Barry Ritholz has had a long career, both participating in the Wall Street machine operates and opining on how it operates. By any account, few understand the ‘street rules’ of modern investing better than he.
And he thinks many investors today, both individual and professional, are letting themselves get dangerously distracted.
In a May article titled Where Sea Monsters Live, he observed that many fund managers spend more time railing at Fed policy than on their own portfolio strategies. Yes, the seas have become more turbulent, admits Ritholtz, but that’s exactly when the captain’s expertise is needed most. Simply cursing at the winds and tides will not get the ship to safety.
By the way, I do not want people to misunderstand this. It's not that people shouldn't be criticizing the Fed; it's not that people shouldn't be actively and vocally debating public policy and monetary policy. But if you are doing that instead of managing your assets, if you are doing that instead of paying attention to how you should be positioning your portfolio, you are going to be in trouble as an asset manager.
The priority, he says, is to accept that – for good or for bad – central bank intervention is an integral component of financial markets now. Whether you approve or not is immaterial; if you are a steward of capital, you’d better work quickly to develop an investing approach that takes the range of likely Fed actions into account.
Markets are driven by human nature; they are driven by psychology of fear and greed. Sometimes the fear is missing out on the rally. Sometimes the fear is uh oh, things are going lower.
What changed the game so dramatically post-2008 crisis is the footprint of the Federal Reserve and what they are doing. And so, if the Fed was not involved in this market I would be looking at decelerating macro economics, I would look at earnings peaking and reversing, I would look at a number of factors that would have me radically reduce my equity exposure.
We run an asset allocation model that uses a 60/40 benchmark. 60% equities; 40% fixed income. We came in to the year 80/20, way overweight in equities, and as the market has rallied – each time we rebalanced to take a little bit off the table. But we have also made a conscious decision to go to equal weight as opposed to overweight. Now, if this was a normal situation I would probably be 40/60. I would probably be 40% equities, but it is really, really challenging to say. Despite the fire hose of liquidity, despite the really low fixed income rates, I want to still sell stocks. In light of what is going on, I just cannot do it.
By making bond yields so low, you drive money out of bonds into equities, and by providing so much liquidity to banks, history has shown us that when that happens it seems to find its way into equity markets. When you look at that historically, when you look at when the Fed says we are going to increase liquidity, we are going to put a lot of cash into the system as a lubricant, the impact is that risk assets go higher. And that is pretty much stocks, bonds, and commodities – and the dollar weakens. Look at what happened under Greenspan and once Bernanke took over. From 2001 to 2007, the dollar lost 41% of its value, and I have no doubt that was driven by Fed policy.
If this was a normal situation, I would be battening down the hatches and waiting for this storm to come forward. Instead we are looking at a Fed with a fire hose and wondering every time there is a 10% to 20% correction in the equity market, they throw more cash at the system in order to generate some improvement. And I keep coming back to this from our original conversation about Where Sea Monsters Live. It's more than just being the armchair critic. The impact of this from an investment perspective is: “I want to own this and I do not want to own that for all of the above reasons.” Where people seem to falter is in taking it to the next step and saying, “Well, what does this mean from a risk versus reward perspective?”
Click the play button below to listen to Chris' full interview with Barry Ritholtz (48m:51s), including his his thoughts on gold:
Chris Martenson: Welcome to another Peak Prosperity podcast. I am your host, of course, Chris Martenson, and today we are going to look at the economy with someone who can truly help us see the big picture. His name is Barry Ritholtz, and it would be impossible to list all of his achievements, awards, appearances, let alone convey his impact on the financial world. So I will just touch on a few highlights here.
He is the author of the book Bailout Nation, lauded as the best-reviewed book on the bailouts to date. You really should read it if you want to know how we got here and where we are going. And, as well, he is the proprietor of the extremely popular and often praised financial and economic website, “The Big Picture,” found at Ritholtz.com. In his day job, Mr. Ritholtz is CEO and director of equity research at Fusion IQ, an online quantitative research firm. And the firm makes its institutional-strength number-crunching available to individual traders and investors at an affordable price. I could hardly think of a better person right now to talk about our turbulent financial markets, where they are likely headed next and where investors may be able to find acceptable returns at acceptable risk. With the ECB, the Fed, and the Bank of Japan now announcing massive new equity injections into global markets, people need that guidance more than ever.
Barry, I am thrilled to have you as a guest.
Barry Ritholtz: Well, thanks for having me.
Chris Martenson: I always like to begin at the outside, widest possible view, if we could, so we share the necessary context to make sense of these details. I would like to begin, as it were, with the big picture here; take stock of circumstances in which we find ourselves. I want to begin back in May of 2012 when you wrote a piece entitled, “Where Sea Monsters Live,” in which you recounted a dinner conversation you observed. Maybe the conversation was not distinguishing very crisply between debating policy and managing assets, and that perhaps there is quite a lot of armchair policy-critiquing going on out there right now, but that people, like you, like me, still have to wake up every day and make decisions.
