In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and Steve Hou discuss:
- How The Pricing Power Index Identifies Market Leaders
- How The Analyst Rating Index Captures Market Improvers
- Bruce Lee’s Guide to Investing: Fluid Strategies and Relentless Focus
- The Crash Landing into a Marshmallow: Are We Heading Toward Recession
- The Sahm Rule Triggered: What It Means for Fed Policy and the Economy
- Exploring Stock-Bond Correlation
- Is a 40% Jump in Small Caps Possible? Exploring Tom Lee’s Forecast
- How Reducing Interest Rates Spurs Instant Economic Reactions
- Why the Banking Sector is Ready for a Recession
- Bond Vigilantes Explained: How Investor Price Sensitivity Shapes Yields
- The 10/3 Yield Curve Inversion May Have Lost Its Predictive Power
- Why US Analysts Are More Optimistic Than Their European Counterparts
You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:
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Transcript
Tobias: And we are live. This is Value: After Hours. I’m Tobias Carlisle. Joined, as always, by my co-host, Jake Taylor. Our special guest today is Steve Hou. He’s a Quantitative Researcher at Bloomberg Indices. He’s the Senior Equity Researcher. He’s got a PhD. What’s your PhD in, Steve?
Steve: Macroeconomics and financial markets.
Tobias: What did you do your thesis on?
Steve: I studied this topic, which at the time was a little bit obscure. I was trying to study what would happen if the Fed was to unwind this balance sheet and what will happen to essentially bond yields if treasury supply was to ramp up and go crazy.
Tobias: But the Fed, everyone wanted its balance sheet?
Jake: Yeah. What’s the answer?
Steve: Well, you know, unfortunately– [crosstalk]
Jake: Smoke comes out of all the computers?
[laughter]===
Exploring Stock-Bond Correlation
Steve: Unfortunately, my job market, the Fed didn’t– and actually going through with it. It was 2018, and you remember the Fed was thinking about raising interest rates and unwinding the balance sheet. And then, got under pressure, Trump was saying, “You’re being an idiot for raising interest rates.” And then, one thing led to another. The Fed essentially, not only went back on not winding balance sheet but also stopped rate hikes and started cutting rates. And then, the next thing, we had a pandemic and interest rate went to zero again. The winding thing was entirely forgotten. I never got an academic job out of my PhD thesis. But I think thesis, the title of the paper, which is When is the Supply Effect Large in the Government Bond Market, it ironically became quite topical today.
Jake: Yeah. Did you have the taper tantrum built into your model?
Steve: Well, that was the motivation, but essentially, the intuition of what I found is actually quite trivial when you think about it, almost intuitive. Basically, I’m arguing that the treasury yield gets impacted by supply because of essentially bond investors charge a price of risk for absorbing the supply. The price sensitive investors assess the price of risk by looking at the bonds correlation with the rest of their portfolio, in particular, a simple way to proxy it by looking at stock-bond correlation.
If stocks and bonds are very highly correlated, you can imagine absorbing a bunch of bonds is going to increase the overall volatility of my portfolio. That probably means I want to demand a bigger concession, a bigger fund flash for getting all this supply of bonds on my balance sheet. But if bonds and stocks are very negatively correlated, as what’s been the case from 2000 onward, you had this very persistently negative correlation, bonds hedging asset, then you wouldn’t see much of an effect. And that’s what we saw for most of 20 years until basically we see–
Tobias: Is that anomalous that they’re uncorrelated like that?
Steve: Sorry.
Tobias: Is that anomalous that they’re uncorrelated like that? They have been correlated at different times. I don’t know what the trigger is to make them–
Steve: So, if you just plot something simple like a trailing– You can do different it ways. Trading, three or five year or even six months. But generally, you see the pattern is more or less that stock and bonds used to be very positively correlated from the 1960s through late 1990s, all the way to 2000, almost, and then, suddenly, see this massive drop. And then, stock-bond correlation started being return correlation being very positive and has stayed positive. It has tried to creep up GFC, and then went even more negative. The broad intuition is essentially how salient is inflation, because you think about asset pricing, pricing assets more or less, we’re discounting a bunch of future cash flows back to the present day.
Inflation enters through the discount rate, the denominator, and it affects bonds and stocks at the same time. Bonds have a bunch of nominal fixed coupons, and stocks have a bunch of cashflows. So, when inflation is salient– When you get inflation shock, stock and bonds are going to go both up and down at the same time. Now, when inflation is mostly muted and it doesn’t really kick in, and you are in a regime, as were in the 2000s, especially after GFC, where it’s mostly about the aggregate economy, cashflow news, real cashflow news, that’s going to impact stock cashflows, but it’s not going to, in fact, impact nominal bonds. So, you get this opposite movement.
So, first order, I think the intuition is basically, is inflation a big deal or not? And inflation was a big deal until 2000, China entered WTO. Suddenly, you get this massive goods deflation and persistent deflation because of GFC, and then you have suddenly now, we’re in a regime where inflation is a big deal again.
[crosstalk]Tobias: Yeah. Sorry.
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Bond Vigilantes Explained: How Investor Price Sensitivity Shapes Yields
Jake: Well, there was this concept in the– I think it was the 1980s in the US called bond vigilantes. What is that now? I feel like you haven’t heard that in a long time. Was that just people who demanded more interest to give their money to the government and they’re therefore vigilantes?
Steve: That’s exactly right. I tweeted this morning. You have seen this chart of who is buying the government bonds. You can broadly divide them up into different categories. The biggest group is foreigners, which mostly are foreign central banks. They are mostly price insensitive. They are price takers. They will buy at whatever quantity that they’ve allocated and they don’t really bulk at the price of the yield. And then, you’ve got your mutual funds and pension funds. They are relatively price insensitive, because they also invest by mandate and allocation inside every half a year, once a year, like asset allocation.
