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- [00:00]
A
Darius, your research is built around this idea of the KISS portfolio, which I think is brilliant, but a lot of people may not know what it is. Can you just walk us through that framework here?
- [00:09]
B
Yeah, I appreciate you man. Thanks for having me, Phil. So what KISS stands for is keep it simple and systematic. And the whole concept of KISS is just to find a very simple way for investors to participate in the upside in financial markets while giving them the confidence to know that their portfolios aren't going to have these, you know, significant left tail events when we're in bear markets. And so what kiss, the systematic part of KISS is that we use some of the tools and techniques that we've acquired from my collaboration with the global buy side over the past near two decades to infuse systematic risk management into that concept. So on the top down side of the risk management overlay, we infuse what we call not what we call what Wall street calls volatility targeting, which is targeting a level of exposure based on the volatilities of the asset classes. And then what we also have are the dynamic position sizing elements as well, which is pretty common in trend following CTA type strategies. And so what we found is that when you marry those two dynamics and when you apply them to very simple asset classes like equities, bonds, gold, Bitcoin, right now the 60 stocks, 30% is gold, it can be gold or bonds, and then the 10% is Bitcoin. When you apply them to these baseline asset classes, what you find is that you can actually create what we call a positively skewed return distribution, meaning by you're chopping off the left side of the left, the left, the leftmost side of the distribution and leaving a positive shape which ultimately allows you to compound well faster. So it's been a wonderful journey. We started that program back in January of 2023. We're currently in the process. We've partnered with a sub advisor to develop a fund, an ETF for that as well. So that's going to be coming out this fall and I'm super excited. One, just because obviously it's been incredibly well performing. It works. We have a proven track record on that. Thousands of customers around the world following the strategy. And two, I just think it's going to be a conduit for a lot of investors to just set it and forget it, to be able to just park your capital ETF that you know will participate in upside but also cap your losses in a bear market. I mean what that's the holy grail of investing. And so I think we built something that's pretty close to that.
- [02:12]
A
I've seen your charts and the performance is fantastic. But help me understand this. It's not as easy as saying 60% of my portfolio will just be in the S&P 500 as stocks. Because you have strategies baked into the actual stock selection and weightings, right? Yeah.
- [02:30]
B
The ETF will feature what we call our discretionary risk management overlay, which allows us to kind of have similar type signals, volume targeting and position sizing across all the different factors. So sectors, factors, geographic sectors within fixed income, all the different sectors in macro. We're not going to put all that stuff in Kiss. Kiss is 60%. When you decompose the drivers of return in financial markets, what KISS is designed to do is give you exposure to those drivers of return while also managing risk for bear markets. And so in terms of the drivers of returns, the 60% allocation of stocks, which is fixed, is to get you exposure to productivity growth. There's no asset class that is better for long term compounding of returns, at least over the last hundred plus years, hundreds of years, than equities. And so it gives you exposure to productivity growth, which is the source of all profits, which is ultimately the thing that causes your wealth to increase. And then the 30% that's currently in gold is designed to defensively protect investors from financial oppression when you have financial pressure, which means the central banks are keeping the interest rate level of interest rates in the slope of the curve at levels that would otherwise not be desired by financial market participants. Financial market participants would probably price, in our opinion, if you had a healthy level of term premium in the bond market, the 10 year would be somewhere closer to 5.75% just having a normal level of term premium. So term premium is still very depressed relative to what is normal. And so ultimately we are being financially depressed across the entire interest rate curve. And so whenever you see these episodes of financial depression, it's usually whenever you have a significant amount of financial oppression, what ultimately happens is the underlying core risk in financial markets, the most important risk is inflation, not deflation. If they had a normal healthy level of interest rates and the markets were appropriately pricing the price of money, which is nothing more than a transferable unit of human time, then ultimately the ultimate risk in the marketplace would be deflation. And so that's when the 30% would be the target allocation for that 30 would be in fixed income. But right now it's in gold. Because we ultimately understand that we're being Financially oppressed. And then finally the 10% for Bitcoin is defensively, it defensively protects investors from monetary debasement. You have just outright explicit monetary debasement, Fed balance sheet expansion, balance sheet expansion from the central banks around the world in a way that increases the supply of fiat money relative to the goods and services that those fiat units of money can buy. Then ultimately that's what we call monetary debasement. And that is a big risk to investors from the perspective of two things. One, sometimes monetary debasement spills over and causes inflation in the real economy. But the more insidious and underreported aspect of monetary debasement is the Cantillon effect. The Cantillon effect is a economic dynamic, but whereby the folks who are making all the money in the capital markets, the folks at the top part of the K who get to participate in the stock market going up year after year after year, 20 plus percent per annum in recent years, they get money in their accounts and that allows them to create, it creates excess demand for goods and services that they consume. And because they get the money first, they push up the price first. So, so they don't necessarily have to deal with the inflation, but it's everyone who buys the good and service after them who didn't get that unit of capital appreciation. So that's one of the more under discussed economic dynamics. And in our opinion we think it's a core contributor to this K shaped economy and a core contributor to why so many families across our country and really around the world feel like they can't get ahead.