Barry Ritholtz: That is exactly right. You know it is an ongoing debate [that] I have been having with a number of friends who are all traders, hedge fund managers, people running different types of assets. And if you are not playing football, there is always the tendency to be a Monday-morning quarterback and say this guy should have done this, why did they go through in on fourth and two? Yeah, it is a very different philosophy when you are on the gridiron making actual decisions. But what I find kind of astonishing are people who are literally on the gridiron, supposed to be making decisions, and they spend most of their time Monday-morning quarterbacking.
The whole idea of “Where Sea Monsters Live,” the analogy I sort of went off on a rant at a dinner party one night, is hey, I am the captain of a sailing vessel and I have passengers and crew that I have to get safely from here to there, and it is my job to know what is the wind like, what does the weather look like, the tides, can I guide the ship by the stars, and where do the sea monsters live. When you are out and there is danger and you have to make decision –do you make a dash for it or return back to port? What you do not get to do is lean back and criticize the tides; you do not get to say, gee, this north wind is really going about it wrong. You have to read the signs, read the sea, read the circumstances, and safely get to where you are going.
And I am finding lots and lots of managers are not doing that. Instead, we receive missive after missive after missive about why the Fed is destroying the world. I have been pretty critical of the Fed over the years, but that is sort of my weekend fun thing. And I criticize Greenspan in Bailout Nation, and I scratch my head over what Bernanke is doing, but that is a footnote. My job is to look out and say, what is the impact on their behavior and their actions on opportunities and risks? How do I navigate those seas knowing that the Fed is a player in the entire situation?
Chris Martenson: So then you followed up this excellent piece back in May with another one in September entitled “Situational Awareness” drawing on a military metaphor. In that one you wrote that these days the FOMC (Federal Open Market Committee) is a – they are a participant, they are in the market, and so the line I like was “critique the Fed, but manage your assets.” Do you see that the Fed, like the FOMC – they are a full-on market participant at this point; is that right?
Barry Ritholtz: No doubt, and it is not like it was thirty or forty years ago where everybody – unless you are a historian, unless you know what the Fed used to do, people forget. There was a day when they never used to make announcements as to what they were doing. You could assume the Fed was shifting their interest rate targets, because someone was selling the hell out of bonds and guess what that did to yields? Just like buying bonds drives them lower, when someone is selling them, it sends them higher. That is how they actually operated. They did not come out and say we are raising our targets 2.5%. It just happened in the bond market.
And so, today not only did they announce their targets, they say, oh and by the way, if you want a front run, we are going to be buying forty billion dollars’ worth of mortgage-backed bonds or mortgage-backed securities as far as the eye can see, at least for the next twelve months and maybe longer. So they are not just a participant, they are a public participant engaging in active jawboning, letting everybody know here is exactly what we are going to do, and the reason for that is they are trying to push markets, they are trying to push interest rates, they are trying to push risk appetites in a certain direction.
I think their thinking is, here is how we will stimulate the economy; here is how we will get people psychologically more comfortable with assuming more credit, spending more money, making more investments. We could criticize that as whether or not it is a well-founded policy, but as an asset manager I have to look and say, okay, what does this mean for fixed income, what does this mean for commodities, what does this mean for the economy, what does this mean for earnings, and what does this mean for equities?
Chris Martenson: Absolutely. You know, my grandfather served on the New York Federal Reserve Board under Volcker for a period of time, and back then one of their policy tools was surprise. But that Fed does not exist anymore. They have taken that tool out of the box in favor of policy directions. So, what is the situation right now? The Fed has clearly said we are asset-priced targeting here, we want to – all sorts of things we would like to have happen, the wealth effect, we would like to repair balance sheets. A lot of good things they want to have happen.
That is the situation, so do you see that changing at any point in time, or do you sort of dial back the element of surprise to near zero and just count it on the idea that you are going to get plenty of advance warning from the Fed when they do decide to start to move in a different direction?
Barry Ritholtz: Yeah, I think surprise has not been in the playbook for a while. It is a shame, because it certainly could be effective. Although I do think a lot of people were surprised at the size and scope of QE3 (quantitative easing) this time. As I mentioned in that piece “Situational Awareness,” there has been this horrific blind spot for the Fed. They should be a “known unknown,” as Rumsfeld used to say, and yet people continue to be surprised. They telegraph what they say very clearly. They have – working with John Hilsenrath of the Wall Street Journal – that is the worst kept secret in the world, that when he writes something it is because Ben whispers in his ear here is what is going on. When you see a week before Jackson Hole, hey we are likely to come out with some form of QE; people were still denying it up to the last minute. Oh, they cannot do it in an election year; oh, the balance sheet is already too big. Hey, these guys have a history; here is the track record. They say something to Hilsenrath, he publishes it in the Wall Street Journal, and then it happens two weeks later, and yet people continue to be surprised by it.
