BRIAN REYNOLDS: Before we invented the margin credit market, the stock market ran on fundamentals, things like earnings, things like valuations. And then the credit market came along, and starting in the 1990s, disrupted that whole process. 40 years ago in the '70s, the average company was highly rated, AA or AAA rated from a credit standpoint.

Now we've added so much leverage in the last 40 years that the average credit quality has gone down to just above junk.

TYLER NEVILLE: Brian Reynolds, here to talk about unfunded pension liabilities, the credit boom and corporate buybacks. And we're here at this lovely New Hampshire Institute of Politics, which is the perfect setting for our conversation. First, why don't you just get everyone familiar with your background and maybe go through that a little bit.

BRIAN REYNOLDS: Sure. So in a month it'll be my 35th anniversary in this business. I started in 1984. And I've been in the business so long, the junk market didn't exist when I started. That's how long I've been in the business.

The first 16 years I spent on the buy side of David L. Babson and Company. It was a great place to work because it started in 1940. I have mentors that go back to the 1920s, '30s, and '40s, they taught me to follow the money. They taught me this business the old fashioned way.

And I've brought that through every job I've ever had since. And it was a great place to be because that was the emergence of credit as an asset class. Not only was the junk market not invented yet but the actual investment grade credit market was still in its infancy. So it's a very different world now than it was then, because credit is now so big it dominates financial markets, but back then it was a backwater.

So I ran our money market funds, which is where shadow banking started. I was in charge of bank and finance bonds, which is some of the original shadow bankers. And then in the late 1980s, as structured finance began to become more significant, I was in charge of that product from the late '80s until 2000.

So I kind of grew up with the Martin credit market. I saw it develop from almost nothing into this large asset class, which is now the tail that wags the dog.

TYLER NEVILLE: Some of the things you talk about, the Daisy chain of capital, now that's like a primary theme throughout your work, can you explain that for the viewers?

BRIAN REYNOLDS: Before we invented the Martin credit market, the stock market ran on fundamentals, things like earnings, things like valuations. And then the credit market came along, and starting in the 1990s, disrupted that whole process. So now we're in the third modern credit boom. The first one lasted from 1991 through 2000, then we had a financial disaster.

The second one went from 2004 to 2007, then we had another financial disaster. And then we launched another one in 2009. And all this Daisy chain is, is our public pensions needing to make outsized returns. They have become the dominant global investor.

Our pensions were only about 60% of GDP in '84. Now they are 120% of GDP. That's massive spectacular growth. There's nothing on earth that's grown that fast from such a high base. So they're the dominant global investor, but they're so underfunded they need to make 7.5%.

TYLER NEVILLE: So talk about how the big, big pension funds work. Why 7.5%? And where's that money going?

BRIAN REYNOLDS: The 7.5% they need to make, that's the difference between what their governors and their legislatures have under the mat versus the promises they've made to our public sector workers, police officers, firefighters, teachers. Most state governments tend to work the same, so they all tend to have that same gap. And that gap works out to be 7.5%, which is crazy because most interest rates are much, much lower than that.

So they really have to push the envelope in terms of what they invest in to try and get that. And you would think they would be in stocks because pensions should be long term oriented, but most pension boards are police officers, teachers, firefighters, and politicians. They have a short term focus, and so they invest in the credit market.

They started doing it in the 1990s. The most famous credit fund they hired was John Meriwether's long-term capital management. But it wasn't just him, it was thousands and thousands of other credit funds that mimicked him. These pensions will hire these credit funds, they'll put money to work on an aggressive leveraged basis to try and get that 7.5% yield they need.

And when they buy these record amounts of corporate bonds from companies, that puts cash into corporate balance sheets. Modern CEOs are incented to get their stock price up, so they take this unlimited money that comes from our pensions via these credit funds and use it to buy back their stock. That's a Daisy chain of financial engineering.

That's what happened in the '90s, it's what happened from '03 to '07, that's what's been going on since 2009.

TYLER NEVILLE: Now, can you put that in a relative context? How much of the buybacks have pushed the market up? First, like say, ETF or mutual funds. How come people don't quantify the buybacks in relative terms to that? They concentrate so much energy on Wall Street talking about ETF flows and mutual fund flows.

And how does it get overlooked? What's the number?

BRIAN REYNOLDS: Because the world has changed in the last 3 and 1/2 decades. As I said, the junk market didn't exist when I started in the business, but from the late 1980s on, the junk market began to become a bigger force for this, and that's when we started putting on leverage. So 40 years ago, in the '70s, the average company was highly rated, AA or AAA rated from a credit standpoint.

Now we've added so much leverage in the last 40 years that the average credit quality has gone down to just above junk. That's how much we've levered up corporate America. And if you look at a chart of who's been buying stocks over the last few decades, there's been money going to ETFs, but that's come at the expense of mutual funds, pensions, both state and private pensions have been large sellers.

