WEBVTT - Richard Bookstaber on the Big Structural Risk in the Market Right Now 0:00:10.880 --> 0:00:15.040 Hello, and welcome to another episode of the Odd Lots podcast. 0:00:15.120 --> 0:00:19.479 I'm Joe Wasntal and I'm Tracy Halloway. It feels like 0:00:19.480 --> 0:00:23.959 we're a little bit of a moment of volatility. I mean, obviously, 0:00:24.040 --> 0:00:26.880 the last eighteen or twenty months now have been this 0:00:26.960 --> 0:00:32.440 sort of extraordinary bull run, full on grab for risk, etcetera. 0:00:33.000 --> 0:00:34.800 I have no idea whether that's coming to an end 0:00:34.880 --> 0:00:36.920 or not, but it feels like with the FED and 0:00:37.120 --> 0:00:40.800 inflation of stuff, we're a little bit of a wobble here. Yeah. 0:00:40.840 --> 0:00:43.279 So we're recording this on the first of December. And 0:00:43.560 --> 0:00:46.280 one of the more interesting things about the past week 0:00:46.400 --> 0:00:50.760 or so is that the wobble started even before we 0:00:50.840 --> 0:00:55.280 had the sort of discovery or the big kerfuffle around 0:00:55.320 --> 0:00:59.560 the new COVID variant Oh my Crown. And it also 0:00:59.600 --> 0:01:02.920 started before we had the FED really start to signal 0:01:03.440 --> 0:01:07.200 that it was looking to potentially taper and raise interest 0:01:07.280 --> 0:01:11.440 rates at a faster pace than the market had been anticipating. 0:01:12.000 --> 0:01:14.960 And this is really interesting to me because, like I 0:01:15.000 --> 0:01:17.880 was kind of thinking back to two thousand seven and 0:01:17.959 --> 0:01:21.240 the quant crisis that we saw that was sort of 0:01:21.280 --> 0:01:24.319 the forerunner to the big financial crisis, and I wouldn't 0:01:24.319 --> 0:01:27.360 want to say that we're about to see something as extreme, 0:01:27.800 --> 0:01:30.200 but it was pretty striking that, you know, in the 0:01:30.319 --> 0:01:35.160 last week of November, when stocks were still basically at 0:01:35.160 --> 0:01:38.720 their all time highs, we did have all this stuff 0:01:38.720 --> 0:01:41.640 that was sort of happening just under the surface. So 0:01:41.680 --> 0:01:44.480 a lot of factor strategies getting hit. A lot of 0:01:44.520 --> 0:01:48.440 the stocks, you know, the growth stocks that were beloved 0:01:48.480 --> 0:01:53.200 by hedge funds UM seemed to be getting hit quite violently. UM. 0:01:53.240 --> 0:01:56.240 So that was kind of striking, like something is definitely happening. 0:01:56.400 --> 0:02:00.080 I'm just not entirely sure what now. You flagged it 0:02:00.760 --> 0:02:05.400 early in a piece in your newsletter, pointing out exactly 0:02:05.400 --> 0:02:07.040 that that is some of There are all these things 0:02:07.080 --> 0:02:10.480 going on, particularly this concentration and this idea that they 0:02:10.480 --> 0:02:14.040 are these very popular investments, and maybe the public gets 0:02:14.040 --> 0:02:16.360 into them and hedge funds get into them, and they 0:02:16.400 --> 0:02:18.680 start to get sold for what might some might be 0:02:18.720 --> 0:02:21.880 called like non economic reasons. And nothing we've seen lately 0:02:22.000 --> 0:02:25.040 like comes close to say this the so called quant 0:02:25.120 --> 0:02:28.560 meltdown the year before the financial crisis hit. But it 0:02:28.720 --> 0:02:30.840 is true that, you know, you have these periods where 0:02:30.840 --> 0:02:32.720 like these winners emerge and the way to win the 0:02:32.760 --> 0:02:35.240 game is to just double a triple down on a 0:02:35.280 --> 0:02:38.040 handful of names, and then as soon as there's any 0:02:38.120 --> 0:02:41.840 elevativation of volatility and you have to pull down your risk. 0:02:42.120 --> 0:02:44.240 You can see some really ugly charts, and there are 0:02:44.280 --> 0:02:47.080 some really ugly charts of a lot of tech but 0:02:47.120 --> 0:02:49.720 not just tech, sort of tech momentum names that have 0:02:49.800 --> 0:02:54.440 been super popular for a while after over the pandemic period. Yeah, 0:02:54.600 --> 0:02:57.919 definitely the air getting kicked out of some of those 0:02:58.240 --> 0:03:01.399 