Odd Lots - Richard Bookstaber on the Big Structural Risk in the Market Right Now

Episode Date: December 6, 2021

The stock market has basically been a one-way ship for 20 months now. So of course, some people get nervous about that, and start wondering if we're in some unsustainable bubble that can only end badly. So what are the biggest risks lurking out there? On this episode, we speak with Richard Bookstaber, a veteran of numerous firms, having done risk management at Bridgewater, the University of California, and elsewhere. He's also the author of the book A Demon Of Our Own Design, which prophetically warned about financial system fragilities in the run-up to the Great Financial Crisis. He's currently the co-founder of Fabric, which provides risk management technology to the financial industry, and he spoke with us about where he sees the biggest risks right now.See omnystudio.com/listener for privacy information.

Thanks for listening to Odd Lots. Follow the show on Amazon Music for more future episodes or just ask, Alexa, play the Odd Lots podcast on Amazon Music. Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Wisenthal. And I'm Tracy Allaway. It feels like we're in a little bit of a moment of volatility. I mean, obviously the last 18 or 20 months now have been this sort of extraordinary bull run, full-on, grab for risk, et cetera. I have no idea whether that's coming to an end or not. But it feels like with the Fed and inflation and stuff, we're in a little bit of a wobble here. Yeah. So we're recording this on the first of December. And one of the more interesting things about the past week or so is that the wobble started even before we had the sort of discovery or the big kerfuffle around

the new COVID variant omicron. And it also started before we had. And we had the sort of discovery or the big kerfuffle around the new COVID-vary Omicron. And it also started before we had the Fed really start to signal that it was looking to potentially taper and raise interest rates at a faster pace than the market had been anticipating. And this is really interesting to me because, like, I was kind of thinking back to 2007 and the quantum crisis that we saw that was sort of the forerunner to the big financial crisis. And I wouldn't want to say that we're about to see something as extreme. But it was pretty striking that, you know, in the last week of November, when stocks were still basically at their all-time highs, we did have all this stuff that was sort of happening just under the surface. So a lot of factor strategies getting hit.

A lot of the stocks, you know, the growth stocks that were beloved by hedge funds seemed to be getting hit quite violently. So that was kind of striking. Like something is definitely happening. I'm just not entirely sure what. No, you flagged that early in a piece in your newsletter, pointing out exactly that. There are all these things going on, particularly this concentration and this idea that there are these very popular investments, and maybe the public gets into them and hedge funds get into them, and they start to get sold for what might be called non-economic reasons. And nothing we've seen lately comes close to say the so-called quant meltdown, the year.

before the financial crisis hit. But it is true that, you know, you have these periods where like these winners emerge and the way to win the game is to just double and triple down on a handful of names. And then as soon as there's any elevation of volatility and you have to pull down your risk, you can see some really ugly charts. And there are some really ugly charts of a lot of tech, but not just tech sort of tech momentum names that have been super popular for a while after over the pandemic period. Yeah, definitely the air getting.

kicked out of some of those tech tires, I guess. But all of it, I mean, look, all of it comes back to a question that people have been asking for a while now. I mean, basically ever since 2009, which was, you know, after the last financial crisis. And that is, are we in a bubble? Are these types of asset valuations unsustainable in one way or another? And secondly, if they are unsustainable, what is going to be the catalyst that actually ends up popping the bubble? Because so far, we haven't really seen it. I mean, we've seen corrections, but we haven't seen anything on the magnitude of what people have been sort of worried about.

