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- [00:00]
Podcast Host
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Podcast Announcer
Jobs we are excited to announce the launch of a new podcast, First Principles with Andy Constant. There are a lot of shows out there that give you opinions on what is going on in markets, but the goal of this show is to go deeper. We want to focus on the lessons and frameworks behind what is happening so we can all develop a better understanding of what actually drives markets and the economy. Less about what to think, more about how to think. In our first episode, we discuss Andy's lessons from investing through bubbles and what it can teach us about AI today. If you would like to continue receiving new episodes of First Principles, you can subscribe on all major podcast platforms using the links in this episode. Description thank you for listening. We hope you enjoy the new show.
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Andy Constant
Being able to pick the top not only of just a general market, but an actual bubble. That's the Holy Grail. I mean, nobody can. You can't find the Holy Grail. It doesn't exist. The reason why a bubble regime is so difficult is because it plays precisely on human nature. You see your neighbor up 100% on some semiconductor stock. It matters to you. Not only did they cut, but they did surprise cuts. And this is from the same guy who, you know, 40% ago had used the term irrational exuberance to describe the stock market he was cutting into a stock market that was up 40% from when he made those comments. There's the root conditions, which don't have to be a bubble, but root conditions can become a bubble. Then there's the escalation events and then there's the peaking. And I think we're in that phase right now.
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Podcast Host
Welcome to the first episode of First Principles with Andy Konson. Andy, thank you so much for doing this with us. We're excited for you to be here with us today.
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Andy Constant
Yeah, I'm excited, too. It's going to be interesting.
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Podcast Host
There are a lot of shows out there that give people opinions on what's going on in the markets and we're going to do some of that on this show. But I think the overarching goal, what we hope to accomplish here is to have a discussion that goes deeper on a lot of different subjects. And what we really want to do is focus on lessons and frameworks behind what is happening in the market so we can help our listeners and our audience develop a better understanding of what actually it is that drives, drives the things in the markets and drives the economy. And so it's going to be less about what to think and more about how to think. And we couldn't think of a better person to launch this show with than Andy. So it's going to be fun, it's going to be exciting, it's going to be informative and appreciate people watching and supporting our guests like Andy. We're going to use your first or a recent substack post that you did where you were talking about bubbles, and it's a very, I think, timely post. I think it's on a lot of investors minds in the current market today. Are there bubbles forming around us or are there not? But I think, you know, today's discussion is going to be about talking about what bubbles are from your perspective, how they form, how investors can recognize and, and how kind of we see things playing out in the current market and what, how investors might be, you know, trying to, or thinking about things. So that's the topic of today's discussion. That's the first sort of topic of the show. And yeah, so let's just get into it. Andy, how do you, when you think about defining a bubble, I mean, in retrospect, it's always everybody's like, oh, yeah, it was obvious we were in a bubble and you know, we will, we all should have seen it. Or we did see it. But, you know, how do you, how do you define a bubble and how do you think we can see it maybe in real time?
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Andy Constant
Right. So I don't think you can. I don't think it's well easily defined in foresight. It's incredibly easy to define in retrospect. And I think that when people hear that term, particularly in this day and age, where everyone wants to know, are you a buyer or a seller, Are you long or are you short? And those are important, very important things, obviously. But when you talk about a bubble, it's hard enough to appreciate what's different in a bubble like regime versus that's hard. It's impossible to determine when a bubble's going to pop. And so this conversation has to be about what is different in a bubble regime. Not hey, the bubble's about to pop. Like that's a call. As a trader, as an investor, I'm going to change my portfolio if I think I see something that indicates the bubble is pop or is about to pop. But I will tell you, that's like the holy grail of investing. Being able to pick the top not only of just a general market, but an actual bubble. That's the holy grail. I mean, nobody can. You can't find the holy grail. It doesn't exist.
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Podcast Host
How do you think you would separate a market that is expensive and maybe over owned by investors from one that is actually seeing bubble like I guess, characteristics. But that's being defined or influenced by a real technological breakthrough? Because that's kind of where we are today, right? I mean the market's expensive. A lot of people are owning these AI related stocks. They're all baked into the Mag 7 to some extent in terms of. But you know, then you have this AI breakthrough that's happening. So how should an investor sort of grapple between those two things, do you think?