tech tires, I guess. But all of it, I mean, look, 0:03:01.400 --> 0:03:03.800 all of it comes back to a question that people 0:03:03.840 --> 0:03:06.919 have been asking for a while now, I mean basically 0:03:06.960 --> 0:03:10.080 ever since two thousand nine, which was, you know, after 0:03:10.120 --> 0:03:13.560 the last financial crisis, and that is are we in 0:03:13.639 --> 0:03:18.920 a bubble? Are these types of asset valuations unsustainable in 0:03:19.160 --> 0:03:22.919 one way or another? And secondly, if they are unsustainable, 0:03:23.040 --> 0:03:25.920 what is going to be the catalyst that actually ends 0:03:26.000 --> 0:03:29.440 up popping the bubble? Because so far we haven't really 0:03:29.480 --> 0:03:32.000 seen it. I mean, we've seen corrections, but we haven't 0:03:32.040 --> 0:03:35.200 seen anything on the magnitude of what people have been 0:03:35.200 --> 0:03:39.960 sort of worried about. March, of course, um was the 0:03:39.960 --> 0:03:45.200 big moment for markets, but that reversed amazingly quickly. Yeah, 0:03:45.200 --> 0:03:47.320 And I would have said one more thing, which is 0:03:47.440 --> 0:03:51.080 a like, are there bubbles? Is there a lot of speculation, etcetera. 0:03:51.120 --> 0:03:54.520 But be is any of the bubblish activity, or if 0:03:54.560 --> 0:03:56.960 there is bubblish activity, does any of it pose a 0:03:57.000 --> 0:03:59.480 threat to financial stability? So it's like we could look 0:03:59.480 --> 0:04:03.120 at like cryptocurrency and say, look, this is unsustainable, and 0:04:03.160 --> 0:04:06.280 probably for many of them they are. But on the 0:04:06.320 --> 0:04:09.840 other hand, much of that activity, perhaps someone could argue, 0:04:10.360 --> 0:04:13.560 is not a threat to financial stability. So these are 0:04:13.600 --> 0:04:16.480 all like big questions that people are always wrestling with. 0:04:16.520 --> 0:04:18.920 But I think, you know, again these days, I don't 0:04:18.960 --> 0:04:21.600 want to over dramaticize the moves we've seen as of now, 0:04:21.960 --> 0:04:23.880 but you know, once again, some of these questions have 0:04:24.120 --> 0:04:26.560 come to the come to the form. It's a good 0:04:26.600 --> 0:04:29.320 time to ask these questions again. I feel like we 0:04:29.400 --> 0:04:32.040 have a strong news peg in the form of recent 0:04:32.040 --> 0:04:34.000 market development. So we're gonna seize on it, and we're 0:04:34.040 --> 0:04:37.240 going to be discussing all these big questions with really 0:04:37.279 --> 0:04:40.880 the perfect person, right, Yeah, we have the perfect person. 0:04:41.040 --> 0:04:44.280 I'm very excited. We're gonna be speaking to Rick Bookstaber, 0:04:44.360 --> 0:04:47.000 Richard Bookstaber. He is the co founder of a new 0:04:47.040 --> 0:04:51.720 firm called Fabric that provides risk management solutions to financial firms. 0:04:52.000 --> 0:04:55.680 He's well known for his writing and theory in the 0:04:55.720 --> 0:04:58.600 world of like risk management. He has a well known 0:04:58.640 --> 0:05:01.520 book that came out prior to the Great Financial Crisis, 0:05:01.560 --> 0:05:05.000 Learning about Complexity and Derivatives is the title A Demon 0:05:05.120 --> 0:05:08.120 of Our Own Design. Many people view that book as 0:05:08.160 --> 0:05:11.200 having been prophetic about some of the uh some of 0:05:11.240 --> 0:05:13.680 the issues that helped blow up the financial system and 0:05:13.720 --> 0:05:18.240 the economy. He's done risk management at various firms, including Bridgewater, 0:05:18.560 --> 0:05:21.640 So we're going to be speaking to him about financial 0:05:21.640 --> 0:05:24.359 stability and markets right now and how he thinks about 0:05:24.480 --> 0:05:28.159 risks and risks to the system. Rick Bookstaber, thank you 0:05:28.240 --> 0:05:31.839 very much for coming on odd lots, Thanks thanks for 0:05:31.920 --> 0:05:34.840 having me. Why do you start off by telling us 0:05:34.839 --> 0:05:37.440 like sort of what you're up to these days? Like 0:05:37.720 --> 0:05:40.120 you know a lot of people almost certainly know you 0:05:40.320 --> 0:05:44.240 from that