David Stein (00:03:00):
First, the credit cycle is the ability or represents the ability or willingness of households and businesses to borrow money. When banks are willing to lend, that increases the money supply. It increases purchases. It can push up asset prices and, as households and businesses are buying, that leads to businesses wanting to expand their output, which is what gross domestic product is. It’s a measure of the monetary value of what businesses produce, and so, collectively, they come together. As households and businesses want to borrow, that leads to an expansion.

David Stein (00:03:43):
On the other side, when people, when households and businesses get more fearful, they don’t want to take on debt when interest rates are higher, then you can have an economic contraction or a downturn in the credit cycle that can lead to higher defaults. That means banks don’t want to lend more, and so you just get these cycles so it feeds into corporate profits. The credit cycle does. It feeds into how the economy is doing. As corporate profits decline, that can impact the stock market, and so everything comes down to pretty much the credit cycle because it’s the credit cycle that leads, really, shows up as that exuberance or that fear.

David Stein (00:04:25):
As individual investors, we can monitor the credit cycle, and there’s a number of different metrics that I use, but one major one that everyone can get access to, it’s available from the Federal Reserve Bank of St. Louis, their FRED account, but it’s the Senior Loan Officer Survey. I believe the Federal Reserve conducts this periodically. I think it’s monthly. They ask loan officers at banks how willing are they to lend to middle size and larger businesses and to smaller businesses or to consumers for credit cards. If you pull up that chart, you can see, you actually see the cycles, and what they’re measuring is the net percentage of banks that are tightening their lending standards, so they’re being more strict about who they will lend to or the qualifications they want.

David Stein (00:05:21):
Right now, for example, if we look at the net percentage of domestic banks that are tightening their standard for commercial and industrial loans to large and middle market companies, it’s 24%. This is their net standard, so they look at who’s tightening, who’s loosening, and then they net it out. 24% would be equivalent to 62% banks are tightening their standards and 38% are loosening, so in terms of the credit cycle, banks are getting more conservative. They’re not as extreme as they were in, let’s say, 2020 during the pandemic when you had 80% to 90% of the banks tightening and only 10% loosening. It’s way less loose in terms of credit than it was a year ago, so we’re seeing it more difficult, and you see it in interest rates also. As interest rates go up, less people want to purchase houses, take out a mortgage. You’re starting to see that in some of the housing data.

David Stein (00:06:25):
The other factor that plays into the credit cycle is also known as spread, so the incremental yield that non-investment grade companies and investment grade companies have to pay to borrow. The way that they measure that spread is they look at the average yield on high yield bonds and back out the yield on 10-year treasury government securities, for example. That spread right now for high yield is about 4.2%. It was, with the average going back to 1990s, 5.3%. Back in June, we were at 5.9%. If we look at over the past eight weeks, it’s actually… Credit’s loosened up just a little bit at least based on some of these spread date. There’s a number of factors that we can look at, but ultimately, when we consider the credit cycle right now, it’s on an upswing where credit is getting more difficult to get and individuals, households and businesses are less willing to borrow because of the higher interest rates. That’s why you’re starting to see some of the economic data, some of the business survey data, for example, is starting to weaken, and it’s partly due to the credit cycle.

Stig Brodersen (00:07:41):
If we had to put a timeline on this, and we’ll make sure to link to this in the show note, if you will be so kind to send the link to this, David, but if you’re thinking about whenever it goes from tightening to loosening, are we talking about months? Is it years for us to imagine this curve?

David Stein (00:07:58):
It can take years, I mean, in the sense of one of the other factors that can show up is like an inverted yield curve, so where you have the Federal Reserve or the central banks raising their policy rates to where short-term rates get higher than longer-term rates. Oftentimes, when you see an inversion of the yield curve, there’s some type of recession, but often time that lead time before the curve first inverts to where recession starts, it can be up to 18 months. These cycles, the weakening of the credit or the more tightening of the credit, I mean, it can take 18 months, two years, and it isn’t guaranteed that we’re necessarily going into a recession.

David Stein (00:08:46):
One of the things that we did with Money for the Rest of Us, so we’re not trying to forecast like this is the time where everything is… where the recession hits. We want to look at what the market’s temperature is today. We’re always monitoring what we call what’s on the leading edge of the present. What does the data suggest today, not knowing if it’s going to worsen or get better, but we want to at least calibrate our risk based on current conditions.

Stig Brodersen (00:09:16):
David, I also think it’s important for the audience to know that, whenever we discuss each type of cycle, we do that in isolation to explain what this specific cycle is about, say, the cycle of the attitudes toward risk, but that is essentially… I mean, it’s not the reality. It’s not so that if something were to happen in cycle A, then something will happen in cycle B that will in turn lead to a change in cycle C. All of these cycles are typically interrelated, and there are many more cycles than we have just talked about here so far in this episode. Could you please provide an example of how interrelated the economic, profit, risk, credit and the other cycles are?

David Stein (00:09:55):
Sure. The other thing to consider is the data is often conflicting, and so we should use not just necessarily one metric. We need to use a variety of metric. If you think about the credit cycle, when the credit cycle, when there’s tightening, so banks are less willing to lend, when there’s less borrowing from households and businesses because there’s higher interest rate, we can see higher delinquency rates, and so that can cause investors to get more fearful, which shows up in the amount of risk they’re willing to take. It can lead to less willing to make large purchases which can impact the sales of companies, which will impact their profits, so that impacts the profit cycle and then, as the businesses are selling less, they’re producing less, that can impact the economic cycle, so you’re getting a downturn there.

David Stein (00:10:52):
With lower profits, obviously, due to… As interest rates go up, that can lead to higher interest expense for companies, so that lowers their profits. They’re also selling less, and then, as I mentioned, ultimately those lower profits can lead to lower prices for stocks. As stocks sell off, and the same as those spreads or those incremental yields for non-investment grade bonds widen out, that leads to price declines for non-investment grade bonds.

