We Study Billionaires - The Investor’s Podcast Network - TIP478: Market Cycle Masterclass w/ David Stein

Starting point is 00:00:00 You're listening to TIP. In today's episode, I invited back David Stein, a former chief investment strategist for an $80 billion investment advisory company. The main topic of today is where we are in the market cycle and how we as investors should persist ourselves. David has worked with some of the best asset managers on the planet, including Seth Claremont and Howard Marks. And during our conversation, we also talk about how to evaluate track records depending

Starting point is 00:00:25 on the market cycle and which questions we should ask as a manager to identify the very best. I hope you enjoy this masterclass as much as I did. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Welcome to The Investors Podcast. I'm your host, Dick Broderson, and I am here with David Stein. David, thank you for once again making yourself available for the podcast. Thanks for having me. It's great to be here. David, you're definitely always more than the welcome. And let's just jump right into the first

Starting point is 00:01:15 question here of today. Today's episode is all about cycles and how to navigate them as investors. Let's start by building the foundation. Why do we have cycles? We have cycles because we're human. There's fear, there's greed, there's exuberance, there's panic. And as investors as humans act, they tend to in some ways act in groups. And so everyone or a majority get more exuberant at the same time. That can bid up asset prices. At other times, they want to borrow a lot of money to purchase houses.

Starting point is 00:01:51 And then something switches and they become less exuberant. And so that action, individual action, but then builds up from the bottom, can lead to really cycles that show up in macroeconomic data, financial market data, and that's why we have cycles. We have many different cycles. Among many others, we could mention the economic cycle, the profit cycle, the cycle, the cycle attitudes toward risk, and perhaps the most important cycle, the credit cycle. And I wanted to read a brief quote from page 138 here in Howard Marks' wonderful book, mastering the market cycle.

Starting point is 00:02:32 And the quote is this, the longer I'm involved in investing, the more than, impressed I am by the power of the credit cycle. It takes only a small fraction in the economy to produce a large fluctuation in the availability of credit, which greatly impact the asset prices and back on the economy itself. End quote. So, David, why is the credit cycle so important and where are we in the credit cycle right now? First, the credit cycle is the ability or represents the ability or willingness of households and businesses to borrow money. So when banks are willing to lend, that increases the money supply. It increases purchases. It can push up asset prices. And as households and businesses are buying, that leads to businesses wanting to expand their output, which is what gross domestic product is.

Starting point is 00:03:31 It's a measure of the monetary value of what businesses produce. And so collectively they come together as households and businesses want to borrow, that leads to an expansion. On the other side, when people, when households and businesses get more fearful, they don't want to take on debt, when interest rates are higher, then you can have an economic contraction or a downturn in the credit cycle that can lead to higher defaults. That means banks don't want to lend more. And so you just get these cycles.

Starting point is 00:04:03 So it feeds into corporate profits. The credit cycle does. It feeds into how the economy is doing as corporate profits decline that can impact the stock market. And so everything comes down to very much the credit cycle because it's the credit cycle that leads really shows up as that exuberance or that fear. As individual investors, we can monitor the credit cycle. And there's a number of different metrics that I use. One major one that everyone can get access to, it's available from the Federal Reserve Bank of St. Louis, their Fred account, but it's this senior loan officer survey. And so I believe it's a Federal Reserve conducts this and periodically, I think it's monthly. They ask loan officers at banks, how willing are they to lend to middle size and larger businesses and to smaller businesses or to consumers for. credit cards. And so if you pull up that chart, you can see, you'll actually see the cycles.

Starting point is 00:05:08 And what they're measuring is the net percentage of banks that are tightening their lending standards. So they're being more strict about who they will lend to or the qualifications they want. So right now, for example, if we look at the net percentage of domestic banks that are tightening their standard for commercial and industrial loans and large and middle market companies, it's 24%. And so this is a net standard. So they look at who's tightening, who's loosening, and then they net it out. So 24% would be equivalent to 62% banks are tightening their standards and 38% are loosening. So in terms of the credit cycle, banks are getting more conservative. They're not as extreme as they were in, let's say,

Starting point is 00:05:56 2020 during the pandemic when you had 80% to 90% of the banks tightening and only 10% loosening. And so it's way less loose in terms of credit than it was a year ago. So we're seeing it more difficult. And you see it at interest rates also. As interest rates go up, less people want to purchase houses, take out a mortgage. You're starting to see that in some of the housing data. The other factor that plays into the credit cycle is what are known as spread. So the incremental yield that non-investment grade companies, investment-grade companies have to pay to borrow.

Starting point is 00:06:38 And so the way that they measure that spread is they look at the average yield on high-yield bonds and back out the yield on 10-year Treasury government securities, for example. And so that spread right now for high yields about 4.2%. it was with the average coin back to 1990s, 5.3%. Now, back in June, we were at 5.9%. So if we look at over the past eight weeks, it's actually credits loosened up just a little bit, at least based on some of these spread data.

Starting point is 00:07:08 And so there's a number of factors that we can look at. But ultimately, when we consider the credit cycle right now, it's sort of on an upswing where credit is getting more difficult to get and individuals, households and businesses are less willing to borrow because of the higher interest rates. And that's why you're starting to see some of the economic data, some of the business survey data, for example, is starting to weaken. And it's partly due to the credit cycle. And if we had to put a timeline on this, and we'll make sure to link to this in the show note, if you'll be so kind, to send a link to this, David. But if you're thinking about whenever it goes from

Starting point is 00:07:50 tightening to loosening. Are we talking about months? Is it years like for us to imagine this curve? It can take years. So, I mean, in the sense of, you know, one of the other factors that can show up is like an inverted yield curve. So where you have the Federal Reserve for other central banks raising their policy rates to where short-term rates get higher than longer-term rates. and oftentimes when you see an inversion of the yield curve, there's some type of recession, but oftentimes that lead time before the curve first inverts to where a recession starts, it can be up to 18 months. And so, you know, these cycles, this the weakening of the credit or the more tightening

Starting point is 00:08:36 of the credit, I mean, it can take 18 months, two years. And it isn't guaranteed that we're necessarily going into a recession. And so one of the things that we do with money for the rest of us, so we're not trying to forecast like this is the time where everything is, whereas the recession hits. We want to look at what the market temperature is today. So we're always monitoring what we call what's on the leading edge of the present. I'm like, what does the data suggest today, not knowing if it's going to worsen or get better, but we want to at least calibrate our risk based on current. conditions. And David, I also think it's important for the audience to know that whenever we discuss each type of cycle, we do that in isolation to explain what this specific cycle is

Starting point is 00:09:27 about, say, cycle the attitudes toward risk. But that is essentially, I mean, it's not the reality. It's not so that if something were to happen in cycle A, then something will happen in cycle B that will in turns lead to a change in cycle C. All of these cycles are typically interrelated, and there are many more cycles that we've just talked about here so far in this episode. Could you please provide an example of how interrelated the economic profit, risk, credit, and the other cycles are? Sure, and the other thing to consider is the data is often conflicting, and so we should use just necessarily one metric.

