Jim (3:04)

Yeah, you guys have probably heard me say this, but I think it's one of the most powerful ways to think about markets and valuation. So much of how the average person thinks about investing is based on fundamentals. And yet academic research clearly shows that fundamentals have very little net effect on market and stock outcomes in any period less than 10 years. And that's a pretty crazy stat given that that's all that CNBC talks about and 90% of the world thinks about when they're thinking about do I want to own this thing or not be on this, not on this thing. That said, as Shiller has shown in his research and lots of others have shown over a 10 year period, they are incredibly powerful and predictive. In the words of Benjamin Graham, you know, in the short term markets are a voting machine. In the long term, they are a weighing machine. And what does that mean? That means the short term, it's just a function of supply and demand. How many buyers are there versus how many sellers? Since time incarnate, if, if, you know, if somebody came to the agora and ancient rome and had 10 cows and there was nobody, no one there to buy the cows except one person. Guess what? They got a, they got a really good price on those, those cows. And it wasn't about what the cow was actually worth or how much it could milk, it could produce, or how many people it could feed. It was about, you know, how many buyers and sellers there were and what, what those counterparties were willing to pay for that thing. That's still 100% the truth. I use the metaphor. People have heard this. But I think it's so powerful. Airplane flying through the sky, right? The elevation, the altitude off the ground is, is actually fundamentals. That's valuation. That doesn't determine where the plane is going. It matters eventually, once there is no gas is the ultimate thing that matters. It's the Only thing that matters when there's no gas in that airplane, how far it can go. But in the short term, all that matters is the amount of gas in that tank, the amount of liquidity for markets, the amount of buyers versus sellers. That's what matters. And that's why we continue to, and many, many times look at the markets and say, how could this possibly go any further? And it just goes to incredible altitudes. Inevitably, something will happen. Liquidity will be drained from the system. It's just statistics as probability. There is a eventual amount of time. Ten years is a long time that. That something happens. Maybe it's a complete black swan. That's unexpected. Maybe it is a response to the price itself and the Federal Reserve or some other entity pricking the bubble. But at some point, that liquidity is withdrawn. And the biggest provider of liquidity in the world, and this is the hardest part to think about, is not the Fed, it's not the economy, it's not the treasury, it's markets themselves. And so once that plane goes into a stall, right, at some point, there's not enough liquidity you can put in the tank to get it going again. And the market itself will draw liquidity out of the system and force outcomes. But this is how it all works. This is this the broad picture of, of how things move. So you can simultaneously be very bullish in the short term because you're like, there's a lot of gas in the tank. And they got these planes flying by that can link back up and refill the tank. And there's all these things. And so the trajectory of where this plane's going is likely up. You can believe that while still being 70,000ft off the ground. And knowing that when that gas tank does inevitably go dry, that the decline is going to be way bigger than you could ever imagine. And this is why modeling and thinking about things in distributions, as opposed to up, down, is so important. This is why risk management, because you never really know when that black swan or that thing is going to happen. Either that risk management is so important. So we are entering a period, put a bow on this. That is fat tail. We are 70,000ft off the ground and we can get into that.

Dave Notig (7:29)

So if liquidity, I love all this. I love this setup. If liquidity is sort of the fuel here, then the market structure, which is how the liquidity is pocketed, moved, changed, transmogrified, has to matter a lot. That's been my whole career focused on that. We've seen this huge change in how that Structure is working. Specifically this massive movement into options over the last four or five years. Right. I mean, zero data expiration options are now 60% of the volume in the S&P 500 complex. Right? It's, we've got a whole new raft of players showing up with new liquidity or taking that liquidity from. Maybe they were just in stocks and now they're trading in the options market. How does that change of venue for the liquidity help us understand what's going on or create opportunities or create risks.

Jim (8:19)

When we might do this? Yeah, that is a huge question and a huge trend that's so important. So first, you guys have probably heard me talk about this, but this is again another critical, important thing. Options are not the tail wagging the dog. I've been saying this for years. I think people are finally catching on to it. When I first said it, people like, you're insane, right? What do you mean it's not a derivative? It's literally called a derivative. It is, we, we look at options as a derivative because we started with the asset price. Everything started as our understanding of, oh, this is a thing and it has a value, a single value that we are going to put on it. But what most people don't realize is options model the full distribution of the outcome of every asset. They are incredibly more precise in terms of being able to model aspects or risks or different types of movements of any asset. I could give you two stocks, same market cap, same exact industry, no name, white label, and you would be like, those must be very similar stocks. There must be the same stock essentially. But you could peel back the option chain and you could look under the hood and one could be right distributed with a fat left tail. Another one could be left distributed with a fat, fat right tail. The other one could, you know, one of them could have earnings and growth potential that is way down the road with very little earnings now. And one can have all of its earnings front loaded with a probability of a decline and loss on the back end. The three dimensional distribution of the outcomes and the projected characteristics of the dog, the asset, is what options give you in three dimensions. And ironically, the expected value of that whole rich distribution, just a average of it all, is the stock price or the asset price. And so the reality is it's always been the dog. It just wasn't liquid enough. There weren't enough network effects for it to be treated and used fully much. It is a better technology. We talk about technologies all the time, often new technologies, new ideas that are dramatically better do not get adopted for quite, quite a time. But then once they do they hit that tip, they get all the network effects, they hit a tipping point and then it explodes and it takes over. And that's options right now that's what's happening to options. They are dramatically better. You're playing three dimensions set of two. We're going from flat world to a three dimensional world. Why in the world would you still play in Flatland? It makes no sense. And the reason you would before was because it wasn't liquid enough. Because there was enough understanding, education because there wasn't access, because regulatory issues, because of size constraints. All of those things have broken down. We've gone from when I started in the business we which was 27 years ago we only had quarterly options in the s and P500 every strike was 25 points and we were trading 4 or 500 in S P. Now it's every 5 points with 10 times the size of the underlying.

