[00:02:48] Trey Lockerbie: In early 2022, it became clear that inflation was going to be much more persistent than expected. I interviewed billionaire and investing legend Jeremy Grantham back in August, 2021, episode 371, and he predicted that the top of the market was just upon us. I referenced it again in my top takeaways episode for 2021, episode 409 at the end of the year.

[00:03:09] Trey Lockerbie: Turns out he was spot on. One of my favorite lines that Jeremy used was that bull markets have these termites that typically eat away at the high-flying tech stocks First, the NASDAQ peaked on November 19th, 2021. The market began to realize that fed hikes would be inevitable due to the persistent inflation and the major selloffs began.

[00:03:28] Trey Lockerbie: Interestingly, 40% of the NASDAQ companies were down by 50% or more by December, 2021. The S&P 500 lag a bit just as Grantham had predicted and peaked on New Year’s Eve before beginning. Its massive reversal on New Year’s. A huge focus this year was on the Fed as it raised rates to combat inflation.

[00:03:47] Trey Lockerbie: This prompted a lot of speculation around whether or not we would enter a stagflationary environment where inflation is joined by high unemployment. It appears that at least for 2022, that didn’t quite pan out as [00:04:00] unemployment has remained low, but in an effort to understand the potential of stagflation, I brought back Jeremy Grantham on episode 466 to get his viewpoints.

[00:04:10] Jeremy Grantham: Well, every period is unique. The seventies had problems with the oil crises. You can call it one giant crisis, or you can call it two or three. But in any case, a triple quadruple quintuple the price of oil in a hurry. We’d come off 50 years of fairly stable low prices, and they shot up and stayed up for a long time.

[00:04:30] Jeremy Grantham: An inflicted enormous pain on the system. They lowered the growth rate. Why wouldn’t it if you have to pay three, four times for your energy? And it also, of course, pushes up the price. So there’s nothing like a, an oil price increase to increase stagflation. And it did. And this time, if you adjust for the passage of time, the price of oil is not as high.

[00:04:52] Jeremy Grantham: But it’s still multiplied recently by three times. And so that is imposing pain on consumption and it’s imposing inflationary pressure. We also have, because of the invasion of Ukraine, we have and had some extra spikes in the price of food, fertilizer, and natural gas, particularly in Europe.

[00:05:15] Jeremy Grantham: Interestingly, they are now almost all of them lower in priced than the day before the invasion. And this is a lovely example of how the stock market. The stock market is saying works. There’s so much damage from commodity price prices, et cetera, et cetera, that we’re going to have a recession. But the recession isn’t bad news because the recession is going to get the fed back in, in our cam of lowering interest rates again and helping stock prices.

[00:05:42] Jeremy Grantham: And we are looking out into the future. And therefore that’s the good news. So the fear of a recession becomes a wishful thinking about future interest rates. And so the market gets a reprieve for a while. It’s quite remarkable, but it’s fairly typical and that’s what we’re having now and that’s why we might have a bit of a rally for a few weeks, I think.

[00:06:03] Jeremy Grantham: Yes. What we should cover is how dangerous it is to get involved in a bubble that has more than one asset class equities, growth stocks, mainly. And this time we’ve also moved into housing. Housing was chugging along okay, but last year had the biggest advance, 20% in 2021 that it had ever had in history.

[00:06:23] Jeremy Grantham: And it went up to a higher multiple of family income, a house price divided by family income, higher multiple than the peak of the housing bubble of 2006, which is it just means there’s a lot of value there that can be lost. And it is dependent on interest rates, as you know, when you’re paying a mortgage.

[00:06:40] Jeremy Grantham: But the bottom of the mortgage was two and a half, and it, it went up to 5.7, 5.8. This is a brutal increase in mortgage. It means a lot of people will not move houses who otherwise would’ve done, which means a lot of people will not take a new job because they’re not prepared to double their mortgage payments.

[00:06:57] Jeremy Grantham: Everyone expanded to pay as much mortgage as they could afford, which meant. That they put merciless pressure upwards on housing prices as the mortgage rates came down. So that’s a problem. And then you have problems with the, a, a bubbly commodities market, inflicting pain on consumption. And as if that wasn’t enough, we have the lowest interest rates in 6,000 years, as Jim Brown would say, or Edward Chancellor’s written a brilliant new book.

[00:07:20] Jeremy Grantham: And the, the price of time. And of course, with the lowest rates in 6,000 years, you have the highest bond prices. And that’s obviously been taken to the cleaners this year too. So you have bonds, housing, stocks, and commodities. The only people who’ve tried that with Japan in 89, they’re still not backed to the price of the equity market.

[00:07:40] Jeremy Grantham: They’re still not back to the price of the land and the housing. From 89, that’s 33 years in Canada. And we did some of that in the housing bubble where the stock market came down in Simpy. And that was brutal. They give you much greater pressure on recessionary forces and we are playing with fire this time, which was not anywhere near as obvious a year ago before that huge move 

[00:08:04] Jeremy Grantham: upwards in housing.

[00:08:06] Trey Lockerbie: While Jeremy was confident in his predictions, and rightly so, a lot of people I spoke to agreed that this was the most unpredictable market environment they had ever experienced in their career. Will there be a recession? Will we have runaway inflation stagflation? What about a deflationary surprise? It reminded me of a quote by Socrates who stated, I only know one thing that I know.

[00:08:27] Trey Lockerbie: Nothing. Macroeconomic developments are endlessly fascinating, and it’s a really fun game to try and predict the future, but a lot of my conversations led me back to wanting to simply focus more on a company’s fundamentals. In my 2021 takeaways episode, I showcased a conversation with Brian Feroldi, episode 375, where we explored the idea that a price to earnings ratio is only relevant to companies once they’ve hit a certain level of scale.

[00:08:52] Trey Lockerbie: This year I explored this idea further with legendary author, professor, investor, and strategist Michael Mauboussin on episode 421, who provided one of my favorite quotes of the year that you have to quote, earn the right to use evaluation multiple. Take a listen. 

[00:09:08] Michael Mauboussin: The answer is that a multiple has to capture a lot of stuff that’s going on, and the two biggest drivers would be the return on invested capital, the business, and the growth.

[00:09:21] Michael Mauboussin: And why are those two things so important? And this I think is quite intuitive. If your returns on capital are well above the cost of capital, you’re creating value and growth is good. And you know Warren’s work very well. Warren Buffet calls this the $1 test. So if you invest a dollar in the business and it’s worth more than a dollar in the marketplace, that’s a good thing.

[00:09:38] Michael Mauboussin: So that means you’re earning above your cost of capital. If you’re earning exactly your cost to capital, the growth makes no difference because every dollar that goes in is worth a dollar. So you’re getting no lift in value. And then of course, you’re investing a dollar and it earns below the cost of capital.

[00:09:52] Michael Mauboussin: That’s bad, right? The more you grow. So the first thing you have to think about is return on invested capital. And then the second thing you have to think about is growth. And the impact of growth is contingent on the return on invested. So all that stuff that’s going on is built into a multiple, so you have to really unpack it.

[00:10:07] Michael Mauboussin: Now, to your point, the reason this is so difficult for young companies uh, there are a bunch of reasons. One is the range of outcomes is huge. So we don’t really know what the returns on of Visa capital are. We don’t really know what the growth is, and it’s compounded by the fact that often young companies have to spend a lot of money on what we call pre-production costs.

[00:10:25] Michael Mauboussin: They basically have to spend money to get up and running. And as a business person yourself, I’m sure you can relate to this concept where you have to spend, you have to invest essentially to, to reap the benefits down the road. And you don’t really know how much that’s going to be and, and the economics don’t.

[00:10:38] Michael Mauboussin: Look, they may be very good, but they can superficially look quite poor at the outset. I always like to say, you open a restaurant the very first day you’re open, you spend a ton of money, right? Building the store and putting in the furnishing and hiring people, and you have no revenue, right? . So like day one, you don’t look so good.

[00:10:52] Michael Mauboussin: It may be in a brilliant restaurant, but it takes some time for that to unfold. So that’s why I think your observation that it’s tougher to do for young companies now. You could still run through scenarios, you can think about things, but that becomes more. It turns out it probably gets easier as you go on.

[00:11:07] Michael Mauboussin: And we always like to say the grim reaper of multiples is basically the, we call it the commodity multiple, is just the inverse of the cost of capital. So pretend the cost of capital is 8% and you earn a dollar, that means the grim reaper multiples 12 and a half times one, over 8% equals 12 and a half.

