ReSolve Crew: Mastering Investment Strategies in an Age of Inflation Volatility

In this episode, Mike Philbrick, Rodrigo Gordillo, and Adam Butler of ReSolve Global dive deep into the intricacies of monetary policy, inflation, and the impact of these factors on the global economy. They discuss the complexities of inflation, the role of the Federal Reserve, and the potential future of the financial landscape.

Topics Discussed

  • Discussion on the shift in monetary policy and its implications
  • Insight into the misunderstanding of inflation and its workings
  • Examination of the impact of inflation on asset classes and financial markets
  • Analysis of the potential increase in volatility across assets
  • Discussion on the potential for more variance in inflation
  • Exploration of the impact of AI on the service economy and potential for re-acceleration of growth
  • Review of historical inflationary shocks and their implications for the future
  • Discussion on the potential for higher volatility in the financial markets
  • Insight into the potential for strong economic growth and low unemployment
  • Discussion on the risk management techniques for portfolios
  • Analysis of the potential for wealth altering events in the financial markets
  • Discussion on the potential for inflation shocks and the role of commodities
  • Insight into the potential benefits of trend following managed futures strategies
  • Discussion on the concept of carry and its potential impact on portfolios
  • Analysis of the potential benefits and risks of investing in concentrated value ETFs
  • Discussion on the potential for a hotter than expected economy over the next year
  • Insight into the potential mispricing in the financial markets
  • Discussion on the potential impact of inflation on equities and bonds

This episode is a must-listen for anyone interested in understanding the complexities of inflation, monetary policy, and their impact on the global economy. The RAM Crew provides valuable insights and strategies for navigating the uncertain financial landscape and better understanding the intricacies of the financial markets.

This is “ReSolve Riffs” – published on YouTube every Friday afternoon to debate the most relevant investment topics of the day, hosted by Adam Butler, Mike Philbrick and Rodrigo Gordillo of ReSolve Global* and Richard Laterman of ReSolve Asset Management.

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The evolving dynamics of inflation and monetary policy are crucial considerations for modern financial professionals. A significant shift in these mechanisms is anticipated, deviating from the patterns observed in the past decade. Inflation, rather than reverting to former levels, is expected to exhibit volatility, with an overall tendency towards growth. This change in pattern, which is especially nuanced in developed markets, has profound implications for asset classes and their correlations. The need for nuanced understanding of inflation cannot be overstated. For instance, while transient fluctuations like gas prices may oscillate, the general trajectory of prices is a gradual increase. This trend is likely to drive greater volatility across asset classes over the next decade, underscoring the necessity of robust risk management techniques in portfolio construction. Economic forces, from growth dynamics to wage patterns, further complicate the inflation landscape. The difficulty of accurately predicting and effectively managing inflation intensifies these challenges. The relationship between economic growth and inflation is complex. On one hand, strong growth and low unemployment might suggest an economy primed for inflation. Conversely, market signals such as expected rate cuts can muddy the waters. These conflicting indicators, coupled with structural challenges and looming geopolitical uncertainties, necessitate an agile and diverse investment strategy. Such a strategy should incorporate a balanced mix of equities, government bonds, and inflation-protected assets to efficiently navigate changing environments. Rising interest rates, attributed to global events and uncertainties, have led to increased variance in inflation. These factors, combined with the evolving inflation dynamics, have altered the volatility and performance of asset classes. The situation calls for investors to adapt and prepare for higher volatility across assets than in the previous decade. In light of these factors, the discussion suggests a diversified portfolio strategy, including a mix of equities, government bonds, and inflation-protected assets. This should be coupled with avoiding overweighting high-risk allocations and emphasizing diversification. As the economy continues to grow, with no imminent recession in sight, the conversation suggests that equity prices are likely to continue their upward trend. However, the current structure of the macro cycle requires rates to go up, exerting pressure on assets and leading to a reduction in inflation. This process will take time and cannot be achieved within a year, suggesting caution and a need for understanding the power of labor in shaping inflation dynamics. In conclusion, the podcast highlights the importance of diversification to mitigate risk and to achieve investment success. It suggests that investors should build a diversified equity portfolio, a diversified government bond portfolio, and a diversified inflation portfolio that includes trend-following strategies. The discussion also emphasizes the need to be agile in moving capital within the portfolio to take advantage of macro inefficiencies, with an optimistic economic outlook and expectations of continued growth in the face of potential inflation challenges. The lessons from the conversation encourage investors to be prepared for inflation shocks, diversify their portfolios, and adjust their strategies based on the current economic and inflationary environment.

Topic Summaries

1. Inflation and Monetary Policy

Inflation and monetary policy are discussed in the conversation. It is explained that there is a changing position on monetary policy and a misunderstanding of inflation. The participants emphasize that inflation does not simply go back to previous levels and that there will be volatility in inflation. For example, gas prices may go up and down, but overall prices will continue to rise. The ReSolve team mentions that there is a need to understand that inflation works differently in developed markets. They also discuss the impact of inflation on asset classes and correlation relationships. The discussion suggests that there will be higher volatility across assets in the next decade due to inflation. The team mentions the importance of managing risk associated with asset positions and the need for risk management techniques in portfolios. They also discuss the potential re-emergence of inflation and the impact of economic growth and wage dynamics. The discussion highlights the difficulty in predicting and managing inflation, as well as the challenges in addressing inflation on the first try. Overall, the team emphasizes the need to be prepared for inflation and to diversify portfolios to mitigate risk.

2. Impact of Inflation on Asset Classes

Inflation volatility has a significant impact on asset classes and their correlation relationships. The team emphasizes that interest rates have experienced a substantial increase, leading to more variance around the average. This increase in rates is attributed to factors such as geopolitical events and global uncertainties. For instance, the invasion of Ukraine and saber-rattling in Taiwan contribute to the potential for greater variance in inflation. The changing environment and inflation dynamics have altered the volatility of asset classes, affecting their performance. The team suggests that investors need to adapt to the current situation, which includes preparing for higher volatility across assets, than in the previous decade. The conflicting signals from the economy, such as strong economic growth and low unemployment, coupled with expectations of rate cuts, create confusion. The structural difficulties are further compounded by the upcoming election year. To navigate these challenges, the team recommends a diversified portfolio strategy, including a mix of equities, government bonds, and inflation-protected assets. Additionally, it advises against overweighting high-risk allocations and emphasizes the importance of diversification. The discussion concludes by highlighting the need for a macro cycle that includes a sequence of events, such as rising rates, pressure on assets, reduced consumer demand, softening employment market, and a subsequent reduction in inflation, to achieve a soft landing.

3. Expectations of Inflation

Inflation expectations are being challenged in the conversation as it discusses the likelihood of higher inflation in the future. The ReSolve team highlights that people are expecting a reduction in prices, but inflation does not work that way. Instead, inflation is likely to have a wider range of outcomes. The IMF paper reviewed a hundred inflationary shocks and found that inflation cannot be solved on the first try. The discussion emphasizes the need to be prepared for inflation shocks and mentions that there will be higher volatility across assets than in the previous decade. It suggests diversifying portfolios with a solid equity portfolio, a diversified government bond portfolio, and a diversified inflation portfolio that includes trend following strategies. The team also mentions the potential re-emergence of labor power, leading to wage inflation. It argues that there is no recession on the horizon and that equity prices will continue to rise, as companies have no reason to cut staff. The discussion concludes that the current structure of the macro cycle requires rates to go up, which will put pressure on assets and eventually lead to a reduction in inflation. However, this process will take time and cannot be achieved within a year.

4. Economic Growth and Inflation Dynamics

The ReSolve team explores the relationship between economic growth and inflation dynamics. It suggests that there may be a re-acceleration of growth and inflation in the service economy. It cautions against becoming too sanguine about the current low inflation, as it may be the trough of a wave and inflation could re-emerge. For example, the team mentions the potential for labor to demand a larger share of the pie, leading to wage inflation. They discuss the importance of understanding how inflation works, noting that prices do not simply go back to pre-2020 levels, but can continue to rise. They also highlight the impact of monetary policy on inflation and the potential for higher volatility in asset classes. They emphasize the need for investors to be prepared for inflationary shocks and recommend a diversified portfolio that includes government bonds, commodities, and trend-following strategies. They conclude by discussing the potential for a hotter than expected economy and the importance of considering the power of labor in shaping inflation dynamics.

5. Preparing for Inflation

Preparing for inflation is an important aspect of portfolio management. The discussion emphasizes the need for diversification to include assets that perform well during inflationary periods. The team suggests building a solid diversified equity portfolio, a diversified government bond portfolio, and a diversified inflation portfolio that incorporates trend following strategies. Trend following strategies, in particular, are highlighted as effective in bear markets and inflationary shocks. These strategies have a set of characteristics that can be relied upon to be present during periods of pronounced trends. Additionally, they straddle the commodities and bonds space, providing a preventative measure and preparation portfolio. The team also emphasizes the importance of not letting highly volatile allocations dominate the portfolio and recommends adjusting the allocation based on risk perspective. Overall, the key message is to be prepared for inflation by diversifying the portfolio and including assets that have historically performed well during inflationary periods.