Dave Notig (11:47)

Is it just an unfettered good though with all these individual investors showing up with the, with the liquidity moving towards this new platform?

Jim (11:54)

Absolutely not. That's the next question. That's the next big topic. 100% now it is a good in the sense that it's more precise and it is more dynamic and allows for more precision and I think the value of that by the way counter seeds overwhelms all the, the negatives by the way my opinion and by the way doesn't mean we're not going to have some blips along the way that'll cause some issues as we evolve and that's just the area grows. But, but I do think there are some issues and the issues are it is a bit more complex Regulatory rules and things supporting the, the options industry are much less sophisticated than they probably should be which allows for mistreatment and issues at the broker level. At the regulatory national level it's also not fully adopted. So most people are playing still in two dimensional land while three dimensional land is having effects on that and so there's kind of a disjointedness between the two. I think that that plays out. I think over time it will be much as it be eats essentially the whole market. I think it'll be much more liquid, much more efficient and, and have a lot less problems. But I think now there's, there's some challenges and it will continue to and there have been for a long time but playing between the options land and the equity land which is kind of what we do and not just equities. Asset land is an incredibly valuable place to be because you're. Not only are you on a rising tide, there's so much inefficiency still in that translation mechanism that allows for dramatic, maybe some of the biggest opportunities on the planet in terms of just scalability and opportunity set. But yes, the biggest part is reflexivity. We talk a lot about that and, and you know, unlike, you know, people think about options like, like insurance. Right. And ultimately tor tornadoes coming through town don't necessarily. Sorry, sorry. Owning insurance for tornadoes doesn't affect the odds of a tornado coming through town. Right, right. That is not true in financial markets. Owning market insurance has significant meaningful effects on supply and demand of whether the underlying asset actually realizes or doesn't realize. And I think that reflexivity, which by the way has always been a part of markets, whether you're talking about options. I mean, Soros talked about reflexivity, you know, many, many decades, decades ago. This is just a more mathematical, precise reflection of it. And that precision is a function of the precision of options themselves. But, but yes, there are difficulties and challenges, but again, the value to me of being able to bet on exactly what my opinion is about an asset, exactly, more precisely is so valuable it dramatically out. You know, it is way more important than any of the ultimate kind of costs and complexities that come along with it.

Justin (15:14)

Just talk about that concept of reflexivity a little bit. I think that's so cool. And it's because some of our audience might not know and honestly I probably couldn't describe it, so I want to hear it from you.

Jim (15:23)

Yeah, no, no, great, great question. To try and simplify it to the best of my ability, we just talked about a distribution of different, you know, every option, option is a moment on the distribution and time and moneyness. Right. For, for each asset. And as I mentioned, the total value of the by arbitrage constraints. By the way, what I mean by that is market makers have to be able, based on what their positioning is on the surface, to hedge it as precisely they can with the underlying. And so if puts go down, if that part of the distribution, the left tail goes down, guess what, the expected value of the stock goes up. The same can happen, by the way, if the upside, the right tail goes up, it's a different part of the distribution, completely different part of the bet. The put side may not move at all, but the stock price will go up as a function of that. And so at the end of the day, the, the movement in the distribution and the positioning in that distribution ultimately drives the underlying asset price. And that's the effect on the underlying. That's the most kind of basic example I can give you. If, if a put starts to decay and a call starts to rally, if Skew goes bid, guess what stock price is going up, right? The flows are going to push a continued bid to, to the underlying asset. But to, to be clear, that's not the only effect because there's also effects of the distribution to volume. So much like the asset price is the delta up, down the. Just the width of the distribution is, let's say the Vix or the, @ the volume, right? And so we, we can see dramatic effects on cross, like a different cross section, which is volatility by what's happening to different parts of the distribution as well. And if you get a decline, let's say in the calls and puts, guess what that means the volume itself is going to decline. And we can project by looking at the underlying parts of the distribution, what's moving, what's trading, what those effects are predictively, not just on the underlying, but on the other cross sections like Vol. Of that distribution, which is the, which is a different measure of that distribution. Right. And again, I know these kind of get wonky and we're talking distributions and. But I do think the more you can enter this world where you're thinking about probability and the outcome of each asset, which by the way, sound complicated, Matthew, but that's how we actually think about things. Whether you realize it or not, I'm guessing when you say I want to buy a stock or sell a stock or buy a bond or sell a bond, you have a much more nuanced opinion than stock good, stock bad. Right? Like it's like I like this stock because. And think about the. Because I encourage people don't get lost in the mathness. You know, sit down with a piece of paper and say, what do I think the probabilities of this is a 10% decline. What do I think the probability of a 5% decline is? What do I think the probability. And guess what you should be able to. You'll have an opinion generally about that. And if you do that, what do I think it's in a month, what do I think in a week? What do I think in a month? What do I think in a year? You've drawn a broad distribution and that is your opinion of that asset, which is way more nuanced than up down.