David Stein (00:11:19):
There is very much a connection between all the different cycles, but, again, the data can be conflicting, and so what we’re always trying to do is try to get a picture of where we’re at, not knowing exactly what’s going to happen, but when, because you can see it in much of the data, it does allow an investor if they choose to calibrate the risk to the opportunities that are there or the lack of opportunities and have some dry powder or reserve for when the cycles start to turn.

Stig Brodersen (00:11:53):
With rising interest rates, the talk of the town is real estate, and real estate is a very interesting market where it seems like everyone is building and stop building at the same time. Why is that, and what does it tell us about cycles?

David Stein (00:12:07):
Real estate is heavily influenced by interest rates. It’s influenced in terms of the willingness of households, for example, to borrow, to take out mortgages, the willingness of banks to lend, so for developers to be able to build, real estate is also impacted. As interest rates go up, the value of real estate can fall because, essentially, the cap, what’s known as the capitalization rate, the yield that they’re getting on the value of that real estate that can… Well, the yield, if the cap rate goes up and so the value of the real estate falls, and you’re seeing it right now. We have a huge boom in home construction, new home purchases, existing home sales in the US and, really, around the globe coming out of the pandemic because of all the money creation and super low interest rates and just the impact of the pandemic. People are realizing that their existing locale wasn’t what they wanted, so you had a lot of activity and purchases, a lot of new sales.

David Stein (00:13:13):
Then we’ve had the Federal Reserve raising their policy rate, and so just the most recent data, for example, saw new home sales have fallen about 30% compared to where they were a year ago. That causes home construction to fall off because the existing inventory, if you… There are all s data that’s also available, by the way, on the St. Louis Fed, their FRED website. You can look at new home sales and you can see the trends there. You can look at the months of supply available of new homes, which is how much inventory is there. For example, right now, we have an 11-month supply of new homes in the US. Now, that’s as high as it was back at the end of the housing crisis back in 2008, 2009. That’s how quickly the housing situation has changed in the US and in many other countries.

David Stein (00:14:13):
At the same time, as interest rates go up, home affordability, the ability of the median family with their medium income to be able to qualify for a mortgage loan, their ability to do that is much less because the interest rates are higher. Mortgage payment is at a much higher percent, so affordability is down over 40% in the past six months. All those things come together and, because interest rates impact everybody and individuals and households and businesses are making individual decisions, but they’re all looking at the same rates, then you can get these periods of these cyclical periods just because of how the macro data influences individual households and businesses.

Stig Brodersen (00:15:04):
Whenever we hear news about the Federal Reserve raising rates, we’re talking about the Fed’s funds rate, but what people see on their bill and whenever they want to buy a house, that’s the mortgage rates. Those two rates are quite different, but they also work in tandem generally. Could you please talk to us about the relationship between those two interest rates?

David Stein (00:15:28):
A typical 30-year mortgage rate is very much tied to 10-year government bonds because most people don’t hold their house for 30 years. On averages, it’s closer to 10 years, and so banks benchmark their mortgage rates really off 10-year treasuries. Now, when we think about the Fed funds rate, now that is a short-term policy rate, very, very short term, but when we look at what goes into market expectations for 10-year government bonds or the current yield, now, longer-term interest rates are made up of shorter-term interest rates, and so, as an individual investor, you can buy a 10-year government bond or you could buy a one-year government bond and roll it over every year, or you could buy 30-day treasuries and roll them over every 30 days, and so there’s a relationship in that the 10-year government bond yield is influenced by current short-term rates, but also expectations for future short-term rates.

David Stein (00:16:32):
As investors believe the Federal Reserve is going to stop raising its short-term policy rate, let’s say, next year, that starts to get reflected in longer-term interest rates, and we’re seeing this right now. If you look at the yield curve in the US, it’s essentially flat. It’s slightly inverted, but it’s almost close to 3% from one year out to 30 years. There’s a little variation, but the reason why it’s essentially flat or slightly inverted is the expectation is that two, three, four years from now, that Fed funds rate is going to be lower than it is today.

David Stein (00:17:12):
Those longer-term rates take into account the future expectations for short-term policy rates. It also includes expectations for inflation, and then there’s a third element that’s known as the term premium, which is additional compensation that investors demand for just unexpected things. The Federal Reserve phrases their policy rate more aggressively or inflation comes in higher, and so those three elements, expectations for short-term interest rates, inflation expectation, and the term premium, that is what comprises a longer-term government bonds, but certainly what’s going on now with short-term interest rates, and what central banks are doing heavily influences those longer-term rates.

Stig Brodersen (00:17:55):
Let’s talk about the market cycle. That is what Howard Marks describes as the sum of all other cycles. The future, of course, is always uncertain, but if we prepare, probably, we can use probabilities to construct our portfolio. Where are we right now in the market cycle, and what does that apply to how we as investors should position ourselves?

David Stein (00:18:18):
We do a monthly investment conditions and strategy report which is very much focused on the market cycle which we consider economic trends, we consider the credit cycle. We’re looking at market valuations in terms of PE ratios for stocks around the world. We’re also looking at what are known as market internals. This is the level of fear and greed. This is more technical analysis. What percent global markets around the world are above their 50-day or their 200-day moving average? We combine those together, and we simplify it for investors. We rate each of those three areas red for more bearish, yellow for neutral, green for more bullish.

David Stein (00:18:58):
Right now, when we look at overall investment conditions, we’re at low neutral. We’re in the yellow territory, but we’re not in red. What’s driving that is economic trends are also low neutral because we’re seeing that, for example, the business surveys that I mentioned, purchasing manager indices, these are surveys done around the world by S&P, market, and other providers, and they’re just asking businesses, “How’s business? What does your new order book look like? What’s your inventory level? What are prices? What’s your expectation a year from now?” They survey and then they standardize it, and generally it can be between zero and a hundred. 50 is very much neutral. When we’ve had recession in a given country, that PMI data, and they look at both manufacturing and services, with manufacturing PMI, it will get below 50, so 48, 46, and so when we look at the latest PMI data, there are a number of countries, including the US, where either the manufacturing or the services PMI is below 50, and so the risk of a recession is higher.