6. The use of carry strategies and alternative betas to enhance portfolio returns

Carry strategies and alternative betas are explored as a means to enhance portfolio returns. The concept of carry is explained as a strategy that performs well in both positive and negative growth shocks. The portfolio is discussed in terms of diversification, with the suggestion that an equal allocation to assets that perform well in different scenarios can help manage risk. The duration premium is mentioned as a reason why longer duration bonds typically have higher returns than shorter duration bonds. The idea of carry as a complement to stocks and bonds is emphasized, with the suggestion that it can help mitigate drawdowns. The team also mentions other risk premiums that can be added to the portfolio, such as merger arbitrage or fallen angels premium. The importance of being agile in moving capital within the portfolio to take advantage of macro inefficiencies is highlighted. Overall, the team suggests that carry strategies and alternative betas can be effective in enhancing portfolio returns, especially when combined with other risk premiums and a diversified approach to asset allocation.

7. Investing in inefficient markets and the benefits of diversification and alternative strategies

Investing in inefficient markets can offer the potential for higher returns. The ReSolve team highlights the benefits of investing in concentrated value ETFs and diversifying one’s portfolio. It emphasizes the importance of not letting the market dictate investment decisions, and considering alternative strategies. By investing in value stocks, investors can outperform the market and achieve positive returns. The team also discusses the concept of carry and the do no harm portfolio, which includes assets that perform well in different economic scenarios. They suggest that longer duration bonds tend to have higher returns than shorter duration bonds, and equities require even higher returns due to the growth risk involved. The team encourages investors to have a solid diversified equity portfolio, a diversified government bond portfolio, and a diversified inflation portfolio that includes trend following. It also advises against overweighting one allocation from a risk perspective and recommends adjusting allocations based on volatility. Overall, the ReSolve team highlights the potential for higher returns in inefficient markets and the importance of diversification and alternative strategies in achieving investment success.

8. Economic Outlook and Market Expectations

The economic outlook and market expectations discussed suggest that the economy is likely to continue growing without a recession on the horizon. It is mentioned that there is strong economic growth in the US, with low unemployment and stable wage growth. Despite these positive indicators, there are confusing signals in the market, such as the pricing in of rate cuts in the next 12 months. However, the ReSolve team argues that companies have no reason to cut staff as long as equity prices keep rising. The market forces may eventually lead to staff reductions to preserve earnings, but for now, the outlook is for a hotter than expected economy. The team also highlights the importance of considering the current market conditions and not being overly cautious. It suggests that the mispricing in the market is due to the amount of fiscal largesse and government spending, which is keeping the economy running hot. They conclude by mentioning the possibility of inflation re-accelerating in the future, which could lead to the Fed holding or even raising rates. Overall, the economic outlook presented is optimistic, with expectations of continued growth and potential challenges in managing inflation.


[00:00:00]Rodrigo Gordillo: Why are we seeing more random events, more spikes of asset classes than ever? And really, I think it comes down to the fact that prior to 2020, for many, many decades, we had been managing the situation both like, with the way the Fed had to manage the situation, and how advisors, by virtue of that, had to manage the situation. It was a two-dimensional game I think, this concept of balancing on a barrel, right?

You put a plank on top of the barrel and you’re either going left or right. It’s a two-dimensional kind of balancing act that you practice it long enough, you kind of figure it out somewhat. It was, it’s not as difficult to game as when you introduce a third variable. So back then, the variable was either a positive growth shock or a negative growth shock. The variable that was introduced in 2020 was inflation. And we equate that as having to balance yourself on the top of a ball now, right? That is a three-dimensional game.

 [00:01:05]Rodrigo Gordillo: All right. Hello everybody, and welcome to another episode of ReSolve Riffs. This time it is truly a ReSolve Riffs episode. We haven’t done one of these in a while, guys. We thought that it would be a good idea to revisit some of the discussions that we had last year with regards to the Global macro space, how it affects the alternative, the liquid alternative space, and really just dig into what the setup is now, how our views have changed or if they have at all. And, I have here our CIO of ReSolve Asset Management Global, Adam Butler, our CEO, Michael Philbrick, and myself, President of ReSolve Asset Management Global, Rodrigo Gordillo. So let’s get into it, guys. You know, one of the key topics that we talked about over and over again that I get a lot of flak on, is the idea of inflation. More specifically, I think, the way we frame it is different, and people get confused, but the concept of inflation volatility.

[00:02:07]Adam Butler: You know what, actually, before you even go there, I think it’s even worth talking about the idea of inflation. And I don’t mean like what the macro definitions are and stuff. I just mean like rate of change versus a change in the price level, which I think, which really gets people confused, right?

So most people, or many people anyways, sort of think that inflation means that prices have gone up, right? Well, and which is fair, right? I mean, that’s what you feel. It’s what you feel in your pocketbook, and it’s what gives you anxiety. You go to the grocery store and the prices are higher than they were a year ago. Maybe your income hasn’t kept up.

But for economists, they only really worry about rate of change, right? So you can have a major, prices over the last year could have gone up 20%. But if they’re no longer rising, then economists say there’s no more inflation, right? So when we talk about inflation, we’re referring to the current rate of change, not, has the price level risen over the past X number of months or years or whatever.

So, at the moment we had a major price shock, for a bunch of reasons. We had huge supply chain shocks because we had shipping shutdown and manufacturing shutdown during the epidemic. And then we had a major demand shock because governments around the world were handing out money as a substitute for income, because so many people couldn’t work. But they had all this, now they’ve got all this money to spend, they’ve got all this money to spend, but there’s a slowdown in manufacturing and shipping, so there’s not enough goods and services to consume. So we had this price shock. There’s a bunch of other dimensions of that. We don’t need to get into all of it, but I think that’s what we sort of saw in early 2022, right?

So as everyone was now paying attention and there was emotional salience in early 2022, because there had been this major price shock, and what we’ve seen over the ensuing sort of 18 months is that the rate of change of the price level kind of peaked in mid 2022. The rate of inflation has stayed high, but it has come down, right? So the year over year price change is going up at a much more moderate rate now. And so now the markets are not so fearful about an acceleration, a continued acceleration in the rate of change of inflation. And the Fed has become more comfortable about that as well. And they’re beginning to change their position on monetary policy, right? So that’s kind of, that’s what’s a very …. over the…

[00:04:48]Rodrigo Gordillo: But it is super important to talk about that because even the President of the United States, or at least his Twitter account, isn’t getting it right. Right? This idea that people are expecting a reduction in prices. They want prices to go back to what they were prior to 2020, but that’s kind of not how inflation works. Prices just go up. The question is whether they’re going up…

[00:05:08]Adam Butler: Well, they can go down. I mean, I…

[00:05:10]Rodrigo Gordillo: But the price level…

[00:05:12]Adam Butler: …see prices go down pretty…

[00:05:14]Rodrigo Gordillo: But let’s…

[00:05:14]Adam Butler: …in the short term.

[00:05:15]Rodrigo Gordillo: But in developed markets, I think people look at Gas prices going up and down to previous levels, right. And so they see a single line item that goes down and they’re thinking, when’s my fruit price going to go down?

What is, where is how, how is it that my household is spending 20% more than they did two years ago? And why isn’t that going down? Well, it’s never going to go down. What’s happening is you’re going to ask for higher, you’re going to ask for a raise. You’re going to ask for higher wages, so that your discretionary spending can remain at pace with that new price appreciation as the basket of expenses. And so, I think the people who are clamoring for lower prices just simply are having a hard time understanding what reduction in inflation is, and that’s partly the industry’s fault in terms of language. And when they say inflation has reduced, they’re not talking, the average person thinks they’re saying prices are going down, when what we actually mean is that the price appreciation has tapered somewhat.

[00:06:20]Mike Philbrick: It’s the variance around that steady rate, and it’s been in the narrative that the Fed has had to dance around. To me, it’s been plainly obvious that Adam’s foresight on inflation, volatility being the thing to focus on, was bang on. The inflation is transitory. How transitory is it? Well, it’s so transitory that we had to raise rates faster than any time in history because we kind of shit our pants a little bit because it didn’t look transitory, even though we were talking it up as transitory.

That is the inflation volatility that Adam brought to the forefront for us to chat about a couple of years ago, was the fact that the rate can be 2%. But how wide is the bell curve around the 2%? Sometimes it’s zero and sometimes it’s six, versus just being two. And from 1982, the falling of the Berlin wall, the opening up of China, the globalization of the world providing so many disinflationary types of opportunities for markets to take advantage, lower, lower interest rates.

That paper by … Fire and Ice just showed how little inflation volatility that we had over such a long timeframe, where the participants of the market didn’t have any real experience with it, and now we’re conversely in another environment, and inflation can run at the same rate it had prior to 2022, with a much larger variance around it.

And that changes everything. It changes the volatility of asset classes, it changes the correlation relationships with those asset classes. And that has occurred. I mean, that has happened. We have rates that were zero and then were five, you know, maybe four in the US, but you know, around jigs and reels. If you wanted to take a little bit of credit risk and whatnot, you could get more than four.

