Odd Lots - The Biggest Lesson Investors Should Have Learned From the Crisis

Episode Date: August 14, 2017

It's been 10 years since the start of the credit crunch that eventually led to the global financial crisis. For many investors, the events of 2007 to 2008 shook their entire understanding of how markets are meant to work. In this week's episode of the Odd Lots podcast we speak to Mark Dow, a global macro trader and financial blogger, as well as a former economist at the U.S. Treasury and the International Monetary Fund.He walks us through some of the most important lessons that investors should have learned from the crisis, including why central bank stimulus efforts haven't had as much of an effect on the real economy, and why oil matters much less to the world than it once did. We also take a brief interlude to learn how a macro manager analyzes U.S. jobs numbers as they come out.See omnystudio.com/listener for privacy information.

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And I'm Tracy Allaway. So, Tracy, I'm a little worried that the next few years are going to be kind of annoying. Annoying in what sense, Joe? Well, you know, it's like we're coming on 10 years since the financial crisis. And so every day it's going to be another story about 10 years since this went under and 10 years since this went under. Everyone's going to be retelling war stories about where they were and journalists are going to be talking about how they're in the office till 2 a.m. I'm already kind of dreading it all a little bit. Really? But I mean, aren't those fond memories as a financial journalist?

You know, 2007, 2008, those were the sort of glory years. People couldn't even keep up with the news flow. There was so much happening. No, see, I'm excited about telling my stories. I just don't want to hear everyone else's. You know, I'm just very selfish. I just love my memories. I just don't want to hear everyone else's stories.

Well, I applaud your honesty, Joe. Yeah. That being said, despite the fact that, you know, we're going to have all of these anniversaries coming up over the next couple of years, it has been obviously an extraordinary time. And I think all of us have learned a ton about how markets and economics work during this period. Yeah, you could definitely say that. I guess you could also argue it the other way and say that the financial crisis and the period after it, were so special or so unprecedented that we've all learned massively new things, right? Like, how many people were really experts on QE before 2009?

And, I mean, I guess you could argue there aren't that many people who truly understand it now. But in any case, at least people know what it kind of is. Maybe we've just exposed how little we know. I frame it this way because today we're going to be talking to a longtime industry veteran, and someone who worked for the IMF, who's involved in mutual funds, who's been a global macro trader for several years, and someone who has sort of cataloged all of the things that we should have learned since the crisis. And I think that his perspective and sort of what he's observed has sort of been an extremely, offers some extremely important lessons from the last 10 years.

So, Joe, I think I know who you're talking about. And if it's who I think it is, I'm very excited. He's a guy who's very active on Twitter and he has a great blog as well and we all read it. Yeah, we're going to be talking to Mark Dow. He, anyone who's involved in finance Twitter has certainly seen him. He has this awesome blog called Behavioral Macro where he talks about big macro topics. He recently wrote a post about 15 things that every investor should have learned from the financial crisis and its aftermath. And we're going to be talking through a few of those things. That sounds great. Mark Zow, thank you very much for joining us. Oh, thanks for having me, guys.

Before we get started, you know, many of us in media and finance Twitter have interacted with you for a long time, read your stuff, read your tweet, talked to you on TV or whatever. But for those of the people who don't know who you are yet, why don't you give us the very brief bio? Yeah, the thumbnail sketch is I started my career at the Treasury Department. as an international economist working on financial disasters in emerging markets primarily. That's where they were then. And then I moved to the International Monetary Fund where I worked on a lot of different countries and the same kind of debt sustainability issues. After that, I managed money at a mutual fund for a number of years, fixed income, primarily emerging markets.

And then I moved to a global macro hedge fund for about seven years and basically ran part of the book. I had my own portfolio where I was primarily currency. in emerging markets, interest rates, commodities, that kind of thing. And now I run glorified private from my hometown in California. What strikes me is important about your background before we get into the various lessons, is that you've seen the eco side and the trading side. And often, the two sides can't really speak to each other very well. A lot of traders can be very good, but they don't really understand economics. A lot of economists have a deep understanding of things work, but they have no idea how markets really work. As you describe your career,