[00:11:26] Michael Mauboussin: And eventually, if all companies earn the cost of capital because of maturation or competition or whatever, that is, the multiple toward which they will migrate. So eventually Bruce Greenwald, my colleague at Columbia Business School’s, got this great line. He says, eventually everything’s a toaster . Then what he means is like, eventually it all becomes a commodity, right?

[00:11:45] Michael Mauboussin: And then you get back to that commodity. So earning the right of, of using a multiple means that you understand the underlying drivers that support that multiple. And I’ll just mention one other thing, Trey, not to go too long on this topic, but I think it’s important. Recently started my 30th year teaching Columbia Business School.

[00:12:02] Michael Mauboussin: And we’re going to be talking about this exact topic in a couple of weeks. So there are sort of the two most popular ways to value businesses are the price earnings multiple, right? So the stock price divided by earnings, usually some sort of forward-looking earnings. And the second is enterprise value to EBITDAs.

[00:12:16] Michael Mauboussin: Enterprise value, most simplistically is the market value of the debt, plus the market value of the equity and EBITDA earnings before interest, taxes, depreciation, amortization are, it’s sort of a gross cash flow number. Well, here’s an interesting thing I point out to my students. By the way, the correlation between those two is about 0.7.

[00:12:30] Michael Mauboussin: So high PEs and high EBITDA multiples usually go together low, okay? But what I show my students are instances where two companies have the same PE, but radically different E V D EBITDA multiples, or the same E V D EBITDA multiple and radically different PEs. Now, what’s up with that? So these are the two most popular metrics.

[00:12:50] Michael Mauboussin: Which one do I pick and why? And so immediately when I point that out, you’re going to say, well, I need to know more. Exactly, you need to know more. And then we’re going to go right back to where we were before, which is I need to understand, you know, how the accounting works and how the cash flows work, and how the returns on capital work, and so on and so forth.

[00:13:06] Michael Mauboussin: So the key is earning the right of multiple just means that you sort of understand the underlying drivers of businesses, you understand the return on capital characteristics, and then you’re using a heuristic based on all this information you have embedded. And by the way, I use multiples myself as a backdrop.

[00:13:20] Michael Mauboussin: There’s nothing wrong with ’em, but I just think this idea of walking around saying that’s 15 times, that’s 27 times, and you know, without understanding what the implications are, is probably not a great way to go. 

[00:13:31] Trey Lockerbie: Michael and I went on to talk a lot more about valuations, how to quantify a business’ moat and discount rates.

[00:13:38] Trey Lockerbie: It was one of my favorite conversations all year. Now, one important thing to remember about your discount rate is that you have to account for expected inflation. And since inflation had been ticking up over the last year, I really wanted to better understand the driving factors. There are a few different metrics for measuring inflation, and I want to highlight advice from our co-host Preston Pysh that you should develop your own personal way of measuring inflation, meaning you should consider what you actually spend money on, and at what rate these items or services are increas.

[00:14:06] Trey Lockerbie: But a very popular metric, albeit controversial to some, is the consumer price index. Typically, when you hear that inflation is at 7%, et cetera, people are referring to the C P I energy goods and services. A category of which gasoline is a major component, accounts for roughly 7.5% of the overall C P I.

[00:14:25] Trey Lockerbie: But it’s also important to remember that energy affects nearly everything else. For example, transportation makes up over 18%, and food and beverage makes up over 14% of C P I, and typically energy is one of the biggest contributing costs to better understand energy. I interviewed energy expert Josh Young of Bison, interest on episode 429.

[00:14:46] Trey Lockerbie: In our conversation, Josh highlighted why the price of oil had skyrocketed this year, peaking at 122 on July 8th. He revealed that due to E S G narratives, a lack of investment in the energy sector has set up a potential huge gap between supply capacity and future demand. When I suggested that high oil prices would create a proverbial gold rush where producers would come in and the price would ultimately fall, Josh responded with this.

[00:15:11] Josh Young: Yeah, so that will eventually happen, but there’s a little bit of a couple of things going on that are going to make that heart. So one, we are at the tail end of the very long bear market for oil. We’re just starting this bull market prices, like you mentioned, the last year, 

[00:15:26] Josh Young: have rocketed higher and they finally gotten to a point where it’s economic to start investing in these long lead time projects.

[00:15:33] Josh Young: The problem with long lead time projects is that they’re a long lead. So in many cases you have to spend 10 years bringing your discovery onto production and developing it more. And there’s been too little activity in discovering oil fields, so you kind of need to like start from the beginning. So in many cases, you may need to spend 15 years in between now and bringing oil on.

[00:15:54] Josh Young: And oil prices have almost, I think they’ve doubled in the last year. So you know, where do they go in between now and that kind of five to 15 year from now window for those long date projects. And then on the short dated shale and other sort of conventional but short cycle projects, we’re just at the tail end of this giant boom and bust in that area too.

[00:16:15] Josh Young: And so there were many companies that misrepresented their economic. And said, oh, we can break even at $30 oil or $40 oil, or whatever their economics were. And many of those companies just reported their Q4 and they were profitable at $80 oil, but like barely profitable. So it turns out that those companies require much higher prices too for their activity to be economic.

[00:16:39] Josh Young: And they’re only going to rush and drill a lot more if their activities are highly economic. So that whole, the setup both for the short cycle and the long cycle, both of those are requiring much higher than historic prices in order to bring on new rigs. And then in the oil services industry, it’s even worse where there’s been even less capital available for even longer. And I think people forget about this. They just kind of assume, oh hey, there’ll be plenty of. And there were more rigs running 10 years ago. The problem is that that was 10 years ago, and many of those rigs have been cannibalized. They’ve been scrapped, and many of the people that worked on them are no longer in the business.

[00:17:17] Josh Young: In many cases they’re retired. And so getting the talented workforce. Along with capable additional rigs and fracks and other sort of equipment. I mean, it’s a real problem. And we’re not even at the point where it’s economic for those oil services companies to start. They’re starting to try to hire, but wages haven’t gone up enough yet and they’re not even starting to build new rigs. So if you think about that from a lead time perspective, that’s a multi-year cycle on its own. Just for kind of the short term stuff. So I think we’re set up for this multi-year bull market where the first thing you need to see is oil services stocks go up five or 10 x. That way they can have an investment boom that way they can go build over the next few years. The equipment that’s necessary to have a drilling boom, to have drilling go way more than it needs over a multi-year period. And then you can have a big crash, but that might be, you know, coinciding with when these long lead time projects come on. So it’s really set up nicely, I think for a very long.

[00:18:16] Josh Young: Very strong bull market that’s really going to incent a lot of investment. But like you’re saying, like why can’t they do it? Well, there’s just all these logistical and investment problems that are keeping it from happening. When you had under investment, you didn’t have, especially in the last couple years, you didn’t have companies building more rigs.

[00:18:33] Josh Young: And since they weren’t building more rigs, there’s a certain number of hours that a rig can work. Before you need to replace the engine, you need to replace various other components. You need to replace filters and at some point you just hit your useful life on a rig and you’re done. And so that’s kind of a analogy to the process from a producer’s perspective, going from undrilled land to a producing well.

[00:18:55] Josh Young: And one of the steps is after you drill the well, then bringing the right equipment on to frack the well and tie it into a pipe and bring it on production. And so as a part of this giant boom and bust and the short cycle shale stuff, there were a lot of wells that were drilled that weren’t completed and brought on yet.

[00:19:16] Josh Young: I think some of it was a capital budgeting and timing thing. Some of it was some of these wells were not very good and they knew they weren’t good and so they didn’t even bother fracking them or bringing them on. And what you’re pointing out is white paper, you know, we talked about, and there’s various other sources that have been focusing on this because it is an issue where we noticed that the number of these wells that were prepared to be fracked but hadn’t been fracked yet was falling a lot. And what that told us and what it tells us in terms of why things are going to struggle to scale, how you. Stacked in a boom is that there’s been essentially this underinvestment, essentially burning the furniture where the wells that were drilled already are being completed faster than new wells are being drilled, and that means that you need to drill a lot more wells in order to be able to complete the same number of wells that you’ve been completing. So if you think about it, step one, step two, oil, well, they did too many step ones to. And now they’re doing too many step twos and you need to kind of coincide step one and step two in order to get to a completed, well that’s on production. So it’s a sequencing issue, but it’s also a budgeting issue, and we’re seeing many producers now subsequent to that white paper, we’re seeing them come out with guidance where they’re raising their capital budgets anywhere from 20 to 25% without raising their production guidance at all.

