The Compound and Friends - The Only Black Swans with William Bernstein

Episode Date: April 6, 2020

On this week's episode, Ben sits down with investor, author, and market historian William Bernstein to put the current crash into perspective with history's worst crises. Hosted on Acast. See acast.com/privacy for more information. Learn more about your ad choices. Visit megaphone.fm/adchoices

I am sitting here with Dr. William Bernstein, former neurologist, current investment advisor and author. And we are going to talk about his background in the medical field and some of his thoughts on investing and some of the books that he's written to try to get a better handle on this market crash and pandemic. So stick around. he's written to try to get a better handle on this market crash and pandemic. So stick around. Welcome to the Compound Show podcast. Each week, we let you in on some of the best conversations we're having about markets, investing, and life. Just a quick reminder, the hosts of the show are employees of Ritholtz Wealth Management. All opinions expressed are solely their own opinions and do not reflect the opinion of

Ritholtz Wealth. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast. Okay, here we go. So, Bill, you were a neurologist before turning to an investment manager. How does that background in the medical field, especially in the midst of a global pandemic, does that color your thoughts at all in the way that you think about investing during something like this, which is almost more of a medical crisis than a financial crisis? Not really. You know, the thing that is most useful about medical training

is that you're scientifically trained. So you're taught to formulate hypotheses, consider data, always think about the possibility that you could be wrong and to update your priors on the basis of new information and to not be too dogmatic about your opinions. I suppose if medicine has one real value is that it's a very humbling profession. You're quite frequently wrong. Not only are you quite frequently wrong, but you observe giants in the field being quite frequently wrong as well. And I think that's an extremely useful thing to observe in any human endeavor, but particularly in finance.

extremely useful thing to observe in any human endeavor, but particularly in finance. So one of my favorite concepts that you developed was this idea of deep risk. And you talk about the difference between deep risk and shallow risk in your book called Deep Risk. Is something like a global pandemic, does that almost fall into the bucket of deep risk? And maybe you could outline what the difference between those two are for the listeners as well. And maybe you could outline what the difference between those two are for the listeners as well. Well, deep risk is the risk of an event not like even the Great Depression, let alone the global financial crisis, but a risk of something like happened, for example, in securities markets after World War II with hyperinflation wiping out the value of certainly bond investments and a large part of stock investments as well, or the most extreme example of what happened in St. Petersburg on the St. Petersburg stock and bond exchanges in August of 1914, when they closed with the outbreak of the war and they never reopened. That's deep risk. All right. I think the closest thing we've seen to deep risk in the modern era is what happened to Japanese stocks after 1990.

If you're a purchaser of Japanese stocks in that year, you're still not above water. So you've seen a real decline in the value, the real value of your investment over a generational period. That's what I call deep risk. I don't think we're in that situation now, but I could be wrong. Right. Now, do you think, you mentioned the Great Depression. People are hearkening to that because we might see some numbers that come close to that in the unemployment figures and the GDP decline. Are those analogies actually fair? Because a lot of times I think people throw that stuff out, this 1929 stuff, and it really doesn't make sense for this one. Does it actually make a little sense to compare it to that?

It depends upon what sphere you're talking about. If you're talking about the overall damage to the economy, I think this very well could be, and the damage and the pain inflicted on ordinary people, very well could be, and the damage and the pain inflicted on ordinary people, the average person, I think that this has the potential for that. You know, I look around, and I see a very large number of people out of work. Not only do I see a lot of people out of work, but I see people out of work who have nothing to fall back on, and a very skimpy social safety net. So at the depths of the Great Depression, we saw unemployment on the order of magnitude of 30%. We could see something approaching that at this point. Now, in terms of the security markets, if you remember, the stock prices fell by almost 90% between the top and the bottom,

