Invest Like the Best with Patrick O'Shaughnessy - Jesse Livermore - Upside Down Markets - Understanding Fiscal and Monetary Policy - [Invest Like the Best, EP.194]

Episode Date: October 6, 2020

My guest today is Jesse Livermore. I’ve worked with Jesse as part of our research partners program at O’Shaughnessy Asset Management for years now. Whenever there is a huge, important, and complex issue to be studied, I believe he’s among the best minds in the world to tackle it. He did that recently on the topic of what he calls “upside down markets,” which is the topic of this conversation. We seek to answer the simple question: against a horrible economic backdrop, how can the stock market be near all-time highs? Jesse explains in detail the impact that fiscal policy has had on the market and may have in the future. Please enjoy this master class in upside down markets.   This episode of Invest Like The Best is sponsored by Canalyst. Canalyst is the leading destination for public company data and analysis.  If you’re a professional equity investor and haven’t talked to Canalyst recently, you should give them a shout. Learn more and try Canalyst for yourself at canalyst.com/Patrick.     For more episodes go to InvestorFieldGuide.com/podcast. Sign up for the book club and new email newsletter called “Inside the Episode” at InvestorFieldGuide.com/bookclub. Follow Patrick on Twitter at @patrick_oshag   Show Notes (2:29) – (First question) – What is Upside Down Markets (5:44) – Overview on monetary easing and the fed’s role in the markets (9:42) – Why fiscal policy is such an important lever and the impact it has on the economy (15:07) – The impact of stimulus on public companies’ fundamentals (19:25) – The mix of assets in the market due to stimulus (22:13) – What made 1929 so different to how we are reacting today (26:14) – Negative concerns: too much money in the system and the risk of inflation (32:43) – Will the pendulum swing back to labor and higher wages (37:23) – How these changes could impact specific companies or sectors differently (41:34) – How he is applying all of this to his personal investment philosophy (44:25) – Biggest risks still out there (49:51) – Most interesting gap in his knowledge putting together this piece   Learn More For more episodes go to InvestorFieldGuide.com/podcast. Sign up for the book club and new email newsletter called “Inside the Episode” at InvestorFieldGuide.com/bookclub. Follow Patrick on Twitter at @patrick_oshag  

This episode of Invest Like the Best is sponsored by Canalyst. Canalyst is the leading destination for public company data and analysis. I'd heard of Canalyst over the past few years and became more interested after meeting the founder and CEO last year to pick his brain about SaaS businesses. Founded by a former byside analyst who encountered friction in sourcing, building, and updating models, Canalist is now used by over 300 institutions, including the largest money managers in North America and by a number of the guests on this show. With detailed company-specific models on virtually every investable public equity, Canalyst clients are able to react more quickly. If you've been scrambling to keep up with the deluge of IPOs these days,

Canalist has models on Snowflake, Unity, Good RX, and everything in between. Their pre-IPO models are built as soon as the S-1 hits and include all segments, KPIs, and non-gap figures. If you're a professional equity investor and haven't talked to Canales recently, you should give them a shout. Learn more and try Canales for yourself at Canales. com forward slash Patrick. That's C-A-N-A-L-Y-S-T dot com slash Patrick. Hello and welcome, everyone. I'm Patrick O'Shaughnessy and this is Invest like the Best.

This show is an open-ended exploration of markets, ideas, methods, stories, and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfield guide.com. Patrick O'Shaughnessy is the CEO of O'Shaunacy Asset Management. All opinions express by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shaunsi Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Shaughnessy Asset Management may maintain positions and the securities discussed in this podcast. My guest today is Jesse Livermore.

I've worked with Jesse as part of our research partners program at O'Shaughnessy Asset Management for years now. Whenever there is a huge, important, and complex issue to be studied, I believe he's among the best minds in the world to tackle it. He did that recently on the topic of what he calls upside down markets, which is the topic of this conversation. We seek to answer a simple question. Against a horrible economic backdrop, how can the stock market still be near all-time highs? Jesse explains in detail the impact that fiscal policy has had on the market and may have

in the future. Please enjoy this master class on upside-down markets. So, Jesse, the topic of conversation today is a short book that you put out on what we're going to call upside down markets. I think the best place to begin would be with you explaining that term. What do you mean in this piece by an upside down market? Thanks for having me back on and I'll go ahead and start. So in the piece, I use the term upside down market to refer to a market where the normal relationship between the broad economy and the stock market is somewhat inverted. So to give some perspective on what that means, normally we would think that an organically strong

economy would correlate with a strong stock market. But in an upside down market, you get a situation where the organic strength could be a negative for the stock market and where organic weakness could be positive for the stock market. It's a situation where good news is bad news and bad news is good news. Now, we're familiar with that, at least the beginnings of that kind of an idea in the context of monetary policy. Sometimes there might be a piece of bad information that comes out, and the inference will be that it could be good news, surprisingly, because it could cause the Fed to lower interest rates, and that could make equities more attractive as a growth asset. The problem with that thinking is that monetary policy is limited in terms of its stimulative effects.

If growth ends up being weak because of the bad news or because of the bad condition in the economy, that could offset the benefit of a lower interest rate or a lower discount rate applied to stocks. You would lose on the growth end, what you gain on the discount rate end. Fiscal policy is what changes that equation because fiscal policy, unlike monetary policy, is very, very powerful and can really achieve any nominal growth outcome that it wants to achieve. An economy that needs fiscal stimulus can therefore end up with a stronger stock market stronger than one that doesn't need fiscal stimulus. So it's almost like you get the same growth either way, whether you're organically strong or whether you're organically weak. The difference is just whether you get the added benefit of stimulus to get you there. So I think we're to give a crude example, you can just imagine a disease that you can get or not get, and the disease has a cure.

And let's suppose that the cure is a pill you take, and it's like a perfect cure. That pill makes you euphoric. It has like all kinds of other positive benefits for your state of mind. It might be better off to just go ahead and get the disease, because if you get the disease, you're going to end up in the same places if you don't get it, you're going to get healed. But you get the added benefit of getting to take this pill that has these other benefits, these other positive impacts on your well-being. In this case, the disease would be kind of like what we would call a savings glut. The economist John Maynard Keynes, he had his famous identity where he concluded that savings and investment for the aggregate economy have to equal each other.