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Andy Constant
Well, I mean, the first thing you said is something that you hear a lot about in markets. Overbought, expensive. I think the first thing one I do as an investor is just respect the fact that the current market prices are the current market prices and that they're neither expensive nor cheap, they're neither overbought or oversold. I mean just even those words like overbought or oversold, it's just not the way I think about things in general. And the reason is, is because at this very moment every single investor on earth has by and large, like, I mean, I guess maybe somebody's about to trade. But by and large, every single investor on earth, no matter what their horizon, has exactly what they want to own. If they're short, they have exactly what they want. Short, they have the leverage they want, they have the cash they want. Everybody's at equilibrium. And so there is no such thing as overbought or over owned or oversold. It's just sometimes various cohorts are doing things in markets that appear unsustainable and so the idea is that when people use the term overbought, they mean some them, whoever they are, have bought more than they should have and are likely going to have to liquidate. That's a classic definition over a bought. So firstly, I just humbly say that when I look out at investing, I think no one really knows that the best thing to do is to recognize that you don't know which way the markets or the economy or technology or anything else is going to go. And so you just own a passive, well diversified investment set of investments and just go about your life. So that's the number one principle when I think about all this stuff. But I think there are differences, Significant. Assuming every market price is accurate, there are still differences in the sort of regimes that exist. And a bubble regime is what I think we have entered into. And so let me get to that. So what does that mean? Well, bubble regimes have certain root causes and certain sets of characteristics that you can loosely define as bubble like. And again, it's not a precise thing like no one can predict that we're actually in a bubble until after the fact. But for me, I've seen a number of, and I've studied even more. I'll only cover the things that I've actually seen in my real career, but I've studied a lot of other things. The environment today looks very similar to other bubble environments. And I look at four of them that we've had in my career. The first one was really kicked off in 1981, 1982 and persisted through the crash of 1987. And it wasn't a bubble the whole time, but it was a regime that ultimately delivered a bubble. Similarly, the Internet bubble, which started, I like to say it kicked off when Netscape Navigator was invented in 1995. And many, we all became aware of how the power of connectivity and that wasn't really a bubble for a number of years and then became a bubble. 2006 to 2000, 2005 to 2008 didn't really start as a bubble became a bubble. Then we go into things that are not risky equity or credit assets, but are bonds, government bonds. After the GFC where short term interest rates were set to zero globally went in one direction for an extended period of time, they rallied for an extended period of time and then ultimately when Covid hit, they became a bubble, rapidly accelerated to basically zero interest rates and that bubble resolved in the following year. So and then today a lot of the things that I look at are bubble like we started A. And so let me get back to how I think about those. So those are the five cases I'd like to sort of think about. So let's get started with Trading at
- [11:53]
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Andy Constant
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- [12:29]
Podcast Host
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Andy Constant
Not exactly what we'd expect from an Oscar winning director. Excellent Simon Williams audition for Wonder Man. I'm gonna need you to sign this.
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Co-host
Assuming you don't have superpowers,
- [12:43]
Andy Constant
I'll never work again. If anyone found out, my lips are sealed. Marvel Television's Wonder man, all eight episodes now streaming only on Disney plus. These types of environments typically start with something new and something new in the Internet boom. And if we're in a bubble today, the AI boom was technology was some new thing. And you can look back to and again before my time, you can look back to a variety of industrial revolution technological advancements. You can look to China where they made a huge productivity move bringing people from the farms to the factories. You can look at major productivity changes as it tends to lead to some sort of bubble like equity outcome. So there's a new thing. That's technology in 1982 through 87, the new technology, it wasn't really new technology. We just had ended a major inflationary episode. The United States deregulated the financial industry, in particular the savings and loan industry. There was a small technology advancement which was the invention of Lotus 123, which allowed people to easily scenario analyzed companies. And there was the innovation of Mike Melken in terms of creating a market for high yield debt. And that kicked off the thing that was really new to the markets and that was the LBO. And so when I think of the 1987 crash, I think it was impacted by lots and lots of things. And all bubbles have lots of things going on them. But in 1987, that bubble was driven a lot by a trend toward the LBO. We know what kicked off the something new in 95, in 2005 through 2008, where you had the housing boom. We had a period of time where globalization had essentially ended inflation. And with the end of inflation. Financial conditions could be left very accommodative with no risk of inflation. And that created a levering up in banks and in the housing market. So the new thing was the end of inflation and globalization. And that was a driver for what ultimately turned into a bubble. And by the way, this is what I think, I could be wrong. This is just how I'm thinking through these things now. As I said, ZIRP and QE drove a bubble in bonds which ultimately peaked when the economy was shut down during COVID And then today we have the ChatGPT moment, which I don't remember what you thought about it, but I thought on January 10th of 2023 when Microsoft made its investment in OpenAI, you know, for many of us we'd been playing with the first version, first public version of CHAT gbt, a new version had just come on. And for any of us who have done any sort of statistical analysis through their careers, there's been a slow burn of regressions leading to neural networks needing, leading to machine learning, all happening as compute power increased. That's been a 40 year slow burn in terms of what ultimately inflected with that pretty much one off event when the AI trade has been one direction since then basically. And so I like to think of those as the precursor to the bubble behavior, which is either a significant regulatory change, a significant easing or a significant technological development and so, or lastly a significant exogenous event. The bubble of the bond bubble would not have occurred without Covid. And then you have escalation events and that happens along the path of that framework and that's when you go into a bubble. And for me those things were just an explosion of deals in 1987, in 1998, the long term capital easing ramped and escalated the tech bubble. In 2005, financial engineering in particular Tranche CDO's Tranche Mortgage product doubled, tripled X the leverage squared the leverage, whatever you might want to call it, and escalated the housing bubble. Obviously the pandemic itself was the final thing that caused the bond bubble to go parabolic. And then as I said, I think we saw some unnecessary easing of financial conditions Today we had a super hot inflation print. It's been, I don't know, 62 months since inflation is above target. And in 2023, and even in early 2020, late 2022, before this whole AI trade got started, the central banks, in particular the Fed, eased to deal with financial stability around the banking crisis. The small banking crisis we saw in the spring of 2023 and they gave up on their inflation mandate and that escalated this thing. So those are the things. There's the root conditions, which don't have to be a bubble, but root conditions can become a bubble. Then there's the escalation events and then there's the peaking. And I think we're in that phase right now. We're in the peaking phase now. How long that can last? Quite some time. We saw Long Term Capital got bailed out in October of 98. It took almost a year later. The NASDAQ still had enough oomph to rally 60% in six months leading up to the final peak. So it can happen, it can take some time. So let me take a breath. Anything you want before I.
