The Compound and Friends - The Credit Crunch Is Just Beginning

Episode Date: November 8, 2023

On this special episode of TCAF Tuesday, Michael Batnick, Barry Ritholtz, and Downtown Josh Brown are joined by Campbell Harvey to discuss: the state of the economy, the yield curve indicator, the next recession, and much more! This episode is sponsored by LifeX. Learn more at: lifexfunds.com. Check out the latest in financial blogger fashion at The Compound shop: https://www.idontshop.com LifeX distributions, which are paid monthly and total $1 per share per year, either fixed or inflation-protected, are known at the time of investment. To support these distributions, LifeX invests in U.S. government securities. These securities include STRIPS (LifeX Fixed) and TIPS (LifeX Inflation-Protected).LifeX funds are designed to liquidate on December 31 of the year investors turn 100. There can be no assurance that a fund will continue to make distributions until the fund liquidation date. Under certain circumstances, a fund may run out of assets prior to the planned fund liquidation date. Investing involves the risk of loss. This podcast is for informational purposes only and should not be or regarded as personalized investment advice or relied upon for investment decisions. Michael Batnick and Josh Brown are employees of Ritholtz Wealth Management and may maintain positions in the securities discussed in this video. All opinions expressed by them are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. Wealthcast Media, an affiliate of Ritholtz Wealth Management, receives payment from various entities for advertisements in affiliated podcasts, blogs and emails. Inclusion of such advertisements does not constitute or imply endorsement, sponsorship or recommendation thereof, or any affiliation therewith, by the Content Creator or by Ritholtz Wealth Management or any of its employees. For additional advertisement disclaimers see here https://ritholtzwealth.com/advertising-disclaimers. Investments in securities involve the risk of loss. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. The information provided on this website (including any information that may be accessed through this website) is not directed at any investor or category of investors and is provided solely as general information. Obviously nothing on this channel should be considered as personalized financial advice or a solicitation to buy or sell any securities. See our disclosures here: https://ritholtzwealth.com/podcast-youtube-disclosures/ Learn more about your ad choices. Visit megaphone.fm/adchoices

Famous people from North Carolina. Billy Graham? Yes. Yes, okay. Dale Earnhardt? Michael Jordan? Ric Flair. Woo!

That was a surprise to me. His real name is Richard Flair. True story. But it's spelled F-L-I-E-H-R. So it was smart for him to change it. Who else? Drop the H. Anthony Hamilton, R&B singer.

Steph Curry. Any American Idol fans? Fantasia. Julius Peppers, hometown hero. I see a lot of long car trips. John Coltrane. A lot of long car trips with little kids in the back? Yes. Who else? Does anybody know with little kids in the back. Yes.

Who else? Does anybody know why it's called the Queen City? Anyone? Alright, but who... Incorrect. It's actually named for Queen Latifah. Who was born here in 1938.

What else do I have? That's all I got, guys. Duncan's not amused. We ready? Hit that button. Welcome to The Compound and Friends. All opinions expressed by Josh Brown, Michael Batnick, and their castmates are solely their own opinions and do not reflect the opinion of Redholz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Redholz Wealth Management may maintain positions

in the securities discussed in this podcast. Today's special live episode is brought to you by LifeX, a first-of-its-kind retirement income solution from StoneRidge Asset Management designed to deliver high, reliable monthly payouts. LifeX provides investors with a choice between fixed or inflation-protected monthly payouts designed to last for life through age 100. LifeX's breakthrough innovation is its ability to target a sustainably higher payout rate for living investors than would otherwise be possible by limiting payouts to an investor's

lifetime and seizing payouts thereafter. LIFX seeks to empower financial advisors with an alternative to traditional fixed income that is designed to free investors from the financial and emotional impact of navigating the risks from market volatility, inflation, and an uncertain lifespan, all of which become more acute for investors as they enter the post-paycheck phase of their life. LifeX aims to give investors the freedom to spend time and dollars with more confidence. Later this month, Nate Conrad, head of LifeX, will be joining Animal Spirits Talk Your Book to go deeper on LifeX, and it should be a great conversation on this innovative solution. Learn more about LifeX at lifexfunds.com. Investors should consider

LIFX's investment objectives, risks, charges, and expenses carefully before investing. The prospectus contains this and other information about LIFX. The prospectus can be obtained by visiting lifexfunds.com. The prospectus should be read carefully before investing. Please refer to the show notes for important information, including links to the LIFX Funds prospectuses. refer to the show notes for important information, including links to the LIFX Fund's prospectuses. Guys, Duncan is a native North Carolinian. Does everybody know that? Give it up for Duncan.

A round of applause for Duncan. What city? I don't know. Where? Oh, yeah, sure. Okay, all right. Duncan, when did you join the team? Okay, so if you were watching or listening to any of our content prior to 2019 and then after,

you probably noticed a significant quality improvement. Duncan has come in and just done an incredible job. One more round of applause for Duncan. Duncan. incredible job. One more round of applause. I also want to give a shout out to our media business, as it were, actually has its own CEO. And he joined us very recently. He's here today, Rob Passarella. Rob, thank you for all your work on this. There he is back there. He looks like Michael Batnick's dad. It's a fellow bald. We all look alike.

There you go, Rob. Love it. And the superstar of tonight's show, before we start the actual podcast, I just want to mention all of this was coordinated and put together and planned by Nicole. Nicole, say hi to everyone. Nikki. Nikki. Nicole is an absolute superstar.

