DANIELLE DIMARTINO BOOTH: Well, hello. This is Danielle DiMartino Booth with Real Vision, and today we've got a real treat. We are bringing your Christopher Cole with Artemis Capital. We've been waiting for over two years for a follow-up to his seminal paper. It's out there. You have to read it. Share it with people-- maybe not people under 18. They wouldn't understand it. But everybody needs to get a copy of this and read it. We're going to discuss what it's all about today. Welcome.
CHRISTOPHER COLE: Thank you. It's a pleasure to be here and back on Real Vision again.
DANIELLE DIMARTINO BOOTH: So I'm going to start with an anecdote. Years ago, I was in Omaha, and I visited with Charlie Munger. And he made the comment to me that the entire pension fund advisory business one day would go out of business. It would go the way of the dodo bird because of the group think that surrounded the industry because of the way that the portfolios were being designed in a world where central banks were effectively running the show.
And he made the comment to me that he saw in the future, he said, I might not live to see, but you will, the death of the efficient frontier. So I'm curious about your thoughts on portfolio construction, how it's done, and how it that evolution has changed basically the way this entire generation approaches investing.
CHRISTOPHER COLE: Well, beginning with that and looking at what Munger has said, as a follow-up to my last letter, the Ouroboros letter that talked about the cycle of risk and how volatility has been used as both a proxy for risk and also as a source of return. I thought, how can I-- what will disrupt that-- what will disrupt that cycle? I posed a question to myself saying, well, if we're going to see what happens in the future, we have to look to the past, and the distant past, not just the recent past, not the last 10 years, not the last 40 years. We need to look back 100, 200 years to understand the cycle of capital creation and destruction.
And I posed this question to myself. I said, imagine that someone gives you generational wealth, enough money that you can live and your children's children can live at a high level. But it's subject to one question, one dynamic. You have to choose an asset allocation and stick with that allocation over 100 years. What allocation do you choose so that your children's children will have prosperity?
And taking that cue, I went back and looked at 90 years of historical data, backtested a wide range of popular financial engineering strategies, everything from risk parity, the traditional pension portfolio, short volatility, long volatility strategies, commodity trending strategies, and looked and how do these perform? And what asset allocation is the allocation that's going to provide wealth, not only consistently over 90 years, but through every generational cycle, through both periods of secular growth and secular decline?
And what I found surprised me, that echoing Munger's statement, the allocation that the majority of US pension systems and retirees are following, which approximately today is about 70% equity-linked products-- that could be everything from stocks to private equity, things that are the profit from secular growth-- and about 20% bonds. That portfolio has done incredibly well over the last 40 years. But when you look at that portfolio over 90 years, you see a very, very different reality. And that has a wide range of social, economic, and social ramifications that become quite startling.
But looking at that, I say, what asset allocation can I find that will actually provide protection over that 90 years consistently? And that answer came not from a macro view. It doesn't come from me having an opinion about whether or not we're going to go into a recession or whether or not there's going to be some continued economic prosperity. It comes simply by looking at data, using mathematics, looking at data, and looking at empirical data over a lifetime to come to that determination. And I think the results are quite shocking. And I think they run somewhat counter to the consensus knowledge as to what optimal portfolio allocation should be.
DANIELLE DIMARTINO BOOTH: So Charlie Munger was right.
CHRISTOPHER COLE: I think he's right.
DANIELLE DIMARTINO BOOTH: Take a step back to the October 2017 paper, if you will. Back then, you drew the scope of the financialization of the markets of the economy. You talked about risk parity, and share buybacks, and the massive effect that they had had on the crowding in to certain asset classes. So talk about what effect this herding instinct has had on the way this generation views investing.
CHRISTOPHER COLE: You and I have a very similar writing style. I love metaphors. I think visually. I think I think you do too.
DANIELLE DIMARTINO BOOTH: Yours are better.
