Speaker 1: Hello, and welcome to another episode of the Odd Lots podcast.
Speaker 1: I'm Joe Wasntal and I'm Tracy Halloway. It feels like
Speaker 1: we're a little bit of a moment of volatility. I mean, obviously,
Speaker 1: the last eighteen or twenty months now have been this
Speaker 1: sort of extraordinary bull run, full on grab for risk, etcetera.
Speaker 1: I have no idea whether that's coming to an end
Speaker 1: or not, but it feels like with the FED and
Speaker 1: inflation of stuff, we're a little bit of a wobble here. Yeah.
Speaker 1: So we're recording this on the first of December. And
Speaker 1: one of the more interesting things about the past week
Speaker 1: or so is that the wobble started even before we
Speaker 1: had the sort of discovery or the big kerfuffle around
Speaker 1: the new COVID variant Oh my Crown. And it also
Speaker 1: started before we had the FED really start to signal
Speaker 1: that it was looking to potentially taper and raise interest
Speaker 1: rates at a faster pace than the market had been anticipating.
Speaker 1: And this is really interesting to me because, like I
Speaker 1: was kind of thinking back to two thousand seven and
Speaker 1: the quant crisis that we saw that was sort of
Speaker 1: the forerunner to the big financial crisis, and I wouldn't
Speaker 1: want to say that we're about to see something as extreme,
Speaker 1: but it was pretty striking that, you know, in the
Speaker 1: last week of November, when stocks were still basically at
Speaker 1: their all time highs, we did have all this stuff
Speaker 1: that was sort of happening just under the surface. So
Speaker 1: a lot of factor strategies getting hit. A lot of
Speaker 1: the stocks, you know, the growth stocks that were beloved
Speaker 1: by hedge funds UM seemed to be getting hit quite violently. UM.
Speaker 1: So that was kind of striking, like something is definitely happening.
Speaker 1: I'm just not entirely sure what now. You flagged it
Speaker 1: early in a piece in your newsletter, pointing out exactly
Speaker 1: that that is some of There are all these things
Speaker 1: going on, particularly this concentration and this idea that they
Speaker 1: are these very popular investments, and maybe the public gets
Speaker 1: into them and hedge funds get into them, and they
Speaker 1: start to get sold for what might some might be
Speaker 1: called like non economic reasons. And nothing we've seen lately
Speaker 1: like comes close to say this the so called quant
Speaker 1: meltdown the year before the financial crisis hit. But it
Speaker 1: is true that, you know, you have these periods where
Speaker 1: like these winners emerge and the way to win the
Speaker 1: game is to just double a triple down on a
Speaker 1: handful of names, and then as soon as there's any
Speaker 1: elevativation of volatility and you have to pull down your risk.
Speaker 1: You can see some really ugly charts, and there are
Speaker 1: some really ugly charts of a lot of tech but
Speaker 1: not just tech, sort of tech momentum names that have
Speaker 1: been super popular for a while after over the pandemic period. Yeah,
Speaker 1: definitely the air getting kicked out of some of those
Speaker 1: tech tires, I guess. But all of it, I mean, look,
Speaker 1: all of it comes back to a question that people
Speaker 1: have been asking for a while now, I mean basically
Speaker 1: ever since two thousand nine, which was, you know, after
Speaker 1: the last financial crisis, and that is are we in
Speaker 1: a bubble? Are these types of asset valuations unsustainable in
Speaker 1: one way or another? And secondly, if they are unsustainable,
Speaker 1: what is going to be the catalyst that actually ends
Speaker 1: up popping the bubble? Because so far we haven't really
Speaker 1: seen it. I mean, we've seen corrections, but we haven't
Speaker 1: seen anything on the magnitude of what people have been
Speaker 1: sort of worried about. March, of course, um was the
Speaker 1: big moment for markets, but that reversed amazingly quickly. Yeah,
Speaker 1: And I would have said one more thing, which is
Speaker 1: a like, are there bubbles? Is there a lot of speculation, etcetera.
Speaker 1: But be is any of the bubblish activity, or if
Speaker 1: there is bubblish activity, does any of it pose a
Speaker 1: threat to financial stability? So it's like we could look
Speaker 1: at like cryptocurrency and say, look, this is unsustainable, and
Speaker 1: probably for many of them they are. But on the
Speaker 1: other hand, much of that activity, perhaps someone could argue,
Speaker 1: is not a threat to financial stability. So these are
Speaker 1: all like big questions that people are always wrestling with.
Speaker 1: But I think, you know, again these days, I don't
Speaker 1: want to over dramaticize the moves we've seen as of now,
Speaker 1: but you know, once again, some of these questions have
Speaker 1: come to the come to the form. It's a good
Speaker 1: time to ask these questions again. I feel like we
Speaker 1: have a strong news peg in the form of recent
Speaker 1: market development. So we're gonna seize on it, and we're
Speaker 1: going to be discussing all these big questions with really
Speaker 1: the perfect person, right, Yeah, we have the perfect person.
Speaker 1: I'm very excited. We're gonna be speaking to Rick Bookstaber,
Speaker 1: Richard Bookstaber. He is the co founder of a new
Speaker 1: firm called Fabric that provides risk management solutions to financial firms.