Dave Notig (18:54)

So what do people get wrong about that? Because I deal with advisors and investors coming in over the transom. Now there are a lot of products that are using options and explaining to, or trying to explain to investors everything from how to use a box spread to pay your mortgage off to how to create instantaneous income out of microstrategy options, that there's a lot going on.

Jim (19:14)

Without sounding like, not, I know, compassionate to, you know, the, the average kind of investor. I think people are lazy. I think the reality is people want an easy quick fix that makes them a lot of money. And I don't think this is that complicated in the end of the day. I mean, I think it is an education. It is something that people need to think about and, and, and learn. I also think it, people get lost and confused in the, in the math. And I do think it's, it's. These are things that can be, the math part can be easily translated, relatively easily translated by, especially nowadays with AI and other things. If you say I have these precise opinions, you just need to be more precise in terms of what your opinion is, what you're trying to express and why. And then the value of those options become incredibly more valuable. I also think, you know, the product speaking to the, all the products coming out, structured products and this ETF and that. I think people dive in without doing their due diligence. And guess what? You know, that's how you get in trouble. I think you need to do. What do you do? What are you buying? What are you selling? Why is it aligned with your opinion for those assets? You know, is, you know, but it's, it really is, if you think about it. What's your opinion on what it's doing? What is your distributional expectations, blah, blah, blah, then look at what they're doing and say, okay, does this, what they're doing, fit with what I'm trying to achieve or what I believe? If you just take things for face value and listen to somebody saying, well, you're going to make a lot of money on this thing, it's great. Guess what? Sometimes that's probably not going to work out so well. I mean, I, I don't want to over complicate it now. There are, David, there are challenges. It's not like, I don't mean to not, you know, be understanding that this is something complicated, relatively speaking, that I've been doing for a long time. I get it. I just think that it is not nearly as complex and mathy as everybody makes it out to be. It really is a matter of how we, we all have nuanced opinions. And now you can translate Those nuanced opinions very directly for more precise risk reward, outcome. And I think that's what's happening. At the end of the day, people are picking up on it. Retail, there's services that help. That's part of the network effects. There's education. Us speaking on here is part of those network effects. And, and again, if there is, you know, hot take, if there's one thing that's going to dramatically accelerate the adoption, it's AI because it's, this is something that is deemed relatively complicated. And you know, I think of that as an easy translation mechanism to, to the value it actually provides. Interesting.

Dave Notig (22:14)

I appreciate taking the time to wade into the options piece. Justin, I know you want to turn the tables here a little bit and talk about what we can learn from this perspective, right? Obviously Jim, you're, you're focused on a different part of the market than most of us are with a different level of depth. I'm, I'm, there's lots we can learn from that.

Jim (22:32)

I appreciate that. Happy to share. And again, exciting to be part of that wave, which I see is still in early innings.

Justin (22:39)

You know, thanks Dave. I think kind of trying to take a step out of options for a little bit here. Wanted to get your take on, you know, some more macro related stuff and you mentioned AI and the power of AI. One of the questions sort of we want to work through with you is, you know, just generally what are your views on this massive build out of AI infrastructure? We just had Kai Wu on the podcast and he wrote an excellent paper on, you know, how much money is going into these data centers and the infrastructure and sort of thinking about the types of returns that these companies are going to need to generate to justify this spending. So just generally like when you see something like this, like how are you thinking about it and you know, where do you, where do you fall on it?

Jim (23:31)