CHRISTOPHER COLE: Yours are-- they're very good. But in that 2017 paper, I think I wanted to use the idea of an Ouroboros, this concept of a snake devouring its own tail. And what this was a metaphor for-- what is now about $3 trillion in equity markets alone. This is just equity markets, US equity markets. The number is much larger if you expand that across asset classes. But of strategies that use volatility as an input for taking risk, but also seek to generate excess yield, either through selling volatility or through the assumption of stability.
So in this number, you have implicit and explicit short volatility strategies. And I think there's a lot of confusion as to what this means. Explicit short volatility strategies are strategies that they will sell derivatives, so they'll sell options.
DANIELLE DIMARTINO BOOTH: So the easiest would be selling the VIX.
CHRISTOPHER COLE: Selling the VIX, that's right. So this paper came out prior to the XIV blow up, and it talked about how the VIX ETPs were likely to have significant problems. But that's a very small component of that short volatility trade. A much larger component of the short vol trade are strategies that replicate the risk parameters of short volatility trades but may not actually be shorting volatility. So strategies like this might be things like volatility targeting funds or some elements of risk parity, for example.
DANIELLE DIMARTINO BOOTH: Risk parity is still something we don't hear a lot about, even though it's massive.
CHRISTOPHER COLE: Yes, yeah. And indeed, the framework there is-- this could be anything between literally shorting vol-- literally shorting volatility, what I'll call short gamma or being short trend-- and we could talk a little bit more about that-- short correlations, short interest rates. These are risk factors of a portfolio of short options that various financial engineering strategies will replicate, maybe not all of them, but certain aspects of them. That doesn't mean all these strategies are bad. It just means that they are formulated to a world where interest rates are dropping, assets are mean reverting, and that volatility is quite low.
And guess what has happened the last 40 years? We are at generational lows in volatility across asset classes. Asset trending-- I think this is something most people don't realize that, actually, assets, equity for example, used to trend higher and lower. You can measure that through something called autocorrelation. All that means is that if today was down, it is likely that tomorrow will be up and vise versa.
DANIELLE DIMARTINO BOOTH: Buy the dip.
CHRISTOPHER COLE: Buy the dip, that's right. So the assets for the greater part of a lifetime were autocorrelated in the sense that higher prices resulted in higher prices, and lower prices resulted in lower prices. That autocorrelation peaked right when Nixon delinked the dollar versus gold, or the US dollar versus gold. And we have underwent a multi-decade decrease in autocorrelations. And now, we're at really peak mean reversion markets. So a lot of strategies make the assumption that mean reversion is implicit to asset price behavior. That's definitely not always the case.
So to that point, one of the strategies we actually tested was buy the dip. How would buy the dip perform going back 90 years? This is very interesting. Buying the dip, you don't think of it as a short volatility, strategy but it is short gamma, what's short that autocorrelation effect.
Well, buy the dip has performed incredibly well over the last 10 years, and really over the last 20 years, as central banks have been very reactive to market stress.
DANIELLE DIMARTINO BOOTH: That's an understatement.
CHRISTOPHER COLE: Right? Well, it's very interesting. If you go back and you test buy the dip over 90 years, that strategy goes bankrupt three times.
DANIELLE DIMARTINO BOOTH: Bankrupt's a big word.
CHRISTOPHER COLE: Flat out loses all of its money three times over a 90 year history. It is only really in the last 10 years where it's compounded at about 10% a year where we've seen that outperformance.
DANIELLE DIMARTINO BOOTH: I think that might-- let's see. Is that the quantitative easing era?
CHRISTOPHER COLE: I think so. It's not a coincidence. Yes, not a coincidence at all.
DANIELLE DIMARTINO BOOTH: So you tweeted out something a few days ago about long-term deflationary trends.
CHRISTOPHER COLE: Yeah.
DANIELLE DIMARTINO BOOTH: It feels like we keep going there. What in your mind could possibly ignite inflation? Because it's the one thing that nobody is expecting. We're all expecting wash, rinse, repeat. More deflation next time there's a disruption of any kind, and again, every central bank comes riding into the rescue with more stimulus.
