We Study Billionaires - The Investor’s Podcast Network - TIP 023 : Stock Market Bubbles and Asset Allocation (Investing Podcast)

Starting point is 00:00:00 This is episode 23 of The Investors Podcast. Broadcasting from Bel Air, Maryland. This is The Investors Podcast. They'll read the books and summarize the lessons. They'll test the waters and tell you when it's cold. They'll give you actionable investing strategies. Your host, Preston Pish, and Sting Broderson. How's everybody doing today?

Starting point is 00:00:30 This is Preston Pish, and I'm your host for The Investors Podcast. And as usual, I am accompanied by my co-host Stig Broderson out in Denmark. And today, we've got a special guest for everybody. We've got Paul Arnold on the show. And Paul is a senior consultant in the Investment Advisory Group of Morning Stars Investment Management Division. Paul worked for two years at the Bank of America before he went to Morningsar in their principal investment group. Paul also holds a bachelor's degree in finance and international business from the Indiana University and a master's degree in business administration with honors from the University of Chicago's Booth School of Business,

Starting point is 00:01:06 which is a fantastic business school, one of the best than the entire world. His master's was in finance and economics, and on top of that, Mr. Arnold holds a chartered financial analyst designation, the CFA designation, and is a member of the CFA Institute. I just want to throw out there, for people that don't know what the CFA is, these guys are like the Jedi Knights of Finance. So the very, very difficult charter to get, if you are not familiar with that, you can look it up on the internet and see how difficult that is to get certified and become a CFA. So, Paul, we are pumped to have you on the show. I know we've got some hard questions that we're going to be slinging your way, but we're really excited to hear your response to those. Thank you.

Starting point is 00:01:45 I'm glad to be here. All right. So we've got our first question, and Stig's going to go ahead and take that one away. So, Paul, I often hear that there is such a thing as a sense. optimal asset allocation strategy. So, for instance, that might be if you're 30 years old, you should have like 30% in bonds and 70% in stocks. Other times here it's just 50-50. But I want to ask you as an expert, do you have like a magic formula to asset allocation? So my short answer is no. And I think there's a lot going on. It might seem like a simple question, but there's a lot

Starting point is 00:02:18 going on in that question. So I'm going to break it into two separate thoughts. And My thoughts are going to be sort of in the long-term strategic picture. And then I'll talk briefly on perhaps a more tactical type of asset allocation strategy. So market expectations are always going to play a role in trying to determine an optimal asset allocation. And, of course, if we were all clairvoyant, you might be able to have the perfect asset allocation decision. But we all know that the world works and probabilities of success in investing. And so to say that there's an optimal asset allocation, that's not accurate. And so what we do is we calculate capital market assumptions.

Starting point is 00:03:05 And we do this on several hundred different asset class benchmarks. And we use our forward-looking expectations on both return and risk and correlation as the baseline for making our asset allocation decision. And our goal whenever we create an asset allocation is to make it as optimal as possible. And one of the reasons why there is no specific optimal asset allocation for everybody is that as an investor, no matter the type, let's say you're an institution or an individual, each investor has some specific goal in mind. And each of those goals might have its own specific asset allocation, and you'd like to get as optimal as possible towards that allocation. But everybody has a need for return over some time period, and this should really drive your strategic asset allocation decision. And risk tolerance is one of the most important components to sort of help you determine what that appropriate mix of assets is for a strategic asset allocation program.

Starting point is 00:04:17 So over the long run, you might have an individual, for example, might want to purchase a car in three years. You also, that same individual, for example, might want to retire in 20 years. So you have the same individual with two separate goals. And those goals will require two separate asset allocation policies. So, for example, why would an 80-20, an 80% equity portfolio be appropriate for somebody retiring in 20 years. And why would a perhaps a 20% equity portfolio be appropriate for somebody purchasing a car in three years? So you could have two separate asset allocation for the same person even. And really what that drills down to and with a risk tolerance questionnaire, when, you know,

Starting point is 00:05:04 when individuals work with an advisor or, you know, when we work with institutions, we always are trying to gather objectives and what the goal of a portfolio is. And that helps us with our asset allocation. So the time horizon and risk capacity, you know, these are really, really important concepts for investors to understand when they're making that asset allocation decision. Now, we've done some research recently on human capital and, you could take the time horizon and risk capacity one step further and look at an individuals or institutions' earning streams. So, for example, if you're a tenured professor, your income is very much like a bond, and that should factor into your asset allocation decision. If you're, for example, I work in finance, my bonus is largely tied to market fluctuations or the fluctuations of my business, whatever that business is for me, finance for others.

Starting point is 00:06:03 You know, it could be more tied to the general economy or a very niche part of the economy. and how do those earnings act? Are they more stock-like? Are they more bond-like? That really paints another sort of slant on how one would come up with a strategic asset allocation policy that is, quote-unquote, optimal. So, Paul, real fast. Yeah, go ahead, please.