say the fall of 1929 and the middle of 1932. And that was an artifact of incompetent central banking. And to a lesser extent, the fall in employment was. Central banks do a pretty good job these days of supporting stock values. And while a fall of 50% or 60% or even 70% is possible, I don't think we're going to see a fall of 90% in securities values. Now, you also mentioned the Japan thing. Anytime that I post this long-term market data and talk about the fact that over the long-term markets tend to work, they're not always perfect, but they do tend to work. Someone will say,

well, what if this is the crash where we see a Japan? So you being a student of history, maybe you could give a quick background on what the difference between that 1989 Japan bubble was versus anything else that we've seen in the US in terms of maybe why that never came back for those investors? Well, it was of the same order of magnitude. I don't remember what the precise fall in the Nikkei was, but it was close to 80%, maybe even a little more. I'm not sure of the exact figures. But, of course, there were two differences. Number one is that Japanese stocks were ludicrously overvalued in late 1989, early 1990. They were selling at very close to triple digit multiples.

of the Great Depression, the PEs were in the 30 range, just as they were at the start of this. And of course, the other difference is that because of the valuations weren't as ridiculous in the US market in the late 1920s, the fall in prices didn't last that long. Prices recovered relatively rapidly, almost getting back to par, I believe, in the late 1930s before the Fed tightened up again and drove stock prices down. But when you factor in inflation, when you factor in dividends, you were made whole within about eight or 10 years, I believe. Now, you write a lot about market history, and I try to do this as well. And every time, Eight or 10 years, I believe. that we don't know how long it's going to last and how bad things are going to get. What do you say to that in terms of trying to think through today through the lens of history, while also realizing that this is a little different than anything we've ever dealt with before? Well, all market crashes are a little different. But the thing that ties them together,

at least in the United States, is that they always seem to recover. Now, that's not a Midas muffler guarantee that that's the way it's going to happen this time. But if I were to bet one way or the other, I would say the markets were going to recover. And if you're buying stocks now, you may be sorry a week from now or even a year from now, but five or 10 years from now, I believe that most people are going to be reasonably happy with the stock purchases they're going to make now, and especially the ones that may be going to be making over the next year. But the proper way to look at it is really not just through the lens of history, but also through the lens of market theory. The value of a stock, after all, is nothing more than the discounted values of its cash flows, all right? So, or its dividends or its earnings, however you want to do

that computation. And so, you know, let's say earnings disappear for the next year completely, and then they slowly recover over the next year or two. What does that mean in terms of the discounted present value? Well, it means a fall of, you know, on the order of what we've seen now, and perhaps even less than what we're seeing now. You know, if you completely knock out a year's earnings of the S&P 500, what does it do to the discounted value of all of its future earnings? And the answer is not an enormous amount. Yeah, I think that's the thing people miss is that even if, I mean, earnings could potentially go negative for a while. And I guess in the great financial crisis, they were down 90%. And that's always hard to compare over periods because those accounting rules have changed over time. But you're right.

It's not just that one year of earnings that matters. It's earnings going out in perpetuity, potentially. And another way that you look at risk in your book, The Ages of Investors, you talk about this idea of risk is really context dependent on where you are in your investing life cycle. So on the one end, you have young people, millennials, and even Gen Z people now, I guess, who are entering the workforce who are very young. And then another end of it, you have the retirees. So maybe you could talk about the difference between what risk means and volatility means to those two different groups. Well, I can admissions like to play this little parlor game of, you know, do stocks become riskier or or less risky with time horizon?

And there are a number of different ways to do it. The orthodox answer is no, they become more risky with time horizon. I think that is a stupid game to play because the real question to ask is not do stocks become more or less risky over time. It's our stocks, do they become more or less risky over time or less risky period at a given points in the life cycle? So if you start at one end, say the 20-year-old who has an enormous amount of human capital and almost no investment capital or no investment capital, that person should get down on their hands and knees and pray for several years of a market that looks just like this, all right? So they can buy stocks cheaply. And then at some point, they will be very, very happy with those purchases. And in fact, when you look at lifecycle investing, it turns out that the

very best time to start work and to start saving is in an awful economic state of the world, because that enables you to buy stocks cheaply. So the person who started work in 1980, as I did, and started to purchase equities at about that time, did extremely well and acquired enough capital to require comfortably within, you know, not much more than a couple of decades. If you start on the other hand, at a point in time, like, you know, the late 1990s, it becomes much harder to save because you're paying much higher prices. So to reiterate the point, stocks aren't terribly risky for the young person simply because they have so much human capital relative to their investment capital. Now, at the opposite end of the spectrum is the geezer.