And then, you’ve got households, which are private investors. And interestingly, hedge funds are also categorized as households. These are shrewd investors. They are doing the calculus. They are figuring out the correlations and price of risk. “How much should I demand to absorb the supply?” And those, I think in those days were the bond vigilantes, I think. I wasn’t around, but I’m imagining basically it refers to the identity of the bond buyer and their demand elasticity or price sensitivity. The bigger the role they play in the overall picture composition of investors, the more you’re going to hear this story of bond vigilantes.
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How The Pricing Power Index Identifies Market Leaders
Tobias: You’re at Bloomberg Indices. What do you do at Bloomberg Indices, and what is Bloomberg Indices as opposed to the Bloomberg TV or the monitors or whatever?
Steve: Yeah, thank you for asking, [chuckles] giving me a push, and an excuse to justify to our folks at Bloomberg Wire. Come on. Bloomberg Indices, so we basically started this business– Bloomberg Indices essentially came from the acquisition of the Lehmann indices, which became the [unintelligible 00:07:46] indices. The Ag, right? That’s the bond index. And then, we also have the Bloomberg Commodities Index that came from initially a collaboration with UBS, and now it’s become whole owned.
And then, I came on to the scene in 2020. At that point, we were thinking about completing our offering by building out the equity’s indices. So, we have all of the benchmarks, passive market-cap weighted benchmarks, but we also building out– So, we filled out style indices. So, when I came on, my first job was to actually build out a family of vanilla style-factor indices with only your typical value, momentum, quality and so on. So, that’s what Bloomberg Indices is. You can go on to bloombergindices.com, and you can find all of our products and our various research insights. The basic stuff we’ve actually built up more things, leverage and Bloomberg data as well.
Tobias: How does your value index deviate from other value indexes?
Steve: There are two types. There is the benchmark type, and then there is the strategy product that becomes licensed as some investment product. For a benchmark, typically, when people just want to track and evaluate their value investment strategy, that construction is not very unusual at all. We try to be as generic and as plain vanilla and explainable as possible using the most commonly used description– [crosstalk]
Tobias: Book. Suppose a book.
Steve: A price to book, book to market or price to earnings, sales, price of the cash flow, and you can find how we weight them and so on. It’s part equal weighted with some typical treatment of [unintelligible 00:09:49] and combination of different descriptors. So, nothing unusual there.
And then, if we want to come up with a value index that is to be tracked by an ETF, let’s say to invest, only then we probably do it in consulting with the client and our own thought process of trying to do it a little bit more thoughtfully with a little bit more of our own ingredients of what we find to be most applicable, especially in the modern context.
Tobias: You’ve created an index, the purchasing power index, can we go through that?
Steve: Yeah.
Tobias: What that involves and how that’s performed?
Steve: Yeah. So, I created a pricing power index. This was like a year and change ago. I recently did a reading of the index white paper with Idea Farm. And the ticker is EPP US index on the terminal. Essentially, this was 2021, I think 2022, we were thinking about how to actually– Everyone was talking about concept of pricing power. Companies with strong pricing power would do well in the inflationary regime. But then, there’s not like a very clear, explicit way people are thinking about pricing, how do you define it?
You can define it by go out and collect a whole bunch of data on all the public companies out there in terms of their market power, market share, and so on and so forth. That’s very onerous. You probably can’t really get a lot of data. So, what is actually a reasonable, sufficient statistic? People will think about profitable companies, maybe ones that have pricing power– But actually, if you look into, it turns out companies that have very high profit margins are not necessarily the ones with pricing power, because the margins can be eroded.
Now, what is interesting is that you can actually make a simple twist. And instead of looking at the level of margin, you look at the stability of margin, in particular, if you look at the stability of gross margin. Now, why gross margin? Gross margin is basically one item away from revenue, the top line. You just subtract more or less the variable cost, that includes your raw materials, that also includes your hourly wages, if you are Chipotle. That basically captures all of the ways in which you can pass through the variable costs.
The idea is that if a trailing five-year gross margin of a company is not varying very much at all, is probably a very good indicator that this company has got very strong pricing power. So, that’s the individual motivation. We built an index using this concept. We’ll go into the detail of how we construct the index in the white paper, but that’s the idea. It has actually done quite well, and we have learned some interesting things along the way.
Tobias: What have you learned?
Steve: You go onto the internet, you go onto Yahoo Finance, you search pricing power, and there’s pricing power ETF. And it’s got things like Nvidia, Tesla, Apple, and all your famous companies in it. I won’t comment on how is it done, but all I want to say is that– What we’ve found in our research, it turns out the companies with the strongest pricing power, not necessarily the ones that are glamorous that you hear a lot about, correct? Apple, for example is a very famous company. People casually think it’s got very strong pricing power. But if you look at the price tag of the flagship iPhone, it’s actually not changed very much for a few years now.
Steve: Now, you can wonder why that is, but it probably has something to do with between competitor and regulator. What we find in our portfolios is that you find companies– A good example I like to refer to is Cadence Design Systems. Have you heard of the company?
Jake: No. I haven’t.
Tobias: [crosstalk] heard.
Steve: Cadence Designs Systems, what do they do? They design software for designing microchips. There are about handful of those companies. Ansys is another one. It’s been acquired by Synopsys. There are like four of them, and one of them is acquiring another one. The private companies with pricing power are ones that are suppliers in niche industries that you don’t ever think about. There’s basically B2B suppliers. They managed to have pricing power and retain pricing power, because you don’t think about them, so competitors are not being drawn to the industry very easily and regulators are not catching their attention. Regulators very often either. So, you’ve got something like a Cadence Design System that’s designing software for manufacturing or designing microchips.