Speaker 1: He's well known for his writing and theory in the
Speaker 1: world of like risk management. He has a well known
Speaker 1: book that came out prior to the Great Financial Crisis,
Speaker 1: Learning about Complexity and Derivatives is the title A Demon
Speaker 1: of Our Own Design. Many people view that book as
Speaker 1: having been prophetic about some of the uh some of
Speaker 1: the issues that helped blow up the financial system and
Speaker 1: the economy. He's done risk management at various firms, including Bridgewater,
Speaker 1: So we're going to be speaking to him about financial
Speaker 1: stability and markets right now and how he thinks about
Speaker 1: risks and risks to the system. Rick Bookstaber, thank you
Speaker 1: very much for coming on odd lots, Thanks thanks for
Speaker 1: having me. Why do you start off by telling us
Speaker 1: like sort of what you're up to these days? Like
Speaker 1: you know a lot of people almost certainly know you
Speaker 1: from that book A Demon of Our Own Design, Tracy
Speaker 1: is we're talking about a little bit before. Tracy kept
Speaker 1: it out our desk for a long time, wanted sort
Speaker 1: of a legendary book. What have you been working on
Speaker 1: in some in recent years. So I recently left the
Speaker 1: University of California where I was the chief risk officer
Speaker 1: for their pension and endowment. Um interesting, the University of
Speaker 1: California has bet a hundred and seventy billion dollars to
Speaker 1: manage between the pension and endowment, and I left there
Speaker 1: to start this firm Fabric, which is really focused on
Speaker 1: providing risk management to wealth advisors and the investment advisory community,
Speaker 1: essentially taking the sort of risk capabilities that I developed
Speaker 1: as I've been in various institutional positions as chief risk
Speaker 1: officer in order to deliver higher quality risk management capabilities
Speaker 1: to the financial advisors. So I'm just going to go
Speaker 1: ahead and jump to the big question to Jore, which
Speaker 1: has to be you know, are we in a bubble?
Speaker 1: Do you see signs or evidence here of bubble like conditions? Well,
Speaker 1: I hate to say bubble because when you say bubble,
Speaker 1: that's always got a sense of prediction to it. But
Speaker 1: I would say that we're in a very vulnerable situation,
Speaker 1: a period of high risk. So the level of risk
Speaker 1: in the market is really greater than what you might
Speaker 1: observe looking at day to day price action, looking at volatility.
Speaker 1: So how do you establish that quantitatively or I mean
Speaker 1: we all feel it, right, we all look at crypto
Speaker 1: and to go, this is crazy, or we go might
Speaker 1: look at meme stocks, I think it's kind of nuts.
Speaker 1: Or the degree to which people are just talking about
Speaker 1: trading is very intense, like nothing we've seen since the
Speaker 1: late nine days, for sure, But these are just like
Speaker 1: sort of like gut feelings, emotions, stuff like that. How
Speaker 1: do you go about, actually from a risk management perspective,
Speaker 1: attempting to quantify the level of risk in the market
Speaker 1: so that it's not just feel Crypto and n f
Speaker 1: T s certainly are canaries in the coal mine. It's
Speaker 1: not quite like credit default swaps pre two thousand eight
Speaker 1: because they're not integral to the market. So that is
Speaker 1: a telling sign. But the key things that I look
Speaker 1: at in terms of vulnerability are the extent that the
Speaker 1: markets levered, the degree of concentration, and how much liquidity
Speaker 1: we have in the market right now. It's like we're
Speaker 1: all partying in a nightclub and having a great time,
Speaker 1: but there's a lot of us jammed into that space.
Speaker 1: So if a fire gets started, we're going to have
Speaker 1: a hard time getting out of the exits. So we're
Speaker 1: very concentrated, and if we're in a nightclub, those exits
Speaker 1: are like the liquidity of the market, how quickly can
Speaker 1: we get out? And uh leverage, which is also high
Speaker 1: by a lot of measures right now, is sort of
Speaker 1: the flammability of the space. How quickly can we get out?
Speaker 1: So we're in a situation now where there's a lot
Speaker 1: of crowding, a lot of concentration. We're although we can't
Speaker 1: observe it day today, the liquidity that will be available
Speaker 1: if people start to head to the excess is low.
Speaker 1: And there are a lot of people who are going
Speaker 1: to have to head to the exits because they're either
Speaker 1: leveraged or they're out ahead of their skis in terms
Speaker 1: of their exposure to the equity markets. So this idea
Speaker 1: of rushing for the exits and everything getting rather crowded,
Speaker 1: that's something that we did observe in March with the
Speaker 1: big market crash, and in particular in the treasury market.
Speaker 1: Um given these sort of relative value trades that a
Speaker 1: lot of hedge funds had taken on, and given you know,
Speaker 1: observations around liquidity problems in that market for quite some time,
Speaker 1: I guess my question is does any of that matter nowadays,
Speaker 1: like the experience of is that if things get bad enough,
Speaker 1: the authorities will step in and prop up the market,
Speaker 1: even with credit, which was one area of concern for
Speaker 1: many many years after the financial crisis, the Federal Reserve
Speaker 1: announced a new corporate bond buying facilities to help that market.
Speaker 1: And even though we saw very dramatic price gaps on
Speaker 1: the way down, arguably because of liquidity issues once again
Speaker 1: and because of you know, crowded one way positioning, it
Speaker 1: was very short lived. And here we are, you know,
Speaker 1: almost two years later now or a year and a
Speaker 1: half later, and it doesn't seem to matter that much.
Speaker 1: What the FIT did in is really breathtaking. They're very aggressive,
Speaker 1: very quick on the trigger, and they really saved the
Speaker 1: markets from a disaster. The a lot of the e
Speaker 1: t f s were failing, nobody could do the arbitrage
Speaker 1: to keep them in line with the underlying stocks. Treasuries.
Speaker 1: There's one day that the treasury market traded to hundred
Speaker 1: and fifty million dollars. I mean, that's this is the
Speaker 1: most liquid market in the world, and it basically was
Speaker 1: shut down. So what the Fed did then was I
Speaker 1: think one of the kind because the situation was one
Speaker 1: of a kind, and they did a lot to pull
Speaker 1: the market from the ABYSS. But there's two questions. Would
Speaker 1: they have the will to do it if what we
Speaker 1: have is simply replay of say two thousands I used
Speaker 1: two thousands as a better example in two thousand eight.