She's about, are you 13 yet? How old? All right. I'm 24. All right. Nicole is 24. Nicole is an absolute superstar. Also joined the team recently and increasingly has taken on more responsibility, including

for this. So if you have a good time tonight, thank her. If you don't have a good time tonight, I'll give you her phone number and you could let her know. All right, are we gonna start the show? We ready to go? Yes, all right, let's do it. Ladies and gentlemen,

welcome to the compounding friends. Ow! We've got you in the house. We've got Josh, we've got Katie here in the Gary, and our very special guest, Campbell Harvey. Well done. I want to, we're going to skip the introduction of me and Michael and Barry. Introduce Cam. If you're here, you know us.

Let's introduce Campbell Harvey. We are so appreciative of your time tonight and you flew here from Durham to to be here from from Toronto from Toronto but you're flying back to Durham that's part of the story right okay his flight was inverted okay thank you so much for joining us tonight here here here's what here's what I want to hang on one second here's I want to start this let's give you an official introduction. Campbell Harvey is a professor of finance at the Fuqua School of Business at Duke. He is a research associate of the National Bureau of Economic Research, or NBER, a director of research and partner at Research Affiliates. There's a lot of research at Research Affiliates,

which advises on over $130 billion in assets. Cam is also best known, though, as the godfather of the yield curve indicator, which he first observed as being predictive of recessions back in the 1980s. Give Camel Harvey a round of applause. And before we get into the meat of the show, we have to thank LIFX by Stone Ridge, which is a product coming to the market in 2024, that if you're an RA, if you're an advisor, you're going to hear a lot about it. So thank you to them for LIFX by Stone Ridge for making this possible for us tonight. All right, so let's start with the yield curve. It's been, this is a couple of weeks

ago, but it's been like, all right, so you started with the inversion, the 10 year and the three month, that was like your baby. It's been a record period of time that the three month yield has been higher than the 10 year. A couple of weeks ago, it was 232 straight days. So I don't know what it is now, 250. The previous high was in the GFC, that was 209 straight days. So what is taking so long for this recession to hit the United States of America? So with all due respect, it's not a record. So over the last four, over the last four recessions, the lead time going from inversion to recession averages 13 months. So right now we're at 12. Next month it'll be 13, which is the average. Okay, so it's way too early to declare a false signal, even though it could be a

false signal. It's just way too early and then people also say well your curve is flattening out and it might univert well before we get before we get there I want you to define for everyone here exactly why the yield curve indicator matters and then we'll talk about the the un inversion but I want to make sure everyone is on the same page for the discussion and understands exactly what it is we're referring to. Yeah. So the usual situation is that long-term interest rates are higher than short-term. That's called a normal yield curve. But when certain things happen in the economy that are abnormal, you get this weird situation

where the short-term rate can actually go above the long-term rate. And that can happen in many different ways. So this particular inversion happened because the Fed started jacking up the short-term rate. And I discovered this during my time at the University of Chicago in my dissertation, and I noticed that every time the yield curve inverted, meaning the short rates are higher than the long rates, a recession followed. But it was only four observations, four recessions. And my committee was thinking, well, maybe this is lucky. But they were kind of

impressed with a few things. Number one, my indicator got the double dip recession in the early 1980s. So we had two recessions fairly close together, and others did not get that. Number two, they thought that the foundation of the idea in terms of the economics was very sound. So my model made a lot of sense and there wasn't a lot of disagreement about that. And then the third thing that they especially liked, at the time, to get a GDP forecast, you'd pay like $50,000 to $100,000 to an econometric firm that employed dozens of PhD economists, and you got a number for that. And what they liked about my indicator, it was a single number, and the cost of it at the time was the 25 cents it would cost you for a Wall Street Journal. Nobody makes money from that. They really like that. And in kind of scientific research,

what usually happens after you publish the idea, the good scenario is that the indicator gets weaker. So the effect fades a little bit. That's the usual situation. And the bad scenario is that it truly was lucky, and it goes away. But my indicator, out of sample, it turns out that it's predicted each of the last four recessions. So it's eight out of eight at this point. And this is important with no false signals. You can have an indicator. It's really simple. Just predict recession every quarter. It's going

to be eight out of eight, but it's going to have a massive false positive rate. So this is an indicator that now I think people are taking seriously, and it only became popular after the global financial crisis. After the global financial crisis, people looked at it and said, oh, what's going on? This is like a seven out of seven, and it gave a clear signal for the global financial crisis. So, Cam, credit to you because when you put ideas out into the world, especially when your ideas are proven right, as they have been with the yield curve out of sample four to four times since you coined it, you become synonymous and tied to the idea.

But you had the intellectual flexibility, which is really, really rare. You went on TV last year and you said, actually, maybe this time is different. What gave you the courage to say that? Actually, no courage whatsoever. I'm a scientist. This is a model.

So think of the economy is so complex. And to think that one variable, the difference between the 10-year yield and the three-month yield, is going to give a correct prediction for economic growth forever? Come on. That is so naive. Is it predictive or causative? Does the inverted yield curve make something happen that causes recession? Or is it just something that happens and then a recession follows and it's more like something that you're observing, or maybe it's a little bit of both?