- [05:54]
A
You know, it's an amazing way to break it down. And the portfolio framework you have, obviously it works very well. Let me ask you about the market cycle you see us in right now. Everyone talks about the AI boom, AI trade. You've written a lot about comparing it to certain chapters of the dot com bubble. Where do you see us in the cycle right now?
- [06:17]
B
Yeah, great question, great question. So based on that we can unpack all the elements of this, but I would say the summary headline is that we think 2026 is more of like a 1998 and a 1999. We think 2027 could be more of a 1999. We don't want to be too specific about that because again, it's convenient to cherry pick the last tech bubble. But the reality is this is a totally different cycle. It's going to have different contours and the shape of distribution is going to be a bit different as well. In the context of some of the inflation pressures that we're seeing and the geopolitical pressure on the treasury bond market. Those are very different than the fiscal policy dynamics and the fiscal dynamics back then. So there's other elements of it, but just from a pure market risk standpoint, we've been of the view that we are building into what could potentially be in 1998. If you recall, in 1998, market was, we're very much in the tech bubbles. Two years after Alan Greenspan's rational, exuberant speech, we're very much still in the tech bubble. But the market was, I think up about 20% in the first half of the year, but then crashed, had a 19.5%, basically 20% drawdown mid year. And then the Fed ultimately responded. This is during the Russian central bank crisis. They basically cut interest rates to bail out long term Capital management. And then the market rallied very sharply to finish up, I think 29% that year. Think about it. We went from up 20 to flat to up 29 in one year, up 20 to flat on the year to up 29 by year end.
- [07:45]
A
So are you expecting some sort of near term pullback this year?
- [07:48]
B
I wouldn't say near term. We don't market time. I think market timing is for newsletter writers. Serious investors manage risk. And so what we're coaching our clients to do is understand that the distribution of probable economic, market and policy outcomes is evolving in a negative manner. So at some point, this crowded, bullish positioning that we've accumulated, we're in the 83rd percentile of crowded, bullish positionings. Very high level. It's higher than the median level that we've observed at major bull market peaks in every market cycle dating back to at least 1987. And so we're higher than the median level that we typically peak at. And right now, with these sort of headwinds building from an inflation and monetary cycle standpoint. And so ultimately you worry about the liquidity dynamic in financial markets ebbing in a way that could cause a material correction this summer or this fall. Again, trying to time that is silly in my opinion. What we're essentially saying is, hey, when you start to see Kiss and Dr. Mo, those two risk management systems take down risk, just passionately take down risk. And Obviously when the ETFs out, you won't have to do anything. They'll just stay long with ETF because it'll take down risk for them.
- [08:48]
A
Today's episode is sponsored by public and they just launched a new product called Agents and it's honestly one of the most compelling uses of AI in investing I've ever seen. The idea is simple. A lot of investing is repetitive. Monitoring markets, moving cash, managing risk, rebalancing positions. It's the kind of stuff investors constantly have to stay on top of. Public's new agents product lets you automate those workflows using plain English. So instead of manually watching charts all day, you can create an agent by typing something like if the Vix hits 25, buy a weekly put option on Spy or if my cash balance goes above 20,000, move the excess into my direct index. Public's AI then turns that into an automated workflow that you can customize, review and activate directly in your portfolio. Public is essentially building what they call an agentic brokerage, a platform where AI can help automate the operational side of investing to based on rules and strategies you define yourself. If you want to start automating ideas inside your portfolio, visit public.com openingbell that's public.com openingbell now let's get back to the show. One of your recent reports suggested or maybe implied time to take some chips off the table as far as the AI trade. Can you explain that a bit?
- [10:07]
B
Yeah. So we have a collection of models that we use and they have forecast horizons that span, you know, different, different length. And from the perspective of our shorter term models, they're essentially saying, hey look, the markets are essentially the key takeaway was that the markets are frothy and there's likely to be a pullback in the context of some of these, the dynamics that we're talking about from the set of the monetary policy cycle and the fiscal policy cycle. And so ultimately what we think is happening right now, the first leg of this correction is investors are booking gains in some of the AI providers and, and starting to rotate into the AI adopters because when you look around, the Fed's not actually tightening monetary policy, right? We're not there yet. The liquidity is still trending higher. Our global liquidity model, which has been very accurate in forecasting trends and inflections in global liquidity in recent years, our global liquidity model is still signaling a peaking uptrend, but not a downtrend yet. And so things are still okay. Our macro weather model on net continues to signal that the probability of risk on market regime is reasonably high in the context of the six key macro cycles, how those cycles are currently interplaying to produce market outcomes. And so we're in a solid place that is getting worse and ultimately we're going to Cross, in our opinion, over the next, let's call it 2 to 3/4, we're going to cross into a place where we're actually explicitly getting worse on a net basis from the perspective of the six key macro cycles, from a starting point of very crowded bullish positioning, and that's how corrections and or crashes occur, is when you start to get negative surprises in those other five key macro cycles. Growth, inflation, monetary policy, fiscal policy, liquidity. I'm essentially saying that we're heading for a negative surprise in the monetary policy cycle that should ultimately cause the liquidity be contributing towards the liquidity cycle having a negative surprise as well.