By the way, I do not want people to misunderstand this. It is not that people should not be criticizing the Fed, it is not that people should not be actively and vocally debating public policy and monetary policy, but if you are doing that instead of managing your assets, if you are doing that instead of paying attention to how you should be positioning your portfolio, you are going to be in trouble as an asset manager.
Chris Martenson: Well, I have talked to a lot of people who are professional money managers – many run some pretty big funds – and there is a level of paralysis out there, particularly for people who had methods, and tools and processes that seem to work for a long time that no longer work; asset correlations spiking, and a variety of things that used to be tried and true not really working as well anymore. Alpha shrinking.
What is your view on this? Do you think the markets have really fundamentally changed and some of this is paralyzed people who do not know how to operate in this environment, or is there something deeper going on?
Barry Ritholtz: I think the markets the same as they have ever been. They are driven by human nature; they are driven by psychology of fear and greed. Sometimes the fear is missing out on the rally. Sometimes the fear is uh oh, things are going lower. What changed the game so dramatically post-2008-crisis is the footprint of the Federal Reserve and what they are doing. And so – look, I have said this a number of times – if the Fed was not involved in this market, I would be looking at decelerating macroeconomics; I would look at earnings peaking and reversing; I would look at a number of factors that would have me radically reduce my equity exposure.
We run an asset allocation model that uses a 60/40 benchmark – 60% equities, 40% fixed income. We came into the year 80/20, way overweight in equities, and as the market has rallied, each time we rebalanced we take a little bit off the table, but we have also made a conscious decision to just go to equal weight as opposed to overweight. Now, if this was a normal situation, I would probably be 40/60. I would probably be 40% equities, but it is really, really challenging to say.
Despite the fire hose of liquidity, despite the really low fixed-income rates, despite casting trash, I want to still sell stocks. I just – in light of what is going on – I just cannot do it. By making bond prices – bond yields – so low, you drive money out of bonds into equities. And providing so much liquidity to banks, history has shown us that when that happens it seems to find its way into equity markets.
I always like to remind people, in October 1999 when the Fed was so concerned about Y2K, which turned out to be misplaced fear, they just did a fifty-billion-dollar one-off, and from that point until six months forward, the NASDAQ, which had been screaming higher for ten years, doubled over the next six months. I tell people October to March – October 1999 to March 2000 – the NASDAQ doubled, and no one believes me. They have to go look it up. We were at 2490 or something like that in October, and the Fed announces this $50 billion liquidity issuance in order to make sure that there are no fears that there is a run on the bank, that ATMs run out of money, there is plenty of cash in the banks for January 1st. And they started that three months earlier, and the markets, which were in full throw, full mode just doubled.
So, when you look at that historically, when you look at when the Fed says we are going to increase liquidity, we are going to put a lot of cash into the system as – I call it a lubricant; I do not know what they call it – but the impact is that risk assets go higher, and that is pretty much stocks, bonds, and as we have seen it, the dollar is weakened, commodities as well. Look at what happened under Greenspan once Bernanke took over. From 2001 to 2007, the dollar lost forty-one percent of its value, and I have no doubt that was driven by Fed policy.
Chris Martenson: When you look at the $50 billion, that injection back in 1999, how quaint [laugh].
Barry Ritholtz: It is quaint today, but relative to Fed interventions at that time, it was a pretty hefty chunk of change. Today you look at it and it is a rounding error, but back then it was like, wow, this is really pretty substantial.
Chris Martenson: Yeah, it had that surprise element, maybe 10X the size of their normal, permanent market operation. It was pretty big. As I saw it, it was – yeah, it caught me by surprise back then as well. So, here we are, we have got forty billion a month now pouring in indefinitely. We have got the Fed saying that as necessary they might do other asset purchases, leaving a little vagueness to potential trajectory. And you think that they are going to continue to step in? And what is it that they are really aiming for here? Can we take them at face value and say they are focusing on employment in the context of price stability, or are they really targeting asset prices here?
Barry Ritholtz: You know, they believe in the wealth assist, and years ago, before the crisis, I recall writing something called “Tales of the Wealth Effect Have Been Greatly Exaggerated.” The concept behind the Wealth Effect is this: When we look at the history of stock markets, when prices rise, people have a tendency – or so goes the narrative – to feel better, and then thus they go out and spend more money, hire more people, make more investments and you have this virtuous cycle.
There is a pretty significant flaw in that argument. There are actually a few, but let me just give you the two biggest flaws. The first is just your classic logical reasoning causation-and-correlation error. When stocks are going up, you have to look at, is that causing the spending to take place, or is there an underlying factor affecting both of those? And historically, when you look at long boom markets, when you look at the history of the stock market, when you have a substantial rally in equities, it tends to be because you are having this broader secular expansion in the macro-economy in employment, in wages, and so it is not a surprise that people spend more.
