MAGGIE LAKE: What is value and does it drive asset prices? This might seem like a really silly question, because of course value drives price. But that begs the question, what drives value? And the answer to that is always supply and demand. Value investors are always trying to figure out what something is intrinsically worth.
But more thematic investors are aware of the fact that markets and sentiment are very dynamic and what we think is important now might not be important in a year. So it's not always as simple as determining what something is actually worth based on earnings, let's say. Oftentimes, at least in the intermediate term, value tends to be more in relative terms of some assets outperforming other assets because of the drivers and regimes we talked about.
That's what legendary macro investor Stan Druckenmiller told legendary value investor Seth Klarman in 2021. "You're a value investor. I'm not-- I don't what value means. I'm sure there's value out there but I'm unable to see what it is, it's really not my methodology. My North Star is every event in the world affects some security and I try to imagine the world as it is today and then try and see if there's some kind of seismic change going on and how the world might look in 18 months. And if it does look that way, what are the securities that would be priced very differently than they are now?
I think a lot of investors live in the present, which is a disaster long term. It might work short term. By the way, this aligns me with a lot of you value investors. Not because I'm buying value but because the way cyclicality of the world works, I end up in that kind of situation."
This is essentially what we're going to unpack in this section. You need to understand what the key drivers of each asset class are so that you can become better at allocating to each one depending on the market environment. In doing so, you'll come to appreciate the interconnectedness of markets and how to dive deeper into individual asset classes and master them if you choose to do so.
For now though, we begin with a look at historical patterns that can advise us about the future performance in each asset class. And on top of this, we want to understand the relationships between these different groups and subgroups of assets to be able to find the best expression of our investment ideas and combine them in a diversified portfolio. Let's get started.
JASON BUCK: We talked about the idea of using semi-vanilla backtests to get an intuition pump of what the last 100 years look like. And then I think about moving into the next 100 years. If I steelman the other side, what should I be worried about? And I think about-- over the last 100 years, 100 years plus, we've gone to one billion people in the workforce to five billion people in the workforce, right?
And if we're moving towards peak population, we may never see a workforce expansion like that that we saw in the last 100 years. And as we all start-- as we're all online and moving into the metaverse, we may see dematerialization effects. So I'm curious to what keeps you up at night worrying about the future? But maybe also it doesn't keep you up at night knowing if you're holding all the world's asset classes and rebalancing, you're doing the best you can, come what may.
CHRIS COLE: Well one of the things that keeps me up at night a little bit-- and it's why I broaden the definitions of the asset classes-- is this idea, like, instead of gold, we say fiat alternatives. And the reason I'll put fiat alternatives instead of gold is because, well, let's just imagine-- I think this is a very trendy thing to imagine right now as Bitcoin is at all-time highs-- but let's imagine a world where we move away from gold into cryptocurrencies. Now, I'm of a belief-- and some of my people might call me outdated.
But we've got over 2,000 years of history on gold and we have a very short history on crypto assets. So I really firmly believe that gold will be the standard bearer, and will continue to be a standard bearer, of fiat alternatives. And that's the way that we plan to run our Dragon Portfolio.
But I want to keep an open mind to this idea that you could have a changing reality where what-- the optimal fiat alternative could shift. And I think one has to maintain an open mind to that effect. So I think those are the types of things that I really try to keep my eye on is this idea, like, it's not the asset class. It's not gold. It's not stocks. It's not real estate. It's how the asset performs in the market regime.
So the question one has to ask-- you're looking to protect against these market regimes. And the question you have to ask yourself continuously is, will the assets I've selected continue to protect me against those market regime events? So that's true-- that's true based on changing technology. It's true based on changing supply/demand dynamics. And so that's the question that keeps me up at night and that requires constant thinking about when you're constructing these types of portfolios.
And the challenges could be structural, flow-based, or regulatory-based. For example, hey, maybe all of a sudden there's a completely different way equities are taxed versus real estate. And maybe real estate becomes a better way to play secular growth than equities. I don't know, but these are the questions that one would have to pose. What matters is how the different asset classes play in the regimes, not necessarily the asset class itself.
RAOUL PAL: So now I've got that. I then spend a lot of time looking at the big-picture charts, the really long-term charts. What does the chart of copper look like not this year, not this week, not last month, not last five years, not 10 years, not 20 years-- 50 years, or 100 years? I want to see the big patterns. And I look at them either outright or inflation adjusted terms, or maybe versus another commodity. I want to understand where we are in all of these. So for example, from that is one of the fallouts is over time if we're getting more bearish on the equity market based on both the economic cycle, the debt cycle, and the demographic cycle, well, it's interesting to see gold is so cheap versus equities over that long-term structure.