The biggest driver of liquidity in the world is markets themselves. There's $500 trillion of long assets in the world, up from $400 trillion just about a year ago. When assets go up in value, when they go up 20% from, you know, call it 400 trillion to 480 trillion, you create $80 trillion of new liquidity and actually create way more because that's collateral that gets leveraged. The whole system is a leverage machine. More, most money is, is leverage, is loans. It's not actual money. And so how do I think about this? Well, I think, I think the reality is that the more markets go up, the more these investments happen. The more that people are like, oh it's happening, all the liquidity is getting pushed into this stuff and we're going to achieve infinite, you know, growth at all these numbers. And so as long as I keep the plate spinning and the liquidity going and valuations going higher, then you know, AI is the tip of the spear and it's a momentum, you know, it's a self fulfilling prophecy. Unfortunately that usually doesn't go on forever. By the way, that's the same thing that happened in 99, 2000. I mean, by the way in, in 2001. I mean I started the business in 98. In 2001. I was naive enough to think to myself, man, nobody's gonna make that mistake again. That was a wild, that was pretty crazy. Why would, why would anybody go that you know that far in terms of valuations? We are above those valuations, equal on some, way above on others. I'd like to highlight in 99, 2000, you know, if you think about it, we, Russia just the USSR just collapsed. We were the undisputed hegemon of the world. We were expanding. Globalization was really just getting going. Interest rates were on the way down, not up. Secularly we just begun the new experiment of you know, Federal Reserve, you know, Greenspan in 96 declared a lower state of natural unemployment and we're going to try something new and just pushing massive liquidity. So I don't know, does it feel like we're in 99 geopolitically? I, I think looking at those valuations just, and then also looking at the risks, the bigger macro geopolitical realities, I'm hard pressed to believe that this goes on for another five to 10 years. And so doesn't mean you should again be selling stocks as I mentioned at the top of this program like doesn't mean you should be getting bearish right now. But you should be aware that if you are betting on 5 to 10 year outcomes, which is what, what's happening here with these investments, these aren't one year investments, you should probably be a little more cautious particularly in the biggest growth kind of expectations or what's needed relative to price evaluations. There are wild and the expectations and the odds of achieving those expectations are incredibly low. And given everything we know about markets, I think I would be incredibly skeptical of that. I think part and parcel is that of that is what we're seeing, starting to see in private markets. Most people are attributing the private market swoon and the issues that we're starting to see which I've been talking about for about a year is likely coming first as a function of poor credit quality to the lower end of the distribution, which is having problems. Why is private equity swing too? That's interesting, right? The, the reality is liquidity premium at the, in, in the end of the bubble. Again, let's talk distributions. If we think in the short term, meaning in the next year or so, that we could go quite a bit higher based on liquidity, but that we think that there is a high probability given valuations and the realities of this world that it probably doesn't last five years. Do you want to be in something that has a 10 year duration? You may want to be in public markets, liquid public markets, but I think the reality is the liquidity premium, which has not been priced for quite some time, is now beginning to be priced. And ironically everybody thought, oh well, they're starting to. The next bull market in privates is coming because they're going to open up public markets for privates to invest in or to, you know, to, to get new liquidity. What people aren't thinking about there, which is very important, is the beauty of private markets is they're not mark to market. When we have a liquidity crisis, what do we do? We pull everything off mark to market. If you all of a sudden start creating mark to market instruments for these, what happens when those mark to market instruments start trading at 50% of the private market? That's a problem. And so I think ironically there's a lot of lobbying effort to bring in the liquidity to the space. Given some of the issues, I don't think they're thinking about the ramifications of creating public, publicly, you know, traded private instruments. That is a meaningful issue. And I think that's starting, we're starting to see that under the hood. I don't think it'll matter till it does, but once it does, I do think that will be an accelerant to some of the issues we're seeing. I know I've kind of gone off tangent from your AI question, but I do think they're related because these are long term investments. These AI investments that they're making are big, structural. These are not going to play out in the next year or two. They're going to play out in the next five plus years. And I think the expectations assume that we're going to stay above 60,000ft for the next five to 10 years. And at 70, 80,000ft right now, I don't think that's very good for the next five to 10 years.

Dave Notig (30:06)

What's your canary in the coal mine then? I mean, obviously price is an obvious one. Things go down 20%, that's a signal. But is there anything in your day to day that you look at to help calibrate the, you know, well, if we're not five years, but we're not saying, Katie, bar the door, it's all going to hell in hand basket today, how are you gauging that on an ongoing basis? How do you play in that? Well, it's not tomorrow, but it's not 10 years. How do you play in that space?

Jim (30:33)

Yeah, so liquidity is the best predictor in the short term. Right. And now looking forward and trying to determine or being able to catch when that liquidity turns precisely is incredibly difficult. And you can't just look at one thing. You have to think of the things that may drive those liquidity outcomes and put probabilities on them and have early indicators for when those things might start to go. And so you have to have kind of a risk dashboard and think about kind of what those things are. And you can't, by the way, predict all of them. You have to be resigned to the fact that you also cannot be swimming without a swimsuit, in the words of Warren Buffett. Right. You need to, you need to understand that there are black swans and things at any time that can happen. You know, we may be able to predict with some, you know, the gray swans and, and some of the other things that come along the way, but there is always going to be things that you cannot predict and price. And knowing that you're that far off the ground, you need to use, you use that as a risk management tool. The left tail is fat. We know that. And so knowing that that part of the distribution, guess what, is underpriced, doesn't mean you shouldn't be net long, that you shouldn't be playing long. By the way, I think in the short term the right tail is also underpriced. It doesn't mean go short, it just means manage that left tail. And so I think at baseline you need to think about the world distributionally and hedge those risks at baseline. But I think in between there you can also manage probabilities and understand when there's a better chance of something or not and be dynamic and active along the way and have that dashboard to help understand, okay, maybe there's a higher probability, maybe that 1% probability has gone up to 1 and a half or two given X, Y and Z. And so maybe we need to be a little bit more, you know, aggressive on that tail or, you know, lighten up a little bit for some short period until this XYZ shows something better. But I think that's the general approach. I can get into dashboard items and things that we're concerned about, but there's quite a few.

Dave Notig (32:53)

But most of them are around liquidity.

Jim (32:56)