But it is the same factors that drive the spending that drive the – that are also driving the increase in stock market. It is expansion, and more hiring, and more spending, and greater profits. Oh, guess what, in that environment, stock prices go up and people spend more! But the stock prices are not causing them to spend more; it is that all the underlying factors that are affecting A are also affecting B. So, rather than assume a causation relationship, it is really a correlation. The same thing that is driving the stock market is driving spending; the stock market is not driving spending.
People make that mistake all the time when they look at elections and the DOW. Does the DOW – is the DOW good for the incumbent, bad for the incumbent? It is like, no, when the DOW is going higher it tends to be good for the incumbent; when the DOW is going lower it tends to be bad for the incumbent, because of the underlying forces. So, that is the – that Wealth Effect is the primary – seems to be, and if you look at – read some of the speeches and listen to what Bernanke has said, that seems to be one of the primary focuses of the Fed.
The problem with that is the numbers are vastly disproportionate to who owns equities. The average family is a $25,000 or $30,000 portfolio. The average 401k, which is a typically higher-income person, is a $60,000 portfolio. And the numbers – it is something like 50% is owned by the top one percent, 80% is owned by the top – or 75% is owned by the top ten percent. And those are my client bases, and I can tell you, they spend money; they do not care what the economy is doing other than full-blown Armageddon. The Fed is not going to stimulate them to spend money. They spend money regardless of what is going on.
And the marginal spender, the marginal retail player, is somebody who really does not care much about what stock market is doing. You know, if you are making $75,000 a year, and a mortgage, and kids going to college, and a two-income family, the Fed moving interest rates up or down is not going to make a difference. You are not going to say, all right, I am going to start a business, and buy a car, and buy a house because rates are three percent lower. It is – you are paying your bills, and what is much more likely to have an impact on your spending habits is, are both people working; is the person who is out of work getting a job; is the person who is working getting a raise? Those are the factors that really impact – is credit available? That impacts spending
You know we just got a proposal from our bank to lower our 30-year mortgage to 3.6%. That is insane. A fixed, no point, 3.6% mortgage, and if you do a 15-year mortgage it is 2.75%. These are just unfathomable numbers, and it means that if you qualify for a mortgage, you actually have about 15% more buying power than you would have [had] two years ago. And yet still, housing is just bumping along the bottom.
Chris Martenson: I think that point that you made before about the concentration of wealth, which has certainly been a feature, has been much-discussed and well-dissected from a data standpoint. That certainly has to be a drag on the Wealth Effect, because, as you know, people who are above a certain income level, their spending habits are not really going to be all that impacted by whether their portfolio is gyrating up or down a few points.
Barry Ritholtz: That is exactly right. And here is the thing that I think people forget: When you go through these long periods of time, if someone decides to take some cash and say all right, I am getting no money out of the 10-year bond yielding 1.6%, let me move ten percent of my portfolio to equities. That is a paper transaction. That is not like building a factory, constructing a building. It has almost no impact other than driving; you know helping to drive stock prices higher. So, I think the underlying belief that hey, if we can only get equity prices higher, people will go out and spend.
Now, keep in mind, the opposite, however, may be true. The opposite is when everything is in free-fall, when markets are crashing, we have a tendency as human beings to be [like a] deer in the headlight and everybody kind of freezes. And you hear a lot – during 2008, 2009, you used to hear, I want to go do this. I want to buy this house, buy this car, buy whatever. I am going to wait a little bit and just see how things shake out. Well why? You own your own business; you know what your cash flow looks like. I know you have money in the bank; you are not buying a billion dollar – you know you are not buying Veyron; you are going out and getting a car. One month to another, do you really think you cannot make the $700 a month payment depending on the economy?
But, that is human nature. People have a tendency to see the backdrop, and I think people tend to overreact to the negative much more than they positively react to the positive.
Chris Martenson: Well, you know what is making me nervous right now is not that the Fed is being so interventionist, but that their interventions, all the trillions of them, including – here I have to toss in the Bank of Japan, as well the ECB (European Central Bank) and the UK.
Barry Ritholtz: It is global, and it is well coordinated.
Chris Martenson: It is, and what is worrying me is that I actually expected more bang for the buck. I was expecting a greater sort of market response, and better yet, an economic response, and it is not there. So, my concern is that the forces of deleveraging – I am worried about being like Japan. Like that this could just be a fairly persistent –
Barry Ritholtz: Go on forever.
Chris Martenson: Yeah, it could go on forever, which means growth is going to be really subpar, and if it slips into recession, all of a sudden we have banks – big central banks – holding onto a lot of very expensive assets in a poor environment. Do you have any concerns that we are not seeing the traction we should have seen? Do you have any worries there?
Barry Ritholtz: Yes and no. The yes is they have thrown an awful lot of fire power and have not gotten a lot of bang for the buck. So that is the initial concern. The no part – I will give you a two-part on that. The first is, history shows us that fiscal policy has a much bigger impact on the broader economy than monetary policy has. Monetary policy has a tendency to affect things that are financed, or purchased with credit, or what have you. So it can impact auto sales, and it can impact home sales to some degree, and it can change those sorts of prices. But it is going to have a modest impact on employment, and it is going to have a modest impact on GDP compared to what I think could be accomplished or not through a fiscal policy.