Yeah, it's a deep, deep question. We have a little bit of time. So thanks for asking that. So in my original dissertation, there was no causality whatsoever. It was purely picking up expectations. But I've come to believe that it is causal now. And let me tell you a couple of channels where it's causal. So the first thing is that after the global financial crisis,

a CFO or CEO could get before the shareholders and say, well, we got whacked, but everybody did. And we were blindsided by the global financial crisis we had no idea it was coming now you think about today you've got an inverted yield curve for 12 months the indicators well-known and suppose that the CEO or CFO pulse the trigger on major capital investment. We go into recession in 2024, and the firm's in trouble. There's no way they can go in front of the shareholders and say, well, I was completely blindsided by this recession. This is the most predictable one of all. So it

changes behavior. So given that you see an indicator that's eight out of eight, given you see that, it changes your behavior. So you become more conservative, you don't bet the firm on capital investment, you don't go out and massively higher, you do the opposite. So you might actually do like some sort of layoff, 10%, or hold back on investment, just so if we do go into recession, the firm will survive. So that cutting back in investment, which we've already seen in 2023, and kind of decreasing the rate of increase for employment. This is consistent with risk management. It's also consistent with the inverted yield curve actually causing the economy to slow.

That's channel number one. Channel number two is the banking system. So inverted yield curves are really bad for the banking system. So think about banks. They take in deposits, and they pay a very short-term rate on the deposits. We're in Charlotte. They all know how banks work. Yeah, exactly. Pretty sure. And they basically lend out longer term. So anytime the yield curve inverts, that hits the profitability of banks. But there's another part of this and that is the way

that the yield curve has inverted is like the worst possible scenario in that both the short rate and the long rate have gone up. And the long rate hits our financial institutions in terms of the balance sheet. So when the long rate goes up, the assets that they're holding, and they might be holding, let's say, treasury bonds, the value of those bonds goes down. And we've seen in March a preview of what I believe is more to come with Silicon Valley Bank going down because they took a duration bet and their assets went down because rates went up and they became negative equity. About 10% of banks looked like Silicon Valley Bank in March of 2023. That's when the long rate was 3.5%. Now we're up 100 basis points, and there is a lot of,

I guess, unrealized losses on bank assets. And that, to me, is disturbing and increases the risk that we actually go into recession in 2024. Do you draw a distinction between held to maturity securities? So because this is why this is important. The bankers will tell us and are telling us, oh, don't worry. It doesn't matter how upside down we are on these mortgages, these treasuries, because they're in this specific part of our portfolios and we are never selling them. Therefore, pay no attention. They'll mature in 10 years, in 15 years.

Everything will be fine. Do you not think that that's a strong argument for why we might be okay this time? Yeah, that's the argument that SVB made. Okay. Yeah, it didn't go over too well. So you exhaust your available for sale because people are withdrawing money, and then you have to sell to hold to maturity.

Right. Okay, and this, look, this is a basic problem. We were talking a little bit before that our banking system today, there's a fundamental mismatch of maturity. So in my opinion, some of the regulations are a problem. The hold to maturity should be mark to market. Everything should be market value, everything. And if we had that, it would be less likely that some of these banks would be gambling. And this is really gambling. So increase duration, you increase risk.

And then if there's a negative duration event, well, the FDIC will bail us out. So we're holding long-term treasuries in our hold to maturity bucket, and that's gambling. Oh, yeah, that's duration risk. It's obvious. And the only reason that you don't mark is because the accounting suggests that they shouldn't. So if I'm holding assets, we need to mark the market.

Now, some of the assets are illiquid, like treasuries, no problem. Some of the assets are illiquid. So we need to work harder in getting a mark on those assets. You can see it in the stock prices. Bank of America took this big bet on duration during the pandemic. I'm not 100% sure what the motivation was. If it's not extra profit, then there's nothing else I could think of why they would have done that.

It's not strategic in any way. So they did that. J.P. Morgan didn't. J.P. Morgan is close to a 52-week high. Bank of America is close to a 52-week low. Wall Street gets what's going on here. Even if the regulators maybe don't or politicians don't yet, Wall Street is sorting out the banks that made the bet and the banks that held back. Yeah. And there's something else

that's really striking that doesn't make it into the media. I got a renewal notice for a five-year CD from my too big to fail bank that happens to be located in the city and I looked at it and said, well that's a little low but it's not that bad And then I looked at it again, and the renewal was, I thought, 2%, but it actually was 0.02%. So that's weird. They're counting on that a lot of people just won't read it. Exactly. And then, you know, I give advice to a lot of financial institutions and asset managers. I'm not very good at my own personal finance. So I call my banker, and I've got a savings account. And I said, well, what is the interest rate on my savings account?

I know, like, on my checking account, it's pretty well zero. And they said, well, you're getting two. I said, well, like two what? Like 2%? Basis points. Two basis points. And then I checked the other too big to fail banks. And the most generous one is Citibank

at five basis points. Okay, so you think about what's happening here. So what do I do and And what should you do? Money market. Just take the money out into money market and collect over 5%. So Cam, I have a question about this. So a trillion dollars has gone into money market funds this year as people are understandably pissed off about getting zero at their banks. But you mentioned that the yield curve inversion could cause a recession because banks are borrowing short and they're lending long.

But they're not really, because they don't follow the treasury curve. They're not paying you 3% or 5%, excuse me, and then lending at 3%. They're paying you zero. And they're lending at rates that are above, they're getting a spread on that. So it's not like the banking system, credit is still flowing.

Maybe not as much as it was. So it's a great point. But I want you to think about this. The spread between savings rate and what you can get in a money market fund is just enormous. It's historically unprecedented. And this to me is a red flag. If they can only afford to pay two to five basis points on a savings account, then there's some serious problems. So you're right, this channel on the profitability, we don't really see. And given the market power of these banks, they're able to keep it low. But think about the implication. There's a lot of people taking their money out of the banking system, going into money market. What does that

do? That means that there's less money in the banking system to lend out to small businesses and to consumers. This is going to cause a credit crunch next year. It operates with the lag but money is just flowing out. So money flowing out and then you put that with this long-term rate going up. And we've lost maybe a third of bank equity already. Can I respectfully push back? So you're saying that they can only afford to pay due basis points. No, there's inertia. They can get away with paying due basis points.