March of 2020, of course, was the big moment for markets, but that reversed amazingly quickly. Yeah, and I would just said one more thing, which is, A, like, are there bubbles? Is there a lot of speculation, et cetera? But B, is any of the bubblish activity or if there is bubbleish activity, does any of it pose a threat to financial stability? So it's like we could look at like some cryptocurrency and say, look, this is unsustainable and probably for many of them, they are. But on the other hand, much of that activity, perhaps someone could argue is not a threat to financial stability. So these are all like big questions that people are always wrestling with. But I think, you know, again, these days, I don't want to over dramatize the moves we've seen.

as of now. But, you know, once again, some of these questions have, like, come to the, come to the fore. It's a good time to ask these questions again, I feel. Like, we have a strong newspeg in the form of recent market development, so we're going to seize on it, and we're going to be discussing all these big questions with really the perfect person, right, Joe? Yeah, we have the perfect person. I'm very excited. We're going to be speaking to Rick Bookstaber. Richard Bookstabber. He is the co-founder of a new firm called Fabric that provides risk management solutions to financial firms. He's well known for his writing and theory in the world of, like, risk management.

He has a well-known book that came out prior to the great financial crisis. We're talking about complexity and derivatives. He's a title, A Demon of Our Own Design. Many people view that book as having been prophetic about some of the issues that help blow up the financial system and the economy. He's done risk management at various firms, including Bridgewater. So we're going to be speaking to him. about financial stability and markets right now

and how he thinks about risks and risks to the system, Rick, Bookstabber. Thank you very much for coming on Nodlots. Thanks. Thanks for having me. What do you start off by telling us, like sort of what you're up to these days? Like, you know, a lot of people almost certainly know you

from that book, a demon of our own design. Tracy, as we were talking about a little bit before, Tracy kept it on her desk for a long time. One is sort of a legendary book. What have you been working on in recent years? So I recently left the University of California where I was the chief risk officer for their pension and endowment. Interestingly, University of California has about $170 billion to manage between the pension and endowment. And I left there to start this firm fabric, which is really focused on providing risk management to

wealth advisors and the investment advisory community, essentially taking the sort of risk capabilities that I developed as I've been in various institutional positions as chief risk officer in order to deliver high quality risk management capabilities to the financial advisors. So I'm just going to go ahead and jump to the big question, DeJure, which has to the to be, you know, are we in a bubble? Do you see signs or evidence here of bubble-like conditions? Well, I hate to say bubble because when you say bubble, that's always got a sense of prediction to it. But I would say that we're in a very vulnerable situation, a period of high risk. So the level of risk in the market is really greater than what you might observe looking at day-to-day price action, looking at volatility. So how do you establish that quantitatively? I mean, we all feel it, right? We all look at

crypto and go, this is crazy. Or we go, look at meme stocks and think it's kind of nuts. Or the degree to which people are just talking about trading is very intense, like nothing we've seen since the late 90s for sure. But these are just like sort of like gut feelings, emotions, stuff like that. How do you go about actually from a risk management perspective attempting to quantify the level of risk in the market so that it's not just feel? Well, crypto and NFTs certainly are canaries in the coal mine. It's not quite like credit default swaps pre-2008 because they're not integral to the market. So that is a telling sign.

But the key things that I look at in terms of vulnerability are the extent that the market's levered, the degree of concentration, and how much liquidity we have in the market. Right now, it's like we're all partying in a nightclub and having a great time, but there's a lot of us jammed into that space. So if a fire gets started, we're going to have a hard time getting out of the exits. So we're very concentrated. And if we're in a nightclub, those exits are like the liquidity of the market, how quickly can we get out? And leverage, which is also high by a lot of measures right now, is sort of the flammability of the space. How quickly can we get out? So we're in a situation now where there's a lot of crowding, a lot of concentration. Although we can't

observe it day to day, the liquidity that will be available if people start to head to the exits is low. And there are a lot of people are going to have to head to the exits because they're either leveraged or they're out ahead of their skis in terms of their exposure to the equity markets. So this idea of rushing for the exits and everything getting rather crowded, that's something that we did observe in March of 2020 with the big market crash. And in particular, in the treasury market, given these sort of relative value trades that a lot of hedge funds had taken on and given, you know, observations around liquidity problems in that market for quite some time. I guess my question is, does any of that matter nowadays?

