Bogleheads® on Investing Podcast 055: Edward Chancellor on economic history and today’s markets

00:00:00.000 | [MUSIC PLAYING]

00:00:09.820 | Welcome to Bogle Heads on Investing, episode number 55.

00:00:14.000 | Today, our special guest is Edward Chancellor.

00:00:17.480 | He is a leading financial historian, journalist,

00:00:21.120 | investment strategist, and the author

00:00:23.360 | of two bestselling books, Devil Take the Hindmost

00:00:26.800 | and The Price of Time.

00:00:27.960 | [MUSIC PLAYING]

00:00:38.100 | Hi, everyone.

00:00:38.760 | My name is Rick Ferry, and I'm the host

00:00:40.440 | of Bogle Heads on Investing.

00:00:42.480 | This episode, as with all episodes,

00:00:45.040 | is brought to you by the John C. Bogle Center

00:00:47.560 | for Financial Literacy, a nonprofit organization that

00:00:51.160 | is building a world of well-informed, capable,

00:00:54.120 | and empowered investors.

00:00:55.600 | My special guest today is Edward Chancellor.

00:00:58.880 | One of the benefits of being a podcast host

00:01:01.240 | is I get to speak with some of the brightest

00:01:03.480 | people in the world.

00:01:05.200 | And as you listen to today's podcast,

00:01:07.240 | I think you will agree.

00:01:08.960 | Ed has studied economics and financial conditions

00:01:12.640 | in markets and economies going back literally

00:01:15.320 | thousands of years.

00:01:16.900 | And it's fascinating to listen to him lucidly

00:01:20.000 | talk through centuries of markets all over the world,

00:01:23.880 | picking out similarities that others have not considered.

00:01:28.040 | Ed graduated with honors from Trinity College, Cambridge,

00:01:31.680 | and from Oxford University, worked

00:01:34.160 | as a mergers and acquisition banker for the Lazar brothers,

00:01:37.720 | and later a member of the GMO asset allocation team.

00:01:42.320 | He currently is a columnist for Reuters.

00:01:45.880 | He has written two books, Devil Take the Hindmost,

00:01:49.320 | A History of Financial Speculation,

00:01:51.100 | which was published right at the top of the dot-com bubble,

00:01:55.400 | and more recently, The Price of Time,

00:01:58.440 | The Real History of Interest, which ironically

00:02:01.880 | was published right at the top of the bond bubble.

00:02:06.120 | So with no further ado, let me introduce Ed Chancellor.

00:02:10.160 | Welcome to the Bogle Heads-On Investing Podcast, Ed.

00:02:13.160 | Thank you for having me, Rick.

00:02:15.000 | You've got such an interesting background.

00:02:17.380 | You've done so much, and you've written so much.

00:02:20.040 | Could you tell us a little bit about maybe your schooling?

00:02:22.960 | How'd you get into journalism?

00:02:24.720 | I understand your family has a history in journalism.

00:02:29.000 | My grandfather was the Shanghai Bureau Chief of Reuters

00:02:34.360 | during the 1930s, during the Sino-Japanese War.

00:02:38.320 | And then he later went on to become managing director

00:02:42.040 | of Reuters.

00:02:43.320 | And then his son, my uncle Alexander,

00:02:45.240 | became editor of the Spectator magazine here.

00:02:48.560 | I read history at university, decided

00:02:50.920 | not to become an academic after my postgraduate degree.

00:02:54.280 | I spent relatively little of my life

00:02:56.600 | in which journalism was my main or sole income stream.

00:03:01.560 | I made a mistake by going into the corporate finance

00:03:04.200 | side of things, what you'd call now M&A banking.

00:03:08.040 | And that wasn't to my liking.

00:03:10.680 | And so after a couple of years, I quit.

00:03:13.640 | I sort of heard these stories about the speculative manias

00:03:17.160 | in the past, which I'd never heard about before going

00:03:19.560 | into a finance job.

00:03:21.600 | I looked around, and I read the available literature type--

00:03:25.760 | Charles Mackay's extraordinary popular delusions,

00:03:29.080 | Charles Kindleberger's manias, panics, and crashes.

00:03:32.600 | And what I thought, being a historian,

00:03:35.640 | is that I could tell the story of the history

00:03:38.320 | of financial speculations that was

00:03:40.480 | more narrative-driven than Kindleberger's taxonomy.

00:03:45.360 | So that's when you decided you were going to write a book.

00:03:48.280 | And you ended up writing Devil's Take the Hindmost,

00:03:51.920 | A History of Financial Speculations.

00:03:54.680 | Well, that book had fortuitous timing.

00:03:58.960 | I was working on it after I'd left the investment bank

00:04:02.120 | Lazard's in about '93 and sort of finished it in late '98,

00:04:09.480 | just when the dot-com bubble was going sort of completely crazy.

00:04:14.800 | And it came out in mid '99.

00:04:17.840 | What was nice about the book when it came out,

00:04:19.840 | it got a good reception.

00:04:22.160 | For the investment world, there were a lot of investors,

00:04:24.880 | in particular the quant investors--

00:04:27.280 | Jeremy Grantham, my old boss at GMO, Cliff Asness at AQR,

00:04:32.400 | Rob Arnott, who was then at First Quadrant.

00:04:36.280 | They were all having problems at the time.

00:04:38.360 | This sort of historical account of speculative manias,

00:04:41.600 | which drew very strong parallels to what

00:04:43.760 | was going on in the US markets in the late 1990s,

00:04:46.600 | was catnip to the quant investment community.

00:04:50.560 | And that really was what introduced me

00:04:52.960 | to Jeremy Grantham.

00:04:54.920 | And then a few years later, I started to work for him.

00:04:58.320 | So yeah, so that was my first book.

00:05:00.840 | Just to clarify, in your own words,

00:05:04.080 | what's the difference between investing and speculating?

00:05:08.840 | Lots of people have had a go at trying

00:05:11.840 | to distinguish speculation from investment.

00:05:14.920 | Some are quite boring and prosaic, the distinctions.

00:05:18.400 | You might say that investment is posited on yield and value

00:05:25.360 | and speculation as desire for capital gains,

00:05:30.840 | not supported by yield or intrinsic value.

00:05:34.920 | Ben Graham put in the margin of safety,

00:05:37.920 | that an investment should have a margin of safety.

00:05:41.160 | The definition I like for distinguishing investment

00:05:45.360 | from speculation is by Fred Schwed, Jr.

00:05:49.920 | in his 1930s book, Where Are All the Customers' Yachts,

00:05:54.920 | in which he says that speculation is an attempt,

00:05:58.760 | usually unsuccessful, to turn a little money into a lot,

00:06:04.080 | whereas investment is an attempt, usually successful,

00:06:08.360 | to prevent a large pot of money becoming a small one.

00:06:12.480 | And I think that alludes to both the sort of principle of safety

00:06:15.600 | in investment, but I think there's another aspect to it

00:06:17.960 | there, which is the speculators are often

00:06:21.040 | trying to gain their fortunes fairly quickly,

00:06:25.600 | whereas the investor, having gained a fortune,

00:06:29.520 | is trying to maintain a yield on it.

00:06:33.880 | In your book, you talked about signs of speculation,

00:06:39.960 | and you listed several of them.

00:06:43.120 | Rumors, fueling a boom, rapid growth of leverage,

00:06:47.560 | and to create the signs that there might be

00:06:50.200 | a speculative bubble going on.

00:06:52.680 | So what we find, take US stock market in the 1920s.

00:06:57.880 | There was rapid growth in margin loans.

00:07:01.360 | And then, if you look historically,

00:07:03.520 | the New York Stock Exchange produces data on margin loans,

00:07:07.720 | and outstanding margin loans tend

00:07:09.520 | to rise during the speculative markets or bubble markets.