Microchips is all the rationale, and that’s a highly cyclical sector. But you can never imagine a microchip manufacturer to say, “Oh, business is terrible. I’m going to cancel my software for designing my microchips.” You’re still going to subscribe. Same thing with Adobe. So, you’re talking about that type of company, and they tend to show up a lot in our index.
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Tobias: Just before we move on, let me just give a quick shoutout to all the folks who dial in. Danny Beltran, first in the house. Santo Domingo, Dominican Republic. Navarre Beach, Florida. Bendigo, Victoria. Early stuff for you. Good for you. Dubai. How are you? Mac in Valparaiso. Petah Tikva, Israel. Bangalore, India. Mendocino, California. Toronto. Savonlinna, Finland. Nashville, Tennessee. Saratoga Springs, New York. Saskatchewan. Golden Grove, Guyana. That’s a new one.
Steve: Guyana? Wow.
Tobias: Gothenburg, Sweden. [Steve laughs] Omaha, Nebraska. What’s up? Good to see Warren [unintelligible [00:15:58] in again. Chapel Hill. Escondido Mine, Chile. Chile. ballynamullan, Ireland. Hong Kong. Tallahassee. What’s up? Thanks for dialing in. Let’s talk a little bit about your analyst rating improver paper.
Steve: Yeah.
Tobias: What is it? What can we learn?
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How The Analyst Rating Index Captures Market Improvers
Steve: So, yeah, thank you. That’s another paper that I put out recently, actually, just a few weeks ago. This is a concept we came up with by looking at analyst ratings. So, everyone has heard Beyond stock price, the first thing people often look at when they hear a new stock is to go look at how well rated it is by Wall Street analysts. Now, ANR is the function on the terminal. If you have terminal and you type in the ticker, you type ANR, you tell you all that different Wall Street sales analysts, their rating of the stock, whether it’s a strong buy, buy a hold, sell, strong sell. And it also gives you price targets, it gives you detailed research colors.
Now, how do you leverage something like in forming an investable strategy in a systematic way? One obvious thing you can do is just to buy up all the ones that analysts love. You get all the top strong buys. You get your Nvidia, you get your Apple, Tesla. Well, maybe not Tesla, because Tesla is famously hated by [chuckles] analysts, because– [crosstalk]
Jake: And you short that basket, right? That’s got to be the–
[laughter]Steve: So, what we found interesting is that while if you go and just form the portfolio of the top 50 most beloved stock by analysts, like say, equal weight or some market weight or whatever, and you compare to the broader index, you’ve done all right over the last 20 years. If not underperformed, but you’ve also not really, consistently outperformed. This outperformed as well as the broad market.
Now, we were thinking, what if you do something a little bit different? One thing is that we know is analysts, often, they are not wrong, but they can be late. They can jump on the bandwagon. By the time all the analysts come to love a stock when the consensus rating is like a strong buy, a lot of upside has already been realized and the stock has already had a good run.
Now, one thing you can potentially do is to say, “What if I toss out all the ones that analysts tell me to buy?” I look at the stocks whose consensus rating has improved the most in most recent period. So, I will construct a metric that is very similar to how you will construct a price momentum metric, where I look at the average improvement in a consensus rating of a stock from the last 6 months and the last 12 months, just to average out those two. That’s how you will construct a price momentum signal, 12 minus 2 and 6 minus 2.
You build that portfolio and you find what’s interesting is that portfolio, on an equator basis, let’s say consumable construction, has actually, vastly outperformed the broader market over the last 20 years. This index is also on the terminal, the ticker is BANRT. So, BANR is Bloomberg analyst rating and the T is total return index. I can go into the intuition of why that works, but that’s the index.
Tobias: I would like you to do that. Just before you do it, just to clarify, you’re looking at the– it’s the momentum of the ratings or its price moments– [crosstalk]
Jake: It’s the first derivative of the analyst ratings.
Steve: Correct. So, let’s say a stock, today’s rating is 3.8 out of 5, because we normalize everything from one to five, one being strong sell and five being strong buy. If a stock today has 3.8, I used to have a 2.9, that difference is 0.9. I’ll compute that metric for every stock and I’ll pick the ones that improve the most, except I will toss out all the ones that today has a buy rating on it.
Tobias: And that’s a five rating.
Steve: Well, that would be a four and above.
Tobias: Four and above. Okay.
Steve: Four would be a buy and five would be a strong buy. So, between four and five is a range of buys of various types.
Tobias: Yeah, keep on going. You were going to say something before I interrupted you before.
Steve: Yeah. So, it’s very interesting. One, it’s not obvious something like this will work and two, if it worked, you almost expect this thing is just going to be exclusively price momentum. It turns out it works, but it’s not price momentum. In fact, it has a very strong value tilt.
We end up picking up on a bunch of turnaround companies, companies that have fallen on hard times whose fortunes are turning, but have not quite turned so much that analysts are reaching consensus just yet. In terms of that exposure, you have value exposure, you have either vol, because different companies can have hard time for different reasons. Like, most on the white paper, I read about a few examples. I mentioned Hershey’s, because of the price of cocoa. It got hit by that. Netflix, because of password sharing. And most recently, this company– What’s the company that Larry Ellison owns?
Jake: Oracle.
Steve: Oracle. Yes, Oracle has had a turnaround. Oracle is falling on hard times of being hated. And suddenly, AI kicks in, all the AI servers has just gone vertical. And then, we buy it and we dump it, because it became too beloved and you got a rating more than four. But that’s the intuition.
Tobias: So, it’s improvers rather than–
Jake: Winners.
Steve: Correct.
Tobias: Whatever that ticker be neutral, but because it’s improving from sell, then it’s preferred.
Steve: That’s right. I’m agnostic about from when it’s improved. It could be middling.
Jake: Yeah, strong sell.