you've really seen and bridged the two worlds. Over my career, you see a lot of shops, particularly the big ones, where there's a stark divide between thought leaders and risk takers, and not that many people speak both languages. So the thought leaders are great for framing things and providing frameworks and backdrop ways to analyze issues and to communicate with clients who want to understand the world better. But they often don't have that market savvy, that psychological dimension that makes a good risk taker, that defines a good risk taker. Speaking of framing ideas, you did pen this blog post about 15 things that investors should

have learned after the financial crisis. And one of the ones that really struck me, and these are all, you know, their number, they're in bullet points, they're relatively short. So we really want you to dig into them a bit more. But one of the ones was this idea that the interest rate sensitivity of economic activity is less than what was previously believed to be the case. And I want to tie that in with another one, which is the idea that the economic channel of monetary policy and the financial channel of monetary policy kind of might be operating and existing separately. Can you walk us through those points? For me, just because I was a little frustrated.

I'd climbed into so many central banks all over the world. I'd seen so many things like a doctor in the ER with a lot of experience that I was kind of ahead of the curve on a lot of these issues just because you've seen financial crisis and money printing and all these things before. But when it came to the U.S., a lot of people who were really deeply steeped in 1980s economics had a very fixed view of money supply and interest rates and economic activity.

And what we know really is, the element that was lacking was behavior. The models that were taught in the 80s and that were perpetuated throughout, really, until the great financial crisis was a very rational way of looking at it. A lower price for money means more borrowing and in the real economy,

and higher rates means less. And if you just look at what happened before and after the crisis, you'll see that this doesn't really hold at the other factors. People were borrowing like crazy and the Fed funds rate was around five. Everyone wanted to borrow, everyone wanted to lend, everybody was on.

After the crisis, for a long period of time, rates were zero, and nobody was lending. Nobody was borrowing. It wasn't just a U.S. phenomenon. You see it around the world. So you have to ask yourself, you know, why is that? Why aren't we more sensitive to interest rates? And the simple answer is risk appetite. People were appetite, whether we feel secure in our jobs, then we are to the interest rate.

If you're securing your job and you know you've got a good income, for the next 10 years, you're more likely to go out and buy that house, even if the interest rate is five instead of three. That's just the way human nature works. So I think that's why people overstated the sensitivity of economic activity to, and if you factor that in, if you look more at people's risk appetite, then you'll get what's going to happen to the transmission of monetary policy into the economy or into finance. Now, with respect to the two different channels, if you just think about it, the financial channel happens fast. These are liquid positions that you can get out of.

Very sensitive often to the funding rate, right? You can leverage something that yields three if your funding rate is one. So the financial channel, on the economic side, you need a much higher level of risk appetite, or new branches because you're going to be stuck with that investment for quite some time. It just requires a lot more confidence. So that can be even sickier. behavioral, just a policymaker, it's super important because you can have points in time when the

financial channel has responded sufficiently and even excessively, but the economic channel is still inching its way up the curve. In fact, I would argue now we're in that kind of situation where the financial channel has responded quite well pretty fully. I wouldn't say it's gone crazy. Seeing robust investment and we're still not seeing wages and we're still not seeing financial channel is too far ahead of the economic channel. Now, it's my belief that happened in the modern. We get too optimistic in the financial channel, and we also get too optimistic in the economic channel,

and at some point we have a financial disruption, some kind of shock. It can be a small one, but it triggers a sell-off in the financial markets, and that forces a retrenchment or a rethink of people in the real economy about how extended they are with respect to risk, and they start laying people off and cutting back on investment, which has a multiplier effect throughout the economy leading to more layoffs and more cutbacks

and investment, and you get a real recession. But if you don't have the real economy extended, that channel very optimistic, you need a much bigger financial impulse to push the economy into recession. And I think that's where we are right now. And this is why my view all along has been on Twitter, we're going to have the longest and slowest expansion, you know, shallow and slow that we've ever seen because people are still looking in the mirror. Even in the financial channel, I would argue, when we get excited, we kind of check ourselves and say, no, no, no, this is a bubble. I mean, we hear people talking about bubbles all

the time. We're afraid of getting caught out. When I talk to guys right now, big investors, the word you hear is caution. Something's going to happen. We don't know what. This is long in the two, those kinds of things. And it's funny after, and that's through the financial channel, which is the one that's more sensitive to the stimulative policies that we've had for so long. So that tells me that the economic channel is just not there, and it would take a much bigger financial shock to push us into recession. So the odds of recession are still, in my minds, I'm very low, even though I don't expect robust growth.