Speaker 1: And do they have the bullets available to do it?
Speaker 1: I mean, typically the FED does not have in its
Speaker 1: mandate tempering the markets when you're talking about credit markets,
Speaker 1: you know, high yield markets, we're talking about e t
Speaker 1: f s when you're talking about equities. So I think
Speaker 1: would be foolish from a risk standpoint to bet on
Speaker 1: that and to make decisions thinking that the FED is
Speaker 1: going to back things up. So just on the liquidity point,
Speaker 1: I mean, you were involved in the vocal rule, and
Speaker 1: this is something that you know, the banks in particular
Speaker 1: like to blame for liquidity issues in almost any market.
Speaker 1: At the moment, they can't come in and take bets anymore,
Speaker 1: and so you know, it means there's less market makers
Speaker 1: and things get kind of weird because Wall Street doesn't
Speaker 1: have the same amount of risk appetite that it once did.
Speaker 1: Is that an argument that you buy into or would
Speaker 1: you say that something like Vulcan has, at a minimum
Speaker 1: at the margins affected liquidity. When I was at Treasury
Speaker 1: and the sec U, you know, as you pointed out,
Speaker 1: I was involved with developing the Vocal rule, and the
Speaker 1: big argument that the broker dealers and banks had was
Speaker 1: this is going to cramp liquidity. And the general sense
Speaker 1: among the regulators was, oh, come on, you guys, yeah,
Speaker 1: you'll figure out some reason to not have this put
Speaker 1: in place because it does reduce their ability to make
Speaker 1: money on the customer facing side. But actually they're right,
Speaker 1: And you know, I pointed this out that the incentive
Speaker 1: will no longer be there with the vocal rule to
Speaker 1: be as aggressive in making markets because the profit capabilities
Speaker 1: are not there. When I was at Solomon in THEES
Speaker 1: and we had the emerging market crisis actually crisis because
Speaker 1: you had Mexico and then Asia, we were losing money
Speaker 1: with every trade, but we did it anyway because we
Speaker 1: wanted to defend that franchise because pre vocal rule, you
Speaker 1: could make money trading proprietarily on the customer desks. Well
Speaker 1: that's not there anymore, and so there's no incentive or
Speaker 1: certainly a much smaller incentive for a broker deal or
Speaker 1: to step up to make markets if things are not
Speaker 1: going well. So yes, I think the vocal rule has
Speaker 1: restricted liquidity that market makers would make available in times
Speaker 1: of distress or crisis. Now you know you have to say, well,
Speaker 1: there's a devil's bargain there, because on the other hand,
Speaker 1: you don't have broker dealers essentially front running clients. So
Speaker 1: the balancing act was there the vocal rules put in place.
Speaker 1: But it is a case that's reduced liquidity and and
Speaker 1: I have to say reduced it in ways that are
Speaker 1: not really evident day to day because everybody is more
Speaker 1: than happy to make markets when there's no stress. So
Speaker 1: this is what I want to get back to. And
Speaker 1: I'm still like sort of searching for When you talk
Speaker 1: about if if people run to the exits, and you
Speaker 1: know that's gonna happen again at various times, there's going
Speaker 1: to be the exit is going to be smaller than
Speaker 1: people think, or that there is a high degree of
Speaker 1: concentration of assets, and that is going to exact a
Speaker 1: survey problems if or when when in fact they do come.
Speaker 1: What are I mean other than the sort of theoretical
Speaker 1: things and also, you know, on vulcaral aside, what are
Speaker 1: the things specifically that you see sort of from a
Speaker 1: numbers perspective or from a sort of qualitative perspective about
Speaker 1: the trading, about position sizing that show you that this
Speaker 1: is a vulnerable market, or that you say, we're in
Speaker 1: an we're in an overcrowded nightclub and the fire warden
Speaker 1: would not be happy with how many people are in it. Yeah, yea.
Speaker 1: So so let me go through one by when the
Speaker 1: issues in terms of leverage, liquid eating, concentration, right, in
Speaker 1: terms of leverage, margin, debt less free cash balances is
Speaker 1: that i'll say an all time high. The date only
Speaker 1: goes back so far, but it's higher than even in
Speaker 1: two thousands. And you have households that are more exposed
Speaker 1: in their liquid assets, have more exposure to equities than
Speaker 1: any time in recent history. And that's not strictly speaking leverage,
Speaker 1: but that's what you might think of his hot money.