But let’s call it the tenure you came to four, or the two year rather. That’s a pretty significant increase. And we’re in for more of that. We don’t have de-globalization. The Berlin Wall is not falling. Ukraine has been invaded. Taiwan is saber rattling. We’ve got all the things in the Middle East that are adding to the opportunity for simply more variance around the average.

[00:08:39]Rodrigo Gordillo: And I think one of the, one of the analogies that we used back then that I think is important to bring back to the forefront is, I was in a podcast interview yesterday and I was asked like, why are we seeing more random events, more spikes of asset classes than ever? And really, I think comes down to the fact that prior to 2020, for many, many decades, we had been managing the situation, both like with the way the Fed had to manage the situation, and how advisors by virtue of that, had to manage the situation. It was a two-dimensional game.

I think this concept of balancing on a barrel, right? You put a plank on top of the barrel and you’re either going left or right. It’s a two-dimensional kind of balancing act that, you practice it long enough, you kind of figure it out, somewhat. It was, it’s not as difficult to game as when you introduce a third variable. So back then, the variable was either a positive growth shock or a negative growth shock. The variable that was introduced in 2020 was inflation, and we equate that as having to balance yourself on the top of a ball now, right? That is the three-dimensional game. And while it is possible to do, if you have the right portfolio, the right balance, the right preparation, the right prediction, it is going to lead to a lot more jittery balancing acts, and you’re going to be caught off side more often than you have in your previous investment career.

And introducing this inflation variable will require allocators and investors to really throw away their intuition as to how they think the markets work, based on their personal experience. And they’re going to have to start digging into, wait, how does the market actually work during a period of inflation volatility, like the seventies, like the forties, like the 1920s. And when you examine that, you realize that hey, it’s just more volatility everywhere. Asset volatility goes up, whether it’s on currencies, equities, commodities, bonds, and as asset volatilities go up, there’s opportunity sets. But there’s also risks, if you are still playing that balancing on a barrel game. You’re not going to find the same success. So I think, the question that that we started with is, has our thesis about inflation changed? No. The thesis was not that it was going to be an inflationary period. The thesis was that there’s going to be a lot of inflation volatility, so yeah, we’re kind of sticking to…

[00:11:09]Adam Butler: The current waning of the rate of inflation for the Fed, or the authorities, or easing of economic situations that were exerting artificial, all these variables are sort of conspiring to tame inflation permanently. And I think at this point, what’s more likely is that we are just, as we said, inflation is going to have a wider range of outcomes than we’re used to over the last two or three decades, in the next decade or so. And we just happen to be sort of near the trough of one of those waves, right? For whatever reason the Fed and probably a variety of other dynamics, we’ve had a slowing of the rate of inflation, and people are becoming a little bit more sanguine right at the point when it looks like growth is beginning to re-accelerate, and inflation is beginning to re-accelerate, especially on the wage front and in important service sectors of the economy.

So, you know, we could easily go back to some of the dynamics that we experienced over the last few decades. I mean, look, if you wanted to buy a TV 10 years ago or 20 years ago, you can buy a TV now that is vastly superior than what you bought 10 years or 20 years ago, for either the same price or a lot less, right?

So, you know, manufactured goods, especially technology-driven manufactured goods, have continued to go through deflation, right? They’re in, especially when you adjust for the utility you get from them. But we don’t really make a lot of new humans, and so the humans are involved in the service sector, and oftentimes you can’t really scale what a human does from day to day, right? Now new technology might be able to implement some pretty substantial changes to that over the next five or six years. We could get into what is happening in AI, but at the moment you can’t really replace humans further, in terms of the service economy. And that is where we continue to see a re-acceleration of growth and a re-acceleration potentially of some inflation dynamics.

So we shouldn’t get sanguine just because we’ve seen inflation tame over the last little while. We’re probably just at the trough of a wave and about to see it re-emerge.

[00:13:46]Rodrigo Gordillo: And, and I was just kind of reviewing some of the notes I had on that IMF paper that went back a hundred years to review a hundred inflationary shocks across all the major countries. And one of the things that they found is that, number one, we don’t nail the inflation problem on the first try. It just doesn’t happen. There’s both structural reasons why not, and there’s political reasons why it’s really unpalatable and difficult to do. And so it doesn’t matter who you are, you’re probably going to have a few tries before you put that genie back in the bottle. The other interesting thing is that those countries that actually did a good job of aggressively dealing with inflation ended up having a negative growth shock that was more pronounced initially, but a significantly higher growth rate five years later, versus countries that did not have that.

And I don’t think, as you look at the landscape, especially, I think it’s more pronounced in Europe where they have, their economies have been much weaker. In the US where they’ve actually stopped raising rates, even when the inflation rate was still higher, and we’re starting to see the impacts of that.

And by the way, that speaks to that diversity in policy, speaks to that, what we’re chatting before, how it’s likely to be higher volatility across assets than we’ve seen in the previous 10 years, right? It’s just, it’s not as uniform as it used to be. And so, yeah, I think we need to get used to the fact that right now we have strong economic growth.

Still, in the US we have low unemployment. We have continued stable wage growth. Yet we have 175 basis points, 200 basis points priced in, in terms of cuts in the next 12 months, right? There’s, this is the type of confusing signals that one gets. Is it over? Are we, now have we hit our inflation marker?

Is the Fed going to reduce rates when inflation is still going up? Are they actually going to ease? So it really is structurally difficult. And then we’re going to an election year where people like Yellen have actually pulled levers to stimulate the economy, when Powell is actually trying to put the brakes on.

So I, we can see how it’s becoming more and more difficult on the inflation side, to navigate this easily. And so it really comes down to what can investors do when we don’t know when the accelerator is going to be pushed, and when the brakes are going to be pushed, and when they’re both going to happen at the same time? So any thoughts on that, on how, what it looks like for investors and what investors can do to deal with that environment?

[00:16:33]Mike Philbrick: Well, the first and foremost is to think through diversity in the portfolio, which is always very difficult to times like this. Assets that have treated you so well for so long, and now you’re going to de-emphasize them. And why now potentially is the challenge. So are, Return Stacked and  Return Stacked is about not having to sacrifice that.

But again, when you think about the discussions lately you’ve seen around valuations, and valuations of what obviously is a very important consideration there. So, US markets, they’re at high valuations. They’re not the highest valuations, they’re at high valuations. What do high valuations mean? Well, they mean that future returns are probably lower because you pull those future returns into the present.

And that’s why valuations are a concern at the moment. So if you are going to ride that momentum wave of AI tech, US equities, you should be quite diligent about managing the risk associated with those positions because when a strong trend upwardly, high valuations becomes a strong downward trend.

That’s where you get periods like 1929, 2000, Japan circa 1990. This is where you get wealth altering events, that are wealth altering and not the way you like. And so if you’re going to take the chance of saying, well, the trend is still so strong, okay, that’s great, well then you better have some other risk management techniques going into the portfolio. Something that’s going to counterbalance that.

Now you could take the view of, well, let me look further afield. Let me look into the small caps. I look into value. Let me look into emerging markets. And there you see valuations that aren’t stretched. Actually, you might even see downright discounts, but it’s again, we come back to the turkey story. You know, how does the turkey know when Thanksgiving’s coming? The farmer treats him real well, and it gets better and better until it’s Thanksgiving. And so this is not an easy challenge and it’s a behavioral trap of recency bias. And overconfidence happens every time.

You know, investors today are expecting 15% return over the last five years. Why? Because they’ve got 15% return with last five years. What’s the long term? The long term’s 10. These aren’t real, obviously these are nominal, but if you did 10, you have to do something else in order to get the, if you’ve done 15, rather to get back to 10, you’ve got to spend some time below the average, and that those corrections have one of two…

[00:19:09]Rodrigo Gordillo: But that’s 10 real, right? Like 10 real versus the long term equity risk premium. real is more like four.

[00:19:17]Mike Philbrick: Of course. And all of that is valuation, that all of that excess return is increased valuation. Now those correct through either time or price. So either you get a very long period of not very good performance while valuation catches up, or you get a significant decline in the markets and those types of things.

We saw it in 2000. We saw the equal weight or small cap stocks actually have positive performance, while the S&P 500 was down 50%. Wasn’t great positive performance, but it was positive, simply because the valuation was way too high in those S&P 500 stocks, and it was reasonable on the rest of the marketplace, which is not too far from here.

So an investor has a choice. They can start to think about those quality factors, start to think about diversity in the portfolio, in the stuff that their friends don’t have, that they’re, they don’t know, that they don’t love, that they don’t trust. Or they can start layering on diversifying strategies like we talk about in the Return Stacked portfolio solutions website and suite, where you take those betas that you know, love and trust and stack upon them diversifying strategies so that when there’s blood in the streets, you actually have something to go buying with.

[00:20:32]Rodrigo Gordillo: Yeah, what’s crazy is, as we came into 2022 and saw the biggest rip-your-face-off drawdown in bonds, I mean it’s, was it officially like the largest drawdown for the long, for the 30 year Treasury in history? I think I heard that. I’m not sure, but it certainly was one of the most aggressive and largest drawdowns.