Starting point is 00:06:24 You know, what I'm taking away from what you're saying is something that Stig and I don't typically talk about with a lot of people. And that's really, what are your goals? And I think a lot of people just say, oh, I have one goal. I want to be able to have, you know, half a million dollars by the time I'm, 55 or something like that. That's their goal. But what you're talking about is that how these, how if you map out all your goals, like I want to buy a car, I want to be able to move into a new house in 10 years, when you map those other goals out, they, they put ripples and waves into

Starting point is 00:06:54 that overarching maybe end state goal that you have. And without setting up these different pots of money and different asset allocations in each one of those different goals and pots of money that you're setting aside and categorizing, you're not going to be able to meet your end state and your overarching big picture goal. And I think that that's really a profound point that I think a lot of people don't think about. Am I catching it straight? Absolutely. And I think perhaps the question might have been targeted a little more towards a shorter term asset allocation decision. But before, you know, before even talking about that, I wanted to at least lay out what you just summarized more succinctly than I did.

Starting point is 00:07:35 And that is, you know, there really are multiple drivers on it. And it's a very individual, specific basis for why somebody, for what somebody's asset allocation picture should look like. And once you, once you have this idea of why you're investing in the first place, settled, you know, then you can work on making the most optimal decision possible. in that regard. And this idea of an quote unquote optimal asset allocation, an investor's decision to make shorter term moves

Starting point is 00:08:13 has a much wider standard deviation of potential results. And so what I mean by that is, just as I mentioned earlier, when we're looking out over a very long-term time horizon, we can be much more confident that our decisions are going to end up somewhere near where we're projecting. I like to think about it as a funnel. If we expect a, this is a high number, but it's easy for people to understand, a 10% return over 20 years. And as you go out and

Starting point is 00:08:44 out and out, you know, that first year, you could have a standard deviation of maybe 20. You could see a gain of 30%. You could see a loss of 30%. But over time, that funnel sort of narrows in and your your average return sort of ends up closer to the range that we're projecting. But of course, in the short run, it's very difficult to be correct. So I think that's important for especially retail and sort of the average investor to understand is that it's very, very difficult to predict and time markets. And over the very, very short term, you might believe you're making an optimal asset allocation decision, but in turn, you could actually be harming your ultimate strategic asset

Starting point is 00:09:34 allocation objective and perhaps harming your ability to meet a goal in the future. All right. So, Paul, one of the things that we're talking about a lot right now is a video that we recently added to our website, the Buffett's Books.com website. We added a new lesson in there, and we haven't added a lesson in probably over a year. And so we added this new lesson, and it was actually a video that the billionaire Ray Dalio, Ray Dalio is the fund manager for Bridgewater, and he's worth about $16 billion. And Ray made this video on basically the economic machine and how it works, how the economy works like a machine.

Starting point is 00:10:14 And in this video, he talks about how we're in this world of de-leveraging situation. And we're just kind of, we've got a lot of conversations happening in our forum about this particular. subject. And we're just wondering what your thoughts are on for the next three years, what they might hold and whether you agree with Ray Dalio at this point. Well, firstly, the video, I would recommend everybody should go to your, you know, your boards and watch that video. Even having been educated in some of this stuff, I thought it was a really easy to understand and down-to-earth lesson on the economy and sort of how the machinations work. And, you know, I think we've certainly come close to the scenario that Ray painted of the longer-term debt cycle, you know, the 75 to 100-year credit cycle event, you know, since 2008.

Starting point is 00:11:12 And, you know, he mentioned, so let's get that out of the way. You know, I think everybody has sort of felt that. And we've seen a lot of reactionary events by many global. players around the world. And Ray talked about this idea of a beautiful de-leveraging. And I think that, well, first, let's talk about the four things that Ray mentioned that need to occur when, you know, one of these larger long-term debt cycle events occur. So number one, cut spending.

Starting point is 00:11:48 Number two, reduced debt. Number three, redistribute wealth and four, print money. And we've seen, you know, so we've seen some of these ideas play out, the cutting spending. You know, there's been a lot of austerity around the world. It's very painful, you know, very, very painful. You know, Greece comes to mind. They've had, you know, particularly severe austerity. And you just saw a new government elected as a result of that, trying to minimize the impact of some

Starting point is 00:12:23 of the austerity. So, you know, the spending cuts have have occurred. Debt reduction. So, you know, there's a McKinsey paper that just came out, and it talks about how debt is now greater, actually greater than where we were in 2007. And so I don't mean to discount, I don't want to discount that paper at all. But there has been some progress in debt reduction. But Paul, so I just want to chime in here. So the paper that you're referencing, the McKinsey paper, I've read that. And yeah, you're exactly right. $57 trillion of global debt has been added since 2008.