Exactly. They're getting away with it. Right. So a trillion dollars has left, but how many trillions remain? Because people just don't know or they're lazy or whatever. They can get away with it. And wouldn't competition just cause them, if there's enough outflow, to say, hey, you're going to get 150 basis points in your savings account? When does that happen?

Yeah, so there are some banks that offer higher rates, but they're riskier. And part of this, like the average savings rate across all banks is something like 60 basis points. Still not very impressive. And the too-big-to-fail banks, they can charge a very low rate because they're too big to fail, that people feel safe putting their money there because the FDIC will bail the bank out if it gets into trouble. But nevertheless, something is wrong with the system if savings accounts only pay two basis points. And yes, the smart money will flee. And many other people don't look at the rate

on their savings account. Probably the majority of people and the bank, it's called financial repression. You take advantage of those that don't really check. I don't think that's fair. Surely when Neil Kashkari spends two hours on Squawk Box talking about everything under the sun other than this, surely this must be somewhere in the back of his mind. Surely Powell is aware. Stop calling me Shirley.

So are they gambling? Is the Fed gambling that they can get what they want to do done before the rubber meets the road here? What do you think that mindset is about? The Fed has done our economy great disservice, in my opinion, to keep interest rates at essentially zero percent for an extended period of time. A time where we had robust economic growth, where we had record low unemployment, where we had

record high stock market prices. It made no sense whatsoever. And the degree of monetization, we're paying the price in terms of their very slow movement, in terms of tackling inflation. The low interest rate that happened for so long was distortionary for the economy. It kept all these zombie firms alive. And that's not good for economic growth. So if the firm should fail, it should fail and capital redeployed to more productive firms so we can get economic growth. So it's been very disappointing,

very disappointing in terms of the Fed performance. But now these companies are failing and we are getting economic growth. Yeah. So what really counts is economic growth going forward. And the print of 4.9% real GDP growth in the last quarter is very misleading in terms of the future. And let me tell you why. So what happened in 2023 is the consumer bailed the economy out. And the consumer had built up savings from COVID, where they weren't actually going out and spending, and government programs that were generous. So those savings have been run down. So you look at many different indicators, you can see that those savings have essentially run out or should run out by the end of the fourth quarter. And then on top of that, you can look at other leading indicators.

For example, delinquencies on car loans and credit cards. Those have turned up, which is consistent with the savings being run down. Because obviously you would prefer to use Your savings rather than a very high interest rate alone So the consumer is not going to be there We've got all these other forces coming at us like the student loan repayments restarting So in 2024, even though it looks great at 4.9% We need to look forward and%, we need to look forward. And the policymakers need to look forward also. They can't be relying upon this constant tunnel vision to the past. They should

be making policy based upon real-time data and expectations about the future. And that's another aspect of the Fed policy that's very disappointing. So, Cam, we totally agree with you that the Fed was on emergency footing for way too long. They were at zero for a decade. But I've read some of your recent writings, and I've been listening to some of the things you've been saying, and I get the sense you think the Fed is way too tight, and they're going to be not higher for longer, Fed is way too tight and they're going to be not higher for longer, but too high for too long, and they're going to cause an unforced error, an avoidable recession, or are they just going to make the inevitable recession much worse? Well, actually, both are true. So let me... Are you guys having fun yet? Yeah. So All right. Yeah, so it was mentioned that...

Mike finished his drink. I don't know if you noticed. Keep going now. Yeah, so January 4th of 2023, I went on LinkedIn to say that my model was probably wrong this time around. And it got picked up because it was not any pundit saying

that my model was wrong. It was like the founder of the model saying it was wrong. So I had some credibility. And I really thought in January that we could avoid a recession or maybe it would be like super soft landing. But in January, I also said that it was time for the Fed to pause. And they have refused to do that. Like right now, even though there is a pause going on, they hiked in 2023, and they have not ruled out another hike. And the reason is inflation. And we all know that they were super late to the game in raising,

And we all know that they were super late to the game in raising, but they're also very late in pausing or starting rate reduction. Can I ask you about that? Yeah. Everyone on earth, every talking head, and I know a lot of them, seems to grasp that the way PCE calculates shelter inflation is on such a lag that it's almost irrelevant. They're looking at data from 12 months ago to make decisions today. Every pundit knows that if you just look at apartments.com or you look at any other way to measure shelter inflation, not only is there not inflation currently, there is almost disinflation in certain areas of the rental market. Do they not know that? So how is it possible that they don't understand this?

But of course they do. Yeah, this is what I've been saying for the last two years. And I don't consider myself a pundit on this. So they missed the shelter. So just to back up a little bit, you can think about how, let's say, rental inflation works. Suppose, like, at one point in time, rents go up by, let's say, 12%. If you're renewing your lease, you're going to have to pay that 12% increase. But if your lease goes for another 11 months, it's kind of, like, drawn out. So the way that inflation is calculated is with something called owner's equivalent rent. And it operates with a lag. So it's stale data. So this is what I was saying when the Fed was keeping the rates really low and inflation

seemed to be going up, that I could see double-digit rent inflation, double-digit housing. And they said, we're going to have an inflation surge and you need to act on it. And the Fed was saying, oh no, this is temporary. But it was obvious just looking at shelter. So shelter is 40% of the PCE deflator and 35% of the CPI. Now, what about today? So the inflation rate, the CPI year over year, is 3.7%. The most important component is shelter, 35%. And that is running at 7.2% in terms of the numbers that are reported. That 7.2% accounts for way more than half of the 3.7. But the 7.2% is totally disconnected from reality. So if you look at apartmentlist.com or Zillow, the rental inflation is maybe 1%. The Case-Shiller 20 is 0, and if you look at housing prices, maybe 1%.