The reason I think we are not running into a full-on Japan – first, unlike Japan, we had the FDIC put a number of banks into bankruptcy. So when you hear Washington Mutual, or Wachovia, or go down the list, you know hundreds of lenders went belly-up. That is the FDIC’s role. They are supposed to a) guarantee the deposits of people up to whatever it is now, X dollars per account, and b) be a regulator of banks and say this bank is insolvent or this bank is not handling the depositors correctly and close them down.
And the FDIC was pretty effective. In fact, if the FDIC would have been in charge instead of the Treasury and the White House and the Fed, we would have been better off, because all of these banks – and that includes Bank of America and Citigroup – would have been put into a reorganization and come out with their debt wiped out, their senior management fired, all of their equity zeroed out, and the bond holders basically own[ing] what is left. So, instead of bond holders being bailed out and getting 100 cents on the dollar for making loans to insolvent companies, they would have gotten – pick a number – 20 cents, 27 cents, somewhere in that range. 15 to 35 is probably a broad enough range to include what they would have been left with after they discharged all their bad loans.
And we would be much healthier. It would have been more painful. Hey, maybe we would have been looking at DOW 5000, I do not know. But, you would have had a much quicker recovery because you are still not saddled with all of this debt. And not only that, do not kid ourselves – when we look at Fed policy, it is very much geared at protecting banks who still carry a lot of bad loans, who are still servicing a lot of mortgages that are underwater, and if we had a normal or a normalized Federal Reserve policy with rates higher, that means real estate might be another 15% or 20% lower. And that would have a significant impact on the lenders and the banks who underwrote those mortgages.
So, not only did the bailouts turn out to be ill-advised, then when we look at countries that did not do bailouts, places like Sweden, or Greenland – or Iceland – I am sorry, not Greenland, Iceland –admittedly much smaller countries than the United States, they ripped the Band-Aid off; they put the banks into sort of a pre-packaged bankruptcy. What we did with GM we should have done with Citi and Bank of America. And while it is more painful at first, the healing process is much quicker. Instead, we are in this ten-year convalescence, and here it is 2012, it is five years – four years after Lehman dropped.
So we are not even halfway through this process, and in order to allow the banks to rehabilitate their balance sheets – it is really a backwards way to do this – it is saving the banks, but letting the banking system falter. That is what the Japanese did. What the Swedish did was something completely – in the early nineties, when they had their banking crisis, their answer was to hell with the banks; save the banking system. And by putting all of these banks into bankruptcy, you end up with a much healthier, much more competitive banking sector.
So, again, not to just wax on the policy, my investing approach to this has been to steer clear from any of the banks with mortgage exposure, any of the banks that have a liability that can potentially come back to bite them. In the finance sector, for example, we do not want to have zero exposure, but we own firms like Visa, which does not take credit risks. They gave that to the banks. You know when you get a credit card through Chase, or Wells Fargo, or Citi, or whoever your bank is, they are the ones with the risk if you decide not to pay your credit card. Visa is really just the toll-keeper. So, it is more than – and I keep coming back to this from our original conversation where “Where Sea Monsters Live” – it is more than just being the armchair critic. You have to say – and the impact of this from an investment perspective is, I want to own this and I do not want to own that for all of the above reasons. And all of these things that we are talking about – where people seem to falter is taking it to the next step and saying, well, what does this mean for a risk-versus-reward perspective?
Chris Martenson: Well, very interesting. I love that description. And a while ago you mentioned that there are actually a number of things that get impacted by QE. One of them is commodities. I am a little confused by world oil prices. I checked Brandt Wright, so we were at 114 yesterday. What do you make of these high oil prices right now in terms of your macro analysis, how it impacts equities, growth, things like that, but most importantly maybe the rescue and recovery operations that are currently underway? I know that in history I cannot find a single example of an economic recovery with oil at, inflation-adjusted, $100 or more a barrel.
Barry Ritholtz: Well, you have a couple of cross-currents working at each other with oil. First, obviously every time there is an issue in the Middle East, there is a real significant concern about prices and Straits of Hormuz being problematic, and Iraq is still slowly coming online. We are still way behind where we should be with that. So, on the one hand, you have the Fed printing money, the Fed – I do not want to say debasing the dollar, but – the Fed creating future inflation expectations and turmoil in the Middle East. Those are both positive forces for prices. That is going to drive prices higher.
On the flip side, you have a slowing global economy. We saw it recently with the Fed Ex data, and it is pretty clear they are a leading indicator that transports in general look awful. You have Europe – look, half of Europe is, if it is not on the edge of a recession, it is already slipping into a recession. Clearly Spain and Greece are in deep recessions. Ireland is in a moderate recession. Germany is near recession. China, we know, has slowed down dramatically, as have a number of other Pacific Rim countries. And the nicest thing we could say about the U.S. economy is it continues to muddle along just above stall speed.
