Preston Pysh  1:16  

Mike, the thing that I kind of chuckled at when I sent out that I was going to be talking with you on Twitter got a ton of responses, a monster amount of responses. One of the responses was somebody said, “I feel like I understand Mike’s positions on where he stands in the market. I want to know more about Mike the person.” 

One of the things that I like to dig into is deep learning and machine learning, how the brain works. One of the things that almost always comes up is that when you’re younger, under the age of 10, there are things that shaped you and kind of polarized how your neural net starts to process information.

Then, there’s this reflex that leads to who the person becomes someday. I’m curious at a young age… Your parents, mother or father, somebody who was really influential in your life, what would you say is something that kind of gave you that initial push in the direction that you ended up going?

Mike Green  2:13  

I grew up in Northern California on a small farm outside of San Francisco. Literally, starting at the age of three, it was collecting eggs and selling them to our neighbors.

My mom in particular was always just very focused on how wonderful and precious I was and making every possible sacrifice she could to give me every opportunity that was plausible. Despite coming from a firmly middle class background, she made the sacrifices to give you the best possible education that she could and really inculcated a love of learning for me.

I remember from the very earliest ages, my house was always filled with books. I remember my father reading to me. My mom did daycare to help defray the costs of living. I remember reading to the small children when I was younger, etc. It’s just all those sorts of things that contribute to who you become when you’re brought up in an environment in which people are telling you, “This is the path. This is what matters.” 

That set off a period of just intense reading. It is the easiest way to put it. By the time I started reading, which is probably five years old or so, I just constantly had books in front of me. Things that you don’t realize are crazy until afterwards. For instance, my mom bought the World Book Encyclopedia. She bought the World Book encyclopedia and of course I said, “Okay, I’ll read the World Book Encyclopedia.” 

I then read cover to cover the World Book Encyclopedia when I was 10 years old. You don’t really think about it, because that’s just how you grew up, right? That’s the environment that you were. 

If there’s one thing that I would point to, it was just an incredibly voracious love of reading that translated to building a body of knowledge that allowed me to start making some comparisons at a very young age of kind of what’s true and not.

Stig Brodersen  4:10  

People [who] have heard you on other shows are probably saying, “Now, it all makes sense.”

What I’m thinking whenever I think of Mike Green is [he’s] also a critical thinker. You are a person who does not take things at face value. You dig deep and then you dig deeper. You are constantly trying to piece things together. I have to ask you, what makes a person a great critical thinker?

Mike Green  4:36  

Well, so now, we can turn a little bit dark on this, actually. It’s funny because I know other people who have similar backgrounds. Josh Wolf, a good friend of mine, has a similar background. I’ll make it actually really easy. 

There are two components that lead to really critical thinking. The first was I was brought up in a household with comparative religion. My father was Jewish. My mother was Methodist. I was raised Jewish until I was six years old then my grandparents, my father’s parents passed away. 

I suddenly switched to Episcopalian. It’s not Methodism, but to Episcopalianism, because my mother thought that that was a better religion. I’d been exposed at that point to Judaism and then Episcopalianism. Then, I went to a Jesuit high school.

All along the way people are telling you their stories that are true, right? This is the truth. You’re supposed to have faith in this, and yet, they’re completely different stories. One of the things that you discover is that that’s just part of life, that people present things with certainty. They have no idea what somebody else is saying that can be at odds with that. So collecting that, and using that information is important. 

The second thing that happened in all candor was that I had a somewhat disastrous relationship with my father, who was a pathological liar. When you’re again exposed to somebody who is supposed to be telling you the truth, and is constantly trying to control the narrative to make themselves look better, that changes you. 

It puts you into a situation where you never really take anything for face value. There’s a number of people in my life that I know who have had similar experiences. It’s not a positive until you make it one.

Preston Pysh  6:08  

That’s just fascinating, when I hear you tell the stories. I just smile a little bit, because it really just demonstrates why you are such a deep thinker, because I’m serious. I think I speak for everybody out there, you’re a super deep thinker. It’s just really enjoyable to follow your feed. 

When we talk to the markets, when you look at these big market cycles, when we look at the last 40 years, the boom and the bust cycle, so much of this just comes down to the liquidity that the central banks are allowing to be in the system as to the big moves up in the talking collectively. 

It appears like the policy that the Fed particularly has shifted from not allowing things to contract or not promoting things to contract. They’re just trying to pump as much liquidity into this. What has caused that change? I’m curious to hear your thoughts in general on the liquidity comment.

Mike Green  7:03  

Well, I think that there are a couple of things that are going on. The John Maynard Keynes’s quote: “Rational men who think they’re exempt from any form of influence are slaves to some defunct economist,” right? 

A lot of what you’re seeing happen with the Fed and the behavior is them attempting to use the expectations channel to inform their actions. If you truly believe that the stock market, the S&P 500, or credit spreads, or any other measure reflect the best collective information gathering of private market participants with an incentive to create collect that information, because of a profit motive, that therefore represents the best possible knowledge of expectations of what could occur and what is likely to occur in the future.

Why wouldn’t you use that information to try to fine tune the system? Unfortunately, the feedback loop that that creates… You create a feedback loop in which the markets in turn are expecting the Fed to bail them out. Therefore they cease to function as an expectations channel. 

Now, I have my own challenges associated with some of the narrative because I do think that there’s a mixture of factors, right? There’s never one single sweeping dynamic. We’ll lay the story at the feet of the Fed, or we’ll talk about crazy retail investors, etc.

I tend to find what’s actually happening as a function of market structure. You build systems *inaudible* in a certain way. It’s almost a variant of a political science analysis in which you’re saying the structures and the reaction function of society determine how the structures are built. 

I think that in large form a lot of what we’ve seen over the last 50 years. I do think that there were components of it that were tied to the central bank and tied to decisions to provide liquidity. 

I would argue though that the vast majority of what we’re seeing is actually an outgrowth of the idea that markets are forward-looking and that the expectations channel controls and contains information. Also, that we can centrally plan and fine tune a system with the benefit of the input from the expectations channel. 

I really believe that they are not trying to do something bad. I think they’re trying to do something good, but just like a parent who constantly gives into their child and constantly gives them what they say they want, you’re ultimately going to end up with quite adverse consequences.