David Stein (00:20:12):
Again, we just want to look at the existing data. There were many people nine months ago, for example, or even a year ago saying, “Wow, the recession is coming because the Federal Reserve is raising their policy rate.” Well, that’s just not true because there have been tightening cycles where we haven’t seen a recession come, and so, rather than just forecast out a year and say a recession is coming and react to that, we’d rather say, “Well, where are we now?” Right now, yeah, the PMI data is worsening. We’re more low neutral. We’re not red. Corporate profits haven’t turned over, so we have 85% of countries still have positive expected earnings growth. We’re still seeing earning surprises. Overall, earnings growth for the MSCI All-Country world index is still over 8% expectation over the next year, and so there are still some positive elements as well as some negative elements.

David Stein (00:21:12):
When we look at the weight of evidence, recognizing some of it’s contradicting, we’re low neutral when it comes to the market cycle, which is why my portfolio pulled off some risk. In some of our model portfolio examples, we pulled off some risk in late June, but we’re certainly not overly bearish right now. We’re just, “Wait and see, and see what the market’s temperature is”

Stig Brodersen (00:21:35):
What does it mean whenever you say lower risk in this case?

David Stein (00:21:40):
Well, for example, in our model portfolio examples, we reduced credit risk, and so we reduced our allocation to non-investment grade bonds. We also added more to cash because yields are much higher, and so you can earn two and a half percent on cash, and so we reduced stocks a little bit. In our case, we have adaptive portfolios that we adjust over time, and then we have some static, more long-term strategic portfolios. The adaptive portfolios are five to 10% underweight stocks relative to the longer-term strategic portfolios. It’s not an environment where we should be freaking out and move completely out of the stock market. It’s just a recognition that the risks are higher now, the risks of a drawdown [inaudible 00:22:33]. I mean, it’s been a challenging a year to invest, period, but, no, now it’s not necessarily the time to take a huge amount of credit risk, for example, because we’re on the other side of the credit cycle, and so you don’t necessarily have to exit all of your non-investment grade bond exposure, but it’s not necessarily time to go hog-wild and go completely in.

Stig Brodersen (00:22:57):
David, whenever you talk about a model like that, would that be based on, and you have multiple factors, would you give them different weight? I guess that’s the first part of my question, the different factors you mentioned before, and whenever you say the probabilities of a drawdown, for example, in the equity market, is that based only on fundamentals or is it also so that, even though one could argue that the stock market is now cheaper with the pullback that we’ve seen, you also have a negative momentum? How does that play together?

David Stein (00:23:27):
I didn’t mention the third element, asset class valuations. When we do look at equity, the valuations are cheaper than average, slightly cheaper than average. You have valuations really high neutral. We have economic trends low neutral, and then the market internals are red, more bearish, because of the severity of the market losses. We tend to put more weight on economic trends and valuations and less on market internals because market internals can be so volatile. Traders will be much more focused on some of the market internals. In our case, we use it just as a confirmation of the overall trend, and then, ultimately, we have a wide variety of data, but we’re always making incremental changes recognizing that we don’t know.

David Stein (00:24:27):
That’s really the basis. After spending 15 years or more as an investment manager, you realize how little you know and it’s incredibly difficult to invest based on predicting the future. You take Howard Marks’ book on cycles and a lot of his memos. He’s pretty clear he’s not out there trying to predict the future because he’s not very good at it, nor am I, nor are most professional investors. What they’re doing is they’re making educated guesses based on where we are today and just trying to weigh the risk. When the market environment is more favorable, then they’re willing to take risk incrementally, little by little, in order to hopefully over the long term create a successful tracker.

Stig Brodersen (00:25:20):
Let’s say that you have the Dow trading at 30,000 points and there was a given risk attached to that. Is that different than if it would go up to 35 and then back to 30,000? We’re just assuming that the earnings are the same, the quality of the company are the same because, now, the market has seen it’s been a 35 and, now, it’s a 30, and some people are not feeling too good about it. Is there anything such as that that you feel is important to model or is it in that case more based on that fundamental?

David Stein (00:25:54):
I personally don’t ever look at levels. I look at valuations. I want to see what is the PE of the Dow or the price to earnings ratio or the dividend yield. To me, it all comes down to the fundamentals. Now, I’ll look at the levels in terms of is the level above its 200-day moving average or its 50-day moving average? It’s all very relative, so I couldn’t, for example… which is interesting that the news media focuses on it all the time. They’ll say that the Dow Jones’ industrial average is at X level or the NASDAQ is just X level. Just based on my institutional money management background, levels, the number, doesn’t matter to me. What I care about is where is that number relative to what it was a year ago and what are the fundamentals for that number in terms of what’s the cashflow being generated, what’s the expected cashflow growth and what’s the valuation in terms of what are investors are paying for that cashflow?

Stig Brodersen (00:27:02):
Let’s continue talking a bit more about Howard Marks. One of the thing that’s interesting not only in his wonderful book, Mastering the Market Cycle, but also in his memos that he sends out on a recurring basis, he’s talking about having both high quality and lower quality assets, depending on where you are in the cycle, implying that you would hold high quality assets where you’re at the top of the cycle and lower quality assets at the bottom. All of this, of course, depending on the price you’re paying for those assets, as it always is, but it might seem surprising to our listeners that you would consider a low-quality asset even if you disregard where we are on the market cycle. Could you please provide an example of low-quality assets performing well and why that is the case?