You know, there is that zone; you really cannot exist in the zero to 1.5 GDP for too long. It is like a plane running on four engines, and when you are at 1-1/2% or 1%, it is like you are flying on an engine or two. You can go a little while, but it is really eventually going to stall. You cannot operate it at that speed. You are going too slowly. So, you need to be over 2% consistently, otherwise – and everybody seems to fear a recession like it is the end of the universe – otherwise, you go into a normal recession, which is not the end of the world.
During a recession, misallocated capital gets reallocated more appropriately; businesses that are on the verge fail. Someone once described recessions and market crashes as events that take place in order to return money to its rightful owners. Meaning money leaves the speculators and heads back to real investors. And yet, so much of the policy we have seen from the Fed and from the government has been what can we do to avoid this next bailout, to avoid this next recession. Sometimes you just have to let the recessions happen, which again brings me back to, if this was a normal situation I would be battening down the hatches and waiting for this storm to come forward.
Instead we are looking at a Fed with a fire hose and wondering every time there is a 10-20% correction in the equity market, they throw more cash at the system in order to generate some improvement. I think the fear is if they let the equity market fall 25%, 30% it has that negative impact. Whether or not that is an intelligent decision or not is a different story. But the pattern has been set, and as an investor, when that happens you can pretty much expect the next hit of heroin from them.
Chris Martenson: Well, speaking of those countervailing forces then, we have got the Fed with the fire hose in the one hand, and I know that they did fund an awful lot of the fiscal deficit last year, if you want to look at it that way. And we have this thing called the so-called fiscal cliff coming up. What is your view on that particular event or potential non-event? Are you positioning for that at all? Does it concern you?
Barry Ritholtz: You know I look at it – there are a couple of factors that sort of make it – I think people make more of a deal about it than they should. Gun to head, the Congress ultimately does what it has to do, number one.
Number two, there is a legal argument – and I say this as a recovering attorney – there is a legal argument to be made that, the Congress in the Constitution has the power of the purse, and when Congress authorizes spending, they do not have to say a second time and we really mean it; this money has already been authorized. That is it. You have Congress authorizing the money. If somewhere else along the line they said, up to this amount, well, too bad; you have already authorized that money. I do not know if anybody wants to go to the Supreme Court and make that argument, but stop and think about it, since the Constitutional authority for spending is with Congress. How can they not spend money that Congress has said here is how much we are spending and here is how much we are taxing? That has kind of been done. That is a little out-in-the-weeds for a lot of people.
The third thing is, hey, so what if they hit the fiscal cliff? What that will mean is a) we will see deep cuts in the military. Not the worst thing in the world. We have a bigger military than the next twenty-five countries combined. (P.S., twenty-two of them are allies.) And b) we will see deep cuts in social security. And c) we will see deep cuts in Medicaid. And then d) you will see the Bush tax cuts expire; we will go back to the tax levels of the 1990s, which was not a terrible time.
So, if sequestration takes place, all those cuts are likely to lead to a pretty significant recession. But, as we just said before, that would not be the worst thing in the world. In fact, in many ways, it has got a healthy cleansing effect.
Now, if I think that is going to happen, if we see signs that it is going to happen, then I am going to want to hedge my equity positions. I am going to want increase my fixed income positions. I am going to want to jettison any commodities I own, because that severe – or I should really call it significant – recession, you can see a 30-40% correction in equities. You could see a significant rally in bonds from already pricey levels, and it means that demand for a lot of commodities is going to fall off the cliff at least for six months and then everybody will figure it out and we will move forward.
But I am not looking at that as the worst thing in the world. That is a potentially healthy recession. A lot of people forget [that] a lot of the troubles that we are in trace back to Greenspan’s refusal to allow a normal recession to take place in 2001 and 2002 following the dot-com crash. Had we had a healthy collapse, had we had an economic equivalent to the dot-com crash, we very likely would not find ourselves in the situation we are in today. Instead, he took rates down to what was then the unprecedented level of under 2% for three years, and actually at 1% for a year. At the time, that simply had never happened, and post-crash, well, here we are at zero. But that was not a full-blown financial crisis. That was just a run-of-the-mill equity bubble that popped. Had he allowed that to run its course, I think we would all be much better off today.
Chris Martenson: Well, there is a sense I have, and I think others share this as well, that we have these mini crises. So, when I look back at, say, long-term capital management in 1998, that is just a blip compared to some of the crises we have going on now. So there is a sense that the amplitude and frequency are sort of building, and maybe this is just the function of just living in a more globalized economy, but maybe it is because we forestalled wanting to take the pain and we sort of have been saving it up.