Starting point is 00:13:07 And I think that you're exactly right when you're talking about how there has been debts reduced on the private sector. I want to say compared to GDP, I want to say that the private sector is probably knocked off maybe 40 percent. to 50% of their debt to GDP since 2008. But the problem is that that amount has done nothing more but then come on to the federal balance sheet and they've increased there. So now they're at what, 75% of GDP? And so it's literally like a water balloon. The way I'm seeing it, at least on the U.S. side of the house, the other countries

Starting point is 00:13:43 I might not be able to speak as intelligently on. But in the U.S., it's been like we've just pushed one side of the water balloon and all of the all of the debt has now been written over to the federal balance sheet. And if we keep pushing that private sector debt over onto the federal balance sheet, we're going to look like Japan,

Starting point is 00:14:01 where their federal government is hundreds of percent of their GDP. Their total national debt is 500 percent of their GDP, which is in my opinion unrecoverable at that point. So I totally agree with you that we're seeing signs of some of the debt

Starting point is 00:14:17 coming down, but I guess my bigger concern is what are we going to do is it now sits on the federal balance sheet and not on the private sector's balance sheet? Yeah. So that's obviously, that's a big question. I think before jumping directly into that, one of the things the McKinsey paper did not, you know, did not touch on directly, I don't believe, is the financial sector debt. And so, you know, a major, major pain point during the great recession that we just had was

Starting point is 00:14:48 the leverage in the financial sector. And that has really worked, you know, that's really worked its way through. And it was a very painful, painful process of de-leveraging. And it happened more swiftly in the financial sector. And, you know, with the financial sector being so levered the way it was, they could not help stimulate the economy in any way. I mean, they were unable to operate as normal. And so we've seen that. down. And so now, and as you mentioned, you know, households no longer a major problem. Debt ratio is lower, lowest level since 2002. So what you're left with is sort of the general government. And, you know, we've seen some positive signs. The federal budget deficit is below

Starting point is 00:15:36 3% of GDP now. The, you know, austerity is still being bantered and bandied about on the, you know, on the hill, but, you know, I don't, I don't know that there's going to be a huge austerity, immediate term for the U.S. But the fact remains that the Fed's balance sheet is still very large. And so, uh, we're going to, we're going to have to see some sort of, um, monetary tightening. Uh, it's going to have to, it's going to have to occur. And I think, you know, Ray, so Ray sort of talked about this idea of beautiful deliver. And the question is, as we move into the sort of the, what I would hope to be the final phase of this very, very, very long deleveraging that has gone on.

Starting point is 00:16:31 And that is, you know, once we finally move away from a zero interest rate environment, can the economy continue to operate? You know, perhaps we'll be in a slow growth environment. I mean, the real question here is, you know, is, can the Federal Reserve properly, properly cut back? And, you know, I don't think anybody knows the answer to that. I think that's really the big, which is why I think they're going to do it very slowly and sort of test the waters, see how markets react, see how companies react. You know, companies are a really great place. you know, they're generally very cash rich and we've seen, you know, profit margins very high. So the question is can companies sort of absorb an increase in rates and can the economy continue to run smoothly?

Starting point is 00:17:29 And I don't think anybody knows the answer to that question, including the Federal Reserve, which is why I think they've been very hesitant to come off zero. They know they have to, but they're hesitant. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering

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Starting point is 00:21:43 That's Shopify.com slash WSB. All right. Back to the show. And I think one of the problems, as you talk about compounding problems, one of the problems is as the national debt continues to go higher, they're in a position where if they raise interest rates, they're not able to pay off their own debts at that point. And so it's this compounding problem where they're kind of locked into this position where they can't raise interest rates. And the longer that they keep interest rates low, the easier it is for the private

Starting point is 00:22:16 sector to just take out loans and finance because there's no cost of money at that point. And so that's where I'm, I guess, concerned is how do you, and just so everyone knows, I really feel like we're in the exact same scenario we were at in 2008, only the debts that we have on the balance sheets, at least in the private sector, aren't as risky as they were, and the interest rates are a whole lot lower. But as far as the total debt, it is literally, and I'm looking at the chart right now because I didn't want to put out any bad information here. But back in 2008, our total debt, that's private sector and government, total debt was around 337%. And here in 2015, our total debt to GDP is also still at 337%.