The person who, now like me, has almost no human capital left, but has hopefully a fair amount of investment capital. For that person, stocks are three-mile island toxic. capital. For that person, stocks are three-mile island toxic. If you start out with an all-stock portfolio and you start burning 5% or 6% of it a year and the market falls by 50% and it stays down, the cavalry may appear on the horizon and return and improve stock prices in 5 or 10 years, but by then, almost all of your money is gone. This falls under the rubric of sequence risk. So the bottom line is for young people, stocks really aren't that risky. For old people, they are extremely risky. And then you have the middle group that everyone kind of forgets about, that Gen X. So they came in, let's say a lot of them started investing in the late 90s,

early 2000s. They've dealt with the dot-com blow up. They dealt with a great financial crisis. Now they're dealing with this 20 years of three huge crises for that group. On the behavioral component, again, as you mentioned, that gave them three opportunities to buy stocks at a lower price, which in the long run, hopefully by the time they retire, that'll be a good thing that they've had these opportunities to use the volatility to their advantage, assuming they continue to contribute. But how does that impact them behaviorally? And I think a lot of people are trying to figure out how is this going to change our behavior in a number of ways as we get through this? And it's obviously too early to tell, but are there

behavioral challenges to living through that many ups and downs for people? Well, that's a really interesting question. I mean, you know, the real question is, is how good of a learner are you? I mean, you know, the real question is, is how good of a learner are you? You know, if you learned anything during the global financial crisis, it's to learn John Templeton's famous dictum that the best time to buy is at the point of maximum pessimism, which, you know, was early March of 2009. At that point, the world looked like it was going to end financially. The world financially looked much worse, much worse than it does now, at least in terms of financial markets. Banks were failing back then, right, left, and center. Banks aren't failing this time,

and we probably won't see large bank failures. Banks are the beating heart of our financial system. And when they start failing, you're in real trouble. And that hasn't happened yet. financial system. And when they start failing, you're in real trouble. And that hasn't happened yet. And I hope it doesn't happen. So that's the lesson I hope that they learned. But really, the question you have to ask is, you know, people sell out of the market at lows. The ordinary investor does that. They sell their stocks in 08, 09, and they buy them back when the prices start to improve. But of course, that's an oxymoron because they have to sell their stocks to somebody. OK, so the question is, how do stocks, the real question is, is how do stocks redistribute during a bear market?

And J.P. Morgan very famously said that a bear market is when stocks return to their rightful owners. All right. Which, unfortunately, is wealthy people. If the average 401k holder sells out of their stocks right now and the markets go down even further and they completely sell out or they sell out like they did in 2009, who is on the other side of that transaction? Well, it was the one-tenth of 1%. Yeah. And you outlined in the Rational Expectations book how broadly defined there's these three groups of people.

Group one has really no plan or allocation. Group two says they have an allocation, they have a plan, but then they're the weak hands, they give up. And then group three is the one that really holds. Do you think that we're at that point of separation where group three separates themselves from group two and they're the ones who actually hold to their plan and they're rebalancing into the pain? Are we at that point where we're almost at the capitulation point where you get down 30%, 35%? Is that here? I have no idea what the answer to that question is. If you made me bet, I would say we're about halfway there.

