[00:01:56] Clay Finck: I thought a good place to start here was with a Mark Twain quote: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” So, Dan, what do investors know for sure today that just ain’t so?

[00:02:10] Dan Rasmussen: Yeah, I think it’s the central question every investor has to ask, right? I think investing isn’t about analysis, it’s about meta-analysis. It’s about what do you think relative to what the market thinks and investible opportunities.

[00:02:24] Dan Rasmussen: And then almost definitionally, there are things that you think that everybody else disagrees with. So, I’ve tried to think deeply about what are the areas of max consensus and what are the areas where I think we can have a different or variant perspectives. I think there are a few ones to note. I talk a lot about private equity, right?

[00:02:49] Dan Rasmussen: Private markets have been the darling of investors for the past decade. You’re seeing many smart endowments, foundations, and families take their allocation up to 40% of their assets. And I’m a skeptic, as you know, Clay. I think this private markets thing is way overdone. I think people are getting way out over their skis on a really risky asset.

[00:03:14] Dan Rasmussen: They don’t really understand the risks of it, and I think there’s gonna be pain. I think there’s already pain in people’s portfolios. They don’t see it yet, and they’re gonna feel it soon. So, I think private equity and private credit and private markets just generally are probably my biggest contrarian view.

[00:03:35] Dan Rasmussen: I think a second one to think about is US first international. Any weighting outside of the United States has been deeply, deeply painful for investors over the past 10 years, and I think we’ve developed a lot of narratives about why the US is the best and why companies in the US are better. And you know, all of these sorts of things to justify this.

[00:04:02] Dan Rasmussen: And I think people are taking up their allocations. If you look at where the Acqui index is now, it’s 65% or so US, and I think there are a lot of investors who are even higher. And I think if you start to look, and I think Japan is very topical right now, but you look at Japan and you look more broadly outside the US, I think there are really rich opportunities out there.

[00:04:32] Dan Rasmussen: And I think people are missing them, in some sense, because they’re so focused on the US, and passive is part of that, by the way, which we can talk about. And I think, third and finally, this growth versus value, which we have reared its ugly head again this year with the success of NVIDIA and the sort of seven or 10 stocks that are driving all of the market’s gains.

[00:05:01] Dan Rasmussen: I think people have been way too focused on growth stocks, and it’s been, you know, a wildly successful strategy. But I think, as we saw in 2022, it’s not a strategy without its downsides, and it tends to be a strategy that works and works and works and works and then crashes. Whereas I think other strategies, like value in particular, have a much different profile and tend to be much better long-term investments as a result.

[00:05:32] Clay Finck: In relation to the US versus international sort of debate, when you look at pension funds and big endowments, you mentioned that they are heavily weighted towards private equity. Are they also heavily weighted towards US investments versus international, or what’s the dogma in that area?

[00:05:50] Dan Rasmussen: Yeah, well, private markets are really US-focused. They’re much more developed within the US than they are outside of the US. So if you have 40% of your portfolio in private markets, you know, I don’t know what percent of that is US, but probably north of 80, off the top of my head. So it’s going to be pretty hard if you then look at your public equity book and you weight that like the Acqui, which is probably 65% US and 35% international or something, and then you’re going to own, maybe you own some corporate credit or some hedge funds.

[00:06:32] Dan Rasmussen: I mean, all of this stuff is so US-focused that I think you have a massive US bias in your portfolio. And by the way, if you think about most wealthy individuals and families, right? Their business and their real estate ownership is also in the US, right? So you own a US house, you probably own a US business or you know, shares in US businesses, right?

[00:06:59] Dan Rasmussen: So I think people end up being massively overweight the US, and in some sense, that has worked in the last 10 years, right? So I think the things where there’s the greatest consensus are the things, you know, I often think about memory, right? So there have been some really interesting studies on how our memory works, and one of the things that they’ve found is that the same neural circuitry that underlies memory is the same that underlies how we make predictions.

[00:07:32] Dan Rasmussen: In other words, we make predictions based on our memory, right? Our projections are echoes of our past. And so things that are more salient or more recent or that we can remember more, we tend to project with more frequency. And so when we find things that are consensus, they’re generally things that in recent memory have worked really well.

[00:07:57] Dan Rasmussen: And I think that the US has worked so well that the arguments for going international are diminished and diminished and diminished because recent memory is so strong, the US is better. And I think there lies the danger because we see that strong conviction and consensus very clearly in valuations where US-listed stocks earn very big premiums to international stocks.

[00:08:21] Dan Rasmussen: You know, even if you adjust for everything you think you should adjust for, you’re ending up with these massive valuation discrepancies. And even if, for example, you think that, gee, you know, the US is the best place to run a business and so I want to be overweight the US, if you run a regression on the percentage of revenue that’s in the US versus where the company is listed, right?

[00:08:50] Dan Rasmussen: Because there are a lot of companies listed in the UK or listed even in Japan that have huge revenue shares from the United States, those companies even trade very cheaply. So it’s not really about the economic fundamentals, it’s about things being listed on the US exchange, and thus, in some sense, also being a recipient of passive investment flows, right?

[00:09:15] Dan Rasmussen: Where your 401k is buying the S&P 500 every month or whatever, it’s not necessarily buying the Acqui or the developed FTSE Developed International Index. And so you’re seeing this consensus, which is built on recent history, push valuations ever higher, and the higher those valuations get, the lower in theory future returns should be.

[00:09:37] Clay Finck: Turning to growth versus value, many of our listeners are aware that value tends to outperform growth over long enough time horizons. But that hasn’t been the case with the FANGs driving the returns of the overall market over the past decade or so, and Howard Marks has taught us that oftentimes the market moves like a pendulum.

[00:10:00] Clay Finck: It swings from these different extremes, whether that be growth versus value, optimism versus pessimism. How far, in your view, has the pendulum swung in favor of growth stocks?

[00:10:12] Dan Rasmussen: Yeah, so I think the way a lot of quantitative investors think about it is the valuation spread. So, if you take the 25th percentile valuation and the 75th percentile market valuation, or the 80th and the 20th or whatever you want to use, and you compare those two valuations, you can come up with a spread of, you know, how rich is growth relative to value. And we’re in the 95th percentile of that, where we were in the 99th in 2021, 2022. We brought it down a bit, but we’re at sort of historic extremes in terms of growth stocks trading very, very expensive relative to value stocks, in the same way that we’re at extremes with growth with US versus international.