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Co-host
Well, actually a few different things. One is, I want to ask you, you were investing through it, did you have any takeaways from the Japan bubble, like of the 80s?
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Andy Constant
So let me be clear. So I worked for Salomon Brothers, Solomon Brothers had a massive presence in all these markets that I just mentioned. And as a personal investor, you're highly limited in terms of what you can actually do. But one thing I'd remember doing is buying the Japanese. The Nikkei put warrants that existed in 1989 as the bubble peaked.
- [20:40]
Podcast Host
But you got those cleared with compliance, right?
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Andy Constant
You had to hold them for like days or something. It wasn't a trading thing. Yeah, you just. I mean, that's throughout my whole career on the sell side. You know, you just can't. We just can't play for good reason. You know, you're for one. It's distracting. I think that's the principal reason why they do it. There's the compliance reason, which is insider trading, all that market manipulation, getting in front of clients, all that sort of nonsense. But I just don't think they want you trading all day in the end, or at least I thought that initially. In fact, I still do. So yeah, you can't really do much investing, but I did get to see every other type of investor flowing through the market. But yeah, I mean, the Japanese bubble has many aspects of those same things. In particular, you know, it was a housing bubble, it was an equity bubble, it was an easy money driven bubble. It was all manner of things.
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Co-host
What was interesting to me, like hearing you go through those. It was 87, because I wasn't investing in 87. But when you typically hear people refer to historical bubbles, like 87 is 1 people talk about as a crash, but they don't really talk about it as a bubble. So it was interesting hearing you talk about the event that led to that.
- [22:03]
Andy Constant
You know, most people don't know that in from the. If you bought stocks on January 1, 1987 and you sold them on January 1, 1988, you broke even that. The crash of 1987 just brought back, just gave away your 1987 returns. The peak of the equity market ahead of the crash was up, I think, 31, 31 and a half percent ahead of the crash. And all it did is give back. So I think you can't look at the 1987 crash without looking at the first nine months of 1987, which looked bubbly. But I do agree not many people talk about that as a bubble. I talk about it because I find there's an interesting market mechanism dynamic there regarding portfolio insurance that maybe for a later time we'll talk about. But portfolio insurance and zero DTE options right now rhyme. And those had a very big impact on the ramping pre crash and then had a massive impact on the crash itself. So it's just an interesting, to me, interesting dynamic.
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Co-host
Yeah, that was gonna be my question because I think it. That was probably the most mechanical. Right. Of the bubbles. You would describe it maybe.
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Andy Constant
Yeah, yeah. There's a. There's an aspect of every bubble that has sort of normal mechanical activity.
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Co-host
How do you think about like having gone through these? I like, I've gone through a few myself and I always question, like, am I any. Do I am any better at this or do I still get wrapped up in the whole thing? Like right now I'm talking about AI as a transformative technology. So it's different than other things. Like do you feel like you get better as you go through these or do you feel like there's a human nature to this that like, it's just very hard to learn the lessons of the past ones?
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Andy Constant
Well, the problem is most people's careers are relatively short and so we don't get to have many, many lessons over time. But what I would say is, without a doubt, human nature across these bubbles doesn't change. Like, guys who were my age back then may have seen bubbles before and may or may not have participated in the bubbles that we've seen when we were in the younger part of our career. But the people today that haven't had any experience, they're not well equipped to understand what it's like. And the bubble is perfect. It's a perfect. The reason why a bubble regime is so difficult is because it plays precisely on human nature. You know, you See your neighbor up 100% on some semiconductor stock, it matters to you. You are affected by that. You are not affected by them up, you know, 60%, I don't know, 15% on their s and P when you've been in cash. But if they're getting enormously and suddenly rich, which is unique to bubbles, I mean, not unique, of course there are people that sometimes get lucky. But when not only this neighbor, but this neighbor and this neighbor are getting enormously rich, suddenly that only happens in a bubble. And it's incredibly compelling. I don't see how, honestly, I don't see us humans, how we can combat that without incredible discipline or just. Well, I don't think we can. I think it's one of those human nature things that there's just bubbles beget behavior. That's the point.
