Author Archive for Cullen Roche

Why Does the Power of the Hard Money/Fiscal Austerity Orthodoxy Persist?

Doc K asks an important question on his blog this weekend – how, after all of these years of being dreadfully wrong, do the Austerians and inflationistas still garner so much attention?  I think it’s simple:

  1. The idea that inflation is always bad is very simple to digest (even though it’s wrong).
  2. The idea that the government is always bad is very simple to digest (even though it’s wrong).

Of course, the economists and pundits who have been touting these views for the last half decade have been largely discredited.   But politicians and the people who really matter don’t cater to economists.  They cater to the general public.  And the general public doesn’t waste their time thinking about nerdy things like the operational realities of the monetary system.

In addition, a huge portion of the US population still thinks the government can’t do anything better than the “free market”.   After all, this is a country built largely on the rejection of “big government”.

Combine those two perspectives together and you get an environment that is perfect for embracing the simple message that the hard money crowd promotes.


Q&A – Ask me Anything

Here we go again.  It’s the opportunity of a lifetime.  You can ask me anything.  Whether it’s how to kiss a girl properly, how to dance the tango, play the violin or any of the other things that I write about on a daily basis here.   Actually, I don’t know how to do any of the aforementioned things, but feel free to ask me some other stuff if you want to.

John Cochrane Talks About the “Asset Swap”

I missed this nice piece in the WSJ by John Cochrane.  It’s a very balanced perspective of QE.  I particularly liked this section which will sound very familiar to regulars:

“This policy is new and controversial. However, many arguments against it are based on fallacies. People forget that when the Fed creates a dollar of reserves, it buys a dollar of Treasurys or government-guaranteed mortgage-backed securities. A bank gives the Fed a $1 Treasury, the Fed flips a switch and increases the bank’s reserve account by $1. From this simple fact, it follows that:

• Reserves that pay market interest are not inflationary. Period. Now that banks have trillions more reserves than they need to satisfy regulations or service their deposits, banks don’t care if they hold another dollar of interest-paying reserves or another dollar of Treasurys. They are perfect substitutes at the margin. Exchanging red M&Ms for green M&Ms does not help your diet. Commenters have seen the astonishing rise in reserves—from $50 billion in 2007 to $2.7 trillion today—and warned of hyperinflation to come. This is simply wrong as long as reserves pay market interest.

• Large reserves also aren’t deflationary. Reserves are not “soaking up money that could be lent.” The Fed is not “paying banks not to lend out the money” and therefore “starving the economy of investment.” Every dollar invested in reserves is a dollar that used to be invested in a Treasury bill. A large Fed balance sheet has no effect on funds available for investment.

• The Fed is not “subsidizing banks” by paying interest on reserves. The interest that the Fed will pay on reserves will come from the interest it receives on its Treasury securities. If the Fed sold its government securities to banks, those banks would be getting the same interest directly from the Treasury.”

I like that.  Sounds like he’s adopted my “asset swap” view of QE.  Swapping red M&Ms for green M&Ms doesn’t help your diet.  That’s exactly how QE works.  Swapping T-bonds for reserves doesn’t mean the private sector has more financial assets or spending power.   And it certainly doesn’t mean that banks are willing to lend more.  Cochrane seems to understand endogenous money and reserve accounting which is pretty unusual for most mainstream economists.

So, the narrative appears to be shifting more and more towards the sorts of things I’ve been saying for the last 5 years.  Which means that we’ve basically wasted all this time focusing on potential transmission mechanisms for stimulus that were never going to happen.  And that’s 5 years of sub-par growth because we put our faith excessively in a program that does a whole lot less than people originally thought.

Better late than never I guess.

Understanding Your Real, Real Returns

Thornburg Funds has a new report out on understanding your real, real returns and it’s fantastic.  I discuss this topic in detail in my book, but they do a much better job covering this than I do.  So go have a read.

The chart below is super important.  Most people who get into investing think only of their nominal returns.  That’s the top line figure.  But what really matters to you is the bottom line.  And in the investment world that’s the real, real return you get.  That’s the after tax, after inflation, after fee return.  It’s the money that actually goes into your pocket relative to your purchasing power.


The interesting part of this discussion is that the mainstream media almost never focuses on this concept.  So we’re constantly fed this myth of generating 10-12% annualized returns in the stock market or generating high returns on housing.  The problem is, the stock market’s real, real return is only 5.97% over the last 30 years.  And single family real estate comes in at a pathetic 0.8%.  In other words, the return that actually goes into your pocket from these assets is substantially lower than most people think.  And that’s because most people don’t calculate their real, real returns.  They don’t properly consider adverse fee effects, adverse tax effects or the problem of purchasing power loss.