Speaker 1: Things turn south. Households are going to realize that they
Speaker 1: have more risk than they might have thought about and
Speaker 1: start to liquidate. In terms of concentration, you've already made
Speaker 1: the point. The top five stocks in the SMP makeup
Speaker 1: around of the SMPS market camp. Of course, if everything
Speaker 1: we're equal weighted, they'd be one The top ten stocks
Speaker 1: are somewhere north of of the total SMP market camp,
Speaker 1: and of course technology is dominant in that area. If
Speaker 1: you go and look at the exposure to technology and
Speaker 1: the SMP using a standard measure like the GICKS sectors,
Speaker 1: it's around That's a level that we've seen at other
Speaker 1: periods where we've ended up with market crisis. For banks,
Speaker 1: it was over in two thousand seven for the Internet
Speaker 1: and TMT stocks technology telecommic media, and two thousand was
Speaker 1: over And by the way, is a low estimate because
Speaker 1: we measure how much how many stocks are in the
Speaker 1: technology sector based on their main business. Of course, many
Speaker 1: companies have technology, and Amazon as a case in point,
Speaker 1: they have cloud computing. And if you do things that way,
Speaker 1: you get a number where it's close to of the
Speaker 1: s and P is exposed to technology. By a lot
Speaker 1: of measures. We've got concentration stocks, and we have concentration
Speaker 1: uh in one particular sector that's leverage. And I already
Speaker 1: spoke about the issue with liquidity. The market making is
Speaker 1: not going to be there the way that it has
Speaker 1: been in the past, and the amount of cash that's
Speaker 1: available to supply in the event that people need to
Speaker 1: head out the exit is low. Uh. The percent of
Speaker 1: liquid assets and money market funds is lower than it's
Speaker 1: been in recent history as well. So what would be
Speaker 1: the catalyst in your view for you know, that big
Speaker 1: rush to the exits. And the reason I asked is
Speaker 1: because the experience of the two thousands was that the
Speaker 1: thing that people thought was safe, um, you know, subpride
Speaker 1: bonds that were being used as collateral. Uh in the
Speaker 1: rebo market. Suddenly we're not very safe at all. And
Speaker 1: I'm aware that, of course some people have been warning
Speaker 1: about this problem for a while, but you know, the
Speaker 1: majority of people were at least acting like everything was fine, um,
Speaker 1: and the collateral was absolutely perfect to use. But nowadays
Speaker 1: we've had so many warnings about specific risks. So people
Speaker 1: have been warning about over value tech for a long time,
Speaker 1: about concentration of big tech in the indusicries for a
Speaker 1: long time. We've been worrying about the possibility of a
Speaker 1: COVID resurgence, you know, ever since the Winter of and
Speaker 1: the impact on economic growth. Now we're worried about inflation
Speaker 1: and the possibility of the FED hiking rates, and maybe
Speaker 1: that's going to impact risk assets. And you know, maybe
Speaker 1: a few years ago we weren't necessarily talking so much
Speaker 1: about inflation, but we were certainly talking about what happens
Speaker 1: to the market when the FED raises rates. So all
Speaker 1: of these kind of feel like known risks in the market,
Speaker 1: And I'm curious if if there's one thing that you
Speaker 1: think is sort of less appreciated that could have a
Speaker 1: destabilizing effect. One of the nice things about systemic risks,
Speaker 1: risks that really can be material to the overall market,
Speaker 1: is they're sort of plane and open to view. I
Speaker 1: don't think there's any secret thing working, you know, that
Speaker 1: we aren't thinking about. It's just that we aren't thinking,
Speaker 1: we aren't looking at what's out there in terms of
Speaker 1: risk and and taking it seriously. We have a pe ratio,
Speaker 1: we have price to sales that's in outer space. Talking
Speaker 1: about another thing that's either at or above recent history.
Speaker 1: Various measures of price earnings and price two sales are
Speaker 1: up there, and people justify it in various ways. You know,
Speaker 1: during the Internet period two thousand, the period that Greenspan
Speaker 1: called irrational exuberance, people justified the crazy pe ratios by saying, oh,
Speaker 1: old accounting methods don't make sense anymore. Today they say, oh,
Speaker 1: rates are very low, so the discounting of future earnings
Speaker 1: should mean that price earnings go up. I don't think
Speaker 1: that's a good argument, but in any case, what's out
Speaker 1: there is plane to be seen. The things that I'm
Speaker 1: talking about should not be a mystery to to anybody,
Speaker 1: but people aren't reacting to it in terms of adjusting
Speaker 1: their exposure accordingly. So it could be that people wake
Speaker 1: up and think, wait a minute, evaluations are crazy. Here,
Speaker 1: a few people start to sell that drops the market.
Speaker 1: It could be that fed tapering or something even worse
Speaker 1: than along the spectrum from tapering to recession causes a
Speaker 1: dislocation to the markets. It could be then Asian causes
Speaker 1: a problem, perhaps because treasuries, which people regard as safe assets,
Speaker 1: start to drop as reeds go up, and that begins liquidation.
Speaker 1: All these are stresses that could be the start of
Speaker 1: the avalanche. So how do you actually adjust your exposure
Speaker 1: in a scenario like this? And for the past um
Speaker 1: decade or so, it feels like valuations were basically driven
Speaker 1: by inflows. So if you wanted you know, to be
Speaker 1: a successful investment manager, you basically jumped on the stuff
Speaker 1: that other people we're buying. And I'd be curious to
Speaker 1: get your perspective as well from you know, your previous
Speaker 1: position as the Chief Risk Officer UM at the University
Speaker 1: of California's Office of the c i O. Because as
Speaker 1: you mentioned, this was a huge portfolio, more than a
Speaker 1: hundred billion, and I'm assuming you have some sort of
Speaker 1: yield target that you need to be reaching, but it
Speaker 1: seems very very difficult to get there without taking on
Speaker 1: some form of risk. Yeah, there's no free lunch, right,
Speaker 1: So if you say I'm concerned, I think volatility or
Speaker 1: potential volatility potential risking market is very high. If you
Speaker 1: have a volatility target, you know, you only want to
Speaker 1: have a certain value at risk. That means you're going
Speaker 1: to take your positions down and that is not pleasant
Speaker 1: if the markets continue to do what they're doing. UM.
Speaker 1: But there are some easier methods. One is diversification, which
Speaker 1: reduces risk. People think they're diversified if they're holding a
Speaker 1: broad based portfolio like the SMP five, but as I mentioned,
Speaker 1: they're not really diversified. They actually have a big bet
Speaker 1: on technology. So one thing that you can do is
Speaker 1: take action to increase diversification, which means moving away from
Speaker 1: a cap weighted index like the SMP. Another thing to
Speaker 1: realize is that what you think is safe may not
Speaker 1: be so safe. Treasuries, longer treasuries, say tenure plus, you know,
Speaker 1: high durration treasuries are not really safe in some of
Speaker 1: these scenarios, especially the inflation scenario, and that would suggest
Speaker 1: that if you are going to take action to reduce exposure,
Speaker 1: you're better off moving it towards cash than simply moving
Speaker 1: it towards bonds, certainly better than moving towards high yield bonds,
Speaker 1: which also have a spread that scenario historic low. So
Speaker 1: step one would be diversifying a true sense, which means
Speaker 1: reducing the overweight that's implicit that you have in technology.