00:07:14.040 | If you lever your returns, you're

00:07:15.560 | getting higher potential return, but you're also

00:07:18.040 | going to face greater potential losses.

00:07:21.000 | So if a speculative market is characterized

00:07:23.880 | by both a sort of greed to enhance returns

00:07:27.320 | and a fecklessness towards risk, you

00:07:30.200 | would expect to find more leverage.

00:07:33.600 | You can provide sort of checklists

00:07:35.600 | for speculative manias.

00:07:38.880 | Leverage would be one of them, margin loans.

00:07:43.360 | The new entrance into stock markets

00:07:46.200 | in inexperienced investors, you saw that 1920s, Japan,

00:07:51.560 | and 1980s.

00:07:52.560 | You see it, China, in its recent sort of bubble episodes

00:07:57.640 | of 2005 and 2015.

00:08:01.280 | In our even more recent, our everything bubble,

00:08:04.400 | the surge of accounts at Robinhood markets,

00:08:07.920 | the online broker.

00:08:09.160 | So that's a new entrance.

00:08:11.600 | And that's often associated with something,

00:08:13.440 | a call for the democratization of markets.

00:08:17.040 | I noticed that speculative bubbles

00:08:19.080 | tend to appear at times when communications technologies are

00:08:24.200 | improving.

00:08:24.800 | The first stock market bubble in the UK

00:08:26.600 | occurs in the 1690s, which is the same time when

00:08:30.880 | there's a proliferation of newspapers and journals,

00:08:34.320 | and people are meeting to discuss investments

00:08:38.480 | in the coffeehouses in London.

00:08:40.240 | And then again, mid-19th century,

00:08:43.400 | you get the railway mania, in which the railway is not

00:08:47.240 | just an object of speculation, but the railways

00:08:49.480 | and the telegraphs are means of transporting

00:08:52.520 | the speculative virus.

00:08:54.920 | And then you get to the 1920s, and you

00:08:57.360 | get the telephone, again, as both objects of speculation

00:09:01.000 | and means of communicating your orders to the broker.

00:09:05.040 | Then you get into the dot-com era.

00:09:07.200 | You get new entrants.

00:09:08.280 | They're establishing stock market accounts

00:09:10.400 | with online brokerages, Charles Schwab, and E-Trade.

00:09:14.120 | And E-Trade becomes both a big player in the day trading

00:09:19.400 | market, but also an object of speculation.

00:09:22.200 | >> And it seems as though, more recently,

00:09:26.640 | using social media, a new app that you had on your phone

00:09:30.360 | called Robinhood, which would allow you to discuss very

00:09:34.240 | quickly and easily, that was adopted by these new entrants.

00:09:38.080 | >> What Robinhood did, which was novel,

00:09:40.120 | is it introduced the gaming techniques developed

00:09:44.680 | in Las Vegas for the gaming machines in Las Vegas,

00:09:48.120 | and introduced them onto an app for investing.

00:09:51.920 | But they also, as you're probably aware,

00:09:53.800 | they often leverage stock market loans at 2%.

00:09:57.840 | And if you had an account with Robinhood,

00:10:00.440 | the sort of premium account, you could get 0% cost leverage.

00:10:06.040 | So your margin loans were no interest charge on them.

00:10:09.040 | And then you're probably aware that the state of Massachusetts

00:10:14.280 | launched a lawsuit against Robinhood's markets

00:10:17.560 | in, I think, 2020 or probably 2021,

00:10:22.040 | in which they accused Robinhood of gamification.

00:10:24.760 | And you had this massive turnover

00:10:27.880 | of trading of these inexperienced investors.

00:10:31.920 | So this rising turnover in the market

00:10:34.680 | is another sort of classic speculative feature,

00:10:38.520 | at least in stock markets.

00:10:40.240 | And then, this is more closer to the subject of my book,

00:10:43.520 | is that you tend to find speculative manias occurring

00:10:46.840 | at times when monetary policy is abnormally easy.

00:10:51.960 | And really, as I point out in the new book,

00:10:55.120 | even the tulip mania in Holland of the 1630s

00:10:59.840 | occurred at a time when there was strong monetary growth

00:11:02.240 | in Holland, Dutch public, thanks to the establishment

00:11:05.400 | of a new central bank, which attracted

00:11:07.840 | foreign capital inflows, and at a time of falling interest

00:11:12.200 | rates.

00:11:12.840 | And the Dutch, for that matter, the speculators in tulip bulbs,

00:11:16.440 | they were using derivatives to lever their returns.

00:11:21.440 | I mean, another feature, I think,

00:11:23.000 | to speak of consumption and luxury spending,

00:11:25.920 | that's the sort of social epiphenomenon of the bubble.

00:11:28.880 | Corruption in public morals or fraud

00:11:33.400 | is another common feature.

00:11:35.640 | I think Walter Badgett, the Victorian journalist,

00:11:38.680 | says, I'm paraphrasing, that when people are most credulous,

00:11:42.840 | when they are most happy, and so to speak,

00:11:46.960 | high markets at times offer opportunities

00:11:49.840 | for ingenious mendacity.

00:11:53.880 | J.K. Galbraith sort of took the Badgett insight

00:11:57.200 | and turned it into his notion of the bezel,

00:11:59.680 | the illusory increase in wealth that

00:12:02.480 | occurs to inspective bubbles.

00:12:04.760 | And the original term bubble is a fraud, a con.

00:12:08.760 | That's what it means.

00:12:10.240 | It's an illusion of wealth that is deliberately dishonest.

00:12:14.240 | And so the term South Sea Bubble,

00:12:16.360 | which was when it came into popular usage,

00:12:18.680 | referring to the stock market bubble of 1720,

00:12:22.680 | really means the South Sea Con.

00:12:25.440 | John Cassidy of The New Yorker wrote

00:12:28.160 | an account of the internet bubble published

00:12:32.120 | after the bubble burst called Dot Con, C-O-N.

00:12:36.280 | And then looking far forward to where we are today,

00:12:39.680 | you see the crypto market, most speculative market ever

00:12:43.240 | created.

00:12:44.200 | It made the tulip mania of the 1630s

00:12:48.160 | look positively conservative.

00:12:50.960 | And you see what looked to be possibly fraudulent behavior

00:12:56.480 | in the crypto world and surrounding

00:12:59.000 | the collapse of the crypto exchange FTX.

00:13:03.440 | So one of the things you should look out for in a bubble

00:13:07.320 | is evidence of corruption and malfeasance.

00:13:11.680 | We saw that going back to the 1990s

00:13:14.120 | that it was pretty clear that US companies

00:13:17.880 | were misstating their earnings and manipulating their earnings.

00:13:21.840 | And then after that dot-com bubble burst,

00:13:24.640 | then you had these scandals that you remember

00:13:27.920 | at Enron, WorldCom, Tyco.

00:13:31.280 | And then after that, you get the liar loans

00:13:34.640 | that push up the US real estate market in the bubble that

00:13:39.280 | peaks in 2006.

00:13:41.920 | So corruption is an inherent feature of the bubble.

00:13:47.400 | Let's go on to your latest book, The Price of Time,

00:13:51.440 | The Real Story of Interest.

00:13:54.480 | At the beginning of your book, you

00:13:55.880 | go back to the history of interest.

00:13:58.960 | My opening words of the book was, in the beginning

00:14:03.200 | was the loan, and the loan carried interest.

00:14:06.680 | What I'm saying is that right at the dawn of recorded history,

00:14:11.280 | we have evidence of lending taking place at interest.

00:14:16.400 | So this makes interest, alongside the act of lending,

00:14:20.320 | the oldest financial practice, which Mesopotamians

00:14:23.640 | were lending at interest long before they'd

00:14:25.520 | invented the wheel, millennia before the Greeks had actually

00:14:29.680 | come up with coined money.