So investors as a whole have really done nothing these last three decades. The buybacks have taken an increasing share to the point where they're almost 100% of the buyers of the last decade. In other words, investors have done nothing on a net basis for 10 years. Yeah, they put money into ETFs at the expense of active product.

And the result is this Daisy chain of money coming in from taxes to pensions, going into credit, which is then used to artificially push up stock prices.

TYLER NEVILLE: And a lot of times that money ends up in not profitable zombie companies. And you talked about in 2015, 2016, I believe, that money flowing into energy companies that oversupplied the market. Can you talk about how that kind of related to back in the WorldCom days?

BRIAN REYNOLDS: This credit money typically zeros in on a particular industry. In addition to boosting the overall level of credit, we overdo it in an industry. So in the 1990s, we focused on companies like WorldCom and Enron. We inflated their balance sheets to the point where their valuations didn't jibe with reality.

And then it came down like a souffle. Then we did the same thing with subprime housing in the next cycle, and that collapsed. And then we did it with energy companies from, say, energy and commodity companies from say 2009 to 2013, then those companies collapsed. And now we're starting to do it with commercial real estate, so it's just like we go from one asset class to another within the context of boosting overall leverage.

TYLER NEVILLE: So in terms of shocks and supply, I know the big concentration these days is on the stock market when it's falling and the VIX is going crazy. What happens to the credit markets? Because I think very rarely you turn on the news and you see, stocks are in turmoil, stocks are in turmoil, but no one's talking about how credit markets are functioning.

BRIAN REYNOLDS: I have three themes. My first theme is that we're in this credit boom, this Daisy chain of financial engineering. But my second theme was that it gets periodically interrupted by these panics, because equity investors just don't believe in this. The stock markets outpace the economic fundamentals over the last decade.

So if you are a fundamentally oriented equity investor, you don't want to buy stocks, you don't want to own them, you want to sell them in a drop of a hat every time there's a worry. We've had 35 pullbacks in the stock market that have been marked by irrational inversions of the VIX curve, where people get so panicked about the downside that they pay up for short term protection when longer term protection is cheaper. The most recent of those was in the fourth quarter of 2018.

And when these stock market panics happen and the VIX gets inverted, the credit market shuts down. Because these credit funds that are hired by our pensions to put money to work, they're allowed to take a break during a panic to see if the turbulence creates a better buying opportunity. So yields and spreads typically go up during these panics. That happened again in the fourth quarter of last year, as demand for credit temporarily stopped.

But once the equity panic runs its course, as it did at the start of January, then the credit market opens right back up. People make up for lost time and stocks go ripping higher on a new round of buybacks and mergers. We've done that 35 times in the last 10 years. We'll probably keep doing it a number of times per year.

These drops feel like the world is ending, and as soon as the panic is over, we go right back up. That frustrates active managers tremendously.

TYLER NEVILLE: Of course. And I think-- so my background is in trading, so market structure wise I think what's happening is outflows work differently. So back in 2008, you could be 30% of the trading volume and not move the price of the stock. Nowadays you can be 5% of a trading volume and move the price of the stock. So buybacks are constantly pushing us up.

And then in the panics, when those corporate pensions pull back and the credit markets seize up, it's like a go trail going out. But what's interesting, I think, what you're saying is pensions actually are always constantly there. I think you said in one of your notes, University of California Endowment lowered their cash weighting.

Can you talk about that and CalPERS and how they're getting even more aggressive on the engine front?

BRIAN REYNOLDS: Well, that example of lowering their cash weighting, it's not just that particular pension, it's a slew of pensions that are doing that, because they all typically need to make about 7.5%. If you've got cash that yields 2%, that's a drag on that. So what we've seen over the last 10 years, especially the last 5, is more and more pensions reducing their low yielding cash in favor of more aggressive credit investments, that helps increase the intensity of this credit boom and it exacerbates these up and down panics, because it removes shares from the stock market, which means that the money that remains can move shares with less effort, as you mentioned.

That makes the downside more rapid and it makes the upside more rapid as well. And that's what-- that further drives people nuts.

TYLER NEVILLE: And now, another thing is the Detroit bankruptcy. how much has that influenced the next exuberance in investing in these needed based investments?

BRIAN REYNOLDS: So the Detroit bankruptcy has actually radically changed the tenor of this credit boom. In the prior cycles, the 1990s with WorldCom and Enron, the next cycle was subprime. We did it purely with leverage. But now we're doing with increased taxes.

Because until Detroit went bankrupt, nobody really cared about pensions, because most state constitutions guarantee pensions. Once you give a pension to a police officer, a firefighter, a teacher, you can't cut it, you can't eliminate it, you just have to keep providing for that pension. But then Detroit went bankrupt and they filed an US bankruptcy court.

And the judge says, yes, I know the Michigan constitution protects your pension, but you filed an US bankruptcy court and US law trumps state law, so the pensioners ended up taking a hit on the unfunded liabilities. And since most pensions are only about 2/3 funded, that sent shockwaves through the public labor union movement.