Starting point is 00:10:03 We need to use a variety of metric. But if you think about the credit cycle, when the credit cycle, when there's tightening, so banks are less willing to lend, when there's less barren. when there's less borrowing from households and businesses because there's higher interest rates. We can see higher delinquency rates. And so that can cause investors to get more fearful, which shows up in the amount of risk they're willing to take. It can lead to less willing to make large purchases, which can impact the sales of companies, which will impact their profits. So that impacts the profit cycle.

Starting point is 00:10:38 And then as the businesses are selling less, they're producing less, that can impact the economic cycle. So you're going to downturn there. And lower profits also, you know, do to higher, can lead to higher. With lower profits, obviously, due to, you know, as interest rates go up, that can lead to higher interest expense for companies. So that lowers the profits. They're also selling less. And then as I mentioned, ultimately that those lower profits can lead to lower prices for stocks. to stock sell off.

Starting point is 00:11:09 And same wise as those spreads or those incremental yields for non-investment-grade bonds widened out. That leads to price declines for non-investment-grade bonds. And so there is very much a connection between all the different cycles. But again, the data can be conflicting. And so what we're always trying to do is try to get a picture where we're at, not knowing exactly what's going to happen, but when, because you can see it in much of the data, it does allow an investor if they choose to calibrate their risk to the opportunities that are there or the lack of opportunities and sort of have some dry powder reserve for when the cycles

Starting point is 00:11:50 start to turn. So with rising interest rates, the talk of the town is real estate. And real estate is a very interesting market where it seems like everyone is building and stop building at the same time. Why is that and what does it tell us about cycles? Real estate is heavily influenced by interest rates. It's influenced in terms of the willingness of households, for example, to borrow to take out mortgages, the willingness of banks to lend, so for developers to be able to build. Real estate's also impacted as interest rates go up,

Starting point is 00:12:27 the value of real estate can fall because essentially the cap, what's known as the capitalization rate, the yield that they're getting on the value of that real estate that can, well, the yield, the cap rate goes up and so the value of the real estate falls. And you're seeing it right now. So we had a huge boom in home construction, new home purchases, existing home sales in the U.S. and really around the globe, you know, coming out of the pandemic because of all the money creation and super low interest rates and just the impact of the pandemic, realizing that their existing locale wasn't what they wanted. So you had a lot of activity and purchases, a lot of new sales. And then we've had the Federal Reserve raising their policy rate.

Starting point is 00:13:18 And so just the most recent data, for example, saw new home sales have fallen about 30% compared to where they were a year ago. And so that causes home construction to fall off, Because the existing inventory, if you use this all data that's also available, by the way, on the St. Louis Fed, their Fred website. So you can look at new home sales and you can see the trends there. You can look at the months of supply available of new homes, which is sort of like how much inventory is there. And so for example, right now we have 11 months supply of new homes in the U.S.

Starting point is 00:13:58 And now that's as high as it was back at the end of the housing crisis, back. in 2008, 2009. And so that's how quickly the housing situation has changed in the U.S. and in many other countries. At the same time, as interest rates go up, home affordability, the ability of the median family with their medium income to be able to qualify for a mortgage loan, their ability to do that is much less because the interest rates are higher. So mortgage payments is a much higher percent. So affordability is down over 40 percent in the past six months. And so all those things come together and because interest rates impact everybody and individuals and households and businesses are making individual decisions, but they're all looking at the same

Starting point is 00:14:51 rates, then you can get these periods of these cyclical periods just because how the macro data influences individual household and businesses. So whenever we hear news about the Federal Reserve raising rates, we're talking about the Fed's funds rate, but what people see on their bill and whenever they want to buy a house, that's their mortgage rates. And those two rates are quite different, but they also work in tandem generally. Could you please talk to us about the relationship between those two interest rates? So a typical 30-year mortgage rate is very much tied to 10-year government bonds because most people don't hold their house for 30 years.

Starting point is 00:15:38 And so on average, it's closer to 10 years. And so banks benchmark their mortgage rates really off 10-year treasures. Now, when we think about the Fed funds rate, that is the short-term policy rate, very, very short-term. But when we look at what goes into market expectations for tenure government bonds or the current yield, no longer term interest rates are made up of shorter term interest rates. And so as an individual investor, you can buy a 10-year government bond or you could buy one-year government bond and roll it over every year. Or you could buy 30-day treasuries and roll them over every 30 days. And so there's a relationship in that the 10-year government bond yield is influenced by current short-term rates, but also expectations for future short-term rates.

Starting point is 00:16:31 And so as investors believe the Federal Reserve is going to stop raising its short-term policy rate, let's say next year, that starts to get reflected in longer-term interest rates. And we're seeing this right now. If you look at the yield curve in the U.S., it's essentially flat. It's slightly inverted, but it's almost close to 3% from one year out to 30 years. And there's a little bit variation, but the reason why it's essentially flat to slightly inverted is the expectation is that two, three, four years from now that Fed funds rate is going to be lower than it is today. And so those longer term rates take into account the future expectations for short-term policy rates. It also includes expectations for inflation.

Starting point is 00:17:21 And then there's a third element that's known as the term premium, which is additional compensation that investors demand for just unexpected things, that Federal Reserve raises their policy rate more aggressively or inflation comes in higher. And so those three elements, expectations for short-term interest rates, inflation expectation, and the term premium, that is what comprises a longer-term government bonds. but certainly what's going on now with short-term interests rates and what central banks are doing heavily influences those longer-term rates. Let's talk about the market cycle.