- [11:54]
A
How does Kevin Warsh and the new Fed regime fit into this thesis here?
- [11:58]
B
Yeah, I think it's right on time. It's very core to that thesis because ultimately what Kevin Wash represents is in our opinion, we think Kevin Marsh is a dove in hawk's clothing and it's going to take the market some time to figure that out. We don't see the at least when we're having conversations with our global investor community, the markets have not the institutional investors that we consult. Many of the top funds on global Wall street, insurance funds, pension funds, family offices, et cetera. The funds that we consult, I think they are aware of our views on this. But when we have conversations with them about what other people are saying to them, the conversation has not started yet. And what I mean by this is that the markets don't know yet whether Kevin Warsh is ultimately going to be dovish. They're just now reacting to what was a very hawkish, directionally hawkish FOMC last week. And I think that's the appropriate path for markets to take because I think that is exactly what they want. We're not going to get the dovish version of Kevin Warren, the dove in Hawks clothing until we take some steam off the boil from an inflation perspective. And so ultimately what we're expecting is the Fed to use its balance sheet policy by first taking reserve manager purchases to zero and perhaps even threatening balance sheet reduction over the medium term. We think they're going to use their balance sheet policy and their communication tools via the dot plot and signaling on the balance sheet. Perhaps, maybe not, we'll see with Walsh. But if you combine those two hawkish policy tilts, it should ultimately contribute to a correction in financial markets, tone down the speculation, maybe send a signal to everyone in and around the AI trade and maybe send a signal to those of us on the top part of the K that continue to support consumption Irrespective of what's happening in the real economy and the labor market, it'll send a signal to us to slow it down and take some steam off the boil. From an inflation perspective, I mean, you have core PCE inflation on a three month annualized basis. In this morning's PCE reported at 3.5%, 150 basis points above the Fed's 2% target. Super core PC inflation. So, you know, xing out core service or core energy and you know, in terms of the residual of that, you're tracking up 4%. You know, the element of inflation in theory, the elements of inflation in theory that the Fed has most control over are 200 basis points above their 2% target on a annualized basis and I think on a year over year basis at about 3.9% as well. So, you know, this is a Federal Reserve who's, you know, failing miserably on its inflation mandate. We don't think they ultimately want 2% inflation, but in order to maintain credibility with the bond market, they have to signal and pretend like they want 2% inflation. So we think over the next couple of quarters, the Fed has got to go from talking about tightening to actually delivering some kind of tightening, whether it be through the balance sheet or the policy rate. We think the balance sheet's more likely because it targets the elements of the economy where the inflation pressures are coming from. We think they'll use the balance sheet policy to achieve that outcome, which should ultimately affect, allow, create the scope that they need to start to deliver a sequence of dovish policy outcomes in 2027.
- [14:58]
A
All of this is a lot. There's a lot of inputs, there's a lot of variables. As an investor, right. If you're an individual investor and you see all these macro variables flying around from the Fed to inflation, you got the Iran conflict still going. Peace deal. Maybe if I'm sitting there as an individual investor, how should I be responding to all of this or trying to respond to all of this to try to hedge myself against some of these risks? Kiss okay.
- [15:27]
B
Yeah, the whole point. So let me further break Kiss down. We use our market regime now casting process to infuse the volatility targeting into the strategy. And so ultimately what we found through our very institutional grade backtesting is that when risk assets go from a risk on market regime, which is what we're currently in, to a risk off market regime for most assets, equities, cryptocurrencies, credit, the volatility of those assets on a realized basis tends to double, in some cases it triples. And so we infused that lesson into our volatility targeting approach. So if our marketing now casting process, which has been very good since we started this firm at pinpointing when the flows dynamic on a net basis really starts to change in a way that creates longer term uptrends or longer term downtrends of financial markets, when that process tells us that hey, we are now in a risk off market regime, it's usually a leading indicator for a downtrend in financial markets. KISS will take the target allocations from 60, 30, 10 to 30, 15 and 5. Right there you're just going to get a wholesale reduction in gross exposure in the program. Depending on where you're starting from in terms of the current allocations, you get a wholesale reduction in the exposure there. And then if those things start to break down independently, let's say the equity market transitions from bullish from the receptive of our volatility just a momentum signal to neutral, then that'll tell it to cut from a dynamic position sizing perspective that'll say, hey, instead of gimme 100% of that 30%, give me 50% of that 30%. So we'll take a 30% position down to 15%. And let's say the equity market goes to bearish from the set of our BAM signal, then it'll say just give me 0% of that target allocation of 15%. So you know, KISS is very systematic in terms of how it increases exposure into bull markets, you know, in and around the start of bull markets, and decreases exposure in and around the start of bear markets. We're never going to sell the exact top. We're never going to sell the exact bottom. Because trying to sell, optimizing an investment process for selling the exact top and the exact bottom exposes you to type 2 errors. Type 2 errors are false negatives and those are much more hazardous from the perspective of your wealth accumulation.