Steve: Yeah. But although with so much great rating inflation– I mentioned this pretty interesting, the paper that there’s so much rating average inflation over the last 20 years, all the stocks are becoming more beloved. Obviously, underlying fundamentals of US stocks have also become better that you see this consensus rating median going up and up. What I like about this metric of the momentum improver one, is that it’s more or less centered around zero. It doesn’t go up with the average level. So, at any given moment, there are some companies that are getting better, some companies that are getting worse.
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Why US Analysts Are More Optimistic Than Their European Counterparts
Steve: What’s also interesting about this signal, by the way, is that it works not just in the US, it works in Europe, it works at APAC. It works in EMEA. If you look at US and Europe, for example, is a very interesting contrast. American analysts are so much more optimistic than European counterparts. Sector by sector, time by time period, they are consistently about 0.25 higher than the European one. I’ll give you a good example.
Jake: USA
Steve: Eli Lilly. Zepbound, today, they came up with a new drug. Eli Lilly is a beloved company. In America, the rating is about 4.67 or something, so strong buy. Now, do you know that European competitor– Have you heard of them?
Jake: What?
Steve: It’s called Novo Nordisk.
Jake: Sure.
Steve: Novo Nordisk invented Ozempic. Now, take a guess what Novo Nordisk consensus rating is on Bloomberg terminal
Tobias: 0.25 lower?
Steve: It’s 3.97. It’s not even a buy.
Tobias: [laughs]
Steve: It’s very hilarious. I have this paper. You can go on our website, the bloombergindices.com to find the ANR paper. Maybe we can put it in the link below later too, that you compare the ratings sector by sector. American analysts just give higher ratings to their stocks than European analysts. Anyway, it’s just a little fact point. I thought it’s interesting to bring up.
Tobias: I got a question from the crowd here. Does it work in reverse? Does it work for finding shorts?
Steve: Yeah. In theory, sure. We created an index as an ETF. So, yes, launched as an ETF with Invesco. We did a quanta analysis. You see the monotonicity and so on. We didn’t investigate too heavily into how you get implemented realistically as a short strategy, but it’s certainly a promising direction.
Jake: Weren’t Lehman and Enron, both still like strong buys, like a week before they filed for bankruptcy?
Steve: [laughs] Yeah, there’s definitely a lot of, I think, persistence, because that goes into the analyst psychology and culture. One interesting thing is, if you go into the paper, if you go to the appendix, the two geographical regions in which that has the highest consensus rating is North America and Asia. In Korea, the analyst ratings are off the chance. What I was told is not because the companies– Analysts are so optimistic as much as I think there is an expectation, that “If you cover my company, you have to give me good ratings. Otherwise, I won’t let you cover my company.” [crosstalk]
Jake: It’s an access issue.
Steve: Exactly. So, I think some of that is probably also present. You see that in Taiwan as well, by the way.
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Bruce Lee’s Guide to Investing: Fluid Strategies and Relentless Focus
Tobias: I want to do some questions about the economy and the macroeconomy in general. But before we do that, JT, do you want to do your vegetables?
Jake: Yes, sir.
Tobias: do it a little bit early today?
Jake: Sure.
Tobias: Steve, Jake brings some interesting learnings for everybody, and then he tries to– from an unrelated area.
Jake: Or, make benefit–
Steve: Okay. Am I getting a quiz?
Tobias: No. Well, maybe then he tries to make it related to investing. So, that’s the best part of the whole thing.
Jake: Yeah, that’s where usually where the wheels fall off the wagon. [laughs] So, this week– This just happens to be a coincidence that we have someone of Asian descent on the show. But we’re going to delve into the world of Bruce Lee today.
And so, I just happened to be flipping on the TV and Enter the Dragon was on. If course, it’s really hard to keep going once that’s on. You got to just stop and watch it. I just remembered how much I loved Bruce Lee. And then, not only was he just a badass in these martial arts scenes, but there’s this inner strength and coolness that to me, just exudes from him that I’ve always been attracted to.
Of course, everybody knows he died super tragically, young at just 32 years old. But he left us a treasure trove of wisdom that’s not just about fighting, but thriving. Maybe we can even draw some investment parallels. We’re going to center off of four quotes from Bruce Lee. So, number one, let’s kick it off. Maybe his most famous piece of advice, which is “Be water, my friend.”
Now, this isn’t just about fluid movements in martial arts, although he did emphasize what he called the style of no style in his fighting. He didn’t want to be that formalized and traditional in his approach. He wanted to be like water. I think there’s something powerful there is investment strategy as well.
So, picture water ever adapting, flowing, taking the shape of its container, finding a way around obstacles. And in investing, I think this translates to embracing opportunity, however it presents itself and then navigating these challenges without forcing things. So, sometimes net-nets are available, like in Korea in the early 2000s. Sometimes it means getting a super high-quality business franchise for an ordinary price. Sometimes it’s merger arb, junk bonds, spinoffs. The point is to have lots of different strategies that you can low toward, depending on what the environment is calling for. Avoid labels. Have the style of no style. Accept this fundamental precept of getting a lot for your money, perhaps, and making good risk reward decisions. Just like water, you don’t have to force it, and take the shape of the container that’s offered by the marketplace.
Related to this concept is wu-wei, which we’ve covered in Season 3, Episode 40. If you want to double click on that concept. Toby, what’s the good working definition of wu-wei that you have?
Tobias: Yeah. Flow state, being in just the right thing at the right time. Minimal efficiency, I think.
Steve: Is this a Chinese phrase?
Jake: Yes.
Tobias: Wu wei is.
Jake: Yeah.
Steve: Sorry?
Tobias: It’s Taoist, isn’t it?
Steve: Okay. Wu wei. All right. Yeah. Okay.
Tobias: What does that mean to you, Steve?
Steve: It is a famous phrase from Taoism. It means doing by not doing, I guess.
Tobias: Yeah.