[00:20:56]Mike Philbrick: I think you gave back half of the returns.

[00:20:58]Rodrigo Gordillo: …at that point, I’m like, that’s the lesson. That’s where people are like, oh, okay, things have changed that you got, and we dropped equities and bonds, number one correlated, which wasn’t supposed to happen. We had a lot of discussions last year. People were like, when is the market going to get back to normal?

And I’m like, that is normal in a rising rate shock environment. That is normal. You just, you haven’t seen it in 40 years. And I thought it was going to change, you know, the chip was going to be changed. We got to figure it out in a different way. I’m scared of just going, you know, 60/40. But what’s happened is, I think all of those accumulated lessons from the previous 10 years, which is okay, be recovery from here. And they have been, it worked out for them. They have been rewarded once again, right? Been rewarded again. They’re like, I don’t know what you’re talking about, Gordillo. Like that was just a blip, right? That was just a blip. Don’t worry about that. That’s a thing of the past. And I think, the benefit, the problem there of trying to show things like, hey, commodities actually were the best performing asset class in the last couple years. Hey, by the way, managed futures is still the one of the best performing asset classes over the last two years, right?

It was up the, the index, the SocGen Trend Index and CTA Index we’re up double digits in 2022 and then gave back half of that maybe a bit more in the last year. Well, the lesson is that was momentary. I’m out, no need, you know, that’s what I think we’re still dealing with today. And if inflation volatility, the inflation volatility thesis plays out, that’s not the only time it’s going to happen, right? It is exactly within the thesis. And now how do we get people to diversify, right? To just move away from that equity/bond exclusive portfolio.

[00:22:48]Mike Philbrick: Let’s maybe not, let’s not let them, make them move away. Let’s stack some things on top.

[00:22:54]Rodrigo Gordillo: I think that is the solution, right? It’s like you’ve got to, how do you get people to move on this? So, you don’t get them to move. You just get them to put it on top. You don’t get them to sell and get out. You get them to put it on top. It’s, you know, I’m just still bitching because…

[00:23:08]Mike Philbrick: Well, the reality is too, that things can always get more expensive. So if there’s one thing that I think all of us have learned, like if you think the Nasdaq was expensive, go look at what Japan was. It was 60 times or 90 times, whatever the ratio you wanted to use, I think it was CAPE Shiller or whatever it was, but it was a full 60% higher than what happened in the Nasdaq and the S&P.

And it’s interesting. So when you look at a statistical background and say, well, if you have high valuations, does that in fact in the short term lead to anything? And it’s like, no, it doesn’t mean anything really. A lot of the times it means it’s going to get more expensive in the one to five year timeframe, in the 10 to 15 year timeframe.

It’s kind of like gravity, but there’s that meaty middle. And if you look at a scatter graph of that chart, you’ll see all of these high valuation, high returns, which came in the late nineties where it just got more and more highly valued. So we could be in the same situation here, if we get into a world where we just start printing money as we kind of have.

Where things could go to a place where you think people are in a zombie-like trance. Now following these AI stocks, this can, we’ve seen it, this can get way, way more…

[00:24:27]Rodrigo Gordillo: What does Cliff say? It can get to a hundred, 10th decile valuation, right? Way more than a hundred percent. But you know, the value is an interesting thing in terms of sequence of return, of value returns. I think, Adam, you’ve done a lot of work on this, on valuation CAPE Ratio and trying to like assess the forward returns of our five year, 10 year, 20 year. Can you like, I kind of feel like value is one of those things that you get all of the returns in a few months, once every 10 years. And you look at Warren Buffett’s outperformance, it feels like, it’s not like you’re going to get a little bit of that sugar every year. It’s almost like you get it, all of it in once every 10 years and then you can suffer again for another 10. But maybe that’s just my…

[00:25:15]Adam Butler: Well, there’s a couple of different things going on, right? One is sort of, I think what you’re referring to is the character of the value premium, right? And absolutely, value is one of these things where you suffer sort of 80% of the months underperforming the market, and then you’ve got kind of like a six to eight month period that if you miss it, it delivered all of the excess returns that you’re going to see for that decade, right? So you really have to hold your nose and stick with it. A lot of strategies are like that. In fact, I would argue that a big chunk of why you might expect to receive an excess return on these strategies because they’re hard to hold, and most people don’t want to hold them, right? So they’re under-owned.

And when something’s under-owned, it means that you require a higher return in order to entice people to own it, right? And so, I think that’s just the nature of it. Trend following can be kind of the same. Momentum is kind of the same, right? Like people, it just hurts to be different from your peer group.

And it especially hurts the longer that you are accumulating that difference, especially if that difference is negative. So, you know, I think that’s a quality that you need to endure, in order to be able to expect to generate higher than market returns. And then, in terms of the profile of markets when they are expensive relative to their sort of historical CAPE ratio or what-have-you, I think Mike nailed it. You know, for the next year or so, the likelihood is the trend’s going to continue. You know, it’s going to, you’re going to get more expensive, not less expensive and, but, it’s, um, Buffett’s mentor now, that I can’t remember his name of, it’s…

[00:27:00]Rodrigo Gordillo: Charlie

[00:27:00]Adam Butler: Bill Graham who said…

[00:27:02]Mike Philbrick: Billy Graham.

[00:27:03]Adam Butler: Yeah, right. The market is a weighing machine, right? So you have to wait for it to start weighing instead of running on emotions. What makes the current environment so especially challenging for those of us with a sense of history, is just how concentrated. It’s not only just that you’re, the only returns are coming from US cap weighted equities. It’s that it’s coming from like 10 stocks. Those 10 stocks represent more of the index than any 10 stocks have ever represented. So, you know, they actually end up representing approximately the, an average amount of the index’s earnings over  the very long term.

The top 10 stocks do historically generate a disproportionate percentage of all of publicly generated earnings. But the market cap of these companies is just so wildly out of whack. And it’s not like you’ve got a diversified, you know, at least in the, back when the nifty 50’s was in vogue. You had conglomerates with very high valuations, but those conglomerates owned divisions across a wide variety of different segments of the economy. Whereas, you’re very narrowly exposed to a group of tech stocks that are in turn, very narrowly exposed to the future of AI. I mean, I happen to have a strong view on how well AI is going to play out, but whether that translates directly to the bottom line of a few tech conglomerates, I have a great deal of suspicion about.

So, you know, it’s just, it’s a very concentrated bet and it’s concentrated and then, it’s concentrated and then it’s more concentrated. And so, I just find it particularly scary at this point. I want to diversify more than ever, but it’s more painful than ever to be diversified.

[00:29:09]Rodrigo Gordillo: And it.

[00:29:09]Mike Philbrick: It’s the railroads, it’s the internet, you know, as I know you’ve pointed this out to, in the past, Adam, same 500 stocks. You equate them over the last year. You get 6%. You market cap weight. them, you had 22.5. It’s the same five stocks, so obviously market cap is dominating.

So what’s that? That’s, the valuation of those stocks increasing based on the potential for their earnings to increase down the track. Boy, oh boy. Starting to sound like Cisco, Sun, Micro, Nortel. I mean, this dance is getting very familiar.

[00:29:47]Rodrigo Gordillo: It is, and it, and it’s that…

[00:29:48]Adam Butler: Good…

[00:29:49]Rodrigo Gordillo: … discussion of like, this time it’s different. It’s this time it’s different. You don’t, we’re not valuing things the same way we used to, right? We’ve got A!. Now it’s different. We got Bitcoin.

[00:29:58]Adam Butler: Like we had the internet, right?

[00:29:59]Mike Philbrick: Exactly.

[00:30:00]Adam Butler: It was a major thing, accruing profound value for all of humanity and generating massive productivity gains. But it just didn’t accrue to nearly the extent that investors were betting to that small number of companies that were getting all of the benefit of the doubt back in 1988, ‘89.

[00:30:22]Mike Philbrick: What do you mean? Look at Netscape? Wait, wait,

[00:30:25]Rodrigo Gordillo: But this is an important discussion that kind of ties into that misunderstanding of how inflation works. It’s, and we had this discussion with, in our last podcast, you, me, who was it that we were, Bianco, right, which is, look, you should be careful with investing right now, but the economy’s fantastic.

[00:30:50]Mike Philbrick: Hmm.

[00:30:50]Rodrigo Gordillo: Like there’s a big difference between an economy doing well and what your portfolio is likely to do, or what level of danger is it in, right? I think Mike, you used to use an analogy, not a historical analog here, which is from something like 1966 to 1997, the Dow Jones annualized at, sorry, let me get this straight, ‘66 to ’82, the Dow Jones annualized at zero, ‘82 to ’97, it annualized at 16. Growth rates for the first portion of that was about 5. Growth rates for the second portion of that were around 5. Like the, the economy isn’t…

[00:31:27]Adam Butler: GDP growth. Real GDP. Yeah.