If there's more demand to save in the economy than there is to invest, that's going to create unemployment, deflation, weak job market, etc. But if you're in a fiscal policy framework, that kind of a savings glut could be positive because it will lead to stimulus that successfully restores employment and growth. but it also has all these other bullish side effects as long as the tendency towards the saving glut remains in place. Once the savings glut goes away, you could have a reverse happen and you can go backwards in the process. But the savings blood could be positive because it gets you to the same place when the fiscal stimulus comes in, but you get the added benefit of the fiscal stimulus and also

of the monetary stimulus that will be accompanied with that. I'd love to talk just a bit about the recent history and then the long-term history of these things. So everyone's been talking about the Fed, the Fed. When you're talking about the market, inevitably you hear people talk about the role that the Fed has played, let's say starting in the great financial crisis through to today. So you've got this great, very simple chart in the paper that just shows economic weakness and it points to two things. One is monetary easing. I want to pick these one by one. The other is fiscal expansion, which I think is the more novel thing that's creating this idea of the upside down market as you just laid out. Just talk through first monetary

easing. So just for the uninitiated out there, describe what the Fed's role has been in the the market, let's say, sort of since the financial crisis, whether or not its activities have changed a lot, how diminishing the returns are to their activities in support of the market, and literally what it leads to through lower interest rates or more supply of cash and bonds. I would say that you could separate the function of the Fed in a monetary policy context into two functions. One of them is to effectively control the interest rate, the cost to borrow money, and then also to provide loans or to serve as a lender of last resort when credit markets freeze up. So with respect to the first role, I guess the logic would be that in a downturn, the Fed will

reduce the cost to borrow money, and that will cause people to borrow and make investments in homes and corporations to make investments in new output capacity and whatnot. And then that will then drive employment growth, income growth, and so on for the overall economy. I would say in this context, I'm skeptical that that has as strong an effect as I think other people think, particularly in this environment. The problem with trying to stimulate economy by lower interest rates is that what ultimately drives growth, nominal growth of any kind is going to be

spending. That's square one of the process. When you lower the cost to borrow money, you don't necessarily create conditions under which people are more able to spend because when you borrow money, you're encumbered by the borrowing process. You have a debt that you have to take on. And you may not be in a position where you can afford to take that debt on or where it makes sense to take that debt on, even if their interest rate is zero or even if the interest rate is negative. It might not make sense. Monetary policy can't really get a around that problem very well to stimulate a spending response. It makes a difference. Don't get me wrong. I mean, if it's easier to borrow to buy a home, then more people will do it. But there's other

considerations that affect that process. For example, your creditworthiness, your ability to get a loan, the trust that the lender has and your ability to be paid alone. And those things are not necessarily going to be as directly affected by monetary policy as they would be by fiscal policy. To the second point, the lender of last resort, I think that's a very important function. And I think that's something that is shifted in the context of the most recent COVID crisis. The Fed has expanded its role as lender of last year or not. Do you think that is having an effect on the market? I think it's a good one in the sense that in 2008, the Fed probably could have done more to extend credit directly if the law had allowed it.

And this can be debated. There's disagreement there. But in the most recent crisis, the actual legislation included a provision to directly lend to corporations, created facilities for that. And that allowed the Fed to, in a sense, bypass the banking system. And that's important because when you have a downturn like COVID, it's a singular risk for the whole economy. And normally the banking system would be there to provide loans to credit worthy borrowers. But in this specific context, the banking system is not in a

position to do that because that's a singular risk that the banking system can't diversify a way. There's no way to really reduce that risk down through diversification through a loan book. You have to basically make a bet that it's all going to work out. And if it doesn't work out, then the whole bank system will take the consequences. And that's not something that banks would want to do, particularly in the downturn when they have responsibilities to their own shareholders. So what the government did in this case was basically had the Federal Reserve step in and kind of take that role or backstop it at least, still the banks that are giving out the loans, but backstopping it with full faith and credit secured funding or loss provisions to make sure that the banks could be able to do

that. That makes sense. I'd love to talk about fiscal policy now and it's renewed impact. So I always think of COVID as like the inertia killer. And some of the inertia was fiscal policy tended to be a very political issue. And it was often hard to maybe you could describe how. It was often hard to get the government to agree to effectively pump money into the system directly into the pockets of U.S. citizens. Obviously, COVID just upended everything. So talk about why fiscal policy is like the more important, interesting new lever and why it is so relevant now, given the shakeup of that inertia? The difference between fiscal policy and monetary policies is that fiscal policy actually increases the wealth of people in the private sector, people and corporations. It doesn't just change

the borrowing cost of borrowing money. It doesn't change the form of wealth. It actually injects new financial wealth into the economy. And that's unencumbered spending power. If the government gives me a $1,200 check, I can go spend on anything that I want to spend it on. It doesn't have to be investment worthy. It doesn't have to be backed by an expectation of profits or of revenue. It doesn't have to be backed by an expectation of profits or of revenues, I can spend on anything. That's very different from the government telling me that they'll lend me $1,200 at some rate, some attractive rate. To borrow that money, I need to have a basis for believing I can finance it and that I can afford that debt on my balance sheet. So the big difference is that fiscal policy is a direct increase in the spending

power of the private sector. And therefore, it tends to drive a greater spending response when it's located and delivered to the right places. I think with respect to how we got to where we are with fiscal policy in the current crisis, if you go back in time to, let's say, the end of the Reagan administration, that was the first time when there was a lot of discussion about the debt getting too big, because we had a very fiscally expansive period in the early 80s, which was a transition from where they were in the prior periods. If you remember towards the end of that, warnings were starting to emerge. That's what ended up driving, I think, President George H.W. Bush to raise taxes and kind of break his pledge. And then you transition there

and you had the Ross Perot candidacy in the early 1990s, and he was talking about the debt. Back then it was like a $3 trillion debt, and he was really, you had all the charts on TV talking about how that was going to be a big problem for future generations. And the warnings have trickled in at that point that was concerned. And then it really came to a head after the 2008 crisis because we needed to have a strong fiscal response. And we got one. We had unified government at the time. At least we were transitioning to unified government under the Democrats with President Obama. And we got a decent, I mean, it wasn't as strong as it could have been, but it was something. And that caused a lot of opponents to raise alarms and to talk about how there was

going to be a default risk. Interest rates were going to spike. We're going to turn into the next Greece. And there were warnings about hyperinflation when combined with what the Fed was doing. And the real thing is that that didn't pan out. The people that were opposing that, which would have been that Keynesians and modern monetary theorists, they ended up being right in an emphatic way. So that really has hurt the credibility of fiscal hawks. And it's made it so that when they warn about stuff now, it's not like it was when they warned about it then. When they warned about stuff now about the bad things that are going to happen, it sounds like it's crying wolf because they've been warning about it for three decades. And here we are in 2020 with interest rates almost at zero with very low inflation.

