It isn’t much fun to talk about. It’s kind of a party killer. The music sounds good, the people are jiving, but then you remember you’re still in middle school, a censored Nelly album is playing, and your parents are outside waiting to pick you up.
Inflation is that. No one wants to talk about those moments. They’d rather tell you about the crazy times they had in college.
What can 1 US Dollar buy you today?
What could 1 US Dollar buy you 30 years ago?
The difference between those two questions, in its simplest form, is inflation. So let’s quickly go over some numbers to see how inflation is the worst party in town and awfully humbling. But first, let’s look at the numbers *before* inflation.
– On a nominal basis, the S&P 500 is up roughly 330% since the absolute depths of the Financial Crisis.
– It’s up about 105% since the highs right before the Financial Crisis in 2007.
– It’s up 110% since the highs of the Dotcom Bubble, before it crashed, back in 1999/2000.
These are the facts you see in headlines everywhere. That the S&P 500 is up 330% since the bottom of the Financial Crisis and it’s now up 105% for those who accidentally bought at the highest points before the Dotcom Crash or Financial Crisis.
Let’s chart it:
If you want to humble yourself, try adjusting all your returns and gains for inflation. I don’t know many people who do that and I think I know why. You are literally about to tell yourself you’re not as good as you thought you were.
So if you can stomach it, if you’re a real one confident in your abilities to fight the forces of inflation, keep reading. Because I will show you what Mordor really looks like.
Since the bottom of the Financial Crisis, inflation-adjusted S&P 500 returns are up about 150%. Not 330%. Had you bought at the peak of the Dotcom Crash, adjusted for inflation, you’re up about 40% right now. Had you bought at the peak of the Financial Crisis, you’re up about 50% right now. Basically each comparison had their returns cut in half.
Let’s chart the party no one wants to go to. Here’s the S&P 500 chart when it’s adjusted for inflation. The difference is startling in scope and pace compared to the chart we shared earlier:
Inflation-adjusted returns suck, I know. They are not as glamorous as nominal returns. But it’s a healthy reality check and a reminder of how important it is to keep up with the inflation rate. It’s also a reminder that you’re not as good as you think you are. Most of us, when we’re invested in risk assets, are just riding the waves of inflation.
If you have the guts to work on your own personal inflation-adjusted returns, please let me know. Hope you hang in there and just remember, the real ones know inflation well and want the challenge. The others will dance around their nominal gains and never speak a word about it.
As time progresses, people generally get smarter. And better.
I just finished a book on how the Internet came to be and I had no idea about the science behind it all until now. Especially the complexities behind the increasing speed that we are able to send data to one another.
A signal travels from phone to tower to tower and back to your phone in seconds. I don’t think I give that enough credit for the pure human ingenuity that went into such an accomplishment. And if we figured that out, what else can we do.
On the fifth day, an Oracle from Omaha descended from thee heavens. “Today,” he said, “I bring you thy S&P 500.”
So it began.
From all across the lands, people began pouring their earned coin into this magical transcendent creature.
“Here ye, here ye! Take all your monies! We can deposit it monthly or quarterly or weekly. We shall call this act, passive investing!”
And that my friends, is the start of passive investing. The story of how it all came to be…
Did you know the S&P 500 Index is actually owned and operated by a company. That company is the S&P Dow Jones Indices. Did you also know this company has over 10,000 employees. Some of those employees, well actually a lot of them, work daily to manage all of the indexes they sell, market, and create.
They add stocks, they remove stocks, they debate new and old methods, and they probably get into some nasty board room fights here and there about what stocks should go where. They have entire committees dedicated to these processes.
I can read it to you if you want, straight from them:
“All committee members are full-time professional members of S&P Dow Jones Indices’ staff. The committee meets monthly. At each meeting, the Index Committee reviews pending corporate actions that may affect index constituents, statistics comparing the composition of the indices to the market, companies that are being considered as candidates for addition to an index, and any significant market events. In addition, the Index Committee may revise index policy covering rules for selecting companies, treatment of dividends, share counts or other matters.”