Starting point is 00:23:03 So it's kind of interesting how when we go back to that water balloon scenario, how we're still sitting at the exact same debt levels that we were back in 2008 here in 2015, only we've basically smushed some of it off the private sector table and onto the national debt. Yeah. And I think getting back to raise four points there, you know, some other. things that we haven't seen occur yet, but that are talked about is, you know, I think still, number one, the cut, you know, cut spending. You know, it's not talked about because we've, we've just had a period where the government has sort of seen increased tax revenue. And,

Starting point is 00:23:46 but, you know, we've, it's, it's very clear that, you know, if you hear how the Republican party speaking, for example, that, you know, they want to further cut spending. And one other, and then on the other end of the spectrum, Ray's third point about redistributing wealth, we see that talked about on a daily basis from the, you know, from the left side of the government. And, you know, from my perspective, the Bulls-Simpson act or plan, you know, this is something that's been floating out for a while. You know, I think ultimately, ultimately it's going to have to come from both sides.

Starting point is 00:24:26 And I don't think, you know, I've seen, I've seen. That's the scary part. Right. And to me, I totally agree. The scary part is that we cannot get, we cannot get an agreement from the government. And it's not surprising that. It's not, it's not surprising that we've seen, you know, the financial sector, the non-financial sector and households reduce their debt. because when, you know, when one person is making the decision, you know, is looking at data and making

Starting point is 00:25:00 the decision, you know, it's very easy. When households see that they're too levered and they can't pay back their debt, they need to reduce that debt. When companies are looking at their forward-looking projections and realize they need to cut debt or if they can't, you know, they have to restructure their debt, that happens very quickly. With the government, nothing happens quickly. And I think there are some very smart people there that know ultimately that would be willing, you know, this idea of some pain in terms of tax increase paired with a cut in spending is something that many people would agree needs to occur. But you've got competing factions and, you know, people need votes.

Starting point is 00:25:47 And so, you know, it's a very difficult thing. I'll go back again to what we talked about earlier with greed. it's not an easy decision to make and it could cost you your position of power. So people are very hesitant to make a move that might lose them votes. It'd be nice if everybody, it'd be nice if, you know, if everybody had, I don't mean to get political. So I just throw this out in Jess. But if everybody had a term limit and, you know, it didn't matter. You might see something more to get done.

Starting point is 00:26:19 But, you know, I think I totally agree with that. I totally agree with that comment. And that's funny that you said that because whenever I talk to people on a personal level, I say this all the time. The critical variable is term limits in Congress in the U.S. at least. I know a lot of our audiences outside of the United States, but if they would fix that one variable right there where people would go to Congress and they would have a specified amount of term, kind of like the presidency, you would see a lot of things get accomplished because you're basically taking out the self-interest piece of. it at that point and it's all about the people. But because people can get a reelected for a lifetime, sometimes the self-interest is put ahead of the people that they represent. And so you fix that one critical variable. I feel you start fixing a lot of problems that you see here in the

Starting point is 00:27:06 U.S. I had one other thing that I wanted to throw out. I personally see, and this is just Preston Pish's vantage point, I personally see where we're at right now as a snapshot in time in 2015 as being so similar to where Japan was in 1990. When you go and you look at their total debt levels of where they were at back in that time frame in 1990, they were at 400% debt to national GDP, more around the 337% mark right now. Okay. So when you look at how Japan has progressed over the last 25 years from that snapshot where, you know, we have very similar points where they were at in 1990 and where we're at in 2015, Japan has progress. since that time for 25 years, for 25 years, their GDP has gone up from that 400%.

Starting point is 00:27:57 Their total debt to GDP has gone up from 400 to 500%. You've seen their private level debt decreased by about 100%, and you've seen it totally ballooned straight into their national federal debt. And you saw that go from 83% up to 283%. So if we take that same path, as Japan, and we just continue to kick this can down the road, and we don't let businesses fail that over-leverage themselves, it made bad loans, and print more money because Japan's not printing more money. If we don't do those two things, we're going to go down this same path.

Starting point is 00:28:32 And you know what? If you look at their stock market, it goes through the typical business cycles, but the only difference is, is the aggregate is it's going down. It's not trending up through those cycles. It's going down. And I think that if we don't have policymakers that really start making some very hard decisions during this next crash, which I think is pretty imminent. I think that we're going to see a very similar cycle as what we're seeing in Japan. So it's kind of interesting. And I don't know if you agree with me or not, Paul, but that's the way I see things. Well, yeah, we've been talking about something similar.

Starting point is 00:29:05 I remember a lot of fund managers would come in. And, you know, we would talk back and forth about projections. And, you know, certainly, certainly it could be a case that the U.S. could go. down that road but you know I think Japan's biggest problem is they they can't drive they're having they're having a lot of trouble creating inflation and you know I think in the U.S. we have more levers at our disposal and we're also not you know we're not at that point yet I think I think it remains to be seen but I you know I still think the U.S. could continue to move through this and come out of it

Starting point is 00:29:46 in a better place than in Japan. I totally agree with you. I do. I totally agree with you. And I think that we're really at that critical point where decision makers, if they start making some very good and hard decisions, not popular decisions, we can pull ourselves out of this and we won't go down that path to, you know, Japan. I don't know how they're going to get out of it.