- [17:43]
A
Wow, man, this is a hell of a crash course here on portfolio management. So Darius, I want to ask you about what we're continuing to see with the Iran conflict. It seems as if from my understanding, markets are really looking through the conflict and, and they're pricing in a pretty quick normalization. How are you thinking about this?
- [18:06]
B
Yeah, look, I'll tell you the same exact answer I gave Tom Keene at Bloomberg, I think on April 8, I think it was the day after the ceasefire. I said, you're removing left tail risk from the distribution of probable economic policy market outcomes. So the net result is that the mean and median of that distribution is shifting to the right, which means markets have to go up to price that in. That's exactly what we've seen. Obviously I didn't expect semiconductors to be up 100% in six weeks, but we expect very positive market outcomes as a function of that. No change to that view. Anytime you remove left tail risk, the mean and median of the distribution, regardless of how it's shaped, is shifting to the right. And that's something that investors aren't positioned for in terms of how we're viewing the Rand conflict, particularly from the perspective of the 14 point memorandum of Understanding, in our opinion, it's very clear that the U.S. wants out. And that's why this Memorandum of Understanding in our opinion, again, this is an opinion, not a fact. We think that's why the US is getting fleeced. I think they're getting fleeced on three vectors. One, it's very clear that the US hasn't learned its lesson in asymmetric warfare from the forever wars that we had in the Middle East. And Iran knows this. They were able to essentially prevent the world's most powerful and by far the world's most expensive military from achieving its objectives with respect to keeping the Strait of Hormuz open with drones that cost about the same price as a Honda Civic or Toyota Camry. We spend a trillion on our defense on a per annum basis. The next 10 countries combined spend 1.2 trillion. So we're almost in terms of our flow of defense expenditures year after year after year is about roughly on par with the next 10 largest countries combined. China being number two at like $350 billion. And so that's lesson number one. And the fact that the Memorandum of Understanding is so skewed in Iran's favor, we think that's a very clear signal that the administration wants out and that the negotiations are going to continue to go well. Number two, it's a pretty clear signal that the US now negotiates with terrorists. That's been a long standing bipartisan policy for decades that the US does not negotiate with terrorists. But now you got the $300 billion fund, they're unsanctioning Iranian petroleum products for delivery and US dollars, they're freezing up, unfreezing various frozen assets around the world. I think it's to the tune of like 350, $375 billion. This would be like the world's 60 to 65th largest economy, that sum of money. And so now it's a clear, clear signal that the US is willing to negotiate with terrorists, people who want the blood of US children, that the US can be bought, we can now be bought. If you have strategic leverage as a terrorist, you can now buy favor from the US Government. That's another signal that this, in our opinion, we think the US is getting fleeced. And the fact that we're getting fleeced is a very clear signal that the US Administration wants out. And then finally the third part, which may be the most damning from a long term perspective, is that this memorandum of understanding allows it signals to the world, both our allies and our adversaries, that domestic political pressure can compromise our strategic national security objectives. You think about this from the perspective of AI. You think about this from the perspective of Taiwan. How many people are going to raise their hand to fight an inflationary war to save AI if China decides to invade? Do you think somebody in the Middle west, midwestern part of the country is going to say gung ho? Yeah, I support this. Sending our sons and daughters to go die in a war to save the advanced semiconductors that are putting me out of a job? And so I think that signal is a pretty powerful signal in the context of all the political backlash. Roughly 70% of the country is opposed to this war. One's out now, obviously we got the House and the Senate both voting with Republican support to end the war. And so it's a very clear signal that, look, the U.S. is on its back foot now from a geopolitical and strategic perspective. And so ultimately the confluence of these three things is a very clear signal that this administration just wanted to be out, and they're just wanting to be out means that the outcome is probably going to be good.
- [22:13]
A
Probably going to be good as in the rebound economically and market wise?
- [22:18]
B
No, that we're not going to have a material setback. We're not going to go backwards from the starting point of the mou. Now we might have some volatility between now and the finish line of what the ultimate agreement looks like, but we're not going to go back to the pre MOU regime where there's the threat of violence and the, and the threat of an extended closure of the Strait of Hormuz. In our opinion, we think that's done.
- [22:42]
A
Okay, that makes sense.
- [22:44]
B
And otherwise, why would you sign an MOU that's this bad for America?