I’m not sure I see the “passiveness” of a monthly meeting to decide what stocks should go into a basket of equities. I guess what I’m saying is that the indexes people passively invest in, are, quite frankly, actively managed. But perhaps there’s more to this story. Let’s keep going.
The other day I was being shown some interesting new software for passive investors. Here’s what I was told:
“You ready!? Our website is going to make life easier for passive investors. Before you do automatic deposits into different asset classes, you need to take a risk assessment test. Depending on your risk level, the website automatically tells you what assets are good for you. It’s that easy!”
I’ve found myself pressing buttons and moving sliders on this website. I want to take massive risk. Nah, I want to take no risk. The website spits out new assets and allocations just for me depending on where I moved these sliders and how I press certain buttons. I can invest in an aggressive basket of assets or a conservative basket of assets.
But wait one second. What exactly are these assets I’m being recommended?
It turns out, most of the “assets” these machines recommend are really just ETFs. I could end up in the TLT ETF, sometimes known as the biggest Longterm Treasury Bond ETF. Or I could find myself in the popular Nasdaq-100 ETF called QQQ.
It’s at this point, in my journey to understand passive investing, that I think I’ve cracked the code. Passive investing is just buying ETFs on a set schedule whether it’s each paycheck or each quarter. The machine has told me I need exposure to classic US Treasuries. So I find myself searching the official TLT ETF website for more information. I think I’m ready to jump in!
“Well that’s weird.”
I’ve just learned the Treasury Bond ETF, the one I was looking at called TLT, is managed by two people. As of this writing, this ETF has $17 billion in assets under management and yes two people are responsible for steering the ship. Not my words, their words:
“Portfolio Managers James Mauro and Scott Radell are primarily responsible for the day-to-day management of the Fund. Each Portfolio Manager is responsible for various functions related to portfolio management, including, but not limited to, investing cash inflows, coordinating with members of his portfolio management team to focus on certain asset classes, implementing investment strategy, researching and reviewing investment strategy and overseeing members of his portfolio management team that have more limited responsibilities.”
There’s nothing wrong with this. It’s kind of nice to meet our portfolio managers James and Scott. I wonder if they like avocados… But what you’re also telling me is that by taking the machines recommendation to diversify into a low cost ETF managed by a couple of guys walking around an office yelling about inverted yield curves is passive investing. Okay then.
The name “passive investing” is good.
It’s friendly. It’s easy.
What’s really happening, however, is a little marketing department has done something clever – that somehow this passive investing thing is better, different, and safer. But in reality, passive investing is the same thing people have done in financial markets since the dawn of the Buttonwood Tree: we trade our hard-earned money to buy a paper asset like a stock because we estimate it will create bigger future returns than if we just held our cash money and did nothing with it.
There’s no secret sauce here.
The funds you buy can screw up just like anyone else can. So yes, you might be a passive investor, but you surely aren’t investing in anything even close to what the word passive actually implies.
What I’m saying is someone behind the scenes of all those ETFs or whatever fund you think qualifies as passive investing is actively moving money and assets around. When I say actively, by the way, I mean like sometimes daily. ETFs rebalance and move things around all. the. time.
Curtain Begins to Close, @Scheplick Walks Unto the Stage
Passive investing was built by those who need your money to continue conducting the alchemy of finance. You see, if it’s too easy, the people will just do it themselves. If it’s too scary, no one will ever want to do it. You need the perfect mixture of too scary and not easy enough and voila – money deposited, business earned.
Just as fast as passive investing became a wonderful buzz word in a massive bull market, it can also become a shunned marketing phrase in a devastating bear market. Because at the end of the day, that’s all it is… a marketing word.
Bill James, the now near 70-year-old who spent his career changing the way people think about statistics in baseball, has a few things to teach.