David Stein (00:27:47):
Low quality assets can perform well over the short term because of the level of fear and greed. For example, non-investment grade bonds’ spreads widened out. As the economy slowed, the yield on non-investment grade bonds went up and the yield relative to government bonds widened out to where they got above average of a yield of 5.9% compared to the average of 5.3. Now, eight weeks later, the yields have fallen to 4.2% as the data has gotten worse, which is surprising, which is why one’s timeframe can’t be eight weeks. When you’re investing based on cycles, you’re basing it on years because you can get the short term-swings, but ultimately, if investors believe a recession is coming, then default rates could increase, and those spreads, for example, got… Right now, they’re 4.2%. They got up to 8% in 2020, in March of 2020, April of 2020. They got up to 20%, close to 20% spreads in 2008. What Marks was referring to, when spreads blow out, the losses can be significant. Non-investment grade bonds lost over 25% in 2008.

David Stein (00:29:12):
In the institution portfolios that we were running, we started adding some non-investment grade bonds late 2008, early 2009 because, once we saw some of the economic trend data start to improve, some of this PMI data just start to improve, then you can start taking some risk, but it’s all incremental because you never really know. I’d rather be investing in non-investment grade bonds when the spread is 20% because, at that point, the yield is so high that it very much more than compensates for the default risk, and so, whereas when spreads are super narrow like they were a year ago, for example, or 18 months ago, then you don’t have that cushion to protect against default risk, and there is the risk of the spreads widening out. That’s why lower quality asset would be non-investment grade bonds, and you would rather own them when the spreads are widening even though the credits are wide, even though the credit cycle is just starting to turn, but there’s conflicting data because, ultimately, you have that yield cushion to that margin of safety to protect you if you’re wrong.

Stig Brodersen (00:30:27):
Whenever you make a position like that where you say, okay, I would do non-investment grade bonds, also publicly called junk bonds, would that be invested in through an ETF? How would retail investors who might see that trend and profit from that trend, but might not feel comfortable about your individual assets, is that the way to go, ETFs?

David Stein (00:30:48):
In ETFs, there’s a way to do it broad based. My preference for non-investment grade bonds is to use active managers because they’re doing some credit research. Hopefully, they’re least because the ETF’s going to own everything and they’re going to own the dogs as well as the better credits, whereas you at least want some level of credit research, and so you can use an active manager. We’ve used Doubleline funds in the past in our portfolio and my portfolio. We’ve used BlackRock. There are some of their closed-end funds in my portfolio in the past as an institutional investor. In fact, we did this back in 2008. We used Loomis Sayles bond fund, which I believe is still operating. I haven’t invested in that fund for a long time, but that’s an example of a fund where we reduced risk and sold some of the fund when things really started to fall apart in 2007, 2008, and then I added it back in late 2008.

David Stein (00:31:50):
For non-investment grade bonds, bank loans is another. Bank loans are floating rate, non-investment grade loans that banks made and then are syndicated out. They tend to use active management for that also just because you want somebody deciding that this is a credit that we shouldn’t invest in.

Stig Brodersen (00:32:10):
Now, let’s talk about active management because we have listeners who are more hands-on with the portfolios. We also have others who use asset managers. We have hybrids. You’ve been the chief investment strategist, the chief portfolio strategist and managing a principal from 1995 to 2012 with Fund Evaluation Group, LLC and you’ve identified asset managers you wanted to work with, including Howard Marks that we just talked about. Another very well-known investor you worked with would be Seth Klarman. How did you and your company choose the right asset manager for your fund? Was it ever relevant where you thought you were in the market cycle, as in this asset manager typically is good in a bear market, another asset manager might be good in a bull market? Is there such a thing as that?

David Stein (00:32:57):
There is. The portfolios that I ran or headed up at FEG, we did what we call active asset allocation. An institutional client, an endowment would give us the discretion to make adjustments to their asset allocation and their portfolio mix and the manager selection within the confines of their investment policy. We were always looking for is there a better positioning, and an example would be Doubleline. DoubleLine is Jeffery Gundlach. He started that firm in December 2009. He left TCW, took his team, a brand new firm, but experts in mortgage-backed securities. We made an allocation right after they started that firm to their fund to the Doubleline, I think it was just the Doubleline bond fund, and the reason being because, at that environment, the yields particularly on mortgage-backed securities, non-agency mortgage-backed securities, so those that weren’t issued by Fannie Mae or Ginnie Mae, so non-agency mortgage-backed securities, the yields were incredibly high. That was an example of allocating to a manager at a time when the opportunities were huge.

David Stein (00:34:20):
In terms of just our overall process, we would meet with several hundred managers a year. We were doing across asset classes, from stocks, bonds, REITs, hedge funds, private equity, and venture capital, real estate. We were always surveying the universe and looking for managers that met our criteria, and they tended to be managers with a very strong investment culture, were pragmatic. They recognized that they needed to have some type of informational competitive edge in order to generate superior returns. Obviously, performance played into that, but also really understanding their personnel, their approach to risk. We had a number of criteria that we looked at, met with them. We would do research reports. We had an investment committee that would, whether we wanted to put the manager on a recommended list, and then that would allow the consultants and other advisors to use them constructing client portfolios. It’s always a constant look for the best managers, which frankly is pretty exhausting because there aren’t that many that really have the skill to outperform. You see it more in the private area than you see on the public side, but that was our approach.

Stig Brodersen (00:35:32):
I wanted to talk to you about how to evaluate a track record. Whenever I started investing, I made the mistake of thinking that I would just Google who had the best, highest performance over the past, I don’t know, 10 years, a very, very unsophisticated way of going through asset managers, but then later you realize that it’s a little more complicated than that. Among the many questions you have to consider is what risk did the asset manager took to achieve this track record, how long is the track record under which my conditions was it achieved and so much more? Whenever you evaluate a track record of an asset manager, what’s your process?

