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Q&A Answers – Part 2

Here’s the last bit of the Q&A. Thanks again for all the great questions. If you asked a specific advisory question I can’t answer it. Sorry.  You should talk to an advisor for specific advice. The internet is not a great place to get personalized advice because no one can know you well enough to give you the proper advice.  Anyhow, I hope my answers add some clarity to your understandings of things.

Blake asked:

As a young but former PM I find your operational views on market functions extraordinarily helpful and refreshing. What I would really like to know is how you began your endeavor to understand how money really flows.. Because aside from you there are not many outlets that give the, dare I say it, pragmatic view. after reading your work and books, I am very interested in knowing what/who got you thinking about markets like this and where you may have went wrong in thinking about markets while you may have been learning these skills.

My journey has been a strange one. I started out as a broker at Merrill Lynch basically just selling stocks/bonds. I didn’t love the business model since I didn’t think I could manage the portfolios well (we used mostly expensive in house products) and with costs in mind. I knew that I could add more value to my client accounts if I just went out and bought index funds for them all and chopped off the 1-2% fees.

I left Merrill after a brief stint there and started trading for my own account. I brought a few clients with me, but nothing that would be considered substantial on Wall Street. I started trading stocks in an event driven strategy. I had somehow gotten very good at beating the analysts at their own game. So, I was essentially trading different events and calculating market expectations vs analyst expectations. I managed to crank out 15% per year during a 6-7 year period when the S&P 500 was flat for much of it (2005-2012).  That’s where I learned how markets really work. I think I acquired a pretty raw intuition about the financial markets by actually being forced to “eat what you kill” every day.

The financial crisis changed everything. My strategy stopped working as well when correlations went to 1 in 2009. And it dawned on me that this wasn’t a viable or scalable strategy. I had always studied macro, but it was never a cornerstone. And the crisis forced me to deep dive into it. The crisis made me realize that a global macro approach just made sense and would likely make even more sense going forward. We live in a world of big trends and if you get the big trends right then you’re likely to make smarter decisions. And the only way to get the big trends right and avoid the big mistakes is to know where the risks come from. An operational understanding of the world substantially increases your odds of being able to connect the dots.

Orcam grew out of all of this evolution in thought. I know low fee indexing makes the most sense for most people. And while indexing is an inherently macro oriented approach, it makes very little sense to me to implement a static portfolio (like a 60/40) in such a dynamic financial world. We can be low fee, tax efficient and intelligent about our asset allocation without being overly active. I can implement a portfolio that doesn’t cost much more than most Robo Advisors or many Vanguard mutual funds, but I can allocate the assets in a personalized manner while accounting for cyclical changes in the markets.  Orcam is designed to give people access to a low fee and personalized approach to asset management. It’s sort of a blend between a global macro hedge fund, personalized advisory and low fee indexing (though I definitely lean towards low fee inactive indexing).

So, long story short – the financial crisis exposed the reality of our macro world to me. And I just adapted to make sure I could evolve with it. I think macro is still under the radar relative to stock picking and most other approaches, but I think it’s going to be the most important approach to know going forward.

Steve W asked about the deficit, high government debt levels and the view that high inflation could come at some point.  

I think we have to be careful talking about “debt”. Debt is only one side of the balance sheet. It is totally misguided to argue that high debt is always bad. After all, what if you have high debt, but your assets are substantially higher? Then your net worth is high.  This is not always a bad thing. In fact, small cap companies often outperform large cap companies precisely because of this. They are leveraged entities using their capital in productive ways.  So, we have to look at both sides of the balance sheet.

Debt is dangerous when it’s used for unproductive endeavors. The housing bust was a great example of this where people were borrowing just to speculate. The recent stock boom in China is another great example. These are examples of leverage being used for nothing all that productive.  And when the asset prices linked to this debt decline the house of cards crumbles and ripples through the economy.

Of course, our money exists due to credit arrangements so this can and does contribute to inflation. But inflation is much more complex than just credit. At present, the USA is experiencing relatively low inflation because technology has suppressed prices and workers have no wage negotiating power. If you think those two trends are going to end then we might get some high inflation. But I don’t see it happening.

Jose asked for my view on the deficit during World War 2 and whether it can be seen as an example of the benefits of deficit spending.

I personally don’t think war is a very good example of deficit spending. Building things that blow up while killing other people is probably about the most destructive thing we can do economically. Obviously, I am being a bit general there. War has served the USA extremely well at times and being a San Diegan I am the last person to demonize the military.  BUT, war is not an economic tool. It is a social tool.  And I think there’s an important distinction there. We use war to protect our society from being torn down, not to build it up. And I should note that the military doesn’t just blow things up. They don’t get nearly enough credit for the building they do in various ways….