[00:11:02] Dan Rasmussen: Then the only way you get to extremes, by the way, is through massive outperformance of one of the sectors. You know, one of the things in the equation, right? In that case, the massive outperformance of growth. And I think there are, to my mind, you know, two real things that challenge that. The first is that growth is unpredictable, and I think this is easy to forget. But when growth is not persistent and it’s not predictable, so we updated a famous academic study called the Persistence and Predictability of Growth, and what we did is we looked at every company in the US stock market over a very long period of time, and we looked at whether they had persistent above-median growth and whether historical above-median growth predicted future above-median growth. And what you see is it’s just pure chance. Maybe the first year, an above-market revenue-growing company has a 60% chance of growing above the median, not a 50% chance. But when you get to two to three years, or you go from revenue down to profits, it’s a coin flip, right? So what you see is that it’s really hard to predict future growth. And because it’s really hard to predict future growth, by the way, there are a lot of opinions, right?

[00:12:29] Dan Rasmussen: Everybody has a lot of opinions about what future growth should be or is going to be. And right now, in the moment, we can’t disprove any of them. This is why there’s no right answer to what Nvidia is going to grow at for the next three years. We can all have opinions, and all of them could be right. We won’t know until those next three years unfold.

[00:12:57] Dan Rasmussen: And so we have markets where some people are, you know, the market can get irrationally, in my view, optimistic or irrationally pessimistic, or let’s say extremely pessimistic or extremely optimistic. But it’s not necessarily irrational, right? Because that growth could happen or that disaster could happen. But over long periods of time, because the future unfolds in a relatively random, unpredictable, and surprising way, it tends to be true that people who are excessively optimistic or excessively pessimistic end up being wrong as the future unfolds in a random fashion.

[00:13:33] Dan Rasmussen: And so this is why growth investing is always dangerous because you tend to be leaning into consensus thinking and you tend to be leaning into fads. Sometimes that can work for a very long period of time, right? So if you lean into the FANG fad or you lean into crypto, those things really worked for a period of time. If you leaned into First Republic Bank stock, you know, it worked for a long time. And it tends to work for a long time until it crashes because the narrative that’s underlying people’s consensus conviction about future growth can be shattered very quickly. Ultimately, multiples drive the majority of volatility in the market, not underlying fundamentals.

[00:14:20] Dan Rasmussen: And so you’re really, you know, as I said before, investing is a game of meta-analysis, not analysis. If you look at the multiples and you say, “Gee, these are the things that people are most optimistic about, these are the things that people are most pessimistic about.” And you basically bet against hubris.

[00:14:42] Dan Rasmussen: You just say, “Gee, I’m gonna take the other end of that bet.” You know, you’re giving me these crazy odds. I just don’t think it’s possible or not likely. It’s possible that this future could end up being quite exactly as you predict. Um, you end up winning over time, and I think that’s the central thesis.

[00:15:05] Clay Finck: Turning back to international markets, I want to talk about Japan. Warren Buffett has been buying more Japanese stocks, and you first got into that a couple of years ago, largely because of the really attractive valuations, and you’ve actually been overweight Japan and vocal about Japan for quite some time now.

[00:15:24] Clay Finck: So, talk to us about the dynamics with Japan and then the recent value mandate that they announced as well. 

[00:15:31] Dan Rasmussen: Yes. So, look, there’s been widespread knowledge that if you know one thing about Japan as an investor, it’s that from 1990 to 2020, essentially the Nikkei 225, which is their S&P 500 equivalent, had 0% returns. It was a lost decade. You never made any money. So people always thought Japan was a sucker’s trade. People always get drawn in by some story or another, and then they get burned, and no one ever makes any money in Japan. Part of that is because people made so much money in Japan in the 1980s.

[00:16:09] Dan Rasmussen: Japan in the 1980s was like the US in the 2010s. Japanese companies were on a roll. People thought Japanese management styles were the most effective. And you had, I think, international equity funds that had up to 40% in Japan or some significant number relative to their economic output. So, you were coming off a massive bubble in the late 1980s that essentially deflated for 30 years.

[00:16:36] Dan Rasmussen: There are a few things that underpin those lost decades. One was that valuations kept getting cheaper. So, it took a while for the bubble to deflate, and then things kept getting cheaper. The second was that growth was relatively mediocre over that period, and the third was that there was essentially a misallocation of cash. Japanese companies didn’t adopt dividends and buybacks to the same extent as the United States and other developed markets did. Instead, they tended to hoard cash or make poor investment decisions with the money. All these factors combined to produce this cocktail of badness.

[00:17:16] Dan Rasmussen: Now, fast forward and ask, “What caused Buffett to go into such a dull, unattractive, terrible market?” And I think one thing is this meta-analysis. If everybody believes Japan is a horrible place to invest and everybody’s been burned by investing in Japan, and nobody wants to put money there, it’s almost certain that there are some attractive bargains there. Japan’s valuations have become extremely cheap, to the point where you’re buying things for a third of the cost that you’d pay for equivalent companies in the United States. It’s just silly for equivalent companies, right? It’s truly remarkable how cheap Japan is. So, you then have to consider the other problems. What about growth and capital allocation?

[00:18:04] Dan Rasmussen: And the capital allocation thing is really cool. So there’s a very interesting story that has happened. Partially, Japan has gotten cheaper and cheaper, and partially, the Japanese government, first under Abe and now with additional moves (which we can talk about), has been improving the dividend policy.

[00:18:23] Dan Rasmussen: Japan’s dividend yield has never been the same as the United States until last year. Finally, the dividend yield on Japanese stocks started to rise above that of US stocks, which is the first time that has ever happened. And that’s a big thing, right? So you’re actually starting to see better payout ratios, and that’s a real move that you can see in the data changing about Japan.

[00:18:50] Dan Rasmussen: The Japanese exchange has actually ordered all companies that trade at less than book value to put forward a plan to start trading at or above book value. Now, at first, this sounds crazy. You just can’t tell. It’s like, I mean, I’d like to order all of my companies’ stocks to go up too, but at first, it seems crazy. However, if you dig a little deeper, you realize that if you have a lot of cash on the balance sheet, you can actually meaningfully change your book value by just distributing the cash.