00:14:31.320 | And then if we look into the etymologies of the word

00:14:34.120 | interest in ancient languages, they

00:14:36.720 | tend to be related to the offspring of livestock.

00:14:41.200 | So there is a sort of what you might

00:14:44.120 | call the fructification theory of interest,

00:14:46.720 | that some are lending an object, lending your capital.

00:14:50.120 | We know that in Mesopotamia, there were loans of barley,

00:14:52.880 | grain, and presumably there were loans of cattle, and goats,

00:14:57.120 | and sheep.

00:14:58.000 | And the idea was that some of the growth of the livestock,

00:15:02.680 | the offspring, would be returned to the lender.

00:15:05.400 | The first law code we had, the Code of Hammurabi,

00:15:09.680 | is actually largely involved with financial regulation

00:15:14.360 | in determining what the maximum rates of interest

00:15:16.840 | and when rates should be forgiven.

00:15:18.480 | And Mesopotamians also had these debt jubilees,

00:15:22.120 | which meant the debt was forgiven

00:15:24.200 | at the onset of a new reign.

00:15:26.520 | And the Israelites, they took a dim view of interest

00:15:31.080 | that I think the ancient Hebrew word for interest

00:15:35.000 | is neshek, which means the bite of a serpent.

00:15:39.160 | As we know, the Old Testament forbids lending

00:15:41.880 | to each other at interest, but not to outsiders.

00:15:46.240 | Put this very succinctly, in a primarily pre-industrial,

00:15:51.680 | pre-capitalist economy, the danger

00:15:54.520 | is that farmers will borrow at interest

00:15:57.600 | and that the interest rate compounds,

00:15:59.880 | the interest compounds at a high level,

00:16:03.120 | driving people into debt, into high levels of debt,

00:16:06.640 | leading them to lose their farms,

00:16:08.240 | or even in cases in the ancient world of going into slavery.

00:16:12.160 | So I think that's the ancient strictures against interest,

00:16:18.760 | or what was called usury, that continue into the Middle Ages

00:16:23.200 | by the Catholic Church, which really

00:16:25.640 | takes the position of Greek philosopher Aristotle, who

00:16:30.320 | complained about interest.

00:16:31.640 | And so that continues through to, let's say,

00:16:37.040 | the 15th, 16th century.

00:16:39.200 | But then as you come to a more capitalist era,

00:16:43.400 | then it's realized that merchants

00:16:48.040 | need capital to trade with, and that they're not

00:16:50.800 | going to get the money unless they're

00:16:52.920 | often paid some interest.

00:16:54.240 | And then it's also seen as fair that the lender should

00:16:58.360 | have a share in the profits of the borrower.

00:17:02.600 | And even in the Middle Ages, before that was conceded,

00:17:06.440 | it was accepted that if the lender was taking risk,

00:17:10.600 | say, for instance, lending to a merchant who

00:17:12.880 | was going on a sea voyage and the ship might go down,

00:17:16.440 | that those type of risky loans would carry

00:17:20.760 | a legitimate rate of interest.

00:17:24.080 | In short, by the birth of capitalism,

00:17:27.960 | interest was grudgingly accepted.

00:17:31.000 | And then there becomes a sort of new idea

00:17:34.360 | that comes in point with the justification for capitalism

00:17:38.640 | or a market system in Adam Smith,

00:17:40.400 | is that everyone should pursue their own interest.

00:17:44.560 | And the acceptance of interest by the 18th century

00:17:47.920 | is uniform.

00:17:49.160 | And as the title of my book says,

00:17:51.080 | interest is a price placed on time.

00:17:54.280 | And we need to put a place on time in the finance world

00:17:57.880 | for a number of reasons, because all our actions take place

00:18:01.480 | across time, what are technically

00:18:03.760 | called intertemporal, whether we're lending or valuing.

00:18:07.200 | And you need to put a price on time for capitalism

00:18:11.880 | to make sense.

00:18:12.840 | We tend to think of capital being something solid,

00:18:15.680 | but in fact, really, capital is a flow of future income,

00:18:20.000 | because you can have anything.

00:18:21.800 | Any object that doesn't generate income

00:18:25.080 | is not really capital from an economic perspective.

00:18:29.720 | It might have value, but it's not capital.

00:18:32.400 | It's only when it's in an income-producing function

00:18:35.120 | that it becomes capital.

00:18:36.200 | And the capital is the present value

00:18:40.120 | of the future income stream.

00:18:42.280 | Now, this was pointed out by English writers

00:18:45.960 | in the 17th century.

00:18:47.240 | If you don't have a discount rate,

00:18:48.880 | if you don't use a discount rate,

00:18:51.520 | then it's impossible to distinguish

00:18:53.880 | the value of one acre of land from 20 acres of land.

00:18:58.160 | Everything has an infinite value.

00:19:00.840 | So if you think about it, the whole notion of capitalism

00:19:06.360 | is actually meaningless without its underlying

00:19:10.560 | foundational support of the rate of interest.

00:19:14.640 | That is the main underlying argument in my book,

00:19:18.040 | is that we have really lost sight

00:19:20.720 | of the importance of interest and how it both affects

00:19:26.400 | valuation, risk assessment, allocation of capital, savings,

00:19:31.960 | and so forth.

00:19:32.720 | The system, our capitalist system,

00:19:35.640 | is only given some type of coherence

00:19:40.000 | by there being a rate of interest.

00:19:43.000 | You talk several places in the book

00:19:45.200 | about what is an equitable rate of interest.

00:19:48.480 | And you've already alluded to in your comments

00:19:52.280 | that there is a minimum rate of interest

00:19:54.360 | for what the lenders are willing to accept

00:19:57.480 | for the price of capital over time.

00:20:00.320 | But then you've also talked about interest rates

00:20:03.240 | that are too high and ends up causing collapse.

00:20:06.320 | So there's some equitable rate.

00:20:09.880 | I think of interest rates as sort of Goldilocks

00:20:12.160 | and the three bears.

00:20:13.320 | Three bowls of porridge, one's too hot, the other's too cold,

00:20:16.320 | and the other's just about fine.

00:20:17.880 | If you go back to the era before the proliferation of banking,

00:20:23.360 | so in Britain, say, roughly in the 17th century,

00:20:26.360 | where an act of lending would be sort of the equivalent of me

00:20:29.800 | lending you a book.

00:20:30.760 | I'm actually lending you, in effect, a physical object

00:20:34.960 | that is of finite supply.

00:20:37.360 | The state shouldn't try and make laws about interest,

00:20:40.120 | but let the interest find its natural price

00:20:43.240 | or its natural level.

00:20:44.720 | So that becomes the first notion of a natural rate of interest.

00:20:50.440 | But when you get into a world where banks create money

00:20:55.160 | through the acts of lending, and then you

00:20:57.120 | get into a world where money is no longer

00:20:59.480 | redeemable or convertible into precious metal,

00:21:02.840 | and you have a monetary system in which the central bank is

00:21:07.040 | in effect determining what at least short-term interest

00:21:10.760 | rates are, therefore on what long-term rates are,

00:21:13.800 | then the interest rate is no longer,

00:21:17.080 | so to speak, market-determined or is no longer necessarily

00:21:21.480 | in line with the natural rate.

00:21:24.000 | And what the central bankers have adopted over the last 100

00:21:28.280 | years or so is a rule of thumb that

00:21:30.920 | says as long as there's no deflation

00:21:33.680 | and as long as inflation is kept around what's

00:21:37.520 | now the 2% target, then we have discovered

00:21:40.360 | the market's natural rate.

00:21:42.400 | And I argue in the book that this

00:21:44.600 | is mistaken because there are some periods when consumer

00:21:47.760 | prices are declining for particularly benign reasons,

00:21:50.680 | such as improvements in productivity

00:21:53.120 | or falling trading goods prices as China starts selling stuff

00:21:57.440 | to everyone, and that these are not necessarily bad

00:22:00.400 | and not necessarily an indication of where

00:22:02.920 | the natural rate should be.