book A Demon of Our Own Design, Tracy 0:05:44.400 --> 0:05:46.400 is we're talking about a little bit before. Tracy kept 0:05:46.400 --> 0:05:47.920 it out our desk for a long time, wanted sort 0:05:47.920 --> 0:05:51.560 of a legendary book. What have you been working on 0:05:51.760 --> 0:05:57.640 in some in recent years. So I recently left the 0:05:57.720 --> 0:06:01.080 University of California where I was the chief risk officer 0:06:01.240 --> 0:06:06.080 for their pension and endowment. Um interesting, the University of 0:06:06.080 --> 0:06:09.479 California has bet a hundred and seventy billion dollars to 0:06:09.560 --> 0:06:12.920 manage between the pension and endowment, and I left there 0:06:12.960 --> 0:06:17.120 to start this firm Fabric, which is really focused on 0:06:17.160 --> 0:06:25.120 providing risk management to wealth advisors and the investment advisory community, 0:06:25.960 --> 0:06:30.359 essentially taking the sort of risk capabilities that I developed 0:06:30.839 --> 0:06:34.960 as I've been in various institutional positions as chief risk 0:06:35.000 --> 0:06:40.320 officer in order to deliver higher quality risk management capabilities 0:06:40.400 --> 0:06:44.320 to the financial advisors. So I'm just going to go 0:06:44.360 --> 0:06:49.240 ahead and jump to the big question to Jore, which 0:06:49.279 --> 0:06:51.680 has to be you know, are we in a bubble? 0:06:51.800 --> 0:06:57.440 Do you see signs or evidence here of bubble like conditions? Well, 0:06:57.520 --> 0:07:00.400 I hate to say bubble because when you say bubble, 0:07:00.520 --> 0:07:04.359 that's always got a sense of prediction to it. But 0:07:04.440 --> 0:07:07.680 I would say that we're in a very vulnerable situation, 0:07:08.200 --> 0:07:12.080 a period of high risk. So the level of risk 0:07:12.080 --> 0:07:15.280 in the market is really greater than what you might 0:07:15.320 --> 0:07:20.880 observe looking at day to day price action, looking at volatility. 0:07:20.920 --> 0:07:23.600 So how do you establish that quantitatively or I mean 0:07:23.640 --> 0:07:25.520 we all feel it, right, we all look at crypto 0:07:25.560 --> 0:07:27.320 and to go, this is crazy, or we go might 0:07:27.440 --> 0:07:29.960 look at meme stocks, I think it's kind of nuts. 0:07:30.080 --> 0:07:32.320 Or the degree to which people are just talking about 0:07:32.360 --> 0:07:36.080 trading is very intense, like nothing we've seen since the 0:07:36.160 --> 0:07:38.720 late nine days, for sure, But these are just like 0:07:38.760 --> 0:07:42.320 sort of like gut feelings, emotions, stuff like that. How 0:07:42.320 --> 0:07:45.240 do you go about, actually from a risk management perspective, 0:07:45.480 --> 0:07:49.400 attempting to quantify the level of risk in the market 0:07:49.440 --> 0:07:52.920 so that it's not just feel Crypto and n f 0:07:53.000 --> 0:07:57.560 T s certainly are canaries in the coal mine. It's 0:07:57.560 --> 0:08:01.040 not quite like credit default swaps pre two thousand eight 0:08:01.120 --> 0:08:04.640 because they're not integral to the market. So that is 0:08:05.400 --> 0:08:09.240 a telling sign. But the key things that I look 0:08:09.280 --> 0:08:12.360 at in terms of vulnerability are the extent that the 0:08:12.400 --> 0:08:19.280 markets levered, the degree of concentration, and how much liquidity 0:08:19.520 --> 0:08:22.080 we have in the market right now. It's like we're 0:08:22.120 --> 0:08:25.480 all partying in a nightclub and having a great time, 0:08:25.760 --> 0:08:28.320 but there's a lot of us jammed into that space. 