You can see the full details in the chart below.  Over the last 30 years every asset class has generated a far lower return than is generally touted.  Commodities are actually negative, as is cash while stocks and bonds are in the low to mid single digits:


We have to be realistic when we get involved in the process of portfolio construction and asset allocation.  Setting realistic goals is one of the most important things you can do because it will benchmark the way you manage your process over time.  Understanding your real, real returns is central to this.

Updated – added second chart.  



Three Things I Think I Think

The latest edition of three things:

1.  I wanted to start by just saying thanks to everyone who reads this site and supports my work.  I don’t say that enough.  Which is pretty crappy of me.

This website is a strange part of my life.  I would have never guessed I’d put so much time and effort into a website if you’d told me that 5 years ago.  But it’s been life changing in ways. I’ve learned so much from so many smart people and I appreciate all the nice people I run into here who give me great feedback and support what I am trying to do.  I won’t get all sappy on you, but thanks.  I mean that.

2.  Larry Swedroe drops the boom on John Hussman in this piece.   It’s a harsh criticism.  I have a huge amount of respect for John Hussman and Larry Swedroe.  They’re both brilliant guys.  And while John’s performance has been pretty, um, bad, in recent years, I do think Larry contradicts himself a bit.

The whole point of the article is to focus on long-term results and avoid forecasting.  He even quotes Warren Buffett.  But in berating Hussman Larry fails to point out that he’s demonizing John’s 5 year performance while quoting a guy who has also underperformed the S&P by his own metric for 5 years.  Yes, Buffett’s own annual reports have discussed the poor recent performance of Berkshire Hathway relative to the S&P 500 where book value per share has lagged the S&P 500 by 5.4% per year.  So it seems a bit contradictory to judge a manager’s short-term performance when you’re emphasizing a long-term perspective.

Anyhow, I think Larry makes some great points.  I disagree with his general point on forecasting since I think portfolio construction involves, at a minimum, implicit forecasts, but it’s a good pieces so go have a read.

3.  Morgan Housel writes just about the most honest thing you’ll ever read on the finance industry.  I won’t spoil it for you, but there are some dark corners in this industry that could use a bit of light.  And I think we’re moving in the right direction.  But there’s a lot of work to be done.



Random Walking (But Only When it’s Convenient)

Okay, I am a little OCD so bear with me here.  Actually, if you plan on reading any of my work in the future you’ll have to bear with me for 30-50 more years since I assume this sort of griping will be a persistent trend given how badly I think the worlds of modern econ and finance have been mangled by politically motivated theorists (assuming my OCD doesn’t kill me first)….

Anyhow, I was reading some more Burton Malkiel thinking on the markets when I came across this gem from 3 years ago.  In this piece trashing US government bonds, Malkiel does something very strange.  He makes the argument that dividend paying stocks are a good substitute for bonds.  Now, I’ve seen this argument a lot over the years and we have to be VERY clear about something:


Did I write that big enough?  Maybe not.  Let’s try again:


Okay, you get my point.  Of course, saying it isn’t enough.  There should be some empirical data to back up this assertion.  First, a bear market in bonds is nothing like a bear market in stocks.  When someone compares the two instruments it means there is a high likelihood that they don’t understand the capital structure very well and haven’t connected all the dots here.  A fixed income instrument has several embedded safety components that make it entirely different from stocks:

  1. It’s higher in the liquidation chain.
  2. It pays a “fixed income” over the course of its life.
  3. If held to maturity fixed income pays you back at par.
  4. The duration on a fixed income instrument is generally shorter than that of common stock.

This explains why fixed income is inherently safer than common stock.  We can see this in the performance data.  Since 1928 the 10 year US Treasury note has been negative in just 14 calendar years.  Those negative years averaged a -4.2% return.  Stocks, on the other hand, have been negative in 24 of those calendar years and with an average decline of -13.6%.  The worst calendar year decline in stocks was -43% while the worst calendar year decline in bonds was -11%.  So it should be clear that a bear market in bonds is very different from a bear market in stocks.

But what about high dividend paying stocks?  People often confuse dividends for making an equity instrument similar in some way to a fixed income instrument.  This is completely wrong.  An equity instrument that pays a dividend still lacks all of the aforementioned built-in safety components that differentiate fixed income from common stock.  It just means the company pays a dividend stream (which isn’t actually fixed and can be revoked at any point as many people found out during the financial crisis).

More importantly, dividend paying stocks can be atrocious performers at times.  And it’s often because high dividend paying stocks are leveraged companies who borrow funds to finance dividends and operations.  This was most obvious during the financial crisis.  Take for instance, the iShares Dividend fund which cratered -62% during the financial crisis.


Going back to Malkiel though – I had to chuckle at this bit of “Random Walk” advice from 2011 when he recommend buying AT&T stock because it’s a high quality dividend paying stock:

“Another strategy would be to substitute a portfolio of blue-chip stocks with generous dividends for an equivalent high-quality U.S. bond portfolio. Many excellent U.S. common stocks have dividend yields that compare very favorably with the bonds issued by the same companies.