00:22:05.160 | You should look to other things, too.

00:22:06.720 | You should look whether there's strong credit growth

00:22:08.960 | or whether there's strong asset price bubbles

00:22:12.080 | and whether the financial sector seems

00:22:13.880 | to be growing very strongly.

00:22:15.000 | Those would all be indications that lending

00:22:18.400 | is being done at what key players

00:22:21.320 | in the financial system would consider

00:22:23.280 | to be a very low rate, or at least a rate that's

00:22:26.200 | very favorable to them.

00:22:28.120 | You also talk about ultra low rates, zero interest rates,

00:22:32.120 | negative interest rates created by central banks.

00:22:35.240 | They're trying to get the economy going and get people

00:22:38.960 | to borrow money, but it causes unintended consequences.

00:22:43.520 | I'll preface my comments with two observations.

00:22:45.640 | First of all, there is a notion that interest actually

00:22:50.440 | emanates from within the individual in their so-called

00:22:53.120 | time preference.

00:22:54.440 | You prefer to have--

00:22:55.760 | which we express with the phrase a bird in the hand

00:22:58.360 | is worth two in the bush.

00:22:59.400 | You prefer-- human beings, by and large,

00:23:01.520 | prefer to have something now than at some date in the future.

00:23:04.240 | Therefore, future goods and services

00:23:06.920 | are worth less to you than your current goods and services.

00:23:10.520 | So the interest is the discount between the current

00:23:14.560 | and the future price.

00:23:16.760 | And so according to some views, is that interest

00:23:20.200 | or in what Irving Fisher, the American economist,

00:23:23.440 | will crystallize in patience is an inherent feature

00:23:27.280 | of human psychology, of mankind.

00:23:29.480 | So to set rates at zero is to suggest that mankind no longer

00:23:35.200 | has a time preference.

00:23:38.280 | To set rates at a negative level is to put

00:23:42.200 | the price of time in reverse.

00:23:45.200 | It's a concept that belongs to Lewis Carroll and Alice

00:23:49.760 | in Wonderland.

00:23:50.800 | It sets a position of normality back to front.

00:23:55.520 | So that, I think, is the sort of strangest thing

00:23:58.440 | about the era of zero negative rates.

00:24:01.400 | It's against human nature.

00:24:03.760 | As I mentioned to you earlier, it

00:24:05.520 | undermines the fundaments of the capitalist system.

00:24:10.240 | And in later chapters of the book,

00:24:12.240 | I discuss in different chapters the role

00:24:15.160 | of interest in valuation.

00:24:17.840 | I discuss the role of interest in the allocation of capital

00:24:21.400 | and interest as an inducement to save,

00:24:24.480 | interest as a measure of risk, interest

00:24:27.400 | as a cost of leverage or the cost of finance

00:24:30.520 | for the financial sector, and interest

00:24:33.440 | affecting capital flows.

00:24:35.520 | And all those aspects, all those different features

00:24:39.000 | of the financial system, were sort of knocked out of whack

00:24:43.000 | by the end of 2021.

00:24:45.640 | Global debt levels have massively

00:24:48.040 | increased since the 2008 financial crisis.

00:24:52.400 | US stock market trading on record valuations,

00:24:56.440 | the so-called everything bubble.

00:24:58.040 | You get misallocation of capital into the most absurd venture

00:25:02.760 | capital and technology ventures.

00:25:05.640 | Then you get the zombie companies.

00:25:07.840 | You get a legacy of a decade or more of chasing yield.

00:25:12.240 | So declining credit standards or underwriting standards

00:25:16.000 | and the growth of debt.

00:25:17.040 | So I think you put all this together

00:25:19.360 | and you say the low interest rate immediately

00:25:22.200 | after the global financial crisis,

00:25:24.920 | it obviously lessened the impact of the crisis,

00:25:28.160 | mitigated unemployment, and helped the financial sector

00:25:31.680 | hold together.

00:25:32.240 | So those are the plus signs.

00:25:34.120 | But then by continuing the same policies for a further, what,

00:25:39.120 | 13 years, you then get these other problems.

00:25:42.960 | And my main beef with the policymaking community

00:25:46.760 | is they focus only on the immediate benefits

00:25:51.640 | of the low rate era and the quantitative easing

00:25:55.160 | after the collapse of Lehman Brothers,

00:25:57.920 | where it averted, as they're keen to say,

00:26:00.680 | another Great Depression.

00:26:02.560 | And then they overlook the role of the very low interest

00:26:06.920 | rates after the dot-com bust, when US Fed funds rate fell

00:26:11.720 | to 1%, which appears to have contributed

00:26:14.560 | to igniting a major fact in driving the real estate boom.

00:26:19.520 | And also the low interest rates encouraged investment

00:26:22.920 | in the subprime securities, which had a higher yield.

00:26:26.760 | So after the crisis, then you have all these other problems

00:26:30.640 | that the policymakers, to my mind,

00:26:32.720 | they don't pay attention to.

00:26:34.520 | And there's one other interesting aspect of this.

00:26:36.600 | And we're seeing it is a rise in inequality.

00:26:41.360 | And social unrest comes along with this.

00:26:44.920 | Yeah, so I mean, think about it.

00:26:48.840 | If you have some assets, a house, a stock market

00:26:52.240 | portfolio, a bond portfolio, and the interest rates go down,

00:26:56.160 | everything else being equal, value of your house goes up,

00:27:00.200 | value of your bonds go up, and value--

00:27:02.320 | so you are richer.

00:27:05.320 | You're better off, at least in the valuation of all your assets.

00:27:10.240 | Whereas, as you know, when valuations go up,

00:27:13.600 | they're more expensive to buy.

00:27:15.000 | So a person trying to buy a house, get on the housing

00:27:18.320 | ladder, has more problems, obviously,

00:27:20.560 | when the house price is higher.

00:27:21.960 | And actually, valuations go up, expected returns, as you know,

00:27:26.080 | decline.

00:27:26.960 | So actually, it's very good if you've

00:27:28.960 | got a fortune to benefit.

00:27:31.280 | But if you're trying to acquire a fortune,

00:27:33.360 | it's a different matter.

00:27:34.520 | And then, as I point out, and perhaps I'm

00:27:37.280 | being a bit hypocritical, because I've

00:27:38.920 | spent half my life working in the finance area.

00:27:42.280 | But the very low interest rates benefit

00:27:45.720 | people working in finance.

00:27:47.000 | Not your conventional banker, because yield curves are flat,

00:27:51.120 | and it's difficult for conventional banks

00:27:53.200 | to make a profit from their lending and borrowing.

00:27:56.320 | But if you're more on Wall Street,

00:27:58.320 | if you're helping companies do their leveraged stock buybacks

00:28:02.040 | or leveraged buyouts, or just if you're running an investment

00:28:05.760 | firm and your markets are going up

00:28:07.680 | and you're being paid a percentage of that,

00:28:09.960 | then what you see after the global financial crisis

00:28:13.040 | is that despite the fact it was a financial crisis,

00:28:15.840 | you see that the role of the financial sector in the US

00:28:19.560 | actually increases.

00:28:20.960 | And contributions to profits rise to a record high.

00:28:25.760 | I show a chart in the book showing

00:28:27.920 | that the share of wealth owned by the--

00:28:30.760 | I think it's the top 1% of the population--

00:28:33.360 | seems to track the inverse of the long bond yield.

00:28:37.400 | So as long bond yields come down,

00:28:40.280 | the wealth of the richer section of population rises.

00:28:44.240 | As you're probably aware, there was this book that came out,

00:28:46.680 | I think, 2013 by the French economist Thomas Piketty,

00:28:50.040 | where he said that when rates of return

00:28:52.120 | were higher than growth, then inequality increased.