[00:31:29]Rodrigo Gordillo: … isn’t necessarily tied to what’s going to happen in your portfolio. I think that it’s what’s priced in, and it’s something that Bob Elliott keeps on, harping on that I love, where he is like, well, what do you think? What’s the setup, and what do you think is happening right now? It’s like, what’s more important is what the market is not pricing in right now. What it’s getting wrong. And that’s how you make money in the market, right? And I think what this, you could, LLMs and machine learning and the tech stocks could be huge for humanity and still be way overvalued and make you zero money over the next 10 years. It could happen, and it has historically happened over and over again. But momentum’s a bitch, right? So it could last a bit longer than what we think.

[00:32:08]Mike Philbrick: It was argued that the part of, part of what happened in the Great Depression was a function of the industrial revolution, and a function of the fact that you did not need all that labor on the farm. The family farm became obsolete, but there was no place for those workers to go. You had a tractor, you didn’t need a horse, you didn’t need a family, you had a tractor, and you had the amalgamation of all of these family farms, which left quite a number of people displaced.

It’s not the only reason, but boy oh boy, if you start displacing three or four or 7% of your employment force because you can make the remaining ninety-five percent more efficient through the use of AI, and then you start to interplay robotics into that, there’s a dislocation there that is not, it’s, this is not talked about very often, and it’s not unusual. Happened with the telephone.

It happened every time there has been a major leap in some sort of technology. Oftentimes it comes with a displaced workforce that needs to be retrained, and how big that workforce is, and what the infrastructure is within the country to retrain it, or what the policies are around re-education and retraining, are incredibly important points to mitigate those factors.

And it’s not being talked about, but if AI is this boon and productivity, okay, well, does that mean we’re all going to make more and produce more, and everyone’s going to consume more, and it takes less? Or will some portion of the labor force be displaced for a period of time?

[00:33:52]Rodrigo Gordillo: Yeah, the addition of all that could be lack of a reduction in productivity for a short period of time, until we get an outstripping of productivity that’ll help reduce government debt, and all these wonderful things that productivity tends to do. But there, this is the thing about preparation and prediction, right?

And I think we’ve been talking about all of these continued gaps in understanding of inflation, and how valuations work and what it can, it’s really tough to then know how to position your portfolio to benefit from these understandings, and it’s really, really difficult to do. So the first thing that we always advocate for is make sure, if you guys are listening to this for the first time, the key thing to take away is, you’ve got to put most of your effort in preparing your portfolio for those shocks. And so you’ve got to have something for bull markets, which generally tends to be equity indices, globally diversified, hopefully, right? So that’s another thing.

Is it going to continue to be US domination? Probably not. If history is any indication, you have to have something for bear markets. And this goes back down to, not credit, but government bonds, right? When there’s a non-inflationary bear market and panic ensues, people give money to the government and they start bidding up bonds, government bonds across the G7 especially, right? So you have that opportunity set to protect your portfolio in bear markets. And then the third one is commodities, in periods of high inflation shocks, and we saw the benefit of that in the last couple of years, right? That’s preparation.

I think, we used to talk about prediction in the context of our alpha sleeves, but I think we can talk a bit more about preparation, with the introduction of Trend replication strategies, right? So this, I think that’s more now become a bit of an alternative beta that has a set of characteristics that we can count on to be there in periods, especially of pronounced trends. A prolonged and sustained trend like we saw in the first quarter of 2022, we saw in ’08.

In periods of duress, Trend following managed futures strategies tend to be really, really good in bear markets, multi-month, multi-year bear markets, as well as inflationary shocks, because 50% of what they trade is in the commodity space. So I would say in terms of preparation, we have to consider, as investors, a solid diversified equity portfolio, a solid diversified government bond portfolio, a solid diversified inflation portfolio that should include that Trend following portion, and that’s a hybrid one because it also tends to help bonds, right? So it’s kind of like, it straddles commodities and bonds in terms of its benefit as a preventative measure, as a preparation portfolio. And then just make sure you’re not letting the maniacs take over the asylum, as we’ve always talked about. Don’t overweight, one allocation from a risk perspective.

So those that are highly volatile, should get less. And those that are lowly volatile should get more, right? And that’s the beginning. I think for me, you know, I’m kind of that set. If I had to like tell my wife, listen, I got one day to live. What are you going to do for the … this is what you’re going to do. You’re going to allocate to something like this. Talk to your advisors. This is not investment advice and all that. But, my wife would get a very simple portfolio.

[00:37:20]Mike Philbrick: So is it your wife that has one day to live or you I, I…

[00:37:22]Rodrigo Gordillo: That’s, see how I feel about that. So I think the message here is it’s going to be complicated, right? And it’s, and you got to start with that. I think that’s how you minimize the shocks that you’re going to get. And then we can try to add more innovative ways to diversify, and we can talk a little bit about the replication world that’s coming out. Mike, you had some thoughts there that make it even more valuable these days to, to really think about that space. So why don’t you tell us a little bit about that.

[00:37:56]Mike Philbrick: Well, I think that when you think about harnessing the Trend factor via managed futures managers, commodity trading advisors like we are, you’re thinking about harnessing both long and short exposures across bonds and stocks, currencies and commodities. Like you already mentioned in the past, these have been harder markets to take advantage of, and they’ve had higher fees associated with them.

So in our Trend Replication Paper, we go through a process of thinking through how you might replicate those return streams. And there’s a bottom-up method and there’s a top-down method, and you get very high correlation to, the Trend factor in the CTA space. But the nice thing is you’re picking up a massive fee alpha, because in the replication, if it were a product would, let’s say the product is done at 1%, but if you’re trying to replicate the B top 50 or the SOCT and Trend Index, those indexes actually include real managers.

But the real manager’s fee is 2 and 20. So let’s say next year, this year is like 2022. We have a really difficult year for stocks and bonds and the Trend factor does really great. Well, if you’re in those higher priced managers, let’s say the return is 20%, and I’ll play a little fast and loose with the numbers.

Well, you got a 20% performance fee minus the 2% management fee. You end up with 14%. That’s great. In a year like 2022, boy, up 14, especially when the world fell apart, and down 25. If you do it through a Trend replication process and save the fee, let’s call it 1% fee, you’re now up 19% versus 14%.

That’s 5% in fee alpha. And we have to remember that you pay the fee when you make the money, and when you make the money in these types of strategies is when the rest of the portfolio is really suffering. So where do you want the 5%? You want it in your portfolio, not the managers, because that gives you the opportunity to rebalance.

It gives you that extra money to buy when there’s blood in the streets. It also prevents you from making the error of buying one of the managers in the dispersion where, you know, if the average is 21, got zero, one got 40. If you have this diversifier that put up a zero in a difficult time, that is going to be a really challenging conversation for the asset owner, if you’re the advisor.

Now, larger asset owners can buy many of these managers and diversify across that, but RIAs, Registered Investment Advisors, smaller DIY investors, may not have the capital to be able to allocate to these very large managers, you know, $5 million at a time. And so the process of replication gets rid of the dispersion, and it allows for a higher capture of the upside when you would pay the fees and when you want that upside in your portfolio.

[00:41:00]Rodrigo Gordillo: That’s an interesting point that I hadn’t actually zeroed in on, until we did the analysis, right? Like, where is the fee alpha? Obviously you just needed to look at it, but it was like, oh, right, you’re, when the SocGen Trend Index, whatever index you’re following, is going sideways or down, there’s not a lot of difference, right?

It’s what I thought. I thought there was some value in doing some replication. What’s going on now? The value accrues, most of the value does really accrue when it’s these massive upward swings and it’s, Cliff’s saying, it hurts when it hurts to get hurt, right?

That’s generally what value I think investing is in this case. It pays when it hurts to get hurt, and you want to get paid the most when it hurts to get hurt. And I think that’s, the fee alpha there is a crucial thing to contemplate if you’re thinking about allocating to those type of strategies.

I want to move on to other things. So we talked about, I think the basis of a do-no-harm portfolio. A Hippocratic Oath portfolio that you can count on. There are things that we can do that we’ve liked over the years, that we’ve implemented internally. And Adam, you did a great summary of this a couple years ago for us, but I want you to kind of talk about it again because if you think about diversifiers, what is it that you want to continue to add on? Once you have your prediction portfolio down, you want to add on things that have a positive expected return that have been true, tried and tested in history. You’re not kind of creating it out of thin air and hope that it works. And you want something that is lowly correlated to your existing sleeves. And one of the things that keeps on coming up in our radar is that Carry strategy or what we, managed futures yield or alternative yield. But can you walk us through again, you know, what is Carry, why we think it works, why we think it exists? And maybe we can talk a bit about some of the benefits of including it into a portfolio.

[00:43:06]Adam Butler: Yeah, I mean there’s a number of frames to explore the concept of Carry. A good place to start is from the Do No Harm portfolio that you described earlier, where you kind of have an equal amount of your risk in assets that do well in inflation shocks, an equal amount that do well in positive growth shocks, and another that do well in negative growth shocks. So you’ve got the sort of equities, commodities, bonds. The idea there, is you just sort of assume that over the long term there’s a duration premium. In other words, investors require a higher return to lock up their money for longer. So longer duration bonds on average, typically have a higher return than shorter duration bonds, required even higher return to put your money in equities because you’re taking on this growth risk.