All of them have an effect on liquidity. Got. So I'll give you an example like we've been talking and this where macro can dovetail in. You know, Justin, the reality is when we think about the risk we've been talking about for some time, I mean, on this podcast we talked about a lot of the trends we've seen coming for quite some time. I mean, in 2020, 2021, we were talking about the increasing of global conflict, which was tied to likely coming protectionism, tied to populism. Does that happen? Yeah, that's happened a lot and it's not stopping, it's accelerating. So you have to look at the big trends and understand what you think is broadly happening and what the drivers are. And in the context of this broad world, you need to then understand, okay, if X is more probable happening, maybe this is something we should be watching more closely. So I think a China, Taiwan thing is been talked about. I think markets will ignore it until it's more relevant. But is that something. I mean, I think Nvidia is a, if there's ever a, you know, an object of mass destruction, right? A vehicle of mass destruction, it's the biggest stock in the world tied to a potential conflict in Taiwan where if it happened, it would decline very quickly by 75%. What do you think is 75% decline in a week in Nvidia would do to the market down 40 in a week. So I think these are the types of things. Like it's not the only thing we're going to highlight. There are risks, there are tails, right? But if you would start to see some warming up or signs that something like that would be happening, you better be hedged, right? Like you better be increasing your hedge aggressively and ready for it. That's just one, I can name that a bunch of other things. And again, we could probably do a whole show on, on the coming risk. I think the private equity, private credit piece is, is one I would highlight. If that continues to, as you start, if you continue to see Jaws where the market rises another 10, 20% and private equity and credit continue to languish or, you know, not participate, that's a pretty big Warning sign. And you need to really start taking that more and more seriously. Particularly if you enter a period of less liquidity, like maybe after the seasonal strength coming in January, that might be a good idea. Right. I could go through many others but these are the types of things you want to be mindful of inflation. Right. We've been talking about the structural realities of inflation. We've managed to hold it at bay here domestically by the way. Break evens globally are way higher than they are here and inflation is way higher than it is in the US the long bonds are breaking out internationally, out here. Do we understand why? Yes, we understand why. We can kind of tell a narrative of, of, of some macro reason. But no, it's because the administration is driving liquidity to our bonds and doing it in a way that has managed to put a cap on that for now. I would not rely that that's going to be the case going forward for many years. Could that be the case for the next year? Yeah, absolutely. And probably. Well, candidly but at some point if they're going to take over the Fed, which publicly saying we're taking over the Fed. I think we have in Arthur Burns a precedent for what could very well happen in the context of it. It's not a given. But sure, if in break even inflation starts breaking out again, if we see the numbers that we can even see the numbers, that's really important. That's the one thing that'll hold this administration's feet to the fire ultimately. Right. And can force a liquidity issue again. We could go through others but these are some of the big ones that I, that keep me up at night.

Justin (36:55)

Work it through to like the portfolio level. Just because I know at Kai wealth like one of the things you're trying, you know, it's like basically saying like listen, a lot of investors just have a very simple 6040 allocation but you know, they really should have given this sort of view that you have, you know, much more is needed to help protect the investor and their long term return. So how would that like strategically look within, inside a portfolio?

Jim (37:23)

Thank you for asking. And not just because this is what we eat, sleep and breathe. Because I think it's the most important thing for 97% of the market which just does stocks and bottles like if there's one actionable thing, the option stuff may be complicated and all the other things that 125 years of history here in the United States most people don't ask the simple question. There's long stocks, long bonds, whatever 125 years of history. Do you know what the Sharpe ratio is of the S&P 500? No. Isn't that wild? You guys don't. It's mind blowing. We don't even talk about risk. Like 97% of the world is doing X. These are advisors that are like advising their clients but nobody understands the risk of what they own. 100% of their portfolio is S&P 500. 125 years is a 0.35 sharp. Do you know what the, the Sharpe is of a 6040 portfolio? 125 years. 0.37. There is zero diversification benefit of bonds relative to stocks over the long run. Zero. In the last 40 years. The Sharpe ratio of the S&P 500 is 0.5 and 60:40 is 0.6. The average annual returns over 125 years are 10% for stocks and about 8% for 60:40. In the last 40 years it's 13% and 10%. Sorry, 11%, 13 and 11. Dramatically different outcomes. You know when that line starts? 1982. Is that a coincidence? No. The diversification benefit, the outperformance of stocks and bonds is a complete direct one to one correlation with, with the 10 year bond going from 19% to zero in a straight line for 40 years. Should we look at a data set that's a little broader than that? 40, 40 years. Given that the discount rate and interest rates are the unequivocally the most important thing in finance, probably we are living in a world of dramatic recency bias because nobody looks at anything longer than 10 years, 15 years.

Dave Notig (39:56)

But, but let me push back on that a little bit. I mean, to some extent isn't that rational? Because the markets of today certainly do not feel anything like the markets I started trading in in 1990.

Jim (40:08)

They are still subject to the same exact rules. And those rules are if the 10 year bond is trading at 20%, nobody is going to buy the S&P 500 at a 5%.

Dave Notig (40:21)

That seems like a fair rule. That seems like a fair rule. But.

Jim (40:25)

But liquidity.

Dave Notig (40:27)

No, I, I get that. But. But what period. So when would you look? You can't go back and say well let's go look at what happened in the 50s because I don't genuinely think the economy and stock markets and investors look anything like that. So how do you find something out of sample for 40 year time window and with a straight face say this is predictive for tomorrow?

Jim (40:51)

I don't think I have to tell you guys saying this time it's different is one of the most dangerous phrases in life and particularly in finance. 125 years I think you could argue is an overestimate because this is the building of the empire. This is the US markets which paint you a way worse picture if you look at global markets. Look, I'm not. This is not a one year call. This is not like a five year call. This is a structural call on investing. And the fact that we built a business, by the way, 6040 as a concept did not exist to the late 1980s. You know why? Like I said, it didn't work before then. It literally didn't work. There are 125 years of history. There is no diversification from bonds. Historically passive investing sold as a low cost technological advancement buy and hold for the long run did not exist to the late 1980s. Recency bias. It has worked incredibly well because we have done a supply side economic model where we've cranked down short term interest rates for 40 years in a straight line. And that has led to incredible outcomes for bonds and even better outcomes for stocks. Not just on return, but on a risk adjusted return. I'm just telling you that it, it is not the long term reality because. And there are other reasons. I can tell you why. If you run supply side economics is where we get in the macro side of things for long enough. You borrow from the future. How do you borrow from the future? Well, first of all, interest rates are zero. So there is something abound that's one. But two, you ultimately drive inequality, dramatic inequality in the whole system. By doing that, it's a cheat code for the Federal Reserve and for government to send all the money to the top.