No one working in Major League Baseball today thinks like they did 30 years ago. Bill James changed everyone’s mind.
That’s how important he is. I think, at the end of the day, we’d all like to do that in the fields we care about most.
In his early days, when maybe 10 people were actually reading his self-published work, he was working to change the perception of common stats that measured a player’s performance. Like batting average.
When you hear, “that player is a .300 hitter” what comes to mind? All-star? Top player in the league?
When you hear, “he’s a .275 hitter” what do you think? Mediocre player? Pretty good?
I’ll let Bill James explain:
“One absolutely cannot tell, by watching, the difference between a .300 hitter and a .275 hitter. The difference is one hit every two weeks. It might be that a reporter, seeing every game that the team plays, could sense that difference over the course of the year if no records were kept, but I doubt it. Certainly, the average fan, seeing perhaps a tenth of the team’s games, could never gauge two performances that accurately — in fact if you see both 15 games a year, there is a 40% chance that the .275 hitter will have more hits than the .300 hitter in the games that you see. The difference between a good hitter and an average hitter is simply not visible — it is a matter of record.”
While everyone can tell you the difference, no one can actually see the difference. You can think it, you can read it, but you will never actually be there for it.
I imagine all the millions of fans who talk about .300 hitters in a completely different light. The brand and image a .300 hitter has compared to a .275 hitter is drastic. For those who know baseball, you know. They practically live on two different planets. One is an all-star, the other is not.
In reality, the difference is barely even noticed.
Investors love to compare baseball to the markets. The statistical observations, streaks of success, and long enduring season all have their commonalities with markets. You will often see traders and investors quoting the great baseball players or comparing their craft.
Warren Buffett is probably the greatest investor ever. But, what if we could see all the other professionals out there and compare their returns to his. I’m sure the second best or third best, the ones without the same marketing or publicity machines, are probably pretty close. So close, most of us probably could not tell the difference between them, especially without Warren’s brand or digging deep into their actual account statements.
Yes, the record says one thing, in this instance, that Buffett is best, or that one batter is better or worse, but they fail to explain just how much worse or how much better they are. Or just how hard it is to actually see the difference. That is rarely discussed.
We are beasts of record without much regard for perception.
I don’t think many people know what a Variable Interest Entity is. But today, in the middle of a Trade War, it might be the most important thing to understand.
In China, it is illegal for a foreigner not living in China to have an ownership stake in a domestic Chinese company. But there are ways around it. Let’s take Alibaba for example – “the Amazon of China.” Today, it trades on the New York Stock exchange under the Ticker BABA. Anyone in the US can buy it. Heck, anyone with access to US markets can buy it.
But how is that possible if China does not allow foreigners outside of China to own a stake in their public companies?
It’s possible because you aren’t buying Alibaba. What I mean is, you aren’t buying THE Alibaba, the one in China that is actually doing the business. You are instead buying a shell company based in the Cayman Islands that’s kind of pretending to be Alibaba. The only reason why that shell company is worth what it is in US markets (Alibaba’s market cap on the US exchange is $436 billion right now) is because it claims to have a contract with the REAL Alibaba in China. This contract basically says the Cayman Island Alibaba is entitled to get economic profits from the real Chinese Alibaba and that’s all US investors are buying. A piece of a contract.
This is what it’s called: a Variable Interest Entity or VIE for short. When Alibaba was getting ready to IPO in 2014, it was the biggest IPO in US history. The ownership structure was talked about quite a bit from major media to social media. But, our financial system is very good at selling the shiniest of things and perhaps no one wanted to really consider what was going on. Or maybe most people did look into it and because times were different in 2014 said, “You know, this is okay because US and Chinese Variable Interest Entities have been working for years and country relationships are good.”
That was 2014.