Stig Brodersen  9:36  

What do you think about the velocity of money? When you look at it over the past 40 years, it’s been a downtrend, even though more and more liquidity is put into the system. When Fed Chair Jay Powell is looking at the levers you can pull, if you’re looking for this to revert and why he needs to add more liquidity into the system and not allow for it to contract.

Mike Green  9:58  

I don’t think that Powell has a principled understanding of the system. Candidly, I think that he, much more so than prior Fed chairs, is really captive to the staff, because he just doesn’t have the academic chops or the theoretical chops to stand up against them. 

He was very quickly cowed by the reaction of the market and market behavior under his administration into doing pretty much whatever was necessary, right? With that said, the entire theory of interest rates of the theory of the quantity of money or the theory of the velocity of money tied back to the idea of MV equals PQ.

When we think about what money actually is, I know this is something that is very important to you, I just have a different theory of how I think about money. I think about money and debt as functionally the equity in a country. It behaves exactly as you would expect corporate debt or corporate equity issuance to behave. 

If I constantly met the shortfall associated with my business by issuing new shares to receive cash, what happens to my dividend deal? It gets crushed because I’m diluting the dividends per share, even faster than the price of the shares are falling due to the dilution, right?

I think that’s what we’re actually doing. I think when we respond by issuing debt to match the shortfall or to offset the shortfall associated with productivity and growth in the labor force and everything else. I think when we do that, we’re creating conditions, and Lacy Hunt talks eloquently about these types of dynamics. We’re creating an overhang, but we just can’t possibly service it.

The declining velocity of money is just, in my book, another way of saying falling interest rates. That, interestingly enough, that was actually John Maynard Keynes’ initial theory in terms of how he thought about interest rates and money was that it was much more tied to effectively a time shift dynamic: what is the interest rate that is required to get you to hold money to reduce the velocity of that money effectively against people who are demanding it? I think the general theory actually probably took a step back. 

Preston Pysh  12:05  

Back when Keynes was writing these things, the world had never been collectively on a fiat standard. Collectively, all nations. So, is there something that’s different about what we’re seeing today? 

We had Bretton Woods. We pegged the dollar to gold. The rest of the world pegged their money to ours, which basically, was a global peg on gold. Then, we collectively on a global scale came off of that standard. 

It almost seems like now that we’re off that standard, collectively, and we’re going through this delusion that you’re talking about, there’s no backstop for anybody to be fiscally responsible. If anything, there’s an incentive structure to be further irresponsible.

Mike Green  12:54  

Again, I think that’s largely the dialogue that you hear. I mean, this is Paul Krugman’s direct lines: “You need to be credibly irresponsible if you want to actually get inflation to appear, if you want to get interest rates to be forced upwards through the *inaudible* bond vigilante arm. The only way you can do that is by being completely irrational.” 

Now, the irony, of course, is that we’ve moved from the idea that that’s completely irrational to the idea that well, of course, that makes perfect sense. We need to have something like universal basic income. In the space of 10 years, we’ve completely changed the dialogue. 

Now, my pushback that we’re going to move as quickly as people think to a lot of this stuff, though, is that you see this. This is what we wrote in our piece policy in the world of pandemics. 

In March, we were saying that the market is ultimately dictating policy. And so, when prices fall rapidly, the policymakers look at it and say, “Oh, my gosh! The expectations channel is telling us that the end of the world is nigh and therefore we have to immediately act.” They immediately rolled out extraordinary measures.

Then, prices move to all time highs. What do we see? Very predictably, they’re saying, “Yeah, are we going to do a $1.6 trillion package or a $2.4 trillion package? Well, since we can’t agree on how we’re going to spend your money versus our money, let’s not do anything because there’s no urgency.” If you look at the markets, the markets are telling you, “Everything’s fine.” 

Stig Brodersen  14:17  

It is the few major companies that are doing fine. When you drive into the small towns, their businesses, they’re just obliterated.

Mike Green  14:26  

The K-shaped economy that Peter Atwater, I believe, is the one who originated that term. It’s been spreading it. I think it’s very accurate. In a lot of ways the companies that were positioned first in line to get those handouts or to benefit from those handouts as people transition very quickly to a work from home environment. That’s Microsoft, Apple, or Amazon, etc. You’ve seen them benefit. 

Now, I’m always cautious because I think that we’re constructing a narrative around that component, and there is a feedback loop. I think that’s influenced or enhanced by the underlying dynamic of passive investing.

At the end of the day, if you have a large sum of money that is coming in and saying, “Whatever the last price was, that’s the right price,” that becomes a reinforcing mechanism for it. 

To me, nothing that has happened is all that surprising. It’s frustrating that we have so blissfully adopted a narrative that says, “Well, it must be fine, right? We’re going to see a giant restocking and cycle. Americans are rushing out to buy new homes, therefore the housing sector is going to drive the economy and just wait till we have a vaccine, then everything’s coming back.”

I would just push back. I do think that we’re going to have a restocking cycle to a certain extent. However, I also think that people forget that much of the spending that we’ve seen has been a function of a collapse in services spending. 

So, people get fewer haircuts. They go out to restaurants less times. They have fewer people clean their house for them. They take their clothes to the dry cleaners far less. They’re getting far fewer cups of coffee from Starbucks, etc.

When they look at the free money that they have, the leftover money that they have, what have they done? They’ve turned around, and they purchased capital goods, particularly leisure-oriented capital goods that enhance the quality of life that they’re experiencing at home. For example, hot tubs, RVs, backyard projects, and all these sorts of things have exploded. 

However, those don’t come back next year. We don’t see an enhancement of that next year. That we’ve pulled forward years and years and years of delayed projects. I think part of the challenges is if you have any form of economic uncertainty going forward, you could very well see that fall in a far more aggressive fashion as we look to 2021 that I don’t think anyone’s thinking about.

Preston Pysh  16:44  

Recently, I saw a clip where Nassim Taleb was asked about what’s the big risk that you think very few people are accounting for in the market. He paused and he kind of looked off in the distance. 

Then he said, “I just don’t think that it’s a guarantee that the dollar is going to continue to be the global reserve asset.” Something to that effect. I’m kind of curious if you would agree with him on that?