And if you are an average investor right now, you are just somebody; you have got a job; you cannot spend all of your day looking at money; you care very much that it does not go away; you are worried about things like the custodial risk that Peregrine Financial and MF Global introduced to the equation; you are worried about maybe the things you have been reading about the NYSC recently; where trading information is asymmetrical to preferred clients, and on, and on, and on. There is enough chattering noise in this sphere out there to erode that confidence. And you do not have time to maybe manage your money on a minute-by-minute basis. What would you do in that circumstance? What advice do you give people?
Barry Ritholtz: Well, I always – I give a couple of different speeches, and one of them is called, “Stop Paying Me So Much.” And essentially, I tell people the average investor should be dollar-cost averaging into a broad set of indexes, and not trying to turn the market, and not trying to pick stocks, and not trying to outguess everybody else. You do not have the time. You do not have the expertise. Oh, and P.S., the way you are wired, you are going to tend to buy too much at the top and panic and sell at the bottom. So I always – oh, and by the way you are paying people too much for advice. If you have a big account, if you have a complicated tax situation, if you are concerned about generational wealth transfer, and blah, blah, blah, well then it is okay, it is worth it to pay somebody. But we see accounts all the time and say to people you are paying way too much for advice. This is a really simple portfolio. You have pretty basic needs and just do this, this, and this, and you should not really be paying anybody a whole lot of anything for that. That is the basic advice.
The biggest problem with that advice is you know the math is unequivocal; the academic papers on it are just conclusive. There is no real debate about this. The problem is execution. Most people do not have the discipline to follow it, which means when everything looks terrible and crappy, they will override the automatic purchase when things were really cheap. Look at 2009 and look at the amount of inflows in the equities. It was de minimis, and if you are really doing that sort of dollar-cost averaging, you should be buying back when the S&P was in the high six hundreds and the DOW was in the six thousands, even seven thousands, eight thousands. And yet, most people do not do that. And when everybody is chatting about stocks, when things are at fifteen hundred on the S&P, sixteen hundred and it is a topic of conversation, the natural inclination is to say hey, I want to get involved in this and to pay up. You know, equities are the only thing in the world that we are much more comfortable paying more for than paying less for. And it is the way we are wired.
Chris Martenson: Just this morning I think I saw every major house have some sort of an article about gold in this post-QEternity sort of environment. What is your take on gold here?
Barry Ritholtz: Well, we first recommended gold based on Greenspan’s behavior back in – it is not quite a decade ago, but it is almost a decade ago. I know it is pretty clear, hey, here is what is going on, and here is inflation, and here is what is happening to the dollar, and I could look at those inputs and say, given those inputs, we are going to see gold prices go up. Now we are in a different environment. We have had the recession; we have had the crash. I am less convinced that I have any sort of insight as to guessing where gold is going to be.
With equities, I could look at discounted cash flow, and earnings, and dividends. With fixed income, I could look at what is the credit rating, is it AAA, is it B, is it this, what is the interest rate, what is the yield to maturity? And so there is some basis of pricing those assets. With gold, essentially I am now stuck with will someone want to pay more for it than I paid for it and that becomes a bit of a challenge, especially when you are coming up on two thousand dollars. This has historically been a place where it is tough to get through absent some major catastrophic events. So we own a little bit of gold. We have it as a little bit of a hedge.
The more I study gold prices, the more I think there is a minimal correlation with inflation and a much greater correlation with the value of the dollar, which is how it is priced, and the behavior of consumers in countries like India and China who are the big marginal buyers of gold. And anecdotally, I can tell you when prices get up to eighteen, nineteen hundred, two thousand, those consumers tend to be sellers, and when they get down sixteen, fifteen, fourteen, those consumers tend to be buyers. It is something that I just do not have a whole lot of insight into.
The one thing I could say about gold – at least when I look at oil, I can look at coal and I can look at natural gas and say, hey what do these cost per BTU, and how relevant is it, and how expensive is it to ship it, and you can easily ship oil, and you can easily ship coal, and it is a little harder to ship natural gas other than compressing it and liquefying it. So, there is some frame of reference to looking at the prices. With copper, and aluminum, and other industrial metals, you can look at demand and the overall economy. With gold, I cannot look at any of those things, so that is a long rambling way of me saying I have no idea where gold is going to go, but I do own a little bit of it.
Chris Martenson: [Laugh] That is fair enough. I like gold as well because there is a small embedded option value in it, which is that if we do have a big international currency crisis at some point, the idea that we might default to something that we know works, which would be a gold standard – whether that is modified, fractional, full-based, it does not matter. If that happens, I see very much higher gold prices, so I like the option value that it has got contained. And like all good options, it is way out of the money right now but will have just an excellent payout if it does come to pass. It is a long shot, but it is the kind of thing I have – I like to have a little of it in my portfolio on that basis alone.