One example is AT&T. The dividends paid on the company’s stock result in yields close to 6%, almost double the yield on 10-year AT&T bonds. And AT&T has raised its dividend at a compound annual growth rate of 5% from 1985 to the present.”

Since then AT&T has generated a 36% total return.  Not bad!  Except for the fact that the high quality blue chip index of the S&P 500 has generated a 67% total return over the same period.  In other words, Malkiel got trounced for engaging in the exact type of activity he mocked stock pickers for engaging in in this recent WealthFront blog post.  The level of inconsistency and hypocrisy in some of this writing disturbs me, to say the least.  One of the most influential thinkers in modern finance is just blatantly contradicting himself in these commentaries and yet people cite his work when it’s convenient to a certain perspective.  That’s rubbish in my opinion.

Okay, I’ll lay off Malkiel now.  But you should be starting to see a common thread in a lot of this work.  There are disturbing inconsistencies and misunderstadings in the views and framework that a lot of this work is built on.  And an entire industry has come to believe that this sort of thinking is a solid cornerstone for thought!

(pulls out hair)

Malkiel’s Mendacity

As I’ve developed an understanding of the macroecon and finance world I find the same disturbing trends across both fields – a highly politicized school of thought has dominated much of the thinking.

Regular readers probably know my views on mainstream economics, but I find many of the same problems muddying the waters in finance.  For instance, concepts like the Efficient Market Hypothesis and Rational Expectations are essentially conservative ideas constructed in a manner to establish an empirical argument against forms of government intervention.  They essentially say “markets do things better than governments so stay out”.  There’s a lot of truth to ideas like this, but they dominate the discussion to the point where they’ve become extremely counterproductive.  And yet people win Nobel Prizes for these ideas and the underpinnings of Modern Finance rest largely on this kind of biased thinking (no wonder they reject behavioral finance given how biased most of these economists are!).

I was reminded of this as I read this blog post by Burton Malkiel who scolds stock pickers for their performance in 2014. For instance, Malkiel, the father of Random Walk and a proponent of the Efficient Market Hypothesis, says you shouldn’t try to predict the future returns of assets because the markets are basically too efficient to outguess them.  That is, of course, unless he feels like predicting the returns of asset classes like he did before 2014 when he told people to avoid long-term US government bonds, the very best performing asset class so far in 2014 (zero coupon bonds are up an amazing 27.5% this year and 30 year bonds are up 17%+):

“Governments wrestling with large budget deficits, huge unfunded liabilities for entitlement programs, and high unemployment rates have adopted policies of keeping interest rates extraordinarily low.

Ten-year U.S. Treasury bonds yielding 3% provide neither generous returns nor an adequate margin of safety to make a shift from equities to high-quality bonds an unambiguous risk-reducing strategy.”

I remember the article vividly because it jumped out at me as being so obviously hypocritical and erroneous.  What’s ironic here is that Malkiel is not only picking assets specifically (something his own theories say you shouldn’t try to do), but he’s making what is obviously an erroneous political argument.  The US government is not at risk of some type of Grecian moment because of “unfunded liabilities”.  The US government is not going bankrupt yet he paints the government’s debt situation as something dire that warrants an underweighting in the asset class.  Malkiel is basically saying he knows more than the markets do so you should listen to him and underweight US government bonds. Malkiel might not like all this government debt, but it should have NOTHING to do with his theories on finance.  But he is clearly just making a political argument masquerading as financial analysis.  Sadly, that’s what much of modern finance and modern economics is – just politics masquerading as science.

This is important stuff.  And if I am right then the future landscape of modern finance and mainstream economics will look very different than it does today because lots of people are going to realize that the underpinnings of the current thinking aren’t just a little bit wrong, but very wrong.


Rosenberg: the Next Recession Could be 4 Years Away

Talk about a flip in perspective.  David Rosenberg, who had been bearish for years, has turned into one of the biggest bulls on Wall Street.  The Gluskin Sheff analyst now says his recession forecasting model could be pointing to another four years of economic expansion (via a recent note of his):



That’s pretty interesting.  We know that the probability of a tail risk event increases dramatically inside of a recession.  So if DR is right then that means the macro trend could be higher for several more years to come….

It’s Time to Eliminate the Term “Passive” Investing

John Rekenthaler of Morningstar wrote a good piece today pointing out that the “active” vs “passive” debate is the wrong question.  He’s right.  We really shouldn’t be concerned at all with these labels.  After all, they are relatively meaningless marketing terms that have been constructed for no other purpose than to differentiate one product from another.  But there’s a more worrisome trend at work here and I think it deserves a lot more attention.  The fact is, most of the adherents of “passive” indexing are not only misconstruing the discussion, but they are working with an underlying model that is inherently flawed.