So if you make an assumption that the true, the real-time rate of inflation is let's say 2%, which I think is very generous, that means that the correctly calculated year-over-year CPI is 1.8%. If you do an assumption of 1% for shelter, it's 1.6%. Surely somebody must have told them this, though. Both these numbers are below the target, yet the Fed is saying, oh, well, we're not sure that we've dealt with inflation. saying, oh, well, we're not sure that we dealt with inflation. That is a false narrative, and it is dangerous to make policy based upon last year's data. You need to make policy based upon the real-time data, and there's no excuse for it. It is a false narrative. Let me play devil's advocate and just ask you this, and I don't disagree with you. I'm just

for the sake of this conversation. If they were to pause or signal that they're going to cut or be or losing conditions, that everything that they've done to this point would unwind so quickly that the market would go screaming, yields would come crashing down, and inflation would come back. Do you think that's what they're worried about? Because surely they know what we just talked about. They know. They have to know. Yeah, the damage is already done. So mortgage rates going from 2% to 8%. The housing market is under stress. The commercial real estate market, and we could talk about that maybe a little later, that is cratering also. So I think that there's a lot of damage that has been done

in raising these rates so quickly. And now with the long-term rate. So the long-term rate going up and the short-term rate going up, the so-called bear situation in terms of yield curve steepening, it is very bad for the economy. So what they should do is say, we're done raising rates. And now we're thinking about decreasing the rates.

Our job on inflation, we're at the target in real time. Oh, just by the way, most people don't know that before 1982, we didn't have the owner's equivalent of rent. So they did this. Tell them how they get the number. It's the most ridiculous thing I've ever heard. They call people and say, what do you think you could rent your basement for? And that's the data.

I swear to God, I wish I was making that up. Yeah, so it is remarkable to me because this is so intuitive, right? And this is really basic stuff. And I actually have a graphic that I show where you look at the real-time rentals, three-time, year-over-year, and then you look at the owner's equivalent rent. The owner's equivalent rent is about one year stale. And again, we don't make really important policy based upon stale data. I don't get it. The Fed has got 400 PhD economists.

Surely there's a handful of them that could go and make the case. If only they had a Bloomberg in the building. Yeah. I want to ask you about the un-inversion. And I want to move to this just in the interest of time because there's a lot of stuff we want to ask you about. So I want to read something. This was written by Jim Colquitt, who writes a great substack. But many people are now saying this. And you've been saying this too. Every time the yield curve inverts, the calls for a recession begin. Further, every time a recession doesn't begin shortly thereafter, the narrative shifts to, see, we didn't have a recession. The yield curve inversion is wrong this time.

The key thing to remember is that it's not when the yield curve inverts that we have a recession. It's when the yield curve un-inverts that we have a recession. The time from un-inversion to the beginning of the recession has historically, looking at has ranged from 49 days to 210 days, an average of 131 days, which equates to a little over four months. So describe the un-inversion and why that's important and why people need to understand that that's actually when the stopwatch starts. Yeah. So I think that this is like a behavioral thing that when you're in a situation like today, you're always looking at the positive data. You want some narrative where there's not going to be a recession. And nobody wants a

recession. I don't want a recession. Actually, I hope my model's wrong. Because I don't want a recession. And it's very painful for people. People laid off, the stress on families and stuff like that. But I do think that you need to be careful. You need to look at the data. And this idea that, oh, well, the yield curve is steepening and we're going to un-invert. Therefore, the model must be wrong. Well, it could be wrong. But looking at the data for the last four recessions, the yield curve uninverted before the recession began. And the other thing to take into mind.

Every time. Every single time. And how does it normally uninvert? Is it because the Fed's cutting or because the long-term? So, again, historically, many of these uninversions are the Fed slashing short-term rates. Because we're in a recession. Yeah. So going into the global financial crisis, the Fed funds rate was like 5.25%.

And then once stuff started to look really bad, they started to cut. So this one is really unusual. Again, you've got the long rate going up, which is bad. The short rate has already gone up a record amount. So probably the way that we'll see this is the Fed decreasing their short-term rates. Josh made a really good point the other day, I think maybe on TV. Thank you. Talking about or asking the question, I think it was to Gunlock, can higher rates actually be stimulating the economy? And don't laugh at me. So listen, so hold on.

So Berkshire Hathaway, which I know most of us don't have the money that Berkshire does, but Berkshire Hathaway, their interest income was $1.7 billion in the most recent quarter, which is $5.1 billion earned over the last 12 months, which is higher than the total interest that they earned over the last three years. They're not the only ones that are the beneficiaries of higher interest rates. Is it possible, or is this just Mike grasping at straws? Yeah, so this is the way I look at it. If the rates go up, that increases the cost of capital for businesses and for consumers.

And the usual economic mechanism is that if your cost of capital goes up, then some investment projects are not pursued because they're no longer economically feasible. So that decreases investment, that decreases employment, that decreases economic growth. So that's on the corporate side. Get something similar on the consumer side where the cost of borrowing goes up. You have to cut back on consumption and it decreases economic growth. And what we're talking about is kind of like distortionary increases like we've seen. So let's be clear. Like a zero interest rate, that's distortionary. And what we've done recently with the Fed policy, jacking the rates above 5%, that's distortionary.