00:28:55.800 | But I say when the rate of interest is below growth,

00:29:00.080 | then actually inequality rises.

00:29:02.240 | Historically, the Gilded Age, which

00:29:04.720 | was a period of these great trusts being put together

00:29:08.120 | by J.P. Morgan, funded with debt,

00:29:10.360 | creating the robber barons, it's no coincidence

00:29:13.160 | this occurred at a time of very low interest rates,

00:29:16.560 | just like the great financial fortunes of recent years.

00:29:20.400 | What you're saying does make the case for a market timing

00:29:24.360 | strategy, but we know that that's very difficult to do.

00:29:29.800 | You have to make two decisions when you do market timing.

00:29:32.520 | You have to decide when it's time to get out,

00:29:35.160 | and then you have to decide when it's time to get back in.

00:29:37.960 | I agree.

00:29:38.480 | And obviously, if one comes from the sort of active investment

00:29:42.600 | market timing side, one's always going

00:29:44.480 | to look for arguments to justify that position

00:29:47.080 | against the passive investment.

00:29:49.520 | If you pay taxes on capital gains,

00:29:52.080 | that's an extra problem.

00:29:54.840 | What worries me, in particular, about passive investment

00:30:00.560 | or the growth of passive investment over the last

00:30:03.240 | decade, I mean, in some part, perhaps just

00:30:06.480 | to do with growth of ETFs and technology,

00:30:10.200 | another thing that I think was probably pushing

00:30:12.160 | it was that when you move into these bubble markets created

00:30:16.480 | by the ultra low interest rates, it

00:30:18.960 | becomes extremely difficult for the active investor

00:30:23.000 | with a value bias to keep up with markets,

00:30:25.880 | particularly when those markets, as happened in the US,

00:30:29.760 | become heavily concentrated in a relatively small basket

00:30:35.400 | of stocks.

00:30:36.400 | And so you get this sort of negative alpha drawdown

00:30:40.200 | going on year after year after year.

00:30:42.840 | And then it becomes a simple decision

00:30:45.400 | for the risk-averse investment committee to say,

00:30:48.920 | hey, active doesn't work, so let's take our money

00:30:52.560 | from active, put it into passive.

00:30:55.160 | And as you make that shift, you're

00:30:56.760 | selling the active position, the active value stock positions,

00:31:02.360 | which is everything else being equal, lowering their price.

00:31:05.280 | And then you're putting it into market cap weighted positions

00:31:09.120 | in the index, which reinforces the demand for the large cap

00:31:14.040 | stocks that have already increased their position.

00:31:16.960 | So you get a lot of, if you will,

00:31:19.680 | blind capital going around.

00:31:22.920 | I see this as indirectly related to the easy money conditions.

00:31:30.440 | I didn't include it as a chart in my book,

00:31:33.600 | but there is a chart which I saw that Nomura, a Japanese broker,

00:31:37.960 | put out in 2016, which showed that the active alpha

00:31:44.440 | and negative alpha roughly tracked

00:31:46.960 | the course of interest rates, so that as interest rates were

00:31:50.760 | falling, this was a very bad time in aggregate for active.

00:31:56.240 | The market's a cap weighted, and most active managers

00:32:00.160 | tend to be equal weighted.

00:32:02.560 | And because of that, they're investing the money more broadly

00:32:08.000 | across the market.

00:32:09.880 | So they may have 15 names in their portfolio,

00:32:12.440 | but it's closer to an equal weighting

00:32:14.160 | rather than a cap weighting.

00:32:15.400 | So as you get lower and lower interest rates pushing up,

00:32:19.400 | particularly in the US market, these large cap growth stocks,

00:32:24.320 | then you've got not only is it a value growth issue for them,

00:32:28.120 | but it's also there's no breath in the market,

00:32:30.880 | so that their names are not benefiting.

00:32:33.400 | I've seen research from the quant shops, AQR,

00:32:37.040 | and research affiliates, and they both

00:32:39.920 | argued that value, US value, but also

00:32:43.800 | value in other parts of the world,

00:32:45.320 | but let's stick with US value, was not at a record discount,

00:32:49.800 | but a close to record discount by the late 2020

00:32:55.200 | when value rebounded.

00:32:57.160 | Now, the value was at the greatest discount

00:33:00.720 | at the peak of the dotcom bubble when long-term valuation

00:33:05.000 | measures like Shiller BE or Topin's Q

00:33:08.400 | were at its highest level ever.

00:33:10.480 | And then you get to 2020, US market on Shiller PE

00:33:14.280 | is its second highest level with the exception of the dotcom

00:33:18.240 | bubble, and value is once again at a discount.

00:33:22.120 | And I imagine that active managers in the US

00:33:26.440 | are looking at early retirement.

00:33:29.760 | No, not this year, quite frankly.

00:33:31.520 | What has happened in this last rally,

00:33:34.360 | I think, is you look back over the last six months

00:33:37.280 | and active managers have outperformed

00:33:39.600 | because of the breadth of the market.

00:33:42.720 | Active managers tend to sit on a bit of cash.

00:33:45.200 | Well, that too, the bit of cash, but also

00:33:47.320 | because of the higher interest rates and the valuation

00:33:50.560 | equation of long-term, way out there,

00:33:53.320 | future earnings of large-cap growth stocks,

00:33:55.760 | they came down a lot, and the breadth of the market

00:34:01.080 | broadening out into other names, and particularly value names

00:34:04.840 | and value industries like energy and materials

00:34:07.960 | have caused the active managers to outperform.

00:34:11.800 | I was saying that in 2020, that was an adder.

00:34:16.240 | Obviously, 2021 market is a very strong market, too.

00:34:20.840 | And so last year, yeah.

00:34:22.760 | Last year is-- heralds the return both of value

00:34:26.520 | and active management.

00:34:29.040 | And if the sort of numera correlation between interest

00:34:34.400 | rates and alpha hold, I did a talk at some investment

00:34:39.120 | conference in Germany last summer,

00:34:41.520 | which I showed the numera charters to the value

00:34:44.680 | investors saying that all hope was not quite lost.

00:34:48.520 | Again, getting back to our discussion about market timing,

00:34:52.880 | very difficult to do it.

00:34:54.920 | And even if your data says, OK, now the market is overvalued,

00:35:00.200 | you should begin to pull back, you

00:35:02.560 | could be much too early.

00:35:05.280 | And that causes other problems, not only

00:35:08.040 | for the professional managers, but for individuals

00:35:11.840 | who now have to figure out how to get back in.

00:35:14.280 | But should you invest in growth?

00:35:16.800 | Should you go to a value tilt?

00:35:19.200 | Again, if you're going to do that, you can't time it.

00:35:25.360 | It's very difficult to time these things.

00:35:27.480 | So just going down the middle of the road

00:35:30.200 | is really what the Boglehead philosophy is.

00:35:32.800 | I'm aware of the timing issue.

00:35:35.280 | Obviously, having worked in an investment firm

00:35:38.880 | when our models weren't necessarily

00:35:41.320 | producing timely or even very accurate forecasts.

00:35:46.360 | Having said that, to go back to what

00:35:47.840 | I was mentioning earlier about the credit cycle model,

00:35:51.360 | or even a general understanding of the impact

00:35:55.160 | of ultra low interest rates, which

00:35:57.600 | is what my book is about, I think

00:36:00.800 | it's important for an investor, even if they're committed

00:36:04.440 | to only using index products for asset allocation purposes,

00:36:10.080 | to understand the environment in which they're operating.

00:36:15.240 | Let's take the most extreme example

00:36:17.200 | and say we were Japanese investors in the 1980s.

00:36:23.200 | Obviously, it wouldn't have been a very good idea

00:36:26.280 | in the summer of '85 to take your money out

00:36:31.320 | of the Japanese stock market.