Whereas when this first started in the late 1980s, we had interest rates that were much higher. We had much higher inflation. So it's a demonstrated empirical disconnect between the warnings that it is. have been made and the actual outcomes. And that, I think, has weakened the resistance to fiscal expansion. Now, an additional thing that you have happening that makes a difference here is the fact that you have kind of a perfect setup politically because it's a political process that controls fiscal policy. And in the case of what happened back in March with COVID, there was an election at the end of the year, the Republicans who were normally the fiscally hawkish party, they had an incentive to try

to do something aggressive to help avoid a really bad downturn that could cause severe election losses. And the Democrats were more constructive on fiscal expansion because they are the more fiscally doveish party, it was much easier to come to an agreement. And then you have the fact that there's no moral hazard either. I think an important obstacle sometimes to injecting financial wealth into the economy is that oftentimes the places where you need to inject it are places where people don't think that it's deserved. If homeowners were to go on a borrowing spree and buy more housing than they can afford, there's maybe a resistance to kind of bailing them out or especially to bailing out banks when banks make those loans. But in this case, you really don't have anything

like that taking place. And so that obstacle is removed. Finally, the COVID situation itself is so extreme and so scary. It almost forced a fiscal response regardless of whether anyone wanted to do it. And that kind of set the perfect storm up. And then as a final point, I'll say this, I've gone on for a while on this, but on the final point is that we have the prospect, it's not determined yet, but a very good chance that going forward, the political obstacles to fiscal policy will be removed because there's a very strong chance that the Democratic Party, which is the more fiscally dovish party, will consolidate power going forward. And it may last for a while. And in that case, there's really going to be a lot stronger fiscal trajectory, I would predict. And that's the case most importantly with

respect to the Senate, which is where I think everything is going to hinge, because both President Trump and possible future President Biden would tend to be more fiscally doveish. It's the area where you have the most hawkishness would be among congressional Republicans, and they may not stay in power. So that's another fact that it's driving, I think, some of the enthusiasm around future fiscal policy. When we've talked about this, I've always felt like the most important thing in all of this is this new player on the field, this fiscal policy and how it looms, how long it will last, how much of an impact it will have on asset prices, et cetera. I'd love me to dig in a little bit deeper because ultimately I think of the stock market as profits, valuations, combine those two things. You sort of get a stock market level.

And I think in this case, the idea of stimulus has impact on profits. It has impact on interest rates, on asset supply. Can you walk us through those direct impacts because if fiscal is going to be around for a long time? I think these relationships are really important. We'll start with profits. Fiscal policy works through the use of deficits. And deficits inject income into the private sector from the government. The government takes a reduction in its net worth and the private sector takes to the opposite end of that and increase in its net worth.

Profit is income and corporations are part of the economy. So if you inject income in the economy, just simplistically, it tends to be supportive of profits. Now, to be clear, deficits don't cause profits in some strict mechanical sense. What I would say is they allow for profits to be accrued and to be earned in the presence of other behaviors that would undermine profits. So every person's income or the income of every person or entity in an economy is made possible by the spending of some other personal or entity. And if people want to earn income and not spend it, that can create a problem for income more generally and particularly profit because it sucks the income out of the system when that happens. And fiscal policy can basically undo that effect

through the injection that it makes. With respect to an economy that's organically weak, where it's an economy that's having a hard time achieving growth in a nominal sense, achieving full employment and so on, because of, for example, a savings glut, those kinds of economies will tend to have low capital formation, low investment, which means low competition. That will also mean low labor bargaining power. And so those are good for profits, technically, in a theoretical sense, because you can keep wages down. The problem is, if wages stay down, if employment stays down, that can come back to haunt the corporate sector because it means that the customers of the corporate sector have less income that they can use to spend, which means less revenue for the

corporate sector. Now, the key area where fiscal policy can affect that is that fiscal policy can effectively undo that effect and kind of supplant the income that's been weak or that's been lost. The fiscal policy can restore that spending by delivering income to the private sector in places where the corporate sector's attempt to reduce its costs would have removed that income. Because again, the cost of the corporate sector are the income of the corporate sector's employees. To simplify what I just said, if there's any embedded productivity in the corporate sector, if the corporate sector could make more stuff with a few number of people, if it could make more stuff with fewer people or with the same amount of people,

fiscal policy is going to tend to support the ability of the corporate sector to capture those gains because any effect, any reduction in the income of the people that are displaced by that can be supplanted by the injected income from the fiscal policy. So you can get to a point where you have lower costs, but the same revenues coming back to you. Another point that's relevant there is taxes. We may see this come up in a future administration, but one way that, the government can fund spending is through taxation on corporations. And that is a direct hit to profits. And you have an organically weak economy that needs stimulus that is tender and kind of vulnerable.

There's less confidence to raise corporate taxes. And so in the current context, I think that might become relevant because possible future President Biden has a plan to raise the corporate tax rate from 21% to 28%. It would be a relevant hit to earnings per share for the S&P 500 and for the U.S. stock market. But if we stay weak, if we stay in a situation where we're not confident in the recovery, where the economy is organically having a hard time getting back to full employment, even with stimulus, that's going to make it harder. It's going to increase the threshold that would have to be crossed for the party that's in power to want to raise taxes.