[00:19:28] Dan Rasmussen: So it’s not as crazy as it would seem. The exchange is basically putting all the companies that trade below book value on notice, which is a huge percentage of Japanese companies, and saying, “Hey, it’s time for you to develop and put forward a real tangible plan to start distributing even more cash.” And at the valuations these stocks are trading at, you can buy an entire portfolio of Japanese small caps at half book.

[00:19:59] Dan Rasmussen: And so, if you think about it, this is real. Over the next three to five years, most Japanese companies are going to start trading at least at book value. You know, you’re looking at a doubling, mostly just from returning cash, right? That they have already earned. It’s just sitting on the balance sheet, and they just need to distribute it or start paying out more of their cash flow in dividends.

[00:20:28] Dan Rasmussen: So, I think it’s a really attractive story in terms of what’s actually changing in the underlying nature of Japan. And then there’s this growth issue, right? Where Japan is in a different economic stage. So, forget about the long-term growth of the economy, which nobody can accurately predict. You know, who the hell knows, right?

[00:20:50] Dan Rasmussen: Growth isn’t persistent, and it’s not predictable. I have no idea what Japan’s GDP growth is going to be in 2026, but we do have some short-term view into 2023. And the reason we have some short-term view into 2023 is simple, which is that Japan closed its borders after Covid from 2020 until October of 2022. Japan’s borders were essentially closed, and travel and tourism account for about 8% of Japanese GDP.

[00:21:20] Dan Rasmussen: And so, they just shut that off and then they reopened it. So, you know, if you think Japanese travel and tourism GDP went down 50% when the border was closed, which is probably somewhat reasonable, and then you think it goes back to 2019 levels, you’re looking at a massive increase in Japanese GDP just from reopening the borders of a small island nation that.

[00:21:46] Dan Rasmussen: For some reason, decided to close its borders to all foreign travel, even though tourism and travel make up a substantial portion of their GDP. So, you have this fascinating dynamic where Japan, in 2022, was really the cheapest it had ever been, and you had a pretty clear catalyst coming as soon as they reopened the border and started allowing travel and tourism.

[00:22:12] Dan Rasmussen: And I think you’ll start to hear it probably from friends or friends of friends who are talking about traveling to Japan or tourists who are planning their trips, saying, “Oh, you should probably go to Japan. Well, the yen’s cheap. It’s been closed for a few years, and people are really going back there, and Chinese tourism is opening up again.”

[00:22:36] Dan Rasmussen: So, I think all these things are driving this really special and interesting moment in Japan. And I think the other thing worth noting is that, you know, if you took the entire Japanese market, I think it’s smaller than Amazon’s market cap. And maybe I’m a little off, right? But we’re talking about a very, very tiny market relative to US mega-cap stocks.

[00:23:02] Dan Rasmussen: So, if you think that corporate Japan, in its entirety, should be worth the same amount as one US company, I mean, so you think, “Okay, well maybe it’s worth two US companies. Maybe it’s worth Amazon plus Microsoft or something.” I mean, you’re looking at, you know, it doesn’t take that much in fund flows, that much change in investor sentiment to drive the entire Japanese market up substantially.

[00:23:30] Dan Rasmussen: And we’ve had such persistent foreign outflows, with people giving up on Japan and moving their money away from Japan for so many years, that any small movement back into Japan can have such a disproportionate impact on prices. 

[00:23:46] Dan Rasmussen: And I think that’s a little bit of what you’ve been seeing over the last three or four months where you’ve seen big surge in Japanese equities.

[00:23:51] Dan Rasmussen: And I think a part of that is just a change in fund flows, driving a very illiquid, very small market, somewhat away from the value extremes. It had been at last year. 

[00:24:00] Clay Finck: I’m by no means an expert on Japan, but when I think about Japan, one of the first things that comes to mind is their yield curve control, which involves pegging their yields at ultra-low interest rates relative to many other countries.

[00:24:17] Clay Finck: I also think of Japan as a nation of savers. If they’re not able to buy bonds at a decent rate, then surely they’re going to be buying stocks. So, I’m curious to know your perspective on that. What is the culture like in terms of where people choose to invest their money if they live in Japan, and how do they view the stock market?

[00:24:44] Clay Finck: I know that many Asian countries are more inclined to invest in things like real estate. So, I guess this also ties into the question of why so many investors are apprehensive about Japan.

[00:24:57] Dan Rasmussen: Yeah, and look, I think it’s important to say that when you think about being scared of Japan, it’s not that people are scared of it because Japan’s not that volatile.

[00:25:10] Dan Rasmussen: One of the interesting things is that the Japanese yen trades in a very correlated fashion with the US ten-year yield. Okay? So if US government bonds are rallying, the yen tends to go up, and if bonds are selling off, the yen tends to sell off. And so, since bonds tend to rally in recessions, the yen tends to rally in recessions.

[00:25:35] Dan Rasmussen: So, if you are a US dollar investor investing in Japan, you actually have a pretty smooth ride. The problem is you’ve had a smooth ride to nowhere. So it’s boredom and a sense of abandonment and a lack of anything to get excited about that has driven investors away, not pain. It’s not like they’ve had pain, maybe in the 80s or the early 90s, but not for 20 years.

[00:26:03] Dan Rasmussen: It’s been a boring market, but that boring market, if you think about it, you know, my dad has always been a Vanguard investor. He’s always been a Boglehead. And so we grew up with that culture, and I love Vanguard, and I’m a bit of a Boglehead myself, and there are all those Boglehead forums. And my dad is not a professional investor; he is a lawyer.

[00:26:30] Dan Rasmussen: But America has this culture, this culture of equity ownership, where people go on blogs and talk about their favorite Vanguard index funds and things like this, right? And whether you’re a doctor, a lawyer, or a dentist, it’s sort of in the DNA to invest in stocks. And so, you know, American retirement accounts are in stocks, and that’s not true everywhere.

[00:26:56] Dan Rasmussen: So, in Japan, people are much more conservative. They want to be in cash and they want to be in bonds, and so they end up with much, much lower equity ownership. And part of that is because equities have gone nowhere. So it’s hard to convince. It’s not like a generation of people have made their retirement by investing in the equity market and told their kids to do that.

[00:27:24] Dan Rasmussen: They’ve made nothing in the Japanese stock market, so what’s the point? Why not just leave it in bonds or cash? So, there’s a huge amount of money sitting on the sidelines. Maybe it’ll always sit on the sidelines, right? Maybe it’s a permanent cultural feature of Japan. But even a very small change in Japanese household demand for stocks would drive the Japanese equity market up significantly. And there’s a very low equity allocation from Japanese households.