00:36:33.000 | However, what you would observe during that period,

00:36:36.480 | first of all, you'd see interest rates kept low.

00:36:41.520 | And you'd see, following from that, strong credit growth

00:36:46.040 | and a real estate bubble and rising valuations in the stock

00:36:49.080 | market.

00:36:49.640 | And you'd have seen this phenomenon

00:36:51.400 | of zytec, or financial engineering,

00:36:54.440 | in which profits are really being created speciously

00:36:58.680 | through direct and indirect exposure of Japanese corporations

00:37:03.560 | to the stock market or the real estate markets, which

00:37:06.240 | is being put through the P&L, sometimes goosed

00:37:10.000 | with a bit of extra leverage.

00:37:12.840 | So you'd see the zytec.

00:37:14.920 | And then you'd notice towards the latter years of the bubble,

00:37:18.960 | you'd see inflation coming back in the system.

00:37:21.200 | And you would observe the Bank of Japan

00:37:24.760 | tightening and putting up interest rates very sharply

00:37:28.800 | in late '89 and into 1990.

00:37:31.640 | You'd have heard the governor of the Bank of Japan

00:37:34.440 | saying expressly that his desire to bring the real estate

00:37:37.960 | bubble to an end.

00:37:39.200 | And if you knew your financial history,

00:37:41.640 | you'd be aware that the end of periods of asset price

00:37:45.240 | bubbles, of real estate bubbles after strong credit growth,

00:37:49.360 | were likely to be fairly calamitous,

00:37:51.600 | as turned out to be the case in Japan.

00:37:53.440 | Now, given that the Japanese stock market was trading

00:37:56.320 | on a price earnings ratio of around 75 times the time,

00:38:00.520 | and now, we're speaking, what, 33 years later,

00:38:04.800 | the stock market still hasn't returned to the Nikkei peak

00:38:08.440 | of December 31, '89, that is a strong case, I think.

00:38:14.360 | It's probably the strongest case you can make,

00:38:16.360 | because I'm obviously giving you an example where actually

00:38:20.480 | being out of the market for a long time

00:38:22.080 | has paid off, at least getting out close to the top.

00:38:25.120 | I think that it behoves one to understand the environment

00:38:29.920 | in which you're investing.

00:38:31.880 | Yeah, and I suppose I would say quite strongly

00:38:34.520 | to adapt your asset allocation at least

00:38:38.600 | to extreme divergences from normal conditions.

00:38:43.440 | I also interviewed Antti Ilmenen from AQR,

00:38:47.080 | and his book, Investing Among Low Expected Returns,

00:38:50.720 | basically said the same case.

00:38:53.480 | In the extreme, if you were to do a little market timing,

00:38:59.240 | you may benefit.

00:39:00.960 | In fact, there's a video out there

00:39:02.720 | by Jack Bogle talking about his own portfolio

00:39:06.600 | and how he incorporated this.

00:39:10.800 | Bogle got slightly tempered his US exposure in the late 1990s.

00:39:16.480 | Correct, by quite a bit.

00:39:18.600 | Now, realize he says in the video

00:39:20.480 | that he did it in 1995 when he was having

00:39:23.400 | some very big health issues, and then he

00:39:25.720 | had to have his heart transplant in January of 1996.

00:39:29.760 | So that had a big factor on him trying

00:39:31.960 | to prepare his portfolio if he didn't make it.

00:39:34.080 | He did say that in the video.

00:39:35.240 | But he did make the case that things

00:39:38.000 | were getting to an extreme.

00:39:39.760 | Now, remember, he was four years early on that call

00:39:44.040 | and was out of the market generally.

00:39:46.960 | He said he was at 25% equity.

00:39:48.720 | He went from 75% to 25% for four years

00:39:52.480 | while the market went up.

00:39:54.080 | And it does create problems for investors

00:39:58.560 | watching the market go up and up and up

00:40:01.000 | and maybe believe they make a mistake

00:40:02.560 | and get back in at even a higher price.

00:40:04.760 | My problem with market timing is market timing.

00:40:10.480 | If you're not right on your timing,

00:40:12.720 | it could lead to exponentially larger errors in your timing.

00:40:20.320 | Look, I understand that.

00:40:22.560 | Are you familiar with the work of Andrew Smithers, who's

00:40:26.120 | an English--

00:40:26.880 | it's a British economist, sort of city of London economist,

00:40:31.480 | now retired.

00:40:32.680 | Came out with a book roughly the same time

00:40:34.640 | as Robert Schiller's Irrational Exuberance

00:40:37.880 | called Valuing Wall Street.

00:40:40.400 | And Smithers uses replacement cost.

00:40:43.880 | And the idea being that the market, US market,

00:40:47.480 | has traditionally traded, I think,

00:40:49.880 | slight discount to its replacement cost valuation,

00:40:53.960 | otherwise known as Topin's Q. And you

00:40:56.680 | can go to Smithers' website.

00:40:58.440 | And you can download his Topin's Q.

00:41:00.640 | It tells you the same story as the Schiller PE,

00:41:03.000 | but from a different angle.

00:41:05.360 | But Topin's Q, for the last 28 years,

00:41:11.920 | has hardly hit fair value.

00:41:14.320 | And the GMO methodology, which is not quite similar in its way

00:41:19.040 | to the Schiller PE, but works on a mean reversion of valuation

00:41:24.360 | and of profit margins, that it was early

00:41:28.960 | the forecast with its negative signal in the late 1990s

00:41:33.800 | when it was developed.

00:41:35.120 | But then it produces outstanding rankings of investment returns.

00:41:40.560 | In 2000, the 10-year forecast, the rankings

00:41:43.360 | of value, and emerging, and US broad stock market, and ether.

00:41:48.480 | I mean, if you look at them, it's almost--

00:41:50.800 | it's sort of spookily good.

00:41:53.120 | It's so spookily good, it might almost

00:41:55.440 | persuade you to believe in forecasting.

00:41:58.160 | The forecasts that were then made by GMO--

00:42:01.080 | the team I was part of in 2009, over the next 10 years,

00:42:05.560 | were decisively inaccurate.

00:42:08.320 | So that moment of glory didn't last.

00:42:12.160 | It's the old saying that it works until it doesn't.

00:42:14.760 | Yeah, and I think that's true.

00:42:16.080 | I have to say, I think that's an investment truism.

00:42:19.760 | And I reckon Bill Bernstein would agree with me on this,

00:42:24.040 | is that there's no permanent investment truism.

00:42:27.280 | And therefore, really, one sign of a good investor

00:42:30.920 | is a sort of flexibility to adopt different methodologies

00:42:35.680 | or different ways of looking at the world.

00:42:38.800 | Think of it this way.

00:42:39.920 | You have Ben Graham with his, if you will, hard value

00:42:43.440 | methodology, and it's a price to book, and earnings.

00:42:46.160 | And then you have Warren Buffett adapting

00:42:48.520 | that into a sort of more of a sustainability of ROE,

00:42:53.280 | or what we would now call a sort of quality focus,

00:42:56.560 | moving from Ben Graham pure value to a sort of quality

00:43:01.600 | value proposition.

00:43:03.360 | That's all great for people who do this maybe for a living.

00:43:07.040 | And I would say that people who do this for a living, maybe

00:43:10.080 | the top 1% of those people could actually do that.

00:43:15.320 | The other 99 basically have the title of portfolio manager,

00:43:18.640 | and they're pushing buttons and following some model.

00:43:20.800 | But there is the 1% of the professionals

00:43:24.320 | who have this belief.

00:43:26.560 | The problem with individual investors

00:43:28.800 | is they're always going to be late to the game.

00:43:31.760 | They're the ones who pick up the model right at the end

00:43:35.920 | when it's got its last maybe correct forecast in it,

00:43:40.000 | and then it all goes haywire.