Like, the experience of 2020 is that if things get bad enough, the authorities will step in and prop up the market, even with credit, which was one area of concern for many, many years after the financial crisis, the Federal Reserve announced new corporate bond buying facilities to help that market. And even though we saw very dramatic price gaps on the way down, arguably because of liquidity issues once again and because of, you know, crowded one-way positioning, it was very short-lived. And here we are, you know, almost two years later now or a year and a half later, and it doesn't seem to matter that much. What the Fed did in 2020 is really breathtaking.

They're very aggressive, very quick on the trigger, and they really saved the markets from a disaster. A lot of the ETFs were failing. Nobody could do the arbitrage to keep them in line with the underlying stocks. Treasuries, there's one day that the Treasury market traded, $250. million dollars. I mean, this is the most liquid market in the world, and it basically was shut down. So what the Fed did then was, I think, one of the kind because the situation was one of a kind. And they did a lot to pull the market from the abyss. But there's two questions.

What they have the will to do it, if what we have is simply a replay of, say, 2000s. I use 2000 as a better example than 2008. And do they have the bullets available to do it? I mean, typically the Fed does not have in its mandate tempering the markets when you're talking about credit markets, you know, high-yield markets. We're talking about ETFs when you're talking about equities. So I think it would be foolish from a risk standpoint to bet on that and to make decisions thinking that the Fed's going to back things up.

So just on the liquidity point, I mean, you were involved in the Volker rule. And this is something that, you know, the banks in particular like to blame for liquidity issues in almost any market at the moment. They can't come in and take bets anymore. And so, you know, it means there's less market makers and things get kind of weird because Wall Street doesn't have the same amount of risk appetite that it once did. Is that an argument that you buy into, or would you say that something like Volker has, at a minimum, at the margins, affected liquidity? When I was at Treasury and the SEC, you know, as you pointed out, I was involved with developing the Volker rule. And the big argument that the broker dealers and banks had was this is going to cramp liquidity. And the general sense among the regulars was, oh, come on, you guys, yeah, you'll figure out some reason to not have this put in place because it does reduce their ability to make money on the customer-facing side, but actually they're right.

And I pointed this out that the incentive will no longer be there with the Volker Rule to be as aggressive in making markets because the profit capabilities are not there. When I was at Solomon in the 1990s, and we had the emerging market crisis, actually crises, because he had Mexico and then Asia, we were losing money with every trade. But we did it anyway because we wanted to defend that franchise because pre-Vulcoral, you could make money trading proprietarily on the customer desks. Well, that's not there anymore. And so there's no incentive or certainly a much smaller incentive. for a broker-dealer to step up to make markets if things are not going well. So, yes, I think the Volker Rule has restricted liquidity that market makers would make available in times of distress or crisis.

Now, you have to say, well, there's a devil's bargain there because, on the other hand, you don't have broker-dealer's essentially front-running clients. So the balancing act was there. The Volker was put in place. But it is a case that's reduced liquidity. And I'd have to say reduced it in ways that are not really evident day to day. Because everybody's more than happy to make markets when there's no stress. So this is what I want to get back to.

And I'm still like sort of searching for when you talk about, oh, if people run to the exits and, you know, that's going to happen again at various times, there's going to be the. the exit's going to be smaller than people think, or that there is a high degree of concentration of assets, and that is going to exacerbate problems if and, or when, when in fact, they do come. What are, I mean, other than the sort of theoretical things and also, you know, Volker rule aside, what are the things specifically that you see sort of from a numbers perspective or from a sort of qualitative perspective about the trading, about position sizing that show you that this is a vulnerable market, or that you say, we're in an overcrowded nightclub and the fire warden

would not be happy with how many people are in it. Yeah. So let me go through one by one, the issues in terms of leverage, liquidity and concentration. Great. In terms of leverage, margin debt less free cash balances is at a, I'll say an all-time high. The date only goes back so far, but it's higher than even in 2000. And you have households that are more exposed and their liquid assets have more exposure to equities than any time in recent history. And that's not strictly speaking leverage, but that's what you might think of as hot money.