0:08:29.200 --> 0:08:33.400 So if a fire gets started, we're going to have 0:08:33.480 --> 0:08:36.520 a hard time getting out of the exits. So we're 0:08:36.600 --> 0:08:40.480 very concentrated, and if we're in a nightclub, those exits 0:08:40.480 --> 0:08:43.240 are like the liquidity of the market, how quickly can 0:08:43.240 --> 0:08:48.000 we get out? And uh leverage, which is also high 0:08:48.080 --> 0:08:50.599 by a lot of measures right now, is sort of 0:08:50.640 --> 0:08:53.640 the flammability of the space. How quickly can we get out? 0:08:54.400 --> 0:08:56.800 So we're in a situation now where there's a lot 0:08:56.840 --> 0:09:01.840 of crowding, a lot of concentration. We're although we can't 0:09:01.880 --> 0:09:06.360 observe it day today, the liquidity that will be available 0:09:06.720 --> 0:09:10.360 if people start to head to the excess is low. 0:09:11.360 --> 0:09:12.640 And there are a lot of people who are going 0:09:12.679 --> 0:09:16.160 to have to head to the exits because they're either 0:09:16.320 --> 0:09:19.760 leveraged or they're out ahead of their skis in terms 0:09:19.760 --> 0:09:24.160 of their exposure to the equity markets. So this idea 0:09:24.360 --> 0:09:28.600 of rushing for the exits and everything getting rather crowded, 0:09:28.679 --> 0:09:33.880 that's something that we did observe in March with the 0:09:33.880 --> 0:09:36.960 big market crash, and in particular in the treasury market. 0:09:37.280 --> 0:09:40.480 Um given these sort of relative value trades that a 0:09:40.480 --> 0:09:42.520 lot of hedge funds had taken on, and given you know, 0:09:42.559 --> 0:09:47.040 observations around liquidity problems in that market for quite some time, 0:09:47.440 --> 0:09:52.360 I guess my question is does any of that matter nowadays, 0:09:52.440 --> 0:09:57.640 like the experience of is that if things get bad enough, 0:09:58.800 --> 0:10:01.840 the authorities will step in and prop up the market, 0:10:02.000 --> 0:10:04.920 even with credit, which was one area of concern for 0:10:05.120 --> 0:10:08.839 many many years after the financial crisis, the Federal Reserve 0:10:08.880 --> 0:10:13.679 announced a new corporate bond buying facilities to help that market. 0:10:14.080 --> 0:10:17.679 And even though we saw very dramatic price gaps on 0:10:17.720 --> 0:10:21.800 the way down, arguably because of liquidity issues once again 0:10:21.840 --> 0:10:25.600 and because of you know, crowded one way positioning, it 0:10:25.640 --> 0:10:28.360 was very short lived. And here we are, you know, 0:10:28.679 --> 0:10:31.040 almost two years later now or a year and a 0:10:31.080 --> 0:10:34.760 half later, and it doesn't seem to matter that much. 0:10:35.559 --> 0:10:42.200 What the FIT did in is really breathtaking. They're very aggressive, 0:10:42.520 --> 0:10:45.400 very quick on the trigger, and they really saved the 0:10:45.480 --> 0:10:48.839 markets from a disaster. The a lot of the e 0:10:49.000 --> 0:10:52.080 t f s were failing, nobody could do the arbitrage 0:10:52.160 --> 0:10:56.680 to keep them in line with the underlying stocks. Treasuries. 0:10:56.679 --> 0:11:00.439 There's one day that the treasury market traded to hundred 0:11:00.440 --> 0:11:03.160 and fifty million dollars. I mean, that's this is the 0:11:03.200 --> 0:11:05.719 most liquid market in the world, and it basically was 0:11:05.760 --> 0:11:10.720 shut down. So what the Fed did then was I 0:11:10.760 --> 0:11:13.959 think one of the kind because the situation was one 0:11:14.000 --> 0:11:16.760 of a kind, and they did a lot to pull 0:11:16.840 --> 0:11:20.520 the market from the ABYSS. But there's two questions. Would 0:11:20.520 --> 0:11:23.760 they have the will to do it if what we 0:11:23.840 --> 0:11:27.800 have is simply replay of say two thousands I used 0:11:27.800 --> 0:11:31.680 two thousands as a better example in two thousand eight. 0:11:32.080 --> 0:11:34.640 And do they have the bullets available to do it? 0:11:34.880 --> 0:11:37.240 I mean, typically the FED does not have in its 0:11:37.280 --> 0:11:41.200 mandate tempering the markets when you're talking about credit markets, 0:11:41.559 --> 0:11:43.800 you know, high yield markets, we're talking about e t 0:11:43.960 --> 0:11:46.719 f s when you're talking about equities. So I think 0:11:46.720 --> 0:11:50.760 would be foolish from a risk standpoint to bet on 0:11:50.840 --> 0:11:54.160 that and to make decisions thinking that the FED is 0:11:54.200 --> 0:11:58.720 going to back things up. So just on the liquidity point, 0:11:59.080 --> 0:12:02.560 I mean, you were involved in the vocal rule, and 0:12:02.600 --> 0:12:05.640 this is something that you know, the banks in particular 0:12:05.840 --> 0:12:10.520 like to blame for liquidity issues in almost any market. 