Mike Green  17:07  

Well, I think it depends on your time horizon. It’s important to distinguish what you mean by reserve currency, right? This reserve currency as measured by the IMF; a reserve currency as measured by central banks, in terms of what are the actual assets that they hold. 

On that front, there are competitors to the dollar, largely because it’s dictated. So, the SDR components within the IMF include the RMB, they include the Japanese yen. They include the British pound. They include the euro. 

However, if I look at the basis of international trade, or global trade, and more importantly, on a like-for-like basis…Remember that euro trade figures include transactions that occur between Germany and France. 

We don’t include in global trade transactions between California and Nevada, but they are functionally identical. They may not like each other as much, although Californians and Nevadans don’t really get along, either. However, the simple reality is that they are both municipalities, not states. 

Germany doesn’t have its own currency. It doesn’t have its own fiat dynamics, right? Then, it’s subsumed itself, whether they want to accept that or not. They’re part of Europe as compared to a true fiat currency or a sovereign nation. They gave that up. They may choose to take it back but if that happens, then the Euro collapses as a reserve currency. Certainly as a measure of global trade, it falls even further. 

When you look at it on that basis, the dollar is actually gaining strength, picking up a larger share of global trade. People have started to hear some of my views on the political economy dynamic and geopolitics, and I would just say very simply that we’ve come to the end of Francis Fukuyama’s The End of History.

There is a somewhat legitimate threat to the US hegemony in the form of China. There are a couple of players out there that are playing it really well and quite aggressively, effectively saying, “Do I switch allegiances from the bully on the playground to another bully on the playground in the hopes to improve my position?”

When I look at Europe, Europe is overwhelmed with a type of schadenfreude, where they’re like, “Oh, wouldn’t it be great if the Chinese dethrone the Americans? Wouldn’t it be fantastic if the Americans got their comeuppance?”

There are a lot of countries that honestly feel that way. Unfortunately, the US in a weird way almost never had more resources available to it relative to everybody else. The single most important of those is human capital. 

People tend to under appreciate that. We were brought up in an economic environment where we’re taught the work of John Maynard Keynes, and almost no one in the audience who hasn’t formally studied graduate level economics knows who Arthur Lewis is. You may know the Solow Swan Model, which has similarities to the Arthur Lewis Growth Economics Model of an emerging economy, but you don’t know it. 

Now, that sits at a primary role, and that’s really the story of the United States. The United States has had the world’s greatest business model. You will send us products cheaply, and you’re going to send us your top human capital from all over the world, those who are actually interested in breaking out of a historical pattern. That doesn’t show up anywhere in the trade accounts. 

Also, the fact that China has a negative brain drain to the United States, or for that matter, almost anywhere in the world, with the possible exception [of Australia.] I think Australia has a negative brain drain to the United States. That doesn’t show up in our accounting and our national accounting systems at all. How can you possibly account for that? 

Think about a system where India devotes its scarce resources educating engineers and then they get on a plane and travel to the United States. To see the dollar fail, you have to see that break. 

I think we’re a ways away from that. We may be doing our best to expedite those events, but it’s really hard to think that the dollar is going to collapse, as long as those conditions remain in place.

Stig Brodersen  20:58  

As our listeners would know, we follow Ray Dalio closely here on the show, and we talked multiple times about his model of the big debt cycle. Our listeners, if you’re not completely familiar with that, I would highly encourage you to go to Episode 224, where we outline that in detail. 

But Mike, do you buy into Ray Dalio’s model of the big debt cycle? Or how do you see the economy?

Mike Green  21:21  

I mean, the long and short of it is that yes, there are cycles. However, the idea that those cycles are going to repeat themselves in any predictable way, I mean, the nonsense of saying, “There’s been hundreds or thousands of these cycles. Millions of times this has played out.” This is just a totally false statement. 

People often hear me refer to what happened to Rome, in terms of the transition from the Roman Republic to the Roman Empire. I do think that that’s actually very interesting, but to point to the dynamics of a debt deflation in Egypt at a time period, when people, the vast majority of individuals were so close to the subsistence line, that basically a failed harvest was the difference between starvation and survival. That’s just not the world we inhabit today. 

That’s one of the reasons people heard me use the idea that we live in the age of uncertainty, right? It’s just a ridiculous concept. If anything, we are more certain about almost everything in our life. If you look at the dynamics around COVID, we’re all completely appalled and up in arms, because our day-to-day lives have been disrupted. 

For the vast majority of us, unfortunately, not the vast, but for the majority of us, even those lives haven’t changed all that much. I worked from home before this. You worked from home before this. 

The only thing [that] has changed is you have to put a piece of cloth over your face, when you go out, so that’s not a meaningful change relative to…I jokingly say things like the Golden Horde invading your village and killing every male taller than a wagon wheel, right? That’s Attila the Hun. That just doesn’t happen in our lives. 

I don’t know where you’re based, but what would happen if an invading horde of barbarians came in and literally started lopping off the heads of every male taller than a wagon wheel? That’s real uncertainty. What we’re going through now is nothing.

Preston Pysh  23:12  

Yeah, when you put it in a historical perspective, I’m with you. Talk to us a little bit about your comments on the Roman Empire. I want to hear this.

Mike Green  23:20  

One of the things that I try to highlight for people is, I think, the critical risk, and this is something that I always try to carry through in my communications with regulators, members of the US government… 

We are in a situation where the biggest risk that we have is actually to ourselves. That in the process of trying to address the risks associated with the rise of China, associated with the inequality that has emerged in our system and associated with the two high levels of debt that have emerged, as the Fed has participated in bailing people out and encouraging them to take on additional leverage, we run the risk that we follow the same path that the Romans did on the Roman Republic.

We are effectively the equivalent of the congressional body of the Senate. It becomes dysfunctional and unuseful. It was divided by partisan factions that it’s incapable of making any decisions. The Romans had a formalized process for how to handle that. That’s what a dictator was. 

Historically, a dictator was used during periods of military conflict where the state needed to quickly marshal the resources and didn’t need to be distracted by various debates. That began to increasingly turn into a de facto norm.  