But we could be all the way there. I mean, the market bottom could have been last week. Or we could have another 40% down from here. I haven't the foggiest idea. Right. Now, one of the things people like to say when markets get hammered like this, and you see emerging markets sell off and international markets sell off and growth stocks and value stocks and pretty much everything get hammered is this idea that, well, during a crisis, correlations go to one. And just when you need diversification the most, it acts against you. So you've written a lot about diversification over time. So maybe defend this argument for me, this idea that diversification lets you down when the market gets crushed. Well, Bruno Solnick, who's a French academic, very famously said that diversification fails

at just when we need it the most. And that's absolutely true. In bad states of the world, the correlation grid goes to plus one and minus one, with minus one being riskless assets. And what I found absolutely fascinating about the last crisis was that the prices of tips got hammered. You would think that people would consider tips to be a riskless asset and a highly desirable asset. But they got creamed, particularly at the long end. There were actually a few days, a week or two ago, when even long treasuries sold off by people with liquidity needs, which I've never seen before during a crisis. They can sell off, I suppose, if people encounter unexpected inflation, but that certainly isn't the problem at a time like this. So actually what happened last week was the correlation grid went

to either plus one or zero, with zero being T-bills. Right. Yeah, cash was king for a while, obviously. It still is king right now. I sold a T-bill yesterday so I could give some money to the food bank, and I sold it at a yield, the T-bill at a price of 100.01. Wow. I didn't quite get par back. It was a tiny commission on it.

So I didn't get my par back, but it was very close. So you've written about the history of capitalism, how we got here over the last few hundred years to this point. capitalism and how we got here over the last few hundred years to this point, does it worry you at all if we hit pause on this $22 trillion system for three months, six months, nine months, maybe a year? I don't know how long it's going to be. Does it worry you at all that will set us back, that we've never really tried this grand experiment before? Or do you think that the economic machine is such in place that eventually we can turn the lights back on and people will pick up their similar behavior? Yeah. I mean, if we recovered from the Great Depression, we can certainly recover from this. Right. Yeah. It still kind of boggles my mind that we did recover from that. When we look at

the point of 90% stock crashes, and obviously back then, not as many people were invested in stocks. But that was the bread lines and 20% unemployment for over a decade. And I guess, again, that's the big worry for people now is that this is going to be with us for a long time. And it's going to be hard to see another V-shaped recovery. Obviously, I don't know what's going to happen here as well. But I think that's the worry for people. Yeah, we recovered, by the way, from the Great Depression by way of an enormous public works program that was called World War II. Right, yeah. I'm apt to call it more of a fiscal rescue plan where we're spending similar percentage of GDP now in stimulus and potentially more as we did in World War II, which is something that they didn't do during the Depression, which I guess would be the hope for a bridge to get us there.

Right. I would hope. So last year, you mentioned to my colleague, Josh Brown, at a dinner, I think it was, you were pondering a question, you question, what happens if the cost of capital never goes up again? And this gets back to your tips thing about inflation. I've been thinking about something like that a lot too, because I tend to think that I fall in your camp of the shallow risk that stocks, yes, it's painful right now, but it's a temporary thing. And I don't know when they're going to come back, but I have faith that the system is going to come back and stocks will recover at some point. But bonds are a lot easier to predict in terms of their returns. And I think the 10-year treasury was at 70 basis points today

or something. And this is totally uncharted territories for nominal bond yields. And I don't know what's going to happen with yields in the future either. But what if the cost of capital stays low for a very long time and bond yields are already on the floor and don't move up substantially from here? What does that mean for capital markets and business formation and savings? How does that change all this stuff? It's really not good for anybody in the long run because several things happen. Number one is when the cost of capital, especially of fixed income capital, falls, you start to see people wasting it, throwing it away on projects that have a very low hurdle rate. When the cost of capital is more reasonable, people think very carefully before they invest capital into new projects. But the other thing that happens when you have a very low cost of capital is you see repeated bubbles and busts. And I'm wondering if we're not seeing the bust part of that now. So one of my theories of the last,