And all of this is not good for the economy. And so generally, higher rates are bad news. I want to make sure we get to this idea that we are all quants, because you really are a prolific writer, and I love this piece you did. And what you're basically saying is that everyone is a quant in today's day and age, money management. However, not everyone actually runs a systematic portfolio, which is what you would expect a quant does. So could you expand a little bit about the message that you're trying to get across here? Yeah. So I did this really interesting

exercise for a research paper where we had a large number of hedge funds, and half of them were actually classified, either systematic or something like that, or discretionary. Can you explain the difference between the two? Yeah, so a systematic, you've got like a model that's telling you what to do, whereas a discretionary fund, you've got a manager making choices. So we had this classification, but for thousands of others, we didn't have the classification. So we actually looked to see what words were associated with discretionary and systematic. And then we're going to use those words to identify thousands of other funds that didn't come out and say what they were doing. You're looking at the literature that the fund itself puts out for the violence? Yeah, exactly.

All of the, you know, this is what we do. And it was a surprising finding that it was more likely that the word quant appeared for discretionary managers. OK, so this kind of gave me the idea that, oh, well, everybody is a quant. And I know many discretionary managers, they make the decision. But they make that decision based upon quantitative information.

So it's not a model telling you what to do. But there is analysis of the data that you get and you make the decision. And it's becoming increasingly easier to do that. So you can take a company, their most recent 10K, and let's say the 10K from a year ago, give those to ChatGPT4 and tell the AI tool, well, can you highlight the differences? And can you indicate whether there's any red flags? And this happens within like a few minutes. So it's very quick to actually do. So these tools are remarkable. Given the amount of data that's available today, the discretionary investor of the past that had, let's say,

an Excel spreadsheet for a company and kind of tweak a few numbers here or there, no, those days are gone. You have to be proficient in the latest tools, and those tools are quant tools. So we are all quants. Well, maybe not all, but those managers will fade. One or two quotes that I liked from the article, you said, the machine is unable to feel regret. And then you also said the main advantage is discipline. And I think that's the important part, because if you think about where sentiment was over the last couple of weeks with the stock market, it was more or less in the toilet before

last week. And then you had one good week, and call option activity on Friday was the highest of the year. And so that is just classic bad behavior for lack of a better word. Is that machine-driven, or is that human-driven? Well, it's a good question. Both. Yeah. So it's really important here. So the idea is that the algorithm doesn't have emotion. And there's so many behavioral errors that investors actually make and investor managers. So you kind of get rid of that. But nevertheless, you need to be careful because some of these algorithms might not be properly specified.

So just because it's an algorithm doesn't mean it's necessarily better than a discretionary investor. It's a different setup, and you need to be careful there. Because if there are some fundamental changes in the economy, and you fit your algorithm on that old data, it might not work at a sample. But nevertheless, you've got some benefits and some costs for each of them. Both of them share a quantitative foundation. So this is something that you relate in your piece, just talking about the rise of machine learning tools, which have been around for a very long time and people have been trying to utilize them on the equity markets to obtain an edge. And some of them famously have. The edges don't necessarily last forever, but this is an established

money management idea. You said three specific factors have led to the surge in machine learning applications. First, computing speed greatly increased. In 1990, a Cray-2 supercomputer cost $32 million in today's dollars, weighed 5,500 pounds, and needed a cooling unit. It was able to do 1.9 billion floating point operations per second. Today, your mobile phone is 500 times faster

than the Cray-2. So round of applause for our mobile phones, I guess. Why can't we just all now systematically do the types of things that would enable us to beat the market or have an edge? What's missing? So let me change that example a little bit, because I recently got this really cool graphics card for my computer. It's an expensive one. And I got it for the sole purpose, I do a lot of Zoom calls. And what it allows me to do, my camera's beside my computer. So I don't need to look at the camera. I can look at my computer, but this tool, it appears as if I'm looking exactly at the camera all the time.

I knew you were fucking with me the other day. I couldn't put my finger on it. It's your chip. It's the SPF of Zoom. This graphics card costs $1,300. You mentioned the Cray doing 1.9 billion operations per second. Well, this graphic card does 32 trillion operations per second. Well, this graphic card does 32 trillion operations per second. And if you wanted to buy that computing power... Is it NVIDIA chip? To be fair, it's $1,300. It's

a lot of money. $1,300? Okay, but this is the issue. If you wanted that computing power back in 1990, it would cost $400 billion. $400 billion. Okay, so to your question, like, okay, we've got this great computing power. Why can't we just like let it go on the market? And we've been doing machine learning for quite a while. Like indeed, I've published a paper in 2001, applying neural net technology to stock returns, and it went nowhere. It wasn't very good. And one of the reasons that it's really challenging to apply these tools is the sparsity of the data. We just don't have a lot of data. Think about my yield curve. I've got eight observations, I've got eight observations, eight recessions.

So these tools don't do that well if you don't have a lot of data. So it's not so obvious. And the other thing that I kind of criticize in this paper is so-called green, what we think of greenwashing as people saying they're environmentally friendly when they're not. Well, there's tech washing also so people put machine learning ai uh in their prospectus and stuff like that and really what that means is they had a summer student that took a course in machine learning and and that's it so so people being fooled by that and so machine learning and AI, there's just such a range of different techniques. You need to pick the right one.