[00:20:37] Josh Young: Some of that’s cost inflation, but some of that’s also replacing. They’re recognizing they did not enough step one, drilling wells, and so now they have to do more step one in order to catch up with the step two, which was completing wells. 

[00:20:49] Trey Lockerbie: It’s worth noting that at the time of this recording, the price of oil has fallen back down to $80 a barrel, but that the US has depleted 177,000 barrels of oil, or 30% from its special petroleum reserve or S P R, which is now at the lowest levels in history.

[00:21:07] Trey Lockerbie: Meaning we’ve been using our reserve of oil to flood the market, and you could argue artificially bring the price down and ease the inflation burden for our citizens, but it’s only a temporary fix. If Josh is correct, we may be setting ourselves up for much higher oil prices in the future, which would inevitably lead to higher inflation.

[00:21:25] Trey Lockerbie: This likely explains why Warren Buffett made some huge bets on oil producers. This year, roughly 80% of Berkshire Hathaway’s, Chevron steak of 170 million shares now worth 32 billion, was accumulated in 2022. Berkshire has also taken a 20% stake in Occidental Petroleum. That position is worth about 15 billion for a combined total of 47 billion.

[00:21:49] Trey Lockerbie: I brought Josh back on episode 468 to learn about Buffett’s bets and his track record in investing in Energy. 

[00:21:57] Josh Young: Buffet and Munger are among the best market timers at Oil and Gas Alive, and they’re not known for that. Right? And if you go around Berkshire like we did, and you talk to people and you listen to like what they have to say about Buffet one, Many people worship buffet, but didn’t even know what my $250 w t I hat meant.

[00:22:18] Josh Young: Very little knowledge or awareness of oil and gas or you know, interest in it or whatever. But they’re amazing at it. So it’s wild. You have like some of the best investors at this thing, right? You look at where Buffet has gotten into oil and gas, where he is avoided it. He got out and was sort of negative on the industry in the early eighties.

[00:22:38] Josh Young: One of my friends found this I think that was actually on your show too. He found this footnote in a annual letter in 1983 from Berkshire, where Buffett talked about how you don’t need to own commodity producers in order to have inflation protection and he’s right. But if he was talking about an environment where you had to buy commodity producers at 20 times cash flow or 30 times cash flow in order to get exposure at two times cash flow.

[00:23:01] Josh Young: He’s all over it. And you know, because Berkshire has so much money, they can’t really go to where bison can go or where individual investors can go. And so if you look at the largest companies that are the most liquid that are relevant for Berkshire, from a public equity share perspective, just getting to go and buy the stock in the market.

[00:23:20] Josh Young: You look at Chevron, which is probably the best run mega cap integrated producer. And you look at Oxy, which. At the time that he started to buy it in March was the sort of cheapest producer with the most upside to higher oil prices. And that was sort of my analysis was it’s not, I don’t think it’s something specific to Oxy in terms of a view on their specific assets.

[00:23:45] Josh Young: I think it was purely that their sort of cash flow torque to higher oil prices was superior to companies of their size and their trading liquidity. And so if you’re only going to buy two, it makes sense to buy Chevron. Again, Mike Berth is just absolutely a rockstar. He’s done a lot of stuff right in terms of balancing, generating enough cash flow while also keeping activist investors at bay through minimal ESG activity, but some in order to sort of keep his job.

[00:24:13] Josh Young: So Chevron makes a lot of sense. And then Oxy for their high oil price torque. And so when I look at that and I think about, okay, like what do I want to own? A number of people are just buying Oxy because Buffett’s buying Oxy and Buffet tells you not to do that. He’s told the, not this meeting, but the one I went to years ago, he talked about how if he was running 50 million he’d be doing everything different and he could get 50% a year compounded returns.

[00:24:38] Josh Young: And so I like to think that I’d rather be like 40 year old Warren Buffett than 80 something year old Warren Buffet. So I think it’s possible to learn what he’s doing, which was the point of that letter, Hey, like he sees a lot of value in oil and gas and he is great at it. And he’s done other cyclicals with mixed success, oil and gas.

[00:24:56] Josh Young: He is great at, he made a fortune for Berkshire, he made a fortune for his partnership. He made a fortune for himself. I didn’t talk about it in the letter, but Charlie Munger, the money that he had to invest a lot in, in Berkshire stock, he made from a massively undervalued oil producer. That honestly like reminds me a lot of journey where just you can do the math and it just doesn’t make any sense.

[00:25:16] Josh Young: And so it took a lot of trust in himself to just own it anyway, and just phenomenal, phenomenal run. And that was where a lot of the money that he spent in the early, I think it was the early seventies or early eighties where you came in and bought a lot of Berkshire was from a oil company too. So I think it’s possible to learn from what they’re doing without copying it exactly.

[00:25:36] Josh Young: And just to have that sort of exposure where there are these companies that can do very well from the things that would make a Chevron or an Oxy do well, but. They can do potentially even better, because I don’t have to go put 10 billion to work when I’m buying it, and I don’t need to only own one or two oil stocks in doing it.

[00:25:56] Josh Young: So I observe the sort of bet that it looks like Berkshire is making and I try to express it in a way that has much more asymmetric risk and reward, and I’m able to do that because I just don’t need to do what Buffett’s doing. 

[00:26:13] Trey Lockerbie: I totally get that and it makes sense. I mean, given Buffett’s size of portfolio he’s working with, I’m kind of curious though if something like a Chevron or even Occidental.

[00:26:21] Trey Lockerbie: Is just massive size of those companies. Is that a moat in and of itself? 

[00:26:27] Josh Young: I don’t think so. I think there’s dise economies of scale for some of these companies. So you look at Chevron and their position in West Texas and Southeast New Mexico and they are growing their production and they are an excellent operator.

[00:26:40] Josh Young: But I think it’s just hard at that scale to be as effective of an operator as some of their competitors who are smaller. And there was this story that was told years ago about how the oil majors were going to inherit the Permian, the West, Texas and Southeast New Mexico oil fields because they were best able to optimize all these different factors and how shale development was really a factory type operation.

[00:27:06] Josh Young: And there are aspects of it that are real, but there’s also aspects of it that I think people missed. And so I think there are dise economies of scale as you get bigger. Companies like Chevron have amazing assets and then they also have terrible legacy assets and you’re getting it all together. Same with Oxy.

[00:27:22] Josh Young: And you know, you’re getting governance issues and you’re getting, I mean, Chevron was in, and there’s still technically headquartered in California. So they have management policies that are more consistent with California companies and less consistent with, let’s say, Texas companies, which. Detrimental. If you’re not having people, let’s say, come into the office as much, you’re not getting as many of this sort of there’s a network effect from having people in an office, especially for a big company. And so there are various challenges that Chevron has, I think from being big, Oxy, similar sort of things.

[00:27:55] Josh Young: So I think there’s some benefit from being big in terms of lower cost of capital, better known, but there’s also some costs. And, you know, I’m not sure that it’s so obvious that’s something that should be awarded with a much higher valuation. 

[00:28:09] Trey Lockerbie: As you can see there, Josh isn’t convinced that the major producers are the way to go.

[00:28:14] Trey Lockerbie: In fact, in our conversation, he highlighted his positions and microcaps like Sandridge, ticker SD, and journey ticker, j o Y. This really intrigued me because this year I have also really taken an interest in microcap. In fact, microcaps had a fairly decent year, and by decent I mean just slightly less bad than their larger cap counterparts.

[00:28:34] Trey Lockerbie: Microcaps are generally companies with market caps between 50 million and 300 million. In an effort to learn more, I invited on Ian Cassel, a microcap expert who highlighted the fact that investors like Buffet and Peter Lynch actually got their start by investing in microcap companies, and maybe even more surprisingly had high turnover, meaning these weren’t buy and hold forever type positions.

[00:28:55] Trey Lockerbie: Let’s take a listen. 

[00:28:57] Ian Cassel: When you look at the partnership,  I believe he started that in 1957 and when he started that partnership, I think it launched with around a hundred thousand dollars in capital. And so a hundred thousand dollars in 1950 $7 is about a million dollars today. So he, you know, Warren Buffet launching today would’ve launched his partnership with a million, and that partnership ran till 1968.