I would argue something very similar has happened in the United States over the past 60 to 70 years. You can start looking back at the march of the growth of power of the executive branch, particularly expanded under FDR, and then continued expansion through additional executive order authority, particularly under Obama and on into Trump, right?

We’re looking at a situation where[in] when we talk about the government, we’re no longer talking about a bicameral legislative system, and we’re no longer talking about in any real measure the judicial system functioning as a series of checks and balances. 

What we’re really talking about is Joe Biden is going to solve the problem. Donald Trump is going to solve the problem. We’re personalizing it, and we’re putting a single person at the head. You’re effectively normalizing the conditions under which people are going to say, “Hey, we just need to have one guy in charge.” 

I drove my daughter and her volleyball team to a tournament probably two years ago. Now, it feels like it was forever. My daughter and I were talking about the dynamics of politics, the dynamics of total war, etc., which again, gives you some idea of how much fun it is to hang out in our house. 

Her friends are sitting in the backseat and going, “I have no idea what you guys are talking about.”

I said, “Your parents never talked about this?” 

They said, “No idea.” 

I said, “Okay, let me ask you just a really simple question. Would you prefer to vote into a system in which you know that the person you’re voting for can’t solve the problem, but they at least more represent your choices than the alternative? Or would you rather have just a person who can make the decisions and really fix it?” 

Literally, every single kid, except for my daughter said, “Oh, absolutely, that guy. I want that guy.”

That sort of changed. I don’t think people understand what we have. I don’t think they understand why a system of checks and balances are brought in. This is ultimately when you start talking about the dollar. The risk that you have to the dollar, is it ultimately an abused ability to be used for force around the world?

There are only so many times Europe will be threatened with access to the financial system before they develop an alternative financial system. China is very actively working to develop an alternative financial system, so that they can quit. 

This is the other thing that I think people tend to forget. We talked about the dollar as the global reserve currency, and that it’s been that way for a couple hundred years or 100 years. Whatever. It really has only been the case since 1991. 

With the fall of the Soviet Union, you ended the ruble block. But when we had Bretton Woods, the Soviets participated in Bretton Woods, but didn’t embrace the dollar as the reserve currency. They chose to use a ruble and offer an alternative. We just totally forget that because we don’t have any real history of interaction with half the world over the Cold War period.

So is it entirely possible that we move to a multi-currency regime with trading blocs that don’t interact? I think that feels very plausible. We’re in a very clear process of deglobalization. I think there’s a variety of reasons why that’s happening. The most obvious one being nobody wants to stand in the way of China as they try to deal with the collapse of aggregate demand. This can be tied to their demographics.

Preston Pysh  27:45  

A lot of people in the comments when they knew you were coming on the show, we got a lot of questions. As you know, I’m a fan of Bitcoin. This question came from a person with the handle @baldcoall. Instead of bold call, he was “bald call” and he was bald in the picture. 

He asked, “Ask him his views on Bitcoin and why he’s so disinterested in it.” So, I’m kind of curious to hear your thoughts.

Mike Green  28:10  

I’m not at all disinterested in decentralized finance, cryptocurrencies. More importantly, smart contracts, etc. I am disinterested in Bitcoin. I could certainly be wrong in Bitcoin. 

There have been many times in the past where I’ve told people, as I was uncertain as to the path that Bitcoin was going to follow, that they should get themselves to be neutral, right? Effectively own enough Bitcoin, so that if it became the story, then they were successful. And if it didn’t work, they weren’t killing themselves. 

It’s hard for people to do effectively, if they do it all the time in trading. It’s what I call going to neutral, and it basically means I take a position, but it is a position that doesn’t matter. I’m not spending my time panicking, [thinking,] “Am I going to miss out? Am I going to lose a crazy amount of money buying into this stupid idea, etc.,” right? 

I become much more comfortable with the idea that I don’t think Bitcoin is going to work. I think the entire focus of Bitcoin was on, “Let’s create an alternative in the aftermath of 2008, to the US dollar, or to fiat currencies.” 

The presumption in 2008, I think, was very straightforward that governments were going to become weaker. The governments were going to lose control. I think the data suggests the exact opposite. 

The governments are becoming stronger. If governments are becoming stronger, yes, you’ll see some defectors. You’ll see a Swiss Canton decide, “Hey, we’re going to take Bitcoin, right?” 

Well, what they don’t tell you is they also take rubles. They don’t actually care. Remember where they are geographically and what they represent. They’re just saying, “Yeah, it’s fine. As long as we can convert it back into Swiss franc, we’re perfectly happy to take it.” I don’t consider that a victory. I actually consider that a mark of weakness, when people say, “Hey, look at the Swiss Canton, right?”

In just really simple terms, do I think we’re going to move to digital assets? Do I think we’ll move away from paper money? Do I think that we’ll facilitate the continued strength and growth of governments as a force in our lives? Absolutely. 

Do I think that there’s possibly a role for something like Bitcoin effectively as the fraud phone cards of the late 90s? If you’re in Mexico or Venezuela, sure. It functions as a money laundering tool. You’re in Venezuela, you can use subsidized electricity to try to effectively mine for gold in an artisanal fashion. 

You see the same thing in Zimbabwe, where farmers were unable to produce stuff on their farms, go and try and find grains of gold in the Zambezi River. But it’s the same thing. It’s not a meaningful component of the economic system.

Stig Brodersen  30:41  

You mentioned decentralized finance, Mike. What are your thoughts on that?

Mike Green  30:47  

For me, it ultimately plays back down to part of what I’m concerned about with the dynamics of passive, right? You’re relatively young, but you don’t remember a world in which preferred equity was an investable instrument or convertible debt.

Those things don’t exist for you. You have to ask yourself, “Why?” And the answer is very simple, because they don’t exist in Vanguard’s world. So, they don’t have funds that have any real way to invest in those, and they receive more than 100% of the marginal capital that’s being invested in the markets. 

As a result, anything that veers from that normal is going to actually face a penalty. You’re going to have a higher cost of capital associated with it, because there isn’t a defined source of that capital. 

Ultimately, the complete wasteland that our equity and credit markets are becoming because of the influence of passive will create the conditions under which they break. When they break, I fully expect that it’ll be effectively a punctuated equilibrium type moment. You’ll see an emergence of diversity in terms of the financing tools that people use.