David Stein (00:36:13):
Exactly that. We want to understand what are the factors that drove the performance. For a typical institutional client, for example, if they let the board maintain discretion so they were selecting the manager, we would do manager searches. Let’s say they wanted to add a new small-cap value manager. We would bring them a selection of four to five, and we would show information about it, and then they would look at their performance. It’s human nature to look at performance and assume that whoever had the best long-term track record was the best manager, but even within something like small-cap value, there can be sub-styles. One small-cap value manager might have more of a micro-cap focus. If micro-cap was out of favor in the last year or two, then that would impact that manager’s longer-term track record. It’s amazing how a bad year or so can impact the five-year number, the 10-year number.

David Stein (00:37:18):
One of the things that I really tried to do in working with boards is to encourage them to hire the manager that had the worst performance, because we’ve already done all our screens, we’ve done the due diligence, we feel fairly confident that it’s a very skilled manager whose style is out of favor, and to get a board to hire a manager whose style is out of favor, to me, was always a win because, if I could do it, when that manager is finally back in favor, then that manager generally significantly outperformed the index and its peers. I can tell you human nature is not to hire the manager who has the worst performance of a group of five because you never really know and… but you always have to understand the nuances like why, what is driving that track record?

David Stein (00:38:12):
One of the ways we did it as institutional advisors is we always looked at peer groups, so how has this manager done relative to its peers or similar type managers? Usually, there was some factor that contributed. Obviously, there are managers that just don’t seem to have the skill and just underperform, but all skilled managers will have periods of trailing their peers as well as the index because the only way an active manager can outperform an index is by structuring their portfolio that differs from the index. If they’re just trying to pair at the index, they’re going to underperform just because of fees and just something that they didn’t foresee. They have to structure the portfolio that differs, which means there will be periods where they underperform because nobody is that skilled that they always outperform. It doesn’t ever happen. Everyone makes mistakes. Everybody’s style falls out of favor.

Stig Brodersen (00:39:08):
That is very, very true. I was reading this book here the other day. It’s called Where the Money Is by Adam Seessel. Being an investor himself, he met up with different CEOs and wanted to vet their business acumen, and he said that he always asked them this one question, which was, “Do we want to optimize for profit or do you want to optimize for return on investor capital?” It was something like 90% that said, “Optimize for profit, not for return on investor capital.” He was always shocked by that, which clearly isn’t the right answer and just shows that the CEO might have a lot of good qualities that made that person the CEO, but perhaps it wasn’t the asset allocation skills that really brought that person to the very top, which is ironic because, as the CEO, you are the top asset allocator. That’s just your job.

Stig Brodersen (00:39:57):
To me, I love that question. That was such a silver-bullet type of question. How about you whenever you have to evaluate the skills of an… As a manager, I can say that I’ve been speaking with hundreds here on the show, and everyone is very assertive. Everyone seems to have the truth. It’s not in any way that people would be lying, but they truly mean what they say. That’s not what I’m insinuating at all, but they still have very, very different opinions from each other. I’m sure you experienced the same thing as you’ve been interviewing all these asset managers. Did you have any kind of, not to make it too pop, but do you have any silver-bullet question where you were like, “This is the question,” that’s tricky, that’s really where you could really see if this person understands what it’s all about?

David Stein (00:40:40):
First off, the reason why CEOs say they optimize for profits is because that’s how they’re measured. They’re not measured. They’re not. It’s did they beat the earnings estimate for that quarter? Their job depends on that, which is an unfortunate, as you know, nature of our financial markets because over the long term it is optimizing for investor capital, but that’s a longer-term metric. It isn’t, and that’s not what traders are rewarding companies for. If a company misses earnings estimate, then the stock plummets 50%.

David Stein (00:41:15):
Back to managers, one of the favorite things that I would always ask managers is to walk us through a portfolio mistake and where they messed up. How well do they answer that? Are they frank? Are they humble? One of the things that we’re looking for with managers is humility. If somebody can’t come up with a mistake, it’s just not a very good example, and so we want to understand when things haven’t gone well. We’re always looking for bad things that might have happened with individual holdings or at their firm and how they handled that because we’re trying to understand their investment culture. Performance is nice, but ultimately we want the investment culture in terms of the team interaction and just how they go about it, because one of the things that we definitely don’t want is a manager that’s always looking for the flavor of the month, so they’re always trying to change what they’re doing or their process based on what clients want or consultants want. We want them to be very confident in their approach even when they’re underperforming.

David Stein (00:42:25):
Obviously, all managers will make adjustments over time, but we don’t want them to change based on pressure from clients because, at the end of the day, managers are in the business of pleasing clients, but the way you please clients is by sticking to your investment approach even when times get hard. Some managers do that, and many don’t.

Stig Brodersen (00:42:50):
I love that you bring that up about humility. I remember, this is years ago, I was really, being raised by the church of Buffett and Munger and the whole thing about talking about your mistakes, which might also be easier if you’re in a position like Warren Buffet, but he’s very known for to be very frank about all the mistakes he’s making. It seems like sometimes he’s even over-exaggerating all the mistakes and how bad of an investor he is. I remember I was taking that mindset to one of the interviews I had here on the show, and the guest had refused to talk about any of his previous mistakes. He’s like, “No, I don’t want to talk about it.” There could be two options. Right? It could either be this is the best investor the world has ever seen who never made a mistake or something funky was going on. Anyways-

David Stein (00:43:35):[crosstalk 00:43:35] and you don’t hire them. If they’re not going to talk about their mistakes, one, you don’t hire them, but, in this case, you were doing a podcast interview, so that’s not really a choice. Good managers are humble. They talk about their mistakes. They learn from their mistakes and they like to talk about their mistakes. They’re confident. It’s a combination of humility and confidence, confident in their process, confidence in their team, but a humility in that they don’t really know what’s going to happen, so they do their best.