If things turn south, households are going to realize that they have more risk than they might have thought about. about and start to liquidate. In terms of concentration, you've already made the point. The top five stocks in the S&P 500 make up around 20% of the S&P's market cap. Of course, if everything were equal weighted, they'd be 1%. The top 10 stocks are somewhere north of 25% of the total S&P market cap. And, of course, technology is dominant in that area. If you go and look at the exposure to technology and the S&P 500 using a standard measure like the GICS sectors, it's around 25%. That's a level that we've seen at other periods where we've ended up with market crises. For banks, it was over 25% in 2007. For the internet and TMT stocks, technology,

telecom and media in 2000, it was over 25%. And by the way, the 25% is a low estimate because we measure how many stocks are in the technology sector based on their main business. Of course, many companies have technology. Amazon is a case of point. They have cloud computing. And if you do things that way, you get a number where it's close to 40% of the S&P 500 is exposed to technology. by a lot of measures, we've got concentration stocks and we have concentration in one particular sector. That's leverage. And I already spoke about the issue with liquidity. The market making is not going to be there the way that it has been in the past. And the amount of cash that's available to supply in the event that people need to head out the exit is low.

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Make us part of your weekend routine on Bloomberg television, radio, and wherever you get your podcasts. So what would be the catalyst in your view for, you know, that big rush to the exits? And the reason I ask is because the experience of the 2000s was that the thing that people thought was safe, you know, subpride bonds. that were being used as collateral in the repo market, suddenly we're not very safe at all. And I'm aware that, of course, some people have been warning about this problem for a while, but, you know, the majority of people were at least acting like everything was fine, and the collateral was absolutely perfect to use.

But nowadays, we've had so many warnings about specific risks. So people have been warning about overvalued tech for a long time, about concentration of big tech in the indices for a long time. We've been worrying about the possibility of a COVID resurgence, you know, ever since the winter of 2020 and the impact on economic growth. Now we're worried about inflation and the possibility of the Fed hiking rates and maybe that's going to impact risk assets. And, you know, maybe a few years ago we weren't necessarily talking so much about inflation, but we were. certainly talking about what happens to the market when the Fed raises rates. So all of these kind of feel like known risks in the market. And I'm curious if there's one thing that you think is sort of less appreciated that could have a destabilizing effect.

One of the nice things about systemic risks, risks that really can be material to the overall market is they're sort of plain and open to view. I don't think there's any secret thing lurking that we aren't thinking about. It's just that we aren't thinking. We aren't looking at what's out there in terms of risk and taking it seriously. We have a PE ratio. We have price to sales that's in outer space. Talking about another thing that's either at or above recent history. Various measures of price earnings and price to sales are up there. And people justify it in various ways. You know, during the internet period, 1999, 2000, the period that Greenspan called irrational exuberance, people justified the crazy PE ratios by saying, oh, old

accounting methods don't make sense anymore. Today they say, oh, rates are very low, so the discounting of future earnings should mean that price earnings go up. I don't think that's a good argument. But in any case, what's out there is plain to be seen. The things that I'm talking about should not be a mystery to anybody, but people aren't reacting to it in terms of adjusting their exposure accordingly. So it could be that people wake up and think, wait a minute, valuations are crazy here. A few people start to sell. That drops the market. It could be that Fed tapering or something even worse that along the spectrum from tapering to recession causes dislocation to the markets. It could be that inflation causes a problem,

perhaps because treasuries, which people regard as safe assets, start to drop as rates go up. And that begins liquidation. All of these are stresses. that could be the start of the avalanche. So how do you actually adjust your exposure in a scenario like this? And for the past decade or so, it feels like valuations were basically driven by inflows. So if you wanted, you know, to be a successful investment manager, you basically jumped on the stuff that other people were buying. And I'd be curious to get your perspective as well from, your previous position as the chief risk officer at the University of California's

office of the CIO. Because as you mentioned, this was a huge portfolio, more than $100 billion. And I'm assuming you have some sort of yield target that you need to be reaching. But it seems very, very difficult to get there without taking on some form of risk. Yeah. There's no free lunch, right? So if you say, I'm concerned, I think volatility or potential volatility, potential risk in the market is very high. If you have a volatility target, you know, you only want to have a certain value at risk. That means you're going to take your positions down. And that is not