Jake: Yeah, that’s right. Effortless effort.
Tobias: Effortless achievement.
Jake: Yeah. All right. Quote number two. “I fear not the man who has practiced 10,000 kicks once, but I fear the man who has practiced one kick 10,000 times.” So, this is really about mastery, focus, repetition, closing feedback loops, super deep concentration, deliberate practice. Really, you got to put in those reps in order to be good at this. It’s this relentless pursuit of improvement that leads eventually to exceptional results. And it’s very nonlinear.
Shane Parrish has this great quote that’s “Ninety percent of success can be boiled down to consistently doing the obvious thing for an uncommonly long period of time without convincing yourself that you’re smarter than you are.” All right, related quote number three. “The successful warrior is the average man with laser like focus.” So, in today’s world, filled with digital distractions, having a laser-like focus on your most important goals is, I think it’s damn near a superpower, these days.
In researching these veggies today, I stumbled across some of Lee’s personal journals. It became clear to me that based on the wording that he used, there’s these little clues, these mantras that he would repeat to himself in his journals. I’m pretty positive that Bruce Lee at one point read Think and Grow Rich by Napoleon Hill. I think it had a major impact on him. So, I personally think it’s a terrific book, and I’d encourage everyone, anyone, to read it. I’ll give a little unsolicited parenting hack that I’ve personally implemented, I thought would be fun to share.
So, I bought each of my boys, a leather-bound copy of Hill’s classic. It looks very serious. It looks like a Bible. It has black leather, it’s gold embossed writing on it, very, very Bible like. I think there’s something to the weight of a message that is derived from the medium that carries it. It feels very serious.
So, when each of my sons, when they turned 12, I gave them their copy of Think and Grow Rich. Before that, I went down to the bank and I got a big stack of $2 bills. I put one bill at the end of each chapter in the book, and I told them that that cash would then be unlocked as they read through the book and got to the end of that chapter. The only catch was that the money had to be spent in pursuit of their dreams. So, [Tobias laughs] that was my little parenting thing you guys can steal that if you want.
Tobias: That’s a good one.
Steve: [laughs] Excellent.
Jake: And then, last quote, number four. “There are no limits. There are plateaus, but you must not stay there, you must go beyond them. If it kills you, it kills you.” Now, that part I’m not sure I agree with, but–
[chuckles]Jake: This is really about pushing past your boundaries, embracing that mindset of continuous growth. In any pursuit, you’re going to run into plateaus. It can be really disheartening and frustrating when you feel stagnant. I think investing is no different. It could feel like ground dog day. Toby, tell me if this rings true for you. Mag Seven up, Russell 2000 value down, value spread [Tobias laughs] widened again, yield curve still inverted. [laughs] I’m going to stop now before you start crying, but–
Tobias: I think that’s an excellent segue, because we got Steve here. That’s exactly where I was going to go next. What do you think, Steve? Where are we? Where are we with all of that, the economy, the stock market, inflation? We’re going to go through all of that with you now.
Jake: Well, let me just finish these off.
Tobias: I’m sorry. I’m sorry.
Jake: Because if I lose my train of thought, I will never get it back. All right. So, after all that– I’m just teasing you, Toby. I think this too shall pass. Even when you feel bored by the market, you could still keep working on your skills. I think Peter Cundill said something like, “There’s Always Something to Do.” That was the title of a book of his.
You can learn about new businesses, you can learn about new business models, you can discover new mental models, you can add new analogies to your toolkit, which I like to work on. You can read history, you can look for interesting data correlations like Steve does, you can read trade magazines, get your physical and mental health dialed in, so that you’re ready for battle when it does shift into the next phase. Work on your metagame of sharpening all of your processes, keep score, track your KPIs, there’s lots of things you can always be working on.
If you think about complex adaptive systems, in general, like the stock market, there is no standing still. The market’s always adapting. It’s always neutralizing edges, and the bar is always being raised for what’s expected of you. And so, if you aren’t serious about that active improvement and you’re not putting in the dedicated work, you’re naturally falling behind. There is no treading water, really. You’re either advancing or falling behind.
So, Bruce Lee’s wisdom, I think, offers us incredible guidance, not just for the martial arts, but for achieving excellence in any field, including investing. So, remember to flow like water, master your craft, stay focused and keep pushing your limits.
Tobias: That was a good one.
Jake: All right. Over to you, Steve.
Steve: [laughs] That’s a hard act to follow. [laughs]
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The Crash Landing into a Marshmallow: Are We Heading Toward Recession
Tobias: Let’s start with, where are we in the economy? How do you see it? Are we in a recession? Is there a recession approaching? Have we had a growth scare? Is this what always happens in the lead up to an election? What’s your sense?
Jake: Climbing the wall of worry?
Steve: I think we are living through, for something cliche, the most extraordinary macroeconomic episode in modern history. I don’t think we are in a recession. We’re definitely not in the recession right now, and there are very many indicators we can point to just say that. But I also don’t think that we’re not at danger of getting into some a sharp economic slowdown that end up in a recession if we’re not careful or lucky.
Jake: Steve, can I ask– Would we be in a recession now if we weren’t running trillion-dollar deficits?
Steve: That is a very difficult question to answer. [chuckles] With macroeconomics, there’s so many confounding variables. I know what you’re getting at. There’s just no question that broad strokes. I think there is something to the effect of the Fed having acted too late, the federal government having issued too much money, fiscal stimulus between the two presidents, and then, the Fed having to then come back and perhaps overcorrect that the two things offset each other. We crash landed into a marshmallow.
[laughter]That’s how I like to think about it. Because we fell so hard, that we’re crash landing into a big piece of marshmallow so fast, so forcefully, what the end outcome depends a little bit on the thickness of the marshmallow, and the speed and momentum with which we’re going to fall and crash. We are trying to arrest the momentum a little bit with the Fed now starting to talk about starting to cutting rates and so on. So, that’s where I think we are.