David Stein (00:44:09):
Like Jeremy Grantham would always say, they had tended to invest on seven-year cycles, and they have had some extended periods of underperformance, and Grantham was very competent. He said, “Over the long term, I know we will outperform and have outperformed,” but it might not be with the same clients that we started with seven years ago because, and I’ve seen this in the institutional space, your average patience for a typical college endowments board member is about three and a half years. If a manager has underperformed for two years, they start to get nervous. After three years, then they really get upset and, three and a half years, they’re ready to change.

David Stein (00:44:52):
The reality is an underperformance of a manager in a given year can draw down that three-year track record below the benchmark. It’s really hard to be patient with underperforming manager because, as a board member, a committee member, an investment committee member, you’re a volunteer and you want to do something at your quarterly meeting, and so you’re going to pick on the manager that’s underperforming and you can get other committee members on board. I used to phrase it as like you feel like you can only defend a manager so long and, at some point, you realize you’re just standing in front of a moving train and you just got to get out and, if they’re so insistent on firing that manager, then you terminate them, and then my job was to see if I could get them to hire a manager with a similar style with the one they’re firing that maybe had a little better track record recognizing… because the last thing you want is to tell them to hire the best performing manager whose style is very much been in favor.

David Stein (00:45:53):
I saw this. One of my first institutional clients, and I was the junior advisor, and we were doing a search, and I wasn’t that involved, but they were hiring small-cap and midcap growth managers, and they picked two managers that were at the top of the cycle. They had the best track record, and I remember that manager telling me… This was like four years later, three and a half because they were probably fired right after that. He was like, “This client, this college endowment, is our worst performing account of all of our clients,” because they hired them at the absolute top because their performance looked the best because they had done so well over the previous year at the top of their cycle.

Stig Brodersen (00:46:39):
Yeah, that’s a powerful mean reversion that you have going there.

David Stein (00:46:43):
You see it in active managers. You see mean reversion in active investment styles even within what’s generally considered a category such as small-cap value. There is mean reversion within sub-styles, within small-cap value and other investments.

Stig Brodersen (00:46:59):
David, I wanted to transition into talking a bit about Ray Dalio. Actually, on the note that you mentioned before, he has this quote where he said that he made a lot more money on what he doesn’t know than what he does know.

Stig Brodersen (00:47:10):
Ray Dalio, for those of you who do not know who he is, is the founder of Bridgewater and Associates, more than $140 billion asset under management and a personal net worth of more than $20 billion. Ray Dalio has this framework of what he calls the short-term debt cycle which happens every fives, eight years. What most of us think about whenever we think about cycles, these cycles all add up to the long-term debt cycles which happens every 75 to a hundred years, give or take. Could you please outline Dalio’s thesis and whether you agree with his framework about long-term debt cycles?

David Stein (00:47:46):
The short-term debt cycles are the credit cycle that we talked about. It’s how much debt is there, what are the spreads, what are delinquencies, what are interest rates, what are bank’s willingness to land, and those are roughly five to seven year cycles. The long-term debt cycle would be just aggregate levels of debt. For example, one of the metrics that, again, you can look at the St. Louis Federal Reserve, their FRED account and pull up a chart for household debt as a percent of GDP, so this is US households, what is their debt level as a percent of GDP? If you look in that chart, you can see the long-term debt cycle. Back in the 1940s, overall household debt to GDP was about 40%. That cycle peaked in 2008, so at just about a hundred percent household debt to GDP.

David Stein (00:48:44):
Now, we’ve been in a down cycle to, now, where it’s 75%. We had an upswing for roughly 60 to 70 years and then we’ve had less debt now. You saw the same thing on the corporate debt side with Japan. Their debt cycle peaked in the late-’80s to early-’90s, and they’ve been on a down trend since then. I agree with it. The problem is it’s incredibly difficult to invest based on a long-term debt cycle because, for most of us, our timeframe is not 75 years. When you have such very long cycles, it doesn’t end on one year, and so it could be plus or minus 10 years to where it actually ends, which is why our approach is to look at where are we now? Yeah, we’re at very high debt levels, but has something changed to where deleveraging is taking place or the behavior of businesses or household is changing?

David Stein (00:49:45):
When a long-term debt cycle ends, it’s typically at the same time the short-term debt cycle is ending. It’s just that the selloff is much greater and the deleveraging is much greater and the recovery is much longer. You can focus on the short-term cycles and current conditions and maybe the downturn’s worth because of the long-term debt cycle, but it’s very challenging to just focus on a long-term cycle and say this is the year when things change, because it may not be and it’s very difficult to get the timing right.

Stig Brodersen (00:50:19):
Yeah, it’s a good point. It’s also one of those things, which is to Ray Dalio’s credit because he’s not too specific, which I actually think is a good thing, about the asset allocation for most investors aside for the whole all-weather portfolio that has previously been discussed because of this long perspective because, whenever you read through it, it makes so much sense and, especially if you’re a student of history, you think it makes a lot of sense, and then, afterwards, you’re sitting there and, thinking, “How do I invest accordingly?” I’m both sad, but also happy that you say the same, that you’re like, yeah, I don’t know, it makes sense, but it doesn’t mean we should go [crosstalk 00:50:53].

David Stein (00:50:52):
Well, right, it makes for a compelling story, so episode 300 of Money for the Rest of Us, we looked at Ray Dalio’s thesis regarding the changing world order, and this is worry about government debt. He’s worried about currency devaluation. This came out a couple years ago, so roughly two years ago, this was his episode. What was the thesis or what was the recommendation that Dalio was suggesting? Well, he was suggesting gold. Well, gold hasn’t done anything in the past two years. In fact, as real rates have increased, gold has actually sold off. It’s really hard to make investments based on any type of long-term narrative that things are going to get worse or it’s going to change because the cycles are too long. It’s much easier to see where we are today and try to invest in areas that seem most attractive given current conditions, not ignoring the long-term cycles. I mean, these are all longer-term risk, but markets are driven by stories and they’re driven by narratives.