I think there’s sound evidence showing that deficit spending during WW2 contributed positively to economic growth, but I am not sure that’s a view I want to endorse since I think war is generally an all around economically destructive endeavor in the aggregate.

That said, from an accounting and operational perspective it is wholly naive to say that deficit spending doesn’t potentially help economic growth. Not only is it a contribution to our financial assets (because deficit spending adds to private sector assets without a corresponding private liability), but when it’s done in a productive manner it has a huge multiplier effect that should add to household net worths. Think  GPS, internet, countless medical breakthroughs, etc.  Of course, the key there is productive, which, we all know is not always the case.

Missy asked about annuities specifically.  

Missy, you have to talk to an advisor specifically about this. I think that financial advice of all types is very personal. It would be highly inappropriate for me or anyone else to give you advice without knowing very specific personal details. I would reach out to an independent CFP for advice there. Best of luck to you!

Anon asked why Northern Rock failed and if that was inconsistent with my explanation of banking.  

Banks can best be thought of as operating a payments system and creating liquidity inside of that payment system. They do so within the regulations that are required for them to operate. A bank that is well capitalized should not have trouble meeting regulatory requirements or managing their payment system. So, banks want inexpensive liabilities that they can match with their assets so that they maximize profits.

You have to be careful with the idea of “funding” because banks manage their assets/liabilities by acquiring cheap forms of funding. But this should not be misconstrued as meaning that banks needs deposits in order to be able to “fund” new loans. That’s not how it works. Banks simply expand their balance sheet when they make new loans whether they have cheap forms liabilities or not. But the best way to do this is to maximize profits by having cheap liabilities. Deposits are usually the least expensive liability to hold for banks. So they all fight for them.

Northern Rock had an upside down balance sheet. They couldn’t acquire cheap forms of liabilities because other banks thought they might be upside down. This is a slippery slope for a bank because once you’re perceived to be upside down it can become a self fulfilling prophecy. When depositors take their deposits out you require more expensive forms of liabilities. This exacerbates the problem and if the Central Bank cuts you off because you don’t meet regulatory requirements then you’re out of business.

Schrat asked:

How will export-heavy, developed economies be able to compete with China in the near future? Do you expect the Chinese will allow a floating exchange rate or more protectionism in Europe?

I don’t think they really can compete all that well in many areas. China and much of the rest of Asia is simply too competitive. In a globalized system where it’s very easy to put up shop in China or Vietnam it makes sense that American companies are increasingly moving their operations. And yes, as a result, we will likely see more protectionism and increased govt intervention in the markets. Govts are trying their best to stay one step ahead of corporate loopholes and new innovations, but they’re usually one step behind. And once the “problems” from this emerge govts are often way behind the curve in responding. But they always do….

Sam said:

I have read and enjoyed your book and site. However, I’m an avowed pessimist about many subjects, especially regarding the long long term. How much, if at all, do you think you might be subject to optimism bias, given that it seems endemic amongst humans?

Hi Sam. I am definitely biased to be optimistic. At the most basic level it just seems very silly to be against human progress in the long-run. There are more people coming into the world every day and we are all evolving and trying to become smarter, more productive, etc. This is a massively powerful long-term trend that you cannot fight.

Of course, our financial lives are not a “long-term”. So I am probably not as naively optimistic as I might seem. I know that our financial lives are shorter than most presume and we have to hedge for uncertainty. So, I am an optimist, but I am a measured optimist. I know that I want a portfolio to have an implicit long-term tilt, but I don’t want to expose that portfolio to a naive sort of “long-term” because I know that our financial lives are multi-temporal and probably require some hedging to establish some degree of stability inside this series of short-terms that make up our long-term.

Ray asked:

Cullen, Have you looked through history at the points at which government debt to GDP peaks and private scetor debt to gdp bottoms peaks seems to the point at which 10yr government bonds rate hit there long cycle low this seems to make sense from a post keynesian model perpspective? I am trying to work out the key factors to watch for a bottom in long term interest rates? Any thoughts?

I’ve never modeled the bond market based on long cycles. In fact, given the near certainty of low rates and low bond returns I think you have to model the bond market inside of about 3 years. The best fixed income investors will predict the short-term moves in the bond market on a short-term basis (1-3 years). That’s basically the world we live in now. You have to be nuts to buy a 30 year T-Bond at 3% and hold it to maturity. So, we’ve all been forced to become much more short-term than we probably wish.

I discussed my view on bonds earlier this year when I said rates were bottoming near 1.7%.  That should give you a flavor of how I am thinking about the bond markets these days. It’s going to be a series of cycles inside a long low return cycle….