- [22:48]
A
It's true. It is true. And this to me is part of the trend that we've seen for years now moving into a multipolar world, which you've done a lot of work on specifically for the market implications of that. Walk us through how this goes into that thesis and maybe how investors should be thinking about this.
- [23:09]
B
It accelerates it for sure. Like I said, it's a very clear signal to our allies and adversaries around the world that the US has not learned its lessons in asymmetric warfare. The US geopolitical objectives can be compromised and ultimately we do negotiate with terrorists. If you have strategic leverage that we have to respect and or we need something from that leverage that is the strait to being open, then we will negotiate with terrorists. And so ultimately, in our opinion, we think it accepts accelerates the move to a multipolar world because it should, and likely and rightfully so, should embolden China to continue to accumulate power and influence, particularly in Asia and ultimately around the world. And this is the right thing for them to do, in our opinion. Who's to say what ordained us as the great kings of the world as the United States of America? That's not a permanent feature of society and humanity. And we're going to look back on this period in time, thousand years later as like, oh, that might have been the peak of the American empire in our opinion. Coincidentally, as we're right about to celebrate our 250th birthday. Not many societies last this long, particularly in terms of one form of stable government. So you know, it is what it is. I'm not making that call. But the call I am making on the geopolitical front is this just accelerates it. And another dynamic that's been accelerating it is the fact that we've had this geopolitically driven supply demand imbalance in the treasury bond market. On the supply side of things, we all know that the deficit's out of control. You can go, anybody with a Google Internet connection can tell you the deficit out of control. But on the demand side of things, that's where it gets very interesting. You think about the biggest buyers of U.S. debt, it's Europe, Japan and China. Well, Europe's remilitarizing, NATO's outlined a target to take their defense from spending from 2% of GDP to 5% of GDP with 1.5% of that being defense related infrastructure. So that's a significant capital call home from one of our largest foreign creditors to the treasury market. You look at Japan, our second largest foreign creditor to the treasury market, they're actively pursuing reflationist policies. The Abenomics, the agenda is alive and well in Japan. And so ultimately they're putting a lot of downward Pressure on the prices of JGBs, which puts upward pressure on the prices of our interest rates as well in tandem. Because again, Japan is one of the world's largest international investment surplus economies. And so if their bond market's blowing up and their money is shrinking, essentially that's what's happening, is their money is shrinking. From that perspective, then they ultimately have less money to capitalize our bond market. And then finally on China, obviously we're strategically decoupling from China, China's strategically decoupling from us. Now if you look at U.S. imports from China, it's about 8% of the total, down from a high of about 24, 25, 26%. The U.S. exports to Chinese exports to the U.S. now it's about 8, 9% of the total, down from A high of 23, 24%. Both countries are accelerating this decoupling process. Now there's obviously some, you know, shift, trans shipment, transnational shipments and all that, but the reality is the, the side, the delta, the magnitude of the change greatly outstrips the, the prospect of transactional shipping to places like Vietnam or Philippines. We would see like, we would see their exports to the US like quadruple. Right. And that, that hasn't happened. And so ultimately we just see that the, these countries are moving away from each other in a way that causes the PBOC to not want to accumulate dollar base, dollar denominated FX reserves. And obviously PBOC has the world's largest pool of FX reserves. And so you have these geopolitical dynamics that are causing our largest creditors. These are the three world's largest net international investment surplus economies and their demand for our treasury securities are going down at a time where the supply of treasury securities has been accelerating and is likely to continue accelerating over the long term as a function of our demographic, our demographic dynamics and the policy choices we continue to make, whether it be spending a lot more money on defense year after year after year, or whether it be cutting taxes so folks like us can have some equity market gains.
- [27:01]
A
Wow. I wonder if we're accelerating into this multipolar world. Is the natural market response or let's say the investor response to look for non US Assets?
- [27:15]
B
Yes, in our opinion, yes.
- [27:17]
A
Okay, so what is the implication of that?
- [27:19]
B
Yeah, so this acceleration into a multipolar world, it basically it traps the U.S. treasury. It makes the U.S. treasury as the world's core risk asset. This is now the hot potato. You have this massive market. I want to say it's about 32, 33 trillion on a marketable basis, close to 40 trillion on a non marketable basis in terms of the securities that are in the Social Security Trust Fund basically have a 32, $33 trillion problem that needs to be dealt with. And so now we have this giant game of hot potato of who's going to capitalize this market at a time where our largest foreign creditors need their own money or don't want to buy them anymore. Again, Europe needs its own money, Japan is lighting its own money on fire and China doesn't want to do business with us to the same degree anymore. And so now we got to find domestic and or international replacements for these where they come in the form of US commercial banks. Their shares now 15% down from a high of 33%. In fact, that's where we think the next round of hot potato is going to go. The previous round of hot potato was pushing the securities off the Fed's balance sheet to the private non bank sector. The private non bank sector's share of the marketable treasury debt market went from 36% at the end of 2021 to 58%. Now that obviously coincided with the explosion in yields from, let's call it 2% on the 10 year to 5% on the 10 year at the peak.