Starting point is 00:30:09 But I really totally agree with you. I think that we are such at a critical time that it's really important. that citizens really start to educate themselves on this so that we can, you know, force the hard decisions. I really think that, you know, when you go back and you look at the Great Depression, you know, at the 1933 point, that's whenever they came off the gold. And when they did that, it basically inflated the currency by 30% or so. And when that happened, that critical point was able to basically help reset, you know, a lot of the issues that we had because the currency got inflated so much. That made for very hard times, but it also put us back on the track where we were

Starting point is 00:30:47 able to move forward. And I think that if we don't have something like, you know, unfortunately, something like that happened, we need somebody in our political offices that start making very hard decisions. Or I just don't know how we're going to climb out of this. And, you know, we could persist in this for decades. That's the thing that's really scary and horrible. But go ahead, Stig. I see you have a point. Yeah, I'm really excited. I don't know if I'm excited as you are, Preston because what people can see is that Preston is holding up his 300-page Redalia note. So we really giggy about economics here. But what is actually interesting is that if you look at this node and if you look at what

Starting point is 00:31:27 Redelia has to say, there's a lot of negative things to be said. And I think if you are a private investor, you're really facing with a dilemma here because if you look at bonds, you know, the rates are so low. It's hard to get any return. and if anything is going to be in a way by inflation. And then you have the stock market, which seems really high in the moment. And as we just heard Paul talk about, we might see a bubble bursting at some point of time. So Paul, if I have some excess cash and perhaps I don't want to invest in stocks, perhaps I don't want to invest bonds.

Starting point is 00:32:01 What should I put my money in? Well, before I dive in, I would at least like to, so for all this doom and gloom, I would at least like to acknowledge. I would at least like to acknowledge the possibility that stocks and bonds could continue to see positive returns and perhaps even acceptable positive returns over the near term. And we talked about a little bit earlier about optimal asset allocation and how it's much harder to sort of predict over the short term. For the past, and just to give an example, for the past four to five years, investors have been expecting a sharp increase in yields. Very wrong. Anybody who has been short duration

Starting point is 00:32:45 has underperformed, all else equal. Even the stock market, you know, last year, S&P did 13.7. People have been predicting that we're going to see a pullback. Valuations are too high, but, you know, it is the case, it is not necessarily the case that, that's going to happen in the immediate term. And so I just want to, I want to start by saying that. Because if you move your money out of stocks and out of bonds and those assets do well, then you're really taking a huge tracking error to your, you know, whatever your, your baseline portfolio is, and it could hurt you in the long run. That being said, you know, let's look at, let's look at what might happen year. So the Fed might also continue to raise rates slowly. And if you look at world yields, the German

Starting point is 00:33:41 boon's tenure, O.36, UK, 1.69, well below the U.S. 10 year. So demand for treasuries, demand for treasuries could still keep rates depressed, even as the Fed starts to raise. And I think they're going to raise rates very slowly. So it's not fully clear how big of an impact. You know, as you guys know and your listeners know, as yields rise, there is a direct negative impact, price impact on the value of your bond. And so, you know, if rates rise very, very slowly over time, that price, the negative price impact is minimized and you can collect some higher coupons.

Starting point is 00:34:31 So, you know, it's important to note that it's unclear how that will end up going forward. So depending on the day and calculation, we think of your, of a simple PE ratio, for example, we think stocks are about one standard deviation overvalued. And that, that might seem high. It is certainly overvalued based on this simple measure and an idea of a long-term sort of average PE ratio. but there is historical precedence for this number to actually even run up further. So I just want to have, I want to, you know, I want that to be out there for people to understand that eventually, you know, markets go through cycles, but it's hard to pinpoint

Starting point is 00:35:16 when those cycles will turn. So if you do believe that rates are going to rise and rise in a fashion that would really make bonds a poor choice to keep your money in over the near term, and you really do feel that stocks are just too rich and you're uncomfortable placing a large portion of your money in stocks. There are two, I've got two ideas. One is more of a traditional idea here. We see value in emerging markets. So emerging markets from our perspective have seen post-Ukraine and post-the-oil drop, they've represented a very good buying opportunity over a longer term from our perspective. Again, you know, we could see further downside here, but relative to other stock markets around,

Starting point is 00:36:10 you know, domestic or developed, we find emerging markets are, provides some of the most value going forward. And, you know, it's no surprise that they've had a tough period. So in 2013, emerging markets were down. around 2.3% while domestic markets were up between 30 and 43%. And in 2014, emerging markets were also negative. So as other markets have continued to see some price appreciation, we find value in emerging markets right now.