So for a policymaker, these two different channels, is something people haven't dealt with because the Fed in particular and most central banks, more broadly, their mandate is keyed to the economic channel. And the Fed, only over the past 10 years has started to really think about how the financial channel feeds back into monetary policy and in their formal modeling. Mark, I feel like that answer explains so much about what we've seen in the, you know, obviously that's the whole point of this in terms of lessons, but, you know, you said this was a really big one. And, you know, just all this stuff about, oh, we're in a bubble, or all these macro hedge fund managers who think that the Fed has behaved irresponsibly by keeping

interest rates low and are causing all kinds of distortions, I feel like if they had all listened to that answer several years ago, unfortunately, it's too late for them now. In 2017, a lot of mistakes would have been avoided. On this theme of the gap between the financial channel and the real channel, Another one of your lessons is commodity markets. And you point out that they're driven first by speculation and that that overwhelms fundamentals. What's the lesson there? So the story of commodities was in 1999, 2000, right around them, they went electronic. So you didn't have to be in the pits and know all the secret handshakes to trade them.

You could trade them electronically from your office and then now from home. and that allowed people to get involved in a way they, and then around 2003, 2004, there were a lot of, there were academics talking about diversifying, the diversifying properties of owning commodities as an asset class, and that gained a lot of traction. At the same time, you had the emerging markets plugging into the grid, China joined the WTO, and that whole emerging markets theme, you know, the paradigm has changed, was starting to take off, and people associated that with commodities. So we moved into a world where, you know, China was going to take over.

They were going to eat all our commodities in an Amalthusian way. And therefore, you had to own it. So as consultants were peddling this story about diversifying through commodities as an asset class, commodities were going up. And when guys are pitched story about an asset class that's going up rapidly, it makes them want to get more involved faster. So we kind of had this boom in investment, speculation, whatever you want to call it. in commodities from 2003 until really until two. And Mark, I want to interrupt you real quickly. We're going to do something.

I want to do something really special. So for listeners, we are recording this episode on August 4th in the morning. It's 8.26 a.m. on a Friday. That means we're about just under four minutes away from the monthly non-farm payrolls report, which is, of course, the most important economic data point of the month. So we're going to do something a little different. We're going to take a little interlude from the podcast. We'll return to the lessons in a moment.

But we're going to talk through the jobs report as it comes out because I think this is very exciting, the chance to be talking to a sort of experienced macro trader about a report as it's coming out. It's coming out in just over three minutes now. And so we'll look at the data. We'll talk about it. We'll talk about the market reaction. People will get this snapshot of how you see things, how you interpret the data. And then, of course, we can come back to it. But ahead of the data, we're just about a little less than three minutes. Do you have any sort of early thoughts about the data? I should just note the economists are looking for 180K jobs for July. The unemployment rates of fall to 4.3% and 2.4% wage growth.

what are you looking at in the minutes ahead of the release? Well, and what kind of to trigger either a shakeout or reversal of these, of the recent trends. And the biggest recent trend has been short dollar, both against the funding currencies like the euro and the pound and Swiss. And against the risk currencies where emerging markets have done quite well. The Antipodeans in New Zealand and the Kiwi are always somewhere in the middle between those two camps. But because dollar has been on a run in a negative way, if you want to call it that, it wouldn't take much. One data, one strong number could trigger a shakeout that could last a day or two or three or a week or whatever. I still think the longer term trend for the dollar is down because we're in that phase of the risk cycle.

You know, the U.S. is recovered. Let's move further out the risk, but haven't been fully fished out. And that's why people have gravitated to emerging markets in Europe. Tracy, are you excited about the number we're about to get in less than 60 seconds? I'm very curious to hear Mark's sort of play-by-play minute-by-minute analysis. Mark, really, really quickly, because it's less than a minute now, would you try to trade around the immediate jobs report, or do you just try to, you know, think about the implications for your portfolio?

It depends on what I'm thinking. In reversal, I might try something. Often I like to see the market react before jumping in. If it's a trade, I also do investments, which... I can be active right now. I have some short dollar positions. I've paired back a little bit to get my sizing right. Make sure I don't get hurt.

