send them pieces of paper.  In exchange we get pieces of plastic.  China also gets jobs, investment, skills, etc.  This offshoring of jobs and talent is real lost wealth for the USA.  We get cheap goods and services in exchange.  It’s hard to say who’s winning this trade, but it’s clear that China’s closing the gap in terms of competitiveness.  So, in relative terms, China is winning.   But this transfer of wealth doesn’t necessarily impose some risk on the USA that makes us at risk of being “owned” by China or having them collapse our bond market.

See this post.

Rich:  You often hear the story of how George Soros “broke the Bank of England”…but, since the UK is a sovereign currency issuer as well, how is such a thing possible ? Can you explain how you perceive this event ?

CR:  I don’t think Britain was technically sovereign.  They were on the ERM back then which meant the Bank of England was forced to defend the currency in what was essentially a peg to the d-mark.  I might be wrong, but if I recall correctly the Bank of England was constrained by external forces.

Cowpoke:  From your previous experience, Do you know if Large Firms on Wall Street have dedicated departments that solely focus on lobbying (influencing)K street (political)? I know they do as all companies, maybe I should rephrase it in a more simple term. What percentage (company resources) would you say a typical wall street investment firm spends on lobby group.

CR:  According to this site, FIRE industry is one of the largest lobbying industries.

troll1:  Cullen: Wondere of wonders, I have a thought/question.  I understamd how you feel about the “inflationistas”, but suppose I frame the issue in a different manner. With the FED’s easy money scenario and the resultant low interest rates, is it possible that we’re having inflation occurring that is masked? Has anyone compared inflation rates to FED interest rates over the years? What would be the ratios? It could produce an illuminating chart. Thanks for being there.

CR:  Again, I am going to go back to understanding inside money.  In a world where there is so little demand for credit I find it very hard to see inflation raging out of control.  Further, inflation’s best indicator, wages, remains extremely low  How can people bid up the prices of everything when their wages aren’t expanding at a rate that would allow it?  I still see the risk of high inflation as being very low at present.

Cowpoke:  OH, One more question..Since it’s open line and all… As far as Women go do you prefer Blondes, Brunettes OR Redheads (believe it or not there is a financial correlation)?  Thanks.

CR:  I don’t discriminate.   :-)

micro2macro:  Cullen, Can you possibly debate on radio or TV Kyle Bass on what Japan’s position is? You could issue a public challenge!  It appears that Kyle is getting upset that his Japan play is not working out for him.

CR:  I think Kyle Bass has bigger fish to fry than me.

Bruce in NOLA:  Hello Cullen et. al., I have been seeing that MR and several of the ideas that have been espoused on Pragmatic Capitalism becoming more mainstream. This is interesting as there is now lots of talk about the balance sheet recession (see and how it’s ending will save the economy for 2013. What is your take on it?

PS Thanks for giving us such a clear picture of the “reality of the economy! It really has reduced my fears over the past 3 years!!

CR:  Yes, the BSR and many other insights regularly discussed here are becoming increasingly mainstream.  It’s nice to see.  But as American politicians discuss austerity it’s clear that it’s not have a wider impact.  Unfortunately, due to its relative newness, Monetary Realism has no caught on in many circles so we’ve still got a lot of work to do.  Education is still the most powerful tool we have.

Brian_Ripley:  From JKH = I + (S – I)JKH: “Private sector saving = investment, plus the change in private sector net financial assets.”AND (S – I) = (G – T) + (X – M)Cullen, why does (G – T) + (X – M) = the change in private sector net financial assets?What is it about the net Federal spending (G – T) (spending less taxes) plus the net Import Export balance (the Capital Account) (X – M) that is a “change” ?S = I + (a change from what to what to what ?)Thanks, BR

CR:  Saving is a flow.  I think it’s sometimes easier to understand our thinking on S=I+(S-I) as a stock of assets and liabilities.  For instance, in the USA, the total net worth of the private sector is $63T.  Of this, about $15T is government net financial assets.  The rest is private sector assets like common stocks, real estate, etc.  The flows of spending in the economy help the private sector to generate these stocks (govt deficit spending results in a stock of net financial assets).  But the private sector is not built on a stock of government net financial assets.  It is built on a stock of private sector assets.

The primary purpose of S=I+(S-I) is about understanding that the private sector generates most of its net worth via the I component.  That is, it is via investment that we build the majority of our financial assets.  MMT argues that the economy is built around the government stock of financial assets through govt spending.  Like all things in MMT, the argument is government centric.  This is a misrepresentation of the way our balance sheets are built.  They are not built around govt NFA, but around private sector financial assets that derive from Investment.

So, when MMT defines net saving as S-I they are essentially marginalizing the most important part of the entire Saving equation by subtracting I from S.  This is not an accurate portrayal of the way our monetary system exists.  The economy is built on a base of primarily private sector assets that develop via Investment.   Hence, the clarification of S=I+(S-I).

Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC.Orcam is a financial services firm offering asset management, private advisory, institutional consulting and educational services.He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.
Cullen Roche

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