You need to avoid the so-called overfitting problem where you use these really high power tools and it looks great within the history you've looked at and fails spectacularly at a sample. So you need knowledge in terms of doing this. It's not you just pull it off the shelf and apply it. You need to know the technique. It is very promising, but there are severe limitations. And indeed, to me, one of the most exciting applications for AI is maybe not what you expect. So let's say we develop a

couple of systematic models for trading, so trading strategies, and we test them. How do we usually do that? Well, we have some historical data, and we test them, and model A does better than model B. But that's just one shot. And indeed, the older data maybe is not representative of the economy today. So what we can do with AI is to create a multiverse. So we can create, think of it as like a history going forward. So a view of the future. All asset returns, all economic variables. Now we can do it again and again and again.

And then for each one of these futures, we can do a horse race between the two models. Is this like Monte Carlo or something different? No, it's completely different because with Monte Carlo, you specify something that's based upon the past. With AI, generative AI, you can go in directions that we've never seen historically. So you've got these credible economic scenarios, financial scenarios, and the two models need to actually go through the same hurdles. And you can see how they do. And for each model, you get, instead of a single metric,

like the average return, or the volatility, the drawdown, the Sharpe ratio, you get a distribution of these. So this is a great tool going forward in terms of selecting the right model. It's also an amazing tool for risk management. So again, you've got these histories that are credible, that look different from the past, not a Monte Carlo, and we can do a much better job of risk management. So don't just think of AI as something that, okay, we just applied to my portfolio and I'm going to beat the market. There's other things.

Sprinkle a little AI on it. A little machine learning. Cam, I want to get back to the economy and get your opinion on the economy and the stock market. So a two-part question. First, are you surprised that the PE hasn't compressed more than it has? It's now 17 times, give or take. And then also, if we do get a recession, as it seems like you're thinking we will,

is it possible that it doesn't take the stock market down with it? Yeah, so I've looked at the stock market. Indeed, in my early research research before the yield curve research, my idea was that we could look at asset prices, and asset prices should have information about the future. And it's kind of obvious, right? So a stock, the value of the stock is the discounted value of future cash flows. And those future cash flows are dependent upon economic growth. So that's kind of where I started. But then when I looked at the stock market, it's like all over the place. And the joke at the time was that it successfully predicted nine of the last five

recessions. So a lot of false signals. So why does it have false signals? Well, and this is kind of interesting contrast to a bond. In the bond price, same idea. You've got future cash flows, and the bond price is the value of those cash flows today. But for a stock, you've got a dividend. Who knows what is going to be in the future? For the bond, you have a coupon. You know exactly what it is. Who knows what it's going to be in the future? For the bond, you have a coupon. You know exactly what it is. For the stock, you have no idea what the maturity of the stock is.

We don't even talk about that. But for a bond, well, let's say 10 years. You know exactly what the maturity is. And then the most important one is the discount rate. What do we discount by? Well, for a bond, fairly straightforward, fairly risk-free. But for a stock, that depends upon risk. And you can get variation, not just due to expected cash flows, but to changing risk. And this makes stock prices very unreliable in predicting real activity.

So you're talking about valuations. Again, we could have a situation where we have a recession. If we have a recession, I hope it's a mild recession. It might be longer period for slower growth, but hopefully it's mild. And yes, it is possible that the stock market might behave favorably during that. And the other thing, obviously, is that the stock market might behave favorably during that. And the other thing, obviously, is that the stock market is unusual today in that the returns are largely driven by a handful of stocks. Is it possible that the market looks past the recession

and looks to the Fed cutting and therefore avoids it? I mean, I know I'm trying to be optimistic here, but would that shock you? So almost nothing shocks me. Stick around. You should see Mike's browser history. Okay. Yeah, your portfolio shocks me. Yeah. So there are many different scenarios here. And again, it's naive to think that just because we go into recession, the stock market tanks. Or it's actually naive to think because the stock market tanks, we go into recession. October 87 is a great example of that.

Minus 25% in October, no recession. October 23 as well. October 23, the market. I'm sorry, 22. October 22, the market. Yeah, there's many examples of this. How will we know if so, so how will we know that you're beginning to be right?

Like what are the signs? What do you mean beginning to be right? I'm saying, so you think there's a cash crunch and some sort of recession, mild or otherwise. What are the things that the audience listening to this and watching this, what are the things that we should look at if we're not looking at stock prices? Yeah, so sure. You need to look at a range of data. So most people don't know this, but my yield curve idea, that was a summer internship job in my first year of master's. How old were you?

So I was 21 years old. My God. And I went into a company as the summer intern. And they said, well, you only have one job this summer, and that is to develop a model to predict real GDP. And I thought, okay, no big deal. That was your internship? And this was the largest copper mining firm in the world. mining firm in the world. And if you think about it, that number is super important for a copper miner because copper moves with the economy. It's like a coincident indicator, Dr. Copper

it's sometimes called. So this is the single most important input in their planning, whether to open a mine, close a mine, exploration, their capital spend, all relies upon this data, and you got some kid coming in with no experience whatsoever, and I developed this model for them. Well, actually, just one more thing. I was about to present it after five weeks to senior management, and I walked in the downstairs, and somebody greeted me with a box that had all of the stuff on my desk. And they said, you're laid off. And the whole division was laid off. So they never saw it. But we were in a recession.