pleasant if the markets continue to do what they're doing. But there are some easier methods. One is diversification, which reduces risk. People think they're diversified if they're holding a broad base portfolio like the S&P 500, but as I mentioned, they're not really diversified. They actually have a big bet on technology. So one thing that you can do is take action to increase diversification, which means moving away from a cap-weighted index like the S&P 500. Another thing to realize is that what you think is safe may not be so safe. Treasuries, longer treasuries, say 10-year-plus, you know, high-duration treasuries are not really safe in some of these scenarios, especially the inflation scenario. And that would suggest that if you are going to take

action to reduce exposure, you're better off moving it towards cash than simply moving it towards bonds, certainly better than moving it towards high yield bonds, which also have a spread that's near historic low. So step one would be diversifying in a true sense, which means reducing the overweight that's implicit that you have in technology. The second is if you are willing to recognize that risk is high and you want to maintain some notion of a forward-looking volatility target, move away from high-risk assets to lower-risk assets. And the low-risk asset that makes most sense is something like cash, where I would define, for investment purposes, I would define cash as, say, being anything that has a duration of less than two or three years. Because

something with low duration is not going to be affected in a meaningful way, should rates go up. I want to talk more about the lack of safety in the safe assets or how that can be a problem. And I think one difference between the great financial crisis and the dot-com bubble is, okay, there was a big crash in assets in the dot-com era. But no one really thought those were like safe assets. Like no one thought at the time like Amazon was like some like core retrospect. You should have bought it. But there's some core safe asset or pets.com or the globe.com or some like core safety. In 2007, 2008, what we discovered, of course, was that a lot of assets that were thought to be AAA literally were not safe.

And that is sort of what caused a crisis and why those two crashes were different. Do you believe that, I mean, you mentioned, okay, if we get inflation, we get rate hikes, there is going to be this hit to some of these so-called safe assets. But do you believe there's anything that's equivalent where people are truly thinking like there's like a bomb? that we've somehow a bomb in here that we've somehow labeled AAA that could oppose systemic risk? Or is it more just about you won't get very good volatility adjusted returns because these assets won't behave the way you expected them to? You won't not only get very good returns, you'll get negative returns. Right.

Unless you are holding bonds that match your target, that, you know, where you have duration matching between assets and liabilities, even treasuries can drop substantially as rates increase. You get your principal back, but if you are, if you're needing to liquidate, you're going to find marked market losses. And of course, if you're in high-yield bonds, it's that times 10. We see periods where the spread with high yield can be 10% and up. You know, it's not just that it won't make the return you might have. hoped, it's actually a risky asset in the face of higher rates and inflation means higher nominal

rates. In terms of AAAs, you know, 2008 is not a good example for just about anything other than things can go down. We had a crisis that hit at the heart of the financial system, banks, short-term lending, and, you know, as you point out, bonds that were supposed to be high quality actually weren't because of some of the magic between the packaging of corporate bonds and the rating agencies and the way that they rated them. That's not going to happen again. I would not really go back to 2008 as the type for what sort of issue we would have. If I were going to pick an analog and no analog really exists for the markets because we change, we innovate, we grow with experience.

I'd more pick 2000 as an example. How does, you sort of touched on it, but how does banking regulation actually play into this? Because, of course, one of the big changes between now and the 2000s is that we had all these new rules around leverage and liquidity coverage and things like that come into effect that actually force banks to. buy what ostensibly should be safe assets like U.S. Treasuries or agency mortgage bonds, things like that. And so on the one hand, I could see the potential to argue this both ways. So you could say that because you have a buyer base that is basically forced to snap up a lot

of these assets, the idea that they're suddenly going to sell them off if inflation picks up, maybe that's less likely. But on the other hand, as you mentioned, if we get an inflationary scenario and bonds suddenly don't look as safe and maybe they start, you know, movements and bonds start feeding into banks internal risk models and things like value at risk, then maybe you would have a moment where they decide, well, actually, we need to do something about this. I think banks are out of the game right now as we look forward towards risk. They've been, I wouldn't say neutered, but their ability to take risk or to be a source of resolving risk is much lower now than before.