Dave Notig (43:00)

But then how is it not different? Because my point is that is different. Like what other period of time runs down interest rates for 14 years?

Jim (43:07)

Disagree, Dave. It isn't different. It is the means of which they're doing it by using interest rates is different. Maybe a bit of the scale and size that they've done it is different. But it's a story as old as time. There is a natural system. If we don't believe in fairness, if you and I are robots or machines or cogs in a wheel, natural selection creates better faster development outcomes. It's evolutionary. All the best violins go to the best violin players. In the words of Socrates, if a winner take all system better get a mutation, you're stronger, you're better, you get more resources, you take over. That's remarkets. All we're doing is pumping oxygen into A free market system and putting it on steroids. Guess what happened during the Mesozoic era? Dinosaurs got really big because there's a lot of oxygen in that atmosphere. Free markets or the natural system. What most people don't realize your mother would tell you life is not fair. Right? That fairness, justice, equality principles that I, I think we all probably hold especially here in the US as relatively important things are not natural constructs.

Dave Notig (44:28)

I, I, I, I understand that. I definitely.

Jim (44:31)

So what happens if we doing the, the free market thing on steroids? We get massive inequality. It happens every time. This is not new. This time is not different. We have driven historic inequality globally, but particularly in the developed world as a function of supply side economics on steroids.

Dave Notig (44:50)

But you just said historic which means it is different. We haven't done it.

Jim (44:54)

It is bigger. I said it is bigger. It is more extreme than we've ever done. So doesn't that the same thing that.

Dave Notig (45:01)

Keynes and queens going to be different and larger as well or in, or go in a different direction?

Jim (45:07)

That back will be bigger. It is still subject to gravity. That's the point I'm trying to get across.

Dave Notig (45:13)

No, no, I, I, I'm not disagreeing with the gravity. I'm trying to say that I think that it's difficult to predict what the reaction function from the organism of markets is going to be given the political and geopolitical environment.

Jim (45:27)

You said the very important word, Dave. Political. At the end of the day we have human beings in the system. I think if human, human beings haven't changed. We still believe in fairness. We still believe in justice, we still believe in equality. We are, we work in relative values as a human being that you learn in biology. First lesson, Biology 100. How is a human being different than an animal? We got opposable thumbs and we got a larger frontal cortex. What does your frontal cortex do? Executive function. Objectification. You are a person. I am a person. We are people, we are equal, we are fair. We are just. Part of our great success as human beings has been being able to objectify and create systems that are structured in one way or another to plan ahead and do big things. But with that comes this sense of fairness and justice. That's what America was built on by the way. It's not a natural construct. That's why they had all the checks and balances. Because in a normal system, you know, if you don't put enough checks and balances, inevitably the natural system breaks it down, which is what we're seeing and eventually drives the non Fair. Everything rises to the top.

Dave Notig (46:50)

So where's the example of when we've hit that in history before and what can we learn from that?

Jim (46:55)

It's every. It's every let them eat cake moment in history which is happening.

Dave Notig (47:01)

Modern markets. I mean, like since we've been trading modern markets with, you know, like I would say since Bretton woods, when we 1929 changed. Right.

Jim (47:09)

1929 would be a great example when.

Dave Notig (47:11)

0% of the population had any exposure to the stock market. Like that doesn't feel like a simple comparison.

Jim (47:18)

And by the way, nobody said anything was simple. I'm not saying this is simple, but.

Dave Notig (47:23)

What I'm telling you, learn about this, right? Yeah.

Jim (47:26)

It's not a coincidence. Is way more repeatable over time. And do you think 1770 was the same thing as 1840? And do you think is 1840 was the same thing as 1920?

Dave Notig (47:42)

I think they were 1920 than we are to 1929.

Jim (47:46)

I don't agree with that at all. It all depends on the scale. If you're going logarithmic, right. Everything advances. And at a rate of change that's higher and higher and higher and higher and higher.

Dave Notig (47:55)

I'm just thinking in terms of systems complexity. Right.

Jim (47:57)

Our ability to model it well, but the complexity relative to the period before was probably infinitely more complex. It's all relative. We are growing, we are evolving. We are changing. Listen, we've been around for a hundred thousand years. Animal kind's been around for a billion years. Evolution, advancement is the way of the world. Right. Every time we get a. What we feel like is a complete sea change. Wow, this is crazy. This couldn't possibly get more crazy. The next step is crazy. Crazier than the next step. It's just how things happen. But you have to remember that things don't go in a straight line up forever. I mean, don't forget we had Rome for a thousand years and then we had the Middle Ages. So my point is, at the end of the day, we are in a system that is driven by a natural system of evolution. And you know, all the money and power flows to the top and we can extend that. That is the natural system. And by the way, that leads to less inflation, better outcomes for the total meaning more progress, more technological advancement, more globalization, more, you know, all the things. But that also leads. The longer we let that go and the more extreme we do that to dramatic increasing inequality. And at some point, always, eventually the people say enough is enough and fight back. And we've been seeing that the the roots of that starting in 2010. If you can't, I've been talking about it for five years plus. And if you can't see it happening, I can't help you. I really can't. It's, it's that clear as day. And, and it's not just populism. Once you get that, it's about our people, not all the poor of the world uniting together. It's about our tribe, our country, our people. And that leads to protectionism instead of cooperation, global cooperation. We get global conflict again, 20, 20, 21. We talked about Russia, Ukraine before it happened. We talked about global conflict increasing. If you can't see that either, I can't help you. You better believe it's coming to Venezuela and you better believe it's coming to China and Taiwan.