I think we are going through some episodes of growth scares. We already saw one. Last month, we saw the job numbers came in very low. And then, it almost was like what economists call like a peso problem where it’s not news. If you look at all the indicators, the ones that matter, the ones that I watch, which basically is the labor market, which is the only one that really matters, forget about everything else. Whether it’s job openings, whether it’s a higher rate, like how many people being hired, the quick rates, how often people are quitting their jobs? Unemployment rate has been kicking up steadily from a very low level, albeit.
Wage growth has been steadily slowing. In other words, no matter where you look, the economy has been steadily slowing. It’s just the last month, I think everyone got a sudden wake up call, “Wait a second, hold on. We may actually be entering recession.” It’s funny enough is because of this indicator that has become famous by my fellow new Michigan Alumnus, Claudia Sahm. She was a few years ahead of me.
She invented, when she was at the Federal Reserve, this rule called the Sahm Rule, which says, if you look at the rolling three months, use three unemployment rate increase and if it bridges 25%, historically, it has always been followed by further increase in unemployment rate and the recession. And everyone suddenly just saw that indicator being triggered and say, “Oh, wait, we’re going to be in the recession, market sell off,” which coincided with this Japanese shortfall carry trade blow up, and everything happened at once. But then, we obviously have to come on the other side of it, like you snapped right back.
Jake: That was a scary 10 minutes there.
[laughter]Steve: Yeah, that was basically one episode of a growth scare. I think we may still have more, but we also, I think going to have conflicting indicators. Since the job report, we’ve had retail– We have continuous claims, essentially for people who are on unemployment insurance. We are seeing signals that maybe the economy is actually stronger than certain numbers indicate. I think we just have got a lot of confluence of different factors, because a lot of the aggregate statistics are a little bit screwed up during the pandemic.
All these numbers that we see, they all come from surveys of either households or companies. Unemployment comes from survey of households, and payroll survey comes from survey of companies. All of these surveys are being responded to with a much lower percentage. It turns out people are suddenly realizing, “Wait a second, there’s this single pandemic. I die any moment. I’m not going to just fill out some long questionnaire for nothing.”
And yet, on top of that, the most prominent political issue across all countries today is illegal immigration. It turns out if you have illegal immigrants that are here in this country and working to support themselves in one form or another, they probably won’t be reached by a household’s mail survey, because you don’t know where they live. [chuckles]
Even with companies which may report them as part of payroll, may not be fully reported because companies may not always want to report how many people they are hiring that may or may not be fully compliant. So, you just have a lot of noise in these aggregate statistics. That’s why we’re almost experiencing a mini version of, what I call, the March 2020, where we are whiplashing a little bit based on noisy little crumps of data, because on the other side, the uncertainty is enormous.
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The Sahm Rule Triggered: What It Means for Fed Policy and the Economy
Tobias: The Fed seems to have decided that it’s time to cut, or that’s what came out of Jackson Hole last week. They say, September. What are the things that they’re looking at to decide that now is the time to cut? How do they consider that? We’ve got the stock market’s essentially at all-time highs. Housing market seems to be expensive by any number of different measures. Unemployment seems to be rising. But as you point out, it’s still historically pretty low. How do they arrive at the conclusion that now is the time to start cutting?
Jake: That’s a trap.
Steve: One second. I have a bit of noise. Give me a minute.
Jake: I asked myself the question also, like, in 20 years, will those 25 basis points mean anything?
Steve: Yeah, it’s obviously not about this 25 bps. Why is the Fed looking to cut even though asset prices are historically high? The Fed basically looks through asset prices. For example, why do you bring up asset prices? Because casually, you have this intuition that asset prices must translate into purchasing power, because people feel richer, wealth effects and so on. But it turns out historically, if you look in the data, there’s not much translation from asset prices into inflation. I think mostly it’s because assets are overwhelmingly owned by wealthy people whose consumption needs are fully met. Additional wealth does not actually translate into additional consumption very much at all.
So, you very much have got this K-shaped thing where this inflation has been accomplished by squeezing the asset light income dependent people who contribute the most to CPI basket consumption, while the wealthiest people who own all of the assets are seeing their assets go through the roof. So, you see a lot of asset inflation, but CPI inflation is actually not responding to it. The Fed is mandated to care about CPI inflation. So, if they see things that might threaten the other side of their mandate, which is jobs, they will start cutting. The other side of the things that will affect jobs are actually flushing red. So, you’ve got this very weird combination. Yeah.
Tobias: So, the Sahm rule has been triggered? Is that right? So, is that what they’re looking at and they’re saying, “Well, it looks like unemployment is coming”?
Steve: Well, Sahm rule, it’s a historical regularity. Even Claudia Sahm herself has said this probably does not mean the same thing as it used to mean. For the most part, unemployment has gone up, because an expansion of labor force. We’ve got more people looking for jobs as a result of illegal immigration and in part because of just more people entering the workforce. In any event, you’ve got this rise in unemployment rate.
Now, what does that mean in terms of actual job markets? The Fed does not just look at the Sahm rule. The Fed looks at a broad set of indicators of which this momentum of unemployment is only just one. The Sahm rule, even if you don’t respect that, it has a sharp threshold at 0.5. You always have to hold this intuition, that once unemployment gets going, it starts rising. It has a certain momentum that you keep on rising a bit more. You don’t really want that to happen, because that usually is what recession is fundamentally.
Jake: I think you saw that with the tech companies. Until someone went first, they didn’t feel like it had the political cover or the safety to go lay people off, right?