As I’ve explained in detail in several past posts (see below), there is nothing in the world of investment products that allows you to be a pure “passive indexer”.  That is, the ONLY pure indexing approach is buying the Global Financial Asset Portfolio and taking “what the aggregate market gives you”.  This portfolio isn’t available though.  You can come close to replicating it by building a 40/55/5 stock/bond/REIT portfolio, but you can’t achieve it perfectly.

What most “passive indexing” strategies really do is pick assets.  That’s all they are.  For 30 years they have constructed a clever marketing pitch berating “stock pickers” without thinking through their own approach entirely and realizing that they are also asset pickers inside of a broader aggregate.  “Passive indexers” determine an asset allocation by taking all sorts of theoretical underpinnings and then make an implicit (some might say naive) forecast about the future that is the precise equivalent of saying they can “beat the market”.  Do you own a “passive 60/40″ stock/bond portfolio?  You are declaring to the world that you think stocks will outperform the (approximate) 40/55/5 stock/bond/REIT allocation of the GFAP.  You are saying you are smarter than “the market”.  You are saying you can pick assets better than “the market”.  You are an active asset picker.  

More importantly, anyone who understands the GFAP from macro perspective knows that it’s an ex-post construction of an index that is basically a rear-view mirror bet hoping that millions of issuing entities are making “efficient” decisions based on the assets they’ve already issued (there’s a contradiction in the Efficient Market Hypothesis there that is the width of a Mack Truck).  Of course, there are times, like the last 25 years, when the GFAP is not just wrong, but tremendously wrong (buying the purely passive 60/40 stock/bond GFAP portfolio in 1980, for instance, generated far worse risk adjusted returns than a bond heavy portfolio did).

Now, don’t get me wrong here – a lot of the general message underpinning the concept of “passive investing” is great.  I love indexing.  Diversification is tremendously important.  Costs are HUGELY important.  Trading can be terrible for your wealth.  But “asset picking” (which is what all asset allocation ultimately comes down to) is totally necessary.  It’s the only way we can construct portfolios that align our risk tolerance and financial goals with a certain set of appropriate assets.

So yes, it’s time to dump the “active vs passive” jargon.  It’s just marketing terminology sold by firms with a vested interest in one or the other.  More importantly, if your advisor or “expert” investor friends use the term “passive investing” they probably haven’t thought all of this through from a macro perspective which means that the entire foundation and rationalization of their approach could be flawed.


The Housing Market is Softening

The US housing market appears to be softening a bit after a torrid run-up in the last 18 months. National home prices, as tracked by the Case Shiller index, had jumped at nearly a 15% rate of change year over year as of earlier this year.  But the pace of change has slowed markedly in recent months to 8%.



The CoreLogic Home Price Index is showing a similar trend with prices slowing to 7.5% in recent months.  The average annual price change in 1978 has been about 5.5% so we appear to be coming more in-line with the historical average.




Some More Q&A…

Here’s some more on the Q&A from last week:

Q: The return on these option indexes created by the CBOE look way to good to be true. Basically they are indexes of writing covered puts and calls on the S&P 500, and the way outperform it. Wondering if you might be able to point out what I am missing. Seems like if these returns were true everyone would be doing this.

CR:  1)  I don’t see the word “fee” in that PDF at all.  I’d be interested in seeing the real, real returns there….2)  Many of those benchmarks are available ETFs.  They haven’t performed nearly as well as that fact sheet says.  See PBP the SP500 buy/write for instance….

Q: Cullen, I was wondering where you think a 30 year mortgage might be in 2017?

CR:  If I had a gun to my head I’d probably bet that they will be marginally higher than today….

Q: I wanted to get your thoughs on the Fed’s recent push, by some members, to push up rates sooner rather than later. It seems like bank lending is just still too slow and new bank Capital requirements restrict them from lending out as heavily as before: hence less inside money in the system and therefore lack of inflation. Wage growth also seems too low to make much of a difference. Am I wrong in thinking this way?

CR:  You’re dead right.  Any fears of inflation are likely overblown.  The Fed is at risk of looking like the ECB in 2011.  There is way too much slack in the economy today to warrant a rate increase any time soon.

Q: How come I suck at investing?

And if you had one question you could ask Yellen what would it be.

CR:  1)  Investing is hard and you probably don’t have a very good process that you can stick to.  2)  I’d ask her what her largest personal asset holding is.

Q: I’m wondering what about the current US fiat system that makes inflation good in comparision to a gold standard where inflation is always bad?

CR:  Well, the idea of inflation has to be put in the right context.  Inflation can rise and have no meaningful negative impact on your life if your wages also rise.  If inflation doubles, but your wages also double then you aren’t worse off.  And for the most part, we’ve seen wages handily outpace inflation over the last 100 years.