I've had a nice run. Here we go. Numbers out. Boom. Wow. 209K jobs. So that's a beat versus 180K last month. Last month revised up from 222 to 231K.

So very nice. Unemployment rate falls to 4.3% from 4.4%. That's in line with expectations. and average hourly earnings growth at 2.5%. That's a little bit ahead of the expectations of 2.4%. And the labor force participation rate, which as many people would argue, has been one of the weak spots, a concerning long-term trend, up to 62.9%. We are seeing rates pick up 10-year yield a little bit higher, not dramatically, from 2.23 to 2.25%. Mark, give us your take. Yeah, so my take is this dollar's position. So now we get a test of that. shakeout. These aren't massively strong numbers, but they're definitely stronger than what people were looking for. I think what will stand out is average hourly earnings that that's up. People have

been very sensitive to labor inflation here. So everything is skewed towards stronger than expected, but not massively so. So this is a decent test for the short dollar thesis and for the long bond thesis. What I would do in a case and what I will do in a case like this, I just stand back and let it play out. And if I want to add to my positions, I wait until I think that this shakeout is over. But it's really a thing you have to feel your way through. You never know. I mean, this is a behavioral animal, this market. And you have to stand back and watch it and see how it plays out and look for correlations breaking down and look for them and other signs that the store trying to take it on. So, Mark, I think you mentioned that you had some short dollar positions. Would this be enough for you

to reconsider those? No. The emerging market. because strong U.S. data. And to your point about, you know, sort of U.S. equities, we mentioned that all the dollar is up, rates were up, but we haven't seen a sell-off in U.S. futures. At this moment, we still see risk assets rising up, not much, but they haven't sold off. But it's not going to change the Fed's the way people have been pricing in. So it's a modestly strong number that will shake some people out of their funding currency shorts, I would suspect. The Japanese yen is a prime one. Euro is another that's had a nice run.

Emerging markets are that hard. One of the fears in emerging markets has been, and we know when they're emerging markets are structurally all that much, first of all, but more important, they're in a much better position to weather it because the euro. We've had stuff with the autos and other areas and see a little counterweight to that. But this isn't nothing, and this isn't anything earth-shaking. media and women are looking for more. More out of themselves, their businesses, their elected leaders, and the world are out of them.

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Let's return to the lessons we all should have learned. Tracy, do you want to pick another lesson from Mark's list for us to go over? I was going to ask the oil question. Yeah, we'll get all commodities and then come on to oil. So the naval electronic trading was enabled. The asset class was being pitched as a diversifier. At the same time, emerging markets were kind of plugging into the grid. And this led to a lot of enthusiasm and commodities.

At the beginning, you know, if you go back to 1999 and that point in time, the breakdown in people trading oil. It's going to be less linked. We've seen a lot of that. A lot of the shale production was coming online because they didn't care about interest rates. It's higher rate than ever. People don't have gold teeth because it's cleaner because it's cheaper. Because it's go down in real terms driver.

Yes, you have emerging markets plugging into the grid and they're less commodity efficient. But I bet you the new houses in China are using PVC and not copper for the most part when they're being built out. Yeah, to some extent human progress is the story. of getting fewer commodities to maintain a standard. In a very real way, it's in case with oil dramatically from two-income markets, is we read way too much fundamental information to moves, et cetera, et cetera. But it was a lot of guys that got the shale producers and other guys who got excited about a high price of oil.

But its economy in general, we're saying, gosh, well, oil falling is going to be really good for the consumer. And I was making the point quite strongly that it won't help very much because it's become such a small share of our overall basket. The oil intensity of our GDP has declined significantly over the past. It doesn't matter so much. It's not going to turn. It's not going to.