Steve: Yeah. So far we have not really seen very much layoffs yet. Unemployment rate so far, what’s been reassuring, it’s mostly come from the lack of hiring, because remember, people move in and out of workforce for economic reasons. Sometimes they will leave a job, and then they don’t get replaced. So, that just contributes to a lack of movement and harder to find a job. The same way we see in the housing market, by the way. The existing home market has more or less frozen. People are not buying, not selling. And the reason people are not selling is because they can’t really buy one wherever they go next. So, you have this two-sided market that are both frozen.
The labor market is sort of a similar. So, you don’t want to lose a job now, because companies are very cautious about hiring new workers, but they’re also not laying people off yet, because they just had this whole experience of not being able to find workers. It’s all just whole hoarding workers– Profit margins are relatively healthy. They’re going to want to hold on to their workers, which you are seeing. After tax margins are at historic high levels. So, that’s the weird situation we’re in.
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The 10/3 Yield Curve Inversion May Have Lost Its Predictive Power
Tobias: Cam Harvey has this 10/3 inversion that he says, “The un-inversion is the event most preceding the declaration of a recession.” A little bit like Claudia Sahm, he’s disavowed the signal as well. I guess I got two questions. Why do these researchers disavow their signals? And secondly, what do you think about the 10/3 and the prospects for that preceding recession?
Steve: First of all, if you just take a step back and you look at all the episodes, all the episodes, they say all these times, he has always predicted recession. We are looking at most nine episodes. And typically, in statistics we say what we need at least 30 data…
Tobias: 30? Yeah.
Steve: Let’s say, they’re all uncorrelated. Here you have nine, highly probably correlated samples that are episodic, because in the 1970s, they all happened in the same fashion. There’s really not very much robust inference you can draw from the nine data points to stay with the tenth. So, that’s point number one.
Point number two, is that I think we are just in an extraordinary, unusual circumstances where we have never crashed so hard into such a big piece of marshmallow before. We’ve never had this much fiscal stimulus support onto what was already a very healthy US economy with US households having historically high home equity, tight net worth, very strong balance sheets on the bank side, and so on and so forth. You have basically robust labor market wage growth that the historical channels through which the, for example, yield curve.
Yield curve is supposed to discourage bank lending, and that would basically discourage—then it would make it difficult for you to finance your new economic activities, whether it’s buying a piece of furniture, buying a car or buying a house or a firm site, so CapEx, right?
Now, if you are already awarded with liquidity, because you had churned out your debt and you have a lot of income and the firms already have access to liquidity throughout the means, this squeeze is not going to feel as painful. You’re still feeling it in certain corners of the economy, but broadly, the pain is just so much more blunted that you’re going to have a more delayed response, is how I’m thinking about it.
Tobias: It does seem to–
Jake: [crosstalk] take a second to appreciate that we’ve had money call it for 5,000 years. We just now figured out exactly how you could just print the right amount, and then you don’t ever have to deal with any real problems. What a lucky stroke for us, as a species.
Steve: [laughs] Well, it works for some countries better than others. It seems to have done wonders for America so far. You look at the UK. I think the Prime Minister of UK just mentioned there’s going to be pain to come. And Australia, Tobias’ home country isn’t doing so hot either, from what I vaguely have heard. Is that right?
Tobias: Yeah, I haven’t followed that closely.
Jake: We had a man on the street there a couple of months ago, what’s the–
Tobias: Yeah, I looked pretty rich when I was down there, honestly.
Jake: [laughs]
Steve: Yeah.
Tobias: It looked a little bit overheated, so maybe they could do raise some rates down there, a little bit. I was going to say that the increase in rates has probably impacted small in micro, and maybe some mid companies, definitely more than it’s impacted the very big end of town. I think that there was a funny little round trip that small and micro did in the end of July, and ran up really quickly and then ran back down. And then, on Friday, when the Powell news came out of Jackson Hole, it all levitated up as well. Is there some connection between rates and small cap? Are they more closely tied?
Steve: That’s exactly right. So, to the extent that we were just talking about rich household and poor households, they have this dichotomy where one is being hurt very much and another side is really benefiting. You’ve got a similar dynamic mirrored on the corporate side. You’ve got your Magnificent Seven. They are generating wads, wads of cash flow, on whatever network externality, they have managed to create. So, they are not very dependent on external financing. They can finance all of their CapEx using internally generated cash flow and earning interest rate along the way on their cash pile.
On the other hand, you’ve got the smaller companies that are more dependent on credit. They are more still cyclical, small value companies. They get almost double whammy in a recession here, because if we get a recession, the cash flow side of their business gets absolutely whacked and they go down.
Now, if interest rates don’t go down, they get hammered on the financing side, because they all have to roll over onto unaffordable interest rates on their credits. So, they really benefit from a soft lending thesis working out, which is why we saw this round trip in July, where we had this growth scare, and suddenly, they look like they may be actually getting from a recession. But then they also get hammered if we get bad news on inflation front and maybe rates won’t go down very much. So, what’s really bullish for, I think the smaller cap value-ish companies is really for this soft lending thesis to work out, which is actually I think reasonably the base case, at least in my opinion.
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Is a 40% Jump in Small Caps Possible? Exploring Tom Lee’s Forecast
Tobias: Tom Lee, who’s @fundstrat on Twitter, he’s a market commentator. He says that “Small micro is going to levitate 40% by the end of the year,” [Steve laughs] which I don’t believe for one second, but I’d love it to happen. I have no idea what he’s based that on, but is that interest rates being cut rapidly? Is that the only way that happens?
Steve: I don’t know. I’ve not read into Tom’s mind. We have had sporadic chats and DMs. He’s clearly been proven extremely prescient over the last couple of years. He is what some people may like to call permabull, and he’s been [Tobias laughs] very bullish on the large cap, the Magnificent Seven. Then suddenly, he’s like, “Oh, by the way, I’m not that bullish on the Magnificent Seven anymore. I think they’re just going to go sideways. But in the meantime, I think the rest of the market is going to go up [Tobias laughs] 40%,” which sounds a little bit hyperbolic. More than a little bit. But he also made hyperbolic predictions about the bitcoin price.