call it 10 to 15 years, is that maybe things in the capital markets have gotten more micro efficient, where it's much harder to pick stocks because there's so many pros and there's so much mindshare out there to do so. But maybe things become more macro-efficient. So micro-efficient, macro-inefficient, excuse me. Is that a reasonable assessment of the world at the moment? Yeah. And that's Paul Samuelson's formulation too. I believe it was Paul Samuelson wrote a letter to Bob Shiller in which he used that exact formulation that the markets are micro-efficient, but macro inefficient. And what he meant by macro inefficiency is that they can go to extremes of valuation

irrationally. But in terms of picking individual securities, the markets are getting increasingly efficient. There's no question about that. the markets are getting increasingly efficient. There's no question about that. So do you think the behavior of investors could be different during this downturn? Because this is actually a forced recession or potentially depression, I guess, however you want to title it. Does that change the behavior of investors? Or do you think that is still the constant that when markets go down and volatility spikes, that human nature is what will win out in terms of people's decisions and actions. Yeah. I'm going to go out on a limb here and say that not only will human nature continue to operate, but it's also going to be amplified

by people's financial fears. It's one thing to watch your 401k get savaged when you've still got a job. But when you don't know where your next meal is coming from and your 401k is what you're going to be diving into to keep body and soul together, I think that brings in a new and different and probably worse kind of psychology. I don't think anything good is going to come of this. new and different and probably worse kind of psychology. I don't think anything good is going to come of this. Yeah. Do you think that there, I mean, the people impacted by this runs the gamut, obviously.

Is there any new personal finance advice that people could even take at this moment? Or is it just survival? And hopefully you manage because especially looking at it from the business perspective, there's no way enough businesses could have ever prepared for something like this. I mean, a restaurant can't have one year's worth of spending saved up in the bank for something like this, that it would never work and they would never survive in the first place. But do you think that applies to individuals as well, that there's just a huge percent of the population that could never prepare for something like this? Yeah, you don't prepare for something like this at the individual level. You can't, as you just pointed out. What you do is you prepare for it as a society.

And what we're finding out in, I think, the cruelest way possible is we don't do a very good job of that in this country. Yeah. Now, you've written a lot of investing books in thinking in terms of the long term. And I think it's probably harder than ever to think and act for the long term when markets are going down like this. And it's almost bizarre because it becomes easy for some people to just get stuck in this negative mindset that things are only going to get worse. And obviously, with the pandemic, as far as that goes, the news is going to get worse before it gets better, potentially for a number of weeks or months even. How do you get out of that mindset as an investor and continue to look over that valley and keep those long-term principles and make sure that

they don't change when stocks are just getting hammered and the economy is getting hammered? don't change when stocks are just getting hammered and the economy is getting hammered? Well, for years, maybe even decades, I sort of taught that the portfolio is the thing and how it was silly to divide your portfolio into different buckets, fixed income and stock. It's what the portfolio did together that really matters. And I realize that that's good advice for a spherical cow, but it's not good for a real live human being. And what I've learned to do psychologically, and I tell people to do, is divide their portfolio into the stocks and the bonds, to do a Tobin separation of their portfolio, if you will. And the bond portion of their portfolio is what they're going to live on and what they're going to meet expenses with

and what they're going to conduct emergencies. And also, if they still have something left over and they can bring themselves to do it, to participate in the fire sale for risky assets. So the other side of that is that your stocks are not current consumption. If you, if you're ever looking, you know, it's an enormous mistake to look at the total value of your portfolio and consider that to be your net current worth. Because in a crunch, your bonds will hold up their value and you can, you know,

use them for living expenses. Your stocks may be worth bupkis. And your stocks are not current consumption, best their future consumption. And the way I look at my own portfolio is I look at the fixed income side of it as what I'm going to be living on, hopefully for a long period of time. And the stocks are not going to be spending for a very long, I'm not going to be spending down for a very long period of time, if ever. I mean, with luck, I'm going to bequeath them to somebody else. With luck, someone with my age shouldn't be managing your stocks for themselves. They should be managing it for future generations. Right, which effectively gives you an even longer time horizon

