7 October 2018

On today’s show, we talk to billionaire, Howard Marks. Mr. Marks has produced a 19% annual return for the past 22 years investing in distressed debt. He has been a money manager for 50 years and is a renowned luminary in security analysis.

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  • Why artificial intelligence has so far shown no evidence of consistently outperforming the stock market.
  • How to factor in volatility in your momentum strategy.
  • How to include value in your momentum strategy.
  • Why the market is signaling that we won’t have conventional inflation in the time to come.


Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

Preston Pysh  0:02  

On today’s show, we’re really thrilled to bring you our interview with quant investor, Dr. Wesley Gray. 

Dr. Gray is the Founder of the Alpha Architect and is also a Contributor at the Wall Street Journal. We’ve had Wes on the show numerous times in the past. We always receive such positive feedback from members of our audience about the discussions that we have with him. 

On today’s show with Wes, we’re talking about artificial intelligence and what impacts it might have in the financial management world. 

Additionally, Wes talks to us about the current market conditions and how he’s currently positioning himself based on the fundamental and momentum indicators that Wes uses. Without further delay, here’s our interview with the talented Dr. Wesley Gray.

Intro 0:46  

You are listening to The Investor’s Podcast, where we study the financial markets and read the books that influenced self-made billionaires the most. We keep you informed and prepared for the unexpected.

Preston Pysh  1:06  

All right. Welcome to The Investor’s Podcast. We’re thrilled to have you with us today. Like we said in the introduction, we have Wes Gray here with us. 

Wes, welcome back to the show. Thrilled to have you. 

Wesley Gray  1:17  

I appreciate you putting the time in.

Read More

Preston Pysh  1:20  

Wes, I want to start off the conversation talking about a thing that Stig and I have been doing a lot of research on lately and that’s artificial intelligence. I’m digging around on the internet. I’m scrounging for research papers and whatnot. I just keep coming up to the same website talking about artificial intelligence and investing. 

It’s your website, Alpha Architect. Almost every hit that I get for any type of search that I’m doing that involves deep learning, machine learning, neural networks meshed with any type of investing, I’m getting hits on your site.  

I know you guys are doing a lot of research in this area. I’m just curious from an overall point of view, how do you see AI interacting with investing? What do you see this progressing to in the coming 5 to 10 years? 

I know if you guys are doing anything proprietary, we obviously want to respect that, but if you can talk to us about what you guys are up to, let us know.

Wesley Gray  2:12  

I’m like you. I’m trying to learn as fast and rapidly as I can. What we’re doing is we’re partnering up and a lot of other folks that have more knowledge in the space than myself. We got a lot of smart people. 

Then another thing I recommend people read, I actually got the book right here called “AIQ.” I like it because it’s highly accessible in the sense that it’s not like a bunch of math equations and Python code. 

Professor Polson was always very open about being a great teacher and I think his book does a good job of saying, “Hey, these are the high level concepts of what this thing is.”

All that said, all this excitement honestly, I think we should be very careful because a lot of this is marketing. We have not found any evidence, at least in the context of long term investment strategies where long term is say, monthly rebounds, which for many is pretty damn short. 

It suggests that it adds any value beyond where kind of common known things like buy cheap stocks and buy momentum stocks. That’s not to be closed-minded to say that it can’t add value, but no one has shown to us beyond any definitive doubt that it would be worth adding from an evidence-based standpoint. 

Whereas I do understand that a lot of people are saying, “Well, that’s great marketing.” But we try to avoid being about marketing and trying to be about transparency and evidence-based. To be frank, exciting, but haven’t found any useful applications thus far, to be completely honest.

Stig Brodersen  3:51  

Wes, would that be because you only have a very limited amount of data? I mean, most AI funds are really new. Is that why you haven’t found anything or is it because of different factors, where you at least for now can conclude that it does not have significant impact?

Wesley Gray  4:08  

What we’ve found is relative to known technologies already out there. It’s very hard to differentiate it like, “Oh, this adds so much value.” After considering the complexity, the blackbox-ness, and the inability to truly understand…

Let’s say, you got a strategy that makes 10% a year having back tested and memorized these databases at this point. It’s so much noise and little things are so much. My data is not going to move the needle one way or the other. 

Now, the big issue also is the level of frequency. We’re kind of more long term, low frequency investors. There’s just only so much data in the samples out there, right? So I don’t even know if you could ever definitively “prove” to yourself that the machine learning was working, given the history of *inaudible*. 

Where I do think it could be more useful and I know it’s in more application and it isn’t super high frequency, where there’s a ton of data and resolution. We take all the data in. Tomorrow, this is resolved because we know who won or lost. I then think there it probably has more applications.