The current political landscape throws the ownership of these variable interest entities and the huge sums of money indexed to them and passively invested into them on center stage. As of this writing, when calculated by sheer market cap, the value of all Chinese Variable Interest Entities being traded on US markets is way in excess of $1 trillion. Yes, more than $1 trillion. So somehow, clearly without much regulation at all, we’ve managed to package quite a few of these Chinese VIEs and sell them across the country and across the world to anyone who has access to American markets.
The investment management company Blackrock collectively holds $12 billion worth of the Alibaba VIE.
Vanguard, Fidelity, Morgan Stanley, and the list goes on all own quite a bit themselves. It’s also a lot more than just Alibaba. Think Baidu, China Mobil, Weibo, and the list goes on and on.
This is how a single loophole potentially becomes the most important weapon in the Trade War. Are either President Trump or Xi crazy enough to threaten the existence of the Variable Interest Entity? What I mean is, what if one of them decided to say, “you know what, Variable Interest Entities are not allowed any more in our country.” Does a Trump tweet about Variable Interest Entities sound that unreasonable?
Would Xi be so crazy to tell Trump he can wipe out millions of American savers who have been peddled into these VIEs overnight?
Essentially, every Chinese Variable Interest Entity you can think could theoretically go to $0. Just like that. Because the ability to invest in something like Alibaba on US exchanges in the first place only exists because of the Variable Interest Entity loophole. The key word here is loophole. And usually loopholes get exposed, closed, or debated.
This loophole connects the shares you bought in the US to the Cayman Islands, which are then connected by a contract that has no legal authority or oversight to the actual company in China. But hey, it’s a promise. If the loophole is ever closed, it would essentially mean all US holders would be left holding a PO Box in the beautiful Caymans and nothing else.
Now what’s really fascinating about this conundrum is that there is no legal authority. If any of this were to happen, no one can sue anyone. There is no oversight for any US shareholders of Variable Interest Entities. Nothing. Unless maybe you want the US military to march overseas and get your money back.
Now, I should be clear that I do not like fear mongering. I tend to champion buying dips and exposing the top callers. This isn’t supposed to be either of those two things. Instead, if anything, it’s meant to expose the packaging and selling of these VIEs.
Wall Street, at its core, is really good at building perfect looking presents. These presents have the best wrapping, the perfect bow, and the most ideal color. They shine and you just want it. You have to buy it. But rarely does the financial machine show you what’s behind the beautiful wrapping. I think of all the Alibaba IPO fees our fantastic investment banks collected along way with their marketing messages. “Dude you’re buying Alibaba, the Amazon of China!”
More recently, we watched the inverse VIX ETN that traded under the ticker XIV. The one that went bust over night. It was marketed as a way to short the VIX with a few clicks from your retail brokerage account. That did not go well.
Now, let’s pretend for a second none of this matters. Fast forward the next 10 years. This blog post sucks and meant nothing. Say Alibaba (the US one) goes 10x from here. Well, that is totally fine. But at the very least, now more people are aware of the ownership structure and risks that are being peddled daily across financial markets, especially VIEs today in the middle of serious political turmoil. For that reason alone, some good has been done.
The relationship between risk and money has been observed since the dawn of our time.
We learn to love putting in hard work for money, but we often forget the immense amount of risk that goes into it. And risk comes in all forms impacting your money, career, family or health.
I’ve come to learn the importance of seeing this hidden layer of risk. Risk isn’t just “risk.” It’s slightly more abstract. It can impact the way you live and enjoy life. It’s there, hovering above, nudging and prodding. The guy at the beach living on coconuts has no risk. His life is pretty simple. Wake up, eat the coconuts, chill by the water.
Risk is not just how much you’re willing to lose on a bet or investment or decision, but also the impact it will have on your mind while you wait for that risk to play out. It is our mental capital. I have come to learn first hand the multidimensionality of risk.
I am not the first person to talk about this. And I will not be the last.
Mental capital is everything. It is your stress, your anxiety, and amount of sheer responsibility you put on your brain. And your brain is an extremely complex muscle. It gets put to work constantly, firing off, connecting dots, and calculating.