Barry Ritholtz: There is some pretty wild forecasts, two thousand, twenty-two hundred. That is spitting distance; that is not a big deal. But I am always surprised when I see people say here is how we figure gold goes to $5000, or here is how gold could reach $12,000 an ounce. I am a little skeptical of those. I have found the Armageddon scenarios. It has always been a bad bet for two reasons. First, it has not happened, and second, if you win, how are you going to collect? So, I have not really been keen on the end of the world scenarios, and the here is what we are going to do because everything is going to hell, and so sell everything, buy bottled water and canned food, and buy gold. By the way, I love the group “Buy Physical Gold;” you do not even want to own an interest in gold. You want to physically have the gold in your – locked in a safe that is embedded in the concrete in your basement. I am not looking to fight off a zombie apocalypse if that is the case.
To me having a little bit of gold in portfolio makes sense. I think it is a good potential hedge against other forms of economic disruption, but I have no idea what the price is going to be.
Chris Martenson: I understand that. I do advocate physical gold, if only because, it is a way of controlling counterparty risk if you cannot assess –
Barry Ritholtz: Absolutely.
Chris Martenson: – where the counter party risk really is. You know that old saying, if you are at a card table and you do not know who the sucker is –
Barry Ritholtz: Yep, that is right.
Chris Martenson: – it is you. I cannot read JP Morgan’s 10q and make any sense of it. I honestly do not know what the risk there is, and I am not saying because of that I assume it is very high. I am telling you I do not understand their derivative positions or how they are hedged, and I lost confidence with their little whale shenanigan saying maybe they did not understand hedging as a verb either. So, at any rate, that is just one reason I get into that.
Oh, hey, as we come up on the end of our time, you have a really interesting conference coming up I would love to hear about.
Barry Ritholtz: Oh sure, so our conference – we do a big-picture conference every year and the whole goal of this is – you know some of the conferences out there are, here is this guy to tell you what stocks to buy, and here is somebody is going to tell you what to short. I have never been a fan of those sorts of things. What we prefer is teaching people to fish, as opposed to giving them a fish. And so, what we have managed to put together is just a killer line up of people coming to speak and it is just a –
I will give you a quick rundown:
- Neil Barofsky was the special investigator general of TARP. He is the first speaker, and he is going to describe the sort of stuff that happens in Washington, D.C. If you think you know what a disaster Washington, D.C. is, after spending time with Neil I discovered it is worse than anything I imagined.
- David Rosenberg, who used to be Merrill Lynch’s chief economist, has been dead on gold, dead on commodities, dead on fixed income for the past few years and has a really good macroeconomic perspective, will be speaking.
- Dylan Grice, very early in recognizing Europe as a big risk area, he is an economist in Société Générale, he will be speaking.
- Jim Bianco, really well-regarded institutional equity and market analyst; some great, great calls over the past few years; Jim is the guy who pretty much turned me on to here is what the impact of QE is going to be way back in August 2010 when people were looking at this market saying hey this is falling apart. He recognized really early QE was going to be the deciding factor.
- Michael Belkin used to be with Solomon Brothers. Now he is out in Washington state, puts out The Belkin Report. His clients are just giant hedge funds and mutual funds. Another guy down on the institutional side, really super well regarded.
- You may have seen the book, What Works on Wall Street; you know that is sort of a quant Bible – James O’Shaughnessy wrote that decades ago and I think it is in its eighth printing now; he will be speaking, super interesting guy.
- Richard Yamarone of Bloomberg is an economist there.
- Bill Gurtin runs Gurtin Fixed Income, just a really savvy, mealy bond shop, has just done really, really well when you have people like Meredith Whitney screaming the sky is falling, he goes through rubble and picks out the winners and losers. They have a great track record. People do not know him because it is a relatively modest size muni shop out in California, but they are great.
- Scott Patterson is a Wall Street Journal reporter, wrote two killer books. One is called The Quants, and the other is called, Dark Pools. They are both really good.
- He is doing a panel with Sal Arnuk, who is from Themis Trading, is a high frequency trading critic, and their book is Broken Markets.
- Actually, the person leading that panel is Josh Brown, who works with me. He is a well-regarded blogger and has a huge following on Twitter.
And then I, each year, use the conference to have a little fun and present something on behavioral economics and neuro-finance, and I want people to understand here is how flawed your thought process is, how you are going to make intelligent decisions about investing when you are really much more likely to panic about this, or misread that, or engage in selective perception with here or there. But, it is October tenth. If you go to “The Big Picture” blog at Ritholtz.com, you can find something for it, and I am looking forward to it. It should be a whole lot of fun.
Chris Martenson: October tenth, and where is that going to be held?
Barry Ritholtz: It is in New York City. It will be at the TIA Craft Conference Center, which is right in Midtown, and we have really put together a great list of people to share. I am very jazzed about it.
Chris Martenson: Yeah, you sound jazzed. It really sounds incredible. That is October tenth, and it is in New York. And we have been talking with Barry Ritholtz of “The Big Picture” and author of Bailout Nation. You should check out the website first, and read the book second, or reverse the order. However you get there, you really want to follow this guy. Thank you so much, Barry.
Barry Ritholtz: Well, thanks Chris. This has been fun.