Preston Pysh  5:22  

Now, I don’t want to confuse the audience here with what I’m saying. The book that Wes recommended was “AIQ.” I was curious if you’ve seen this ETF ticker called AIEQ and if you have any thoughts on it, because so far, it’s been outperforming the market since its inception. However, it’s only been on the market for coming up on a year here pretty soon.

Wesley Gray  5:44  

Yeah, so I figured you might ask a question about that because I know you guys had the gentleman on your podcast recently that runs it. That was, by the way, a fascinating conversation and there’s nothing against what we’re doing. 

Again, we’re looking at it in one understanding as well, but here’s the thing. If you look at our stuff this past year today, especially our momentum fund, we’re also destroying the market. We’ve also been destroyed in the past. We’ve just had a lot more time and grade than they have.

They actually move very similarly and we’re actually beating them. That’s not to say that we’re that great. It’s just to say that controlling for known things like concentrated momentum investing, it kicked ass this last year, but we don’t have 10,000 data points. 

We’re not fueled by IBM Watson. I don’t think that there’s a reason to be super excited with AIEQ based on the performance, because I think it’s really just their factor tilts are probably expanding a lot of what they’re doing. 

It’s always important to dig in the weeds because you can just beat the market over any given time period, especially short windows. That’s pretty easy to do, depending on what the characteristics of your portfolio look like and how those characteristics perform.

Stig Brodersen  7:01  

That’s a very interesting point and what’s going to happen when you see seasons change and all stocks drop, what’s going to happen with these AI stock picks? 

Looking at some of the holdings they have, it kind of looks like momentum picks. As you mentioned before, momentum has been really strong here and has been outperforming. Could you also mention the stock ticker for the fund that you’re running in terms of momentum and then perhaps people can even compare?

Wesley Gray  7:30  

Sure. What I recommend is just go to our ETF website, alphaarchitect.com. We generally refrain from talking about our own tickers to find *inaudible* on here, but if you just Google it, and type in momentum, Alpha Architect, you’ll be able to find out about it. Not a problem.

Preston Pysh  7:46  

Awesome. How do you think about volatility in a momentum strategy? What I’ve noticed is I’m trying to implement momentum and I’m obviously not the best momentum guy, but what I’ve noticed is when I find something that has very low volatility but has the same momentum qualities of something that doesn’t have so much volatility, that is a huge benefit for me. I’m kind of curious how you guys view volatility when you’re trading momentum.

Wesley Gray  8:12  

People should always consider the beta or the volatility whenever they’re doing momentum because stepping back and thinking about it. If you’re in a market with tons of raging stocks, i.e. like right now, or maybe like the last few years, by nature, all the high momentum names are just going to be the most volatile, most risky, because they paid off the best, right? 

So what a lot of people will do is there’s a thing called alpha risk adjusted momentum. They’ll look at all the stocks, but then they’ll control for their market beta and for market exposure, in your sense, essentially saying, “Hey, like low vol that also has the similar momentum.”

In general, that seems to be a more effective way of picking momentum stocks. 

In particular, we wrote a whole book about this and looked at *inaudible*. What came out there is we used an algorithm called “frog in the pan.” The “frog in the pan” algorithm is essentially saying… 

And the reason it’s called “frog in the pan” is we want to look for this slow boiling momentum, not like the ice momentum, ie, we kind of like this more low vol momentum, not like the biotech goes up 100% as a momentum. 

It’s called frog in the pan, and really, anything that captures that idea if you’ve got high momentum, but the path to get there was to dip the frog in the cold water and you slowly turn them up and he gets cooked in the end. That’s the better type of momentum that you want, at least empirically to work that from an investment standpoint.

Preston Pysh  9:43  

That’s what I was hoping you were going to say and I’m glad you did.

Wesley Gray  9:46  

Yeah, it’s just a caveat. Like anything, it’s noisy and doesn’t work all the time.. When I say “works,” I mean hammering on every market we could find over a super long period. 

On average, it has an edge relative to just generic momentum strategies. I would just like to reiterate, every time you say something works in investing, it means it works over long periods with a small edge. It’s not like the day trading strategy that will make you a private island owner.

Preston Pysh  10:20  

I’ve got a question for you. We saw the market hit a huge top. It was like going parabolic back in January of 2018. Then it had a really abrupt correction. The S&P 500 comes down and hits the 200-day moving average. It bounces around at that level and then has slowly started to recover off of that 200-day moving average.