Q: Rocky’s? The Tap Room? or Cass Street Bar?

CR:  A local.  I love it.  I lived in PB for 8 years and am moving to north county now.  I’ll miss it, but I’ve hit my expiration date.  Rocky’s – best burger in San Diego.  Cass – best local bar in PB.  Don’t love Tap Room.   I pretty much live at Fish Shop….

Q: You may address this in your book, but why did the world (generally) decide to outsource the creation of money to private banking? What’s the history involved there?

CR:  Good question.  I think that most free economies developed with a high degree of skepticism about the govt controlling the money supply too much.  The private banking system created a buffer of sorts and allowed the money supply to be only loosely controlled by governments.

Q: Farmers that have a bad year might expect a higher price for their milk/wheat/vegetable. Less supply should equal higher price. But they are then told that the markets are global and just because one country have bad crops one year, prices don’t rise unless global supply is down.
Now Russia cut food imports from Europe. Suddenly the price crashes. European diplomats urge other countries not to step in and take the market.
I don’t get it. If the market is global. Supply is the same. Demand is the same (Russia can import from other countries). Why does the price of food crash in Europe? Is the market so inefficient?

CR:  The real effects here are probably too micro for my pay grade, but my guess is that yes, the markets are a lot less efficient than people generally think.  Just look at the volatility in the global price of oil.  I mean, every little shock causes a huge ripple through prices.  But time and time again we see that these big geopolitical events don’t have nearly the impact that people assume.  But the end producers still have to hedge their bets and ensure that the risk of less supply is not borne entirely by them.  So yes, I think the market is inefficient in part because the people setting prices have to be rather imprecise in how they manage their risks (which is efficient for them, but looks very inefficient to everyone else)….

Q: Given the constraints of a finite resources and the law of diminishing returns, do you think it is probable that over the long term that productivity growth can/will outpace that of credit growth?

CR:  I don’t think productivity has to decline because of the lack of available resources. The global economy is becoming more diverse than ever.  More and more of what we “produce” are services that don’t necessarily translate from real resources.  This is actually a big part of the increase in productivity.  It’s a lot easier to build a webpage than it is to build a factory.  It can be as efficient also depending on your business….


You think Ms. Yellen is reading your website?

CR: God save us all if the Fed Chief takes me input into serious consideration.  And no, I don’t think she reads my website.

Q: Do you believe that America is sustainable as a whole(unemployment, bubbles, banks, wars, energy, entitlements, population growth, government ect.)? When you look at the macro picture that you seem to put in a lot of effort to understand, do you honestly think the U.S. is progressing, or regressing? Do you think Americans will see a lowering standard of living in general(for larger portions of the population) as future progresses?

CR:  My general view is that we’re sort of like Micrsoft.  The USA is this big developed entity that has likely seen its best days, is now losing market share, but continues to do a lot of really great things.  So we’re making progress, but at a slower rate.  I am not a permabull, but I am an optimist.  But there are places in the world where I am much more optimistic than the USA over the long-term because I think the USA is bound to lose global market share….

Q: What are your thoughts on expanding the EITC vs. increasing the minimum wage? Perhaps it should be an “either/or” question.

Lot’s of discussion about inequality, Piketty, a $15 minimum wage, etc. these days.

Perhaps a better question for you is what do you think the federal government should do to help low income workers?

CR: The minimum wage debate is a moral debate.  I mean, increasing wages doesn’t necessarily make the economy better off because it doesn’t mean that households will necessarily save more of their income.  So raising wages is just a redistribution of sorts.  Which means that it’s really a moral discussion that centers around making sure that corporations don’t mistreat their employees.  I am not against an increase in the minimum wage.  But that has nothing to do with me thinking it’s good for the economy.  It’s because I think corporations can and will take advantage of their employees if given the opportunity and I think someone should stand up for the workers of the world who can’t stand up for themselves.

Q: are you going to launch an ETF based on the Global Financial Asset Portfolio? i suppose the Vanguard 40/60 LifeStrategy would perform similarly and i might switch to it soon – my main 80/20 is far too risky now i think about it.

CR:  No, I have no ETF plans in the future.  But I am getting back in the asset management game this year.  :-)

What do you think we will see first, 1% or 4% on the 10 year Treasury?

CR:  That’s a hard one.  It would take a real shit show for the world’s safest asset to hit 1%.  I’m not bearish right now, but I can’t see that in the coming years.  I also can’t see 4% any time soon….Can I guess neither and update you later?  :-)

Q: “If the output of a society declines or is viewed as less valuable to its users then the money which is used as a medium of exchange will also be viewed as less valuable.”

I could not understand that. I certainly would agree that the two would be highly correlated in a statistical way, but I couldn’t understand why it was (absolutely) necessary.