Ultimately, that’s what I’m really interested in because of the dynamics of something like a smart contract on an Ethereum base. I could care less about the Ethereum itself other than the dynamics associated with the smart contract components to it. 

There are other people who are far more in the weeds on this, in part, because I think we’re at least five years out from any of this really mattering. 

However, if you stop and think about what you’re doing with a smart contract, you’re taking a simplified CUSIP that would say something as equity or something as debt. You’re suddenly converting it into something that can be any of those things and all of those things.

A debt covenant, a covenant, and a debt contract [are] just a real world option. It gives me as the debt holder the ability to enforce action on the part of management that I otherwise don’t have the ability to enforce.

If I put that into a smart contract, and I can compare that across thousands of securities, I think about it in terms of its payout feature. I can start to value that as an option. That’s my job. That’s what I do: figuring out how to value those options. 

So, the idea of smart contracts and their ability to diversify and create thousands upon thousands effectively unlimited types of securities, that’s incredibly exciting to me.

Preston Pysh  33:05  

What’s crazy right now in that space is you effectively have a CDO type event from the 2008 and 2007 timeframe that was playing out in a lot of the real estate. I suspect you have the exact same thing happening in the *inaudible* space right now, where you got all these unknown entities that are creating these tokens. 

They’re then dropping them into these decentralized exchanges, and because they can’t capture any type of liquidity, because they’re not listed on an exchange, they’re pulling them together, in order to narrow the volatility. 

Then, the more expensive coins are stepping in. Call it, the Ethereum and the Bitcoins are stepping in, and people are receiving “high yield” on them supplying the liquidity. Then, that liquidity is nesting itself down into these bowls just like a CDO 12 years ago. It’s playing out in that space right now. 

I’m with you on the technology of it in five years from now, or 10 years, or whatever it might be because that might be the relief valve to what we’re seeing in the passive side, where so much is just, I mean, it’s mind numbing, where all the passive is going these days. 

Back in, I think it was 2015, Carl Icahn basically rang the bell on his opinions on passive, and it kind of being this ticking time bomb from a systematic standpoint. Lo and behold, it wasn’t more than a couple weeks later, you had Larry Fink from BlackRock step in and challenge them to a debate. I don’t remember the specifics on what Larry was effectively coming back to Carl with, but what was basically his response.

Mike Green  34:43  

Carl’s focus was on the credit securities, so the credit ETFs. Highlighting was the liquidity assumptions around things like HYG, relative to the illiquidity of the underlying components. 

Larry Fink obviously came back in and disputed this for a variety of reasons. The most obvious being for purely business purposes. However, in Larry’s defense, these systems work great as long as money is going into them. So, the provision of liquidity is fine, as long as there’s a net inflow in. 

The other component that I love, in terms of ETFs, Vanguard and others defend themselves on this basis. It actually just made it into a piece from the Boston Fed talking about passive investing and systemic risk. 

They always come back to us saying, “Well, look. We don’t actually have to pay you cash or HYG. We can just give you the component parts, and therefore there’s not a problem.”

That’s completely insane. I didn’t come to you and say, “I’m selling my HYG because I want to receive a series of schlocky bonds that I’m then going to have to dump into the market without the ability of the sponsor from HYG to efficiently do that.” 

I’m going to suddenly have thousands and millions of retail investors and other players who now have corporate bonds, that they have no idea what to do with. They’re going to be forced to dump this stuff. 

At the end of the day, what Larry Fink argued is that there’s no evidence that this is the case, and they have delivered on the positive liquidity associated with it. 

To be honest, he’s right so far. I mean, the system works as long as money goes into it. It’s Ponzi-like in that frame, and I want to be very careful, when I say that. I don’t mean that it is Ponzi and that they aren’t actually trying to do something, but it is Ponzi-like in that once the process begins running in reverse, that’s where you care about the liquidity.

Stig Brodersen  36:32  

We can make the argument that back in March, the system was running in reverse, and then the Fed stepped in. They shot this elephant gun and just loaded the economy with liquidity. When you see what happened with the extra liquidity in 2008, and whether the days of tightening are just over, would we see twice as much liquidity be pumped in? 

Perhaps the actual amount is not the key point here? How do you see the Fed reacting to a new crisis, Mike?

Mike Green  37:01  

Yeah, I think that’s right. The question is always when you say double the liquidity does actually mean anything, right? Because I mean, there are two sources of money creation. There’s money creation that comes directly from the government, so the government can spend money into existence. 

The other way that money can be created as to the credit system: I can lend you money into existence, if I made a legal entity called a bank, or have access to the leverage that couldn’t be obtained through a bank. 

In order to break that system, you need to have defaults, which effectively destroy collateral. This is the thing that I think is actually happening when the Fed steps in. I don’t think they fully appreciate it. 

I think that there are some market participants that think in these terms, but it’s not that the lowering of interest rates radically changes purchasing behavior, right, if you look at things like credit card interest rates, or you look at auto loan interest rates? 

Housing is a little bit different, because it has some components of it that have fallen significantly, but housing interest rates have fallen 90 basis points for the highest quality credit borrowers. Lower quality credit borrowers struggle. We’re already seeing dynamics of tightening credit availability in that space. 

The pass through is not really that meaningful, and you’ve done the analysis, right? The difference between a 3.5% mortgage rate and a 2.5% mortgage rate, if that’s what you’re relying on to buy the house, then that’s just kind of silly. I mean, it really is, because at some point, you’re going to take it to zero. If you have a 30-year mortgage, you’re still going to have to pay back the principal. 

You can engage in rank speculation and get a zero interest only loan with zero interest rates. Then, sure, you get to live in the house [for] “free” for 10 years, or five years, whatever the length of your no-interest mortgage is. But how is that really positive for the economy, because what happens to the rents then? 

Effectively, you just end up in a situation in which nobody in their right mind is going to do anything other than build and sell houses until you’ve exhausted the supply. Then, you need to be thoughtful about what you’re going to get back in 10 years. Is [it] going to be enough to pay off that no-interest loan? You’re kind of trapped in that framework. 