Starting point is 00:17:57 That is what Howard Marks describes as the sum of all other cycles. The future, of course, is always uncertain, but if we prepare probably, we can use probabilities to construct our portfolio. Where are we right now in the market cycle? And what does that apply to how we as investors should position ourselves? We do a monthly investment conditions and strategy report, which is very much focused on the market cycle, which we consider economic trends. We consider the credit cycle. We're looking at market valuations in terms of PE ratios for stocks around the world.

Starting point is 00:18:33 We're also looking at what are known as market internal. So this is a level of fear and greed. This is more technical analysis. what percent global markets around the world are above their 50-day or the 200-day moving average. And so we combine those together, and we simplify it for investors. We rate each of those three areas red for more bearish, yellow for neutral, green for more bullish. And right now, when we look at overall investment conditions, we're at low neutral. So we're in the yellow territory, but we're not in red.

Starting point is 00:19:05 And what's driving that is economic trends are also low neutral because we're seeing that, for example, the business surveys that I mentioned, purchasing manager indices, these are surveys done around the world by S&P, market, and other providers, and they're just asking businesses, new house business, what's your new order book like? What's your inventory level? What are prices? What's your expectation a year from now? And then, so they survey, and then they standardize it, and they generally, it can be between zero and 100. 50 is very much neutral. And so when we've had recession in a given country, that PMI data, and they look at both manufacturing and services, but manufacturing PMI, it'll get below 50, so 48, 46.

Starting point is 00:19:57 So when we look at the latest PMI data, there are a number of countries, including the U.S., where either the manufacturing or the services PMI is below 50. And so the risk of a recession is higher. And again, we just want to look at the existing data. So there were many people nine months ago, for example, or even a year ago saying, wow, the recession's coming because the Federal Reserve is raising their policy rate. Well, that's just not true because there have been tightening cycles where we haven't seen a recession come. And so rather than just forecast out a year and say a recession's coming and react to, of that, we'd rather say, well, where are we now? And right now, yeah, the PMI data,

Starting point is 00:20:43 the PMI data is worsening. We're more load neutral. We're not red. Corporate profits haven't turned over. So we have 85% of countries still have positive expected earnings growth. We're still seeing earning surprises. Overall, earnings growth for the MSCI All-Country World Index is still over 8% expectation over the next year. And so there are still some positive. elements as well as some negative elements. And so when we look at the weight of evidence, recognizing some of its contradicting, we're sort of low neutral when it comes to the market cycle, which is why, you know, my portfolio pulled off some risk and some of our model portfolio examples, we've pulled

Starting point is 00:21:26 off some risk in late June. But we're certainly not overly bearish right now. We're just wait and see and see what the market's temperature is. 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 its 18th year, bringing together activists, technologists, journalists, investors, and builders from all over the world. many of them operating on the front lines of history. This is where you hear firsthand stories from people using Bitcoin to survive currency collapse, using AI to expose human rights abuses, and building technology under censorship and authoritarian pressures.

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Starting point is 00:25:38 That's Shopify. dot com slash WSB. All right. Back to the show. What does it mean whenever you say no risk in this case? Well, for example, in our model portfolio examples, we reduced credit risk. And so we reduced our allocation to non-investment grade bonds. We also added more to cash because yields are much higher.

Starting point is 00:26:08 And so you can earn two and a half percent on cash. And so we reduce stocks a little bit. But one of the things, in our case, we have adaptive portfolios that we adjust over time. Then we have some static, more long-term strategic portfolios. And we're, you know, the adaptive portfolios are five to 10 percent indoor-weight stocks relative to the longer term strategic portfolios. And so it's not an environment where we should be freaking out and move completely out of the stock market.

Starting point is 00:26:38 It's just a recognition that the risk are higher now, the risk of a drawdown in highway. I mean, it's been a challenge year to the last period, but now it's not necessarily the time to take a huge amount of credit risk, for example, because we're on the other side of the credit cycle. And so you don't necessarily have to exit all of your non-investment. some great bond exposure, but it's not necessarily time to go out wild and go completely in. David, whenever you talk about a model like that, would that be based on, and you have multiple factors, would you give them different weight? I guess that's the first part of my question,

Starting point is 00:27:17 the different factors you mentioned before. And whenever you say the probabilities of a drawdown, for example, on the equity market, is that based only on fundamentals, or is it also so that even And though one could argue that the stock market is now cheaper with the pullback that we've seen, you also have a negative momentum. Like, how does that play in together? Well, right. I didn't, so I didn't mention. So that third element, asset class valuations, you know, when we do look at equity,

Starting point is 00:27:43 the valuations are cheaper than average, slightly cheaper than average. So you have valuations a really high neutral. We have economic trends, low neutral, and then the mark internals are. are red, more bearish because of the severity of the market losses. And so we tend to put more weight on economic trends and valuations and less on market internals because market internals can be so volatile. So traders will be much more focused on some of the market internals. In our case, we use it just sort of a confirmation of the overall trend.

Starting point is 00:28:25 And then ultimately, we have a wide variety of data, but we're always making incremental changes recognizing that we don't know. And that's really the basis. After spending 15 years or more as an investment manager, you realize how little you know, it's incredibly difficult to invest based on predicting the future. And you take Howard Marx's book on cycles and a lot of his memos, he's pretty clear. He's not out there trying to predict the future because he's not very good at it, nor am I, nor are most professional investors.