You know, five years could go by and the value of the portfolio is lower today than it was when you invested in it. because you don’t know what the trajectory of that price evolution is going to be, and that over time, because of the steady drum of inflation, commodity prices are going to rise. But there actually are a double handful of extended periods over the last a hundred or so years, where those basic assumptions don’t, actually, they’re not true, right? And we just went through one in 2022.

So, like I said, typically longer duration bonds have a higher return or higher yield than lower duration bonds. Well, at the moment, and you know, for the last couple of years or so, that has been reversed. And so investing in longer duration bonds and locking up your money for longer has actually earned you lower returns than just keeping your money in T-bills or two year bonds, right? So why are you taking more risk for less return?

That equation is inverted in commodities over the long term. You do end up earning a roll yield because the near-term commodity is at a higher price than the commodities, sorry, than the contracts that are further out on the curve. That the, as those further out on the curve contracts roll up, they approach the, being the most recent contract or the nearest term contract, they approach the same price as the near-term contract.

So they roll up in value, right? So you earn this kind of roll commodity yield, but a lot of the times commodities are, that is inverted. And so you actually, if the price of the commodity, if the spot commodity doesn’t change, you actually want to be short the commodity, because the far away contracts are higher than the spot and they’re going to roll down, and you’re going to expect that price to come down. So, you know, the idea of Carry in this context is, well yeah, you want to have equal allocation to, equal risk allocation to all of these different areas of the economy, and different financial markets, for these diverse reasons, but you don’t always want to be long them. Sometimes you want to be short them, right?

And so Carry is just the return that you expect to get on a market. If the price doesn’t change in equities, it’s the dividend yield and bonds. It’s the coupon. And in commodities it’s this roll yield that we discussed, right? Well, most of the time this duration premium and bonds is positive.

Most of the time the equity risk premium is positive. You know, dividends, the dividend plus shareholder yield is higher than the risk-free return, etc. You just want to be allocated to all these different asset classes, but in the direction of the expected premium, right? Yes. Most of the time that premium is positive, but Carry, because it allows you to go short, it gives you a chance to earn that premium when the sign flips on it, right?

And I mean, there’s a good question on why this premium exists, especially in commodities. And I really like the idea that Carry in commodities is a win-win. It’s a win for producers and it’s a win for speculators. It’s a win for producers because they want to sell their production forward to lock in a price and have visibility on what their earnings are going to be. And the equity and credit holders that supply those producers with the capital to run their business really like having that earnings visibility because their earnings volatility is a lot lower, and they’ve got a much higher probability of being able to deliver those dividends, and pay those coupons to the money, that loan those firms the money to operate.

And so those companies are willing to pay speculators a premium in order to take on that price risk. They lock it in, the speculators take on the price risk, and so the speculators get paid basically for selling insurance on the earnings of the producers. The producers make out and the speculators make out Because they’re selling insurance and earning that premium. So, you know, it’s great to think about Carry as just a really great way to get access to a diversified basket of asset classes in the direction that they are currently paying that premium, rather than always assuming that that premium is positive.

[00:48:37]Rodrigo Gordillo: Sorry to interrupt, but I did want to take a quick second to remind listeners that while we do absolutely love providing our audience with world class guests and weekly investment insights, we wanted to remind you that we actually do our best work outside of this podcast. And we try to do this by providing cutting edge, globally diversified, and systematic investment strategies that are designed to be broadly non-correlated to traditional equity and bond portfolios.

So we actually manage private and public funds, as well as bespoke separately managed accounts for investors that seek the potential to smooth out portfolio returns in the long run. So if you do want to see that theory that we’ve been talking about put into practice, please do go ahead and check us out at Now back to the podcast.

So that’s, that’s a great summary. It’s a great summary. And I think the example for the average investor of  the Carry of a stock being the dividend is appropriate, right? You look at a stock that pays a 5% dividend, you don’t necessarily expect to make 5% total return on that stock, right?

You could make a 5% dividend and at the end of the year that stock has gone down 5%. You made zero, right? So it, the crucial point here is the definition of Carry being what you expect to make if the price doesn’t change. But of course, price does change, which makes it, it’s not a no brainer, right?

It is, again, you’re taking risk. You could have years where that bet is not paying out off for you. You know, in Canada it’s, everybody’s enamored with the big five banks and their big dividends and their consistent dividends that, in 2008 you had negative 55% to negative 75% drawdowns in those banks. It is just another risk premium that you’re taking. The importance here being, how closely correlated is that risk that you’re taking to achieve that long-term return, by choosing futures contracts, whether they’re in contango or backwardation, right? Whether you’re getting a high Carry or a low Carry, what is the correlation to everything else?

And it turns out it’s extremely low when you’re using a diversified set across commodities, currencies, equities, bonds, and the decision making is different than the decisions you’re taking for everything else, right? You’re getting an equity risk premium based on economic growth.

You’re getting a term premium based on the fact that the longer term bond is paying more than the shorter term bond over time. Not all the time. And on Trend, you’re making your choices as to whether to be long or short a futures contract, on anchoring and adjusting hurting effects.

These are cascade effects that tend to explain human nature and people wanting to pile into something for a short period of time. Well, it turns out that the decision to choose something to go longer, a short based on Carry, is very different than Trend. And therefore, even the correlation between Carry and Trend is quite low.

I think our internal numbers show something around 0.25%, right? So very, very accretive. And, you see that the combination of those two is kind of killer. It’s not surprising that a lot of Trend managers starting started adding Carry more and more to their Trend following strategies. Not a lot because you know, it does have a different character. It is useful. So anyway, I just…

[00:52:11]Adam Butler: Carry got a bad name too, because, you know, it was, for the longest time it was associated with currency Carry. So you’ve got managers who are effectively long developed market currencies, and short emerging market currencies. And the emerging market currencies pay a higher yield than the developed market currencies because they’ve got more currency volatility.

They typically have higher inflation dynamics for a variety of reasons. And so you could own these emerging market currencies with high yields, and borrow in developed market currencies, and are in that spread, right? Well, the thing is that the profile of that return stream, to Rodrigo’s point earlier, is such that it hurts when it hurts to hurt. And so you want to have a more diversified basket of markets that you’re using to be in the direction of this Carry, right? You know, we, in a diversified Carry strategy, you do have currencies. Adding emerging market currencies does change the Carry, sorry, the character of a Carry strategy.

We don’t actually invest in real emerging market currencies in our Carry strategy, for that reason. There’s just so many different bets you can take around all of the different global bonds, global equity and global commodity markets that when you’re, when you have all of them in the portfolio, you don’t have at all the same character you had when it was just that kind of currency Carry, right?

So, you know, Carry gets this bad rap because it was a very different strategy than what we described when we talk about kind of global Carry, right? And I think…

[00:53:54]Rodrigo Gordillo: It is interesting why, people who don’t know it, don’t understand it, you know, you kind of explain it to them on the different side. They get people who have heard Carry, they immediately say, oh yeah, but that’ll blow up in your face. because it, well actually, I don’t even think they think about it as like emerging market and domestic currency.

I actually think about, it’s a Yen/US cross, right? That is kind of steady, steady, steady, and then you’re gone. And so every time I bring up Carry, they’re like, oh, that’s dangerous. And you know, the quote that I always use is, it ain’t what you don’t know that gets you into trouble. It’s what you know for sure.

That just ain’t so. And I think that Carry falls into that category, because there’s also an, one other thing that adds to that story is that allocators didn’t love, for example, when Winton started adding a lot of Carry to their strategy, because they wanted that crisis alpha. So the, I think the takeaway from that line in the newspaper was, oh, it, Carry must lose all of the money that Trend gives you.

And I think when we look at, I’ve just kind of gone through all of the major years of paying for equity markets and it’s just, it’s not that it loses, it’s that it makes less, it is, the Trend tends to be more trendy. It tends to like, oh, that’s exploding upward or downward. I’m going to go long and short that aggressively. Whereas Carry’s taken a whole different approach. It’s still trying to be an absolute return type of product. And most years where we’ve seen bear markets in equity markets and when we’ve seen negative growth shocks, Carry’s strategy, muddles along quite nicely. Not always, but most of the time. Yes. So I think we need to, you need to, it just ain’t so that Carry always loses money when there is a negative growth shock.

[00:55:47]Adam Butler: Oh, it’s, yeah, most of the time it doesn’t. It really is very uncorrelated with stocks and bonds, and a very effective complement most of the time. It’s not the only premium, right? I mean, I love a variety of premiums. You know, I think eventually we’ll probably add something like a merger arbitrage, or a convertible arbitrage, or, you know, there’s the fallen angels premium.

Like there’s a number of really great risk premium out there, and I, you know, people should be seeking all of them, right? But, but in that basket. I would put Trend at the top and I would put Carry right next to it. And so, I’m excited to be on the verge of offering both of those to investors just for Stacking purposes.