Dave Notig (50:26)

No, I don't disagree with that.

Jim (50:27)

It's just a matter of time. So my point is, yes, this time it's bigger and it's happening. This time is not different. In the big, big grand scheme of things, things are different within it, but the core driving things behind it, which is evolution, free markets, natural selection, greed, and we are human beings, in the context of that world are still true. And in the context of that, these are big things, 5 years, 10 years, shifts, and things can happen. But physics, the reality of the structure of how things work, still alive. And so this is how you can look at five year. I'm losing my voice. You got me. I'm excited now.

Dave Notig (51:23)

It means I'm getting depressed.

Justin (51:24)

Well, no, try to tie it out to the portfolio level though, because we still haven't gotten quite there yet with how, you know, it would look with different asset classes and the different things you would hold and how, how someone would be allocated.

Jim (51:37)

No, actually, before we get to the asset level and I'm, I thank you, I really thank you for ties back to that because it's so important, because there are simple things that you can do that can make a dramatic difference. But I will say the last thing to put a positive note on this. If you think this is a crisis right now and that, you know, people are stressed about where we are, go tell people in 1969, 1970, assassinations, you know, Vietnam, getting drafted, you know, race riots. Go tell the greatest generation. Yeah, go tell, go tell the greatest generation who's getting drafted and sent over to war overseas that this is a crisis. You ain't seen nothing yet. And by the way, this town needs an enema like you need a crisis. A crisis is what solves the problem it was. It's clearing of the underbrush. It's the Federal Reserve's desire. And it's what when I say it's not their fault. Congress created a thing to help smooth the business cycle. If you smooth the business cycle and you remove the burning of the underbrush, that forest fire is going to be a hell of a lot bigger when it finally comes. And that's where we are. That's where we are now when that forest fire is coming. I can't tell you exactly, but we haven't cleared the underbrush in a long time. And the best thing that can happen is a crisis. If we didn't have World War II, where would we be if we didn't have the equality?

Dave Notig (53:17)

What does that mean?

Jim (53:18)

What does that mean in terms of. Sorry, the portfolio.

Dave Notig (53:21)

Back to the portfolio.

Jim (53:22)

Let's get to the portfolio. Exactly 100. So 6040 is a 0.35 sharp over the long run. And if you take out the last 40 years, you believe there's some mean reversion. That's more likely over the next 20, 30, 40 years. Big picture, 0.25 sharp. During the other times, 68 to 82, you lost 50% of your money. In real terms, that was the period right before the last 40 years when interest rates went the other way. So you need to be hedged to the risk. Many risks. But the risk of rising interest rates, that's 1. Something that people have just slept on and assumed that is not that important and they got stung by it in 22. So some people have at least taken the first step and taken the duration off the table. A lot of people have. But most people I talk to still don't realize. Most people believe, actually institutional investors, many of them believe that equities are a great hedge to inflation. That is wrong. Historically, it is the opposite of truth. People like, oh, it's an asset. Inflation happens. This maintains value. The most important thing for owning equities is not the earnings stream that you get from equities. It's what people are willing to pay for that earnings stream. That concept is like not just foreign to most regular investors. It's. It's foreign to most institutional investors. Again, 68 to 82, interest rates went from 5 to 20. You lost in real terms 45, 50% of your value of your investment market went nowhere in nominal terms. So equities are also dramatically at risk in rising interest rates. So that's one. So how do we do that now? Brass tax? First of all, you shouldn't have 60 I think goes without saying you should have 60% of your net worth in equities. You should have some. The cheat code investing again. Very few investors manage risk. What we do at Kai wealth is focus on risk adjusted returns. If I told you you could get instead of a 0.35 sharp which is what 60, 40 is over the long run. Over the long run. Get over it too sharp by just using a couple very simple principles. Instead of owning 10 things that all are correlated, instead own 10 things that are circular spheric and their risks completely opposite uncorrelated risks. Diversification is less than 101 in finance. How much diversification is deployed in Your average portfolio? 0. So like it's not rocket science. You should be diversified, truly diversified, not like 500 stocks diversified. So that's what we do. First principle diversification. Second principle you even if you use diversification at some point on the far tail, you tend to have some correlation to everything because liquidity affects everything. So you need to have a little longfall, you need to own a little tail. We do a 5% allocation to Longfellow and it alternates between 0 and 10.05 10. And we doesn't move very quick.

Dave Notig (56:46)

Because.