And it could in a sense mean that there's kind of an upside down relationship there because it's almost like if the economy just weak enough to make the party in power not want to raise corporate taxes, that would be better than if it kind of steams ahead strongly. and pushes it to a point where now everyone is confident that the crisis is over, everything's done, go ahead and hike the corporate tax and so on, and that would hurt profits. So that kind of covers the profit impact. So I'm also interested in, we've talked a bit about interest rates already, but something you've written about a ton in the past, it would be helpful to just boil this down is I think the right term would be asset supply. So if we just thought about this really simply,

it would be there's bonds, there's cash, and there's stocks and equities in the overall pool, the total portfolio of everyone in the country. And I think there's important relationship between all of what's going on and what that mix looks like. And I think that mix also historically has said a lot about future returns. So maybe just talk through that dynamic. When the government injects wealth into the private sector, some of it circulates, but eventually a lot of it turns into savings in investor portfolios. That savings takes the form of cash or bonds depending on whether the government sterilizes the spending, that it's engaging, whether it sells bonds against its spending or whether it uses, whether the Fed buys the bonds, there's different mechanisms that can happen there.

But it turns into cash or bonds. And in this current environment, this is an especially important point. Cash and bonds are really the same thing. They perform the same function because they have effectively the same yield. There's not really any return to be earned in either asset class right now outside of maybe high yield bonds and emerging market bonds. But in terms of government bonds, basically it's the same thing as just cash in the bank. When the government injects that into the system into investor portfolios, the investors have to hold that. It affects their allocation to growth versus allocation to safety. And so, for example, in the end of 2019, the allocation to equity was about 46% on average across the entire US economic universe. Just the simple injection of what I've estimated as the likely stimulus measure that we're

going to get over the next two years, about $7.5 trillion. That's going to drive down the allocation from 46% down to around 42%. And the question to ask is, do investors want to have their allocations to equities reduced right now. We're in an environment where the interest rate has been cut to zero. So you're looking at if the Fed achieves its inflation target, you're looking at a negative 2% real return on cash and on most bonds or something close to that in bonds against, we don't really know what the equity return will be, but it would presumably be a lot higher than that. Why would people want to reduce their exposure to equities in an environment like that? The important thing to realize is that it's not a choice. It has to be reduced because

somebody has to hold that cash and those bonds. And that tends to have a buoyant effect on markets. It's very difficult to precisely say what the effect is because there's so many variables involved in what determines prices, but I tend to believe that it has an effect that's meaningful and that matters. I know for myself, the experience of seeing this recovery has not made me more bearish. It's made me more bullish. And I don't want to be increasing my cash right now. I don't want to be increasing my cash more generically. I'm happy with where I was at the end of 2019. If I get cash injected into my portfolio right now, there's going to be a pressure to not keep it in cash because you're guaranteed to lose money if you keep it there. So that tends to be buoyant

for equity prices more generally. And that would be the point. I think a lot of people in March and April and maybe a bit beyond that were thinking about what is the worst thing that could happen. You know, it's 1929 tight market scenario on the table. I think obviously the stock market, if you believe it discounts the future, has changed its view a lot since then. I don't know if we're at all time, sort of near all time highs, which I think is the craziest thing. I think it's why you started writing this piece. How could we have an economy this bad and a stock market this good, which begs the 1929 question. What was so different about how the world, and I guess the country reacted to a crisis then versus now and why have the outcomes been so divergent?

I think as a generic point, all economies are subject to an expansion and contraction cycle, a quote-unquote, a boom-bust cycle. And the bust portion of that cycle can create positive feedbacks that lead to bad outcomes for an economy. So, like, if you think about it on the fiscal side, Reduced employment can lead to reduced income, which leads to reduced spending, which leads to reduced revenue, which leads to less confidence on the part of corporations, which then leads to reduced income, reduced employment. So it's like a feedback loop that's really bad for the economy. And that would be on the fiscal side. On the monetary side, you can have a similar feedback loop develop around creditworthiness and lending. Reduced creditworthiness and credit quality can lead to tighter lending standards, reduced lending, which then makes those who have already borrowed less credit worthy, more subject to bankruptcy risk, which then leads to more risk management from the part of it.

of banks leading to more reductions in lending and so on. So you've got these feedback loops that can develop. Now, eventually that will stop somewhere. If you leave the economy alone and if you just let it kind of go wherever it goes, it will eventually stop because we're not going to like stop. I mean, we're going to spend on something and we'll hit some bottom somewhere. But the problem is that we don't know where that is. And as we saw in the Great Depression, it can be at a really, really low place. And I think that that tends to be an even greater risk when you have an economy that's more interconnected. So if we were all a bunch of islands living very primitively and we were very separate from each other, you could probably have a bad thing happen in one place and let it kind of go wherever it goes. It wouldn't necessarily

cause the kind of downturn you saw. But if you have a very highly interconnected economy where each part is connected to every other part and there's a lot of counterparty relationships, I think that risk of how low it will go if you leave it alone, it increases. In 1929, you had a situation where you had very extreme initial conditions. You had a lot of wealth in the stock market. You had record corporate profitability. You had high debt levels for both consumers and for corporations. You had a global economy at the time that was more connected than it had been at any prior point. That led to a very strong downward cycle. The understanding of how to combat that, how to reverse that, wasn't fully formed. I think if you go before 1929, if you go hundreds of years before that,

we used to have a free banking system, which was like the extreme version of laissez-faire economics, where you don't even have a centralized monetary authority to act as a lender of last resort. You're on a gold standard. It's a completely different universe. We weren't there necessarily in 1929. They had the Federal Reserve. There was a lender of last resort, but there was a lot of hesitation to use that power, particularly with respect to failing banks. And that created bank runs and it created a complete contraction and credit for the whole economy. The fiscal side was even more underdeveloped in the sense that there was a lot of embedded fear that it wasn't responsible to use fiscal power in that way. They didn't really have a history to go off up to know what the effects would have been. And so

there was a lot of hesitation in terms of using fiscal policy. And then even more importantly, I think that was a more moralized economy. The moral themes were more salient and the moral themes around moral hazard for speculators that had been speculating in the market going up to that point for corporations that had been exploiting the market bubble. Those kinds of considerations further complicated the willingness to step in with fiscal power to stop what was happening. And it took an actual extreme outcome to kind of for, the country in that direction. So anyways, to summarize, if you don't intervene in the boom-bust cycle, things can get ugly, and that's especially true when you have the wrong initial conditions,

