Mike Green: Passive Investing Dynamics, Inflation vs. Hyperinflation, Digital Currencies & more September 10th,2020 Erik: Joining me now is Mike Green, Chief Strategist and portfolio manager for Logica Funds. Mike, it's great to get you on the show this one is overdue, you've really gotten a lot of popularity lately since you came out from hiding behind the compliance wall that you used to hide behind. Let's start with a topic that I know you've touched on recently on another podcast you did with our good friends Grant Williams and Bill Fleckenstein. They did a series called the Stock Market End Game or I guess it was just called the End Game and it was fascinating to me to listen to because I used to say the exact same thing almost that Bill said in that series, which is, hey, look, this whole stock market rally since 2009 it's been artificially propelled by monetary policy, not by economic fundamentals. It's artificial and therefore it has to end badly someday, there has to be eventually a crash of the stock market or something because there's no free lunch in finance, that's just not how it works. I've changed my view, I don't really think that's true anymore, I think that it has to end badly but it's not necessarily nominal down in the stock market. Now, you've done a bunch of research that I think is maybe a little different. I was thinking on the MMT lines of why maybe we just end up seeing more money printing and more inflation and asset prices going up not down in nominal terms, you've got maybe a different explanation for why we might see that upside. So, first of all, do you think I'm right to consider that maybe the stock market doesn't really have to crash ever after all just because of this so-called artificial stimulus? And how did you see it? What are the drivers? Let's review some of the research that you've done on active passive. Mike: So, I definitely think that you are both actually hitting on a key point, which is that the market is "unhealthy", right? So, the behavior that we're seeing most of us who have been involved with markets for an extended period of time can rationally look at it and say something is off and a lot of people put it at the feet of the Fed. My analysis suggests that in more important forces actually the change in market structure driven by the growth of passive investing and in just really simple terms, the introduction of passive investing changes the character and the behavior of market participants moving it from a discretionary purchase decision where cash is a legitimate asset that can be held when valuations or economic fundamentals suggest that investing in securities would be unattractive. When you move to a passive framework it becomes rules literally as simple as: Did you give me cash? If so then buy; and in reverse, did you ask for cash? If so then sell, with no consideration for the underlying fundamentals or the economic backdrop in which the events are occurring. That change and the reduction in cash that those funds hold versus traditional vehicles in our analysis is actually responsible for the vast majority of the price increase that we've seen relative to the fundamentals. Absolutely, there was an improvement after 2009 as the global financial crisis came to an end that supported recovery in asset prices and certainly activities like corporate share buybacks have contributed as others have noted. But by far the dominant feature appears to be this dynamic of passive investing. And as a result, I tend to think that we need to consider both, I think it would be silly to say that markets can't crash roughly five months after they just did, right? But I also think that it's very difficult to argue that until those dynamics change, until the flow of money into passive changes, that we're going to see a significant change in the character of this behavior and I do think there's a very real risk that we break markets by having them go too high. Erik: Let's talk a little more about what you just said. You said the mechanics here are there's no thought to economics, it's basically investors give asset managers money if so buy, if investors took money away from asset managers then sell. Well, the second half of that I think if we go back to Bill Fleckenstein's logic is, okay, that means at some point, you get a self- reinforcing vicious cycle of withdrawals where investors are taking money away from asset managers, a driver of that might be something like demographics around aging baby boomers leading to the beginning of something that develops into a self-reinforcing vicious cycle. So, does there have to be a bad ending for the stock market when eventually that process reverses? And what you're seeing is investors taking money away from asset managers, is somehow changes something in the world and passive is no longer the thing anymore? Mike: Well, first, I think it's very difficult to have passive no longer be the thing because I think the arguments for it and the regulatory advantage that have been conferred on it are so extraordinary at the stage that we're probably going to see this to its logical conclusion. So, in really simple terms, most people think about passive in terms of an aggregate share where it's somewhere between most would say somewhere between 40 and 45% of the total market, we think it's about 44% right now. If you look at those characteristics and split them by demographics, for those in the younger generation the vast majority of their exposure in excess of 90 plus percent of their exposure to markets as we know them is through passive products. For those in the older generation it's much closer to 20% and so the dynamics in terms of passive penetration suggests that we're going to move increasingly rapidly to a world that looks more and more passive. And under that type of framework, the models that I have suggested that you should largely expect to see an inflationary condition, not inflation in terms of consumer prices but inflation in terms of the price that people will be willing to pay and the prices that we'll see in securities markets. On the other side of that equation though is when that is happening effectively you can be thinking about the velocity or the volatility of those events is accelerating. So, I've used the analogy, it's like trying to explain to people that the brakes are broken in a car that is traveling uphill, it's actually somewhat irrelevant until you start to hit downhill, and then you hit a moment of panic. And you're fine as long as the road turns back up at some point but if you've crested the mountain and come down the other side and you have no brakes, it becomes a very scary situation. We saw something like that I would argue in March, right? That characteristic that there's no absolute level that you can point to and say it has to turn down from here, when you're talking about this type of dynamic of moving from a population set that holds the majority of the assets that are roughly 20% passive, to a population set that will slowly accumulate those assets through contributions to 401K's, requests, etc. That doesn't necessarily have to turn down but the dynamics of gravity or the dynamics of how markets are structured suggests that at some point, it's actually likely to. Now, the simple example for that would be those who are buying in and contributing are doing so in a somewhat linear fashion, their contributions are tied to their incomes. On the other side of the equation, those who are making withdrawals whether it's because they're hitting retirement age demographics, as you suggest, they are typically taking a fraction or a percentage of their profit or percentage of their securities out, when they do that it means that ultimately you have an increasing mismatch between the contributions coming in from incomes and the withdrawals that are coming out from withdrawals. And that would suggest that there will be a topping point that's going to happen now. That of course has happened in the past and actually that's very much what happened in 2002 when you saw the stock market crash over the summer of 2002 into July, August, September. In response to that we have repeatedly seen central banks or policymakers step in to create substantive changes, whether that is inflating the value of bonds by cutting interest rates, directly purchasing securities as we've seen in other geographies, changing the 401K rules so that contributions can be delayed for a longer period of time, or they can be increased or to create tax incentives for employers to increase their contributions and thereby raise the quantity of money that is going in. Those are all actions that I think that we should anticipate. Ultimately, it's a question of, will you be aggressive enough to stop it and will you permanently break the markets at some point? To me that's unknowable so we remain agnostic, the trading positions we take at Logica is effectively we buy straddles, we want to participate in both directions.