- [28:34]
A
When you're thinking about your own kiss portfolio, the 60% equity allocation, do you anticipate that will, let's say, shift downward in U.S. equity allocation and start to go global equities?
- [28:46]
B
Yeah, the KISS is allocated to the global equity market of which 60% is roughly US, 60% is US, 40% international. And that 60% US allocation is because we're using the Vanguard Total International Stock Market ETF is the equity exposure in kiss. That's a signal. If you look at the Vanguard, I think the state sheet has a total international stock market allocation ETF and BlackRock does as well. IShares does as well. You put the mean US equity allocation from those ETFs together, it's about 63%. Well, the US stock market is only about 50% of the total international stock market. So that means US based investors have a 20 plus percentage point overweight to US stocks. And so going back to answer your previous question about does this increase investor demand for international securities in our opinion, we think yeah, we're about as extreme as we can possibly get from a US investor. Home bias to US stocks relative to what are some pretty clear and obvious dynamics that should cause the flow of funds from an international capital perspective to flow outside of our borders. And so going Back to answering this question with respect to kiss, do I expect KISS to reduce its equity exposure in the coming months? Yeah, that's my core fundamental belief. Sorry, it's my modal outcome belief. There's a distribution of outcomes around that. There's a right tail on the right side of the distribution. We are still on the liquidity cycle upturn. Our model's only signaling a peaking macro. Weather model's telling you on a net basis, the six key macro cycles are fine. So I could see the market continuing to rally here over the next few months. But ultimately, as you get forward in time, if that, if that outcome does happen, it just increases the probability that the Fed is going to have to use its balance sheet policy or its communication toolkit, or maybe even the interest rate tool to tone down some of this inflationary pressure. So ultimately, I still think we correct. But again, like I said, market timings for newsletter writers. We manage risk like serious institutional investors at 42 macro.
- [30:49]
A
Yeah, you put it very well. And it's. These are very challenging concepts for the everyday investor to try to wrap their heads around because there's so many variables at play. So, Darius, let me ask you about the Mag 7.
- [31:02]
B
Can I say something like that? These are challenging concepts. Managing risk in global financial markets is very hard. I think a lot of folks got tricked into believing that it was easy in 2020 and 2021 when the Fed and the federal government in the US in particular, was expanding its deficit by $6 trillion and the Fed monetized by more than half of that. So everyone looked like a genius until 2022. But I think what a lot of people learned since 2022 is that this game is actually hard. They don't pay us millions of dollars because it's easy. It is hard. And so if you want to be good at this as an investor, then the simplest way to be good at this is to dedicate time and resources to learning. And so one of the things we did in terms of meeting our members of our global investor community halfway, particularly the retail investors in our community, I cut my teeth servicing the institutional investors over the course of my career. Now that we have this large and growing community of retail investors in our cohort, we've built all these educational tools that allows them to kind of come up the curve and understand all these dynamics, these complicated economic and financial market dynamics from a first principles perspective. So go to 42macro.com education. That's kind of the entryway to those educational materials. There's other ones that are in Front of and behind our paywall. But again, I'm not here to advertise. I'm here to help educate and change the world.
- [32:18]
A
And you do such a good job because you also share an unbelievable amount of video and written content pretty much everywhere. You're very easy to find online. Okay, before I let you go though, I want to ask you about the Mag 7. Right now you have this theme you've been writing about called source of funds. And my understanding of it, I might get it wrong. Rotating out of the Mag 7 to fund other winners in the AI trade. Is that the right way to think about it?
- [32:42]
B
100%. Absolutely. Nailed it.
- [32:44]
A
So why is that what you've been focused on right now?