- [26:09]
Co-host
I remember the same thing in 08 because I knew some people who are buying three and four houses on these stated income loans with nothing down and they were just making a killing. Like, at least on paper the houses were going like crazy. And it's like, why am I not doing this? Why am I not buying these houses?
- [26:22]
Andy Constant
Yeah, I missed. So I have to admit I did not see that part like the, the, the housing bubble per se. Yeah, I saw it just didn't affect my neighborhood or my community, my, my, my friends and my, and other investors that said credit investing and the way to make money using the securities that came out of that was highly speculative.
- [26:53]
Co-host
How do you think. Can you talk a little bit about the late 90s again? Because you wrote the piece about the analog. Between that and you Talked about the 94 bond market crisis and Greenspan's pivot. Can you just talk a little bit more about the late 90s and the analog you see to today?
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Andy Constant
Right. Again, I think you start with conditions. And the conditions are we had right before Netscape Navigator came out, which again, I'm just putting pinning that as being at the time was a big deal. It was a sudden wake up to the rest of the world. One year prior to that, the central bank had gone in, had basically banked, rupture the mortgage market, bankrupt the Orange county pension fund and created a massacre in the bond market and then pivoted. And when they pivoted, they eased financial conditions in a meaningful way. So the money, the money creation, the credit availability, the price of money started ahead of this 95 technological event. Very easy. So that's a good start. And so then you have this period of time between 95 and really 97 where people thought, wow, this is going to be a big deal and we're going to need all manner of capital investment. And that capital investment started being funded and started flowing through to, you know, market prices and deals were getting done and so on. And that was a period of time in which we all know what was happening. But at the same time there was no sort of like euphoria, there was just this is going to be a big deal. So when I think about that, I think about the prelims to what we're involved in now and the prelims to that were the stock market bottomed in early October, maybe 6th or 7th of 2022 after the Fed had gone through this hiking cycle and announced QT and started doing qt. Bond market had sold off from its bubble and all of a sudden we have the beginning of an easing cycle. And so that set us up to a point. Meadow was in the 80s and all the stocks that are now 10x that or 5x that were all double digit stocks and now they're all deep into the triple digits, all the MAG7 Nvidia. And then we had October, sorry, we had January of 2023 and that was the Netscape Navigator moment. Soon after that we had the SVB crisis. And so we had the next couple of years was a very nice run Runway for technology, but we hadn't had the escalation, the meaningful escalation. And that brings us back to 97 and 98. In 97 and 98 what happened? We had an Asian crisis because all this easy money flowed outside of the United States and went into Indonesian taxi companies and Thai companies. And there was a speculative frenzy in Asia that unwound suddenly causing stocks to US stocks to crash and then recover. And then we had the long term capital crisis in 98. And so when I think of those proxies, I said October 97 we had an Asian crisis. October 98 we had a long term capital crisis. Huh, well that's interesting. 2025 we have Liberation Day. 2026 we had the war in Iran and we had major sell offs, similar timing. So now you have those things, they've been resolved, the financial conditions have been kept easy because they wanted a successful resolution of those things. In 99 and in today you're having a expectations explosion which in the, you know, I point to, I pointed to something in one of my posts in March, right in the middle of the Iran war, the chairman of Nvidia came on and made a very, very aggressive announcement about Capex and We all knew Capex was coming, but it had a step change in expectations for semiconductors. The semiconductor stocks ended up falling. But that step change ultimately when the war was resolved, immediately got recognized and started a parabolic move in semiconductor stocks that we're still in the midst of. And so you have to look for that step change in expectations. A world in which the bubble, the main asset that's in a bubble, is flowing through for expectations for earnings that are simply never going to be bad. And you had that in 99 as well. So we're somewhere in that phase where you have massive expectations of immediate benefit from the technology that has resulted in a parabolic move in assets.
- [33:32]
Co-host
Yeah, and I do wonder, like when we look back at this, I wonder if we'll look at the announcement of Claude Beatos, because that was very tied to, you know, the move in semis recently. I wonder if we'll look at that as a big event in terms of like what ignited a parabolic fees here.
- [33:43]
Andy Constant
Well, I mean, I think that one lines up better with timing, but I think there's a lot, I think a lot of what, again, I don't know everything, but I, the what I see a lot of the bullishness on semiconductors is the step change in earnings expectations. We already expected 60%, 70% increase year over year in earnings. In March you had a change from 60 to 70% earnings growth for the next couple of years to 100%. I point to that, but I think yours lines up better on timing. And that's the way things work. You know, you just have these, you know, you don't, you have this constant, what's the right word? You prime the pump with the main thing and then each time you get an accelerant that makes you go the next phase up.