Starting point is 00:29:09 So what they're doing is they're making educated guesses based on where we are today and just trying to kind of weigh the risk. And when the market environment is more favorable, then they're willing to take risk incrementally little by little in order to hopefully over the long term create a successful tracker. Let's say that you have the Dow trading at 30,000 points and there was a given risk attached to that. Is that different than if it would go up to 35 and then back to 30,000? We're just assuming that the earnings are the same and the quality of the company is the same

Starting point is 00:29:48 because now the Magh has seen it's been a 35 and now it's at 30 and some people like not feeling too good about it. Is there anything such as that that you feel is important to model or is it in that case more based on that fundamental? I personally don't ever look at levels and so I look at valuations. So I want to see what is the PE of the Dow or the price to earnings ratio or the dividend yield. So to me, it all comes down to the fundamentals. Now, I'll look at, you know, the levels in terms of, you know, is the level above its 200-day moving average or it's 50-day moving average, but it's all very relative. So I couldn't, for example, which is interesting, the news media focuses all the time. They'll say that the Dowduring industrial average is at

Starting point is 00:30:42 X level or the NASDAQ is just X level. And just based on my institution, money management background, like levels, the number doesn't matter to me. What I care about is, you know, where is that number relative to it was a year ago? And what are the fundamentals for that number in terms of what's the cash flow being generated? What's the expected cash flow growth? And what's the valuation in terms of what our investors paying for that cash flow? So let's continue talking a bit more about how it marks. One of the thing that's interesting, not only in his wonderful book, Mastering the Market Cycle, but also in his memos that he sends out on a recurring basis. He's talking about having both high quality and lower quality assets

Starting point is 00:31:28 depending on where you are in the cycle, implying that you would hold high quality assets where you're at the top of the cycle and lower quality assets at the bottom. All of this, of course, depending on the price you're paying for those assets, as it always is. But it might It seems surprising to our listeners that you would consider a low-quality asset, even if you disregard where we're on the market cycle. Could you please provide an example of low-quality assets performing well, and why that is the case? Low-quality assets can perform well over the short term because of the level of fear and greed. So, for example, non-investment-grade bonds spreads widened out. As the economy

Starting point is 00:32:12 slowed, the yield on non-investment-grade bonds went up, and the yield relative to government bonds widened out to where they got above average of a yield of 5.9% compared to the average of 5.3. Now, eight weeks later, the yields have fallen to 4.2%. As the data has gotten worse, which is surprising, which is why one's time frame can't be eight weeks. When you're investing based on cycles. You're basing it on years because you can get the short-term swings. But ultimately, if an investor's believe a recession is coming, then default rates could increase. And those spreads, for example, got, you know, right now they're 4.2%. They got up to 8% in 2020 in March of 2020, April 2020. They got up to 20%, close to 20% spreads in 2008.

Starting point is 00:33:10 And so what Marx was referring to, when spreads blow out, you know, the losses can be significant. Non-investment-grade bonds lost over 25% in 2008. And so in the institutional portfolios that we were running, we started adding some non-investment-grade bonds kind of late 2008, early 2009, because once we saw some of the economic trend data start to improve, some of this PMI data just start to improve, then you, you can start taking some risk. But it's all incremental because you never really know. But I'd rather be investing in non-investment-grade bonds when the spread is 20%, because at that point, the yield is so high that it very much more than compensates for the default risk. And so whereas when spreads are super narrow, like they were a year ago, for example, or 18 months ago, then you don't

Starting point is 00:34:10 have that cushion to protect against default risk, and there is the risk of the spreads widening out. And so that's why a lower quality asset would be non-investment-grade bonds. And you would rather own them when the spreads are widening, even though the credits are wide, even though in the credit cycle is just starting to turn, but there's conflicting data because ultimately you have that yield cushion to that margin of safety to protect you if you're wrong. Whenever you make a position like that where you'll say, okay, I would do non-investment-grade bonds, also probably called junk bonds, would that be invested in through an ETF? How would retail investors who might see that trend and profit from that trend but might not

Starting point is 00:34:52 feel comfortable about your individual assets? Is that the way to go, ETFs? And ETFs is a way to do it sort of broad-based. My preference for non-investment-grade bonds is to use active managers because they're doing some credit research. So hopefully they're at least, because the ETF's going to own everything and they're going to own the dogs as well as the better credits, whereas you at least want some level of credit research.

Starting point is 00:35:22 And so you can use an active manager. So we've used double line funds in the past and we're portfolio in my portfolio. We've used BlackRock. There are some of their closed-end funds in my portfolio in the past as an institutional investor. In fact, we did this back in 2008. We used Luma Sales bond fund, which I believe still operate, haven't invested in that fund for a long time. But that's an example of a fund where we reduced risk and sold some of the fund when things

Starting point is 00:35:52 really started to fall apart in 2007, 2008, and then I added it back in late 2008. And so for non-investment grade bonds, bank loans is another. Bank loans are floating rate, non-investment grade loans that banks made and then are syndicated out tend to use active management for that also just because you want somebody deciding that this is a credit that we shouldn't invest in. Now, let's talk about active management because, you know, we have listeners who are more hands-on with the portfolios. We also have others who use as managers.

Starting point is 00:36:29 We have hybrids. But you've been the chief investment strategist, the chief portfolio strategist and managing a principal from 9 to 9 to 2012 with Fund Evaluation Group LLC. And you've identified asset managers you wanted to work with, including Hot Marks that we just talked about, another very well-known investor you worked with that would be Seth Claremann. How did you and your company choose the right asset manager for your fund? And was it ever relevant where you thought we were in the market cycle, as in this asset manager typically is good in a bear market, another as a manager might be good in a bull market.

Starting point is 00:37:06 Is there such a thing as that? There is. So the portfolio that I ran or headed up at FEG, we did what we call active asset allocation. And so, you know, an institutional client and endowment would give us the discretion to make adjustments to their asset allocation and their portfolio mix and the manager selection within the confines of their investment policy. And so we were always looking for, is there a better positioning? And an example would be double line. You know, double line. is Jack the Gunlack started that firm in December 2009. He left TCW, took his team, brand new firm,

Starting point is 00:37:48 but experts in mortgage-backed securities. And we made an allocation right after they started that firm to their fund, to the double-line, I think it was just the double-line bond fund. And the reason being because at that environment, the yields, particularly on mortgage-backed securities, non-agency mortgage-backed securities, so those that weren't issued by Fannie Mae or Ginny May. So non-agency mortgage-back security, so yields were incredibly high. And so that was an example of allocating to a manager at a time when the opportunities were huge.

Starting point is 00:38:30 In terms of just our overall process, we would meet with several hundred managers a year. So we were doing across asset classes from stocks, bonds, reeds, hedge funds, private equity, and then to capital, real estate. And so we were always surveying the universe and looking for managers that met our criteria. And these tend to be managers with a very strong investment culture were pragmatic. They recognized that they needed to have some type of informational competitive edge in order to generate superior returns. Obviously performance played into that.