[00:29:21] Ian Cassel: By the time. , the partnership ended in 1968. I believe he had around a hundred million in capital in those dollars, which is around 800 million today. So, which is pretty incredible when you think about it. He went from, you know, basically a million dollars equivalent today to 800 million over the course of 11 years, you know, in that fund and in the middle of there, I believe it was 19.

[00:29:45] Ian Cassel: Some, some Berkshires going to yell at me. I think it was 1965, that he kind of bought control of Berkshire. So during that partnership, he actually brought control of Berkshire Hathaway and Berkshire Hathaway, even on an inflation adjusted basis, was a micro cap even in today’s dollars. But he started purchasing kind of large chunks of public companies and even a few private companies, even in, in the mid 1960s.

[00:30:06] Ian Cassel: I mean, so. Entree into Microcap probably only lasted a few years cause he was so successful. He quickly, you know, grew out of that ecosystem. When you look at his performance kind of over those first five or six years, I mean they’re actually probably fairly equivalent to what he did over the next 10 years, which makes sense.

[00:30:26] Ian Cassel: I mean, when you think about it, if I’m the best varsity QB of my high school football team, you know, hopefully I excel and become the best QB on the college team and things like that. And so your performance can sustain at different levels and different market cap classes. And that’s what the greats do.

[00:30:40] Ian Cassel: I mean, they’re able to kind of continue on with their success, compounded those great rates as they go upstream and up market cap. So I think most of his micro cap experience was, was the first five or six years, and I believe he compounded at 31% gross during his partnership years. 25% net, you know, which was probably on track with what he did over the next 10 years, once he was kind of going upstream a little bit further.

[00:31:04] Ian Cassel: When you look at somebody like Peter Lynch. . I think he launched his fund officially to the public in like the early eighties and I think he had around a 22% average rate of return. So probably somewhat similar, but a little bit better than what he did than when he was forced upstream. Cause he went from imagine a hundred million in the early eighties to about 16 billion by the time he left.

[00:31:26] Ian Cassel: You know? So he was obviously going upstream, but he also increased the amount of positions that he was in. I mean, he was in 1200, 1300 companies at a time by the time he was done, which was pretty amazing. When you think about that being in 16, you know, being an active investor and being over a thousand names.

[00:31:42] Trey Lockerbie: Incredible. Yeah. You know, back in 1999, Buffett said that he could still achieve 50% annual returns if he was working with like 10 million or. What strategies do you imagine he’d be implementing in that case? Would it simply be just concentrating heavily into these smaller companies, I think like you are, or are there, like, you know, are we talking Greenblatt spinoffs and other kind of strategies thrown in there? What do you think the playbook would look like? 

[00:32:08] Ian Cassel: I think it would probably be, yes, concentrated, and again, he’s one of the smartest people on the planet, so you have to watch when you talk about concentration because everybody glorifies it. But you, there’s also a, it’s also a dual-edged sword, but I think if Buffet was doing it today, it would be a combination of probably small, micro, small cap companies & probably doing something similar to what Brent Beshore does. You know, where it’s like acquiring private, small companies for two or three times cash flow. It’d probably be some combination of that, but concentrating in that approach. 

[00:32:37] Trey Lockerbie: Yeah. As you mentioned earlier, some small companies eventually grow up to be bigger companies. Netflix comes to mind. They IPOed a little over 300 million.

[00:32:45] Trey Lockerbie: what are some of the biggest success stories that you’ve followed from Micro that have transitioned into macro? 

[00:32:52] Ian Cassel: That’s a good question. I mean, there’s some big bald bracket names like Walmart, when it went public in 1971 as an i p, it was Microcap. You know, intuitive Surgical was kind like Netflix, where it was kinda a larger, you know, microcap Monster Energy and one of those monster drawdowns that it had actually went down into Microcap for a short period of time.

[00:33:11] Ian Cassel: Berkshire Hathaway, like I said, I believe Celgene as well. And there’s a few other kind of life science companies that made, you know, huge runs over time. There’s also a bunch of companies that a lot of people probably haven’t heard of that. I mean, listen, you can 10 x a hundred x, you know, and still be a relatively small company too.

[00:33:29] Ian Cassel: You know, a company that like Expel and the symbol is X P E L. You know, that was a company that was profiled on Microcap Club by one of our members at 25 cents a share back in 2012 or 2013. That hit a hundred dollars a share last year. And so they, that’s, that’s the other thing kinda attracted me to kinda the smaller area of micro cap is because, you know, you can find a 10 or $20 million market cap company and if a 10 x is, it’s still only a hundred or 200 million market cap company.

[00:33:56] Ian Cassel: But I think one, one of the other interesting that parallels this conversation is also illiquid micro caps. Roger Tson, who’s a Yale finance professor, also runs Sbra Capital. He actually has a few white papers on illiquidity as a factor and he did some work looking at all market cap classes, all liquidity profiles, going back to 1971.

[00:34:17] Ian Cassel: And in their, in one of his reports, I think the most public or most recent one that’s public is year ended 2017 or 18. But he, he updates it annually, but he has it there, matrix. And it shows the best performing company since 1971. And every year, you know, over since 1971, it’s illiquid micro caps, not liquid micro caps not.

[00:34:40] Ian Cassel: Mildly liquid micro caps, but illiquid micro caps, you know, versus, you know, liquid large caps, illiquid large caps, mid-caps, small caps. Since 1971, the best performing, you know, kinda quartile is illiquid micro caps. 

[00:34:54] Trey Lockerbie: Surprisingly what beat out most micro, small, mid and large cap stocks this year was cash. 

[00:35:00] Trey Lockerbie: The Almighty dollar in 2021. I interviewed Brent Johnson of Santiago Capital episode 397 about his dollar milkshake theory, a controversial theory that flew in the face of those who believe that the dollar is on the verge of its demise. I highly encourage you to go back to my 2021 interview with Brent, episode 3 97, where we explore the theory in depth.

[00:35:21] Trey Lockerbie: In that conversation, I asked Brent, what d x, y, or dollar index level would cause him to be concerned. His answer was 97, with a caveat that the rate of increase was much more important. Well, the DX Y Index peaked at 114 on September 27th, 2022, an increase of nearly 19% from the top of the. Prior to seeing this play out, Brent’s short answer to when the dollar milkshake would go into effect was when debt matters.

[00:35:48] Trey Lockerbie: Again, I invited Brent back this year on episode 449 to ask if that’s where we are today. 

[00:35:56] Brent Johnson: Well, I think ultimately everything in economics comes down to two things, supply and demand and, and kind of a subset of supply and demand is a cash. A business needs to receive cash flows in one form or another.

[00:36:10] Brent Johnson: Either either needs to receive cash flow from current customers who are sending cash into it in exchange of our product, or they need to be out there raising money and getting cash flow from new investors. But if you’re not attracting cash flow and you’re not getting any incoming revenue stream, then that company is going to fail even.

[00:36:28] Brent Johnson: And the same things for an individual or for a country or kind of any organization. And one of the things that governments have been absolutely, and governments and monetary authorities have been absolutely great at, you know, and I tip my cap then is kicking the can down the road and extending the game.

[00:36:45] Brent Johnson: And typically the way that they’ve done that is when cash flows from customers stop flowing in, they’ve provided cash flow from government stimulus or bailouts or whatever you want to call it, right? And for that reason, debt hasn’t mattered. We just kicked the can down the road in a weird way. So lemme take a step back.

[00:37:03] Brent Johnson: As you’ve said, I kind of started talking about this in 2018 and I, in the first one to say that I was early, you know, on Wall Street, you’re typically, if you’re early, you’re wrong. And so from that perspective, I was wrong. Now I don’t think I’m going to continue being wrong, but I, there’s no question, I was early, I kind of saw this playing out 2019, 2020 timeframe.

[00:37:22] Brent Johnson: And when Covid hit, I thought that was the trigger In hindsight. It was not the trigger. And again, I’m not blaming being wrong on Covid. It kind of drives me crazy when people blame all their problems on Covid. But what I think happened was Covid was such a, for lack of a better word, globally, systemic event.

[00:37:37] Brent Johnson: It sort of forced the whole world to work together to combat it. And so we kind of saw the whole world. You know, do the same thing from a monetary policy perspective, from a government spending perspective, from a trade perspective. You know, perhaps Trump and China kind of took it a little bit easier on each other than they otherwise would’ve if they didn’t have to deal with that.