[00:27:55] Dan Rasmussen: So, I think that’s another part of the story. One is that foreign investors haven’t been interested in Japan, and then another thing is that Japanese investors haven’t been interested in Japanese stocks.

[00:28:08] Dan Rasmussen: And I think, you know, over the last decade, one of the things we’ve commented on is that people have had such enthusiasm and interest in China, and China hasn’t performed better than Japan. China has been a lot more volatile and hasn’t gone anywhere either. And when you own equities in a communist country, who knows what it means? Do you actually own these companies? Will you ever get the money back? Who knows?

[00:28:38] Dan Rasmussen: But with Japan, we have a marine base there, right? They’re one of our greatest allies. You know exactly what you’re getting. It’s safe, and it’s as safe as any other country with a US Marine base, and it can be.

[00:28:55] Dan Rasmussen: So, I haven’t understood this vast investor preference and interest in China and Chinese equities relative to what I perceive to be a much safer investment with generally higher ethical standards in Japanese equities.

[00:29:08] Clay Finck: Think that part of that might be your previous employer, Ray Dalio at Bridgewater, who has been quite bullish on China with his most recent book.

[00:29:16] Clay Finck: Now you’re aware of what’s going on in many of these international markets, call it Japan, Europe, emerging markets. I’m curious if there are any other countries you believe offer really attractive valuation levels relative to the US. 

[00:29:29] Dan Rasmussen: I think all developed ex-US markets, I mean, Europe and Japan, all look really, really cheap relative to the US.

[00:29:37] Dan Rasmussen: But cheapness alone isn’t enough. Cheapness over the long term is a thesis, but in order to drive immediate asset allocation, you probably need something more. And when I look out today, as a long-term investor, do I feel more comfortable putting my money in European equities or US equities over a 10-year basis?

[00:29:59] Dan Rasmussen: Yeah, I do. I mean, look at how cheap the UK is compared to how concentrated the US equity market is in a very small set of stocks that could go wrong. I love Microsoft. It’s a great company, and they’re doing awesome. But will they always do really well? There are a lot of other companies that were huge 10 years ago or 20 years ago that have really screwed something up, and 10 years later, Microsoft itself looked terrible in 2010. So people’s perspectives can fade, and great companies can become okay companies.

[00:30:37] Dan Rasmussen: I look at that and say, relative to an entire country’s market, like the UK or Japan, that could fit into one of these large US mega-caps, I just find that much more compelling. And I think over the long term, you’re going to be rewarded for being willing to take those risks.

[00:30:58] Dan Rasmussen: Now, in the short term, I look at your short-term growth forecasts, right? And I think it’s pretty clear what’s going on in Japan, and you can see it in the guidance. All companies in Japan are required to release guidance, and they’re required to update their guidance if there’s a meaningful change. And these companies are guiding up massively. So it’s pretty clear that, and Japanese CEOs are always pessimistic. So if they’re all guiding up massively and forecasting big increases in profit, that’s a pretty good sign relative to, say, Europe, where I think there still remain a lot of concerns about energy costs and the Ukrainian war that might all resolve favorably as it had this winter.

[00:31:46] Dan Rasmussen: Right? Everybody’s worried about energy causing a big problem, and it didn’t. Everyone was concerned about the war in Ukraine causing a big problem, and it really didn’t, but that still remains a really big risk, and I think it makes me a little bit more cautious about Europe. But Japan, I just don’t see those same risks.

[00:32:09] Dan Rasmussen: In fact, I see a very clear bullish narrative coming out of this lockdown reopening dynamic. So, I think broadly, you know, I’m in favor of if the allocation is 65% US, what should investors be? Probably 50%. That’s sort of where I get to. I mean, you want to be maybe you match the GDP share, the revenue share of US companies or something like that.

[00:32:36] Dan Rasmussen: But being so overweight in one country, especially for US investors whose homes or businesses are here, it just seems like a risk not worth taking. And I think the conservative path is to choose, actually, and this is always contrarian investing. You say, “Well, aren’t you telling me to invest in stock markets that have done worse over the past 10 years?”

You know, how could I move away? Look at how well the US has done. That’s a much safer, better-performing market. And I think it’s the psychology of investing, right? Where you say, “Well, no, the safer market is the one that’s done poorly.” And the harder one, you know, the riskier one is the one that’s done better.

And that’s true because valuations drive the majority of volatility. And so when you’ve had a big run that’s as big and as amazing as the US has run over the past decade, it tends to be, in part, in large part, driven by changing valuation dynamics. And that’s, in fact, what we’ve seen.

[00:33:46] Clay Finck: Very interesting.

[00:33:47] Clay Finck: Now, in our previous conversation on our show, episode 455, we discussed your approach to investing during a crisis and crisis investing. Earlier this year, we witnessed the collapse of S VB and others, and I wanted to get your take on that and also discuss the concept of the financial accelerator and how small events in the economy can have significant consequences in the end due to factors such as leverage.

[00:34:16] Clay Finck: So, I’d love to hear your thoughts on the financial accelerator concept and its relation to the banking crisis we observed.

[00:34:24] Dan Rasmussen: Very interesting. Yeah, so small shocks can lead to big crises. If you look at all the previous major market shocks, many of them seem to be driven by very small things. Sometimes it’s even impossible to pinpoint the exact cause, like the 1987 flash crash or the crash in December of 2018. Sometimes you never really know. It can be some small thing that causes a big shock.

[00:34:52] Dan Rasmussen: Ben Bernanke conducted important research on this question, and he found that small shocks lead to big crises when financial intermediaries, which are usually banks but can also include investors, become more risk-averse in response to the shock. They lend less money, and if they go a step further and stop lending altogether, that’s when things really become problematic.

[00:35:15] Dan Rasmussen: The US economy heavily relies on credit and debt. The level and circulation of debt really matter. While people often focus on the Federal Reserve (Fed), it’s important to note that most people are not borrowing directly from the Fed. They obtain their money from local banks or private investors. For them, the rate that matters is the spread over the government rate that their businesses are getting.

[00:35:43] Dan Rasmussen: So we look at the high-yield spread as the best indicator of actual credit going to businesses that drive employment and consumption for the economy at large. When those spreads widen out, especially significantly, it signifies that people have stopped lending, and this has a major impact on the economy. Bernanke refers to this as a financial accelerator event, where the financial intermediaries become the cause of the crisis by cutting off credit, which is the lifeblood of the economy.

