MAGGIE LAKE: As you know, over the years on Real Vision, we've spoken to literally thousands of experts, including the world's best investors. All of that learning has been woven together to create this course so that you get the core principles based on real experiences and real market situations.
In these segments, throughout the modules, we're going to share with you some specific extracts from the Real Vision archive and break down the relevant concepts. This will give you more context for developing your own framework. Today, we'll focus on the different variables that drive financial markets. We'll focus on time horizons, breaking down secular, cyclical, and tactical market drivers, the importance of having a catalyst and a tailwind, liquidity, and much more.
Touching on an earlier point, change is the one thing that you can be certain of in markets. Whilst you need to be confident in your framework, you must also be prepared to adapt to the changing environment. Now, in order to do this, you'll need to have an understanding of what the dominant themes, or regimes, in markets are and know how to position for them.
Take, for example Harris Kupperman from Praetorian Capital, who uses macro tailwinds as part of his investment process before moving to select the right investments for the dominant theme. Many novice investors think they can just buy cheap stocks and short expensive ones, and they'll make money. But that's not really how it works.
As Harris explains, you also need a tailwind and a catalyst that will change the perception of the world about a given investment. Let's hear from him now.
MAX WIETHE: How do you layer in this macro thesis onto something where maybe you're finding some value to play that theme or there's an event that's going to really kick start it, but you are identifying larger trends as well?
HARRIS KUPPERMAN: Right. Well, see the thing is, there's a lot of cheap stocks in this world. Cheap stocks stay cheap. That's kind of my view. But when you have a macro tailwind. That tailwind pushes, and it bails you out of your mistakes, but more importantly, it pushes revenue and margins and everything else. And let's face it, most people like themes and they like narratives. Valuation is just a spreadsheet thing. It's always backwards looking anyway.
And so once you find a theme and people start connecting with that theme, you see huge price moves. Because themes are good on television and in newsletters, and people like to blog about themes. Saying this stock is at 10 times and we think it's worth 12 times, like you know?
So I mean, I started realizing that when you overlay multiple of these things, especially with a macro tailwind when it just goes better, and I start putting more and more of my time into the macro tailwind. Because you can identify the tailwind first, then you can drop down and figure out how to play it. And there's always different tools in your toolkit for how to play a theme.
I think that's really what I've spent more and more of my time on is just being smarter about playing a theme with less risk and upside still, and that's the hard part.
MAGGIE LAKE: So this is the crux of what we've been trying to get across in this module so far. Markets and asset classes don't just move randomly. There are themes that drive them across different time horizons, and understanding those themes and the environment you're playing in is usually the best starting point for generating solid investment ideas. And just to be clear, idea generation is only the start of the investment process, and there are many important steps that we'll review, but it's still a crucial component.
Now, in contrast to what we've heard so far, there are some investment managers that don't actually believe that they can consistently and accurately predict the market cycle at all. So they focus, instead, on building a portfolio that's exposed to the predominant regimes and seek to deliver consistent returns across all market environments.
Let's hear Chris Cole talking about this approach.
CHRIS COLE: We threw out all of that and said the best way to diversify, to choose diversifiers buyers is by their return according to market regimes. So you look at different diversifiers based on, OK, these assets perform well in a stagflation. These assets perform well in deflation. These assets perform well in secular growth.
And you look at diversification based on market regimes, rather than by asset class or by trailing volatility and correlations or covariance matrices. So when you do that, it becomes readily apparent what the optimal portfolio is, which really represents about 1/5 exposure to five different thematic or market regime asset classes.
The first asset class that I would talk about is equity linked or secular growth linked assets. These would include things like equity, real estate, value investments. These are assets that perform best during periods of growth cycles in the economy, so equity linked to equity like investments.
The second class would be interest rate-linked assets. These are assets like bonds, of course. The third is what I would call fiat alternatives. These are assets that perform during periods of rampant inflation or distrust in central government. Gold is the perfect example of a fiat alternative.
The fourth asset class is long volatility, something that performs in periods of change and turbulence in markets. Artemis is a long volatility hedge fund. And the final asset class is commodity trend. That represents trended momentum following in commodities or in currencies. And these are investments that perform particularly well during periods of deflation or stagflation, like the '70s.
So each of these five different market regime diversifiers, if you put about 1/5 exposure in each of these individual buckets, you end up with a portfolio that performs consistently through all market cycles, whether it's the 1930s and the market is crashing and we have 20 years of deflation and poor asset returns, whether it's the 1970s, whether it's the last 40 years of secular growth. At any point in time, one to three of these different asset classes are producing nonlinear returns that end up carrying the portfolio.
And I think last year was-- I cannot find a case study for what we call the dragon portfolio, this balanced portfolio. 2020 was the perfect case study for the dragon portfolio because it was almost like an entire business cycle in 12 months. We touched upon every single aspect of those market regimes in a 12-month time period.
MAGGIE LAKE: So it sounds like a pretty different approach versus Harris, right? In fact, the principle is actually the same. There are different tailwinds that drive markets, and they are in a constant state of flux. How you build a portfolio around them is up to you. Let's look at each of these trends individually to better demonstrate what we mean.