And I, as you were talking earlier about the optimal or do more, do no harm portfolio, and I know we’ve been talking, harping for 10 years about this Global  Risk Parity portfolio, and it’s what we all prefer, and I don’t think any, it’s still in our hearts is it, it takes center stage, but I do like the fact that we’ve got solutions for people who just aren’t ready to move far enough away from that sort of more traditional 60/40 orientation and that Trend, that the Return Stacked concept. Allows them to preserve that 60/40 that they’ve come to love. So, you know, they just want to hold onto it because it’s been so good to them for so long, right? I get that. But you don’t need to let go. You can put something on top. You can already Stack the Trend on top. You can, very soon you’ll be able to Stack Carry on top.

And, you know, there’s lots more coming down the pipe. And I think people should really start to, if you’re not ready to go right to that Global Risk Parity portfolio that we all three know and love, and lots of devotees among the sovereign wealth managers and largest hedge funds in the world. But if you can’t quite get there, Return Stacking is a really good place to start.

[00:57:53]Rodrigo Gordillo: So I want to, that’s actually a point I wanted to hit today. So you nailed it, right? We are All Terrain lovers. We want everybody to invest in this very weird high tracking error portfolio that, it doesn’t matter which All Terrain, whether it’s a Permanent Portfolio, Adaptive Asset Allocation, Cockroach or otherwise, in the last two years has avoided most of the pain, but it’s kind of flat lined, single digits, maybe flat returns in the last two years, avoided most of the pain.

And people are like, well, what if that was All Terrain? That’s a type of pain that you get when you invest in something that weird. But the other thing that is really interesting about this concept of Stacking is for those who don’t want the All Terrain, who have been, who have spent their careers or their investment careers as individual retail investors, trying to beat a benchmark.

Let’s say you’re trying to beat the S&P 500 for the longest time, forever. The way to do that is what, stock selection? You’re trying, there’s 500 stocks. Here’s what I’m going to do. I’m going to choose a style, growth investing. I’m going to have a subset of those 500 or 2,500 if you’re looking at the full market, 2,700, whatever it is. And you’re going to choose a subset that is going, that because of whatever characteristics you like, is going to outperform that benchmark. And there’s been endless research done on this. We talk about how markets are micro efficient, but macro inefficient. And that just means that the efficiency in the stock selection market, the micro market, is such that it’s really difficult to outperform, right? We’ve seen all those SPIVA reports that come out every year, how many active managers are able to outperform. It’s really…

[00:59:42]Adam Butler: Picture these value managers, you know, back in the back of in their office hanging their heads, and the growth managers walk by and they’re hiding behind their shelves, and they don’t want to look at them. And all the growth managers are all huddling around the water cooler, high-fiving each other, and then a year goes by, and then all the growth managers are hiding behind the, under their desk, while the value managers are walking by with the head held high, and strutting, and high-fiving each other at the water cooler. But it just ends up being this, from growth, the value of growth, the value, and over time, because the stock picking orientation is so much more efficient, there’s just, there’s not much to eke out of that, right?

But the fact is that there are just very few players in the global investment landscape that have the mandate flexibility and the agility, because they’ve got a small enough portfolio to be agile in moving around your, the capital in their portfolios, to be able to take advantage of those macro anomalies, macro inefficiencies, like Trend following, Global Carry, etc. So like I, I think it, this is just a way more inefficient area to operate with more sustainable, larger premia over time.

[01:01:06]Rodrigo Gordillo: But let’s just, can I just…

[01:01:08]Adam Butler: …that as an alternative.

[01:01:09]Rodrigo Gordillo: I want to, yes, and this, Adam, I want to say, look, if you have the wherewithal, and if you’re willing to invest in some of the more concentrated, for example, Value ETFs that Alpha Architects puts in, right? Forty stocks, you know, you may be able to outperform, you may, you will likely, if history is any indication, and intuition, and how valuations work, you should eke out a positive rate of return. That’ll be painful, but useful. But what does that pain do? Like, you can do it. Okay. Let’s give the benefit of that and people who want to follow that should, and if you want to beat a benchmark, that’s a way of doing it that you should pursue, if that’s your passion, and then you can stick to it.

But let’s take the value concentration. For example. When you measure the beta of a Value ETF like that, you find that the, a lot of the variance is not explained by, or a portion of the variance is explained by the beta of the market, and another portion of the variance is explained by the value factor, right?

What that means, in essence is you’re taking, you’re not taking the 15 vol risk of the market. You’re taking 20, 25% volatility in order to achieve that excess return, right? Taking more risk to get more return. And so it, for you to achieve higher returns against a benchmark, oftentimes it means that you have to take higher risks. So if you’re into that, more power to you. Go do that, but let’s diversify.

[01:02:34]Adam Butler: Into higher risk, go for it.

[01:02:37]Rodrigo Gordillo: But let’s think about another way of trying to do that, right? And this is where I come in now with this concept of Stacking, what if you’re not about stock selection, right? You want the S&P 500 and beat it. Okay. Well, what if you were to find Stacks that had a positive expectancy most years, but also had the benefit of being lowly correlated to the S&P 500? Okay. Well, what does that mean in actuality, if that indeed comes to fruition, is that you will over time Stack a return that is above the S&P 500, but because of that low correlation, you may not actually be taking higher risk to achieve that excess return.

You may in fact be reducing drawdowns. You may be in fact maintaining or even maybe you’re slightly increasing your volatility because you are Stacking, depending on how big your Stack is. But it’s just, if you’re not into the game of All Terrain and All Weather, but you’re into the game of outperforming the S&P or the global market, then this is just another way to try to do that. And I’m super excited by just that. And you don’t have to take that. It’s tracking error’s low. You’re just saying, hey, we’re going to try to beat the benchmark and one way, it’s going to be Value. Another portion of our portfolio is going to be Growth, and the other portion is going to be Return Stacking, right? I just, I love that.

[01:04:00]Adam Butler: You know, people like meat and potatoes, right? And we’ve been like, yeah man, but you got to try Thai food, and you got to try this Indian curry dish, and you got to do this and that. And, you know, instead it’s like, dude, just add a little gravy, right? Yes. Have your meat and potatoes, right?

But you need to try this jus with your meat, right? Or this gravy. And man, is it spectacular? But yeah, I mean it’s just a really good gateway to learning more about what else is out there, when you sort of take the peelers off and use your peripheral vision. There’s, turns out there’s a lot of different ways to earn a living off of capital markets, and it’s great if you can find diversification against those meat and potatoes that you’ve grown to know and love so well.

[01:04:49]Rodrigo Gordillo: Sorry to interrupt, but I did want to take a quick second to remind our listeners that the team works really hard on these podcasts. We spend a lot of hours trying to get the right guests and we do a lot of prep work to make sure that we’re asking the right questions. So if you do have a second, just do hit that Subscribe button, hit that Like button, and Share with friends, if you find what we’re doing useful. Thanks again. Now back to the podcast

Okay. Now guys, what do we think about the setup? Let’s go back to macro for a second and leave people with, you know, I don’t even know if you guys have any opinions about the current setup and what to expect in 2024?

[01:05:25]Adam Butler: Well, I, I will say one thing we haven’t touched on is the, just the, we’ve got a lot of elections this year. I think more countries are going to the polls this year than any other year in modern history.

[01:05:37]Rodrigo Gordillo: And that…

[01:05:38]Adam Butler: There’s a lot of polarity, right? There’s a lot of people with very strong views on both sides of the island where we seem to be having more trouble than usual coming together, and having a consensus. And so there could be a lot more surprises in store. This year politically then, we’re used to, and that also could be a source of volatility in both interest rates and in currencies, and potentially growth expectations. And we’ve also, at the same time, we’ve got massive fiscal stimulus. You know, you’ve got the US Treasury running six to 8% annual deficits over the next, right out to 2032, according to the Budget Office. And when the deficit of the government is a surplus for the private sector, that is extra money that the government puts into the private sector, year in, year out, for it to spend and generate wealth, and over time, inflation really is too much money chasing too few goods.

And so, if we continue to put this amount of extra spending power in people’s pockets, it’s not just the US, the Canadian government, the Australian government, Europeans, the UK. There’s just a lot of fiscal largesse out there. And it’s not just a supply issue, it’s also an excess demand issue, and that’s going on as far as the eye can see.

And some people have pointed out that maybe, you know, if Trump comes in, he might trim some of the spending side of the income statement, but he’s also likely to preserve more tax cuts, right? And you get deficits both from direct spending, and also from lower taxes, which means that there’s less money coming out of people’s pockets, and flowing back to the government.

So, you know, there’s a lot of reasons and you know, we’re starting to see in several key areas that both growth and inflation are picking up. We haven’t even seen, labor is still way behind the eight ball. We’ve had that big price shock and labor is still catching up, so there’s every reason to believe, based on what we’re seeing, that there, over time we’re going to see the power of labor begin to re-emerge, more unionization, and eventually labor is going to insist on having a larger share of the pie. So, all of these things are potentially inflationary.

[01:08:18]Mike Philbrick: Wage inflation.

[01:08:20]Rodrigo Gordillo: Well, That’s his…

[01:08:20]Mike Philbrick: The seventies.