to hopefully look past some of this stuff. And that sort of mindset gives you, imparts to you an enormous amount of equanimity. And with, again, bond yields being on the floor, that hasn't changed your thoughts about how to view bonds in the portfolio construction side of things. Because obviously, even though rates are minimal at the moment and investors

here are for sure over the long term going to have low returns and potentially negative real returns, bonds still hold up as a hedge for equities. That hasn't changed in your mind? Yeah, absolutely. I'm no one's buffetologist and I don't meticulously read all of his annual reports, but if you look at them, every year you will see a sentence or two that is a little pay on to T-bills. And I believe one year he spent almost an entire page listing all of the disadvantages of T-bills. And this was at the time when T-bills, just like now, were yielding almost nothing. And it was just this absolute deconstruction of T-bills. The last sentence of that page was, however, we will continue to hold all of our reserves in T-bills. All right. And that's the face of market mayhem.

And a large part of that equanimity is the large pile of T-bills he's sitting on. It's really a great tranquilizer. Right. So in your mind, obviously, investing for the long term and thinking for the long term, eventually we get through this. What in your studies has shown, why do you think we're able to get through these periods? Because obviously, when this happens, there are people who think, all right, this is it. This is the one we're not coming back from. What is it about the human spirit that allows us to make it through some of these tough times like this? that allows us to make it through some of these tough times like this?

I mean, I'm no one's Ayn Rand, Milton Friedman enthusiast, but capital markets and free market capitalism does a good job of producing wealth, and it is extremely resilient. And that's really all there is to it. I mean, one of my favorite graphs is the graph of GDP in Germany through the 1940s. And what you see is Germany was reduced to rubble by 1945. They had no productive capacity at all, or almost no productive capacity at all. It had been completely destroyed. But within three or four years, they were back to pre-war levels. That's how resilient capitalism is. I've never seen that before. Actually, I'll have to look that one up. I don't think I have anything else for you. I appreciate your time. I always love hearing your thoughts on the markets and

thinking in long term. And I know a lot of people are really nervous right now. It's good to see you still have the cool hand and the steady hand. And I appreciate your time. Yeah. One thing I'd like to add is, is this is the first time I've set myself up in this particular way for a video and people occasionally ask me as a writer, what does my process look like? It's a question that all writers get asked. I'm sure you get asked it too. And you're looking at what my process looks like. It's just a mess of papers. Now, maybe that's another question, because I find myself writing a ton these days, because I feel like the topics are just never ending. Do you get inspiration from a time like this as a financial writer? No. I really don't like the term black swan.

And the reason why I don't like it is because the only black swans are the history you haven't read. This is what we're looking at financially is not any different than what we've seen before. I mean, the one thing that we've seen this time around that no one's commenting on is we're seeing, you know, days when you've got, you know, six or 8% up in the market and people get all enthusiastic when that happens. And, you know, the one thing that we learned that you always learn from market crises, whether it's 19, you know, the early 1930s or the more recent global financial crisis is that big up days, 6%, 8%, there were some 10% up days in 2008 and 2009. That's volatility. And volatility is volatility and it's bad. And a 10% up day is just as bad as a 10% down day. They mean both the same thing. Yeah. Yeah, I agree. And it's funny because people blame that on the algorithms these days. Maybe that stuff is pushing things around, but those things didn't

exist in the 1920s, right? And we still had those big up and down days back then just as well. We had them in the 20s. We had them during the global financial crisis, and we're having them now. Right. Okay. Well, Bill, again, thanks for your time. This is great. And I hope to talk to you again in the future. Okay. You take it easy. Thanks for listening. Check us out at thecompoundnews.com for daily investing and market insights. You can watch all of our videos at youtube.com slash thecompoundrwm. Talk to you next week.