when you have a high level of interconnectedness, which we have today. So if the government had done nothing in this crisis, there's nothing to say that this couldn't have gotten as bad or worse than the Great Depression. But you see from the actual effects that the response can be extremely powerful and it can almost fully heal the wound. I mean, the wound that we face right now has nothing to do really, in my view, with the job market, with balance sheets. It has everything to do with the virus. And if you just get that out of the way, we will be fully healed and on our way. So it's very powerful. And this event has demonstrated that. I think, again, using the stock market as a barometer, it's one of the best barometers we have to kind of get a gauge of what a very smart

system thinks is going on now and in the near future. It's high. So it seems to be that the report card on using fiscal stimulus to the degree in speed. that we've done it has been a smart decision. I want to talk about the reasons potentially that it's not. And I'll play the role of perma bear here or something and ask about some concepts that I think people are worried about. The first is, I guess I'll use money supply. Like a lot of money has been injected into the system. If you show the chart of M2 or something, some measure of money supply, it looks like a vertical line up five, six times or something. That implies that there's a lot of risk of inflation. Talk about those two concerns.

from people that are negative on the market of too much supply of money now and runaway inflation around the corner. I talk about this in the piece. And so there's charts in there that you can go look at if you want to get a better context. But my view on the situation with money supply right now is that it's very difficult to use money supply as a gauge of possible potential inflationary pressure because the Federal Reserve to keep interest rates low has conducted a large number of asset purchases. Those asset purchases, contrary to what some people think, those asset purchases, actually do increase the broad money supply. Not in the way people think, but they don't increase it because of lending. They increase it because the government, a Federal Reserve effectively takes an asset

that would not count as part of the money supply, specifically a treasury bond or a mortgage-backed security, and it converts those into a bank deposit, a bank liability. It's a deposit for the person that has the money of the bank, and then it's also a reserve on the asset side of the bank's balance sheet. It creates basically money that way and substitutes that money for the asset that it takes out of the system. And that was a little bit confusing way I said it, but you get my point. What I'll say is this. I don't think that that action is very important for inflation because in that action, again, inflation is about, in my view, too much spending. The kind of inflation that we're talking about is about too much spending. And spending is a function of spending power. And that action doesn't really change the spending power

of the private sector. It does a little bit because maybe it drives down the interest rates on mortgages and it makes it easier for people to be able to afford buying a new home. But in terms of the actual money that gets injected through that process, it's not unencumbered money. All it's doing is just substituting for an asset of equal value that was taken out of the system. And the person that was holding that asset was saving it. They weren't spending it when it was in the form of the mortgage bond or in the form of a treasury bond. Why would they spend it just because now it's in the form of cash? That's especially true when the yield, it really isn't that different because the yield on cash is pretty much very close and maybe a management fees difference away from the yield on a treasury bond. So I don't view the changing of the

format of that wealth as really matter. What matters is the absolute level of wealth. And that's not really changing here. There's also the PPP loans. You can see this. There's a chart in the piece that talks about the impact that that's had on the money supply. But those loans are very, very special kinds of loans because they're being given as a way to help companies that are having extreme difficulties right now, keep people on payroll. So I don't think we should view that as a sign of like an organic inflationary process that's occurring. That's a corrective measure for a very significant problem that has hit the corporate sector. I don't think that's any reason to expect an inflation. The inflationary risk, if there is one, is from the fiscal expansion, particularly the CARES

Act and then the future interventions that will occur. Just using common sense, if you increase the wealth of the private sector, you're increasing the private sector spending power. And there's a limit to how far you can increase that spending power before you end up with too much spending relative to the economy's productive capacity, i.e. it's capacity to fulfill spending. So people can argue where that location is, but I'm sure we all would agree that if you were to inject $100 trillion right now, or if you were to inject that over the next two or three years, that you would get inflation. So it's really a question of trying to figure out where that is. And I think the biggest area where the risk is, in my view, is that we don't know where it is,

but we do know that there's all these benefits to fiscal policy. So that creates kind of a problem because it's hard to really say this is the stopping point. And you don't necessarily find out that you've gone too far until your economy has recovered. So right now, you can probably inject an enormous amount of wealth into the private sector and not get inflation because we're all kind of constrained in terms of what we can spend money on. But two or three years from now, hopefully with the virus resolved, we're going to be back to who we used to be in terms of how we function as consumers. And if we're all significantly wealthier because the wealth has been injected, that could create inflationary pressure. I think one way that I would frame it is that there's a famous economist named Hyman Minsky who had a point that stability breeds instability. The way he made the point was that if you have a situation where you have good economic conditions where everything is stable and people feel comfortable, that tends to encourage people to take more risk, which then sows the seeds for future instability that ends up emerging. In this context, I guess the analogy that would make is is that we're very confident that fiscal policy is not going to be inflationary, that it's not

going to have, if we're very confident, if we keep doing it and nothing happens, we're going to push it and we're going to keep pushing it. And we could eventually push it to a point where something does happen, but we do get high inflation pressures that become a problem for both the economy and for the stock market. I will say that I'm a little bit skeptical that we're going to get there because we have a system in the United States that is one that encourages gridlock, that makes it hard to act unilaterally. And I think that that system is going to help avoid a situation where we go too far. And I think also it's important to note that just because the fiscal authority wants to spend, the Fed still has a job and the Fed could potentially address the

inflation by raising interest rates. It may be appropriate right now. I think it probably is. to go very strong on fiscal because the cost benefit for all of us in terms of our human well-being outweighs the harms in terms of possible future inflation pressure, especially because it probably won't be very hard for the Fed to stop an inflation process that emerges. We have a very heavily indebted economy, an economy that has a high demand for savings, a lot of wealth inequality, and those tend to be deflationary forces. So I think we can probably go harder, but a lot of people think on this. You mentioned wealth inequality, which begs an interesting question. So we've had this crazy long run in pretty much bull market in asset prices for gotten depending on how you measure it really really