Starting with the secular, here's Raoul Pal talking about the importance of knowing the secular backdrop within your framework.
RAOUL PAL: I trade macro. What is macro, and why do I use the word investor? Now, the reason macro is basically the macroeconomic impact on asset prices and dislocations create asset prices by the movements in the economy. By definition, economic data generally comes monthly or quarterly. Yes, there's some high-frequency data.
So when you've got few data points, your time horizon has to be reasonably long, which many people don't understand with pure macro investing. That's old-school style macro. It's all based around that longer term narrative.
So when I look at macro, I start with the secular trends. I try and get an understanding of where the world is and where it's going in the longer term. And for things like that, these things build up over time, but if anybody is starting into macro, firstly, take out charts of every asset price and look at them over 50 years.
Long-term horizons, what are they doing? Are they are going up or down? So the secular trend in equities has been up. The secular trend in bonded yields has been down. Currencies move in bands. Gold tends to rise over time. There's certain understandings of that.
So that gives you a framework, and that's trend, but within that is macro because you need to understand why those things are happening. And those things have happened because of secular trends in the background, whether it's demographics. So demographics is the biggest driver of all because, as the Baby Boomers have put records amounts of money into the equity market, into their pension plans, they have done two things. They've driven up equity valuations over time.
So i.e. equities have got relatively more expensive versus the economy as a whole. And you can see that, let's say, in market cap to GDP. It's a good way of looking at that particular structure or the rise in PEs over time.
On the other side, it's driven down inflation because as people get older, their spending habits tend to be less inflationary, because there's less marginal consumption. It tends to be they already have. It's stock to flow. They've already got most of their stuff, and so you're not buying much. But if you were max to furnish that apartment that's behind you or the house that's behind, you that's a lot of spending. If you own it, you replace the light bulb and you change a sofa once every 10 years. Your marginal spending is less. And that is deflationary.
Additionally, the older you get, the more likely you have fixed income investments and you drive down bond yields. The other thing, the other big trend of our time is debt. We've seen a huge rise in debt. So that, I would say, is a secular trend.
How does that impact asset prices? Well, we've seen, for example, that companies have issued debt to buy back stock. So that's part of the equation of why the equity market has done this. But also, more and more debt makes it harder to raise interest rates and therefore, the absolute interest rates overall fall over time because of the debt burden.
So these are big macro pictures. These are the ones most people look at, but there are other ones as well. And other people will have their own views on what the secular themes are. Clearly, the rise of technology and the SaaS business model is a huge one that Stan Druckenmiller talks about. It's not one that I have been playing because it's more equity specific than my comfort zone.
I do look, for example, at the fantastic demographics and low debts of the countries around the Indian Ocean, which I call the monsoon countries. That's a secular investment opportunity that you'd rather be a buyer of India or the Middle East, et cetera, into large sell offs or bear markets, which come along. It gives you a bias towards your investments.
MAGGIE LAKE: First things first, the core secular drivers that Raoul identifies are demographics, debt, and technology. These are the variables alongside globalization that drive markets over very long time frames and open the door for long-term investment themes.
As Raoul says, don't worry if you only have a few data points to work with, but do realize that the fewer the data points the longer your time horizon should be. Keep that in mind. Whatever your time horizon is, be mindful of the longer term trends and behaviors of the different asset classes. Even if you have a shorter term focus, context always matters.
Next, let's hear from Lyn Alden about the role of inflation in this puzzle.
RAOUL PAL: What I'm trying to figure out is whether this is creating a step change in inflation, i.e. the trend of the last 30, 40 years is gone or whether demographics technology still kind of trump out in the end and this is a temporary structural shift we're seeing, which is generating this.
LYN ALDEN: So I think I mean most inflation is transitory, but transitory can last for years in inflation's case. So I mean, the '70s were transitory, but it was long enough that it wasn't really transitory in terms of a trading perspective and investment perspective, a lifestyle perspective. And so my base case for a while has been that the 2020s would be more inflationary than the 2010s.
The exact height they were going to reach depends on these variables that are hard to predict ahead of time, like whether or not there would be war, whether or not there would be factors like that. And so I think now we're at risk of hitting some of the higher levels of that kind of range, that probability range that I think was going to play out anyway, and now we're kind of on a higher side.
So I would characterize as kind of like the '70s or the '40s in the sense that we are going to probably have a pretty persistent amount of inflation, but even that, it won't be a straight line. If you look at the '40s, you had price controls at some point. '70s, you had price controls. You had wage controls. Basically, there are periods where even in an inflationary decade, you can have dis-inflationary periods. So you get these waves of inflation.
And I think the 2020s will be no different, where you could get, for example, a de-escalation of some of the big trends we're seeing now. Things can be overdone. Traders can pile in, things get to consensus, and then there's some sort of unwind of that, and then you can have another spike up. We've already seen this happen in European natural gas. For example, there are periods where it got overdone, came back down, and they got even more overdone.