0:12:10.880 --> 0:12:13.840 At the moment, they can't come in and take bets anymore, 0:12:14.120 --> 0:12:17.480 and so you know, it means there's less market makers 0:12:17.520 --> 0:12:20.480 and things get kind of weird because Wall Street doesn't 0:12:20.520 --> 0:12:23.480 have the same amount of risk appetite that it once did. 0:12:23.840 --> 0:12:26.960 Is that an argument that you buy into or would 0:12:26.960 --> 0:12:30.280 you say that something like Vulcan has, at a minimum 0:12:30.320 --> 0:12:36.640 at the margins affected liquidity. When I was at Treasury 0:12:36.720 --> 0:12:39.920 and the sec U, you know, as you pointed out, 0:12:39.960 --> 0:12:44.679 I was involved with developing the Vocal rule, and the 0:12:44.760 --> 0:12:48.400 big argument that the broker dealers and banks had was 0:12:48.880 --> 0:12:53.040 this is going to cramp liquidity. And the general sense 0:12:53.400 --> 0:12:55.960 among the regulators was, oh, come on, you guys, yeah, 0:12:56.000 --> 0:12:58.720 you'll figure out some reason to not have this put 0:12:58.720 --> 0:13:02.080 in place because it does reduce their ability to make 0:13:02.120 --> 0:13:06.800 money on the customer facing side. But actually they're right, 0:13:07.720 --> 0:13:11.640 And you know, I pointed this out that the incentive 0:13:11.760 --> 0:13:14.800 will no longer be there with the vocal rule to 0:13:14.920 --> 0:13:20.640 be as aggressive in making markets because the profit capabilities 0:13:20.640 --> 0:13:24.880 are not there. When I was at Solomon in THEES 0:13:25.240 --> 0:13:29.360 and we had the emerging market crisis actually crisis because 0:13:29.360 --> 0:13:32.760 you had Mexico and then Asia, we were losing money 0:13:32.800 --> 0:13:35.840 with every trade, but we did it anyway because we 0:13:35.920 --> 0:13:40.560 wanted to defend that franchise because pre vocal rule, you 0:13:40.600 --> 0:13:45.880 could make money trading proprietarily on the customer desks. Well 0:13:45.920 --> 0:13:49.199 that's not there anymore, and so there's no incentive or 0:13:49.240 --> 0:13:53.000 certainly a much smaller incentive for a broker deal or 0:13:53.040 --> 0:13:55.800 to step up to make markets if things are not 0:13:55.880 --> 0:14:00.760 going well. So yes, I think the vocal rule has 0:14:00.880 --> 0:14:06.079 restricted liquidity that market makers would make available in times 0:14:06.120 --> 0:14:11.160 of distress or crisis. Now you know you have to say, well, 0:14:11.640 --> 0:14:14.320 there's a devil's bargain there, because on the other hand, 0:14:15.240 --> 0:14:21.320 you don't have broker dealers essentially front running clients. So 0:14:21.840 --> 0:14:25.200 the balancing act was there the vocal rules put in place. 0:14:25.600 --> 0:14:29.560 But it is a case that's reduced liquidity and and 0:14:29.600 --> 0:14:32.480 I have to say reduced it in ways that are 0:14:32.520 --> 0:14:36.160 not really evident day to day because everybody is more 0:14:36.160 --> 0:14:39.240 than happy to make markets when there's no stress. So 0:14:39.280 --> 0:14:41.640 this is what I want to get back to. And 0:14:41.680 --> 0:14:45.160 I'm still like sort of searching for When you talk 0:14:45.240 --> 0:14:47.960 about if if people run to the exits, and you 0:14:47.960 --> 0:14:50.600 know that's gonna happen again at various times, there's going 0:14:50.680 --> 0:14:52.720 to be the exit is going to be smaller than 0:14:52.760 --> 0:14:55.400 people think, or that there is a high degree of 0:14:55.920 --> 0:15:00.040 concentration of assets, and that is going to exact a 0:15:00.040 --> 0:15:03.560 survey problems if or when when in fact they do come. 0:15:03.840 --> 0:15:06.520 What are I mean other than the sort of theoretical 0:15:06.600 --> 0:15:10.720 things and also, you know, on vulcaral aside, what are 0:15:10.720 --> 0:15:13.480 the things specifically that you see sort of from a 0:15:13.560 --> 0:15:17.440 numbers perspective or from a sort of qualitative perspective about 0:15:17.520 --> 0:15:21.000 the trading, about