CHRISTOPHER COLE: More stimulus-- so look at looking back at-- there have been other cycles across history that are like an Ouroboros eating its own tail. If we take this beyond just short volatility, we can think of it as part of the entire debt deflation cycle. So this idea that you start out with something good, you start out with real economic growth, technology, and demographics, and that leads to growth. And fantastic-- you're growing. The economy is growing. It's fundamental growth. At a certain point in time, the fundamentals get stretched and we become reliant on fiat devaluation and debt expansion.
DANIELLE DIMARTINO BOOTH: So think of the baby boomer generation generating genuine economic growth, and then they're starting to move to spending less. And how do you fill that gap?
CHRISTOPHER COLE: Exactly. So to this point, we start out in this framework. It's in the period of 1984 to 2007-- one of the most incredible periods of asset price growth and asset appreciation growth in not just American history, in history period. 90% of the returns of a 60-40 stock-bond portfolio came from the 22 years between '84 and 2007. Just 22 years drove 90% of the gains of that portfolio over 90 years.
DANIELLE DIMARTINO BOOTH: I probably couldn't count on one hand the number of investors who have been around since before 1984.
CHRISTOPHER COLE: Exactly. The average investment advisor is 52 years old. They were a kindergartener during the stagflationary period of the 1970s. So you have all these baby boomers, 76 million baby boomers-- largest generation in American history. They're teenagers right into the devaluation of gold in the 1971. That is driving a tremendous amount of inflation at that point in time.
Interest rates go up to 19%, and then these baby boomers, 76 million of them, enter the workforce in the early '80s. And they start making money. They start making money, and they start spending. They start investing.
So you have baby boomers coming on in. Then you have a trend towards globalization, so we're able to export our inflation overseas. You have a technology boom as well. And then, interest rates begin dropping.
DANIELLE DIMARTINO BOOTH: Oh, yes.
CHRISTOPHER COLE: So and--
DANIELLE DIMARTINO BOOTH: May he rest in peace, Paul Volcker.
CHRISTOPHER COLE: Exactly. And as if that's not enough, taxes start coming down. So you have this once-in-a-generation, once-in-several-hundred-years economic boom, asset price boom that occurs, driven as baby boomers come into the workforce, begin savings, enter into their prime earning years.
But now, those boomers are going to be retiring. They are going to be drawing $20 trillion dollars out of markets instead of putting that into markets. This, obviously presents a tremendous deflationary force.
So I'd like to think about this as a snake. If we take the snake metaphor and we pull it out, it's not just short volatility. It is almost like a snake devouring its own tail as part of a business cycle. The snake is eating prey and naturally compressing inwards through secular growth. And that's healthy.
But towards the end of the secular growth cycle, that snake relies on financial engineering, excess leverage, and begins eating its own tail. And that is where we're at, I would say, in the cycle right now. And you've written beautifully on this about some of the debt problems out there. Currently, we're at 48% debt to GDP, highest corporate debt to GDP, highest level in American history.
DANIELLE DIMARTINO BOOTH: You tack on-- you aggregate non-financial, we're at 74%.
CHRISTOPHER COLE: 74%.
DANIELLE DIMARTINO BOOTH: Unheard of numbers.
CHRISTOPHER COLE: And what are we doing with this? What are corporations doing with this debt? They're issuing debt to buy back their own shares at a trillion dollars a year. And then institutions are funneling that in in order to-- they need to find ways to generate yield absent any fundamental growth.
So we had a year like last year, where there's no actual earnings growth, but it's all multiple expansion driven by share buybacks and speculation. So this is-- we're at this end of the cycle, where the snake is devouring its own tail. Now, this can go on for a long time.
DANIELLE DIMARTINO BOOTH: Clearly.
CHRISTOPHER COLE: Well, what breaks that cycle? And this comes to the image in the paper of the allegory of the hawk and serpent. And I was thinking about this. Outside our offices here, we have a peregrine falcon that flies around.
DANIELLE DIMARTINO BOOTH: I saw that on Twitter. You need to tweet more often, by the way. Can We. Got on "Real Vision" thumbs up on that? Thank you.