Starting point is 00:36:48 And now I'd also like to talk about a more broad and sort of different idea here. I think that one of the hottest areas in retail and in the retail investment product space, I'll call the 40X space. So the space where retail investors can purchase mutual funds or purchase other investment vehicles. Alternative investments is one of the biggest areas of growth. And there's not a day that goes by that I don't receive an email. a call for a due diligence request or, you know, providing information on new fund launches or fund performance in the alternative space. And I think it's really important to provide

Starting point is 00:37:40 a little bit of background for retail investors to help them understand what, you know, what is an alternative asset class. So, you know, we view an alternative asset class is an asset class that has a lower or maybe non-existent correlation with the stock market or with the bond market. And it's been, there's been a large swing. You know, you used to have to be very, very wealthy and be an accredited investor in order to get into some of these hedge fund type strategies. And so what you're talking about are.

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Starting point is 00:41:48 All right. Back to the show. So it used to be the case, you know, if you were in a hedge fund, you would, or a private equity, you know, you would be locked up. You would have to, first of all, you'd have to have a lot of disposable income in order to qualify. You'd have to grant a portion of your net worth to a fund, the fund would invest it on your behalf. And then, you know, there are periods where you could pull your money out.

Starting point is 00:42:12 those firms are now transitioning. I mean, those funds are still obviously running, but a lot of shops are trying to move some of those type of strategies down. They're trying to push it down to the retail investor. So number one, I don't want to forget. I heard the word expensive. And I don't, I want to come back to that. So don't let me forget to bring that up because some of them are very expensive.

Starting point is 00:42:37 But what's interesting is, you know, before investors could not get access to some of these types of strategies. And well, Paul, can you can you say what one of maybe like an underlying asset of something like this would be just so the audience would know what you're referring to? You know, there's just, there's many, many categories now of alternatives. So you could have a long short equity fund. You could have a long short credit fund. And what's going on in that in that scenario is funds are trying to, you know, they're in a way, they're balancing risk. So you could have you could have a market neutral fund, which is, going long a basket of stocks and shorting a basket of stocks. And the end result between the long and the short portion is that you have a potential zero beta to the market. So this is a really interesting point you bring up here, Paul, with the alpha and beta. So I think it might be something

Starting point is 00:43:36 that you might want to consider if you think that the stock market is overvalued. And as Paul was saying before, perhaps we were seeing a overvalue with one standard deviation. So what Paul is actually saying is that you are not neutral if you think that the stock market would crash, but you still think that you can find some stocks that are doing better than others. And this is the process that the Hats Fund has been using for many years. So that might be a direction you want to look. Again, if you think that the stock market overall are overvalued, but if you think that you can or someone else can find stocks that in comparison, Harrison will do better.

Starting point is 00:44:14 Yeah, absolutely. And I would, just, you mentioned expenses. I would be very, you know, I'm very critical about mutual fund expenses. And I find that some alternative investments, because they have to use, you know, they're using derivative type instruments like swaps, futures to sort of implement their positions, expenses can be a little bit higher. And so I think it's important, you know, if a market. a neutral fund is going to return on average because it's because it's unlevered in for the retail

Starting point is 00:44:47 investor if it's going to return uh you know one to three percent but you're going to have 150 basis points of fees um you know at that point i'd at that point i'd rather just be in short-term bonds um and pay 20 basis points in fees or whatever it's funny you said that because whenever you're talking about these these you know the upside and the downside basically being a wash that's what I was thinking like, well, put your money in a short-term bond so that you can just basically protect your principal because that's what that's what it is. If people, and I find it really interesting, you have a lot of people that are interested in this type of alternative investments at this point. I find that very interesting that the interest in that has gone up because all that,

Starting point is 00:45:31 the way I understand it, that's just people wanting to protect their principle. So as we go to here, I want to ask this next question here because it totally correlates to what we're discussing. So we're big fans of Warren Buffett. And when he does certain things, it makes us start asking important questions. And right now, Buffett is sitting on over $62 billion of cash and cash equivalence. I personally find that very interesting. And I'm real curious to know what your thoughts are on his capital allocation decisions to hold this much cash or cash equivalence on his balance sheet at Berkshire Hathaway. So it's hard to know Mr. Buffett's true motivation, but, you know, I for one, I'm not, you know, I'm not one to bet against him.