CR:  Well, it’s about understanding how the outstanding balance of assets relates to price/value.  If there is a fixed quantity of money in the economy and the quality of output is declined then the value of the money MUST, by definition, decrease in value because its value relative to the reduced quality of assets makes it less valuable, all else being equal.

Q: How would you interpret this chart?

CR:  Well, there’s a blue line and a red line and the red line appears to be winning the race to the upper right hand corner which is pretty great for the red line because that means it’s winning and winning is good, right?  Oh wait, that’s not a sports scoring sheet.  Sorry.

That’s just a representation of QE.  There has been weak loan demand in recent years so loans are stagnating, but QE has resulted in deposit creation so QE has resulted in a continued expansion of M2 by reducing the pvt sector’s quantity of T-bonds.  Some people make this out to be very scary, but it’s just a representation the basic asset swap accounting behind QE.

Q:  the left sees the economy as a fixed pie, with some people taking more than their fair share. the right says that the pie grows enabling everyone opportunity to benefit. how do you see it, and where are they wrong?

CR:  They’re both right to some degree.  The economy does expand the pie for all of us by creating goods and services that enhance our lives.  But it can also become very uneven in terms of who benefits most from producing these goods and services.  I think the living standards of Americans are expanding at a faster rate than economic growth would imply.  But I also think the disparity between how people benefit from this is expanding more rapidly.  So they’re both right to some degree.

 Q:  I would be interested in your comments on this article in Foreign Affairs entitled “Print Less but Transfer More: Why Central Banks Should Give Money Directly to the People” (by Mark Blyth and Eric Lonergan).

Basically, they propose a helicopter drop equal to 2% of GDP (which works out to around $1000 per person), along with using interest rates as a control valve for inflation.

CR:  If the Fed were to print dollars and shoot them out the front door then that would clearly have a big impact on the economy.  It would be similar to deficit spending in that it adds to the private sector’s financial net worth dollar for dollar.  In an economy where so many people are debt burdened I think that would be a net positive.  I think firing dollars out the front door is a bad way to do it.  I’d prefer a tax cut or some government investment in infrastructure or something like that….

Q:  What do you think will cause the next recession?

CR:  Corporate America will stop investing.

Q:  Federal debt takes two forms. Debts to individuals, institutions, and other governments. The other form is where it owes itself for the money it has created.

If we maintain the obligation to the individuals, institutions, and other governments but erase the balance sheet obligations for the second kind of debt, what would be the consequences? Why recognize any type of obligation for debt we have purchased with created money?

CR:  Well, most of the debt the government owes to itself is actually owned by citizens.  It’s military pension funds, Social Security and things like that.  So I don’t think it would make sense to wipe it off the books.  The government’s liabilities are generally the non-government’s assets.




Is the Global Financial Asset Portfolio the Perfect Indexing Strategy? – Part 2

Last week I presented the Global Financial Asset Portfolio (GFAP).  In case you missed it here’s a brief summary:

    • The GFAP represents the current allocation of the world’s financial assets.
    • The GFAP is the only pure “passive” index as this is the index that gives you “what the market gives you”.
    • The GFAP is approximately a 55% bonds, 40% stocks, 5% REITs index at present.
    • The GFAP has performed extremely well in the last 30 years on both a risk adjusted and nominal basis.

While I think this portfolio could be fine for many people I also believe this analysis has exposed several flaws in the traditional view of “forecast free” and “passive” investing.  Instead, this analysis requires us all to take a much more nuanced perspective. It’s very likely that the people selling the idea of a purely “passive” or “forecast free” approach do not understand the underlying dynamics at work.  Let me explain.

First, as I explained previously, the true global asset portfolio (as depicted in this paper), is impossible to replicate perfectly.  So there is really no such thing as buying exactly what the “market gives you”.  You have to alter the index using various subjective assumptions.  In the case of my GFAP I removed commodities for instance because I wanted to remove non-financial assets based on the understanding that commodities don’t perform well in real terms over the long-term.  Clearly, that’s been somewhat wrong over the last 15 years as some commodities have performed extremely well.  But the point is that there’s a degree of subjectivity here that makes this a much more nuanced and active endeavor than we might think.

Second, the GFAP is an ex-post snapshot of what the financial asset world looks like today.   Historically, the GFAP should change over time as the underlying balance of assets will inevitably change over time.  So the GFAP has to be reactively dynamic to some degree.  Therefore, the portfolio requires its own degree of reallocation just to remain consistent with the actual underlying allocation of outstanding financial assets.