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Co-host
Can you talk a little bit more about Long Term Capital? Because you talked about that in the pieces. What happened in the wake of that is something that might have ignited the last phase of that bubble. But could you just talk about what happened with Long Term Capital? I mean, you've talked about bubble like regimes. Is that the type of thing you'd expect to be happening in a bubble like regime? You know, they weren't really necessarily directly associated with the bubble.
- [35:05]
Andy Constant
Right. That's an interesting point. You know, one of the. There are a couple of things that happened during a bubble. You always look for what I call contagions that could either cause the bubble to extend or are consistent with the post bubble world Long term capital had. It's interesting, One of the contagions you can have in a bubble is those who are fighting the bubble being bankrupted. But generally those don't have meaningful contagions because whatever they have to dump, they dump and whatever unwind. There's so much liquidity around, there's so much available capital around that losses can be absorbed by the system. So inflation bubble, the period of time when a bubble is inflating, you rarely have contagion. So I don't think the Long Term Capital thing was caused by the stock market rally. There's some tweaky little stuff about their volume position that probably had some impact, but it's not really there. Long Term Capital was over levered in primarily fixed income instruments and got a margin call. The problem is that the central bank massively overreacted. This is what they did is they arranged for the entire fund, which by the way, the numbers are laughable how small they are right now. They forced the, I believe the number was they forced 13 banks or 11 banks called the consortium to come up with $1.3 billion. That's B for billion, not billion, T for trillion. That's crazy nothing. $1.3 billion to buy the positions that Long Term Capital had and assume their positions. So there was, it was nothing. But they still cut significant interest rates significantly to make sure this didn't become a, a financial crisis. It wasn't going to become a financial crisis. It was taken care of. That was that. But they still did these. Not only did they cut, but they did surprise cuts. And this is from the same guy who know 40% ago, had used the term irrational exuberance to describe the stock market. He was cutting into a stock market that was up 40% from when he made those comments, I think. And so that was like adding rocket fuel to the bubble.
- [38:38]
Co-host
One of the interesting things you had in this is we were just interviewing Cliff, as in this yesterday and we were talking about this, this period. And one of the things he said is he's like, Andy beat me to it. He's like, I was going to talk to you guys about this idea that one of the huge differences here is this idea that tech was so much smaller in the 90s as a, as a portion of the S and P or as a portion of the market than it is now. And this is a very different thing because tech is so much bigger now. And like you, when he was going to say that on the podcast, you would come out with a blog post ahead of it and talk about this. But I'm just Wondering like, why does that matter? Was that cliff as nested? Yeah,
- [39:11]
Podcast Host
yeah.
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Co-host
So I'm just wondering how do you think about why that matters? Because that's a really, really important point. I mean, tech was very, very small going into the beginning of that bubble. And now tech is sort of at the beginning of this bubble was a very big part of the market. Why does that matter?
- [39:28]
Andy Constant
I saw somebody talk about how tech could become 100% of the economy and it's just, it's like, no, no, it cannot, it could not become 100% of the economy because I'm going to still want some dominoes or Burger King or whatever. I'm going to, I'm going to, I'm going to want to go play golf. I'm going to want to get my hair cut, whatever.
- [39:48]
Co-host
Until tech cuts your hair, I guess. Which is maybe someday that's going to happen. I'm not sure.
- [39:53]
Andy Constant
I do get a haircut occasionally and beard from. Listen, I just can't imagine. So anyway, the point being there's a bunch of stuff that the economy does that it's going to do and it's going to require stuff that's not semiconductors. So the share of the economy matters. And so when an industry has no share, 4% share and it can 4x, well that's, you know, offers a real significant earnings and stock price upside. But if you're already at 15x, you can't go to 60x, you can't get a 4x because there's not a, there's just not a lot. You can't, there's no, some of the pie slices of the economy are claimed, they're never going to be tech. So that I think that's the point, which is once you start, if you're starting at a small base, you can get a 4x return, but you can't get a 4x return on a limited pie. If you're already a significant factor not only in the investments but in literal earnings share of GDP now, does that mean that we can't see another 5, 6, 10% share growth in earnings coming from the economy in tech over the next few years? We can, I don't know where it's going to come from and who's going to pay for it. And so that's sort of when I think about what the upside for this is. I look at it and I've described this as a pie where great new technology, and this is true throughout history, great new technology increases the size of the GDP pie. It does, it because people get a new tool and can generate more output with that tool, full stop. That increases the size of the piece and a majority of that pie increase. The increase in that pie can go to the tool maker. I got no problem with that. It can mostly go to the tool maker and that creates an increased share of the pie. But that means the rest of the. But unless that happens, any bit of share that technology takes comes from somebody else. And so that speaks to jobs, it speaks to incomes. If technology is going to take more of the share, everything else going to get less of the share. That means everybody's income, that own that is involved in that lesser share is going to fall. So who's going to be the customer to buy the new GDP from the tech? So that's the thing that I think is. So it's all about the S curve in the end of the day. That's a lot of people describe that you can grow a lot when you're small. You can grow steeply until you get to a point and then your growth level's off. It's all the same basic conversation.