And that's just the way it happened. But if I was doing the job again, there's no way that I would look at one number. That's just way too simple. You need to look beyond the yield curve. You need to look at different things, different leading indicators. What are some of the things? I'm getting to it. Okay. You have a hard stop now, Dave. It's hard to shut up. We could stay here forever. Yeah. So I've already told you a few of the things that the most important component of GDP is consumer spending. So close to 70% of GDP is consumer expenditures. So you need to look at that very carefully and look at kind of leading

indicators. And I mentioned delinquencies. That's very powerful to actually look at that. The other thing that I focus on is the health of the banking system, because if there is a credit crunch, that's not good for economic growth. And we've already discussed that a little bit. I look at things like the health of the housing sector. And the housing sector actually right now is not bad. So the equity compared to debt in the regular housing sector is pretty good. But commercial real estate is not good. So 35% vacancy rate in San Francisco, record 20% in Chicago. All of this is very bad news. So the other thing that I look at is expectations. So we run a global CFO survey for the past 25 years at Duke University, and we asked the CFOs about their

hiring plans and spending plans. And these numbers are known to the CFO before the purchasing managers. So it's a leading indicator, and that's also important. So you look at all of these data, you put them together and you come up with a view of the future. If I'm wrong, that CFO survey in 2022 basically guaranteed a recession that still hasn't happened yet. Do you think that though it's still in effect, it's just extremely leading versus just being regular leading is that yeah, so when you look at all of these indicators Some of them will deliver small signals But that's why you put them together and you've got a diverse

Diversal head portfolio of signals that's telling you something about what will happen so you need to look beyond One or two indicators, so I know you have a hard stop and you're making a flight tonight. So I just want to make sure I say once again, thank you so much for joining us. Normally we close the show with favorites and we name some Netflix shit or whatever. I want to close the show by asking you, what is the most rewarding part of teaching finance to students at Duke University? What do you get out of that that you don't get out of any of the other professional activities? And maybe let's end with something a little bit hopeful about the future of America from

your standpoint as an educator. I'd just love to hear your thoughts on that. So I'm going to miss my flight. You could do that in time allotted. No, no, no. I'm joking. So I do a number of things and my research is the primary thing at a research university. And that's a lot of fun for me. And

I'm in this business to positively impact the practice of management and to help us grow. the practice of management and to help us grow. And if I can train my students to identify good opportunities, to be able to discard bad opportunities, I think that's a good thing. I teach at Duke University, but I also have 100,000 students on Coursera, and all of this is good. And I think that what we need to do is to focus on what's the most important thing right now for our future. And if you look at our economic situation, it's pretty dire, given that we've got $32 trillion of debt in the U.S., given that we're paying $700 billion a year in interest, and the average interest rate on that debt is 2.97%. It will go up. It's easy to see that next year, the amount of spending just for interest will be the largest, the second largest category behind social security. So more than Medicare, more than defense.

So this is not a good situation where you've got a structural $1.7 trillion deficit. So what do we do? And there are a few alternatives. Number one, we raise taxes. You do that, you kill growth. Number two, you print money. Well, that's going to create inflation and that's going to kill growth also. And inflation is a tax. Number three is the most attractive and that is growth. We need growth. If we've got growth, then tax revenues just naturally go up. So what I teach my students and what I encourage in my research through my findings. So my finding that is probably the one that I'm most proud of is if you reduce financial frictions, that leads to increased economic growth. And we need economic growth. How do you reduce those frictions? It's political,

it's regulation, it's blockchains. Yeah, there's many different ways to do this. But right now, for example, our financial system, and not just the US system, but other systems are really just not serving the economy as well as it should. So we talk about 1.7 billion people unbanked, but there's a lot of underbanking going on. And the example I like to use is an entrepreneur with a great idea, needs financing to go to their bank, and the banker likes the idea, but says, well, I'd rather have one large loan outstanding than dealing with like 100 people like you, even though I like the idea. But you're a customer of the bank. You've got a credit card.

So what we'll do is increase the limit for borrowing on your credit card. So think about that. You've got an idea, 20 plus ROI, and then all of a sudden you're told, well, the only way it can be financed is with borrowing on your credit card. Okay, and what happens? That project isn't pursued. That's under banking, and those projects, those 20, 30 plus ROI projects, those are the gateway to economic growth. When we kill that, then we're stuck in this lethargic 2% or 3% real economic growth, and we dig a deeper hole in terms of debt. What we need is to move to 4% or 5% real economic growth. And it can be done. And obviously, we need leadership in terms of politicians. But many actors in our current economy are not

serving the economy well. They're profitable, but they're extracting economic rents by having prices that are distortionary. They make money, but when the consumer loses, then you lose those growth opportunities. So we need to focus on growth. I think that's a really great place to stop. I think it's a great message. I think we could all agree with Campbell Harvey, ladies and gentlemen.

Guys, let me just ask you, Campbell is running to the airport, so I know people would love to stop and chat with him, but we have to get him out of here. We promised Michael Batnick will be around for the duration of the evening, Barry too, myself, we're all hanging out, but let's get Campbell on his way. One more round of applause. Thank you so much. And last thing I want to say, last thing. All of you have made a donation to No Kid Hungry as part of coming here tonight. And we raised over $8,500 just for doing a live podcast. And to celebrate you guys for helping me do that, I am taking $10,000 and throwing it right on top of that. So tonight, we raised about $20,000 to throwing it right on top of that. So tonight, you raised about $20,000 for No Get Hungry. Thank you.

It means a lot to me. Thank you. All right. Compound and Friends is out. Thanks for listening to everyone watching. Thanks for watching us on YouTube. Thanks to all of you

for being here with us. We love you. We'll see you again. Thanks again. Thank you. We'll see you again. Thanks again.