[01:08:22]Rodrigo Gordillo: Wage inflation. The problem is sticky, is what you do that year, what you ask for that year, you’re going to ask for the following year, right? So it really is, as a Latin American, I can tell you that it’s the ex-inflation expectations, is a tough thing to kill it. That really is a behavioral thing. And this is why Powell wants to signal as much as possible that they’re going after inflation aggressively. But you know, the story tells it itself. This is again, back to what the belief has been for the average person, is that inflation has not gone down. And it, the more they believe that, and they don’t understand that indeed we have tempered inflation, the rate of change of inflation, then the more entrenched they’re going to get, and the more they’re going to ask for that wage growth to get higher.

And that’s why the Genie is going to be put back in the bottle. Not today, not tomorrow, but probably in a few years. And in terms of pricing, I, right now it’s, again, it’s crazy to me to think that there’s over 30% probability that there’s going to be 200 points of rate cuts this year. Does anybody have any thoughts on how, which is it, right? Are we, do we have continued wage growth, strong economy,

[01:09:42]Adam Butler: We had Constan down here in the summer of, it was early summer, I think Mike….

[01:09:49]Rodrigo Gordillo: July, I think.

[01:09:50]Adam Butler: …and he had. We were talking about soft landings, no landings, higher for longer. And I think we ran around the table and eight outta 10 people thought we were going to be in recession by…

[01:10:03]Rodrigo Gordillo: Yeah.

[01:10:04]Adam Butler: … as of last summer. And I remember saying not with the amount of fiscal largesse that we’ve got coming down the pipe. There’s just way too much money flowing into public purses for us to have a recession.

We continue to be sub-four percent unemployment rate. The employment rate, number of people out in the economy working is higher than it’s been in 15 years. And we’ve got the government even while the economy is running this hot, the government is continuing to put 6% to 8% of GDP back into the economy for extra spending.

So, you know, I just don’t see a recession on the horizon. And as long as equity prices keep going up, then companies have no reason, even if their productivity growth is above expectations and they have excess staff, there’s no reason to cut, because they would, just went through this period where it was hard to get workers. It was like a couple years ago, it was hard to get the workers you need, so they’re likely to hold onto them unless the market forces them to cut to preserve earnings. So all of the things seem to be conspiring for a hotter than expected economy over the next year. Not a, not a loose…

[01:11:15]Rodrigo Gordillo: And it’s, Andy’s roadmap is bang on. I mean, the way it has to go, right? The timing of it is always what makes it difficult to invest. But the way things have to go in order to have sustainable low inflation is, first you have to have from here, rates need to go up on the long end, right? That’s either, it’s unlikely, given the growth that we have, that the Fed’s going to be cutting 200 basis points.

So I think that’s the mispricing that he’s talking about consistently. So, if rates go up, that puts pressure on assets, right? Bonds are going to go down obviously at the same time, but then that’s going to put pressure on equities. Equities should get hurt from there. You have a lower demand from consumers. That’s going to hurt earnings. That’s going to allow for the wage, the employment market to soften, which is going to allow for reduction in wage growth, which is then going to lead to a permanent or more consistent, hopefully, reduction of inflation. But that’s the order of operations that we need to see historically, in terms of a macro cycle, for us to finally say, soft landing. We killed it.

But those things need to happen. There’s not, we’re not going to get from here to there in 12 months, right?

[01:12:31]Adam Butler: Especially not in, with the current structure we…

[01:12:34]Rodrigo Gordillo: No. And macro cycles.

[01:12:36]Adam Butler: …and…

[01:12:37]Rodrigo Gordillo: Macro cycles aren’t months, they’re years, right? I think Bob Elliott talked about the fact that 2008 was not a macro cycle. It was a credit crunch. 2020 was not a macro cycle, it was a negative growth shock. Macro cycles move insanely slowly and take a long time to move. If we look at what, how people have perceived the outcome of the economy over the last 18 months, like you said, Adam, was it a soft landing? Was it going to be a recession? Now we’re talking about soft landing again, like the variation around the actual macro numbers. The macro numbers have been fairly consistent. They have not, with the exception of inflation changes, you know, the employment, the wage growth, the amount of fiscal spending, and it’s all maintained relatively the same rate. And the only thing that’s changed wildly is the narrative around that, right?

So I think we’re, people need to get prepared for the long haul here. And again, you know, the reason you want to be prepared is because while Andy was right about the order of operations, one felt when you spoke with him that, oh, this is eminent. Like, this rates up, assets down. That’s it. And it happens for two months, and then we recovered very quickly, right? So it’s not, it’s one thing to know what the order of operations is, and it’s another thing to be able to get it right in time and win. Again, more emphasis on why you need to prepare, first and foremost. All right. Any other thoughts, gentlemen?

[01:14:14]Mike Philbrick: Yeah, the NASDAQ went from like 2,500 to 5,000 in the last six months of its run. That’s a bubble. And, we’ll see. We’ll see.

[01:14:26]Rodrigo Gordillo: Well, it was crazy. Remember the one we did, the Pandemic Portfolio that we had in March, or of 2020, where we kind of like, okay, what’s going to happen here? And we said a lot, everything can happen. Again, it’s just a testament, like, we don’t know. It could be this, it could be that. What happened was not, I think, high in our guesstimations, right? We knew that. We didn’t know. But if you were to poll us, really at that point, we’re like, oh, it’s probably going to get worse from here. And it got so good.

[01:14:58]Mike Philbrick: Still falling short. You know, the Russian debacle, the Thai baht, I mean the NASDAQ went from 1400 to five grand. We got another…

[01:15:07]Adam Butler: 1994, August, 1994, the US Equity market hit the most expensive it had ever been on a PE basis, in August of 1994, and then went on to double again by 1999, right? So, absolutely anything can happen. We’re not, this is not a prescriptive exercise, but it is helpful, I think to explore all of the other things that might happen, that may not be quite as favorable to everybody’s favorite portfolio.

[01:15:41]Mike Philbrick: Oh, I don’t think that would be a favorable outcome. Market’s going up with that kind of intensity. I’m not sure. We have a lot of people who are like, wohoo, did I ever do good? And then, investing from 2000 to 2014 was like two 50% drawdowns, with a return of zero,

[01:15:58]Adam Butler: Mm-Hmm

[01:15:59]Rodrigo Gordillo: Well, look, it’s how many…

[01:16:01]Adam Butler: In US equities. That’s exactly the S&P…

[01:16:03]Rodrigo Gordillo: … that you know in 2023 that actually participated in this run up? It happened in the last quarter, right?

[01:16:10]Mike Philbrick: In…

[01:16:12]Rodrigo Gordillo: The favorite portfolio was cash. Cash was king, 5%. Why would I do anything else? Why would I take the risk? Boom, two months, 20% return? I mean, I don’t know anybody that was fully invested for their…

[01:16:22]Adam Butler: Well, this is the other thing that we need to re-emphasize. I know you mentioned this earlier, Rodrigo, but the, we could easily see a situation where the Fed holds or even raises in six or nine months, because inflation’s re-accelerated, and what, we’re coming into an election. And in all likelihood, Janet is going to allow the amount of Bills issued to get way outside any historical precedent in an effort to avoid having to issue long-duration coupons to fund the deficits. And therefore, equity markets could continue to do well. It takes both the Treasury deciding that they’re going to allow equities to drain out, and the Fed saying that we need the economy to run a little less hot in order for the market to capitulate here, and coming into an election cycle with what a lot of people feel to be existential things at stake. It’ll, I think we need to acknowledge the potential for very extreme things to happen.

[01:17:39]Rodrigo Gordillo: Amen. Yeah. All right. Well, gentlemen, thank you so much for the 2023 recap. I think we’ve got to do this more often. I really enjoyed this one. Maybe once a quarter, get back in there, bring a special guest in, right?

[01:17:58]Adam Butler: You guys are special enough.

[01:18:00]Rodrigo Gordillo: I guess. All right guys. Thank you so much for doing this with me today. I know that I pushed for this last minute, but I think it worked out.

[01:18:11]Adam Butler: That was…

[01:18:11]Rodrigo Gordillo: Any other, any final thoughts? Where can everybody find you guys? Everybody knows where…

[01:18:15]Mike Philbrick: There it…

[01:18:15]Rodrigo Gordillo: Gestalt, you got @GestaltU for Adam Butler and Twitter. I got @RodGordilloP, the worst Twitter handle on the planet.

[01:18:25]Adam Butler: Rumor has that your LinkedIn profile’s on fire. Lately though, you got to find Rodrigo on LinkedIn

[01:18:31]Rodrigo Gordillo: RodrigoGordillo/ RodrigoGordillo. And then Mike, you’re @Mike99. @Mike99.

[01:18:36]Mike Philbrick: Mike? Mike Philbrick At? @MikePhilbrick99

[01:18:38]Rodrigo Gordillo: @MikePhilbrick99.

All right.

[01:18:40]Mike Philbrick: On Twitter. That is. But…

[01:18:42]Rodrigo Gordillo: And for our content, you can always find us on, on, where we have a ton of research videos, podcasts that will continue to help you out in your journey. Okay. Thanks everyone, and we’ll see you next week.

[01:18:57]Mike Philbrick: Rock on.

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