Speaker 1: The second is, if you are willing to recognize that
Speaker 1: risk is high and you want to maintain some notion
Speaker 1: of a forward looking volatility target, move away from high
Speaker 1: risk assets to lower risk assets, and the low risk
Speaker 1: gasset that makes most sense is something like cash, where
Speaker 1: I would define for investment purposes, I would define cash
Speaker 1: is say, being anything that has a duration of less
Speaker 1: than two or three years, because something with low duration
Speaker 1: is not going to be affected in a meaningful way
Speaker 1: should rates go up. I want to talk more about
Speaker 1: the the the lack of safety in the safe assets
Speaker 1: or how that could be a problem. And I think
Speaker 1: one difference between the Great Financial Crisis and the dot
Speaker 1: com bubble is, Okay, there was a big crash and
Speaker 1: assets in the dot com era, but no one really
Speaker 1: like thought those were like safe assets, Like no one
Speaker 1: thought at the time, like Amazon was like some like
Speaker 1: core retrospect, you should have bought it. But this course
Speaker 1: save asset or pets dot com or the Globe dot
Speaker 1: com or some like. Of course safety in twenty in
Speaker 1: two thousand seven tight what we discovered of worse was
Speaker 1: that a lot of assets that were thought to be
Speaker 1: triple A literally we're not safe, and that is sort
Speaker 1: of what caused the crisis and why those two crashes
Speaker 1: were different. Do you believe that, I mean, you mentioned, Okay,
Speaker 1: if we get inflation, we get rate hikes, there's gonna
Speaker 1: be this hit to some of these so called safe assets.
Speaker 1: But do you believe there's anything that's equivalent where people
Speaker 1: are truly thinking like there's like a bomb that we've
Speaker 1: somehow a bomb in here that we've somehow labeled triple
Speaker 1: A that could post systemic risk or is it more
Speaker 1: just about you won't get very good volatility adjusted returns
Speaker 1: because these assets won't behave the way you expected them to.
Speaker 1: You will not only get very good returns to get
Speaker 1: nagod returns unless you are holding bonds that match your
Speaker 1: target that you know where you have duration matching between
Speaker 1: assets and liabilities. Even treasuries can drop substantially as rates increase.
Speaker 1: You get your principle back. But if you are if
Speaker 1: you're needing to liquidate, you're going to find marked market losses.
Speaker 1: And of course if you're in high old bonds, it's
Speaker 1: that times ten. We we see periods where the spread
Speaker 1: with high yield can be temper sent end up. You know,
Speaker 1: it's not just that it won't make the return you
Speaker 1: might have hoped. It's actually a risky asset in the
Speaker 1: face of higher rates and inflation means higher nominal rates
Speaker 1: in terms of Triple A's two eight is not a
Speaker 1: good example for just about anything other than things can
Speaker 1: go down. We had a crisis that hit at the
Speaker 1: heart of the financial system. Banks, short term lending, and
Speaker 1: you know, as you point out, bonds that were supposed
Speaker 1: to be high quality actually weren't because of some of
Speaker 1: the magic between the packaging of core reponds and the
Speaker 1: reading agencies and the way that they read it. Then
Speaker 1: that's not going to happen again. I would not really
Speaker 1: go back to two thousand eight as the the type
Speaker 1: for what sort of issue we would have if I
Speaker 1: were going to pick an analog, and no analog really
Speaker 1: exists for the markets, because we change, we innovate, we
Speaker 1: grow with experience. I more picked two thousands as an example.
Speaker 1: How does UM you sort of touched on it, But
Speaker 1: how does banking regulation actually play into this? Because, of course,
Speaker 1: one of the big changes between now and the two
Speaker 1: thousands is that we had all these new rules around
Speaker 1: UM leverage and liquidity coverage ratios and things like that
Speaker 1: come into effect that actually forced banks to buy what
Speaker 1: ostensibly should be safe assets like US treasuries or agency
Speaker 1: mortgage bonds, things like that, and so on the one hand,
Speaker 1: I could see I could see the potential to argue
Speaker 1: this both ways. So you could say that because you
Speaker 1: have a buyer base that is basically UM forced to
Speaker 1: snap up a lot of these assets, the idea that
Speaker 1: they're suddenly going to sell them off if inflation picks up,
Speaker 1: maybe that's less likely. But on the other hand, as
Speaker 1: you mentioned, if we get an inflationary scenario and bonds
Speaker 1: suddenly don't look as safe and maybe they start, you know,
Speaker 1: the movements and bonds start feeding into banks internal risk
Speaker 1: models and things like value at risk, then maybe you
Speaker 1: would have a moment where they decide, well, actually we
Speaker 1: need to do something about this. I think banks are
Speaker 1: out of the game right now as we look forward
Speaker 1: towards risk. They've been I wouldn't say nude, but their
Speaker 1: their ability to take risk or to be a source
Speaker 1: of reasonvolving risk is much lower now than before. You know,
Speaker 1: we talked about the restrictions in terms of market making. Uh,
Speaker 1: they also and and that's proprietary treating on the client side.
Speaker 1: They also don't have internal proprietary treating for their own book.
Speaker 1: They have very tight leverage constrains and monitoring in terms
Speaker 1: of what they can do there. So I don't think
Speaker 1: banks can be part of the solution. I also don't
Speaker 1: think banks will be part of the problem. If if
Speaker 1: we're looking at where the problem will come, I think
Speaker 1: it's you know, we see the enemy and it is us.