- [32:48]
B
Yeah, so it's both an offensive trade and a defensive trade. And we've outlined this theme since I want to say the all time high in the relative ratio of the Max 7 index relative to the MSCI all Country World Index. I think we first published theme, I think it was at the all time high of that index and it's gone down since it's had some oscillations, but it's much lower than it was then. And so we've been right on the seam and we think this theme has legs on a multi year time horizon basis. So on the offensive side of the equation, you know, the diffusion of AI. AI is a general purpose technology that will cross borders much like the Internet did. And so in our opinion, we think the diffusion of AI will ultimately compress the spread between the productivity, the profitability, the margins and ultimately the valuations of the basically the rest of the companies in the index. Right now, the tech companies and all the AI providers have these super elevated gross margins. They had super elevated rates of free cash flow expansion. And ultimately we think those spreads compress in a way that ultimately compresses the valuation of non max 7 businesses here in the US market and international businesses around the world. That's the offensive side of the trade. On the defensive side of the trade, we can very clearly see that the Max 7 is running out of free cash flow. There's a couple of dynamics there that are worth calling out. One, when you have a significant reduction in free cash flow and obviously they're starting to issue debt issue equity at a very, I would say alarming rates, but certainly rates that should raise your eyebrow in terms of how much money they need from capital markets to keep this thing going. They're raising capital at alarming rates. That tells you that hey, their internal cash burn is very high and so part of the reason their internal cash burn is very high. And I'm citing the Wall Street Journal, they did a wonderful work on this recently about how some of the stock based compensation is actually understating the rate of cash burn at some of these businesses. Again, I'm not an equity analyst, so take everything I say with a grain of salt. But you know, especially this. So that's an issue on the free cash flow generation side. But I think the bigger issue is something that no one's talking about yet because the market doesn't need to talk about it, but they will at some point in the future, which is if you look at sell side estimates for, you know, max 7 cash flow generation, you know, they basically go to like a low in 2027 and then they just start hockey sticking. Your free cash flow growth in 202820 might be off by a year or so in terms of the expectation. But the slope of the chart is true, it's accurate. They're expecting a massive acceleration in free cash flow growth at some point starting in 2028 or 2029. And that makes very little sense in the context of two things. One, historically speaking, CapEx bubbles tend to conclude in secular bear markets that ultimately cause recessions in the real economy. Then we saw this with the railroad capex bubble in the 1950s, 1970s or sorry, 1850s, 1870s. We saw this with this consumer durable goods capex bubble in the 1920s which led to the Great Depression. And then we saw this with the Internet technology capex bubble which led to the dot com bust and that recession as well. So that seems to be, in our opinion, we think that is the highest probability outcome on the other side of this rainbow. And so that's a problem in the context of a hockey step recovery and free cash flow growth. And secondarily you also have, when you go from an asset light business to an asset heavy business, you have this thing that you have to bring along with you call it maintenance capex. And right now I would imagine there's not a lot of modeling of maintenance capex across global Wall street because we haven't gotten to that part of the trade. But at some point we're going to get to a place in the future where there's a bunch of data centers already built and now you have to maintain, you got to spend money to keep them at tip top shape. So that's an issue from the perspective of the max seven. So in our view, source of funds is a very, it's likely to prove to be increasingly lucrative trade over the next in the coming years because you're protected from these free cash flow Dynamics from the max 7, which is what everybody's position was. Go back to last fall. That was their number one core holding across US and international investor portfolios. And then you had this offensive convergence in productivity, margins, profitability and ultimately valuations. And the final thing I'll say on this is that we have seen this source of funds movie before in financial markets. We go back to China's ascension into the WTO in 2001, which gave China access to a unified global market for the first time. And so we saw Chinese equities outperform U.S. equities by about 500 percentage points. In the ensuing years. That unified global market diffused throughout the Chinese economy and allowed them to converge their productivity, their margins and ultimately their valuations. So that's one, we've seen that dynamic before. And then number two, if you go and look at the European bond market, the bond market has seen this sort of hum movies before as well. Once the Masters treaty was signed back in the early 1990s, the master treaties, the treaty that essentially created the euro, that took us from the deutsche mark and the Italian lira and the French franc and all these other countries, the independent currencies, and put them all into the euro. That process which took probably seven, eight years to play out. The euro was first adopted in 1999 and first circulated in 2001 or 2002. From 1992 to 1999 we saw compression in spreads by magnitudes of hundreds of basis points across all these peripheral economies towards the German boom. Now I'm using Italy as an example. I think their peak spread relative to the 10 year treasury yield was somewhere about 600, 700 basis points. In the early 90s it compressed to I think 50 basis points, which is where the German boom was. And that happened across all of the European bond markets as they adopted as this sort of singular monetary policy diffused throughout Europe. And so ultimately we see AI as a general purpose technology that's going to diffuse across of businesses and across borders that ultimately does cause that convergence in operating metrics.
- [38:28]
A
Covering a lot of ground here, a lot of different angles into the investment thesis here. Of all the things we're talking about, let's say we get together 12 months from now. What do you think we're most likely to be wrong on?