Third, because the GFAP is an ex-post snapshot of the underlying financial assets it is inherently reactive.  Therefore, it could be positioned in such a manner that it will not provide optimal future returns.  For instance, today’s balance of financial assets reflects the falling interest rate environment of the last 30 years.  So the GFAP reflects this balance.  As a result, the portfolio is bond heavy relative to equities because it has become significantly less expensive to issue debt relative to equity over the last 30 years.  As a result we’ve seen a huge decline in equity issuance relative to debt.  So the GFAP has shifted from what was a stock heavy portfolio 30 years ago to a bond heavy portfolio today.  But this is a reactive shift in the landscape.  Any smart asset allocator would look at this environment and argue that there are some unsustainable trends in place here.*

For instance, the Aggregate Bond Index has generated 8%+ annualized returns since 1980.  With overnight interest rates at 0% there is about a 0% chance that bonds will generate the same returns in the next 30 years as they have in the past 30 years.  So this bond heavy portfolio has an overweight to fixed income thanks to the ex-post nature of this index.  But there’s also a strong argument to be made that stocks are expensive in relative terms and likely to be more volatile going forward than they have been in the past.  This means that anyone actively choosing to deviate from the GFAP bond heavy allocation is potentially exposing themselves to a high degree of equity market risk which creates a whole other risk for investors in a low interest rate environment.

Lastly, we should note that there are many factors that play into an asset allocation decision outside of trying to replicate a “pure” index like the GFAP (there is a degree of indexing overkill in some discussions these days).  Clearly, this allocation isn’t appropriate for all investors and you need to be very precise about understanding risk and how it relates to your personal decision before you can allocate your assets appropriately.  So generalizations about the GFAP should be taken with a grain of salt as they do not apply to everyone.

All of this presents an interesting conundrum for asset allocators.  Using an ex-post snapshot of the financial world is clearly not always an optimal approach for everyone.  Most importantly, there’s an obvious contradiction in the idea that we should just accept “what the market gives us” since this implies that the forecasts of the asset issuing entities comprising the current underlying asset allocation, is optimal, and we should therefore just accept the return that their asset issuance generates.

A reliance on a “pure” indexing approach like the GFAP is not necessarily a bad idea for some people, but it has obvious flaws as well.  Asset allocation requires a certain degree of active forecasting and “asset picking” based on how we think the future performance of specific asset classes will translate to our risk profile and financial goals.  There’s a certain degree of forecasting and guesswork involved in any of this.  A reliance on a pure ex-post approach is reactive and static relative to what must be a proactive and dynamic endeavor (asset allocation).  Finding the perfect balance will be difficult for all of us to achieve.  Hopefully this series helps you put things in the right perspective so you can come a little closer to optimizing your own approach.

*  To highlight this point consider the fact that a 40/60 bond/stock portfolio has substantially outperformed a 60/40 bond/stock portfolio over the last 30 years on a risk adjusted basis and only slightly underperformed in nominal terms.  In other words, buying the GFAP from 30 years ago when it told us to be stock heavy, was precisely backwards!


Three Things I Think I Think

Since I am still working through the Q&A from last week I figured I’d take some of the questions for a segment of three things:

Question # 1 – “How can one invest, as opposed to speculate, without knowing value?”

There are many factors that drive price outside of perceived “value”.  In fact, as I’ve made clear in recent weeks, I don’t think value is a very clear factor driving price because “value” is a rather nebulous concept.  No one really knows what the “value” of the stock market is the concept of value has to be dynamic.  Therefore, I don’t even see how this can be the most influential factor in price.

I could be wrong there of course, but the point is that there are lots of different factors that drive price.  Things like momentum, quality, yield, volatility, market cap are some of the more popular ones aside from value, but I’d argue that even that is too micro.  If you give me the macro direction of the economy, a general idea of what type of environment we’re in (high inflation, deflation, de-leveraging, etc) and the health of corporate profits (using Kalecki equation, etc) I’ll tell you which direction stocks are headed 75%+ of the time.  Combine that with general sentiment and I think you can put together a potent mix for making high probability directional bets on the market.  In other words, give me the direction of the current and I’ll tell you, with a high degree of confidence, which way the boats will move.  I could care less what “value” and all those other factors say so long as I know the direction of the current….

Macro modeling is complex and forecasting is difficult, but so is defining any factor that moves price.  In my view, a macro perspective gives you a much clearer perspective and results in a much higher probability of being right about the big trends.  And if you can get the big trends right then the details tend to fall into place much more easily.

Question #2 - Well done on publishing your book recently. Any tips for others writing and publishing/promoting a book?

Thanks.  I’m no guru in promotion of writing.  After all, Pragmatic Capitalism was my first book.  But I do have some advice.  First, go into the process knowing that books don’t make people rich these days (except for a very small percentage of them).  So you have to realize that this huge project is going to have a relatively small monetary payout in all likelihood.  The benefits of writing the book are intangible – maybe someone learns something from you.  Maybe it helps build credibility for you.  Maybe it’s just something you’ve always wanted to do.  I just think you have to go into it with your eyes wide open knowing that it will be a huge amount of work with little monteary payout, but a potentially large intangible payout.  That’s how I viewed it anyhow.  And I can tell you from the feedback I am getting that it’s helping a lot of people better understand investing and money and that’s hugely rewarding for me.