[00:36:15] Dan Rasmussen: When the economy’s lifeblood is cut off, the results are relatively predictable. Small companies, particularly those that are less liquid and more reliant on borrowing, are hit hard in the stock market. On the other hand, large-cap companies are not as affected because they have better access to borrowing and generate enough cash to pay off their debt if needed.

[00:36:39] Dan Rasmussen: However, small manufacturing businesses with a significant number of employees face trouble if they can’t secure new debt facilities. These companies experience substantial declines. Here’s what we found: If you can invest in small, illiquid, undervalued companies that have been heavily impacted during a crisis and take the opposite side of the trade when intermediaries start lending again, you can potentially witness astronomical gains.

[00:37:04] Dan Rasmussen: Owning those types of companies coming out of a crisis, so we designed this whole strategy in 2019 around crisis investing. We said, “Hey, gee, the next time high yield spreads blowout, go and buy really small, really illiquid, really cheap companies, especially in cyclical sectors. And if you buy them, you know, soon after high yield spreads blowout, you’re gonna do really well.”

[00:37:30] Dan Rasmussen: And so we did that to great success during Covid, which was sort of lucky. We came out with all this research in the beginning of 2020, and then the crisis hit, and it turned out the research was right, basically because it’s a very simple, logical idea. And thank Fleet turned out to be right. And so we’ve been waiting for the next crisis.

[00:37:56] Dan Rasmussen: So we have investors, we have a lot of investors who have backed us to go and do this the next crisis. And our metric is high yield spreads going above 600 basis points. That’s what we look at. And Silicon Valley Bank and First Republic, they indeed caused the high yield spreads to bump up and jump above 500, but they never got close to 600.

[00:38:23] Dan Rasmussen: And actually, they’ve come back down to about 420, which is pretty close to the 10-year median. And so, the banking crisis could have become a financial accelerator event. It could have become a real crisis, but it didn’t. And I think that’s one of the puzzles of 2023. 2023 is a strange year from a macro perspective, right?

[00:38:46] Dan Rasmussen: That typically when you see every bank in the country stop lending, you know, it tends to be bad. But this year all the banks in the country essentially stopped lending, and it wasn’t bad. And so, or at least it doesn’t seem like it’s been bad, and the market basically completely shrugged it off. But I still think if you look at a composite of macroeconomic indicators, things look worse than the equity market would suggest.

[00:39:17] Dan Rasmussen: I think we continue to see risks that inflation comes back and our sort of immaculate disinflation wasn’t quite so good as it looks right now, and if it does come back, rates need to go high or stay higher for longer, and that we might not be fully done raising rates. And I think a lot of those things could be quite devastating to growth stocks in particular. They could be quite devastating to private equity, which relies on floating-rate debt.

[00:39:50] Dan Rasmussen: And I think people aren’t necessarily pricing in that type of scenario right now. 

[00:39:54] Clay Finck: While you’re a student of history, and you previously stated that if history is any indication, as it oftentimes is, a Fed pause would come after the Fed has felt like there’s been some sort of an economic slowdown, and then equities tend to bottom sometime after a fed pause.

[00:40:13] Clay Finck: As we’re recording today, the s and p 500 is sitting around 7% below. Its all time highs. We saw a fed pause last week, they paused their hikes. So I’m curious what your take is on the equity markets. We’ve seen a lot of the gains in equities be driven by the big names, the top seven or so, and a lot of the other companies sort of lagged.

[00:40:37] Clay Finck: So what are you sort of seeing here? 

[00:40:40] Dan Rasmussen: Yeah, so, you know, when we think about the Fed, it’s important to have a model for what rates should be, and I think the simplest model for what rates should be relies on the work of John Taylor as an economist at Stanford who came up with what’s called the Taylor Rule, which is a monetary guide.

[00:41:03] Dan Rasmussen: It’s a calculation based on macroeconomic inputs of what the real rate should be, and you can simplify it or approximate it and just say, “Basically what Taylor is saying is that your real interest rate should roughly equal nominal GDP.” So you take what real GDP is, you add the inflation rate, and roughly that’s where your interest rates should be, right?

[00:41:28] Dan Rasmussen: So if you think, you know, inflation’s running at three and real GDP’s at two, you know, maybe you think rates should be at five or something like that. And so you’d say, “Hey, maybe we’re roughly where we should be.” Now there’s a little bit more math to it, and so that’s an approximation. But the really nice instinct that that gives you is if you have in your mind that rates should equal nominal GDP.

[00:41:59] Dan Rasmussen: Then you should also understand that when nominal GDP is going up, whether because growth is doing well or inflation is doing well, rates should be rising, and when real nominal GDP is collapsing as it does during a recession, rates should come down, right? So your mental framework should be in good times.

[00:42:21] Dan Rasmussen: Rates go up, and in bad times, rates go down. And I think that people have, in their minds, rates going up is a bad thing and rates going down is a good thing, but that’s not really the way it actually is, theoretically, right? It’s just been the recent experience where people have sort of said, “Oh, you know, rising interest rates put a damper on asset prices, and lower interest rates have been good for growth stocks, etc.”

[00:42:53] Dan Rasmussen: But over the long term, that’s the way you should think about it. And what you’ve seen is that when the Fed stops hiking, they’ve stopped hiking because nominal GDP has stopped rising and started actually to decelerate or fall. Now, part of that’s because of inflation, but inflation and GDP tend to actually be quite correlated when the economy is really heating and GDP is ripping, and inflation starts to be rising.

[00:43:22] Dan Rasmussen: And when the economy is collapsing and GDP’s collapsing, inflation tends to be sharply negative. And so because of that correlation, you do see this phenomenon where Fed raises rates, raises rates, raises rates. They stop. Why do they stop? Well, they stop because they say, “Gee, we raised too much. The economy is really slowing down,” and they’re, by the way, looking at backward indicators.

[00:43:48] Dan Rasmussen: And then what happens next is that the economy, in fact, does slow down, corporate earnings then drop, the equity market drops, and then the Fed says, “Oh shoot. Now we need to cut rates because we need to bail the economy out of this, you know, bad situation. We’ve now gotten ourselves into.” Now, the lag between when they stop raising rates and when.