You know, we talked about the restrictions in terms of market making. They also, and that's proprietary trading on the client side. They also don't have internal proprietary trading for their own book. they have very tight leverage constraints and monitoring in terms of what they can do there. So I don't think banks can be part of the solution. I also don't think banks will be part of the problem. If we're looking at where the problem will come, I think it's, you know, we see the enemy and it is us. I think it's the institutions, retail, and individuals who are caught up and exposed in the market, it's really irrational exuberance type of a risk as opposed to a fundamental

structural risk within the banking and guts of the financial system. Cryptocurrency is a great example of that. It's on the edge. It itself is not, in my mind, systemic or sufficient to really trigger something for the market's broadly based. But what you see with crypto, is just a dramatization of what is happening in the markets overall. We have a lot of speculative activity, and we don't have a lot of people who are in a position of supplying liquidity in the face of people suddenly either needing to exit the market or wanting to exit it. You can get the news whenever you want it with Bloomberg News Now.

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I think this is super interesting. I mean, you know, when banks get in trouble, that's a big problem, obviously, in part, because normal people have money with those banks and their deposits are kind of loans to the banks and they expect to get them back one to one. And if that ever blows up, that's a real problem. It sounds like the main issue is, in your view, just that we're so exposed to risky assets, all of us, either through retirement funds, our day-to-day, hot money, our pension funds and so forth, that it would be a really big problem if they went down. You know, one of the things that Tracy and I have talked a lot about on the show is like this sort of 40 year. I mean, we talk about the last year and a half or the last 10 years or whatever, but, you know, the sort of 40 year simultaneous bull market in stocks and treasuries.

And I'm curious if in your experience, having looked at the worked at the pensions side, whether this sort of is just taken for granted that on a short term basis that treasuries sort of at a short and mediocre, term treasuries act as a volatility buffer for risky assets. But at the long term, you sort of get paid out on both, which has been this very sweet deal for the diversified investor, but perhaps is just not always going to be the case to our detriment. This is one of the things I think is an issue in the markets that people tend to be short-sighted. They don't look at history with a broader scope. If you're a hedge fund or a broker dealer, that's fine because you're going in and out and your time frame, your perspective is daily or monthly. But if you're an individual or pension funds, if you're an asset owner, you have to be concerned about the nature of the market

over decades. If you have that view, it's worthwhile to go back even to the 1970s to see what can happen. If you look from 1968 to 1982, if you were standing in 1982, you were in the same place in terms of your portfolio as you were in 1968. We talk about Japan having lost decade. That was more than a lost decade for investors. If you look from 2000 to 2013, same story. You had a period where in 2013, you're in the same place that you were in 2000. There can be periods of a decade or more where things are flat. And if you're a longer-term investor, if you have a time frame of 10 or 20 or 25 years, that's a big problem because if you're saving for retirement, if you've got a portfolio with the idea of liquidating retirement, your reasonable expectation is an average return.

inequities of around 7%. That's the actuarial rate that's assumed by pension funds, 7% average annual return. So if you're flat for 10 or 12 or 13 years, you're not really flat. You're down about 50% from where your expectations reasonably should have been. So when we look at what can occur, we need to sort of look at situations beyond 2009, on where, of course, we've had this stupendous run-up. And with rates, it's the same story. We've had, you know, as you pointed out, this incredible secular bull market in rates, people think now that rates of two and three percent are the norm. This is where life is supposed to be. In the early 1980s, I was building a house, and I got a mortgage, I got a construction loan

of 21%. I got a mortgage of 13.5%. In the mid-1980s, I was at Morgan Stanley, and one of the traders did a print when treasuries got to 8%, because the view is, ah, we're finally back to normal, and he wanted that to sort of memorialize that event. So rates can go up. Rates can be 5%. They can be 7 or 8%. that is sort of to many of our minds distant history. We sort of think that where we stand now in this bull market is it, but it may not be it. And we don't need rates to go up to 8% for things to really be difficult for people who think they're in safe assets. I want to go back to what you were saying earlier and the distinction between risk on the sell side with the banks versus risk on the buy side with investors, whether they're big institutional investors or retail investors.