00:43:42.480 | And then they wait for the next model to come along that

00:43:44.920 | has worked for the last 10 years,

00:43:46.440 | and they jump on that model, which

00:43:48.360 | is right at the end of it.

00:43:50.480 | Individual investors have this problem.

00:43:52.520 | I know.

00:43:53.240 | I mean, it is, and you see it.

00:43:55.320 | And I think I've even seen reports in the Wall Street

00:43:59.160 | Journal over the last couple of years

00:44:01.040 | with retail investors piling into the market in 2020, '21,

00:44:05.240 | and then the market cracks.

00:44:06.920 | And then suddenly they're getting out of the market

00:44:09.520 | just before the market's about to rebound.

00:44:12.720 | And I think that if you're going to do market timing,

00:44:15.040 | you not only need to understand the valuation aspects,

00:44:17.520 | you need to understand certain extraneous other factors that

00:44:21.440 | might influence or help market timing work, of which

00:44:25.880 | I think the monetary situation probably

00:44:28.200 | is a fairly important one.

00:44:30.400 | And then you need to have some confidence in your position,

00:44:33.880 | and you need to have a strong contrarian aspect

00:44:37.720 | to be willing to go against the market.

00:44:40.600 | And I think you probably also, going back

00:44:42.840 | to your question of whether you're out of the market,

00:44:45.920 | you also need to be able to reassess your decisions

00:44:49.560 | and, if necessary, overturn them.

00:44:52.160 | Are you asking a lot from the typical individual investor,

00:44:54.920 | or--

00:44:55.400 | Quite a lot.

00:44:56.600 | Or you could do the Vogelhead version of it,

00:44:59.880 | which is to come up with an asset allocation,

00:45:01.840 | call it 60% stocks, 40% bonds, be super diversified

00:45:06.320 | into global equities on your stock side,

00:45:08.560 | US index fund, international index fund,

00:45:11.600 | be diversified on the bond side as well,

00:45:13.960 | do an occasional rebalancing, which

00:45:16.200 | does pick up these valuation differences over time,

00:45:20.920 | and then stay the course.

00:45:22.240 | And it ends up being the default model that

00:45:24.800 | ends up pushing these individual investors who actually

00:45:27.280 | do this model up into the 90th percentile

00:45:29.960 | as far as rates of return.

00:45:31.320 | So you're never going to be number one,

00:45:34.000 | but you're going to be up there in the 90th percentile.

00:45:36.280 | It's always quite dangerous to make generalizations

00:45:39.320 | of investment based on sort of a back testing of the positions.

00:45:45.120 | I'm not saying the Vogelhead portfolio, but let's--

00:45:47.280 | No, no, no.

00:45:47.800 | I just wanted to explain what the Vogelhead kind of--

00:45:50.600 | how it ended up defaulting to that.

00:45:52.560 | In other words, the people who are the Vogelheads

00:45:55.120 | are very intelligent.

00:45:56.360 | They study everything.

00:45:57.520 | They read everything.

00:45:58.440 | They're going to read your books.

00:46:00.040 | If not, I've already read your books.

00:46:01.600 | They are into everything.

00:46:03.840 | We're talking some of the smartest people I know,

00:46:06.960 | much smarter than me.

00:46:08.320 | They've come to the conclusion that, yes, there

00:46:10.720 | may be people out there who can do this, but it isn't me.

00:46:14.240 | And so what do I need to do for me that works for me?

00:46:19.120 | And that's where you end up with the Vogelhead philosophy.

00:46:23.400 | And we come off this period of very strong US bull market

00:46:28.560 | and reasonably strong, but obviously not quite so good,

00:46:32.360 | global markets, with the US market ending up

00:46:34.920 | at a close to record high valuation at the end of 2020.

00:46:40.640 | You've also had this period in which this 40-year bull market

00:46:45.520 | in bonds, in which nominal bond yields declined

00:46:49.360 | around the world to their lowest level in history

00:46:54.320 | and negative in some countries.

00:46:56.160 | If you remember, $18 trillion worth

00:46:58.640 | of bonds cited by Bloomberg with negative yields.

00:47:03.120 | And during this period, the correlation

00:47:05.640 | between bonds and equities is not stable at all times.

00:47:10.360 | Historically.

00:47:11.840 | But there seems to be the case that since we moved

00:47:14.520 | into the recent bubble era, which

00:47:16.600 | we might take collapse of the long-term capital management

00:47:19.640 | hedge fund in September '98, that

00:47:22.480 | was a period in which there was quite

00:47:25.320 | a strong inverse correlation between bonds and equities

00:47:29.880 | so that as you were losing something on the equity side,

00:47:32.640 | you were getting something on the bond.

00:47:34.560 | And that may have been due to the fact

00:47:36.320 | that the markets were aware of a sort of deflationary risk

00:47:40.640 | from all the debt and the bubbles that were being created.

00:47:43.240 | And perhaps they were also aware that whenever

00:47:45.800 | the markets faced trouble, the Fed

00:47:48.400 | was likely to cut rates that would be good for bonds.

00:47:50.840 | And the markets were aware that inflation pressures would

00:47:53.760 | appear to be in abeyance.

00:47:55.000 | And therefore, there wasn't much of an inflationary.

00:47:57.120 | So that was a very nice period on the whole

00:48:00.200 | to have your classic automated 60/40 portfolio.

00:48:04.840 | But you're aware in the 1970s, you

00:48:07.320 | have a positive correlation between the bonds

00:48:10.960 | and the equities.

00:48:11.760 | And then inflation is permanently

00:48:13.400 | eroding the value of the bonds and temporarily depressing

00:48:18.320 | the valuations on equities.

00:48:20.160 | But let me stop for a second.

00:48:21.720 | That is a good point.

00:48:22.720 | You see, where we are right now in history--

00:48:24.560 | and we've been here now for, well,

00:48:27.160 | since the financial crisis-- is bonds

00:48:29.640 | have given us a negative real return.

00:48:32.880 | And that's before taxes.

00:48:34.360 | And we all eventually have to pay taxes.

00:48:36.600 | This is a real dilemma.

00:48:38.280 | We are losing purchasing power with every bond that we hold.

00:48:42.680 | Unless you're going to buy BBB or BBB-rated bonds where

00:48:46.000 | you get a high enough yield or you buy Treasury Inflation

00:48:48.640 | Protected Securities, we're there.

00:48:50.920 | Only recently, the interest portion of it

00:48:53.680 | has been high enough so that maybe after you pay your taxes,

00:48:57.600 | maybe you break out even.

00:48:59.560 | So bonds are a real dilemma right now

00:49:01.200 | for people who are actually trying to grow real wealth

00:49:03.720 | after taxes and inflation in their portfolio.

00:49:06.720 | First of all, if you think it's difficult to time equities,

00:49:10.120 | try timing bonds.

00:49:11.840 | There's another project I had at GMO.

00:49:14.160 | I looked at our bond forecast.

00:49:16.040 | I back-tested it over the previous century

00:49:19.360 | and found that it had been right on about three occasions

00:49:24.200 | and it would often be wrong for sort of multi-decade periods.

00:49:30.000 | And then you actually realize-- and if you ever

00:49:33.120 | move in the circle of fixed income investors,

00:49:35.760 | is that they never-- they really don't talk about market timing.

00:49:38.840 | Equity guys, you know, do talk--

00:49:40.960 | It's interesting.

00:49:41.680 | You're absolutely right about that.

00:49:43.120 | That's interesting you say that.

00:49:44.440 | Yeah, there are no--

00:49:45.080 | I think I made a presentation saying there are no value

00:49:47.480 | investors in the bond world.