- [38:42]
B
Ooh, that's a good question. What are we most likely to be wrong on? I think the thing that we're most likely to be wrong on because the thing that has the highest band of the widest band of distributional outcomes is our view that Kevin Walsh is a dove in hawk's clothing. He could prove to just be a dove, he could prove to be a hawk in doves clothing or he could just prove to be a hawk. Right. There's sort of four different outcomes right there. And the path that we think is the highest probability outcome is that he's a dove in hawks clothing. And the reason we say this is because I think he did a very clever political exercise that I may borrow from him one day. If you're trying to create a lot of regime change, which is to enlist people and bring them along with you by creating these task force and so you break these five task force down into their core components and try to predict what they're going to say. Based on our understanding of all the critical economic dynamics and the geopolitical risks, our view, we think the communications task force is going to result in a net negative outcome for the financial markets from the perspective of widening term premia. But ultimately we'll get to a better outcome perhaps years later once the markets are no longer chasing the Fed's tail and pricing in what the Fed's saying and start pricing in again what they think the economy is going to do. So that's a good outcome, but I think that might be years away. The nearest outcome from this is a modest expansion of term premia on the what was the next time the balance sheet task force. It's highly likely that the Federal Reserve eases bank regulation in a way that reduces their demand for reserves and increases their demand for Treasuries so that you can that which will allow the bank, the Federal Reserve to lower the balance sheet in a way that is not as disruptive for the economy and financial markets, particularly to those of us in the top part of the cave that have been enjoying 20 plus percent returns in the equity market over the past few years, which obviously this year this would be year four if it happens again fourth year in a row, which is absurd obviously in a way that would be not too harmful for us. So we think that the net outcome is negative. Fed balance sheet going down is bad. But if you have some offsetting factors from a bank regulation standpoint, it doesn't have to be very negative. And so I think the outcome is going to be positive relative to the market expectation. If you ask gold, if you ask Bitcoin, that the Fed's just going to shrink its balance sheet meaningfully without any offsetting dynamics. So I think that's positive from a surprise risk perspective if you look, but negative from an absolute perspective. And then you look at the other three task force, in our opinion, we think the outcomes are explicitly positive. The data task force, if you pivot the Fed to looking at more real time measures of labor market dynamics, you're ultimately going to realize the labor market's weaker than it is. If you go back the last three years on average, the QCEW has the benchmark payroll revision somewhere around minus 550,000 per year. In fact, last year we were minus 861,000. We basically almost had a million fake jobs reported in real time. So we have less jobs reported in real time. At least the Fed thinks there are less jobs then they're going to think there's more productivity growth. And more productivity growth will cause them to think that trend rate of inflation is lower, which ultimately creates scope to lower the policy rate. So that's positive. That's the data task force on the productivity and jobs task force, those things all combine together. And then on the inflation task force we know that measures like truflation, these kind of real time inflation statistics have underreported, they've underperformed realized inflation from the government in recent years. And so if you start to shift your focus at the margins towards these market based and these alternate data provider based inflation measures, you're probably going to get a dovish read through on inflation as well. So inflation should be more dovish whenever they start to report the findings of the task force. The jobs picture should be more dovish whenever they start to report the findings of the task force, which should ultimately push up the productivity estimates and push down the trend inflation estimates, which ultimately push down their dot plot estimates. And so those things should all be positive and we expect, you know, some concrete proposals out of those committees in the direction of what we're talking about by year end now. That's a lot to predict. And so you think about the distribution outcomes, you know that that's a pretty wide distribution. So if we're sitting here a year from now, where would we be most wrong? It'd be on all that.
- [42:38]
A
That is a unbelievably thorough answer and I'm not surprised in the least. Darius, where can people find your work? Online?
- [42:45]
B
Yeah, no, I appreciate you man. So 42macro.com that's sort of the, the home for, for, for our business. And you know, we serve large thousands of investors around the world in 80 plus countries around the World super blessed to be at the epicenter of that. All the education that's going on in our community. We have this community forum where everyone's asking questions and learning and all this other stuff. Obviously, we publish research, we publish our signals, our risk management overlays, KISS and Dr. Mo. KISS being the 60, 30, 10 stocks go Bitcoin currently, but it could be in the future. Stocks, bonds, physical commodities, whatever satisfies those three core drivers of asset markets. You know, we have the. That's where you can get access to KISS, access to Dr. Mo discretion, risk management overlay. It's basically KISS, but for every single factor in financial markets, you know, across 70 different core factors of financial markets. And so, you know, 42macro.com is where all that stuff lives. And then obviously we, you know, we have our protopro business as well, where I'm, you know, having these kinds of conversations with institutional investors around the world.
- [43:41]
A
Wow, Darius, thank you so much for your time. This was fantastic. I learned a hell of a lot of. And you're welcome back anytime.
- [43:48]
B
No, I feel. I appreciate you for having me, man. This is a, this is a pivotal moment in time. You know, I don't want to be too big about it, but I think this, this is, you know, it's funny, we're celebrating America's 250th birthday this year, and I think there's a lot of change that's happening in the economy from a cyclical and structural standpoint, not the least of which is the regime change we're seeing at the Fed. And so whenever you have a widening distribution of outcomes, regardless of how the distribution is shaped, whether it be positive or negative, it puts the onus on the risk management function of your investment process because it's harder to forecast accurately. The wider the distribution, the wider the range of probable outcomes, which means your forecast variance is going to be up, you're increasing your standard error and your predictions. And so if you think you're going to invest with just fundamental predictions through all this change with a super wide, historically wide distribution of outcomes, then I think you're going to be disappointed in your results. So I think it does put the onus on the risk management function of your investment process.
- [44:46]
A
Well said, Terius, thank you so much.
- [44:48]
B
Thanks, Phil. Appreciate you. Thanks for having me.