If we say we look at something new. So Mark is very energetically and very eloquently connecting all the dots in all his lessons for post-crisis investors. So let me see if I can get in there with one more that I think is connected to all of this. And that's your very first lesson about potential growth in developed economies, being lower than it was before the crisis. Well, I'd go back to the early 80s, and we had a that we're driving,

baby boomers were plugging into the grid, and the labor coming online. I think it peaked $7.99, according to the everything else, on top of that, very powerfully, we had a decline in interest rates and a decline in inflation. Remember, the 80s had a very high inflation. We're just two heights come down. People borrow more when inflation is more.

more stable and when people don't have any debt on the balance. Real obstacle, relationship between financial innovation, graphic portions slowed down by the end of the 90s. The credit, though, continue to deepen in demography for a long time, giving us the on credit. So really, the change in the demographic headwinds. When the GFC is done, it's over, now it's a headwind. Cover the demographic week. At the time, I was referring to it as reversion to a different means. probably going to have the same demographic phenomenon. Credit headwinds or relation when you're thinking globally about where to... All right, Mark, I'm going to ask you one more question, and it's going to be really unfair because I'm going to ask you the most controversial question, but we have to do like a speed round.

Okay. So I'm going to make you... This is a question we probably could have done a whole episode on, but we're going to have... It's got to have to be very short answer. Okay, you got it. Number 13, I'm fascinated by. You say very few investors can disentangle their political preferences. from economic analysis. What's the story there?

Retain, deep into our own narratives and the confirmation bias is so strong. I mean, look at how many guys became bullish when Donald Trump became president and how many people turned bearish when he became president and how many people objected or were fighting the stock market for the whole period under Obama because they didn't like his policies and how many people like the policies, right? So this is what you see. And you see it time and time again. And the seasoned investor just kind of gets past that. I didn't think Trump was going to get elected. And definitely someone I don't think is suited for the job.

That's my personal view. But I didn't think he was going to cause a recession. But a lot of guys, I saw a lot of guys fall into that trap. And a lot of people who have been embarrassed for eight years, you saw them flip the switch and say, oh, I'm bullish now. And they mumbled something about tax cuts that haven't materialized. But we can see now in the data that, you know, what really happened is we went into the election coiled, right? everyone was ready to take risk. And it played out a little bit differently than most people thought.

But, you know, the economy underlying economy is doing okay. And the fact that Trump's policies didn't materialize and we're still holding up is a sign that things are okay. All right, Mark, phenomenal conversation. Got to leave it there. Great talking to you. I loved how we did that Jobs Report thing. That was really cool. I feel like I learned a lot there.

really appreciate you coming on. My pleasure. It was great talking to you guys. Tracy, I thought that was really fun. Mark obviously knows way more about so many things than, you know, sort of we do or even a lot of, you know, typical people in finance do. I thought that was a pretty cool conversation. Yeah, and I thought the way he put this idea of sort of the financial world and the real economy running at two different speeds, the way he framed that is really, really useful. And it kind of amazes me now that it feels like others and in particular the Federal

Reserve are only just beginning to think of it in that way. But it seems like a pretty big deal. Yeah. And I think that's sort of like the underlying theme of all of this, which is that human behavior, I mean, his blog is called behavioral macro. And so the sort of traditional macro ignores what, these sort of behavioral things, that humans do things because we're animals and we run in herds and we have fear and greed that don't necessarily correspond with supply and demand. But they're trying to really like suss out which of those, you know, factors are driving what has sort of been a key aspect of understanding the post-crisis period. Yeah. And also the idea that human beings have a tendency to cling on to their previously

understood notions of how the world works, is really. really important. So I know we were talking about the financial crisis anniversary coming up. I remember when I first started writing about quantitative easing in 2009, you know, writing analysis about how this was going to push up financial asset prices through a substitution effect. And I remember people getting really, really outraged about that idea. And now it's just common knowledge, right? Well, and also it's like everyone just assumed that it was hyperinflationary. like all these sort of deep seed, oh, printing money, that's going to cause Wimar. Just like all these things that we, you know, Mark referred to as like we anchor on a certain period.

So when it comes to money creation, we might anchor on some hyperinflationary period. When it's oil, we might think about the late 70s. And just without very little thoughts, sort of draw that one thing we know to the current thing. And of course, you know, history is never quite the same as the first time around. Yeah. Human beings are weak, weak entities. flawed. And on that note, that's the perfect way to, you know,

sort of set the stage for the next few years, just a reminder that we're weak, week, weak, flawed entities. All right. Well, this has been another episode of the Odd Lots Podcast. You can follow me on Twitter at Tracy Alloway. You can follow me on Twitter at the stalwart, and you can follow Mark Dow on Twitter at Mark Dow. So check out his blog, markdow.t.tow.com.

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