So it gives you a bias there that you probably want to own gold more than you want to own equities, and certainly in certain types of environments. So I look at all the long-term charts from the big emerging market patterns, all the major stock markets, all the major sectors, every major currency, all the currency indices, the commodity indices, the metals, the precious metals, the agricultural commodities. I look at the bond markets around the world. I want to what Indian bond yields are doing versus US bond yields.
I want to know what all of these things look like. I want to understand the correlations between them. What are the bets that's actually happening here?
Because when, for example, you adjust the Euro stocks-- no, if you-- if you were to put the US banking sector into euros, it actually looks like the European banking sector. So actually, what we've got is a currency difference, not a banking sector difference. Things like this. And that takes time. And it's fun, because you're playing around with stuff, and he just looking at it, trying to get variant observations of what could be going on.
MAGGIE LAKE: So to pick up with that last point that Raoul makes, because it's a very easy thing to add into your idea process and it almost certainly puts you one step ahead of other investors. And that is, look at the relationships between different assets. Don't just look at a gold mining stock or an oil company in isolation. Instead, view them versus the price of gold or oil and understand their sensitivities to the raw commodities that they produce. Look at what countries import and export and try to apply that knowledge to analyzing their currencies. For instance, why is the Australian dollar so correlated to copper?
Play around with all these assets. Have some fun. Share a chart with a friend or the entire community. The next step is, as Chris Cole says, understanding how those assets will perform during different market regimes. Because the one certainty we have in markets is that they're always changing. So putting these two things together, let's now explore how each underlying asset class performs under different scenarios, starting with the most popular one-- equities.
DARIUS DALE: Yeah I'm less concerned about sectors and more concerned about style factors. But I'll answer the sector question.
TONY GREER: OK, no, however you like, Darius. Answer the question your way.
DARIUS DALE: Yeah, I believe the audience certainly understands the difference. And there's plenty of investors, professional investors, watching who understand this as well. With respect to sectors, I think in the environment that I'm describing, you want to be long things like health care. You want to be long things like consumer staples. You want to be long things like utilities and REITs. I do believe tech has a place in there as well, particularly the megacap FANG type exposure, the quote unquote secular growers, or the high-quality compounders as they call them in Boston.
So I do believe those are the kinds of exposures you want. And again, notice I didn't say financials, materials, industrials, energy. It's not that those things won't work in a bull market that's peaking. But certainly, it's not where I want to be in terms of trying to get out of those exposures whenever I think it's time to get out.
And so I just I want to be cognizant of the changing dynamics in the economy that might actually facilitate some disparate changes. And we're actually already picking that up in our dispersion analysis. One thing we track every day is 50 US equity sectors and style factors on a month-on-month Sharpe ratio basis.
And the reason we look at it like that is as a proxy, a real-time proxy for institutional flows, particularly the flows of the PodShop community. You've got your Citadels, the Millenniums, the Balyasnys, the Point72s of the world, the guys who are making shorter term trading decisions but have an enormous influence on the overall turnover in the market, both as a function of their fundamental bets and the function of their systematic hedging. So that process has already picked up a shift towards a slight defensive tilt in the equity and sector style factor leadership. And I do believe that is likely to persist into next year.
But with respect to style factor specifically, again, I think it's low beta over high beta. I think it's megacap over small cap. And then I think it's growth over value. To me, if you just make those three pivots, you don't really need to do any other work at the sector level, quite frankly, because I think style factors trump sectors when you're talking about risk managing of growth slowing environment.
MAGGIE LAKE: So that there are various different sectors which all seem to trade differently. But broadly speaking, they fall into two buckets-- cyclical and defensive. Utilities, for example, are more defensive as we still require water, electricity, and heating even during a recession. And luxury goods, on the other hand, are more economically sensitive, of course. Darius says we can really break them down into three main categories, which he calls style factors. These are high versus low beta or, in other words, high or low sensitivity to the overall stock index. This definition helps with risk management, too, as we'll see later.
The next is small versus mega caps, meaning the size or capitalization of the company. And finally, value versus growth, which is focused on the valuation drivers of the stock. The point is that each of these style factors perform differently depending on market environments. In good times, for example, the smaller and more market-sensitive companies tend to outperform. This reverses when the tide turns.
Now, you can mitigate all these sensitivities by only investing or trading one sector and picking stocks against each other. If you remember, that's what Jamie talked about in the discussion. He only traded insurance companies against each other and was relatively sheltered from broader market influences. But for the vast majority of investors, knowing companies at that level of detail is likely impractical, particularly if investing across a number of sectors. In that case, zooming out a little and going up to the sector and style factor level will prevent you from having to select individual stocks. Let's hear what Eric Basmajian had to add to this subject.