And you know this because you were involved in post-financial crisis regulation. I remember you gave some speeches or guidance to Congress on these issues. And this was really a conscious choice by the regulators to de-risk the banks after the 2008 crisis and move a lot of risk-taking. into either the by-side or shadow banking institutions when it comes to things like lending. And I guess my question is, you know, now we're talking about the risks that are facing primarily the buy-side, the investors who have been buying all these over-inflated assets. And is it, I mean, this was the intended results of all this reform.

So how much of a problem would it actually be if we suddenly saw risk assets tank tomorrow? Yeah, I guess the horses are out of the barn. And it's much harder to control what goes on in the market than, of course, what goes on in the banks. So this is the point I'm making that the risk now resides in the markets with, institutions and much more than in the past with retail investors. And that's a little harder to control than when it's within the regulatory system. So I think we sort of have little to do from a regulation standpoint than to sort of watch things play out. You know, we do have controls, obviously, on how much leverage people can hold. But that's the main tool that's available.

when you get to retail, the risks also are quite different and require different sort of management than when you're talking about hedge funds or banks or broker dealers. And actually, that's the center of what I've been doing at Fabric. If you're an individual, you have risk coming from two sides. You have the risk of your portfolio. And the risk of your portfolio, by the way, has to be looked at over the course of years, not over the course of the next month. So you have a much longer time frame. But you also have risk coming from your own decisions and your own need for assets. So you have to manage not just the risk in the market and not just look at that risk as it progresses longer term.

You have to do that in the context of how you would react based on that. Would you suddenly reduce your risk tolerance if the market goes down? basis sell even more. Well, you suddenly have expenses where you have to sell and de-risk on that basis. The complication as you get to the individuals, the level of complication in terms of risk is greater. The models that you need to use are different from what you have for institutions. So the move that we're seeing from the banks and the broker dealers and the larger institutions into retail, not only is more difficult to control, it also creates a different type of a risk dynamic. So I want to ask a question, and it's kind of verging away maybe from finance more towards the realm of economics.

But this issue of like, we are all highly exposed to risky assets, and this could feed through to, you know, pose problems. It'd be a different set of problems that we saw in 2008, 2009, but it'd be problems not. nonetheless. Would there be a case, therefore, to sort of think about macro policies that make the economy or make households or make retirees less reliant on gambles? I mean, I think about crypto, again, as you say, it's sort of canary in the coal mine, but how many people are trading crypto because they feel that they need to, like, hit some level or they feel a level of financial precarity in their own life, and they see an opportunity to rectify that by winning big on some coin. And so could some of these things that we identify as financial problems be addressed, were we to have an economy?

And we don't, you know, there would be different ways of getting about that. Were we to have an economy in which households and individuals weren't so reliant on a stock market that just kept going up all the time in order to basically make their monthly payments? Well, if you think that you're behind and have to take risk, if you're inequities already in this market, you've got a problem. You know, we've seen, it's hard to envision a time where we've seen this sort of appreciation that we've had over the last number of years. You know, so people who want to win even bigger, they may as well buy lottery tickets. we really are, you know, in an unusual time in terms of the opportunities that have been laid before us. And I think right now, you know, people get this exuberance and feel like, hey, you know, I've made this much money. Let's keep, really, let's keep the party going.