Speaker 1: I think it's the institution's retail and individuals who are
Speaker 1: caught up and exposed in the market. It's really irrational
Speaker 1: exuberance type of a risk as opposed to fundamental structural
Speaker 1: risk within the banking and guts of the financial system.
Speaker 1: Cryptocurrency is a great example of that. It's on the edge.
Speaker 1: It itself is not in my mind, systemic or sufficient
Speaker 1: to really trigger something for the market's broadly based. But
Speaker 1: what you see with crypto is just a dramatization of
Speaker 1: what is happening in the market's overall. We have a
Speaker 1: lot of speculative activity, and we don't have we don't
Speaker 1: have a lot of people who are in a position
Speaker 1: of supplying liquidity in the face of people suddenly either
Speaker 1: needing to exit the market or wanting to exit it.
Speaker 1: So I think this is super interesting. I mean, you know,
Speaker 1: when banks get in trouble, that's a big problem, obviously
Speaker 1: in part because normal more people have money with those
Speaker 1: banks and their their deposits are kind of loans to
Speaker 1: the banks, and they expect to get them back one
Speaker 1: to one, and if that ever blows up, that's a
Speaker 1: real problem. It sounds like the main issue is, in
Speaker 1: your view, just that we're so exposed to risky assets
Speaker 1: all of us, either through retirement funds, are day to
Speaker 1: day hot money, are pension funds, and so forth, that
Speaker 1: it would be a really big problem if they went down.
Speaker 1: You know, one of the things that Tracy and I
Speaker 1: have talked a lot about on this show is like
Speaker 1: this sort of forty year I mean, we talked about
Speaker 1: the last year and a half, for the last ten
Speaker 1: years or whatever, but you know, the sort of forty
Speaker 1: years simultaneous bull market in stocks and treasuries. And I'm
Speaker 1: curious if, in your experience, having looked at the worked
Speaker 1: at the pensions side, whether this sort of is just
Speaker 1: taken taken for granted that on a short term basis
Speaker 1: that treasuries sir at a short and medium term treasuries
Speaker 1: act as a volatility buffer for risk has it. But
Speaker 1: at the long term you start to get paid out
Speaker 1: on both, which has been a very sweet deal for
Speaker 1: the diversified investor, But perhaps it's just not always going
Speaker 1: to be the case, to our detriment. This is one
Speaker 1: of the things I think is an issue in the
Speaker 1: markets that people tend to be shortsighted. They don't look
Speaker 1: at history with the broader scope. If you're a hedge
Speaker 1: fund or a broker dealer, that's fine because you're going
Speaker 1: in and out in your time frame. Your perspective is
Speaker 1: daily or monthly. But if you're an individual or pension funds,
Speaker 1: if you're an ascid owner, you have to be concerned
Speaker 1: about the nature of the market over decades. If you
Speaker 1: have that few it's worthwhile to go back even to
Speaker 1: the seventies to see what can happen. If you look
Speaker 1: from nineteen sixty eight two, if you were standing in two,
Speaker 1: you were in the same place ace in terms of
Speaker 1: your portfolio as you were. You know, we talked about
Speaker 1: Japan having lost decade. That was more than a lost
Speaker 1: decade for investors. If you look from two thousand to
Speaker 1: two thousand thirteen, same story. You had a period where
Speaker 1: in you were in the same place that you were
Speaker 1: in two thousand. There can be periods of a decade
Speaker 1: or more where things are flat. And if you're a
Speaker 1: longer term investor, if you have a time from a
Speaker 1: ten or twenty or twenty five years, that's a big
Speaker 1: problem because if you're saving for retirement. If you've got
Speaker 1: a portfolio with the idea of liquidating retirement, your reasonable
Speaker 1: expectation is an average return inequities of around seven percent.
Speaker 1: That's the actuarial rate that's assumed by pension funds seven
Speaker 1: percent average annual return. So if you're flat for ten,
Speaker 1: twelve or thirteen years, you're not really flat. You're down
Speaker 1: about fifty from where your expectations reasonably should have been.
Speaker 1: So when we look at what can occur, we need
Speaker 1: to sort of look at situations beyond two nine on where,
Speaker 1: of course we've had this stupendous run up and and
Speaker 1: with rates, it's the same story we've had. You know,
Speaker 1: as you're pointing out this incredible secular bull market in rates,
Speaker 1: people think now that rates of two and three percent
Speaker 1: or the norm, this is where life is supposed to be.
Speaker 1: In the nineteen early nineteen eighties, I was building a
Speaker 1: house and I got a mortgage. I got a construction
Speaker 1: loan of I got a mortgage of thirteen and a
Speaker 1: half percent. In the mid nineteen eighties, I was at
Speaker 1: Morgan Stanley and one of the traders did a print
Speaker 1: when Treasury's got to eight percent. Because the view is
Speaker 1: off we're finally back to normal, and he wanted that
Speaker 1: to court sort of memorialize that event. So rates can
Speaker 1: go up. Rates can be five percent, they can be
Speaker 1: seven or eight percent. That is sort of too many
Speaker 1: of our mind's distant history. We sort of think that
Speaker 1: where we stand now in this bullmarket is it, but
Speaker 1: it may not be it, and we don't need rates
Speaker 1: go up to eight percent for things to really be
Speaker 1: difficult for people who think they're in safe assets. I
Speaker 1: want to go back to what you were saying earlier
Speaker 1: and the distinction between risk on the cell side with
Speaker 1: the banks versus risk on the bye side with investors,
Speaker 1: whether they're big institutional investors or retail investors. And you
Speaker 1: know this because you were involved in post financial crisis regulation. UM.