David Stein (00:52:02):
You can see this in the European debt crisis. We had the great financial crisis in 2008, 2009. It wasn’t really until 2011 that investors started to focus on European debt, and so their spreads widened up, their yields went up, and then Mario Draghi said, “We will do whatever it takes,” and then things suddenly [inaudible 00:52:23] suddenly yielding less than [inaudible 00:52:25] way better than that, and then it got… even that narrative, and then people started… and then they started worrying about European debt again. It’s important to recognize cycles exist, but what is the narrative driving the market, and are investors worried about it then because that’s what will drive returns over the short term?

Stig Brodersen (00:52:45):
Yeah. I also think it’s important to recognize this hindsight bias that we all have. Whenever we look back at 2008, oh, it was obvious that Lehman Brothers would default Bear Stearns or whenever we saw what happened in Southern Europe, oh, it was so obvious that it would unravel afterwards. Living through it, I don’t think it was all that obvious. Perhaps, it was just me. Whenever we look back, it just seems that was inevitable to happen. Whenever you are sitting there, it’s just very blurry. I remember, back in 2020, in March, with COVID happening and the market was just declining, dropping every single day, and I remember I was reading, rereading some of the books about holding on to your assets because that’s what you’re supposed to do. Whenever you look at a graph and you hear about the crash in 1987, for example, Black Monday, you’re like, “Yeah, of course, you would just hold on. It was just a blip. Everyone could see it would just pop back again,” but living through it, that’s hard.

David Stein (00:53:48):
Fear is real it. We didn’t know in March 2020 what was going to happen, and this PMI data and, in our frame of reference, investment conditions turn red, we reduced risk. We eliminated all credit risk in our portfolio and in my portfolio because our biggest fear is if 50 to 60% drop in the stock market and 25% drop in non-investment great bonds.

David Stein (00:54:16):
What was different in 2020 versus 2008 is the willingness of central banks to act and to start buying up assets. If you recall, in 2008, during the whole TARP thing, there was a lot of debate should the Federal Reserve buy corporate bonds or buy mortgage debt or any of this, but, 2020, they just went out and said, “Yeah, we are going to do this.” As soon as they announced, for example, that they were willing to buy corporate bonds, corporate ETFs and even some downgraded investment-grade bonds that were now high-yield bonds, that’s when the market changed, and that’s when, in our portfolios, we added investment grade bonds because they were now yielding three and a half, 4%, 5%. As a result, it makes it incredibly more difficult to invest now because now you have the central bank and you never know what they’re willing to do because they’ve been willing to do so much more than they have in the past.

David Stein (00:55:20):
2008, I was investing institutional money in 2008. You could see the housing crash. I mean, you could see the risk. We were reducing risk, but we didn’t reduce risk enough to where clients didn’t lose money. Everyone, your average institutional client lost 20% in 2008, 25%, and it felt awful. You never know enough to get completely out because, especially with the wildcard of the central banks right now, and so all we can do is calibrate our risk based on where things are so that, hopefully, we have enough in reserve to take advantage of opportunities, and that’s essentially how Howard Marks has invested at Oaktree and their firm. They’re just calibrating based on where things are, trying to add some value on the margin without… because you never have enough high conviction to completely exit the market.

Stig Brodersen (00:56:18):
David, I think this is a great segue into the next question here and also talking about your wonderful podcast, Money for the Rest of Us. There’s this quote there, and what you’re saying is that, “Investing-wise, my experience through losses, managing assets through the Asian financial crisis of 1997, the internet bubble crash of the year 2000, the great financial crisis in 2008, the longer I invest, the more I realize that I can’t predict what’s going to happen, and I have to manage through this uncertainty. As a result, my loss aversion has increased as I’ve gotten older and wealthier.”

Stig Brodersen (00:56:55):
I found the latter to be an interesting take because it sounds counterintuitive, because we also hear that we should incur more risk while we’re younger and have less to lose because we have a lot of human capital. Could you please elaborate on this and how your loss aversion has changed over the years?

David Stein (00:57:14):
There’s two things. There’s loss aversion, which is just your unwillingness to take losses, but there’s also loss capacity, the ability to do so. Younger investors tend to have less assets and more human capital, and so they have the capacity to take losses because they have many years of work ahead of them to build up their assets and their loss aversion might be less because they just have a much smaller asset base, but someone in my case that’s invested for a number of decades and financially independent, I don’t need to take big risk, and losses hurt more than they ever have because the numbers are bigger.

David Stein (00:57:58):
I recognize that I just don’t know what’s going to happen. I can see where we are. I can see where the risks are, but, ultimately, how it will play out, I don’t know, and so I invest incrementally, do my best, but, ultimately, my portfolio is fairly risk-averse with roughly 40% in illiquid investments, 60% more liquid, but I’m not sitting there 80% stocks because I’m not confident that the stock market will return what it has historically because of where we are starting valuation-wise because when I look at the long-term profit cycle… We recently did a study looking at… we were coming up… We’d come up with a capital market assumptions or market expectations for a couple of dozen different asset classes on our site, and we recently went from a 10-year timeframe to a 20-year timeframe to do this analysis.

David Stein (00:59:00):
One of the most surprising things from that, because we’re getting data now from MSCI, was to look at earnings over time and to see that, except for the US, many places around the world never have reached their earnings peak from the 2007, 2008 period, and so earnings aren’t increasing, which makes it hard to justify an expectation of eight to 10% for the stock market if the earnings aren’t increasing. The only reason they increased in the US more was because they were more stock buybacks, which was funded by debt. The bottom line is I’m more risk averse because I can see the underlying data and can’t come up with a thesis for why we should get eight to 10% stock returns, and then you got the issue with inflation, and it just causes one to be humble in recognition that we don’t know, but we just do our best. That’s what great investors do. They just do their best and try to pick areas where they feel like they have at least some type of a competitive advantage if they’re an active manager.