- [43:35]
Co-host
I do wonder, we already talked about how you can't time these things, but I do wonder the idea that tech started bigger here, like does that mean there's maybe more potential for the bubble to get bigger and maybe also the more potential that's going to be more problematic for the market eventually because tech started out as such a big part, you know, before the thing even started again.
- [43:50]
Andy Constant
I don't think it can double from a big base and I do think it can double from a small base. So I think that is fundamental. Does it matter that it's big on the way down? Sure, I guess a little bit in that it can fall harder. But that's not, I don't, I don't think this techno. Well, I guess it's possible. I don't want to be. I'm a big believer in statistical analysis that turns into neural network, that turns into machine learning. That as compute gets bigger and bigger and bigger, we can do more and more interesting things that becomes AI. It's been a 40 year journey for me to watch things that happen in the world. Amazon has been able to anticipate my buying needs for 20 years now. They know exactly what I want to buy, exactly when I want to do it. They didn't call it AI back then, but it was AI. Right. So these things have been going on. We're not going away from, I don't think we're going away from it now. Is the new version of AI that's got people excited going to be extra disruptive? Maybe. Or maybe it won't work. I'm a big believer long term in this tool and I do believe technology will continue to be a, isn't going to shrink. So the question is, is it going to grow as rapidly as is expected? That's really, I think, the only thing that we're talking about here. It's like talking about fiber. They overbuilt fiber now. We use every strand. So I don't think that's the story here. I think it's just a matter of expectations and pricing.
- [45:45]
Co-host
Do you think you've mentioned some policy errors like in previous bubbles? What do you think the biggest lessons for policymakers are if you look back through the bubbles you've lived through? Like, what are the biggest lessons for policymakers in terms of the mistakes they've made in bubbles?
- [45:58]
Andy Constant
Gosh, that's hard. I mean, there's so many mistakes. I'm pretty cynical about the ability for the government to do anything but steal from the future and to give to the current. I guess the, you know, we had today, we had the somebody, a senior in the Korean political system suggesting that they are going to tax Korean AI to deliver a citizen dividend. And so, you know, that's an interesting thing. It's a redistribution. It says, these are the guys that are making all the money. We're going to take it from them and give them, give them to those guys. And so governments love to do that stuff. They do it all the time. And you look at housing, great example. Why was housing in a bubble? Lots and lots of reasons. But perhaps the greatest reason is that this country's politicians have always, always favored home ownership and created subsidies for cheaper mortgages. And so when you do that, you have an impact. So, yeah, I mean, I think it's, you know, you're in a world in which major disrupt. So I don't think this AI is going to be disruptive. And I think in many bubbles we've seen disruption. What does disruption mean? It means people lose their jobs. The LBO bubble, if you call it that, was the hollowing out of the manufacturing sector in the United States. That's what we did. The LBOs were socially destructive, according to Dan Rostenkowski, who was the House Ways and Maine's chair, ultimately a criminal, I think socially destructive. And I think we all look back and say, yeah, gosh, we lost our manufacturing. You know, we've got the vice president whose entire career has been about Levering the anger in that cohort. And you can believe it was a good idea or not, but it was. Congress blamed LBOs and decided to target them. And so it's very likely that policymakers can by their actions stimulate bubbles. And when they try to muck with who gets the benefit of the bubble and try to redistribute that benefit, can kill the bubble. Do I see anything on the horizon? Yeah, I do. I mean there's no chance that politicians in this country will allow the complete hollowing out of the income potential of a significant portion of possibly the gross majority of the population from being able to earn a living to allow shareholders of AI companies to become oligarchs. They may not allow it for some period of time depending on who's in charge. But at some point the country's going to rise up and there's going to be a politician who says give me your money. Is that something that's going to happen in the near term? No, but it always happens. So you can count, you can absolutely count on it that at some point they're going to take the money from capital and redistribute it.
- [50:09]
Podcast Host
I want to go back to the point you made about the earnings growth revisions and how there was that step up change that they went from, I don't know what it was projecting 50 to 60% growth, you know, to maybe double that for some of these, some of these semiconductor and other tech related companies. So are you within this bubble regime? Is it that the earnings growth estimates are too optimistic or is it the reaction on the stocks is too optimistic or maybe some combination of both. But I just want to kind of flush that out a little bit because maybe if the earnings growth comes through, I mean then maybe some of these like price moves can be substantiated. But I don't know, I'm kind of asking, right?