position sizing that show you that this 0:15:21.120 --> 0:15:23.360 is a vulnerable market, or that you say, we're in 0:15:23.400 --> 0:15:26.160 an we're in an overcrowded nightclub and the fire warden 0:15:26.200 --> 0:15:29.640 would not be happy with how many people are in it. Yeah, yea. 0:15:29.840 --> 0:15:32.440 So so let me go through one by when the 0:15:32.520 --> 0:15:37.280 issues in terms of leverage, liquid eating, concentration, right, in 0:15:37.360 --> 0:15:43.800 terms of leverage, margin, debt less free cash balances is 0:15:43.840 --> 0:15:46.920 that i'll say an all time high. The date only 0:15:46.920 --> 0:15:50.760 goes back so far, but it's higher than even in 0:15:50.800 --> 0:15:55.880 two thousands. And you have households that are more exposed 0:15:55.880 --> 0:15:59.800 in their liquid assets, have more exposure to equities than 0:16:00.280 --> 0:16:04.920 any time in recent history. And that's not strictly speaking leverage, 0:16:05.280 --> 0:16:07.760 but that's what you might think of his hot money. 0:16:08.560 --> 0:16:12.680 Things turn south. Households are going to realize that they 0:16:12.720 --> 0:16:17.000 have more risk than they might have thought about and 0:16:17.080 --> 0:16:22.160 start to liquidate. In terms of concentration, you've already made 0:16:22.160 --> 0:16:26.360 the point. The top five stocks in the SMP makeup 0:16:26.720 --> 0:16:31.240 around of the SMPS market camp. Of course, if everything 0:16:31.320 --> 0:16:35.120 we're equal weighted, they'd be one The top ten stocks 0:16:35.640 --> 0:16:39.400 are somewhere north of of the total SMP market camp, 0:16:39.880 --> 0:16:45.120 and of course technology is dominant in that area. If 0:16:45.160 --> 0:16:49.480 you go and look at the exposure to technology and 0:16:49.520 --> 0:16:54.480 the SMP using a standard measure like the GICKS sectors, 0:16:54.760 --> 0:16:59.720 it's around That's a level that we've seen at other 0:16:59.760 --> 0:17:03.560 periods where we've ended up with market crisis. For banks, 0:17:03.920 --> 0:17:09.000 it was over in two thousand seven for the Internet 0:17:09.400 --> 0:17:14.720 and TMT stocks technology telecommic media, and two thousand was 0:17:14.800 --> 0:17:20.640 over And by the way, is a low estimate because 0:17:21.640 --> 0:17:25.840 we measure how much how many stocks are in the 0:17:25.840 --> 0:17:30.320 technology sector based on their main business. Of course, many 0:17:30.480 --> 0:17:34.320 companies have technology, and Amazon as a case in point, 0:17:34.359 --> 0:17:37.520 they have cloud computing. And if you do things that way, 0:17:37.800 --> 0:17:40.800 you get a number where it's close to of the 0:17:40.920 --> 0:17:45.840 s and P is exposed to technology. By a lot 0:17:45.880 --> 0:17:51.119 of measures. We've got concentration stocks, and we have concentration 0:17:51.880 --> 0:17:58.120 uh in one particular sector that's leverage. And I already 0:17:58.160 --> 0:18:02.000 spoke about the issue with liquidity. The market making is 0:18:02.040 --> 0:18:03.720 not going to be there the way that it has 0:18:03.760 --> 0:18:07.320 been in the past, and the amount of cash that's 0:18:07.320 --> 0:18:10.960 available to supply in the event that people need to 0:18:11.040 --> 0:18:15.600 head out the exit is low. Uh. The percent of 0:18:15.680 --> 0:18:19.720 liquid assets and money market funds is lower than it's 0:18:19.760 --> 0:18:37.880 been in recent history as well. So what would be 0:18:38.560 --> 0:18:42.520 the catalyst in your view for you know, that big 0:18:42.640 --> 0:18:45.320 rush to the exits. And the reason I asked is 0:18:45.359 --> 0:18:49.080 because the experience of the two thousands was that the 0:18:49.200 --> 0:18:54.080 thing that people thought was safe, um, you know, subpride 0:18:54.119 --> 0:18:57.760 bonds that were being used as collateral. Uh in the 0:18:57.800 --> 0:19:02.280 rebo market. Suddenly we're not very safe at all. And 0:19:02.680 --> 0:19:05.040 I'm aware that, of course some people have been warning 0:19:05.040 --> 0:19:07.800 about this problem for a while, but you know, the 0:19:07.840 --> 0:19:12.359 majority of people were at least acting like everything was fine, um, 0:19:12.400 --> 0:19:17.280 and the collateral was absolutely perfect to use. But nowadays 0:19:18.040 --> 0:19:23.000 we've had so many warnings about specific risks. So people 0:19:23.040 --> 0:19:26.000 have been warning about over value tech for a long time, 0:19:26.040 --> 0:19:29.240 about concentration of big tech in the indusicries for a 0:19:29.240 --> 0:19:33.199 long time. We've been worrying about the possibility of a 0:19:33.240 --> 0:19:37.199 COVID resurgence, you know, ever since the Winter of and 0:19:37.240 --> 0:19:40.760 the impact on economic growth. Now we're worried about inflation 0:19:40.920 --> 0:19:45.000 and the possibility of the FED hiking rates, and maybe 0:19:45.040 --> 0:19:48.080 that's going to impact risk assets. And you know, maybe 0:19:48.119 --> 0:19:50.879 a few years ago we weren't necessarily talking so much 0:19:50.920 --> 0:19:53.720 about inflation, but we were certainly talking about what happens 0:19:54.160 --> 0:19:56.800 to the market when the FED raises rates. So all 0:19:56.840 --> 0:20:01.320 of these kind of feel like known risks in the market, 0:20:01.520 --> 0:20:04.240 And I'm curious if if there's one thing that you 0:20:04.359 --> 0:20:08.640 think is sort of less appreciated that could have a 0:20:08.720 --> 0:20:15.240 destabilizing effect. One of the nice things about systemic risks, 0:20:15.440 --> 0:20:17.960 risks that really can be material to the overall market, 0:20:18.119 --> 0:20:22.639 is they're sort of plane and open to view. I 0:20:22.640 --> 0:20:26.960 don't think there's any secret thing working, you know, that 0:20:27.119 --> 0:20:30.199 we aren't thinking about. It's just that we aren't thinking, 0:20:31.240 --> 0:20:35.359 we aren't looking at what's out there in terms of 0:20:35.480 --> 0:20:39.760 risk and and taking it seriously. We have a pe ratio, 0:20:40.240 --> 0:20:45.680 we have price to sales that's in outer space. Talking 0:20:45.680 --> 0:20:49.560 about another thing that's either at or above recent history. 0:20:50.040 --> 0:20:53.880 Various measures of price earnings and price two sales are 0:20:54.000 --> 0:20:58.359 up there, and people justify it in various ways. You know, 0:20:58.800 --> 0:21:04.960 during the Internet period two thousand, the period that Greenspan 0:21:05.040 --> 0:21:12.159 called irrational exuberance, people justified the crazy pe ratios by saying, oh, 0:21:12.520 --> 0:21:17.320 old accounting methods don't make sense anymore. Today they say, oh, 0:21:17.480 --> 0:21:21.639 rates are very low, so the discounting of future earnings 0:21:22.200 --> 0:21:24.520 should mean that price earnings go up. I don't think 0:21:24.560 --> 0:21:28.040 that's a good argument, but in any case, what's out 0:21:28.080 --> 0:21:30.120 there is plane to be seen. The things that I'm 0:21:30.119 --> 0:21:33.439 talking about should not be a mystery to to anybody, 0:21:33.480 --> 0:21:36.080 but people aren't reacting to it in terms of adjusting 0:21:36.760 --> 0:21:41.840 their exposure accordingly. So it could be that people wake 0:21:41.960 --> 0:21:45.520 up and think, wait a minute, evaluations are crazy. Here, 0:21:45.840 --> 0:21:49.040 a few people start to sell that drops the market. 0:21:49.680 --> 0:21:52.600 It could be that fed tapering or something even worse 0:21:52.680 --> 0:21:57.240 than along the spectrum from tapering to recession causes a 0:21:57.280 --> 0:22:00.719 dislocation to the markets. It could be then Asian causes 0:22:00.760 --> 0:22:06.520 a problem, perhaps because treasuries, which people regard as safe assets, 0:22:06.520 --> 0:22:11.640 start to drop as reeds go up, and that begins liquidation. 