[00:37:57] Brent Johnson: But you know, now we fast forward and now we’re in 2022. Maybe Covid isn’t totally behind us, but it isn’t kind of the front and center that it was two years ago, or even a year ago. But now what we have is, rather than the world working together, We have the bifurcation of the world. I don’t think it’s too much of a stretch to say we’ve kind of gone back to this cold war mentality where we’ve got Russia and China on one side and the US and the west on the other, and you know, sides are being drawn and partners are being picked and red lines are are being put down.

[00:38:26] Brent Johnson: And I think it’s the opposite of coordination then. Not only that, but within those two sides there’s fractions. And now we have not only monetary policy divergence between the two sides, east versus west, but we’ve got monetary policy divergence within the west and within the east. Some countries are tightening monetary policy and some countries are loosening monetary policy.

[00:38:50] Brent Johnson: That is the environment, especially when the US is tightening monetary policy where really volatile things happen. And it’s primarily a reason because the whole world trades in dollars because it’s a global reserve currency and because there’s so much dollar debt out there. And it’s the primary funding currency of most countries.

[00:39:09] Brent Johnson: When the US raises rates or tightens monetary policy, they’re not just tightening it on the United States, they’re tightening it on the whole world. You know, when Japan does monetary policy or Europe does monetary policy, or Brazil or Australia, when they do monetary policy, it’s typically for their own region.

[00:39:22] Brent Johnson: It’s typically not a global event, but when the US does it as a global event. And so I think because of that happening, going back to what will cause debt to matter, is I think flow of cash is going to start leaving certain places. And I think it’s going to come mostly to the United States if it moves at all.

[00:39:37] Brent Johnson: I think it’s going to come to the United States. And if, again, if it doesn’t move, capital’s not moving, you’re not going to get that cash flow, you’re going to have a problem. And I think it, if it does move, I think it’s mostly going to come to the west. Until the United States in particular. And I think that’s going to deprive the rest of the world of capital.

[00:39:51] Brent Johnson: And so I think that is what’s going to cause debt to matter, the lack of coordination and the lack of liquidity. Now we’ll see if that doesn’t happen, I’ll be wrong again, but that’s kind of how I see it playing out. But that’s what I think causing debt to matter. 

[00:40:04] Trey Lockerbie: That’s so interesting. And when I asked earlier about when debt is going to matter again, I almost expected you to say, you know, when inflation matters again, now we have to increase interest rates to quell inflation.

[00:40:15] Trey Lockerbie: And you have everyone in the US at least scratching their heads, like, why on earth are we raising into weakness into a lot of things that are happening in the market right now? Yes. And to your point, what I’m hearing from you just now is that the Fed is thinking more globally, right? And they’re saying, well, we gotta raise race because we’re going to have to print more money.

[00:40:32] Trey Lockerbie: We’re going to have to create more bonds to fund that money printing, and who’s going to buy it? Ideally not the Fed. You know, ideally it’d be the rest of the world and maybe they will if we are able to provide some real yield. Is that correct? 

[00:40:43] Brent Johnson: I mean, that’s part of it. I think them raising rates is kind of threefold.

[00:40:46] Brent Johnson: One, you make it more attractive and then you get more capital. Number two, if you raise, then you have more room to cut later if you want to. Number three is the inflation point that you just brought up, and you know, if you think back a year ago, It was an absolute given that interest rates were never going to be raised, and the government was never going to stop sending checks.

[00:41:06] Brent Johnson: The playbook was financial repression. We’re going to hold real rates negative, we’re going to keep rates low. We’re going to keep spending fiscal stimulus, and we are going to inflate our way out of this problem. If we can get 5% inflation for the next 10 years, that decreases the, the debt burden by 50%. And the point is, is that works really, really well on a spread.

[00:41:26] Brent Johnson: It doesn’t work that well in real life because there’s political ramifications of having 5% inflation. The other thing is it’s very hard to get 5% inflation without it splurging out of the toothpaste tube and becoming 10% inflation or 15% inflation. And once that happens, it starts to happen.

[00:41:41] Brent Johnson: Politicians start to feel it. And politicians are nothing but short-term thinkers. I mean, that’s how they get reelected is taking care of short-term problems. They don’t get reelected by taking care of long-term problems. So, and we’ve already seen, and so my point is, is the certainty with which financial regression was going to take hold a year ago has just a year later we’re having rate hikes.

[00:42:02] Brent Johnson: And they’re going to raise rates again tomorrow or Wednesday. They may raise rates again in June. They’re going to start doing qt. And if you don’t believe that they’re going to do this, then I think you’re not paying attention. Now, at some point they’re going to have to reverse, but I think they’re going to keep tightening until something breaks.

[00:42:17] Brent Johnson: And I think that they know that if something breaks, it’s in a break overseas before it breaks here. And if it breaks overseas before it breaks here, that gives the US political leverage. Which is, you know, again, that’s what they want as the global hegemon. That’s what the US wants leverage on the rest of the world.

[00:42:33] Brent Johnson: So that’s why this inflation, your point about inflation, it’s an important one. And to your point, inflation is causing the rate rises. The rate rises is pulling the dollar higher because you get more bang for your buck if you put it into dollarS&Put it into treasuries. And then putting the dollar going higher, squeezes the rest of the world.

[00:42:51] Brent Johnson: So now the rest of the world, we’re in a global slowdown from a growth perspective. So the rest of the world, their top line is slowing down. But because the dollar is going higher and rates are going higher, their bottom line financing costs are going up. So they’re getting squeezed and their currencies are starting to fall because many countries are trying to combat this squeeze with more fiscal stimulus and spending more money and doing more QE in easy money policy.

[00:43:15] Brent Johnson: And again, so it becomes this vicious circle which actually perpetuates the problem rather than solving the problem. So to your point, what causes the debt to matter is inflation is a very good, is one of the answers and maybe the best answer 

[00:43:28] Trey Lockerbie: Besides the DXY and its rate of change I focused in on some other indicators this year.

[00:43:34] Trey Lockerbie: One indicator that I’ve added to my arsenal is the high yield spread in episode 455 with Dan Rasmussen. He explains why he uses the high yield spread as a primary indicator. Check it out. 

[00:43:46] Dan Rasmussen: Yeah. Well, let’s start by talking first about what the high yield spread is and why you should care. The high yield spread measures the difference in the cost that risky borrowers, generally small cap companies or companies that have borrowed too much pay to borrow relative to the equivalent treasury rate.

[00:44:01] Dan Rasmussen: And this is a, a wonderful indicator for two reasons. One, these are the borrowers on the margin, right? They’re the big borrowers on the margin. And so if you think about what the high yield spread, rising or falling is telling you, it’s telling you what banks and fixed income participants are thinking about default risk.

[00:44:19] Dan Rasmussen: And so if that spread moves up materially, right? That means that banks and fixed income investors are saying, Hey, there’s materially more default risks than there was a month or two ago, and that’s not a good sign, right? Those people are sophisticated. They’re not thinking about hopes and dreams of the future, right?

[00:44:35] Dan Rasmussen: They’re thinking like, will I get my money back on this 4% yielding bond, right? When that gets repriced, it’s worth looking at because it’s giving you a very clear picture of where those people are worried about downside risk are pricing that downside risk. The other reason it’s really useful, and Ben Bernanke did a lot of his doctoral research on this, is that there’s something called the financial accelerator.

[00:44:56] Dan Rasmussen: This is Bernanke’s idea that when, and the ideas and [00:45:00] answer to the question of how small shocks turn into big crises, right? If you’re watching, you know, if you’re watching financial markets this year, you’d say, well, we’ve, we’ve had sort of a number of small shocks, right? You know, fed has started raising interest rates, but they haven’t raised them that much, right?

[00:45:12] Dan Rasmussen: Russia invaded Ukraine. It’s obviously a big deal. They didn’t invade France or Germany, right? We’re not in a nuclear war, and tech earnings came in slightly worse than we might have hoped, and yet the market reaction has seemed to be very big. And so why does the market sometimes have a big reaction to what seems like small shocks?

[00:45:31] Dan Rasmussen: And what Bernanke says is that the financial accelerator happens when first something happens, like Russia invades Ukraine or tech earnings come in a little weak. And then people in the financial markets reprice risks. So the people in the high yield market say, gee, maybe we should charge Netflix an extra a hundred basis points to borrow, or an extra 200 basis points to borrow or think about mortgage rates, right?