And I think you could have the same thing and a longer trend line. So I do think that if you look over the past 25 years or so, historically, money supply in CPI, if you say five-year rolling periods rather than the noisy kind of year-over-year period, there generally is pretty strong correlation, but there are periods where you can have a pretty significant disconnect. And that's usually due to some rapid technological change. We've unlocked some new abundance that allows for less inflation than you'd expect from the money supply growth.
And so that happened, for example, in the late 1800s. You had the invention of the internal combustion engine. You had electrification. You had the discovery of oil. The United States had nearly unlimited land, and so that was abundance. And you kind had a similar thing over the past 25 years, where we unlocked so much global labor. And corporations were able to do a lot of geographic arbitrage that you've had a disconnect between, say money supply growth and wages domestically in many countries.
And so I think that that particular force is probably coming to an end, at least for a period of time. Because I think we've kind of squeezed a lot of juice out of the globalization orange, and now, we might have hit kind of peak globalization, meaning that we don't unwind globalization necessarily, but we could stop accelerating globalization and all else being equal, that should be more inflationary.
MAGGIE LAKE: As we all know, technology is one of the key drivers of secular trends, and Lyn illustrates that perfectly. New breakthroughs in technology tend to be a catalyst for change in the economy. From the internal combustion engine in the late 1800s to the evolution in oil drilling and the current drive to commercialize space, technological progress provides new opportunities.
Sometimes, though, the next big trend is simply a reversal of the last one. After all, almost everything in life is cyclical. In this instance, Lyn talks about the world potentially slowing down the rate of globalization. This is right at the intersection of demographics, debt, and geopolitics.
Speaking of which another trend unequivocally is the rise in debt that swept the majority of central banks around the world. This is a really important secular theme. So let's have a listen as to how debt has affected the investment landscape.
LYN ALDEN: So if you were to take a step back and explain why debt is deflationary and maybe how different types of debts could interface differently with the economy.
Eric Basmajian: Sure. So I guess I'll give you my summary of all of the research on debt that I find useful. There's remarkable consistencies across some of the research on debt, and I note four or five consistencies. First is that a little bit of debt is good. A little bit of debt can boost growth and can be pro inflationary because it can raise output above potential for a period of time. So that's the first thing.
The second thing is that a lot of debt is bad for growth. The third thing that's remarkably consistent is the thresholds that are outlined in these various academic papers at which debt starts to really have a negative impact on growth. And this is not just Reinhart and Rogoff, or this is dozens and dozens of studies that have been replicated across different statistical techniques that all seem to settle on the range of about 80% to 90% of GDP.
And that's not just at the government level, that's 80% to 90% of GDP across the household sector, the business sector, the government sector, and the financial sector. Any one of those sectors tends to cross 80% to 90% of GDP, we tend to see a negative impact on growth.
The other thing that's consistent, the last thing is that once you surpass those thresholds, the decline in growth gets non-linear. So it starts to look like a U. A little bit of growth helps, then it starts to level off and then it becomes like an upside down U.
So those are the four consistencies. And if we map the US's long-term growth-- I published some of these charts on Twitter, look at a 20-year annualized growth rate of real GDP-- our growth rate is taking on that upside down U-shape very consistent with the research.
So then you say, why is the debt causing that downdraft and growth and the inflation rates following? Mainly, it's because private investment is what tends to suffer, as debt levels get too high. And when private investment suffers, the infrastructure of the society tends to collapse. You tend to have overcapacity in certain issues or unutilized resources, things like too much excess labor.
And when you have too much capacity in some areas, then that tends to bring the inflation rate down. So the lack of investment tends to suppress the real growth rate, and then the real growth rate tends to drag the inflation rate down because as growth gets lower, you end up having an abundance of resources that you're not using for that growth, and that tends to drag the inflation rate lower.
So that's kind of how I square the debt picture with the growth and inflation picture is that too much debt ends up reducing private investment, which ends up reducing real growth, which ends up causing an excess of capacity in certain areas of the economy.
MAGGIE LAKE: So this provides another valuable insight on how to approach a shift in the long-term trend. If debt is something that plays a part in your analysis than having a broad understanding of how it affects pricing and growth is important. Once you've established the trend, you should perform further research to validate it and identify related opportunities.
Eric Basmajian: It's exactly right. I mean, it's critical to have the long-term view, right, Raoul? But what I think a lot of people miss is when you don't have that long-term secular view, that structural framework. We've seen over the last 10 years that people made these big mistakes, where every time we had a cyclical upturn, they mistaked it for a new secular regime, right?
But if you didn't have that backdrop to fall on, you're, OK, no, this is a cyclical upturn within a secular downturn. We're going to run into that secular ceiling. This isn't the start of something totally new.
RAOUL PAL: And also, the reverse. There's a lot of people who have this big picture view that the dollar is going to collapse or fiat money collapses. But that might be a 10 or 20-year view, but the business cycle exerts itself in the middle of all of that.
Eric Basmajian: Exactly. That's exactly right.
MAGGIE LAKE: And this is crucial, always be aware that there are three different time horizons at play-- secular, cyclical, and tactical. And don't let one of them deter you from the fact that the others are still in play. So with that, let's talk about one of the most widely followed, cyclical trends.