No marathon runner ever sprints the entire time. And no marathon runner ever runs back-to-back-to-back marathons with no time to rest. What’s strange, though, is that when it comes to our minds, we never think like that. We run marathon after marathon. We place bet after bet. And we rarely stop to think – is that really worth our mental capital?
There is very little science that attempts to explain that question. There’s beauty in giving your brain and body a rest. This isn’t just disconnecting or unplugging, either. This is different. What I mean is giving your mind and body time to live without any risk. That’s why even a vacation isn’t really a break from risk. Because those things are still on your mind, still something that could go wrong while you’re away.
There aren’t many professions out there that will put you through as much mental anguish as investing or trading. It is straight up brutal. I luckily have lived to tell about it and I pour some out for those who came before me but didn’t put it down on paper. One question I have learned to ask myself: is that amount of risk also worth the mental capital?
Everyone needs to be that one guy or girl on the beach living on some coconuts.
No matter the outcome, the mental capital that goes into a big bet is rarely ever worth the payout. The mind is too valuable. Living a meaningful life with a healthy mind free of that risk is worth something that has no price tag.
While this all sounds wonderful, there’s still a twist here. Let me quickly explain.
It’s essentially impossible to live without any risk. There will always be risk around you. From your own personal bets, to your family and your work. The risk is that one of those decisions goes wrong and weighs on your mind. So perhaps the real goal is building around you in a way that fits the risk your comfortable with beyond just your capital or portfolio or trading account.
The best investors and traders I know always talk about managing your monetary risk. They are right. But few will tell you to also manage the risk related to your mental capital, your mind. At the end of the day, the answer to that, is where the real wealth is.
That’s all for now. Yo I should I write more deep posts more often.
(Side note: maybe this is the real reason why Treasury Bonds have been in a near 50 year bull market. If you saw my post the other day, you get it. Because it’s really about more and more people who are ditching all the risk to their mental capital. Buy the Treasuries and walk away. 😂)
In the world of economics, a certain phrase should be popping off like a young millennial who just chugged a White Claw at the Red River Showdown yelling, “It’s lit!”
But it’s not.
It has been happening beneath the surface for several years now. I have failed to really understand the significance of it. Regretfully, I am here to tell you I arrived late. At this point, I am only writing on what has already happened. The smart money has been made.
The Government sometimes needs money to fund new initiatives and keep its doors open. It raises money by issuing bonds. These bonds have an interest rate that they promise to pay investors for loaning them money. Okay this pretty Econ 101, but this stuff has been happening since Ancient Rome when emperor Diocletian was fighting inflation within a world of 15% interest rates.
Things have changed quite a bit since Ancient Rome. This is especially true for the Central Banking system. You could make an argument that the Central Bank you know today did not exist until 1931. That’s when a Central Bank, for the first time, ditched the gold standard (for the trivia squad out there it was Great Britain who did it first).
Prior to that, everything had been connected to gold in some way. What I’m saying is that the Central Bank you know today, is less than 100 years old. A gold standard Central Bank is entirely different from a non-gold standard Central Bank. This means your great aunt Cindy might be older than the most important institution to literally everyone’s economy, across the globe.
This is not your grandpappy’s Fed.
As the Fed and other Central Banks age, they discover new and interesting ways to conduct their business. And that’s natural. When my grandma hit 80, I remember her eating habits changed quite a bit. She was open to anything and everything! Put a plate of food down, and seconds later it was gone. We eventually nicknamed her, “The Wolf.”
Since the Financial Crisis, Central Banks have found new way to YOLO. The Bernank, jellin like Yellen, and Super Mario have been at the forefront of this change in Central Banking magic.
It starts with the countries these Central Bankers work for. They tend to have some glaring issues. One of those is debt. It’s hard to find a major country today that does not have debt. And a lot of it. I guess that’s just the way things are going at the moment. Excessive debt leads to worry, the worry leads to fear, and the fear leads to instability. This gets even worse when you’re trying to recover from something as serious as the 2009 Financial Crisis.