[00:45:53] Dan Rasmussen: Mortgage rates go up a hundred basis points, 200 basis points, right? And then what happens is that the people that were borrowing those marginal borrowers that might have invested to build a new factory or do a new deal, or in the case of the consumer buy a new house or invest in a renovation. They say, ah, maybe I should scale back my plans or, you know, maybe I should hold off for now until the market clears.

[00:46:12] Dan Rasmussen: And then the person that was going to build that house, or the person that was going to work in that new factory, they don’t get a job. Or they don’t get a raise. And then they don’t go buy jeans at American Eagle. And then American Eagle stock goes to town, right? And then the value of everyone’s four goes down and then people say, wow, gee, you know, I used to have 150,000 of savings, now I have 120,000.

[00:46:32] Dan Rasmussen: You know, really I should definitely not buying a new car this year. And then all of a sudden the auto parts companies go down, right? And that’s the financial accelerator. It’s this feedback loop. And that’s why I watched the high yield spread so closely, right? Because when the high yield spreads starts to rise as it has of late, it’s a real danger sign, right?

[00:46:49] Dan Rasmussen: The financial accelerator could be happening, right? If spreads continue at this level, we’re wide. Now further, we’re there, right? We’re at a place where lending is actually constricting the US economy. And we’re there right now, right? For spreads at four 70 is not good, right? I mean, that’s not a good

[00:47:03] Dan Rasmussen: That’s not a good market, right? That’s not helpful. It’s businesses, it’s not helpful to the consumer. It’s a sign that the financial accelerator is starting to see some pickup. But when the financial accelerator really blows out, and we say 600 is sort of the metric we look at, but 600, you know, if the spreads go above 600, they often go much wider.

[00:47:22] Dan Rasmussen: They might go to eight 50 or a thousand, or in 2008 and nine when the market totally froze, you know, they were up over 2000, right? But spreads blow through that point, and that’s basically when the market just kind of shuts and everything. A liquid gets sold off, everyone’s panicking. Nobody can get new debt.

[00:47:37] Dan Rasmussen: All of Wall Street kind of shuts down, right? There’s no new deals being done, et cetera. And that’s a very, very dire situation. On the other hand, one that we can analyze discretely, it’s this unique environment where we say, okay, let’s say high yield spreads are that wide and external financings essentially shut off from the economy.

[00:47:55] Dan Rasmussen: And the financial acceler is in full swing. What does that mean? What do we do? How do we react? Because those are quite rare and unusual moments. 

[00:48:03] Trey Lockerbie: Now I want to ask about this, but I do want to go back to the time period, cause I still am curious about that. But as far as the 600 mark on the high yield spread, some of your latest research was showing that while the number, the nominal number is important as like a mile marker, it’s the direction of the spread, either rising or falling, that’s adding, that actually adds value to the strategy.

[00:48:25] Trey Lockerbie: It reminds me a little bit of, when I was talking with Brent Johnson recently about the D X Y, he said, you know, as soon as it gets to 97, I get worried. But it’s actually the rate at which it gets to 9 0 7. Now the rate it gets to, you know, 104, wherever it is now, that is actually more important than the number itself.

[00:48:41] Trey Lockerbie: So can you walk us through why that directional focus adds value to the strategy? 

[00:48:46] Dan Rasmussen: Yeah, so we look at both the absolute level and the direction right? You can think of our spread’s tight, right? So the financial market’s moving, everything’s kind of fine. Or are they wide where you say, gee, you know, the financial market’s actually constricting the economy.

[00:48:59] Dan Rasmussen: Right? And generally we’d say when spreads are tight, you tend to see an environment that’s inflationary. And then when spreads are wide, it tends to be deflationary. You know, one of the calls we would make is, hey, spreads are, are wide enough to be a deflationary force right now, right? They’re putting downward pressure on inflation.

[00:49:16] Dan Rasmussen: Now there’s supply shocks that are competing with that, but broadly would say the level of the spread is giving you a sort of inflationary or deflationary metric. And it’s also telling you, hey, gee, is the economy broadly kind of healthy and working? Or is the financial accelerator at risk? And, and are we at this you know, potentially in a, in a crisis?

[00:49:33] Dan Rasmussen: And then the, the direction matters. I think I have a very credit driven view of the economy, right? I think people buy things on, credit deals happen because the availability of credit, right? Think of most of the large purchases we make, whether it’s buying a house or if you’re an investor or buying in a multi-family apartment building or buying a small private company, you’re going to use debt to do it.

[00:49:51] Dan Rasmussen: In fact, you might fund the majority with debt. So the, the actual cost of that debt matters. And when the price of that changes, it changes the actions of all the participants in the market economy, right? I mean, if mortgage rates go up, fewer people are going to be, you know, people are going to readjust their prices down because they can’t afford as much and they might even delay purchasing.

[00:50:11] Dan Rasmussen: However, on the other hand the spreads are tightening, right? And people say, oh my gosh, I can get a really cheap mortgage, or mortgages are so much cheaper. Or, you know, the price of debt is so much cheaper. I could really go do a deal that was pretty big right now and get pretty good money to do.

[00:50:24] Dan Rasmussen: That’s going to fuel the economy. And so we, we broadly say, you know, when spreads are coming in and they’re tightening, right? That’s a positive thing. It suggests that GDP is growing cheaper, debt is stimulative. And on the other hand, you know, when spreads are rising and sparrings getting more expensive, it’s contractionary because there’s just less money to go around.

[00:50:43] Dan Rasmussen: So I think that paying attention about the level and direction is really important. And right now we’re in this moment where spreads are wide and they’re rising. And that’s not a good general scenario for the economy. It’s a very worry. 

[00:50:54] Trey Lockerbie: Another market indicator that I’ve only recently picked up is the put call ratio.

[00:50:59] Trey Lockerbie: The put call ratio is calculated by dividing the number of traded put options by the number of traded call options. Let’s say equilibrium is around 0.7. If we go higher than that, it’s a very bearish signal, and if we go below like 0.58 where it is at the time of this recording, it’s actually a very bullish.

[00:51:16] Trey Lockerbie: I brought back Joe Brown on episode 507 to break it down for us. 

[00:51:21] Joe Brown: Yeah, absolutely. It is one of those things that every once in a while is, you know, kind of flashing a signal saying, Hey, look at me. And basically what it comes down to is you want to be looking at what the consensus is, thinking, the consensus of professional traders, the consensus of retail traders.

[00:51:37] Joe Brown: Usually those are different. And then as Ray Dalio always says, if you want to make money investing, you have to bet against the consensus, but you also have to be right. And most of the time the consensus is. And so when we look at the put call ratio, this is one of those things that it measures sentiment on the market.

[00:51:53] Joe Brown: It looks at the total number of puts being traded, the total number of calls being traded, and then so the higher that ratio is that above one. That means that there are more puts being traded. There are two different put call ratios. One of them is for indexes, so on things like S P X, the actual index, and then there’s other ones.

[00:52:12] Joe Brown: It’s the equity put call ratio. The index put call ratio is mostly professional traders, mostly used for hedging. So that number’s going to be higher most of the time because, More puts are going to just, there’s a bias towards that institutionally for hedging. When you have the equity put call ratio, that is more going to be retail traders.

[00:52:29] Joe Brown: So the small investor, and we know that small money is typically dumb money. And so when that number peaks high, that means there’s a much larger number of puts being traded, which indicates the average retail investors very bearish. This is considered a contrarian indicator because by the time the masses have become the most bearish to where that number will get really high, most of the bad stuff is going to be baked into the cake already.

[00:52:53] Joe Brown: And so when we use this in light of everything else that’s happening right now, macroeconomically speaking, like what the Federal Reserve is doing, what the inflation numbers are doing, what the money supply is doing. When we put the put call ratio in light of all of that, it looks like a pretty strong contrarian indicator that the bottom might already be in with the stock market.

[00:53:12] Trey Lockerbie: Now, a big belief or narrative at the top of the year was that if the Fed were to raise rates, They would really struggle to increase them beyond 2%. This was believed to be true because the last time they attempted this in 2019, things began to get a bit shaky very quickly in the reverse course.

[00:53:28] Trey Lockerbie: Shortly thereafter, the repo market froze up. Joe brought to my attention the reverse repo market, which I believe to be a big focus for 2023. . So what is the reverse repo market? Let’s find out from Joe. 

[00:53:40] Joe Brown: Repo stands for repurchase not repossession, like a car and a bank. And so the repo market is one where the banks would go to each other very basically simply, oh, I’m oversimplifying it here.