Speaker 1: I remember you gave some speeches or guidance to Congress
Speaker 1: on these issues. And this was really a conscious choice
Speaker 1: by the regulators to d risk the banks after the
Speaker 1: two thous crisis and move a lot of risk taking
Speaker 1: into either the by side or shadow banking institutions. UM,
Speaker 1: when it comes to things like lending. And I guess
Speaker 1: my question is, you know now we're talking about the
Speaker 1: risks that are facing primarily the by side the investors
Speaker 1: who have been buying all these overinflated assets. And is
Speaker 1: it I mean, this was the intended results of all
Speaker 1: this reform. So how much of a problem would it
Speaker 1: actually be if we suddenly saw risk assets tank tomorrow. Yeah,
Speaker 1: the guess the horses are out of the barn. And uh,
Speaker 1: it's much further to control what goes on in the
Speaker 1: market then, of course what goes on in the banks
Speaker 1: the So this is the point I'm making that the
Speaker 1: risk now resides in the markets with institutions and much
Speaker 1: more than in the past with retail investors, and that's
Speaker 1: a little harder to control than when it's within the
Speaker 1: regulatory system. So I think we sort of have little
Speaker 1: to do from a regulation standpoint, the sort of watch
Speaker 1: things play out. You know, we do have controls obviously
Speaker 1: on how much leverage people can hold, but that's the
Speaker 1: main tool that's available. When you get to retail. The
Speaker 1: risks also are quite different and require different sort of
Speaker 1: management then when you're talking about hedge funds or banks
Speaker 1: or broker dealers. And actually that's the center of what
Speaker 1: I've been doing at Fabric. If you're an individual, you
Speaker 1: have risks coming from two sides. You have the risk
Speaker 1: of your portfolio, and the risk of your portfolio, by
Speaker 1: the way, has to be looked at over the course
Speaker 1: of years, not over the course of the next month,
Speaker 1: so you have a much longer time frame. But you
Speaker 1: also have risk coming from your own decisions and your
Speaker 1: own need for assets. So you have to manage not
Speaker 1: just the risk in the market and not just look
Speaker 1: at that risk as a progress is longer term. You
Speaker 1: have to do that in the context of how you
Speaker 1: would react based on that. Would you suddenly I'll reduce
Speaker 1: your risk tolerance if the market goes down, and on
Speaker 1: that basis sell even more well, you suddenly have expenses
Speaker 1: where you have to uh sell and de risk on
Speaker 1: that basis. The complication as you get to the individuals,
Speaker 1: the level of complication in terms of risk is greater.
Speaker 1: The models that you need to use are different from
Speaker 1: what you have for institutions. So the move that we're
Speaker 1: seeing from the banks and broker dealers in the larger
Speaker 1: institutions into retail not only is more difficult to control,
Speaker 1: it also creates a different type of a risk dynamic.
Speaker 1: So I want to ask a question, and it's kind
Speaker 1: of verging away maybe from finance more towards the realm
Speaker 1: of economics. But this issue of like, we're all highly
Speaker 1: exposed to risky assets and this could feed through to uh,
Speaker 1: you know, pose problems would be a different set of
Speaker 1: problems that we saw in two thousand and two, thin,
Speaker 1: but it would be problems. Nonetheless. Would there be a
Speaker 1: case therefore to sort of think about macro policies that
Speaker 1: make the economy or make households, or make retirees less
Speaker 1: reliant on gambles? I mean, I think about crypto again.
Speaker 1: So it's just say, a sort of canary in the
Speaker 1: coal mine. But how many people are trading crypto because
Speaker 1: they feel that they need to hit some level or
Speaker 1: they feel the level of financial pridcare procarity in their
Speaker 1: own life and they see an opportunity to rectify that
Speaker 1: by winning big on some coin. And so could some
Speaker 1: of these things that we identify as financial problems be
Speaker 1: addressed were we to have an economy and we don't,
Speaker 1: you know, there'll be different ways of getting about that.
Speaker 1: Were we to have an economy in which households and
Speaker 1: individuals weren't so reliant on a stock market that just
Speaker 1: kept going up all the time, in order to basically
Speaker 1: make their monthly payments. Well, if you think that you're
Speaker 1: behind and have to take risk, if you're inequities already
Speaker 1: in this market, you've got a problem. You know, we've
Speaker 1: seen it's hard to envision a time where we've seen
Speaker 1: this sort of appreciation, uh that we've had over the
Speaker 1: last number of years. You know, so people who want
Speaker 1: to win even bigger, they may as well buy lottery tickets.
Speaker 1: We really are, you know, in an unusual time in
Speaker 1: terms of the opportunities that have been laid before us.
Speaker 1: And I think right now, you know, people get this
Speaker 1: exuberance and I feel like, hey, you know, I've made
Speaker 1: this much money. Let's keep really, let's keep the party going.
Speaker 1: I don't think, but you know that being said, we've
Speaker 1: really moved towards the whole ethos away from divine defined
Speaker 1: benefit to defined contribution. That's true with pensions, and that's
Speaker 1: led people to be much more aware of the markets.
Speaker 1: The technology is now there so that they can monitor
Speaker 1: the markets, transact in the markets very very easily. For
Speaker 1: some people, I think the markets have become a source
Speaker 1: of entertainment and UH an extension of their social media presence.
Speaker 1: So this is sort of the world that we're in now.
Speaker 1: And and I actually think that crypto is not only
Speaker 1: an indication of exuberance and i'd say in a sensor
Speaker 1: of foolhardiness in terms of an investment perspective, but it's
Speaker 1: kind of an indication of how the markets are evolving.
Speaker 1: A lot of information, some of it not good information.