long time it's been really good for capital notoriously it's been not great for labor per person wages on an inflation adjusted basis and in many cases haven't moved much at all it's been great for corporate profit margins too in addition to just capital more broadly speaking do you think that this might all change some of that do you think that we might start to move and tick back the other direction after a really long run of success for capital and assets and profit margins and all these things versus labor? I don't know, first of all, whether we will. If we do, I don't think it's going to be because of fiscal policy. So I think that the diversion and income between labor and capital and I think some of the inequalities that have emerged there, I think that's

not so much about fiscal policy or monetary policy. That's more about market power. And I think it's about the fact that, for example, technology has kind of reduced the value of our endowed labor skills. In 1950, for example, it was a lot easier to translate your endowed natural labor ability into value-added contributions to the system than it is now where you need to, sometimes you need to know how to program, you need to do all these sophisticated things. And it's a lot harder and it requires a lot more training to add significant value to this. It's a high-tech economy. I think that maybe one of the factors, maybe there's also a factor around concentration, the fact that there's more concentration in industries, which means that there's less.

competition for employees and they have the short end of the stick on those negotiations. And then globalization, you can't leave that out, the effect that that has had on wages. The decline of unions is one that comes up that you could mention. I think those are more significant contributors to what we've seen than quote unquote, the Fed being too tight or fiscal being too tight. In fact, if you look across history, the periods where profit margins tend to be the highest have been periods where labor markets have been tight. So for example, if you go back to But 1948, for example, that was a period where we had a tight labor market and we had record profit margins in 1948. If you go back to the 2006 at the end of the housing bubble, we had a tight labor market there and we had strong inflation and we had, again, high profit margins, a high profit share of income relative to the past.

So I don't think there's really much of a relationship there would be my answer. Some people have framed it in terms of inflation. They've said, look, if the Fed in particular takes a more tolerant stance towards inflation, that will cause multiples to contract. And I also disagree with that view because I think it conflates the actual causality. I don't think inflation is bad for equity performance in itself. There's no reason theoretically why inflation should be negative for equities. In fact, equities are real assets. And so they're one of the few ways you can avoid the negative effects of inflation over the long

term is to have your money invested in real assets like businesses, factories, land, etc. But I think the reason what there is a relationship historically between inflation and PE multiples, and I kind of discussed a little bit of that. prior piece on earnings. But I think an important reason for that is the fact that when you have higher inflation under GAAP accounting, you end up having earnings that overstate the actual real value that's being created by corporations because the depreciation expense is referenced to historical cost investment value that really is outdated, that is lower, much lower than the real cost of maintaining the asset in the present day. So I think the market kind of picks up on that and

realizes that the real value creation is not as strong as the earnings would suggest. the real ability to pay dividends, the real cash flows are not really as strong as the earnings are suggesting. And therefore, multiples tend to go down because if you have earnings that are more overstated, it makes sense to have multiples that are lower. Those earnings should be priced more cheaply because they're not as high quality. I think that's one reason why there's a relationship historically. Another reason is that when you have inflation, it's kind of a destabilizing thing that forces policymakers to intervene with interest rate increases that can potentially increase the risk of bankruptcy, that can increase the risk of recession. In the past, particularly in the

70s, when inflation spikes have caused stock market crashes, I think it's been because of those concerns around, okay, this is going to force the Fed to be much tighter and what's that going to mean for the stock market and for the economy more generally. I think that's what has created that correlation. So the causality is happening through interest rates. If the Fed comes out and says, hey, we are going to tolerate more inflation and we're going to hold interest rates down, even as inflation builds up, that to me is incredibly bullish. In that case, you kind of neutered the causal path that would have made inflation. negative because you've taken the interest rate hikes off the table. And so then I would think that

inflation would be bullish for equities and I would want to have my wealth invested in equities to protect myself from the losses that those that are holding cash and bonds would incur. I'm curious if you've thought about market internal. So everything we've talked about so far is pertaining to the entire overall market, let's say the Russell 3000 or something or the S&P 500. Have you thought much about how all of this may affect certain types of companies, whether that be cyclicals versus non-cyclicals, certain sectors, value versus growth, and any of the sort of things that people tend to care about inside of the market? Well, I guess obviously we're all observing the divergence that's happening right now between tech, growth and value, with the value side

being more sensitive to the COVID-impacted parts of the economy. A lot of that, I would still maintain that's a bet on COVID, really, and that's going to be a function of the COVID outcomes going forward. But I do think that fiscal policy, if it helps either side a little bit more than the other, helps probably the value side a little bit more because direct injections of money into the economy, at a minimum, what they will do is strengthen the banking system because they'll make it more possible for borrowers to make good on their debts. And that would be bullish for banks. I don't have this idea fully formed out to where I can make a strong argument for it. But my suspicion and kind of my hunch would be that a strong fiscal policy response going forward is

going to be better for value than for growth all else equal because value is kind of in a more financially vulnerable situation because of its exposure to COVID. I do think that in defense of indexing, more generally, there is one positive of indexing that has come up from this crisis maybe would have been missed in the past. And that's the fact that when you're allocated in a market cap weighted manner, you are effectively agnostic to where stimulus gets put. Well, explain it as like this. We normally think that when your market cap weighted, from the perspective of your own portfolio,

you have a different allocation to every company. But from the perspective of the economy, you have an equal weight to every company because you own the same percentage of the shares outstanding of every company in the economy. So to kind of make that point concrete, if you were to go to like the SPY ETS and you were to look at the individual components and look at the number of shares that are owned by that ETF, Apple has some number of shares. If you were to take that number of shares of Apple that is owned by SPY and you were to divide it by the total number of Apple shares that are in existence, you would get about 1%. What that means is if you own SPY, you own about 1% of Apple the company. And if you did the same calculation for like, say, Microsoft, Amazon, Facebook, it's all roughly 1%, which is to say that a market cap weighted allocation from the perspective of the economy is really an equal weight allocation in the sense that you end up owning the same percentage. Now, if you own the same percentage of every company in the economy, then you don't really care where the revenues in the economy go or where the fiscal spending goes. Either way, you're going to own 1% of it.