And since then they've gone to every major state. And every major state since then has either raised or is thinking of raising taxes to try and narrow this funding gap in our pension system. And the result is overwhelming. Every month I tracked pension votes going into credit from these new tax flows, the chart I do goes up and to the right.

It's now growing faster than the average annual value of the federal tax cut that was passed in 2017. In other words, we did $1 trillion tax cut over 10 years, that's 100 billion a year. State and local taxes just for pensions are now growing at more than 115 billion a year.

So fiscal policy is actually negative now. That's one more reason why the economy's cooling. But this money goes into levered credit and it comes back in the stock market with five times the buybacks, because that's the leverage they start to employ. And so if you're a fundamentally based investor, you're looking at a historically slow economy relative to prior decades and prior economic cycles.

Yet, we're putting more money to work than ever in credit and doing it on a leverage basis, so you get one of the greatest stock market bull markets in history.

TYLER NEVILLE: That everyone hates.

BRIAN REYNOLDS: That everyone hates because it way outpaced the economic fundamentals, because of these new inflows of money at the state and local level.

TYLER NEVILLE: And there, can give me like a recap of California? I know you talk about Kentucky, I believe. Any of those specific.

BRIAN REYNOLDS: It'll be easier to list the pensions that are in good shape and are not raising taxes. I think Delaware is in good shape, but they're kind of small relative to the other states. Starting in California, whether it's fashion or finance, the trends start in California.

So the California legislature passed a bill giving CalPERS an extra 5 billion a year over and above what they've been doing. And then they passed another law giving CalSTRS another 5 billion a year over and above what they've been doing. And you can go down the list of all the major states, Texas, Colorado, Michigan, New York, Pennsylvania, New Jersey, Massachusetts, they've all taken steps to raise taxes and bring more money into the pensions, which doesn't do anything for the economy.

It's actually a net negative for the economy, but it helps boost our financial markets. And that's why this is the most intense credit boom in our nation's history.

TYLER NEVILLE: And the short interest remains because all the economic fundamentals look horrible on the surface. The short interest remains high, which causes those extra short squeezes higher, correct?

BRIAN REYNOLDS: People hate stocks.

TYLER NEVILLE: Yeah, they hate them.

BRIAN REYNOLDS: Short selling, which is a bet that stocks are going to go down is higher now than it was during the 2008 financial crisis. It's near a record. So active hedge fund managers have been betting against this bull market in near record amounts. That's another reason for active management underperformance.

On the hedge fund side they're betting stocks are going to go down. And we're in one of the greatest bull markets in history.

TYLER NEVILLE: Why is it that hedge funds ignore that? They want to talk next quarter's earnings. But when you're talking giant liquidity, they seem to ignore it. And why are you one of the lone wolf voices on the street that analyzes pensions whereas everyone else is stuck in the weeds?

BRIAN REYNOLDS: I managed pension money for 16 years. So I was there at the beginning of this process. I helped do some of these practices that we're doing now. So I bought one of the first auto loan deals in the 1980s. One of the first credit card deals, one of the first manufactured housing deals in the 1980s, which of course, turned into subprime in the next cycle, so sorry.

At the time we were doing them we thought they were great, they were good, but Wall Street always takes a good idea and runs with it and pushes it until it becomes overdone and a negative for the financial system. So there's not a lot of strategists on Wall Street that have actually done structured finance the way I have.

My mentors let me run in credit, but they also gave me experience in equities. So I can speak both languages. It's like I can be a general contractor and explain to the plumbers what the electricians are doing, whereas most people who come into this business on the equity side, they're taught equities and they're taught classical equities, Graham and Dodd type stuff, fundamentals, valuations, margins of safety.

Whereas our public pensions don't worry about any of that. All they focus on is the need to make 7.5%. So that's kind of like the dumb money. And the smart money wants to short, because fundamentally this doesn't make any sense. But there's that old saying that markets can stay irrational longer than you can stay solvent.

And it looks like this irrationality is not only going to continue but it's going to intensify.

TYLER NEVILLE: So how does it all end? What indicators are you looking at to give you a heads up on when things change? Because these 35 that you talk about is-- how are you going to know next time that this is the one?

BRIAN REYNOLDS: My third theme is that this is just a credit cycle. Credit cycles always end and they always end badly. So this will be the same with this one. My first theme was that it's a Daisy chain of financial engineering.

My second theme was we're going to have periodic panics. My third theme was it will end in a crisis. And that's the difference. We've had 35 panics that had been brief and seen stocks go back up. Eventually we'll have a crisis like 2008, like 2000, where you have a multi-year financial market disaster.

And the difference between a panic and a crisis is that in panics we see pensions keep voting to put more money to work in credit, even though there's a panic. So we saw that in the fourth quarter of last year. October, November and December were horrible for stocks. The credit markets shut down towards the end of that, but yet pensions