It’s a terrible situation to be in.
It’s like a student coming out of college with a boatload of student loans and no good job prospects. The only way they can survive is if they take another loan at a higher interest rate to fund their next steps. But now, the losses and debt are growing on top of each other. It hurts my mind just to think about.
The cycle gets more and more viscous.
Most Governments, in the last 10 years, have found themselves in this precarious situation at some point. In 2010, fresh from the Financial Crisis, the US 10-Year was nearing 4%. People were flat out scared! Today, it’s at 1.5%. What’s so strange about this is that things are magnitudes better now than they were then. You see, it’s supposed to be the other way around. We are taught that risk-free yields like Treasury bonds go higher in good times and lower in bad times. Because, for example, in really dire times, when all around you is melting down, people would rather own a risk-free asset like a Treasury Bond than a few shares of Beyond Meat.
This could not be more wrong at the moment. Burn the textbooks.
Enter stage left, The Great Debt Monetization. A time when Central Banks, not long ago, realized something. Why don’t they start buying their own Government debt? Buy the debt, collect the interest, return the profits and principle back to the country all while pushing interest rates down so that it becomes cheaper for the Government to borrow money in the first place. It’s giving your local Government the best refinancing terms imaginable. The Fed is saying, “don’t worry, even if markets get scared, we will be there to buy back your debt and fund you. Even better, we will make it cheaper for you to borrow. Heck, why don’t you borrow more money now to pay back your old debts that had higher interest rates!”
They are, “monetizing the debt.”
It’s why we have charts showing Spain and Portugal 10-Year Government Bond Yields drop from levels of 15% to almost negative today. Yes, from 15% to negative in under 10 years time. The Central Banks shot their shot and the crowd is going wild:
There’s no other explanation. Did people suddenly just get that excited about the Portuguese economy to swoop in and buy tons of their debt on the open market pushing it to nearly negative? Not a chance. Someone with infinite fire power did that.
This is also why an economics PhD and rising star in the bond management business is getting crushed today. Literally from hero to zero. His name is Michael Hasenstab.
In a normal world, interest rates should rise as an economy gets better. In a perfect PhD world, with the S&P 500 just near all-time highs, and GDP rocking, bond yields should be trending higher. But, they’re not:
It is a new world out there for economists and investors. For everyone. The old legacy ways of investing are dead. Because there’s a buyer you don’t want to get in front of or take the other side of. And they will be there as long as they have to be.
The following chart is presented without much comment – see all the bars going upward? That’s Central Bank holdings of public European debt. See the bars going downward? That’s every other sector and their holdings of public debt:
Now here’s where things really get wild. Let’s talk about expectations for the future. There’s no reason not to expect Central Banks to monetize Government debt. In good times and in bad. Why wouldn’t they? I often look back at the PIIGS (Portugal, Italy, Ireland, Greece, Spain). Remember when every European country was about to go bankrupt? Now most of those countries are nearing interest rates on their Government debt that is nearing negative. That’s because the European Central Bank has their back. Super Mario Draghi is backing up the truck and loading up as I type.
You won’t find this in your macro textbooks from 99’.
Strangely enough, though, is that this might be the future of modern Central Banking. Monetize debt as often as possible. Perhaps in times of crisis push rates negative. Pump money into the Government by flooding them with cash, buying their bonds, and helping pay off their debts at cheaper rates. More funding at cheaper rates, more spending, more construction, more direct investment into the economy as opposed to boring alternative methods. I mean come on. Lowering the the Fed funds rate is so 2000s.
Negative interest rates on Government debt… what the!? Who would even buy those bonds!? That’s what most people are trying to wrap their head around. But you know who would help fund Government debt to the point of driving those interest rates negative, purposefully losing money on their investments to that Government body so it can spend more and stimulate its economy? I can think of a certain someone.