Speaker 1: The ability to trade for apparently no cost on your phone,
Speaker 1: the ability to make trades, and bite size sort of
Speaker 1: dinner and dinner and a movie size where it's it's
Speaker 1: really inconsequential. All these things are moving the market in
Speaker 1: a direction where it starts to look a little more
Speaker 1: like what we've seen in social media. And if you
Speaker 1: don't like what social media has done to common discourse,
Speaker 1: you're probably not gonna like what that might lead to
Speaker 1: in terms of the markets. But that's so it's not
Speaker 1: just the move that we've had from banks and institutions
Speaker 1: towards retail, And it's not just the increased embrace of
Speaker 1: retail into the markets. It's very recently some of the
Speaker 1: changes in the way people interact with the markets, and
Speaker 1: we haven't even seen the start of that playing out yet.
Speaker 1: I think that can be the next level of concern
Speaker 1: that will have because that would be a structural systemic
Speaker 1: change in the market structure. Rick. I think that was
Speaker 1: a great place to leave it. Thank you so much
Speaker 1: for coming on odd lots great to get your perspective,
Speaker 1: lots to think about, and uh, hope to be back
Speaker 1: at someone. Okay, great, Well, thanks you guys after the crash. Yeah,
Speaker 1: take care of Rick. Thanks for I appreciate it. Tracy.
Speaker 1: I thought that was really interesting, and I really think that,
Speaker 1: you know, we go through this frame of thinking about
Speaker 1: the last crisis and I don't mean March because it
Speaker 1: was so weird, but you know, and it's like, oh,
Speaker 1: what is going to blow up the system? And the
Speaker 1: idea that like maybe the next big problem is not
Speaker 1: like a blow up, but stocks go down and stay down,
Speaker 1: and a lot of people have lifestyles premised on stocks
Speaker 1: going up is sort of like a risk that we
Speaker 1: don't really talk about. Yeah. I also I thought your
Speaker 1: question about whether or not there's an economic reason for
Speaker 1: this was really good because I mean, I do think
Speaker 1: that plays into it. Where we have seen lower levels
Speaker 1: of economic growth since the two financial crisis, people have
Speaker 1: been a lot more upset about things like wages or
Speaker 1: just general unfairness of the socio economic system. And so
Speaker 1: I do feel like people are by suing a lot
Speaker 1: of risk assets, not as long term investments, but basically
Speaker 1: like a lottery ticket. I know, Rick said like, well,
Speaker 1: you might as well buy a lottery ticket, but that
Speaker 1: is essentially what people are doing with some of the
Speaker 1: meme stocks or some of the you know, coins and
Speaker 1: things like that. Yeah, you know what, And there's something
Speaker 1: that I've meant to bring up with you, and maybe
Speaker 1: we should do another episode on it. But something that
Speaker 1: I think about a lot is what you've written about
Speaker 1: with this sort of degree of speculation that exists in China,
Speaker 1: and China obviously a poorer country and not a particularly
Speaker 1: robust safety net in China, and and then you have
Speaker 1: all these people who do things like trade iron or
Speaker 1: futures at home. Would you would us speculators retails speculators
Speaker 1: rarely trade commodities at home, and yet that's like a
Speaker 1: big thing in China. And so I often wonder if
Speaker 1: there is this connection between countries that are like unequal,
Speaker 1: have procaredy sort of mediocre safety nets, and the impulse
Speaker 1: that people feel that they need to like speculate in
Speaker 1: order to like it's some level of income or some
Speaker 1: level of wealth because they can't get there through like
Speaker 1: sort of like the normal job for ways. Totally, although
Speaker 1: I would say a, I mean, I'm kind of worried
Speaker 1: about the day that Wall Street bets wakes up, discovers
Speaker 1: commodity futures and decides to like drive up I don't
Speaker 1: know the price of oil or copper or something like that. Um,
Speaker 1: but be it is kind of ironic that in one
Speaker 1: when we have had all this craziness in the market
Speaker 1: and stocks up until recently we're at all time highs,
Speaker 1: that China is actually going in the other direction and
Speaker 1: really cracking down on a lot of speculative activity. Um.
Speaker 1: So it's just interesting to see the West and the
Speaker 1: East sort of going in two different directions on this. Yeah. No,
Speaker 1: it is interesting hearing Rick's perspective, like from the port
Speaker 1: of pension fund manager, and it really does seem like
Speaker 1: it's just been the gravy years. If you're like a
Speaker 1: long term investor and you have a big slug of
Speaker 1: stocks and you have a big slug of bonds, and
Speaker 1: you don't have to react to like every dip of
Speaker 1: the market like this has been like a dream several
Speaker 1: decades because you get this short term is short term counterbalancing,
Speaker 1: but long term bowl market and both. And so if
Speaker 1: something were to change, and the thing that could change
Speaker 1: would be inflation and a sustained rate hiking regime and
Speaker 1: response to that inflation, like, how many of these like
Speaker 1: pension funds are like positioned to deal with that. I
Speaker 1: think it's an extremely interesting question. Yeah, I mean this
Speaker 1: gets into the whole sort of question of whether or
Speaker 1: not we're going to see a big regime change. And
Speaker 1: I think, you know, again, I'll just say it's December one.
Speaker 1: There's a lot to talk about, but I have a
Speaker 1: feeling we're gonna be keeping up this discussion in the
Speaker 1: coming months. Should we leave with there? Yeah, let's leave
Speaker 1: it there alright. This has been another episode of the
Speaker 1: All Thoughts podcast. I'm Tracy Alloway. You can follow me
Speaker 1: on Twitter at Tracy Alloway. And I'm Joe Wisenthal. You
Speaker 1: can follow me on Twitter at The Stalwart. Follow our
Speaker 1: producer Laura Carlson. She's at Laura M. Carlson. Follow the
Speaker 1: Boomberg head of podcast, francesco Leavi at Francisco Today, and
Speaker 1: check out all of our podcasts on Twitter under the
Speaker 1: handle at podcasts. Thanks for listening.