Starting point is 00:46:18 But I will say for all we know, he's loading up for a big acquisition. It sounds to me like you believe he's being defensive. And if that's the case, you know, as a firm, we don't, we don't necessarily disagree with that sentiment. You know, again, I, obviously, I can't make a comment on why he's, why he's holding that much cash. but we are actually as a firm in our tactical portfolio overweight cash and we've had many fund managers as well come through our doors over the past six months and talk about their increasing cash position as they find less and less acceptable asset valuations and you know downside protection is not something that is sexy. But it's one of the major advantages of active management. You know,

Starting point is 00:47:13 if you really believe that there is a correction on the horizon, you can insulate yourself from some of the overall market losses. And, you know, I think that's really important. You know, Warren Buffett obviously has a very good grasp on the level of risk that he's taking. And I'm certain that he has something in mind to do with that $62 billion of cash. Perhaps he's just waiting for a better buying opportunity. You know, I think back, I believe it was in 2008. And I think it was Goldman Sachs. He loaned, I think it was a, or he purchased a $5 billion.

Starting point is 00:48:01 I don't know if it was a preferred, preferred security vehicle. But I know it was at the time where there was a lot of concern about many of these banks and investment banks collapsing. Yeah, yeah, yeah. It was $10 billion, preferred stock that he could exercise in the common stock at $115 a share is what it was. Yeah. And so, you know, that would potentially be at a time where, you know, everybody else in the world was saying, sell, sell, sell, you know, build cash. and, you know, he went out and made a purchase while everybody, you know, there was a great amount of fear in the market and that's when he jumped in. So, you know, perhaps right now he isn't

Starting point is 00:48:43 seeing, you know, he isn't seeing that those types of buying opportunities. But again, again, it's hard, it's hard for me to comment on what he's doing. I can only say, I can only say that if, you know, if he is being defensive, we don't necessarily disagree with that. You know, you don't really see him go into preferred stock too often, but during the last crash, it was very brilliant the way that he exercised it because he basically got the common stock price that was a reasonable price. And at the time, 115 was the book value on Goldman Sachs whenever he struck that deal. But it was nice as he was able to get a 10% dividend on that preferred stock that he continued to collect 10% basically a billion a year because it was a $10 billion deal. He got a 10% dividend

Starting point is 00:49:29 And until he wanted to go ahead and exercise the option on converting it into common stock. And Goldman went way past the 115 mark because that was the book value at the time. And I think Goldman's, what, at 200 a share or somewhere around that price point right now. So I don't know if he's exercised that or not. But he continues to basically collect his 10% dividend while that common went. And then whenever he exercises it, he gets that price too. So it's a brilliant move. But go ahead, Stig.

Starting point is 00:49:54 Yeah. It's really such a brilliant move because he didn't have any downside. I want to say it was a really Warren Buffett classic. He basically had no downside, and his upside was just phenomenon. And he dared to enter the mug when anyone was just, you know, screaming bloody murder. So, I mean, this was just a fantastic move by Warren Buffett. His only downside was whether they were going to let the bank fail or not back then, which, you know, for us common folk, we probably wouldn't know that. But he probably had some good information as to whether that was going to actually happen or not.

Starting point is 00:50:26 So anyway, stick ahead and take the next question. So, Paul, I think that we learned a lot about asset allocation and a lot about macroeconomics, but if I would ask you to recommend a book or a resource where I can build on my knowledge, perhaps especially in terms of asset allocation, where would that be? So I've got a couple for you. I think that I'm going to start with Andre Schleifer. It's called Inefficient Markets and Intro to behavioral finance.

Starting point is 00:51:01 And also, this one's been a while for me, but Burton, Melkeel's random walk down Wall Street, I'm sure a lot of your listeners have probably heard of that book or read it. These two books build a foundation. They talk about, first of all, behavioral finance is one of the most important, in my mind, overlooked factors that lead retail investors and even institutional investors, for that matter,

Starting point is 00:51:27 to make poor decisions. And I think that it's really important to understand, you know, what's going on in, you know, your own brain, investors' brains in general that lead to investment decisions. And, you know, by knowing that, you might be able to help yourself make, you know, some, make some corrections to your actions. Fantastic. And just so our audience knows, we'll have all those. books listed in our show notes. So if you go to our web page, go to the very bottom and you can

Starting point is 00:52:01 find all those books that we have listed. We'll also have the Ray Dalio pamphlet that Stighead reference that I was holding up whenever I was talking. We'll have a link to that. And that's completely free. That's a 300-page document. I highly recommend that you read it. Actually, I couldn't recommend it highly enough. But we'll have a link to that. And you can download the PDF right to your computer. And also, I'm very interested in the book that Paul just mentioned. But anyway, Paul, this was just fantastic having you on the show. We really can't thank you enough for coming on. And please tell Morningstar, we appreciate them letting you come on as well. Really appreciate it, Paul. Thank you guys very much. And thanks for having me. Hopefully,

Starting point is 00:52:41 I provided a bit of information for everybody. All right. So it's time in the show for our question from the audience. And this one comes from Jamar Griffith. And here's his question. I have a question. My question is, do you use the PE and the book value method to buy stocks today? What would be the best method to choose a stock? As an up-and-coming entrepreneur and an investor, I will want to know the best methods to use when I'm making a decision. So, Jamar, I really like this question, and this question's really appropriate for the discussion we had today on the show. So one of the questions that we didn't get to during our show is this question that we had about using the PE ratio and how sometimes during really large market bubbles or even in a slight market bubble, PE ratios can be misleading because people are looking at them and they're actually using money and earnings that are in this overall economic system that's inflated. and because the whole system is inflated, the PE ratios sometimes look like there may be better than what they really are. I'm of the opinion that we're kind of in that phase right now. I kind of think that we're – and you heard even Paul say this, that they're saying that the market's overvalued by one standard deviation.