As a momentum investor, I’m just kind of curious how you guys were viewing this event back then. How close were you to liquidating some of your positions because from a fundamental standpoint, we all know this thing is screaming high right now, but from a momentum standpoint, I know you might say, “Hey, if the momentum is good, I’m just going to continue to hold until that change.” 

I’m really curious how you guys were viewing this event back then and were you guys kind of getting a little bit on edge?

Wesley Gray  11:07  

I don’t get on edge because I have computers worry about that for me so I don’t have to get emotional about anything. We weren’t that concerned because we’re using a 12-month moving average and 12 months of what they called time series. We were always still pretty far away from those. 

If you were in the 10-month 200-day range, your feet were getting a little bit on fire there. To be frank, I don’t know if that would trigger things. I know our stuff was pretty far away. We weren’t worried about it. 

That said, the international markets have been way rockier that has sparked it. We did hedge a little bit a couple months ago, pulled it back off and now we’re potentially going to put it back on. 

We are in the phase right now, at least on international markets, where we are either being hedged or about to be hedged again. We want to start by *inaudible* for that market risk off there, but the US is long and strong.

Stig Brodersen  12:02  

Which international markets are you talking about here? 

Wesley Gray  12:05  

I’m actually talking about all of them. I’m talking specifically about International Develop. You look at all of them like Develop, China, I mean, any of the international markets, it’s been a much rocky road than the US equity has been. Trend following is earned. It matters a  little bit out there. We’re here in the States and we’re just riding the Trump wave, I guess.

Stig Brodersen  12:30  

I would like to continue talking about this concept, then in association with inflation. Whenever we look at inflation, at least by the conventional metrics, you have your basket of various goods that you need such as household, energy, and so on and so forth. If you look at those metrics, it seems like inflation has barely moved. 

On the other hand, then we have something like quantitative easing, where you will go in and supply the system with a lot of money. Basically bonds will be replaced with cash and that cash would be pumped into the system. It allows that into the equities market. 

I guess this is my long winded way of asking you, how do you see this relationship here? Do you see this as quantitative easing having an impact on inflation, just not inflation that is getting reported?

Wesley Gray  13:23  

Honestly, I should think I knew about this stuff. Frankly, I have no clue. However, I will tell you a story.  

I’m a University Chicago Milton Friedman bible thumper here. I’m a “free markets, I believe in his idea.” I used to say, “Hey, if you print a bunch of money and do a bunch of events to pay the piper in the form of price inflation.” Of course, it always comes around and they’re printing money *inaudible*. 

My intuition was holy cow, we’re going to have inflation and of course, in normal price inflation indexes, to your point, we haven’t seen that. A lot of people say, “Well, they printed money, but it’s in the bank.” But they also inherently kept basically the risk-free hurdle rate way low. It encouraged people to invest in rich assets. They could get a premium, which was embedded in kind of an asset inflation. 

Now, here’s the thing, whether it’s in asset inflation or where it is, in the end, too few dollars chasing too few goods. I was still expected, according to the old theories to be in AI type metrics. 

I think this is almost a narrative that we’ve somehow backed in, “Oh, well. It went into assets.” However, I don’t know of any theory or any macro communications out there that explain how this story ends. 

I agree with the narrative there, but I just don’t have any clue on the dynamics of how that plays out in the future. 

Preston Pysh  14:53  

Yeah, that makes two of us. 

Wesley Gray  14:55  

All you have to do is look at all the extra Chicago guys that came out of 2008. Everyone with that New York Times guy, Krugman, he was explaining at the time, “No, this will not end up in inflation. You guys are all wrong. You’re not thinking about this right?”

He was getting blown off the mountain in Chicago. The guys were just saying he was an idiot and we’re all screwed. However, they were all wrong. 

Again, I kind of got mentally screwed up there because my old mental model obviously didn’t explain the world that well. So I’m still learning myself here, man. I’m trying to figure out on how this all plays out, to be completely honest.

Preston Pysh  15:36  

Let’s say we go through another cycle and we fast forward years in the future here and we go through another credit cycle, they obviously turn right back to the QE again. Well, we know we can’t say with 100% confidence, but I think we could say with quite a bit of confidence that if we do more QE, it’s going to drop interest rates lower because of somebody buying at any price really in the bond market. 

Wesley Gray  15:57  

At least in the short side of the Treasury market.

Preston Pysh  16:00  

Yeah, and I think even in this last credit cycle, we saw Operation Twist where they were buying even outside of the short end of the cycle. I think that that’s really kind of the play during the next credit cycle is that they’re going to extend themselves, not just that the federal funds rate, but they’re going to actually go out on the longer end of the bond yield curve. 