At the end of the day, when the Fed cuts interest rates, all they’re doing is making bonds go up in price. When bonds go up in price, if you have a balanced portfolio, or you have a risk-parity-type portfolio, the bond portion of your risk has now expanded relative to your overall portfolio. You need to turn around and buy equities. 

Well, the stop levering part is hard because all of a sudden the interest costs associated with your leverage and your short interest rates have fallen. It’s easier if you’re doing it in the corporate sector, and you don’t have to worry about personal liability associated with it. Whereas, for the household sector, we’ve got an incredible way towards eliminating the dischargeability of various types of debt. 

I do think that that’s another factor that people need to consider. [It] is that in the last 15 years, we’ve eliminated the non-dischargeability of student loan debt. We’ve eliminated the dischargeability of student loan debt. 

We’ve eliminated the dischargeability of many forms of credit card debt. We’ve created conditions under which people can’t escape many forms of debt that they take on, particularly when they take it at an incredibly young age, right? 

I mean, it’s completely absurd to me that a 17-year-old is supposed to figure out how they’re supposed to take on enough debt that is the equivalent in many cases to buying a house for the generation that came before. Then, go study something where the availability of that debt has destroyed the price signal from the market that says, “Hey, you should really become an engineer, even if you think French medieval literature is more interesting.”

We’ve built a system that is slowly driving people back into serfdom, trapped in a system where they have to work whether they want to or not.

Stig Brodersen  40:39  

You had multiple conversations with Peter Thiel and Seth Klarman. These are two people who are just amazing critical thinkers. What is something that you feel is distinct about [their] personalities? What did you take away from those conversations?

Mike Green  40:55  

Peter is a brilliant thinker. He surrounds himself with really smart people and allows himself to be challenged in a way that many don’t. Right now, I think the hardest part about being Peter Thiel is when you’re working for Peter, it becomes an interesting situation, when many of those around him would place the value in being in his orbit higher than they do in intellectual curiosity.  

I do think that like everyone else, there becomes a component of an echo chamber. I think Peter offsets that for the most part by surrounding himself with people outside of his organizations and regularly bringing people in that are amazing, just absolutely unquestionably talented. 

If I’m thinking about the only thing that Peter does, that I think everyone should do, is just every once in a while, you will feel comfortable and stop. You say something to Peter, and he will literally sit there and just go, “Hmmm.”

The vast majority of us feel a need to actually say something. You feel a need to actually verbalize why you either agree or disagree. He doesn’t have that. It’s an incredibly powerful tool. 

Seth is a really, really interesting guy. I’ve interacted with him a couple of times. First of all, he is so warm and so genuine and such a kind person. It’s almost impossible to reconcile the idea of a hedge fund genius and one of the truly warmest, kindest people that you’ll ever meet. 

He just says very consistently, if you meet Seth, he’s always happy to listen to what you’re saying. I don’t think that’s just me. I think it’s true for everyone. 

The thing I would say with Seth is that he’s one of those people who makes leaps that are extraordinarily well-founded in logic, but does them faster than logic would actually allow you to make that leap. 

The way I described value investing, I think, would intuitively appeal to anyone who has read that book. When he talks about margin of safety, what he’s really describing is [for you to] actually figure out all the possible ways you’re wrong and how that’s not going to cause you to lose money. 

For me, value investing is about figuring out why somebody has to sell something to me. They’re coming to me and saying, “Hey, you want to buy this from me.” I can’t figure out that now they’ve got to make their mortgage payment. 

Therefore, they’re going to give it to me for a really nice price. Instead, I constantly find these things where people are saying, “This is being sold by so and so and it’s being sold, because he’s diversifying his personal assets.” That’s not how the world works, right? 

You want to find somebody who’s being forced into a liquidation mode and being forced to give you something, or you need to figure out a totally different angle in which it fits into a piece of your puzzle, and complete something creating a “synergy” that radically changes the outcome. 

To me, that’s just the only way the value investing makes sense. The idea that you’re going to look at a company and do a better job of forecasting their cash flows than everybody else put together and calculate their weighted average cost of capital to the seventh decimal point, all you’re doing is building an incredibly fragile model. 

I mean, like I spent the first 10 or 15 years of my career in one form or another, trying to figure out better than somebody else what was going to happen next, right? But free cash flows would be with XYZ company, and the access to the cost of capital is in really simple terms. 

You’re just creating fragility when you do that. You’re creating a portfolio that is very brittle to your individual forecast, as compared to very robust to the possibilities that can emerge around you.

Preston Pysh  44:33  

Why is the book not listed now? 

Mike Green  44:37  

He refuses to have anyone print it. There are bootleg copies all over the place.

Preston Pysh  44:42  

No. I know that, but why would Seth do that? To put an element of scarcity into the number of copies that are out there? What is his logic of not keeping it in print?

Mike Green  44:52  

I mean, look. I think it’s a little bit like Paul Tudor Jones with his trader video, right? You enhance the legend by keeping it away. If everybody had access to it like, “Oh, yeah, I know. I read Seth Klarman’s book.”

I mean, it’s like “Security Analysis.” It’s sitting on everybody’s bookshelf. Graham and Dodd, I’m an acolyte of Graham and Dodd. I’m a super value investor. I’ve read it, but I read everything. If you took away something remarkable from the book, that’s impressive to me.

Preston Pysh  45:18  

Let me go to a question from Lynn Alden, who said, “My understanding is that you think that Volcker was a bad Fed Chairman, which is a very contrarian point of view. Ask him about that.”

Mike Green  45:31  

I think that Paul Volcker was an extraordinary political animal. I think that he was a terrible Fed chair. The simplest example that I would use of that is the actual data that exists. There’s a paper written in 1983 by Alan Blinder about the anatomy of double digit inflation in the United States in the 1970s. Very readable, quite easy. 

What he points out is something very straightforward, which is that the metrics of inflation that the Fed was monitoring during the early periods of the Volcker administration from 1979 until 1981. It included mortgage rates in inflationary conditions. 

When the Fed hiked interest rates, what it was actually doing was raising mortgage rates, which then was showing up as an increase in the mortgage payment, which was then coming through the CPI and saying, “Hey, the inflation rate went up.” 