- [50:56]
Andy Constant
So, So there's this idea of valuation which has never been a good metric for understanding markets at all. Like there's, you know, we've seen for a number of years some of the usual suspects talking about, including myself, talking about given the pricing 10 year forward returns on assets or equities or whatever are going to be sub normal. You can't do much with that. It doesn't help you to know that to determine whether you're should be buying or selling stocks or whether you're in a bubble or not. It comes down to expectations, positioning and value has become less to me relevant. But for instance, semiconductor stocks on a price to sale, forward sales basis are extremely elevated on a price to earnings basis. Nope, they're fine. They're actually pretty, they look pretty cheap actually. So, you know, you can look at valuations and say does it is our value? I think it is a helpful and necessary understanding to, to a piece of information that is, contributes to a bubble if valuations are crazy, but it's not. You can have a bubble without valuations being crazy. And that's because valuations are based on expectations, based on earnings expectations. And if you have a step change of 50% earnings growth to 100% earnings growth, it shouldn't surprise you that stocks rally a lot on that expectation change. Turns out they rallied more than that, like, well, more than that. Which not only tells you that the expectation, the Recent expectation for 26 or 27 was higher, but all future expectations went up. And that to me is indicative of a market that expects semiconductors to continue to grow well past people's normal horizons, which to me is a bubble indicator. When people extrapolate recent historic growth with an order book, that's by the way, their order books are nuts. They're just unbelievably packed with orders. So they're going to deliver those earnings, I think, I think they're going to deliver their earnings. But at some point. Things don't go to the sky. And so the question is when people stop extrapolating this sort of earnings growth year over year over year. If it delivers. Listen, if, if, if we grow Semiconductor earnings 100% a year, for every year, forever. Just firstly imagine, you know, you know, what, doubling something, what happens to something if you double it for ten years, you know, it goes from one to a thousand. Anything's possible. I mean, I guess it's possible, but this is where I come back to the big, the point I was making earlier, which is, where's it coming from? For one, where's the money coming from to buy all this stuff? Like where's the money coming from? If we need to buy a thousand chips ten years from now and we're only buying one today, how are we paying for it? Yeah, what I mean by that is the chip companies are going to make shitloads of money. I get that, but I'm talking about the customers. How are the customers going to make the money to do that? Because the customers are getting disrupted. So if you look from a macro standpoint, I think it's very possible. And again, it's one of those funny things. If semiconductor earnings deliver such that their valuations and their such, you can continue to get sizable returns owning semiconductor stocks. A bunch of other companies are going to be really struggling. And so the bubble may stick, we may grow into the. I don't. Listen, I don't think there's any chance we will. Just to be clear, I'm not timing the market but semiconductors could double. Fine, got it. They aren't going to go up much more than that. And when they stop going and unless everything else gets crushed and I don't see how that's possible, I don't see how you can have continued semiconductor demand except for one thing. Massive leverage. The only way you can get the rest of the economy to get its share of the pie and semiconductors to get their priced in growth is through massive leverage borrowed money from the future. So far we haven't seen that and more importantly so far we haven't seen the financing. I think one of the things that we miss when we think about all of this is where is the source of the rally from the semiconductors? The source is that people are buying a lot of chips. Who's buying a lot of chips? Data centers and hyperscalers who need compute. Why do they need compute? Because people, frontier models are demanding compute. Now are the clients demand of the frontier models demanding compute? Yes, partly. But also the frontier model builders are demanding compute because they want to create the next thing which will actually be the thing that changes the world. You know, as you know LLMs are going to do what they're going to do but it's the next thing that's going to that they need to continue to advance to get that to be really the productivity miracle. So you've got this chain and people like to call it circular financing. I don't. It's pretty straightforward computer. It's all about compute. We need a bunch of money to build compute. And if you just think of it that simply where's the source of money? It can come from revenue from those who already have installed compute. It can come from revenue that happens from the frontier models or it can come from borrowing and financing. And so what do we know about that? Well the first. What do we know? We know the capex promises are massive trillion dollar capex year over year which has doubled from the prior year. Which doubled from the prior year. So we know there's a tremendous amount of capex. The source of money has mostly there's been a little bit of it coming from the. Frontier guys but most of the source of the money has come from the hyperscalers and they've handed that Money to Nvidia who has then handed it to others. And I get that. But most of the money for the compute build is coming from the hyperscalers who are building the compute. And that compute needs funding. And so the first source of funding was okay, we've got plenty of cash flow, free cash flow. That means their customers by giving them profits for their tools, allow them to spend that cash flow on instead of just putting it in the bank and accumulating cash, spend it on capex. So that got used. They had a cash hoard already from years and years of being a capital light business Businesses they're spent that now they're canceling