Starting point is 00:39:04 but also really understanding the personnel, their approach to risk. And so we had a number of criteria that we looked at, met with them. We would do research reports. We had an investment committee that would, whether we wanted to put the manager on a recommended list, and then that would allow the consultants and other advisors to use them constructing client portfolios. So it's always a constant look for the best managers, which frankly is pretty exhausting because there weren't that many that really have the skill to outperforms.

Starting point is 00:39:34 You see it more in the private area than you see on the public side. But that was sort of our approach. I wanted to talk to you about how to evaluate a track record. You know, whenever I started investing, I made the mistake of thinking that, you know, I would just, I would just Google who had the best, like, highest performance over the past, I don't know, 10 years. A very, very unsophisticated way of going through as a manager. But then later you realize that it's a little more.

Starting point is 00:40:04 complicated than that. Among the many questions you have to consider is what risk did the asset manager took to achieve this track record? How long is the track record under which my conditions was it achieved and so much more. So whenever you evaluate a track record of an asset manager, what's your process? Exactly that. So we want to understand what are the factors that drove the performance. And so let's just, you know, for typical institutional client, example, if they, that the board maintained discretion, so they were selecting the manager, we would do manager searches. So let's say they wanted to add a new small cap value manager. And so we would bring them a selection of four to five. And we would show information about it.

Starting point is 00:40:54 And then they would look at the performance. And it's human nature to look at performance and assume that whoever had the best long-term track record was the best manager. But even within something like small-cap value, there can be sub-style. So one small-cap value manager might have more of a microcap focus. And if microcap was out of favor in the last year or two, then that would impact that manager's longer-term track record. It's amazing how a bad year or so can impact the five-year number, the 10-year number. One of the things that I really really tried to do in working with boards is to encourage them to hire the manager that have the worst performance. Because we've already done all our screens. We've done the due diligence. We

Starting point is 00:41:41 feel fairly confident that it's a very skilled manager whose style is out of favor. And to get a board to hire a manager whose style is out of favor to me was always a win. Because if I could do it, when that manager's style went back in favor, then that manager generally significantly outperform the index and its peers. I can tell you, human nature is not to hire the manager who has the worst performance of a group of five because you never really know. But you always have to understand the nuances. Like, why, what is driving that track record? And one of the way we did it as institutional advisors is we always looked at peer groups. So how has this manager done relative to its peers or similar type managers? And usually there was some factor that contributed. And obviously,

Starting point is 00:42:36 there are managers that just don't seem to have the skill and just underperform. But all skilled managers will have periods of trailing their peers as well as the index because the only way an active manager can outperform an index is by structuring a portfolio that differs from the index. If they're just trying to pair at the index, they're going to underperform just because of fees and just something that they didn't perceive. So they have to structure a portfolio that differs, which means there will be periods where they underperform because nobody is that skill that they always outperform. It just doesn't, it doesn't ever happen. Everyone makes mistakes, everybody's style who's out of favor. That is very true. And I was reading this,

Starting point is 00:43:21 here the other day. It's called Where the Money is by Adam Cecil. And he said that he was like being an investor himself, he made up with different CEOs and sort of like wanted to vet their business acumen. And he said that he always asked them this one question, which was, do we want to optimize for profit or do you want to optimize for a return on investor capital? And I don't, it was something like 90% said, optimized for profit, not for a return of investor capital. And he was always shocked by that, which clearly isn't the right answer. and just shows that the CEO might have a lot of good qualities that made that person the CEO, but perhaps it wasn't the asset allocation skills that really brought that person to the very top,

Starting point is 00:44:03 which is ironic because as the CEO, you are the top asset allocator. That's just your job. But to me, I love that question. I was such a silver-burly type of question. How about you? Whenever you have to evaluate the skills often as a manager at, I can say that I've been speaking with hundreds here on the show, and everyone is very assertive, everyone seems to have the truth. Like, it's not like in any way that people would be lying, but like, they truly mean what they say. That's not what I'm insinuating at all.

Starting point is 00:44:29 But they still have very, very different opinions from each other. So I'm sure you experience the same thing as you've been intemuing all these asset managers. Did you have any kind of, not to make it too pop, but do you have any kind of silver-billed question where you're like, this is the question that's tricky. There's really where you can really see if this person understands what it's all about. First off, the reason why CEOs say they optimize for profits is because that's how they're measured. Yes.

Starting point is 00:44:57 They're not measured. They're not, it's did they beat the earnings estimate for that quarter? And their job depends on that, which is unfortunate, you know, as you know, in nature of our financial markets, because over the long term, it is optimizing for invested capital. But that's a longer term metric. It isn't, and that's not what traders are rewarding companies for. And a company misses earnings estimate and the stock plummet's 50%. And so, but back to managers, one of the favorite things that I would like to, I would always ask managers is to walk us through a portfolio mistake and like where they messed up. Indicative is like how well do they answer that.

Starting point is 00:45:39 Like how they frank, are they humble? You know, one of the things that we're looking for with managers is humility. And so if somebody can't come up with a mistake or it's sort of a, it's just, not a very good example. And so we want to understand when things haven't gone well. So we're always looking for bad things that might have happened with individual holdings or at the firm and how they handled that because we're trying to understand their investment culture. And that's, you know, performance is nice, but ultimately we want the investment culture in terms of the team interaction and how, just how they go about it. Because one of the things that we definitely don't want is a manager that's always looking for the flavor of the month. So they're always trying to change what they're doing or their process based on what clients want or consultants want.

Starting point is 00:46:30 We want them to be very confident in their approach even when they're underperforming. And obviously, all managers will make adjustments over time, but we don't want them to change based on pressure from clients because, At the end of the day, managers are in the business of pleasing clients, but the way you please clients is by sticking to your investment approach, even when times get hard. And some managers do that, and many don't. You know, I love that you bring that up about humility. I remember this is years ago, but I was really being raised by the church of Buffett and Munger and the whole thing about talking about your mistakes, which might also be easier if you're

Starting point is 00:47:12 a position like Warren Buffett. But, you know, he's very known for him, to be very frank about all the mistakes he's making. It seems like sometimes he's either or exaggerating all the mistakes and how bad of an investor he is. And so I remember I was taking that mindset to one of the interviews I had here on the show. And the guest that had refused to talk about any of his previous mistakes. He's like, no, I don't want to talk about it. And so, you know, that could be two options, right? It could either be, this is the best investor the world has ever seen who never made a mistake

Starting point is 00:47:40 or, you know, something funky was going on. Anyways. And you don't hire them. Like, if they're not going to talk about their mistakes, one, you don't hire them. But in this case, they're going to a podcast interview. So that's not really a choice. But good managers are humble. They talk about their mistakes.