It was a positive feedback loop that Volcker created, where that became the driver of inflation in the 1979 to 1981 time period. He literally just kept hiking it until he destroyed the entire economy. His lack of awareness of this is appalling to me. 

I think it’s perfectly fitting that the post GFC worst legislation that’s had almost no positive impact whatsoever, the Volcker Rule bears his name. He was a terrible Fed chair. He truly did not understand what he was doing. 

Most people think of the 1970s as this terrible decade in which unemployment was high paying jobs were hard to find, etc. Inflation was running rampant. Your life was terrible. The 1970s had the highest level and rate of job creation of any decade in the United States history. That’s a fact. That’s not a disputed number. That’s not my opinion, etc. That’s a fact. 

What actually happened in the 1970s was that we had to deal with the dynamics associated with an explosion of our labor force, tied to the baby boomers, tied to the entry of women into the labor force, tied to the formal entry of minorities into the labor force under the Civil Rights Act. Most people tend to think about a labor force as a reduced labor force means the cost of labor goes up. They forget the demand side of the equation. 

Somebody entering the labor force is making the single, simplest and most powerful declaration they can possibly make: I want to consume more. Otherwise, you’d sit on your sofa. 

When you enter the labor force, you’re saying upfront, “I want to consume more.” What form does that consumption make? Well, you need a place to live. That requires somebody to borrow money in advance, construct a structure for you to live in, put a dishwasher in, and put a refrigerator and put air conditioning in it, etc. All that has to be done before you touch it. You’re doing that entire thing on credit, right? So it’s money that is being created on another form. 

What did Volcker do and what did the Fed do in the 1970s by reacting to the increase in prices associated with this outward shift in the aggregate demand function, tied to an explosion of the labor force, largely tied to demographics and some regulatory changes?

They chose to respond to it by trying to hike interest rates to keep prices from going up. Well, that has almost no impact. I don’t know if you remember what it felt like to be in your 20s and your income is rising rapidly, and you could literally care less. That’s why so many 20 year olds rely on credit card debt, because they presume that their income is going to rise so rapidly. They absolutely need that toaster oven right now. 

It has very little impact. Effectively, there’s a hyperbolic discounting rate for young generations that were streaming into the labor force and wanted everything. We’re being presented with a variety of financing options that allowed them to obtain it in a manner that they hadn’t previously. 

The Fed is out there hiking interest rates at the exact same time that the oil crisis destroyed a significant component of the capacity of the US economy that relied on oil fired generation. So you had an outward shift in the aggregate demand curve, an inward shift in the aggregate supply curve, guess what? You get a spike in prices.  Volcker’s reaction to that was more cowbell.

Preston Pysh  49:41  

Ray Dalio said that he was the best Fed Chairman ever…

Mike Green  49:44  

Well, there we go. Ray and I are just going to have to disagree on that.

Preston Pysh  49:49  

To wrap up the discussion, I had to throw that in there. 

Mike Green  49:52  

I know. Perfect. One of the things that I would encourage people to do is to look around the world and look at what happened to inflation rates. They rose on a coordinated basis on a global front, from basically 1965 to 1979. The minute that Volcker took office.

Everywhere else in the world inflation rates fell starting in 1979, except for the United States where Volcker hiked interest rates, driving this dynamic well documented on a contemporary basis in Alan Blinder’s piece in 1983. The Fed itself drove that inflation and yet we celebrate Volcker as having solved inflation. It’s just not true.

Stig Brodersen  50:27  

All right, the last question is, you’re such a well-read person. We talked about how Seth Klarman’s book “Margin of Safety” is perhaps the best value investing books out there. Which other books would you recommend that have really shaped your character as a critical thinker?

Mike Green  50:43  

I don’t like the world that we live in is passive. I would not encourage anyone to try to replicate what I have done in terms of building that body of knowledge, because my hope is that it doesn’t continue to exist. 

I would encourage people to try to focus themselves on doing. What you’re supposed to be doing with investing, which is figuring out how to identify valuable companies, how to be thoughtful about how you allocate your capital to them, etc. 

One of the things that I always want to make very clear to people is I’m extremely concerned about the environment that we’re in. I don’t think that means that we should all throw up our hands, walk away, and stop. 

So, books that were particularly powerful for me early in my career, Phil Fisher’s “Common Stocks, Uncommon Profits.” It is world class. Given a choice between the enjoyable read of “Common Stocks, Uncommon Profits” by Phil Fisher, and rereading “Security Analysis,” I’ll choose a gun. 

The second thing that I would say is that I encourage people to read biographies. I know you do your stuff on billionaires, for example, because what you want is you actually want the anecdotes and if you can retain those. I mean, if there’s one thing that I would say that I’m really, really good at, it’s holding these like really, apparently meaningless pieces of information until they become valuable.

A huge chunk of my insights on the dynamics of Vanguard, I remember reading a newspaper in 1994. I mean, this is crazy, right? This is literally 22 years before I began to really develop my theories around passive and reading this paper in 1994. There was a discussion around the challenges the Vanguard was having in terms of tracking here, right? 

I have no idea where that sat in my memory and how that sat there in that way. Reading is kind of the most important… It doesn’t actually matter what you read, it could be an aberrant piece of information, if you can hold on to it. 

The other thing that I would say is read Jack Schwager’s “Market Wizards.” Read things that inspire you personally, that give you the ability to capture little pieces from history, and that allow you to capture how people were going to react. 

One of my favorite books people have heard me recommend before is “The Mind of Wall Street” by Leon Levy. It’s out of print, I think, at this stage. He has even less incentive than Seth Klarman because he’s passed away, but it’s just such an extraordinary insight into how somebody could approach investing after the Great Depression. 

I really think that that’s part of what we’re looking for, as we come out of the desert of passive, which we eventually will. I don’t know how it’s going to resolve itself. I don’t know how we’re going to come out of it, but I know we will. 

To be prepared on the other side of it, that’s part of the reason you hear me talk about things like the dynamics of crypto and smart contracts because I’m trying to already prepare my mind for what that’s going to be like.

If I allow myself to be overcome by the despair of what we’re watching right now, that’s totally useless. It may not come in time for me to have a serious career doing it because I’m 50 years old. That’s what I would encourage people to be thinking about, what do you want to be doing in 10, 15, 20 years and how are you preparing your mind for that world?