[00:44:14] Dan Rasmussen: You know, when that final raise is, and then when markets bottom, you know, there’s not an exact science or number to that, but it’s a few months after. Now we don’t know when the Fed, you know, we don’t know, is this the last hike? And so we don’t know, say, is there some clock ticking from now?

[00:44:38] Dan Rasmussen: You know, I don’t know if they could raise rates again and reset that clock. But generally, from whatever point it is, when the Fed stops raising rates, that tends to be when things become really problematic. And that’s one reason I’ve objected to the way the market has priced growth stocks, where they say any indication that the Fed is stopping raising rates should be good for growth stocks because it should mean that discount rates are now coming down again.

[00:45:11] Dan Rasmussen: And so the terminal multiple should go up. And I’ve said, you know, gee, that’s a crazy way to think about it because what really matters is also the corporate earnings. And you know, those corporate earnings are going to go down if, in fact, the Fed starts cutting rates because they’d only cut rates in a recession.

[00:45:34] Dan Rasmussen: So I think that people have it a little bit backwards, and I think the market’s gotten ahead of itself, and they’ve gotten into this euphoria around AI. And I think market euphoria and fads, you know, they tend to rip for a little bit. And then, you know, a year or two later when all of the excited, enthusiastic buyers have moved on to some other fad, the multiples tend to decompress and the air comes out of the balloon.

[00:46:06] Dan Rasmussen: And, you know, I’m afraid that that’s likely what will happen with this AI thing. And I think, you know, who knows when Nvidia stops working, but at some point it does. And I think that from a macroeconomic perspective, there’s a lot more to worry about in the US than there is to be excited about.

[00:46:29] Dan Rasmussen: Whereas I think if you look at a place like Japan, there’s a lot more to be excited about than to worry about, and the valuation gap is huge. You know, you can pay a third of the price for a company in Japan that you would for the same company in the US, and Japan seems to have better economic prospects.

[00:46:54] Dan Rasmussen: So for me, it seems like, why solve the hard problem, the really hard problem, which is why is the equity market going up in the US when macroeconomic conditions don’t look that great? Why not look at the easy question, which is there are really cheap valuations in a place like Japan and really good economic fundamentals, and that seems a lot safer.

[00:47:20] Clay Finck: One thing that’s sort of been ingrained in me is Buffett’s famous saying that interest rates are like gravity, and we’ve had this decreasing interest rate environment for 40 plus years until the Fed cranked up interest rates. So it’s like, “Oh, well if the Fed’s cranking up interest rates from practically zero to 5%, then equities should be going down,” but that’s not what we’ve seen lately. And essentially, we’ve had many guests on who have kind of called for the giant kind of super bubble in the US, and it’s like when you’re in a bubble, you don’t really know when it’s gonna end. I’m not saying the US is gonna see its downfall or last decade over the next 10 years, but it’s quite tricky to time these sort of things in the short run.

[00:48:15] Dan Rasmussen: Yeah, we actually did a study on that where we looked at the ’90s and we looked at all of the great investors, the Ray Dalios and the Seth Klarman’s and the Howard Marks of the world, and they all called the ’90s tech bubble. They all did. The problem is they called it in ’95, ’96, and ’97, and the bubble went on until the late ’99.

[00:48:42] Dan Rasmussen: And so, in some sense, overvaluation and bubbles, if you’re smart and you’re a quantitatively oriented investor, you’re always going to call bubbles two or three years too early. I mean, it’s just a constant problem because you’re going to get out before the real euphoria starts, and that can be a real pain trade.

[00:49:04] Dan Rasmussen: And it was a real pain trade for those very smart investors in ’98, ’99, ’97. That was tough. But you fast forward to ’01, ’02 because those growth very expensive glamor stocks tend to go up and up and up and they go parabolic, and then they crash. Right? I mean, First Republic is a great example because it went to zero.

[00:49:29] Dan Rasmussen: But that was everyone’s favorite bank stock. It was the only growth stock in banking. And you look at what happened to that, right? That’s the pattern these growth stocks follow. We call them growth bankruptcies. It’s actually riskier to invest in very expensive growth stocks than it is to invest in companies that have the risk of bankruptcy, right?

[00:49:53] Dan Rasmussen: That have a lot of debt on the balance sheet, which is counterintuitive, but it’s because these valuations actually do matter. They don’t matter until they do. As long as it’s just story-driven and narrative-driven, they don’t matter. But at some point, they do matter, and then you can get really, really whacked.

[00:50:14] Dan Rasmussen: And I think it’s much more prudent as a result to play it a little bit safer. And even if you can look like a total idiot, like this year, you know, if you are a US value investor, you look like a total idiot, right? The NASDAQ’s up 30 and value large value stocks, or maybe up one or two or something disastrous like that.

[00:50:41] Dan Rasmussen: So you look like a total idiot. But on the other hand, I think it’s a more prudent strategy over the long run.

[00:50:50] Clay Finck: Most would naturally assume that with much higher interest rates, companies rolling over their debts is going to lead to a lot of downward pressure on companies’ earnings and income statements.

[00:51:02] Clay Finck: What are you sort of seeing in regards to this? And then I also didn’t even mention inflationary pressures on their costs and maybe not being able to keep prices up with inflation. What are you seeing in terms of earnings and companies rolling over their debts?

[00:51:21] Dan Rasmussen: Yeah, so I think one important thing to realize is that the US, especially US large caps, in terms of net indebtedness, is very low.

[00:51:31] Dan Rasmussen: I mean, these companies don’t have a lot of debt relative to their market cap or relative to their profits, by and large. Now, if you go into small caps, you’ll see more leveraged companies. But by and large, rising interest rates and thus rising interest costs for public companies in the United States is not a huge problem.

[00:51:55] Dan Rasmussen: Another thing to remember is that good companies borrow long and fixed, and bad companies borrow short and floating. So just like someone with a very good credit score can get a 30-year mortgage at a very low rate, and it’s a fixed rate, if you have bad credit, you know you’re gonna be paying your credit card company 18% above LIBOR for a one-month loan, right? So there’s this dynamic in the US market as well.

[00:52:26] Dan Rasmussen: And so, by and large, if you’re investing in public markets, this isn’t a real risk to you. Who it’s a real risk to is private equity and private credit. So the really small, really risky companies who, by the way, have all borrowed from the private credit markets, all floating rate, pretty much. It’s a loan-based market.