Starting point is 00:48:00 They learn from their mistakes. And they like to talk about their mistakes. They, like, they're confident. It's sort of a combination of humility and confidence, confident. It's confident in their process, confidence in their team, but a humility in that they don't really know what's going to happen so they do their best. And like Jeremy Grantham would always say they tend to invest on seven-year cycles and they have had some extended periods of underperformance. And McGratham was very confident. So over the long term, I know we will outperform and have

Starting point is 00:48:35 outperformed. But it might not be with the same clients that we started with seven years ago. Because, and I've seen this in the institutional space, your average patients for a typical college endowment's board member is about three and a half years. If a manager has underperformed for two years, they start to get nervous. After three years, then they really get upset. And three and a half years, they're ready to change. And the reality is, an underperformance, of a manager in a given year can draw down that three-year track record below the benchmark. And so it's really hard to be patient with underperforming manager because, you know, as a board member, committee member, investment committee member, you're a volunteer and you want

Starting point is 00:49:22 to do something at your quarterly meeting. And so you're going to pick on the manager that's underperforming and you can get other committee members on board. Then it's, I used to phrase it as like you feel like you can only defend a manager so long. At some point, you realize you're just standing in front of a moving train. And you just got to get out. And if they're so insistent on firing that manager, then you terminate them. And then my job was to see if I could get them to hire a manager with this similar style,

Starting point is 00:49:51 that the one they're firing that maybe had a little better track record recognizing, because the last thing you want is to them to hire the best performing manager whose style has very much been in favor. And I saw this like one of my first institutional clients. And I was I was the junior advisor and we were doing a search. And I wasn't that involved, but they were hiring small cap and midcap growth managers. And they picked two managers that were at the top of the cycle. They had the best track record. And I remember that manager telling me this is like four years later, three and a half because they were probably fired right after that.

Starting point is 00:50:31 It's like this client, this college endowment is our worst performing account of all of our clients because they hired them at the absolute top because the performance looked the best because they had done so well over the previous year at the top of their cycle. Yeah, that's some powerful mean reversion that you have going there. And you see it in active managers. You see mean reversion in active investment styles even within what's generally considered A category, such as small cap value. There is mean reversion within sub-styles within small-cap value and other investments. Let's take a quick break and hear from today's sponsors.

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Starting point is 00:54:24 prospectus at fundrise.com slash income. This is a paid advertisement. All right, back to the show. So, David, I wanted to transition into talking a bit about Redallio. He actually, on the note that you mentioned before, he has this quote where he said that he made a lot more money on what he doesn't know, that what he does know. Redalio, for those of you who do not know who he is, the founder of Britswater and Associates, more than $140 billion as an management and a personal net worth of more than $20 billion. Red Delio has this framework of what he calls the short-term debt cycle, which happens every five, eight years. And what most of us think about whenever we think about cycles, these cycles all add up to the

Starting point is 00:55:06 long-term debt cycles, which happens every 75 to 100 years, give a take. Could you please outline Delia's thesis and whether you agree with his framework about long-to-dead cycles? So the short-term debt cycles are the credit cycle that we talked about. It's how much debt is there? What are the spreads? What are delinquencies? What are interest rates?

Starting point is 00:55:29 What are banks' willingness to land? And those are roughly five to seven years cycles. The long-term debt cycle would be just aggregate levels of debt. So, for example, one of the metrics that, again, you can look at the St. Louis, Federal Reserve, their Fred account, and pull up a chart for household debt as a percent of interest. as a percent of GDP. So this is U.S. households. What is their debt level as a percent of GDP? And you can see, if you're looking at that chart, you can see the long-term debt cycle.

Starting point is 00:56:00 So back in the 1940s, overall household debt to GDP was about 40 percent. That cycle peaked in 2008. So at just about 100 percent household debt to GDP. And now we've been in a down cycle, so now we're – It's 75%. So we had an upswing for roughly 60 to 70 years. And then we've had less debt now. You saw the same thing on the corporate debt side with Japan,

Starting point is 00:56:33 that their debt cycle peaked in the late 80s to early 90s, and they've been on a downtrent since then. So I agree with it. The problem is it's incredibly difficult to invest based on a long-term debt cycle. Because, well, most of us, our timeframe is not 75 years. And when you have such very long cycles, it doesn't end on one year. And so it could be plus or minus 10 years to where it actually ends,

Starting point is 00:57:01 which is why our approach is to look at where are we now? Yeah, we're at very high debt levels, but has something changed to where the leveraging is taken place? Or the behavior of businesses or household is changing? or, you know, because when a long-term debt cycle ends, it's typically at the same time the short-term debt cycle is ending. It's just that the sell-off is much greater and the de-leveraging is much greater and the recovery is much longer.

Starting point is 00:57:32 And so you can focus on the short-term cycles and current conditions and maybe the downturns worth because of the long-term debt cycle, but it's very challenging to just focus on a long-term cycle and say this is the year when things change because it may not be. And it's very difficult to get the timing rate. Yeah, it's a good point. And it's also one of those things, which is to Redelia's credit, because he's not too specific, which I actually think is a good thing about the asset allocation for most investors, aside for the whole all-weather portfolio that has previously been discussed. Because of this long perspective, because whenever you read through it, it makes so much sense. And especially if you're student history, I think it makes a lot of sense.

Starting point is 00:58:13 And then afterwards, you're sitting there and thinking, so how do I invest accordingly? And so, you know, I'm both sad but also happy that you say the same. They're like, yeah, I don't know. It makes sense, but it doesn't mean we should go. Well, right. Because it makes for a compelling story. So episode 300 of money for the rest of us. We looked at Ray Dalio's thesis regarding the changing world order.