If I tell you right now, I'm going to put $100 trillion or $10 trillion or whatever amount into the corporate sector right now, if you have a 1% stake in every company, you are going to end up with the same revenue from that injection, which is going to be 1% of the amount injected, whether or not it is in Apple, in Microsoft, in some small cap biotech company, it won't matter. What market cap weighting offers as an advantage, what proved to, in hindsight, be an advantage in this specific environment is that it didn't really matter where the money went. the risk of where it would be concentrated was taken off the table by the fact that you own an equal

stake in everything, if that makes sense. And so to summarize, I think right now it's very expensive to basically take a market cap waiting because you have to buy into all of the heavily, extremely expensive, very pricey, fashionable growth stocks that are not cheap. And so if you want to buy the same stake in every company right now, it's expensive. And that could be a sort of risk going forward. But the risk associated with the actual location of the injection itself is not present inside of a market cap weighted portfolio. I think it may make sense, though, to want to take that risk, because if you know that you're going to get stimulus, and if you know how the stimulus is going to affect certain parts of the market, you're going to want to take that risk and actually

get more out of the stimulus than some other parts might get. And I think that right now, again, a loose view, not a high confidence of you, but a loose view that I have is that I think it will be more beneficial to the value side of the market. I know some of our favorite conversations together are often just talking about what you do with all this insight and information. I know you're invested in markets. You think about how these big thematic issues affect your own personal portfolio. I'm not asking you to predict anything, but just walk me through how you're thinking about it as an investor that cares that spent all this time thinking through the impact that what's happening at the government and federal layer will have on equity prices. How are you

processing that for yourself personally? I definitely don't want to make any predictions, but I'll say that what I'm watching is probably what most people are watching. I'm watching the election very closely because I think that there's one election scenario, and this is not to make a partisan point, but there's one election scenario that could be very negative for fiscal stimulus. And that would be the scenario where possible future President Biden wins the presidency and the GOP holds the Senate. That would create a misaligned incentive structure that could thwart a strong fiscal response. And in particular, I would be afraid of that scenario in a scenario where you also have maybe a longer delay on some of the vaccine technology, some of the palliatives or some of the treatments

that are going to be needed to get us out of this COVID mess. That scenario is kind of my downside risk scenario that kind of keeps me from being massively bullish right now and maybe also valuations. But in terms of how I'm thinking about this, I'm thinking about, first of all, the virus, because I don't think we're in an upside down market fully. There isn't a full guarantee right now of whatever amount of fiscal stimulus you need you're going to get. And so I think the virus still does matter. And it especially matters for the parts of the economy that are exposed to the virus. And I think that it also affects sentiment and other things that are going to affect where we end up going in terms of the final equity outcome. So I'm watching that like everyone else is.

And then I'm also watching the fiscal planning, but I'm not really too worried about the fiscal policy, whether we get a deal before the election or after the election. To me, what's most important is what's the next two or three years of fiscal policy going to look like. I think it's looking more and more. I don't want to make predictions, but it's looking like the possibility of future President Biden with a GOP Senate is looking less. less and less likely. So in my view, that's turning things a little bit more bullish. I do think that you have to think about the corporate tax issue too. I think that that's one possible reason. I've kind of tweeted about this. That's one reason why it may make some sense to get some international exposure,

because foreign companies aren't exposed to that. But I do think that if we have this booming stock market, loads of money that are being made by the top 1% that are invested in stocks that own a large part of the stock market, I think there's going to be some pressure to kind of even the score a little bit between that aspect of the economy and Main Street, possibly by raising the capital gains tax and or raising the corporate tax. And I think that in very bullish scenarios for the economy, I think it'll be easier to do that and I think it might get done. And in that case, I think there will be a hidden advantage to having more exposure to international. And also there is a potential advantage for the right countries to have exposure to non-dollar currencies that you may

appreciate. So that's where my general view is right now. I think the so what of all this is maybe that we should have been deploying this policy tool earlier to smooth cycles and make things less risky overall. But I think we probably share the view that risk doesn't really just get destroyed. It just gets shifted around. So what else are you thinking about on the negative side of the ledger as potential areas of risk that people should be mindful of? With respect to risk more generally, we obviously have the laissez-faire risk, which is the kind of the 1929 risk that would have been in play in a less developed economic regime. And I think a lot of that has been taken off the table. We've proven that it's been taken off the table by the responses that happened first in 08 and

then in a more sophisticated and effective manner of what happened in COVID. That, I think, is not really a credible risk. I think you have political risk around incentives. That doesn't go away. And we're seeing that in today's market, because every news headline is, oh, are we going to get a stimulus deal before the election? Are we not? That's still in play. And it may still remain in play, depending on how the government composition looks over the next two or three years. There's implementation risk because you don't know that there's a lag between the action itself and the effect of the action. And you don't always know if the money is going to the right places, if it's enough, if it's too much, that risk is always in play. You have a risk also in the targeting

because just because you're targeting revenues or you're targeting growth or you're targeting employment, it doesn't mean that the fiscal action, the fiscal action that follows from that is going to necessarily hit profits. Profits could still go down even as those actions are in those targets are met. There's a translation between revenues and profits that could shift if profit margins contract, if labor bargaining power increases for other reasons. That's always a risk. If taxes go up, the direct risk right there. But then I think, The big risk, I think this is to the point of the question around where does risk go, I think no matter what you do in any system, you cannot eliminate the risk that is simply naturally embedded in the price itself. The way that I would explain it is like this. When you buy a security, people say you don't lose money until you sell. Well, I think a little bit differently. Like when you buy a security, you lose money the moment that you buy because you don't have money anymore and you now have a security. And if you had to make that trade on a permanent basis, we could ask the question, what of a return or what kind of a yield would you demand? In that kind of an environment, you would probably

demand a very high return and a very high yield because you're losing your liquidity. Now, obviously, we know that we're in a market where someone else is going to be willing to pay something near the price that you pay. You may take a small 1 or 2 percent hair cut, maybe a 10 percent correction, but if you're confident that you're going to be able to take your money out whenever you want to, you're not going to demand as high of a return, as high of an earnings yield, as high of a dividend. You're going to be willing to pay much higher prices. And so I wrote a piece on this several years ago, but I call the price that you would pay if you couldn't sell the intrinsic value of a security. And that's the price that you would demand in terms of yield and income and earnings and growth if you had to give up all the liquidity and had to hold the security forever and then decrees it to your errors.