Preston Pysh  53:58  

Well, Mike Green. Wow. I can’t thank you enough for coming on our show. If people want to learn more about you, give me a hand off where they can find more about you.

Mike Green  54:08  

You can go to LogicaFunds.com. I’m well-followed on Twitter. Confusingly, I’m an old bald guy from The Princess Bride on Twitter, but it makes for interesting cocktail conversation. My Twitter handle is @ProfPlum99 and I would encourage people to follow my partner Wayne Himelsein, who is absolutely brilliant as well. He’s at @WayneHimelsein.

Preston Pysh  54:30  

We’ll be sure to have all that in the show notes. Mike, thank you so much for making time for us.

Mike Green  54:36  

My pleasure. Thank you very much.

Stig Brodersen  54:38  

All right, guys. At this point of the show, we will play a question from the audience. This question comes from Anthony.

Anthony  54:45  

Hi, Preston and Stig. My name is Anthony from Melbourne, Australia. I’m a huge fan of the show. So keep up the incredible work you guys are doing. 

I recently listened to an interview with an expert investor who said that for insiders there are plenty of reasons to sell stock, but only one reason to buy. They think the price is going to rise.

How often do you look inside of transactions of directors, CTO and CEOs as confirmation when to buy a stock? Also, what stock options do insiders get access to that gives them an edge over retail investors? How do these stock options generally work? Thanks for having me on and I look forward to your response. Thanks.

Stig Brodersen  55:22  

Anthony, you bring up a good point that all investors should include in their analysis of a stock. We should always look up what the insiders in the business are doing. Insiders per definition know more than anyone else about the company. Whenever they buy or sell, we should pay attention. 

As you mentioned, insider selling is not as significant as buying. Insiders are usually exposed to the company much more than US investors. For instance, you can have a CEO that’s already been compensated based on how well the company performs. So, it’s not surprising that the CEO wants to lower his or her exposure to the performance of a company by selling options. 

Another example could be that of a founding or key employee. He got stock options as a part of the compensation plan. They’re now looking to cash in for private consumption. That is perfectly understandable. There’s nothing wrong with that. 

Buying is more interesting, because it often indicates that the company will do well in the future. There is also why insiders are required to disclose their actions to the SEC. 

An example is Warren Buffett, who recently entered his stake in Bank of America. He already owns more than 10% of the company. Even though he’s not holding a former job at the management or for the company, he’s considered to be an insider because he has information that the market does not have. 

Whenever you ask whether or not I look at insider trading before buying individual security, the answer is yes. I always look at it. But it’s never a deciding factor. Multiple times I bought into a stock whether *inaudible* inside selling. While that is not a plus, I don’t consider it an issue in most cases. 

Having said that, I don’t think I’ve ever sold a stock when I saw a lot of insider buying. It is one of the key factors that is interesting to look at. Insider trading is one of the key factors that is always interesting to look at. 

All companies have different key metrics that are very important. You should first of all pay attention to what the business and industry specific key raters are telling you, but really what is neat about insider trading is that it’s important for all companies to understand. At least you should take note of if you see anything significant. 

Keep in mind that it’s very common for most companies to do a little insider selling and really what you’re looking for as an investor is a significant change in the volume. You can find much more information about options of warrants in the annual report. 

We tend to use the terms options and warrants as interchangeable. But technically there is a difference since warrants are issued by the company itself, while options are traded between investors. 

Whenever you look at it a first glance, it can look a little overwhelming looking at the annual report, and especially about options and warrants. With a little practice, you’ll see what is important. The exercise price meaning at which price a share can be bought is one thing and then you have how many options they have and the expiration date. 

Unfortunately, you have this crazy accounting rule that options are not expensed. So you can find a significant dilution off the shelf standing there, meaning it’s not unimportant if you want to invest in the company. 

Even worse, you see new management being hired getting a lot of options that can be exercised way below market price. 

Now, there’s nothing wrong with options per se, but since they are tied to the performance, it’s hard to see why they want to issue options at a price that traded years ago, whenever that new person in the management didn’t even have an impact on that performance. 

It is effectively taking money away from the owner or giving it to the new management. Again, it’s not even being expensed to the income statement but hidden as a sub point in the annual report. 

Okay, enough about my rant here.

Then you have an expiration date and that’s important to look at because if you suddenly see a high degree of selling, often it’s because it’s near the quarter’s end, where the money would be lost if the options were not exercised.

Preston Pysh  59:13  

Anthony, I don’t have too much to add beyond what Stig already covered because he pretty much covered everything from the same vantage point that I see this as well. I pay much closer attention to the buy side than the sell side just like Stig had mentioned. 

Though, the one big tip I would like to give you is a resource that I personally use. The name of the website is insidearbitrage.com. We’ll have a link to this in the show notes. The founder of the site is Asif Suria and he does just a fantastic job laying out all sorts of not only buys and sells of insiders. 

He also does merger arbitrage spin offs and buybacks. He does a fantastic job just laying out all the information for key executives and people that are holding significant chunks of stock in various companies. 

Whenever they’re making big moves that are getting published in the open markets, Asif’s website is just capturing all this information. I would highly encourage you to go there and check that out. Hopefully, it’ll be a useful tool for you. 

Anthony, for asking such a fantastic question, we’re going to give you access to our TIP Finance tool, which helps you do intrinsic value calculations that helps you out with capturing momentum information, correlation data, all sorts of things. 

It helps you manage your portfolio, the sizing, all that kind of stuff. We’re really excited to be able to give that to you.

If anybody else wants to get a question played on the show and to potentially get access to TIP Finance, just go to asktheinvestors.com and you can record your question. If it gets played on the show, you get free access to TIP Finance. All right, Anthony. Thanks so much.

Stig Brodersen  1:00:55  

Alright guys, Preston and I really hope you enjoyed this episode of The Investor’s Podcast. We will see each other again next week.

Outro  1:01:03  

Thank you for listening to TIP. To access our show notes, courses, or forums, go to theinvestorspodcast.com. This show is for entertainment purposes only. 

Before making any decisions, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permissions must be granted before syndication or rebroadcasting.