Stig Brodersen (01:00:15):
David, let’s go full circle on this interview and let’s, again, talk about Howard Marks. One quote that I in particular love, I’m going to paraphrase this, is that he’s saying, “More risk won’t always lead to higher return since, by definition, if you knew you would get a higher return, it would not be risky.” David, how do you think about the relationship between risk and return for your own portfolio?

David Stein (01:00:41):
I wouldn’t understand what the return drivers are, so it’s not enough. Look, I don’t want to look at historical returns because I want to know what. Well, let me step back. I mean, I’ll look at the historical returns, but I want to know what were the factors that drove those returns, and it goes back to the building blocks that we use, so what was the cashflow growth historically and what do we expect that cashflow growth to be going forward? What’s the current cashflow yield, be it the dividend yield, be it the cap rate for real estate, and so what is the current cashflow as a percent on a yield basis? What do we expect that cashflow to grow at, and then what are our investors paying for that cashflow?

David Stein (01:01:21):
To me, the more expensive, and Marks would agree, the more expensive the asset class, the lower the expected return because investors are expecting perfection of that asset class or they’re expecting earnings growth to be much higher, and that’s what’s baked into those valuations. I think you have to look at the return drivers and where we are today in order to come up with realistic return expectations and then invest accordingly and invest in those areas that seem to have the highest expected return given the potential risk and risk being measured by the potential maximum drawdown.

Stig Brodersen (01:02:01):
Yeah. Going back to your original point about looking at historical returns, yes, that is definitely important. It’s also important not to be blindsided. One of the most interesting takeaways I had from Changing of the World Order, Ray Dalio’s book we talked about before, was that he has this… Well, he said, “Let’s go back to the 1900 and let’s invest in the 10 biggest economies in the world.” Hindsight is always 2020, and he said, “Do not fall into the trap.” I’m probably paraphrasing here, but, “Do not fall into the trap of just looking at US data. Seven out of those 10 of the biggest economies, a bearish stock market, just banished.” It was blown up by world wars, hybrid inflation and whatnot. There were three countries, the US included, who the stock market survived, yes, and their currency was heavily diluted, but that’s the best case example. Whenever we look at historical returns, it’s obvious it’s natural for us to look at US data.

Stig Brodersen (01:03:02):
Everyone who listened to this podcast understand English, so there was a natural bias just to go to English-speaking countries to look at that data. Americans are great at providing data. It’s accessible for everyone to analyze, but keep in mind there’s a survivor bias here. You can’t go back and say, “This is what happened in the 20th Century. We can more or less assume the same will happen in the 21st Century.” Well, you’re looking at one of the three of the top 10 economies who survived. The world superpower of this century is the US. That’s the stock market returns you’re looking at. It doesn’t mean that it can’t repeat itself. Let’s hope it can, but there’s no guarantee just because it had happened in the past. Think about those poor people in, say, Germany, for example, Russia, Japan, strong economies at the time it looked like. Who knows what could have happened with those three countries? I would assume there will be a strong home bias in those countries, too. Make sure to diversify. I guess that applied both to the home bias piece, but also to the asset class piece.

David Stein (01:04:04):
Absolutely. When I got into the investment business in the mid-’90s, Japan made up 40 to 45% of the global stock market on a capitalization or size-weighted basis. Now, it’s less than 5%. Now, we’re looking at a situation where the US makes up 60% of the global stock market. 20 years from now, will US be 60% of the global stock market? I don’t know, but given the higher valuation of the US, we should all have a meaningful allocation in the US, but the idea that many investors have all of their equity in the US because they say, “Well, these global companies that make up the US index, they have international exposure,” but the country right now, when you think of which country has the highest potential from a population trend basis in terms of number of workers, et cetera, it’s India, whereas much of the developed world has a huge demographic headwind. The only way that they’re going to be able to overcome that is to be more accepting of immigration, for example.

David Stein (01:05:17):
When you think about the US, are they willing to do that right now politically? Not really, and so there are some trends in the US, political trends that are not favorable to the US continuing to be 60% of the global stock market 10 to 20 years.

Stig Brodersen (01:05:38):
I remember during the last Berkshire meeting, Buffett was looking at the 30 biggest companies today and then 30 years ago. I can’t remember how many of the same companies there were, but there weren’t a lot. Let’s just put it like that. It’s just-

David Stein (01:05:52):[crosstalk 01:05:52].

Stig Brodersen (01:05:52):
No. Capitalism is brutal. You mentioned Japan. Even if you had the best companies in Japan or in France or whatever they might be, and right now it’s arguably in the US, they still have the same systematic risk to, for example, legislation. I guess this is just my way of saying you be very humble and, going back to this quote about making more money what you don’t know of than making money of what you do know, and be humble to diversify across different asset classes, different countries, too.

David Stein (01:06:23):
David, I would like to give you a handoff to where the audience can learn more about you and Money for the Rest of Us and also if there’s anything that we haven’t covered in this episode. I know we covered a lot of grounds here, but I wanted to give you the opportunity to take this question to any kind of direction you want to go.

David Stein (01:06:38):
No. I appreciate it. I think we’ve had a well-rounded discussion. Most our information is at moneyfortherestofus.com. It’s where you can find the podcast. We have a number of free investment guides on different asset classes and other topics related to investing in the economy, so you can check those out at moneyfortherestofus.com.

Stig Brodersen (01:07:01):
I could just give my personal endorsement. I absolutely love David’s podcast. I’m not just saying that because we’re also friends outside of the podcast, but it’s a wonderful podcast that I subscribe to, so make sure to check that out.

Stig Brodersen (01:07:13):
David, thank you once again for taking time out of your busy schedule to join us here today on the podcast.

David Stein (01:07:18):
I very much enjoyed it. Thanks, Stig. Anytime.

Outro (01:07:21):
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