Starting point is 00:58:36 And this is, you know, worry about government debt. He's worried about currency devaluation. and this came out a couple years ago, so roughly two years ago, this was his episode, right? And what was the thesis? What was the recommendation that Dalia was suggesting? Well, he was suggesting gold. Well, gold hasn't done anything in the past two years. And in fact, as real rates have increased, gold has actually sold off.

Starting point is 00:59:04 And so it's really hard to make investments based on any type of, long-term narrative that things are going to get worse or it's going to change because the cycles are too long. It's much easier to see where we are today and try to invest in areas that seem most attractive given current conditions, not ignoring the long-term cycles. I mean, these are all longer-term risk, but markets are driven by stories and they're driven by narratives. And you can see this in the European debt crisis. We had the great financial crisis in 2008. 2009, it wasn't really to 2011 that investors started to focus on European debt. And so there's spreads why now that yields went up.

Starting point is 00:59:51 And then Mario Draghi said we would do whatever it takes. And then things suddenly, you know, Greece is suddenly yielding less than credit, et cetera, way better than that. And then it kind of good even that narratives. And then they start worrying about European debt again. So it's important to recognize cycles exist, but what is the narrative driving? the market and our investors worried about it then because that's what will drive returns over the short term.

Starting point is 01:00:18 Yeah. And I also think it's important to recognize this hindsight bias that we all have. You know, whenever we look back at 2008, oh, it was obvious than Lehman Brothers would default bear sterns or whenever we saw what happened in Southern Europe, oh, it was so obvious that unravel afterwards. You know, living through it, I don't think it was all that obvious or perhaps it was just me. Whenever we look back, it just seems there was inevitable to happen. Whenever you are sitting there, it's just all, it's just very blurry. I remember back in 2020 in March, with COVID happening and

Starting point is 01:00:54 the market's just declining, you know, dropping every single day. And I remember I was reading, rereading some of the books about, you know, holding on, you're holding on to your assets, because that's what you're supposed to do. And whenever you read about, whenever you look at a graph and you hear about, you know, the crash in 1980. 7, for example, like Monday. You're like, yeah, of course you would just hold on. It was just a blib. Everyone could see it would just pop back again.

Starting point is 01:01:17 But living through it, that's hard. Fear is real. We didn't know in March 2020 what was going to happen. And there's PMI data. And like in our frame of reference, investment conditions turn red. We reduced risk. We eliminated all credit risk in our portfolio and in my portfolio.

Starting point is 01:01:39 Because, you know, our biggest fear, is a 50 to 60% drop in the stock market and 25% drop in non-investment-grade bonds. What was different in 2020 versus 2008 is the willingness of central banks to act and to start buying up assets. If you recall in 2008, during, you know, the whole TARP thing, you know, there was a lot of debate should the Federal Reserve buy corporate bonds or buy mortgage debt or any of this. But 2020, they just went out and said, yeah, we are going to do this. And as soon as they announced, for example, that they were willing to buy corporate bonds, corporate ETS, and even some downgraded

Starting point is 01:02:24 investment grade bonds that were now high-yield bonds, that's when the market changed. And that's when in our portfolio, we added investment-grade bonds because they were now yielding three and a half, 4%, 5%. And so, but when it's happening, and as a result, it makes it incredibly more difficult to invest now because now you have the central bank and you never know what they're willing to do because they've been willing to do so much more than they have in the past. But 2008, I was investing institutional money in 2008. You could see the housing crash. I mean, you could see the risk. And, you know, we were reducing risk. We didn't reduce risk enough to where our clients didn't lose money.

Starting point is 01:03:09 Everyone, your average institutional client lost 20% in 2008, 25%. And it felt awful. But you never know enough to get completely out, because especially the wildcard of the central banks right now. And so all we can do is calibrate our risk based on where things are so that hopefully we have enough in reserve to take advantage of opportunities. And that's essentially how Howard Marks has invested at Oak Tree and their firm. They're just calibrating based on where things are trying to add some value on the margin

Starting point is 01:03:45 because you never have enough high conviction to completely exit the market. David, I think this is a great segue into the next question here. And also talking about your wonderful podcast, Money for the Rest of Us. There's this quote there, and what you're saying is that investing-wise, my experience through losses, managing us through the Asian financial crisis of 1997, the internet bubble crash of the year 2000, the great financial crisis in 2008, the longer I invest, the more I realize that I can't predict what's going to happen, and I have to manage through this uncertainty. And as a result, my loss aversion has increased as I've gotten older and wealthier, end quote.

Starting point is 01:04:28 I found the latter to be an interesting take because it sounds counterintuitive because we also hear that we should incur more risk while we're younger and have this to lose because we have a lot of human capital. Could you please elaborate on this and how your loss aversion has changed over the years? There's two things. There's loss aversion, which is just your unwillingness to take losses, but there's also loss capacity, the ability to do so. So younger investors tend to have less assets and more human capital. And so they have the capacity to take losses because they have many years of work ahead of them to build up their assets. And their loss aversion might be less because they just have a much smaller asset base. But someone in my case that's invested for a number of decades and financially independent, I don't need to take big risk.

Starting point is 01:05:25 and losses hurt more than they ever have because the numbers are bigger. And so I recognize that I just don't know what's going to happen. I can see where we are. I can see where the risks are, but ultimately how it will play out, I don't know. And so I invest incrementally, do an invest, but ultimately, you know, my portfolio is fairly risk-averse with, you know, roughly 40% in, you know, liquid investments, 60% more liquid, but I, like, I'm not sitting there 80% stocks because I'm not confident that the stock market will return what it has historically because of where

Starting point is 01:06:09 we are starting valuation-wise, because when I look at the long-term profit cycle, and we recently did a study looking at, we were coming up, we come up with a capital market assumptions or market expectations for a couple dozen different asset classes on our site. And we recently went from a 10-year time frame to a 20-year time frame to do this analysis. And one of the most surprising things from that, because we're getting data now from MSCI, was to look at earnings over time and to see that, except for the U.S., many places around the world, never have reached their earnings peak from kind of the 2007-2008 period. And so earnings aren't increasing, which makes it hard to justify an expectation of 8, 10% for the stock market if the earnings

Starting point is 01:07:06 aren't increased. The only reason they increased in the U.S. more was because they were more stock buybacks, which was funded by debt. And so the bottom line is, I'm more risk-averse because I can see the underlying data and can't come up with a thesis for why we should get 8 to 10 percent stock returns. And then you got the issue with inflation and it just, it pauses one to be humble in recognition. We don't know, but we just do our best. And that's what great investors do. They just do their best and try to pick areas where they feel like they have at least some

Starting point is 01:07:44 type of competitive advantage if they're an active manager. David, let's go full circle on this interview and then again talk about Howard Marks. One quote that I in particular love, I'm going to paraphrase this, is that he's saying, more risk won't always lead to a higher return, since by definition, if you knew you would get a higher return, it would not be risky. End quote, David, how do you think about the relationship between risk and return for your own portfolio? I wouldn't understand what the return drivers are.