When they do that, what we’re seeing is that they’re replacing credit with hard currency. You can continue to do that as long as you’re doing one for one swap, where you’re taking hard cash and you’re replacing it with credit. 

However, once you have exchanged all that, and now you’re trying to manufacture growth through manipulation of the currency is really what’s happening. I think you would agree. That’s where I think you might start to see the inflation go crazy if all of that would continue to play out.

If what I just described is tools that are used, I think that’s where you could potentially see it. I think why Krugman was right on this last credit cycle was because it was kind of a one for one swap with the hard currency for the credit that it was replacing.

Wesley Gray  17:04  

One thing that I am fascinated about, look out there, the term structure right now it’s crazy. The 30-year, the 10-year versus the 2-year. They’re about the same. It seems like market participants and I do not believe that the federal government has enough clout to control the 30-year… 

It’s basically saying that it’s expected inflation for the next bazillion years is not that high. That’s just really perplexing to me, because I just can’t believe that it seems like the economy is on fire. 

They’re doing a lot of things like policy wise, or even if the president is kind of a little bit out there from a PR perspective. From a straight economic policy, outside of the trade war stuff, lower taxes, lower regulation that we see in our business. It just seems like this sucker is raging and everyone I talked to, business people, says, “This thing is awesome. You got a raging bull economy.” 

Then somehow somewhere all this inflation, fake money and printed dollars were put out there somewhere. It seems to me like it’s got to get rocking here at some point, but again, a mild mental model of how the world works. I’m kind of naturally like a gold guy. l would like to know that my dollar is worth that.

Stig Brodersen  18:23  

Now, if you look at Japan, they might be 10 or 20 years ahead of us in terms of a long term cycle. If you look at their inflation numbers, I mean, they’ve been so low a thing back in 2014, for a brief period of time, it was over 2%. 

However, it’s been zero, sub zero. It’s been outrageous and they’re not just buying up the bond market. Now they’re starting to buy out the equities market.

Wesley Gray  18:50  

That’s a perfect example of how many hedge fund graveyards have been dug by being short the frickin JGB. I’ve seen so many smart pitches over the years. All these people are just face down in a grave right now. They got their face ripped off and have that mental model of like print money. Here comes a debt and eventually inflation monsters will be here. It just doesn’t happen. 

However, I think the key difference is we’ve got some difference. We’ve got a ripping raging dynamic economy on the cusp of potentially happening here, whereas Japan kind of went from like a pinnacle monster asset bubble that blew them out. They were never able to recover from that economic window. 

Whereas here we could have a monster asset bubble, but I think we have a lot of real growth and real change that is generating real GDP, which could put us back in the inflation potential camp, versus like 20 or 30 years from now or on CPI of 10 dips or whatever. Who knows? We’ll find out. It’ll be an interesting experiment.

Preston Pysh  19:58  

I mean, the great thing about your strategy is you could be dead wrong about that but you’d probably still make money because you’re following the momentum and you’re following the trend. If it tells you something different than what your thesis is telling you, you go with what the trend is telling. 

Wesley Gray  20:13  

The great irony is prices tell you everything and usually have the wisdom of the crowds embedded in them, even if it’s entirely against your narrative. So if the prices on bonds start ripping, i.e. yields start going way up, freaking short that. 

Similarly, if bond prices start going way up, and you’ll start coming down, even though I believe inflation is imminent. I don’t care. I’m going to get long bonds. That’s why I love trend following. 

You no longer have to rely on what you want. You just follow what the market is telling you. It feels to me like relying on what the market thinks a lot of times is a lot smarter than relying on what your monkey brain says that your narrative is so powerful.

Stig Brodersen  21:07  

Is the process more that you would find undervalued stocks and then find the right momentum or is it looking at momentum and then see if some of those momentum stocks also are undervalued?

Wesley Gray  21:20  

I don’t know. I buy cheap, nasty value stocks, things like Kohl’s or Macy’s or whatever. Total dirtball mean reversion trade, and I say, “Great, that’s my religion.” That’s my story and if I died, no problem there. Though I also recognize that a lot of these things are controlled by Amazon. 

On the other hand, I got momentum. So, I’m just buying the highest flyers out there. The divergence is great. I got the mean reversion trade, but I’m coupling that in a barbell with you know the non-mean reversion trade, the momentum trade. You want to pull those together. You kind of went either way. If you knew exactly which one was going to work, you pick that.

Name me the guy who has a genie in their bottle that can tell him what the future is going to hold. No one can. So I’m just going to hold the best of those. Then as far as managing data or managing my overall market risk, I’m going to use trend following on that.