I don’t know what to make of his hyperbolic prediction, but I do think that probably is aligned with there not being a recession, and interest rates coming down as currently forecasts and then, you get this Goldilocks situation that really will benefit small cap value that has just been suppressed for such a long time. I think something to that effect directional, qualitatively could happen. We’ve certainly seen days in which the Russell is up 3% when the Dow itself is up 80 bps or something. But I don’t know whether we actually get 40%. [laughs]
Jake: That’s what the models say. So, that’s what you get to– [chuckles]
Tobias: You don’t look at that trend in unemployment and think when historically, it’s been pretty consistent. When it starts taking off, it really goes vertical. That doesn’t concern you? That’s going to happen?
Steve: I think when we would say something like that, there’s an implicit assumption about the nature of the economy being more or less the same as the past. A lot of the sample we were talking about is from the 1960s, 1970s, 1980s. If I asked you, Tobias, do you think today’s US economy is comparable in nature to economy in those days? I don’t know, you actually would so readily say yes. There’s a lot that has changed in a very big way, right?
Tobias: Yeah, for sure. No doubt.
Steve: The economy has become a lot more services oriented. Manufacturing has become a much less important portion of the economy. So, when we say manufacturing sentiment, PMIs in some dire straits, what does that really mean?
Meanwhile, you go outside, you walk on the streets, people are walking up and down the strand, having a good time consuming like there’s no tomorrow. [laughs] So, it’s hard to, I think, square those two. I do think there is something structurally different about today’s economy. It’s not to say that there cannot be momentum in unemployment that keeps going up. I personally believe that if the Fed does not start easing, you’re going to start seeing an acceleration of weakness in pockets of the economy. That being said, I also don’t subscribe to the view some seem to hold on Twitter and elsewhere that is already too late, and we’re going to necessarily enter a recession.
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How Reducing Interest Rates Spurs Instant Economic Reactions
Tobias: Because there’s such a long lag between when they act and when it shows up.
Steve: Actually, I want to argue the opposite. I actually argue. There’s actually a very immediate response, that if rates come down, you’re going to have pockets of the economy that will instantaneously react. Whether we are talking about refinancing, people are taking out money out of their equity, home equity. Today, I think we’re sitting at probably the highest home equity since 1960 in the US. It’s just been a one-way recovery since GFC.
The last few days, I’ve been checking my email. I’ve been inundated with email from Rocket Mortgage and Bank of America saying, “Hey, we urge you to take money out of your house.”
Tobias: [laughs]
Steve: So, there is a lot I think of net worth to support. You’ve got a secular demand of housing from millennials being shut off the housing market. They are now eager to form a family, buy a home somewhere, and suddenly rates went so high so quickly and home prices have not come down that they couldn’t buy. So, if rates come down, even just marginally by a few percentage points, you’re going to see this spring of activities coming up, not to mention the unlocking of the existing home market.
People have not moved. Historically, people will move across countries for jobs that have nothing to do with the value of their homes. They will buy somewhere and sell somewhere, and that entire market will get unlocked. That means that people who are realtors will get hired, people who are in renovation are going to get fine business, and so on and so forth. So, the operating leverage on interest rate actually can be very fast and very high. I think if anything, the lag is very short, instantaneous in fact.
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Why the Banking Sector is Ready for a Recession
Tobias: I should ask you– I’ve got a question from the audience here. It’s related. “Any thoughts on the banking system? Equity ratios double from pre-GFC for some of the banks. Do you think that’s sufficient to reduce the intensity of a recession?”
Steve: Well, first of all, I’ve already said I don’t believe we have a recession in the [unintelligible 00:58:10]. But even if we did, I think it’s going to be a pretty mild one, like a skirting one. I think the banking sector is rock solid. I’m not a banking expert by any means. You want to listen to some outlaw episode with Steve Eisman, who was in The Big Short movie. And he explained this back last February, very eloquently. “All the major big money center banks have what–”
I think Jamie Dimon calls fortress balance sheets. They’re just rock solid. Not many people don’t know this. We’ve got thousands of thousands of banks, unlike other countries. Obviously, we’ve got 3,000, 4,000 banks, like long tail, tons of banks that you’ve never heard of, local banks.
The fact that we’re going to lose a couple hundred here and there really should not alarm anyone, because their market weights are very tiny and their lending can easily be substituted by a competitor that will acquire them easily. So, what we saw with SVB was a unique situation, but generally, I don’t foresee the problem to come from the banking system this time.
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Tobias: Well, that might be a good note to leave it on, Steve.
Steve: [laughs]
Tobias: Thanks very much for sharing your thoughts with us today.
Steve: Yeah.
Tobias: Steve Hou from Bloomberg Indices, thank you very much. We have an unusual podcast scheduled this week. Tomorrow, we have Guy Spier coming on the show. We’re going to be starting a little bit earlier than usual. I think it’s about 10:15. But we’ll be on tomorrow with Guy. So, Steve, thank you very much.
Steve: Thank you so much for having me.
Jake: Steve, if people wanted to follow along with your work, what’s the best way for them to do that?
Steve: So, they can definitely follow me on Twitter, @stevehouf, actually with an F at the end. They can also find my work on bloombergindices.com. And Tobias, maybe we can put a couple of my papers link in the bio or in the video description. They can certainly also reach out to me at fhou9@bloomberg.net.
Tobias: Awesome.
Jake: Great.
Tobias: Thanks, JT. See you tomorrow. Thanks, everybody. We’ll see everybody tomorrow. With any luck, Steve.
Steve: All right. Look forward to that. I’ll be tuning in too.
Tobias: [chuckles] Awesome. Thanks so much.
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