[00:53:52] Joe Brown: Overnight. The banks would go to each other and they’d say, Hey, I’ve got a bunch of extra cash. Does anybody need some cash? And then the other bank would say, Hey, I’ve got collateral, but I need some cash. And so they’d go to each other and they’d say, here, I’m going to sell you my collateral. And you’ll gimme some cash for that because I need the cash.

[00:54:06] Joe Brown: And I promise, at some point in the future, whether it’s tomorrow or, or a later date, I will repurchase that collateral from you. So if we go back to like 2005, 2006, a lot of this collateral was mortgage backed securities that were being bought and sold to each other for overnight cash needs between banks.

[00:54:22] Joe Brown: At a certain point, all the banks decided at once this collateral is not actually good anymore, and so I’m not going to buy it from anybody. So a lot of banks were strapped for cash, and this is actually what caused Leanin to collapse is because they couldn’t access any overnight cash. So they were bankrupt overnight.

[00:54:38] Joe Brown: And so this is why the repo market was central to the potential of the financial system collapsing and why the Federal Reserve and the Treasury stepped in there because of the way that the banking system operates. Well, when we fast forward to September of 2019, the rates. For that cash, that overnight cash spiked again in September of 2019.

[00:54:56] Joe Brown: Many people were scared that there was rot in the system again, that there was a bunch of bad collateral on the bank’s balance sheets. Well, it ended up not being the case. Really what was happening was everybody had just bought so many treasuries that there was no cash left in the system. And so government has a high appetite for borrowing.

[00:55:11] Joe Brown: They borrow mainly from financial institutions. Financial institutions create those loans and loan that money to the government. So financial institutions like banks have a ton of US treasuries on their books and they realized, Hey, we need some cash. But nobody had cash to lend. So they was rates skyrocketed.

[00:55:25] Joe Brown: And again, banks were at risk of collapsing if they couldn’t access that overnight cash. So the Federal Reserve stepped in and they just said, we’re going to operate directly in the repo market, and we are going to be creating cash to lend into the repo market at this point, so that any banks who need that overnight cash can access it directly from us, the money printer.

[00:55:42] Joe Brown: So those rates don’t skyrocket. Now, a lot of people said, Hey, this is, you know, this is a way for, you know indirect, roundabout money printing. But just a few months later, everything with covid happened and that blew up. And so that gave them the opportunity to kind of switch and get out of operating in the repo market because it wasn’t necessary anymore given the amount of new money that was created.

[00:56:01] Joe Brown: Through the trillions of dollars that were printed and then spent by the government. So what you had at that point was the government borrowed, you know, a couple trillion dollars and started spending that all into the economy. So you had this huge influx of cash into the system. So suddenly now banks have this overabundance of cash, well cash deposits for banks.

[00:56:20] Joe Brown: because when the government spends that money, that money goes into somebody’s bank account. Like that’s what happens when they spend money. It goes into a businesses or an organization’s or a politician’s bank account, an individual’s bank account, and then that person then spends that money to somebody else’s bank account.

[00:56:34] Joe Brown: And for banks, deposits our liabilities because they owe that. And so there’s a certain amount of collateral banks are required to own, to offset their liabilities. And so they’d have to go out there and. Like T-bills and treasuries to offset their liabilities. Well, at the time, interest rates were so low that this could have pushed interest rates negative.

[00:56:53] Joe Brown: The Fed didn’t want that, so they opened up the reverse repo facility so that banks could access collateral. Directly from the Federal Reserve. Instead of going out and buying it on the open market and pushing rates negative, they wanted to soak up a bunch of this excess capital so they increased the rate they were paying in this reverse repo facility.

[00:57:13] Joe Brown: So basically telling all of the banks, Hey, if you need collateral, come park your cash with us. We’ll give you the collateral and we’ll pay you an interest rate on that cash. So that’s a great deal. It’s literally the only risk free. We talk about treasuries being risk free, but you still have the risk of the, the price of the bond fluctuating if you have to sell it beforehand and you risk the government defaulting if for some reason they can’t fix the debt ceiling issue or whatever, and they default on the debt.

[00:57:36] Joe Brown: But the Federal Reserve, they’re the ones with the monopoly on printing money. So it literally is the place where you can go to get risk free return. So banks park that cash with the Fed, get that interest rate paid to. And it, it’s great. The problem is it soaked up about $2 trillion worth of cash from the system, and that’s all still in there.

[00:57:52] Joe Brown: And so what your question was alluding to in the beginning was what are they doing with this and, and what’s the, you know, potential next step here. At some point that money will leave the reverse FPA facility. And so when we look at interest rates right now, how they’re rising and borrowing costs for the government are going up, my opinion is that at some point when that gets too tight for the government, not for households, not for corporations, but for the government, the federal Reserve will drop the amount they’re paying in that reverse repo facility.

[00:58:20] Joe Brown: Suddenly then you don’t have that risk free return. Banks have to take that cash and go out to the open market and buy bills and treasuries. And so when they do that, that will be a nice little boost in funding for the government. When it’s not coming from the Federal Reserve, it’ll come outta the repo market and that’ll be about a 2 trillion buffer that ends hitting the government’s purchasing power there. Won’t, it won’t be a permanent solution, but a 2 trillion bandaid is a pretty big bandaid. 

[00:58:47] Trey Lockerbie: Now, would you consider that move to be a fed pivot? You know, everyone’s talking about this fed pivot that could potentially happen. I think everyone’s thinking they’re going to just lower interest rates, but you, are you thinking that instead of doing that, or in lieu of doing that, They would actually just add liquidity through this reverse repo system.

[00:59:05] Joe Brown: I do think this will be first. Absolutely. So they’ll be able to maintain face and save credibility by saying, Hey, we’re still raising interest rates, we’re still selling assets off of our balance sheet, but because they stop paying, you know, that risk free rate onto into the reverse repo facility, all that money has to go somewhere.

[00:59:23] Joe Brown: And that’s all cash that’s in the system that right now. Is kind of held outside. And so if they do that and shut off the free money flow into the reverse repo facility, all that money comes out, buys t-bills, buys treasuries, and suddenly then that makes borrowing costs a little bit lower, makes borrowing a little bit easier for the government.

[00:59:43] Joe Brown: So if there is some sort of issue where the government cannot fund itself, cannot access, maybe the rates get too high for when, when they try and do their auctions, maybe they go no bid or whatever. Well now you have $2 trillion of funding for the government that they can use to continue to sped. And so I think that will be kind of an undercover first phase.

[01:00:00] Joe Brown: Of the pivot, most people will not know what’s going on there. Most people won’t understand the mechanics of it. And so it’ll just be like, you know, hey, the Fed is still still tightening, just like they said they were. And there’s this, you know, other thing out there that’s making it a little bit easier for everybody and people will kind of shrug their shoulders.

[01:00:16] Joe Brown: But I do think this will be kind of the first phase of the pivot before they’ll do that, before they change, you know, their interest rate policy, lower interest rates, or start increasing their balance sheet again. 

[01:00:26] Trey Lockerbie: So when we talk about using this as an indicator, because you kinda listed it earlier, Yeah.

[01:00:31] Trey Lockerbie: Are you looking for the, the 2 trillion to start going down as far as the Fed’s balance sheet holding less and less of that repo money? 

[01:00:39] Joe Brown: Yes, and this will happen a little bit naturally anyway because as conditions get tighter and tighter, well, interest rates are going to continue going up. And so the amount that’s being paid to the repo facility right now is just about as much day-to-day it changes as the 10 year treasury.

[01:00:54] Joe Brown: And so as interest rates continue to go up, that gets more and more attractive where lenders might be willing to say, Hey, I’m willing to take on some risk by putting it into you know, bills or treasuries or other form of debt instead of keeping it with the Fed because there’s a much higher return.

[01:01:11] Joe Brown: So we might see that reverse repo facility start to dwindle down. The problem is the Fed keeps on raising the rate that they pay into that facility every time they raise rates. And so when we see that change, And when we see a, a difference in how much they pay versus the federal funds rate, that’s when I think we’ll see the big draining start to happen.

[01:01:29] Joe Brown: And that’s when we’ll see a probably a sizable impact on asset prices 

[01:01:34] Trey Lockerbie: and a bullish impact. If I’m understanding correct. Yeah. Now that we’re winding down 2022, there’s a strong and widely held belief that if the Fed keeps on its current path, something will break and the most obvious assumption is likely unemployment.