CHRISTOPHER COLE: I do a lot of research and work, but I'll try. I'll try a little bit more. I'm still getting used to it, by the way. The whole retweet thing--
DANIELLE DIMARTINO BOOTH: It gets tricky.
CHRISTOPHER COLE: It gets tricky a little bit. But that hawk-- I noticed the idea of hawk. And there is an old symbol of a hawk fighting a serpent. And this symbol has deep roots. It's actually on the great seal of the US. It's on the coat of arms of Mexico. It has important ramifications across different traditions ranging from Aztec to Egyptian to Indian.
But this idea to me, what it represented is the serpent represents the secular growth cycle that becomes corrupted at a certain point in time, where the serpent begins devouring its own tail. It is unable to generate growth naturally and has to self-cannibalize. And the hawk comes down and represents the disruption of that cycle.
But the hawk has two wings, which also work with the probability distribution. On the left wing--
DANIELLE DIMARTINO BOOTH: Wow, that's deep. OK.
CHRISTOPHER COLE: So the metaphor goes deeper. On the left wing, we have debt deflation. This is what Japan has experienced. That's one way you get out of this decaying growth cycle.
DANIELLE DIMARTINO BOOTH: Slowly.
CHRISTOPHER COLE: Slowly. Painfully. That's what the US experienced in the '30s. But on the other end of it, you have fiat devaluation and reflation. That is where you simply devalue your currency. And that could be helicopter money, devaluation currency, money printing. That is another way that you get out of that crisis. This is as old as money itself. And one wing can occur before the other. You can have a deflationary crisis before you have a reflationary crisis.
So to get back to your original question, what will cause-- what I see causing inflation. You have a scenario today where the two largest blocks of the US population are baby boomers, at about 22% of the population right now. They're rich. They have a lot of money. They've lived through one of the most incredible periods of asset price growth in history.
And they want to protect that money. So they are going to-- they're going to support policies or are incentivized to, I should say. They don't need to, but they're incentivized to support policies that protect their retirement and their entitlement benefits.
Now you have millennials, which are now the largest generation at 26% of the population, and Gen Z following, are likely to be the first generation in American history to be poorer than their parents.
DANIELLE DIMARTINO BOOTH: Remarkable.
CHRISTOPHER COLE: Remarkable, yeah. Lower household creation rates-- they have-- the average millennial has substantial student debt.
DANIELLE DIMARTINO BOOTH: Low savings.
CHRISTOPHER COLE: No savings, that's right. So the incentive of the average millennial, they're incentivized in essence to pursue policies that represent redistribution of wealth and seek to tax, redistribute, and cause inflation. So I think the time to look, and maybe what could cause inflation is the political sea change towards--
DANIELLE DIMARTINO BOOTH: At some point-- we're at $23 trillion now. But to your point, at some point, you're going to hit a level of debt if truly all of these social spending initiatives are financed by printing money. Theoretically, at some point, you will hit a limit. I agree with you.
You talk about passive investing. It's a hot button. 90% of flows go into passive strategies. Even pensions are in passive strategies. Talk about the perfect-- perfect liquidity of passive investing.
CHRISTOPHER COLE: The concept of passive-- and now, we are at a point where passive investments have eclipsed active for the first time in history. And my friend Mike Green who's a friend of "Real Vision" has a lot of fantastic research on this.
DANIELLE DIMARTINO BOOTH: Yes, he has.
CHRISTOPHER COLE: And I've done some work, in essence, trying to replicate his assumptions using some toy models and was able to do that. His theory, at the end of the day, is that at a certain point, if the market is dominated by passive actors, it not only amplifies volatility, which I completely agree with-- if there is no other incremental seller against a buyer or buyer against a seller, each incremental buy or sell will result in massive movement in the underlying.
DANIELLE DIMARTINO BOOTH: It's an amplifier.
CHRISTOPHER COLE: It's an amplifier. Because if you look at active investors, active investors are a volatility dampener. Value investors will come into the market, and they will buy when there is a big collapse in asset prices. So they will in essence put a floor underneath asset prices. And they'll sell when asset prices go to high. Well, you remove all the active investors, and that will amplify volatility.