Starting point is 01:08:17 So it's not enough. I don't want to look at historical returns because I want to know, well, let me step back. I mean, I'll look at the historical returns, but I want to know what were the factors that drove those returns. And it goes back to the building blocks that we use. So what was there the cash flow growth historically and what do we expect that cash flow growth to be going forward?

Starting point is 01:08:39 What's the current cash flow yield, be it the dividend yield, be it the cap rate for real estate? And so what is the current cash flow? as a percent, you know, on a yield basis. What do we expect the cash flow to grow at? And then what are investors paying for that cash flow? And so that's, to me, you know, the more expensive, and Marx would agree, the more expensive the asset class, the lower the expected return, because investors are expecting perfection of that asset class. Or they're expecting earnings growth to be much higher. And that's what's baked into those valuations. And so I think

Starting point is 01:09:13 you have to look at the return drivers and where we are, are today in order to come up with realistic return expectations and then invest accordingly and invest in those areas that seem to have the highest expect of return given the potential risk and risk being measured by the potential maximum drawdown. Yeah, and going back to your regional point about looking at historical returns, yes, that is definitely important. It's also important not to be blindsided. One of the most interesting takeaways I had from changing of the world order. Redale's book we talked about before was that he has this, why he said, let's go back to the 1900 and let's invest in the 10 biggest economies in the

Starting point is 01:09:56 world. Hindsight's always 2020, right? And he said, do not fall into the trap. I'm probably paraphrasing here, but do not fall into the trap of just looking at US data. Seven out of those 10 of the biggest economies, their stock market just banished. It was just blown up by World Wars, hyperinflation, whatnot. And there were three countries, the U.S. included, who the stock market survived. Yes, and their currency was heavily diluted. But that's the best case example. And so whenever we look at historical returns, it's obvious, it's natural for us to look at U.S. data. Everyone who listened to this podcast understand English. So there was a natural bias just to go to English-speaking countries to look at that data. Americans are great

Starting point is 01:10:43 at providing data, it's accessible for everyone to analyze. But keep in mind, there's a survivor bias here. You can't go back and say, this is what happened in the 20th century. We can more or less assume the same will happen in the 21st century. Well, you're looking at one of the three of the top 10 economies who survived, the world's superpower, the century of the US. That's the stock market returns you're looking at. It doesn't mean that it can't repeat itself. Let's hope it can, but there's no guarantee just because it had happened in the past. Think about those poor people in, say, Germany, for example, Russia, Japan, like strong economies at the time, it looked like, who knows, what could have happened with those three countries.

Starting point is 01:11:26 I would assume there would be a strong home bias in those countries, too. Make sure to diversify. So I guess that's sort of like a point both to the home bias piece but also to the asset class piece. Absolutely. When I got into the investment business in the mid-90s, Japan made up 40 to 45% of the global stock market on a capitalization or size weighted basis. Now it's less than 5%. So now we're looking at a situation where the U.S. makes up 60% of the global stock market.

Starting point is 01:11:59 And 20 years from now, will U.S. be 60% of the global stock market? I don't know. But given the higher valuation than the U.S., it's, it's, it's a lot. It's, we should all have a meaningful allocation in the U.S., but the idea that, you know, many investors have all of their equity in the U.S. because they say, well, you know, these global companies and make up the U.S. index, they have international exposure. But the country right now, when you think of which country has the highest potential from a population trend basis in terms of number of workers, et cetera, it's India.

Starting point is 01:12:36 Whereas, you know, much of the development. world has a huge demographic headwin. And the only way that they're going to be able to overcome that is to be more accepting of immigration, for example. And so when you think about the U.S., are they willing to do that now politically? Not really. And so there are some trends in the U.S. that political trends that are not favorable to the U.S. continuing to be 60 percent of the global stock market, 10 to 20 years for that. I remember during the last Berkshire meeting, Buffett was looking at the 30 biggest companies today and then 30 years ago. I can't remember how many of the same companies

Starting point is 01:13:21 that were, but it weren't a lot. Let me put it like that. No, capitalism is just brutal. You mentioned Japan. And even, you know, even if you had the best companies in Japan or in France or whatever that might be, right now it's arguably the U.S., they still have. the same systematic risk to, for example, legislation. So I guess this is just my way of saying you be very humble. And going back to this quote about making more money, what you don't know than making money of what you do know, and be humble diversify across different asset classes, different countries too. David, I would like to give you a handoff to where the audience can learn more about you and money for the rest of us. And also, if there's anything that we haven't

Starting point is 01:14:03 covered in this episode, I know we covered a lot of ground here, but I wanted to give the opportunity to take this question in any kind of direction you want to go. No, I appreciate. I think we've had a well round of discussion. So most of our information is at Money for the Rest of Us.com as we can find the podcast. We have a number of free investment guides on different asset classes and other topics related to investing in the economy.

Starting point is 01:14:30 So you can check those out at Money for the Rest of us.com. And I could just give my personal endorsement. I absolutely love David's podcast. Not just saying that because we also friends outside of the podcast, but it's a wonderful podcast that I subscribe to. So make sure to check that out. David, thank you once again for taking time out of your business schedule to join us here today on the podcast. Very much enjoyed it.

Starting point is 01:14:52 Thanks, Dave. Anytime. Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision consult a professional, this show is copyrighted by the Investors Podcast Network.

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