[01:01:48] Trey Lockerbie: Now, if something does break, it’s interesting to think about what the Fed’s response might look like for that. I brought back famed economist Richard Duncan, on episode 488 to get his thoughts. 

[01:01:59] Richard Duncan: I think that the response would be similar to what we’re seeing from the Bank of England. When this dynamic took hold in the UK with the pension funds being forced to sell their government bonds to cover their hedged positions, their their derivatives exposure, then that set off a dynamic that pushed the bond yields in the UK even higher.

[01:02:20] Jeremy Grantham: And caused them the pension funds to sell even more bonds. It was creating an out of control vicious spiral that was driving up the government bond deals in the UK and endangering the pension system in the UK so that the Bank of England Central banks are created to be the lender of last resort to prevent banking panics when they occur.

[01:02:41] Jeremy Grantham: That’s their main purpose from the beginning of time. And so what the Bank of England did is exactly that. They became the lender of last resort. They announced that over the next, I believe, as a two week period, that they would be willing to buy up the 65 billion pounds of UK government bonds in order to prep, essentially, in order to prevent the bond yields from moving any higher and stopping the panic in the bond market.

[01:03:06] Jeremy Grantham: But in fact, they haven’t had to buy 65 billion pounds worth of bonds. I don’t have the precise figure. , but I think it’s more like it’s, they actually only to spend five. Yep. Yeah. And so by just spending creating 5 billion pounds and buying 5 billion pounds worth of bonds, they showed everybody in the market that they were there and that they would buy as many bonds as necessary to stop the interest rates from going any higher.

[01:03:34] Jeremy Grantham: Well, they were supposed to end this on Friday, and maybe they will, maybe they won’t. If the bond yields start moving higher again, they’ll have to spend some more. And so the same sort of, and that’s the way the Bank of Japan controls the Japanese government bond. They’ve been doing quantitative easing in Japan even longer than we have.

[01:03:52] Jeremy Grantham: But what they discovered is just by the Bank of Japan. We will buy as many Japanese government bonds as necessary to peg the yield on the 10 year Japanese bond. At 25 basis points. They discovered they didn’t really have to buy that many bonds. They ended up buying far fewer bonds than they had been earlier on when they had set a fixed amount for buying every month.

[01:04:14] Jeremy Grantham: So the amount of bond buying that they’ve had to do is, is much lower than when they were saying they would buy X amount of Japanese government bonds every month. So it doesn’t take that much government intervention. It only takes the announcement that we are determined if you get the situation under control, and we have limitless amounts of resources to do this.

[01:04:33] Jeremy Grantham: When they say that they’re going to control the bond yield at a certain level, if the markets believe them, they don’t really have to spend that much money to do it. And if the markets don’t believe them and test them out, the central bank creates a little bit more money and burns everybody who tested them out.

[01:04:48] Jeremy Grantham: So that’s probably what we would see in a, if we have some sort of financial crisis emerge in the us the the Fed would. Make an announcement similar to the Bank of England that they’re prepared to buy, you know, a hundred billion new dollars. Of US government bonds or whatever is required to support that particular crisis, to stop that particular run, whether it’s in the bond government, bond market, or the corporate bond market.

[01:05:13] Jeremy Grantham: And by making that announcement, they would calm the the markets again. And so in that sort of crisis, that’s what we would most probably see. 

[01:05:21] Trey Lockerbie: Whether it was the fed’s responses to inflation, Russia invading Ukraine, and compromising energy resources, pension plan bailouts in the uk, FTX and other crypto exchanges collapsing.

[01:05:32] Trey Lockerbie: It’s safe to say that 2022 was full of surprises. To wrap up my top takeaways episode, I wanted to zoom out and get some perspective on what we’re all trying to do by listening and learning from this podcast. And that’s to become better investors and hopefully better people. In episode 441, I interviewed financial planning expert Peter Mallouk, whose firm manages over $200 billion.

[01:05:53] Trey Lockerbie: Peter has advised countless people who have achieved financial greatness and I was curious to see what he’s learned from their experience. 

[01:06:01] Peter Mallouk: It doesn’t matter how much money people have, where they live, how long they’ve been investing, it’s always the same thing. I’ll cover a few of them. The big ones, one big one is going in and out of the market and it, some people are dramatic about it, like, I’m going to go to cash because of Ukraine, I’m going to go to cash.

[01:06:17] Peter Mallouk: Of the pandemic, right? Or I’m going to go to cash cause I don’t like Trump, or I don’t like Biden or whatever. And that’s deadly. It’s just deadly. Cause the market can go up. If you’re in it, great, you’re happy. It can go sideways. It’s still better than cash. You’re collecting dividends and it can go down.

[01:06:30] Peter Mallouk: Your worst case scenario is it goes down well. What happens if it goes down? Well, this just happened a hundred times before. We know how the story ends. It comes back. That’s your worst thing is you suffer through the pandemic or tech bubble or 8 0 9 or nine 11 or whatever. If you go to cash. Because you don’t like who was elected or you don’t like the war that’s happened or whatever you think it’s going to impact your money.

[01:06:48] Peter Mallouk: Well, again, the market can go up and you’re in trouble. It may never go back to where it was when you exited. I mean, there are people that exited at Dow 10,000. Is the Dow going to go back to 10,000? Probably not. Could it? Of course it could, but probably not. Civic was up. The problem for you is that loss is permanent.

[01:07:04] Peter Mallouk: Okay? So if you’re in the market and it goes down, it’s temporary. If you’re outta the market, it goes up. It can be permanent. And I think that’s the real problem with market timing. All you have to do is mess it up once in your life and the game is over. So you’ve got this lifetime for people to go. This time is different and get out.

[01:07:20] Peter Mallouk: And I’ve seen it with. The pandemic. I saw it with Trump. I saw it with Obama elected. I saw it with the tech bubble oh 8 0 9 9 11. I mean, he just takes one mess up. Right? The other is, I think, is this active trading and the friction that comes with active trading and things can turn very, very quickly. I mean, things, something can look like it’s doing really great for three years and lose everything in three months.

[01:07:42] Peter Mallouk: I think that’s really surprising to new investors that if it can go up 30% in a week, it can go down 30% in a week. You might not have seen it yet, but that’s how it works, right? And so I think people get surprised sometimes at how quick things can turn on them and you get really get cut off in that and active security selection.

[01:07:58] Peter Mallouk: And I think. You know, the biggest one, I’ll, I’ll go to the end, which was kind of the sixth bonus mistake, but it’s probably the biggest saddest mistake I see is that people don’t enjoy their money. And I think that people that are great savers and great investors, they kind of get some joy outta saving and investing and they forget the purpose of the money in the first place.

[01:08:14] Peter Mallouk: At one point, they wanted money to do charitable things or to help their kids, or to go on vacations or to have a nice car, and then instead it just becomes piling up money just to have buddy. To me, that’s the most tragic mistake, and I’m constantly talking to clients about, Hey, enjoy this. You know, it doesn’t matter if your kids get 2 million instead of three or 12 instead of 14 or 500,000 instead of 700,000.

[01:08:37] Peter Mallouk: No difference, but a huge difference. If you spend a little bit more incrementally every year, if you can, like if you’ve established a good. Don’t kill yourself to save the extra dollar. Enjoy yourself. Now, there might not be a tomorrow, and it’s not just you. Everyone around you, you care about, you lose one person.

[01:08:53] Peter Mallouk: You know, you see this a lot, someone retires and maybe they’re perfectly healthy, but the spouse has an issue and then they can’t travel anymore. I mean, you’ve gotta have fun along the way. To me, that’s the biggest tragedy that comes with. And it happens to the great investors because they’re the ones that create the big pile. They have a hard time enjoying it. 

[01:09:10] Trey Lockerbie: So with that, enjoy it. Friends, and thank you for listening to TIP we wish you health, wealth, and happiness in 2023. Happy New Year. 

[01:09:20] Trey Lockerbie: All right, everybody, that’s all we had for you this week. If you’re loving the show, don’t forget to follow us on your favorite podcast app, and if you’d be so kind, please leave us a review. It really helps the show. If you want to reach out directly, you can find me on Twitter @TreyLockerbie. And don’t forget to check out all of the amazing resources we’ve built for you at theinvestorspodcast.com. You can also simply Google TIP Finance and it should pop right up. And with that, we’ll see you again next time.

[01:09:58] Outro: Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by The Investor’s Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.