Question # 3  - Hi Cullen. Recently read and loved your book. Your analysis if central banking was very easy to understand. I particularly liked your point about how the US government has tremendous assets, which more than balance the debt. Can you comment on Japan in this regard? Are they tipping the boat over there at all? I do continue to feel like interventionist central banking will find its Waterloo in Japan, and fear this will lead global markets to ultimately lose faith in the other CBs. Any thoughts on this that you might have would be appreciated! Keep up the good work.

I am by no means an expert in Japanese monetary policy, but my understanding is that the MOF and BOJ essentially modeled their system after the Fed system.  So most of what I say about QE and deficit spending in the USA applies to Japan.  Also, Japan is what I describe in the book as a country that is high in terms of being an autonomous currency issuer.  This gives them a degree of flexibility that a country like Vietnam doesn’t have.

I have expressed my skepticism about how much the BOJ can really positively impact the Japanese economy in recent years, but the currency devaluing is certainly working better than I expected.  Not sure how long that can last though.  And I have a feeling that once that’s run its course that the BOJ will continue to run into the disinflation monster again.  It’s not the BOJ that worries me in Japan.  It’s the structural demographic issues that worry me more so.  And this is deflationary in nature and not likely to be inflationary or result in currency collapse.

How To Respond to Someone Screaming About “Money Printing”

Here’s a response to the first question from last week’s Q&A.  I feel like it’s worthy of its own post because it’s important.  The question was:

‘How do you respond to someone who is constantly claiming that inflation and therefore interest rates are bound to shoot up with “all of the money the government is printing?”‘

That’s easy.  Here is how that conversation will usually go:

Inflationist: “Can you believe how reckless our government is printing all this money every year?”

Monetary Realist: “Well, technically, the government doesn’t “print” most of the money we use.  Most of the “money” we use is created by banks and is created when banks issue loans which create deposits.  These deposits make up the majority of the “money” we all use to transact”.

Inflationist:  “Yeah, but can you believe the high government deficits were’ running and all that new money that gets printed when the government spends?”

Monetary Realist: “The government isn’t printing new money when they run a budget deficit.  They’re actually “printing” a government bond that is used to raise “money”.  This results in the redistribution of existing money and the issuance of a new government bond.  There actually isn’t any “money printing” going on there.”

Inflationist:  Yeah, but what about all those paper dollars floating around.  Those have to be inflationary at some point, right?

Monetary Realist: “Not necessarily.  Paper money is only accessible to people who have previously had bank accounts.  That is, any cash in the monetary system is placed there by someone who withdrew money from a bank account.  They essentially transformed their deposits into cash notes.  But the “money” still originated with the banks creating deposits even if the US Treasury is the entity that actually prints up the physical notes.  They only do that so you can transact in physical currency more conveniently and this money is distributed THROUGH the banking system.

Inflationist:  “Oh yeah, but Quantitative Easing has been crazy money printing.  Have you seen the size of the Fed’s balance sheet?  Just wait until those dollars all get out of the banking system and cause crazy high inflation!”

Monetary Realist:  “Well, that’s not exactly right.  The Fed has created reserve balances through QE’s asset purchases which resulted in the increase in outstanding reserves in the private sector, but the reduction of another asset in the private sector.  This isn’t asset printing.  It’s asset swapping.

And more importantly, these reserves are used by banks INSIDE the banking system.  That money doesn’t “get out” of the banking system in any meaningful sense.  Remember cash is transformed from deposits so even if customers withdraw cash then this doesn’t mean there is necessarily “more money” in the system.  It just means the type of money has been exchanged.

Inflationist:  “Well, what about when the banks start using all those reserves to multiply the money supply through new loans?  Won’t that cause crazy high inflation?  ”

Monetary Realist: “That textbook story is cute and all, but it’s not really how banks operate.  Banks make loans and find reserves later if they must.  They aren’t reserve constrained.  The money multiplier is a myth.  “

That should help you out.  Good luck.  It’s an uphill argument every time!



Buy Cullen Roche’s New Book Pragmatic Capitalism – What Every Investor Needs to Know about Money and Finance

Housekeeping: You Asked For It….

Okay, I got a TON of complaints after turning the comments off last week so I am going to test an alternative this week.  I am turning Disqus on with the hope that user registration and a more organized commenting system makes the moderation and handling much simpler from my end.  Posts can be voted on so bad content will get pushed down and users can be picked as moderators to help with any negative commentary on the site.

I hope this is a healthy and productive alternative to just shutting things down entirely.  Any feedback during the week would be appreciated.  Thanks.