[00:52:49] Dan Rasmussen: It’s all floating. And so, great idea—borrow short and floating in 2018, 2019, 2020, 2021. That was a great idea. And there was a binge on that debt, a total, total binge in private markets. And we wrote a piece on it recently, and we think that the median private equity-backed company probably has around eight times net debt to GAAP EBITDA of debt on their balance sheets.

[00:53:16] Dan Rasmussen: And so if interest costs are 10%, which is essentially L plus 500, right? Which is probably not an unreasonable number, 80% of EBITDA is getting eaten up by interest. 12-15%, all of your EBITDA is going to interest. So I think that this is a real, real current, direct right now problem for most private equity portfolio companies.

[00:53:40] Dan Rasmussen: And so I think everyone’s favorite asset class, which is now 40% of a lot of portfolios, is in a lot of trouble.

[00:53:49] Clay Finck: Now when companies aren’t hitting their targets earnings targets set by Wall Street, many of them will try and manipulate their earnings higher if possible. And this tends to occur more often when the economy is teetering into a recession and it’s actually tracked and into what’s called the M score.

[00:54:07] Clay Finck: Could you talk to us about the M score and what we’re seeing in it today? 

[00:54:12] Dan Rasmussen: Yeah, I’m not, I haven’t run the MCO model myself. It’s not something I actively use. But I think you can see it in these adjustments to EBITDA, adjusted net income, adjusted EBITDA, or in companies, you see it in the accruals line, so what they’re doing with accruals. And you’ve seen a lot more of those types of adjustments recently, and some people would say that’s a bad signal.

[00:54:40] Dan Rasmussen: You know, I don’t know. I haven’t looked at it as a macroeconomic signal. I don’t have a strong view on it. But on an individual stock level, looking at those types of adjustments and accruals, it’s generally a bad sign. And so the more of that you’re seeing, the more concerned you should be.

[00:55:02] Clay Finck: I recently had Scott Patterson on our show who wrote this great book called “The Chaos Kings,” which covers investors like Bill Ackman, Nassim Taleb, and Mark Snaggle, and how they make billions of dollars during a crisis.

[00:55:18] Clay Finck: And when I was reading it, I was like, if anyone’s smart enough to implement this sort of strategy, I think it’s Dan Rasmussen. So since you have your own strategy of investing in a crisis, I’m curious if this is something you’ve looked into, considered, or maybe even implemented.

[00:55:38] Dan Rasmussen: Yeah, so if you think about the Taleb and Spitznagel strategy, let’s broaden that into the category of tail risk hedging. This tail risk hedging idea has gained a lot of traction lately. Interestingly, at the same time, shorting stocks has gone down in popularity. Well, why would I short stocks? That’s a crazy idea. Instead, I’m gonna buy tail risk hedging, right? So there are just different ways of hedging.

[00:56:06] Dan Rasmussen: But if you then say, “Okay, let’s look at tail risk hedging as a strategy.” The first problem you’re gonna face is that tail risk hedging is done through options, right? Essentially buying out-of-the-money puts. Now, if you want to put any money into buying out-of-the-money puts, you’ll very quickly find that there’s only one index where you have liquid out-of-the-money puts, and that’s the S&P 500. So if you’re running a tail risk strategy, you are almost definitionally buying S&P out-of-the-money puts.

[00:56:39] Dan Rasmussen: Now, there’s a lot of other stuff you can be doing around volatility trading, and there’s some interesting volatility trading to be done and whatever, but the bulk, the sort of intellectual core of tail risk hedging is buying S&P out-of-the-money puts, and buying S&P out-of-the-money puts is a terrible strategy, right?

[00:57:00] Dan Rasmussen: It’s a money-losing strategy because you’re buying insurance, and the people that make money in insurance are the people that sell insurance, not the people that buy insurance. Now, owning insurance when something really bad happens always seems smart and prudent. And so there’s an argument to be made that’s logical and consistent with people’s common sense judgment that they should buy this type of insurance.

[00:57:26] Dan Rasmussen: But the problem with S&P out-of-the-money puts, in particular, is that the market not only has to fall a lot but has to fall a lot fast in order for you to make money. Historically, it hasn’t fallen a lot fast except in very few occasions. And most of the time, it falls a lot slowly.

[00:57:49] Dan Rasmussen: And when it falls a lot slowly, it’s hard to make money on options-based strategies because you’re always recycling the options, and the options market prices in that decline and that volatility. So every backtest I’ve done of buying S&P out-of-the-money puts, which is, albeit a simplified strategy, but is the essence of tail risk hedging, suggests that it’s a real waste of money and not a good addition to a portfolio. And there are much better ways to risk manage.

[00:58:21] Dan Rasmussen: One of them is, for example, to use trend-following signals to help reduce exposure. Even shorting stocks isn’t all that bad. At least there’s alpha in shorting, right? In theory, there’s alpha in shorting stocks. You’re picking which stocks to short, not just shorting the index, which is essentially what you’re doing when you buy out-of-the-money puts. And so, you know, I tend to be on the skeptical end about this tail risk hedging, and what makes me doubly skeptical is when I see these Bloomberg articles where they say, “I made 3000% returns” or something, right?

[00:59:00] Dan Rasmussen: And then you look at the actual hedge fund return database for that month, and their fund is up 5% or 10%, and you say, “Well, they must be quoting that they made 3000% on one option that they bought, that they put 50 bps of the fund in or something, right?” And so I think that sort of marketing rubs me the wrong way because it’s just not an accurate picture of what’s going on.

[00:59:30] Dan Rasmussen: And so, broadly, I think tail risk hedging sounds really good and sounds really sexy and sounds really smart, but it doesn’t seem like it’s actually, to me at least, a useful thing to do with your portfolio.

[00:59:46] Clay Finck: Yeah, your strategy is much different than the Chaos King. So I’m curious in light of the banking crisis earlier this year, equity markets recently rallying how you’re positioned today.

[00:59:57] Dan Rasmussen: Yeah, so we have had a long overweight to Japan, and we’ve added to that overweight over the past year. So a pretty large chunk of our money is in Japan. Japan’s doing better in yen, doing better than the Nasdaq this year. Although, if you’re a dollar-based investor, it’s not quite as good as the Nasdaq, but still probably substantially beating the S&P 500.