Starting point is 00:54:00 So when you get into statistics and stuff like that, that's where you get into different standard deviations. But I guess my point is this. I think if a person is out there investing solely off of price to earnings ratios and price to book value ratios, I think that they might be setting themselves up for not entering the market at the proper time. This market, like Paul said, this market could go for another three years before you see it burst. And you could potentially lose out on gains that could happen from right now at the start of 2015 to whatever that point is. I'm of the opinion that all the money to be made in the stock market happens at the very bottom of the crash to, you know, call it the 75% mark as it comes back up and starts rising again. You know, if I was going to put a percentage on where I think it's at right now, I really don't know, but I would be, you know, guessing that it is around that 75% if not higher mark.

Starting point is 00:54:57 But I don't know that, and it's almost impossible to be able to predict it. I do know there's a lot of credit in the system. And I think when you look at it from a macroeconomic standpoint, that's really kind of the biggest indicator that you're kind of reaching a peak. And the credit in the system right now is higher than it's ever been. So that's my point. And I guess for people that are down into the individual companies, that's really important stuff. And you've got to really understand that. But at the same time, you've got to make sure that you're entering the market at the correct time.

Starting point is 00:55:25 And you've got to understand that through the macroeconomic principles. So I'm going to throw it over to stick and see what he has to say. So Jamar, I completely agree with you. Price earnings is often a very good indicator to search for undervalued stocks. Now basically, when you are looking at a stock, you are looking at the cash flows because the cash flows that will return to you as an investor really determines if it's a great pick or not. One thing, and I think this is also in relation to what Preston was saying before, was what is the quality of the earnings?

Starting point is 00:55:59 If it's high quality earnings, then they are worth more. So if you are looking at a company that has a lot of debt, and if they have high earnings, they might be due to this debt, I would definitely be cautious about that company. So I would always try to find what I would call normalized earnings because we know what the price is. It might be $50 for a company. But I would always try to see if I can find what the normal earnings are.

Starting point is 00:56:27 So for instance, one thing that I might look at is, if I'm looking at the mining company, say, in copper, then I would look at the price of that cover and see if that is like historical high, historical low, what are the fundamentals that are driving this sector? And from that, I will try to see if I can find a normalized earnings. And it's just the same way if you're looking at debt. So if you have like a high debt environment and you're seeing that you have artificial earnings, well, then you probably shouldn't trust the price of earnings because, well, you're looking at the earnings. So a fantastic question. And even though it might seem a bit vague, I would say that the quality of earnings is really

Starting point is 00:57:08 the fundamental thing to be looking at. All right, Jamar. So I don't know how much we helped you out with that, but I guess from our vantage point, it's very, if you're a first-time investor, you're just getting into the market. I would tell you to be very cautious to go at it a little slowly and definitely not take all of your capital and invest it all at once. This is something that you definitely want to slowly educate yourself with as you're doing it. All right, Jamar, so we're going to send you a free signed copy of the Warren Buffett Accounting book for submitting your question. And if anybody else out there wants to submit their question, go to Asktheinvestors.com

Starting point is 00:57:42 and you can record your question there. We really enjoy having this interaction with our audience. And I'll tell you, we appreciate you more than you could ever imagine. You're helping educate us with your questions. Stig is actually starting to stand up his own question and answers by video. So if you guys go ahead and submit your questions, you might just get Stig to respond back to yours personally by video. But we really appreciate all this interaction. So we'll see you guys next week and thanks for listening to us.

Starting point is 00:58:10 Thanks for listening to The Investors Podcast. To listen to more shows or access to the tools discussed on the show, be sure to visit www. www.com. Submit your questions or request a guest appearance to the Investerspodcast. Investors podcast by going to www. www. www. Ask theinvestors.com.

Starting point is 00:58:28 If your question is answered during the show, you will receive a free autographed copy of the Warren Buffett Accounting Book. This podcast is for entertainment purposes only. This material is copyrighted by the TIP Network and must have written approval before a commercial application.

We Study Billionaires - The Investor’s Podcast Network - TIP 023 : Stock Market Bubbles and Asset Allocation (Investing Podcast)

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