Right. I don't think, but, you know, that being said, we've really moved towards the whole ethos away from divide. defined benefit to defined contribution. That's true with pensions, and that's led people to be much more aware of the markets. The technology is now there so that they can monitor the markets, transact in the markets very, very easily. For some people, I think the markets have become a source of entertainment and an extension of their social media presence. So this is sort of the world that we're in now. And I actually think that crypto is not only an indication of exuberance, and I'd say in a sense sort of foolhardiness in terms of an investment perspective, but it's

kind of an indication of how the markets are evolving. A lot of information, some of it not good information, the ability to trade for apparently no cost on your phone, the ability to make trades in bite-sized sort of dinner and a movie size where it's really inconsequential. All these things are moving the market in a direction where it starts to look a little more like what we've seen in social media. And if you don't like what social media is done to common discourse, you're probably not going to like what that might lead to in terms of the markets. But that's, So it's not just the move that we've had from banks and institutions towards retail. And it's not just the increased embrace of retail into the markets.

It's very recently some of the changes in the way people interact with the markets. And we haven't even seen the start of that playing out yet. I think that can be the next level of concern that we'll have. because that would be a structural systemic change in the market structure. Rick, I think that was a great place to leave it. Thank you so much for coming on odd lots. Great to get your perspective, lots to think about, and hope to have you back at some point.

Okay, great. Well, thanks, you guys. After the crash. Yeah. Take care, Rick. Thanks, Rick. Appreciate it. Tracy, I thought that was really interesting.

And I really think that, you know, we go through this frame of thinking about the last crisis. And I don't mean March 2020 because it was so weird, but, you know, 2008. And it's like, oh, what is going to blow up the system? And the idea that, like, maybe the next big problem is not like a blowup, but stocks go down and stay down. And a lot of people have lifestyles premised on stocks going up is sort of like a risk that we don't really talk about. Yeah. I also thought your question about whether. or not, there's an economic reason for this was really good because, I mean, I do think that

plays into it where we have seen lower levels of economic growth since the 2008 financial crisis. People have been a lot more upset about things like wages or just general unfairness of the socioeconomic system. And so I do feel like people are buying a lot of risk assets, not as long-term investments, but basically like a lottery ticket. I know Rick said, like, well, you might as well buy a lottery ticket, but that is essentially what people are doing with some of the meme stocks or some of the, you know, coins and things like that. Yeah, you know what? And there's something that I've meant to bring up with you.

And maybe we should do another episode on it. But something that I think about a lot is what you've written about with this sort of degree of speculation that exists in China. And China, obviously, a poorer country and not a particularly robust safety net in China. and then you have all of these people who do things like trade iron ore futures at home, which U.S. speculators, retail speculators, rarely trade commodities at home. And yet that's like a big thing in China. And so I often wonder if like there is this connection between countries that are like

unequal, have precarity, sort of mediocre safety nets, and the impulse that people feel that they need to like speculate in order to like hit some level of income or some level of well, because they can't get there through like sort of like the normal job market. Through normal ways. Totally. Although I would say A, I mean, I'm kind of worried about the day that Wall Street bets wakes up and discovers commodity futures and decides to like drive up. I don't know, the price of oil or copper or something like that. But B, it is kind of ironic that in 2021, when we have had all this craziness in the market and stocks up until recently were at all. all-time highs that China was actually going in the other direction and really cracking down on a lot of speculative activity. So it's just interesting to see the West and the East sort of going in two different directions on this. Yeah, no, it is interesting. Hearing Rick's perspective, like from the port of a pension fund manager, and it really does seem like it's just been the gravy years.

If you're like a long-term investor and you have a big slug of stocks and you have a big slug of bonds and you don't have to react to like every dip in the market. market. Like, this has been like a dream several decades because you get this short term, a short term counterbalancing, but long term bull market and both. And so if something were to change and the thing that could change would be inflation and a sustained rate hiking regime in response to that inflation, like how many of these like pension funds are like positioned to deal with that? I think it's an extremely interesting question. Yeah. I mean, this gets into the whole sort of question of whether or not we're going to see a big regime change. And. Yeah.

I think, you know, again, I'll just say it's December 1st. There's a lot to talk about, but I have a feeling we're going to be keeping up this discussion in the coming months. Should we leave it there? Yeah, let's leave it there. All right. This has been another episode of the Odd Thoughts podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Allaway.

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