[01:00:23] Dan Rasmussen: And so we feel very lucky in that sense, and I hope that Japan becomes a bubble like it did in the ’80s because we have so much money there that if it becomes a bubble, we’ll be one of the big beneficiaries of it. I forget, I think it was Jeremy Grantham who said, “The goal of every investor should be to capture just one bubble, of course, in their investor lifetime.” So, I’m really, really hoping that Japan becomes a bubble so I can cash in big.

[01:00:59] Dan Rasmussen: But by and large, what we’re focused on here at For Dad, we have a lot of Japanese equity holdings that we’re really excited about and are thriving this year. We also manage a lot of high-yield credit, which we think is a really interesting market. And then we have crisis funds where we’re waiting. We’re just waiting for spreads to blow out and for a crisis to happen.

[01:01:27] Dan Rasmussen: And I think if you think about that relative to the Chaos Kings, right? In some sense, chaos does create opportunity, right? Crisis does create opportunity. In our view, the opportunity is having money when the crisis happens.

[01:01:42] Dan Rasmussen: So you can buy really dislocated stuff rather than trying to buy insurance for when the crisis does happen, which seems like a place where it might be harder to make money. 

[01:01:51] Clay Finck: Related to Japan, how do you think about their central banks, their policy of yield, curve control, and how that relates to history and how that affects maybe currency, debasement, how you, figure out your returns and what to expect?

[01:02:05] Dan Rasmussen: Yeah, I mean, look, the Japanese model is the model for what the US has been doing, right? The US has been copying the Japanese central bank and looking at the tools the Japanese central bank came up with and trying to apply them here in the US. And a lot of the tools that Japan was using were to try to stimulate some inflation or at least stop deflation, and they’ve been unsuccessful.

[01:02:35] Dan Rasmussen: So Japan has been, let’s call it, not unsuccessful. They haven’t produced inflation, right? They’ve maybe produced a little bit, but nothing like what we’ve seen in the US or anywhere else, right? Mostly they’ve had deflation. And so you compare that to the US, which adopted the same policies and pretty quickly had a lot of inflation.

[01:02:58] Dan Rasmussen: I think if you said, “Well, who’s the more prudent central bank?” I’d say, “I don’t know.” And if currency debasement specifically is what you’re worried about, I think a country that experiences persistent deflation is probably the definition of something I’d see as safe. Especially when the yen tends to trade with a 10-year treasury, so it tends to be a flight to safety asset even more so than the dollar.

[01:03:27] Dan Rasmussen: And so I like the Japanese yen. I like it as a currency. And I look at that, you know, I look at what our central bank and what our government is doing. And maybe you could say Japan was irresponsible from a debt-to-GDP perspective 10 years ago. But you know, you look at what the US did during Covid, and I think we’re worse than Japan now.

[01:03:54] Dan Rasmussen: And so, you know, I think on a relative basis, Japan has gotten a lot more attractive just because the US did so many stupid things from a fiscal perspective. . 

[01:04:06] Clay Finck: So, as a student of history, as I already mentioned, and given your understanding of base rates, you tend to be pretty skeptical of new technologies that people get really excited about and just pile into.

[01:04:21] Clay Finck: I’d like to flip this idea on its head and ask you if there are any technologies that excite you. Maybe not from an investment standpoint, but maybe just the technology itself and its potential for improving society as a whole. 

[01:04:37] Dan Rasmussen: You know, it’s funny because we’re a quantitative firm and we use a lot of quantitative tools, and I like to think we’re pretty sophisticated. So, I never owned Snowflake stock, but we use Snowflake and we love it. It’s an amazing product. It has really revolutionized the way we do our work. You look at Chat GPT, we’re not there where it has revolutionized anything. Does it make our lives a little bit easier? When we need to look up how to do some sort of code? Yes. Is it helpful? Yes. Does it enhance productivity? Yes. But it’s not the leap for us that Snowflake was. Nonetheless, we’re certainly using it.

[01:05:22] Dan Rasmussen: So, I like to think that I’m a skeptic, but I’m not a Luddite. I’m a highly technologically advanced skeptic. And in that regard, I think the promise of all these technologies is ultimately that they benefit the consumer. They have to benefit the consumer more than they benefit the company that created them. And so, we in the US should be delighted about economic progress and technological innovation and thrilled that so much of it happens here.

[01:05:53] Dan Rasmussen: And we should be thrilled about AI and the advances in the cloud, database technology, and punctuation. All these things are wonderful for companies like mine, and I’m thrilled about them. Where I’m more skeptical is whether they work as investments, right? Should you buy Snowflake stock? Should you buy AI company stock?

[01:06:15] Dan Rasmussen: And I think one concept that I really like to think about in this regard is competition neglect, right? Sam Hansen, who’s a consulting economist for us, has done some really interesting work on that, which is, you know, when you see a really interesting investment opportunity, probably there are 10 other firms that see the same investment opportunities.

[01:06:38] Dan Rasmussen: So if the market size is, if the TAM is huge, probably there are a lot of other people chasing that same TAM, and only a few of you are gonna win. And people invest as though their company is gonna be the winner. But there are 10 other people investing in 10 other companies that all think they’re gonna be the winner.

[01:07:03] Dan Rasmussen: And so, in aggregate, investing in that hot space ends up being a losing bet. Even if the TAM is massive, and even if there was one massive winner because of competition neglect, people don’t realize that the game is a lot harder and more competitive than simply saying, “AI is gonna be huge. I’m gonna buy this AI stock, I’m gonna therefore make money.”

[01:07:29] Dan Rasmussen: The problem is, again, that there are other people doing that, and investing ultimately is a game of meta-analysis, not analysis. It’s where your view diverges from the market, not whether your view is right or wrong. AI could still be amazing and awesome, and you could still lose money buying AI stocks.

[01:07:51] Clay Finck: Well, Dan, it’s always a pleasure having you on our show. As always, we wanna give you a chance to hand off to how people can learn about you, how they can get connected with their dad, and any other resources you’d like to share. 

[01:08:03] Dan Rasmussen: Thank you, Clay. I’m on Twitter at @verdadcap, and we write a weekly research email. You can sign up for it on my Twitter bio or on our website, verdadcap.com.

[01:08:15] Dan Rasmussen: So, if you liked hearing about what we’re studying and some of our findings, I encourage you to follow me on Twitter and subscribe to our research.

[01:08:26] Clay Finck: Awesome. Thanks so much, Dan. 

[01:08:28] Dan Rasmussen: Thank you, Clay. This was fun. 

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