LYN ALDEN: So if you focus on those indicators and then how they pertain to market prices, what sort of correlations or causation have you found? So say you're accurate about all these-- the growth and the inflation. How do you translate that into an investment portfolio? And how do you monitor risk or monitor if those trades are working out?
ERIC BASMAJIAN: Sure. So I start with a balanced framework. And this can be applied to any sort of balanced framework. I gravitate to the all-weather framework, combination of long-term bonds, intermediate-term bonds, stocks, gold, and commodities. And that's sort of where I approach every situation. I come to the table with a balanced framework.
Then I tilt in a direction that's most aligned with the long-term trend. So I'm always going to have a bias towards the treasury allocation or the growth slowing allocation, which tends to favor treasuries over things like commodities. But then I also am cognizant of the short-term trends.
So when the short-term trends are pointing higher, you'd want to be doing the opposite, basically. You'd want to be overweight, or starting to overweight, commodities, risk assets, things that perform well when growth is increasing. And those are the correlations that I find. So when growth is increasing, specifically nominal growth, equities perform basically the best out of all those assets, commodities the second best. And within the equity sector, you want to be tilted more towards the cyclical equities, the small caps, the industrials, things that benefit from that manufacturing upturn.
So I come to the table with a balanced framework. I have a long-term bias to my long-term views. Then I take the shorter term indicators and I sort of tilt or overlay that on top. And right now with the indicators pointing higher, I'm tilted more heavily towards commodities than I normally would be. And my stock allocation has small caps where it's typically more large cap defensive as a balanced framework.
LYN ALDEN: And how are you seeing banks fitting into that? Because I saw some interesting charts the other day showing that banks and energy have been just key underperformers for a while now. So a lot of people focus, for example, on growth versus value.
But value can be further separated into defensive value versus cyclical value. And it's really been in that cyclical value where there's been a lot of underperformance. And there's some kind of a recent rebound there where you see them upticking, especially ever since we got some of the vaccine announcements a few months ago. So how do you see the energy and financial sectors playing out over the next six months or maybe longer term?
ERIC BASMAJIAN: So I'm a little bit more cautious on the banks. I mean, I've had a long-term short position on specifically the regional bank since 2018, which has worked out quite well. But I've pared that back to basically the smallest allocation I could have on the short side. Because these cyclical trends, when there's an upturn, the bias for long-term interest rates is higher. So the bias for the yield curve is steeper. That's going to tend to benefit the banks.
But I'm cautious on the banks. Because they're fighting such a secular trend of rock bottom, both short-term interest rates and long-term interest rates, that-- I'm aware that the short-term trends can benefit them. But I think that the banks, specifically the regional banks-- I don't really deal too much with the large banks that have much more diversified revenue streams. Focusing mostly on the smaller banks that are mostly just spread plays. And I'm still cautious there. But I've pared back the short position to as small as I can because of the cyclical upturn.
So once I see the indicator start to roll over again, and I would think that long-term interest rates would start to have downward pressure, I would increase that short position again. Because I think the long-term trends are very powerful against the banks. Looking to things like Japan and Europe, I think that our smaller banks will go the way of Japan and Europe. Larger banks, totally different story.
Energy is interesting as well. I don't like the energy sector. I prefer to just be exposed to the commodities at this point. The energy sector-- high debt.
The business model of the energy sector, specifically the frackers, is one that makes me cautious. Have to spend a lot of capital to build a well that just depletes. And then you have to spend more capital on another well. And that business model, to me, is tough. Because it's so reliant on constantly issuing new debt or new equity that during these upturns, I prefer to just be exposed to the actual commodity price versus the energy sector.
MAGGIE LAKE: As we heard, Eric considers style factors and sectors together in order to identify what should outperform in various market environments. He has a view and looks at the sectors and style factors to know which ones to play when. If the economic data is improving, he wants small cap, cyclical, and growth to be a leveraged play on the regime. And then he can stock pick within that to further increase his chances of outperformance. It's almost like he's mapped out a flowchart in his head for which types of stocks to play when.
Here's the interesting thing. Eric explained his approach to investing in equities without talking about valuations once. The reason for that is, similar to Stan Druckenmiller, he likes to think of regimes and catalysts as the main driver to stock performance over his time horizon rather than intrinsic value.
But then again, there are times when fundamentals dominate. And that's what Roger talks about a lot in the discussion. This may not have been the case for a while now, but that doesn't mean that fundamentals are irrelevant and they won't make a comeback at some point.
If there's one principle to remember, the longer your time horizon, the more relevant fundamental value will be. Stronger economies grow faster than weaker ones, better businesses outperform average ones, and so on. But usually, you need time on your side to capture that long-term value. You just have to understand the market you are in and select an approach accordingly. Now, let's take a look at the other three asset classes-- commodities, currencies, and bonds.