their buybacks because they had been using cash flow to buy stocks. Their stock back in meta canceled theirs 2/4 ago. Google canceled theirs this quarter. Amazon doesn't really buy. Microsoft has shrunk its buyback for a while now and they'll likely cancel more. So that takes a bid out of equities just as a broad thing. And they're issuing corporate debt, lots and lots of corporate debt. All of those things, that lack of stock buybacks, that additional corporate issuance all is how this capex is going to be funded. So you have to ask yourself who's buying the corporate debt? Do they have the ability to buy that corporate debt to lever up to buy that corporate debt? And what about the pricing? Because eventually all capex ends when the cost of financing is in excess of the return on the capex usually happens after it's already, after it's already crossed over. Classic business cycle. But right now we're in the face of everybody wants to buy compute and everybody needs money to buy it. And so one of the things that's a potential catalyst for a bubble top is that issuance being a headwind on assets. And so I'm looking with great curiosity about how the three frontier model guys are going to ipo. Just their proceeds alone rivals the proceeds of even corrected for inflation, et cetera rivals the proceeds for all 400 of the IPOs that happened during the four years of tech, all coming in three tranches this year, corporate debt exploding higher in terms of issuance. That supply to me is the big risk if they get it done. If somehow the financial markets lever up and take on that debt, take on those IPOs, take on more risk assets relative to their capital lever up, then you get a virtuous circle because the money does get spent on compute. And if it works, if it delivers, the promise of AI will pay off as a positive roi, which means Everybody will get, who invested, who lent money to these companies will get a nice return. So there is a very bull case. If without a hiccup, all of these financing, all of this capex gets funded by the market and the capex delivers ROI without a hiccup, you can have an extremely long, not this. That's how you grow out of a bubble. Like bubbles can bubble and then consolidate for years as earnings grow without ever popping and you can get back to health. That does happen, it's just very unusual. Now at McDonald's a McDouble is 250. So you can get your gym gains on or just get lunch for only 250. Get more value on the under $3 menu. Limited time only. Prices and participation may vary. Prices may be higher for delivery.
- [63:25]
Podcast Host
I think that was a excellent overview of sort of looking at today's environment. Specifically with you can taking this semiconductor question, taking my question and really getting at sort of like the first principles under the surface, how you should think about this. Where does the money come from? Like are they going to get the return on the investment that they think they're going to get? All this stuff is very first principle,
- [63:51]
Andy Constant
you know, based and the consequences for everybody else.
- [63:56]
Podcast Host
Right, right. Those are important questions. Yeah, absolutely. I mean, I don't know. And that's exactly why we want to have these discussions with you, Andy, about this and a number of different things in the future. But just to sort of try to sum up, if I could explain it back to you, you know, at a high level, a bubble forms when something new comes to the market or the economy, whether it's a new technology, a new financing sort of scheme or what have you. And then that kind of puts us in this possible or potential bubble regime. And once you enter that bubble regime, you have escalations that take place and they can take different forms. Obviously you have sort of like the fomo, the neighbors over here getting rich. You have everybody talking about sort of how they're making money in this bubble. And that sort of puts us in this bubble peaking phase, which is to your point, it's hard to time, but there are signals that, you know, you can kind of look to that say, okay, this looks like we are in sort of maybe the tail end of the bubble. Do I have, am I explaining that back to you in a very simple simplistic way? Do I have that right? Did I miss anything?
- [65:10]
Andy Constant
Absolutely. And I think the, the key thing there is we're somewhere along the way to this, in this escalation and FOMO regime. And so the question that maybe we can address in another time is what do you do about it as an investor? Like George Soros used to say, and I'm sure this has been misquoted, that when he sees a bubble, he rushes in to participate. I'm no George Soros, and I think I'm late to this being a bubble, so I'm not rushing in. But as an investor, you have to think about whether you want to. You know, the type of mistakes made during bubbles are the most costly. And so and that's the reason why the regime, identifying a regime that's a bubble is important because you have to change your behavior. You have to resist keeping up with the Joneses.
- [66:08]
Podcast Host
In the next episode with you. That's what we're going to discuss. You know, our plan is to do this show with you monthly, but I think for this discussion and this next one, we want to get this out sooner. So we'll record that here in a couple of days and we'll put these episodes out pretty close to each other. This has been a great conversation.
- [66:23]
Andy Constant
That was great, guys. Thanks.
- [66:24]
Podcast Host
Thank you for tuning in to this episode. If you found this discussion interesting and
- [66:28]
Podcast Announcer
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- [66:37]
Podcast Host
have any feedback or questions, you can
- [66:39]
Podcast Announcer
contact us@excessreturnspotmail.com no information on this podcast
- [66:45]
Andy Constant
should be construed as investment advice. Securities discussed in the podcast may be holdings of the firms of the hosts. There's a new way to sweetgreen Meat wraps Handheld, hearty and made for life on the move. With bold, chef crafted flavors, fresh ingredients and over 40 grams of protein, they're built to set satisfy without slowing you down. Try wraps today in the app or at order sweetgreen. Com available at all participating locations.