Jim (56:46)

There are times when you know, much like home insurance, your risks are increasing. You probably want to own a little more insurance and guess what? Once the house burns down, you probably want to monetize it, take your money and rebuild. But the people shy away from Longville because they look at the long term expected return and they're like it's in a long term negative expectancy. They miss the whole picture. In the words of David Dredge, my good friend, long volume is brakes on a race car. You don't put brakes on a race car because you think they're going to make you go like the brakes are going to make you go faster. But brakes win races because they allow you to go faster. And so you got to have a little break in the portfolio too. 5% we're not talking about should be a dominant part of the portfolio. But that can offset a 35% on average equity portfolio, which is what our allocation on average is. 30 to 40%. 0 to 10%. 0510 total. That bucket. We, we put a 40%, you know, allocation to. I understand it's different than the 6040 allocation. I get it. What do we do with the other 60%? We do a bond alternative. We use options to do a box spread which is a buy. Arbitrage constraints gets you after taxes 1% in the current environment higher than a T bill. Arbitrage. Who gives away 1% for free? You can get that in a box which is by arbitrage constraints a T bill. It's the same return after taxes as a municipal bond that has 17% a 17 year duration on average and credit risk in the form of municipal bonds. Why in the hell would you buy a municipal bond without returning that risk when literally you could buy a risk free asset as long as T POS are risk free. This is by arbitrage constraints a very almost identical asset with the same return. And then you get capital efficiency because now you have a box in a portfolio account and you can do essentially what structured products do in your own and manage accounts. We do this in manage accounts for clients directly liquid daily liquidity, tax advantaged. Anyway, I won't go into the details of that. But yield stacking is what we call it. And so that's a 30% correlation. It is a R. The way we look at it, a bond alternative except the risk free part which is better you get for significantly better return and then the part you stack on the. On it. The risk instead of credit risk and duration risk which are awful historically and particularly right now. An awful risk reward you replace with a different risk reward that is significantly better and structural which is. Well, I can we. Unfortunately I can't talk through all the details today. Right, we can, we can have a different. But we do option strategies on top of defined risk option strategies that, that generate structural yield. Right. With a defined risk then on a risk adjusted return are dramatically better than direct duration risk and credit risk without a tail which credit risk and duration risk clearly have had tails we've seen in 08 09, we've seen in 2022. Both of those things have dramatic tails for not much return. So just better risk adjusted return. And we could do that in bespoke fashion just like you can with bonds for what the risk appetite is for people. And then lastly 30% non correlated strategies. I don't, I'm not, I'm not using the word alternatives because that. That gets abused with private equity, private credit, real estate, commodities. I don't see those as true alternatives. I'm talking of things that aren't even owning an asset. They're trading strategies that are non correlated. Trend following, you know, managed futures, merger arbitrage, convertible arbitrage, long short equity, longshore credit, commodity trading strategies. I can list, you know, even, even legal settlements, life settlements. There's a million things that you can not a million but There are hundreds if not thousands of strategies that are truly non correlated with great yields that are non correlated. In that diversified alternatives bucket we can get a 2 sharp plus alone with a 10 to 1314 yield. Historically not too different on a yield stacking a little bit lower on a yield stacking scenario with way defined risk and then stocks and longfall. Right. But the rebalancing which actually we take a value approach, not value as a factor, not like a value trap but really focused on Warren Buffett style discounted cash flow analysis which we know historically as dramatically less long term volatility with equivalent if not higher returns. And we also focus on that equity back on that last thing I talked about which is stocks that actually make more where their profit margins expand as interest rates go up and that's about 25% of the S&P 500. Most stocks have their profit margins collapse into rising interest rates which is a double whammy for equities. So we really focus on this type of equity basket. By the way we 2x market performance in that diversified 50 name bucket with a 0.7 sharp dramatically less drawn out those names and the trends that we're focused on we call this our thematic equities are playing incredibly well on a risk adjusted return. And I think they'll likely continue as well given we've seen coming and what we generally see from a macro perspective as well. So this may sound crazy. Guess what? It's. It's not. Our beta historically is a 02. You know w. By the way, I'm not talking about 25% better, 50% better, 100% better risk adjusted returns. What we're talking about is 400, 500% better risk adjusted returns. I don't think you can't eat risk adjusted returns is what the response I get. Right. Like but in a world with increasing risk and the things we're talking about, why would you, if you can make 10 to 12% annualized consistently, why would you opt for something that over 125 years makes 10% with five times the risk. Right. It. It doesn't make sense. Like we're not even in the neighborhood of rational in terms of what 97 of people are doing. And what I'm doing is not rocket science. It really, I mean to some people it sounds like rocket science. It's not rocket science. It's diversification which is a very like investing 101 with a little bit of tail which is a well known understood concept. That's it. Maybe an implementation. I have some edge on, you know, because I understand volume and I can use options and this and that. But you can find people like me out there. I'm not the only one that can do those things for you.

Justin (63:49)

I think, I think that, that, you know, appreciate that overview and I think it will give our audience some ideas and into how they can truly get diversified and, and kind of be prepared for when things might not be going as as good in the markets as, you know, we've been fortunate to be in, in the last 15 or 20 years. But Jim, really appreciate your time today. Thank you very much and lively discussion. Dave, thanks for your input too. Good seeing you guys. Take care.

Jim (64:19)

Thanks for having me, guys. It's always a pleasure.

Justin (64:21)

Thank you for tuning in to this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio platform or on YouTube. You can also follow all the podcasts in the Excess Returns network@excessreturnspod.com if you have any feedback or questions, you can contact us@excess returnspodmail.com no information on this.

Jim (64:40)

Podcast should be construed as investment advice. Securities discussed in the podcast may be holdings of the firms of the hosts or their clients.