00:49:50.560 | But the thing is, we also know--

00:49:52.480 | and let's throw ourselves back in time

00:49:54.680 | to the previous period in which interest rates in the--

00:49:59.880 | let's stick with the US-- in interest rates

00:50:01.800 | were kept at an extremely low, manipulated down

00:50:05.400 | to a very extremely low position during the Second World War,

00:50:08.840 | where I can't quite remember, but I think sort of T-bills

00:50:12.040 | were fixed at 25 to 50 basis points

00:50:14.880 | and a handful of basis points above that for the centuries.

00:50:19.240 | And the yield curve was manipulated.

00:50:21.880 | And then you come out of the Second World War,

00:50:25.360 | pent-up demand, and you get a surge of inflation.

00:50:28.520 | It's only there for a year or so,

00:50:31.440 | but then the inflation comes down.

00:50:33.720 | And you could say there are certain similarities to today,

00:50:37.160 | although I actually think that the US,

00:50:38.880 | from an investment perspective and an economic perspective,

00:50:41.600 | is in a much better position after the Second World War

00:50:44.680 | because the debt had been paid down

00:50:46.800 | due to the Great Depression.

00:50:48.080 | There was a lot of suppressed consumer demand,

00:50:50.280 | and valuations were quite low on the equity side.

00:50:53.520 | So it wasn't sort of post-bubble valuation

00:50:56.640 | probably to deal with.

00:50:58.000 | Anyhow, if you're a treasury investor then,

00:51:02.360 | you actually have to deal with 35 years of rising yields

00:51:08.720 | until they peak in the early 1980s.

00:51:12.200 | And by the end of that period,

00:51:14.200 | bonds are known as certificates of confiscation.

00:51:18.440 | If you and I went back in a sort of time capsule

00:51:21.480 | and someone to argue a balanced portfolio

00:51:24.280 | would be having equities and nominal bonds,

00:51:28.280 | you know, 40% nominal treasury bonds,

00:51:30.840 | they would think you were completely mad.

00:51:33.360 | Having said that, we do know that there are,

00:51:36.400 | historically, these bond markets,

00:51:39.440 | their cycles have gone in roughly three to four decades,

00:51:45.080 | sometimes five decades.

00:51:47.360 | The bond bear market after the Second World War

00:51:49.200 | lasted 35 years.

00:51:51.680 | And then the bond bull market that followed it

00:51:54.920 | lasted 40 years.

00:51:56.680 | We know now that there is a strong incentive,

00:52:01.600 | as strong, if not stronger incentive,

00:52:04.640 | for governments to push for keeping interest rates

00:52:09.000 | below the level of inflation,

00:52:10.880 | if only to facilitate the reduction

00:52:13.640 | in the real burden of government debt.

00:52:16.720 | The idea of negative real interest rates

00:52:21.280 | is here to stay for a very long time.

00:52:25.520 | It becomes policy going forward.

00:52:28.680 | And this is a real dilemma for investors

00:52:31.160 | who are on fixed income.

00:52:32.760 | And we have this saying here in the US,

00:52:34.600 | as you get older, you should buy more fixed income,

00:52:37.680 | your age in bonds.

00:52:39.320 | And I'm not so sure that that's true.

00:52:41.520 | It's just maybe a bad idea,

00:52:43.760 | given this world that we're in.

00:52:46.240 | - From a subpractical investing perspective,

00:52:48.880 | compared to where we were at the beginning of last year,

00:52:53.480 | is that the tips of inflation-protected,

00:52:56.680 | treasury inflation-protected securities

00:52:58.880 | now have a positive real yield.

00:53:01.680 | At the beginning of last year,

00:53:03.160 | they were in negative territory,

00:53:05.640 | or at the end of 2021.

00:53:07.720 | And they took quite a big hit, the tips.

00:53:11.600 | - They did.

00:53:12.440 | - Their yields, real yields, moved with nominal yields.

00:53:16.120 | - Yes, that's true.

00:53:17.280 | But now, as we stand today,

00:53:20.520 | they are at, short-term tips are at 2%,

00:53:25.280 | like a one-year tip for us here in the US are at 2% yield,

00:53:29.440 | and longer-term tips are at 1.5.

00:53:31.720 | So you could actually invest in tips today,

00:53:35.040 | and you will have a real return

00:53:37.280 | on your fixed income portfolio.

00:53:39.440 | - One of the arguments of my book

00:53:41.000 | is that the ultra-low interest rate environment

00:53:43.640 | has created a bubble economy,

00:53:46.480 | and contributed to misallocation of capital,

00:53:51.160 | whether it's in your pie-in-the-sky

00:53:54.360 | venture capital investments,

00:53:56.440 | or in your zombie companies.

00:53:59.360 | And it's also contributed to a lot of financial engineering,

00:54:03.920 | and companies, particularly in the US,

00:54:06.640 | having levered themselves up,

00:54:08.360 | and obviously a great private equity boom.

00:54:10.920 | And then a decline in savings, in actual savings,

00:54:15.920 | discouraged by the low interest rates,

00:54:19.280 | and also savings discouraged by, frankly,

00:54:22.400 | the extraordinarily strong position returns in the market.

00:54:26.360 | If people are getting, you know,

00:54:27.800 | 7% or 8% real returns from a balanced portfolio,

00:54:31.360 | there's less encouragement to put money away.

00:54:35.480 | And so I think the upshot of all that

00:54:38.680 | is that it will probably, so this is not a forecast,

00:54:42.040 | but there's a reasonable chance, I would say,

00:54:45.760 | that we are about to go through a period

00:54:49.280 | of continued low growth.

00:54:51.400 | Bear in mind that since the global financial crisis,

00:54:55.200 | US and European GDP growth

00:54:57.480 | has been at sort of near-record low levels.

00:55:00.920 | And I argue in the book

00:55:02.480 | that the accommodating monetary policy,

00:55:04.920 | and the resistance to allowing the market to clear

00:55:08.120 | by monetary policy, has contributed to that.

00:55:11.040 | If this were to continue, that low growth,

00:55:14.840 | or even exacerbate that trend over the next decade,

00:55:19.280 | and if, as we've already mentioned,

00:55:21.800 | the authorities have a strong incentive

00:55:24.480 | to keep interest rates below the level of inflation,

00:55:28.240 | policy of financial repression,

00:55:30.480 | as we had after the Second World War,

00:55:32.120 | then I think your 1.5% on TIPS today

00:55:37.240 | will look like an outstanding bargain.

00:55:39.800 | You know, for US retirement investors,

00:55:42.560 | I think TIPS should be a core holding,

00:55:46.920 | and probably, to my mind, probably bigger

00:55:49.800 | than the 40% allocated in the average portfolio.

00:55:54.480 | - Thank you so much, Ed, for being on the show today.

00:55:56.640 | We've talked about a lot of things, a lot of concepts.

00:55:59.440 | I think I've learned a lot today,

00:56:00.880 | and I hope all the Bogleheads have also.

00:56:03.080 | - My pleasure.

00:56:04.080 | - This concludes this episode of "Bogleheads on Investing."

00:56:08.160 | Join us each month as we interview a new guest

00:56:10.920 | on a new topic.

00:56:11.960 | In the meantime, visit boglecenter.net, bogleheads.org,

00:56:16.240 | the Bogleheads Wiki, Bogleheads Twitter.

00:56:18.720 | Listen live each week to "Bogleheads Live"

00:56:20.960 | on Twitter Spaces, the Bogleheads YouTube channel,

00:56:23.640 | Bogleheads Facebook, Bogleheads Reddit.

00:56:26.600 | Join one of your local Bogleheads chapters,

00:56:29.520 | and get others to join.

00:56:30.880 | Thanks for listening.

00:56:32.160 | (upbeat music)

00:56:34.760 | (upbeat music fades)

00:56:37.840 | (upbeat music)

00:56:40.420 | [BLANK_AUDIO]

Bogleheads® on Investing Podcast 055: Edward Chancellor on economic history and today’s markets

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