Obviously, in a modern market, you don't have to price things at that price because you're not going to lose your liquidity. you're going to be able to sell to somebody else. And so you're willing to accept lower yields, lower income, lower returns in exchange for the risk because the liquidity is not being taken away. There's intrinsic value. And then what gets you all the way up to the market value is the liquidity value, which is this latter point. It's the premium that you're willing to pay on the asset because you know you can sell it to somebody else. And I think that as you get into a situation where assets become very expensive, that's how the risk expresses itself.

Assets just become very expensive. And more of their value becomes a function of the liquidity. value of this network of confidence that everybody has that other people will be there to buy, you're not going to have a sell-off, you're not going to have a mass exit. And that risk goes up, when price goes up. And just to come back to the point, if we took a situation right now where we like, if we just made everything in the world perfect, and we had COVID gone, fiscal backstop, all the fiscal stimulus that you need to have a very strong recovery, the Fed's going to stay at zero, which is going to mean a negative 2% real rate for cash. In that environment, you can't take away

the risk of equities. The risk would simply go into the valuation. The S&P would go to whatever crazy value that it would go to. The risk would now be manifest purely in the valuation itself, because there's no rule that says that if the S&P is trading at 40 times earnings, that it has to trade there. People could get scared of a correction of the Fed of something else and sell it down to 30 times earnings. And if that happens, regardless of what cash is offering you, if you invest in that situation, you're going to lose quarter of your money. It's going to hurt. That is there as a source of risk to dissuade you. And it sounds like if you make one asset class into a very unattractive asset class, the unattractiveness is going to tend to kind of permeate and spread

across the rest of the market. And that will be where the risk and equities emerges, is that you have extremely expensive equities that could any day correct for any reason a butterfly could flap its wings. The market becomes more sensitive to that network of confidence because the intrinsic value, the intrinsic returns being produced is not enough in itself to justify possible losses in terms of your liquidity. If you buy the S&P at 40 times earnings or 50 times earnings, it's going to take you 40 or 50 years to get your money back or maybe something a little bit less than that, but it's going to take you a long time. And when you make that purchase in the current environment, you're not budgeting the idea that you're going to be stuck in that position for the

next 30 or 40 years with losses that will eventually be recovered. You're thinking that you're going to be able to sell tomorrow if you want to. If you start to doubt that because things have moved a lot and there's a lot of instability in the market, that itself becomes a source of risk. And that's what's going to dissuade the marginal buyer from stepping into the equity markets and create an equilibrium, if that makes sense. So your research process. I've seen your process many times now, which is a full deconstruction of history and of a system, and then sort of building back up from component parts.

And you've done that here with the entire economy and the way that governments intervene in the economy or set policy around it and how that impacts stock markets. As part of the research process itself for this piece, this upside down markets piece, what was the most interesting gap in your knowledge? In what areas do you think you learned the most that you didn't know well coming in? I mean, a lot of the piece is devoted to the Kalecki-lele-e profit equation. Every time I look at that equation, I have to kind of spend a long time kind of re-intuiting it, getting it to where it actually makes sense. And in the process of this most recent exercise, just the process of going through it and really understanding it helped

me to kind of really nail down the understanding in a tight way that maybe wasn't as tight in the past. I think in addition to that, one of the things I kind of used the pieces and excuse to do this, but I really wanted to make the point that a monetary policy, in particular quantitative easing, that it does increase the money supply, particularly when the Fed buys assets that ultimately come from private sector non-bank entities. And the experience of going through some of the data on that and building it all out, it took me a while to really figure out why, if you just take M2 as a measure of the money supply, you can't create the kind of correlation that you want to create. And so I was able to go in and find some data that allowed me to decompose everything. And that made everything perfectly clear as to

why sometimes when the Fed engages in quantitative easing, the money supply can stay constant or drop, even though we know the quantitative easing itself is actually increasing it. And it's because other things are happening in other parts of the system at that same time or as sources of noise that are offsetting the gain in money supply that is coming from the Fed injection. So that was another one. And then I'll say for probably the final one, this is kind of a little interesting, the process of watching some of the rhetoric around Robin Hood. And that was often used as a narrative for why the market was going up. The process of thinking through how a fiscal injection would ultimately lead to increases in savings that ultimately lead to increases in asset prices, that was an enlightening process

just to try to walk it through in a very concrete way. As a final one, I would say this. A big part of the piece was spent trying to make predictions about inflation because the problem with inflation in fiscal policies, you don't really have a lot of history to use. It's very hard to make a data-driven argument or an empirical argument because it really isn't a lot of history that you can use, and there's so many variables and there's so much complexity and so much non-stationarity in that relationship. It's hard to just show, hey, look, if you add this much fiscal stimulus, you get this much inflation. What I did in that section of the piece was kind of illuminating this, that I kind of went back and tried to build a velocity-based argument that's conservative for how much

inflation you can expect. And I was surprised to see that very large amounts of stimulus would not cause as much inflation as I would have thought on that analytic line of thinking. And you can go read the section if it interests you more, but probably too complex to discuss here. But just the whole process of trying to work through the inflationary implications of fiscal policy led me to maybe be a little bit less worried about inflation, though I'm still a little bit worried about it. I'm a little bit less worried about it than I would have been coming in, just seeing the kinds of numbers that were being thrown out for fiscal policy. I think the best way for people to think about this if they want to dive deeper is in markets, you have to update your views. You have to update your views for changing conditions, and this whole fiscal variable is important. It's obviously mattered this year tremendously.

I think there's no doubt that whatever happens with it is going to matter for the future. And this is a piece I think of as like a tool and a toolkit to understand and update one's beliefs about how the markets are working. So thanks for laying out for us here today in audio format. And to everyone interested, you can go read the paper. It's like I said, a short book, but really appreciate your insight and all the work you put into this. Awesome. Thanks again for having. I really appreciate it. If you enjoyed this episode, you can sign up for a new email newsletter sent out each week called Inside the episode. Each week I condensed that week's episode to my favorite big ideas, quotations, and more.

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