0:22:12.119 --> 0:22:17.119 All these are stresses that could be the start of 0:22:17.119 --> 0:22:21.880 the avalanche. So how do you actually adjust your exposure 0:22:22.040 --> 0:22:26.040 in a scenario like this? And for the past um 0:22:26.560 --> 0:22:30.720 decade or so, it feels like valuations were basically driven 0:22:30.760 --> 0:22:34.080 by inflows. So if you wanted you know, to be 0:22:34.119 --> 0:22:37.560 a successful investment manager, you basically jumped on the stuff 0:22:37.600 --> 0:22:41.240 that other people we're buying. And I'd be curious to 0:22:41.240 --> 0:22:44.920 get your perspective as well from you know, your previous 0:22:44.960 --> 0:22:48.960 position as the Chief Risk Officer UM at the University 0:22:48.960 --> 0:22:52.040 of California's Office of the c i O. Because as 0:22:52.040 --> 0:22:55.159 you mentioned, this was a huge portfolio, more than a 0:22:55.240 --> 0:22:58.199 hundred billion, and I'm assuming you have some sort of 0:22:58.280 --> 0:23:02.919 yield target that you need to be reaching, but it 0:23:03.000 --> 0:23:07.640 seems very very difficult to get there without taking on 0:23:08.200 --> 0:23:12.800 some form of risk. Yeah, there's no free lunch, right, 0:23:12.880 --> 0:23:17.159 So if you say I'm concerned, I think volatility or 0:23:17.280 --> 0:23:21.159 potential volatility potential risking market is very high. If you 0:23:21.160 --> 0:23:23.879 have a volatility target, you know, you only want to 0:23:23.920 --> 0:23:26.959 have a certain value at risk. That means you're going 0:23:27.000 --> 0:23:30.400 to take your positions down and that is not pleasant 0:23:30.480 --> 0:23:34.160 if the markets continue to do what they're doing. UM. 0:23:34.359 --> 0:23:39.560 But there are some easier methods. One is diversification, which 0:23:39.600 --> 0:23:43.879 reduces risk. People think they're diversified if they're holding a 0:23:43.920 --> 0:23:47.160 broad based portfolio like the SMP five, but as I mentioned, 0:23:47.440 --> 0:23:50.960 they're not really diversified. They actually have a big bet 0:23:51.000 --> 0:23:54.880 on technology. So one thing that you can do is 0:23:55.680 --> 0:24:01.400 take action to increase diversification, which means moving away from 0:24:02.160 --> 0:24:06.280 a cap weighted index like the SMP. Another thing to 0:24:06.400 --> 0:24:10.560 realize is that what you think is safe may not 0:24:10.640 --> 0:24:16.440 be so safe. Treasuries, longer treasuries, say tenure plus, you know, 0:24:16.520 --> 0:24:20.520 high durration treasuries are not really safe in some of 0:24:20.520 --> 0:24:24.879 these scenarios, especially the inflation scenario, and that would suggest 0:24:24.960 --> 0:24:27.960 that if you are going to take action to reduce exposure, 0:24:28.400 --> 0:24:32.280 you're better off moving it towards cash than simply moving 0:24:32.280 --> 0:24:36.840 it towards bonds, certainly better than moving towards high yield bonds, 0:24:36.880 --> 0:24:41.080 which also have a spread that scenario historic low. So 0:24:41.200 --> 0:24:44.760 step one would be diversifying a true sense, which means 0:24:44.800 --> 0:24:50.520 reducing the overweight that's implicit that you have in technology. 0:24:50.640 --> 0:24:54.879 The second is, if you are willing to recognize that 0:24:55.040 --> 0:24:57.439 risk is high and you want to maintain some notion 0:24:57.520 --> 0:25:02.120 of a forward looking volatility target, move away from high 0:25:02.200 --> 0:25:06.160 risk assets to lower risk assets, and the low risk 0:25:06.160 --> 0:25:09.440 gasset that makes most sense is something like cash, where 0:25:09.480 --> 0:25:13.320 I would define for investment purposes, I would define cash 0:25:13.640 --> 0:25:17.240 is say, being anything that has a duration of less 0:25:17.280 --> 0:25:21.159 than two or three years, because something with low duration 0:25:21.320 --> 0:25:24.120 is not going to be affected in a meaningful way 0:25:24.359 --> 0:25:27.720 should rates go up. I want to talk more about 0:25:27.840 --> 0:25:31.680 the the the lack of safety in the safe assets 0:25:31.720 --> 0:25:33.440 or how that could be a problem. And I think 0:25:33.520 --> 0:25:37.320 one difference between the Great Financial Crisis and the dot 0:25:37.320 --> 0:25:40.080 com bubble is, Okay, there was a big crash and 0:25:40.200 --> 0:25:42.880 assets in the dot com era, but no one really 0:25:42.920 --> 0:25:45.200 like thought those were like safe assets, Like no one 0:25:45.240 --> 0:25:47.719