If risk is paying off, and I see that in price trends, I own it. If it’s not, get flat. I don’t call a buy and hold. I call a buy and suffer which is great if you’ve got the ability to do that. But if there’s a way to kind of sidestep the suffering, and it seems somewhat reasonable, why not do that? 

I’m just a trend follower and on stock picking, I like mean reversion and  I also like momentum. I just pull them together because I just don’t know. It’s really about placing your bets. Know the different buckets out there, knowing full well that one of them is not going to work that’s why you need to diversify your concepts. 

Preston Pysh  23:02  

Right now is 30 of August 2018. So what we’re about to talk about, it’s pretty specific to when we recorded this, but right now, what are some of the trend following and momentum areas that you like?

Wesley Gray  23:14  

Where are the trends?

Preston Pysh  23:16  

Yeah, what would you say are some of the strongest trends that are going on right now?

Wesley Gray  23:19  

Really, what you got right now is US equity, obviously. A lot of things mix. The bond complex has been kind of whipsaw around. Right now if you’re short on the bond, like the 10-Year complex across the globe, you’re generally long.

Commodity complex is kind of mixed like metals, you’re generally short. So a lot of the energy sector, you’re generally long, but that’s starting to change as well. 

I would say across the board, outside of US equity, and it’s just a broad based statement. It’s kind of whipsawing around and mixing. But that’s why you trend follow, eventually some trend will probably emerge here. Just for the most part, we haven’t been in any great positive trends and the only thing you’re starting to see now are big negative trends. 

One example I was telling you about there’s like international equity. That’s where a lot of storms are out there brewing and you’re seeing that in price action. That’d be a market. If you believe in trend following, you might want to start risking or at least watching where those price action is going and take your risk gingerly.

Preston Pysh  24:29  

The one thing I want to talk about, Wes, last year at this time I participated in this amazing event that you put on. I had the pleasure of hanging out with Ted and Patrick O’Shaughnessy, yourself and many others. 

For people that don’t know, Wes is a former Marine and once a year he, Jack Bogle and some other folks there at Alpha Architect put together this event in coordination with the Pennsylvania National Guard.

They go out and they get a barracks. I show up and there’s Drill Sergeant Gray bossing everybody through the open bays, we’re all sleeping in open bays. We’re all eating chow together. Then we go out and we do this massive hike, 28 miles. Let me tell you, what an event.

Wes is doing it again, unfortunately, I am not able to go this year. I was going to be there and then my schedule changed a little bit and I wasn’t able to pull it off. 

Wes, what’s the date for this year?

Wesley Gray  25:25  

So, it’s *inaudible*. A lot of people just know that this is not a charity event at all. We’re not going to ask you for money. We float all the chow, all the lodging. Just got to show up. This is a living memorial. 

Represent and look at a gold star family. If people don’t know what a gold star family is, it is if someone had a son or daughter who was killed in action. Let them know that we still remember the sister or son. It’s like a living memorial. So that’s your charity: showing up.

It’s basically the 29th of September. The plan though is you show up on the 28th, that Friday and we do some tribal bonding. We got some chow, we got some speakers. You can do five miles or ten miles.

Preston Pysh  26:10  

I can tell you personally this was just an amazing event. The people that are there are amazing but really the mission of why you’re going there and what you’re doing. 

Every mile marker, they had a soldier who had lost his life or her life. It was just amazing to go and every time you passed another mile, you put your hand on the picture. You keep going. Just an amazing event the way that they have it all structured, so I can’t promote this enough.

If you are wanting to know more about this, we’re going to have a link in our show notes. You can click on that and where you can sign up and then Wes will take it from there once you’re signed up. 

You’ll start getting emails on prep: what to do to train. All sorts of things because if you’re going to do the whole thing, this is no walk in the park. It’s quite intensive. But like Wes said, if you want to go out there hang out with some people, just do five miles. No one’s judging you or anything. I can attest to how awesome the experience is. 

We’ll have the information on our show notes for that. 

Wesley Gray  27:06  


Preston Pysh  27:07  

Wes, thank you so much for taking time out of your day to come on the show. You always willingly say yes, even though I know you’re very busy. We just really appreciate that, because you always give us so much information to think about. Thanks for your time, Wes. 

Wesley Gray  27:21  

Thank you. I mean, our mission is empowering through education. I love what you guys are doing and you are one of my favorite podcasts. Yeah, I love what you guys do, man, keep it up and keep educating. People should tune in and tell their friends about podcasts. 

Preston Pysh  27:37  

Thanks, Wes.

Stig Brodersen  27:39  

All right, guys. That was all that Preston and I had for this week’s episode of The Investor’s Podcast. We will see each other again next week.

Outro 27:46  

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