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- [00:00]
A
So, Mike, you are a bit more cautious on the AI market than most of the investors I've been speaking with. Make your case here.
- [00:07]
B
Well, I want to be clear. I'm very bullish on the application of the technology. I actually think that this is a true, genuine innovation. I actually was sitting and having breakfast earlier this morning, listening to a young woman explain to somebody the stacks that she was building within her AI applications. And I was thinking to myself that you certainly didn't hear anything like this with crypto or really anything else. It reminds me very much of the rollout of the Internet, which had a very profound impact, was clearly formative in terms of my perspective on this stuff. But I do think that there is a very material misunderstanding between the economics that are being presented and the likely economic reality that is going to emerge. I think that there are a couple of things that are really critical to understand. One is that the adoption curves that we have seen to this point have largely been about people just seeking advice in their daily lives. They're not building broad applications, they're not revolutionizing the world in any material way. They're simply saying, where should I go on vacation, which hotel should I stay at, how should I plan my trip, et cetera. I like to give the example. My mother in law asked me to install ChatGPT on her iPad and the very first question she asked is not how do I build a multi factor agent to simulate my retirement flows or whatever. Instead she actually said, how old is Julianne Moore?
- [01:22]
A
Right?
- [01:22]
B
It's a replacement for Google Search. It is better than Google Search. It does not have the same ads that have become completely endemic in the context of something like Google Search, although you're starting to see that flow over into things like Gemini as they seek for ways to pay for it. But the reality is people have an endless demand for opinions or insight into their lives. It's the reason why the Dear Abby columns were so popular within newspapers for years and years and years. And this has simply taken that and elevated it in a variety of ways, right? It can be your therapist, it can be your girlfriend, it can be your boyfriend, it can be the person who explains why you're not the asshole in the conversation, everybody else is. These are all things that people have desperately sought throughout time. And the fact that it's available in a personalized non recourse manner, meaning there isn't somebody thinking ill of you for asking the question, by and large is completely validated by the adoption curves that we see. People want that information and they Love it when it's subsidized at very cheap costs. Now it's somewhat absurd that we're seeing the AI companies lose thousands of dollars per user in order to provide this type of advice. Newspapers subsidize that with subscription fees and with advertising. My hunch is we'll ultimately end up seeing something very similar, but it's going to be at a much lower cost because people don't value advice at a couple of thousand dollars a month, they value it at $20 a month or ad supported or whatever. That I think is going to create a real challenge for the AI. Space is effectively separating the two. The much more impactful component is going to come from an over time realization that many of the procedures and processes that we're now building agents to start to replicate things like a call center or a customer service helpline, those can be totally rethought in a world of agents. We can answer questions that may not actually be asked or maybe haven't been asked yet. Really simple example, a call center for customer support currently exists for you as the user to call up and complain and say it's not working. What do I do about it? An AI based agent at zero cost could actually follow up with a customer who made a purchase and say, hey, I noticed you haven't brought it online and registered it yet. Was this a gift? If so, here's a coupon to get another one for yourself. And if it is not a gift and you're experiencing troubles, how could we proactively begin to address it? What could we incorporate? That would be rethinking things. And the closest parallel that I can draw to that is the early stages of the 19th century when manufacturing and factories moved from places where you pulled together the factors of production to the assembly line when you fundamentally rethought what you were actually doing. That I think is the transition that sits ahead of us with AI. And I think it's actually incredibly exciting and will likely deliver an unbelievable number of services and tools that individuals can use at prices that are far lower than we're currently able to access them. Think about a fiduciary agent that replaces an investment advisor with your own personalized agent operating at extraordinarily high levels of intelligence with unbelievable access to all the information, but most importantly, information to your own life that changes the process materially. Likewise, the process of buying real estate. I currently get an agent who ostensibly is going to show me the available properties. Well, since MLS has existed, vast majority of people know more than their real estate agent because they're using Zillow and Realtor to find homes that they've pre selected. And so we're still paying somebody a sizable fraction to effectively shepherd us through a transaction that becomes immediately available for AI disintermediation. And the process could materially change in that manner. We simply don't know. There's unrevealed preferences that exist out there that we haven't yet begun to explore. So I'm very bullish on the rollout of it and the opportunity that it has. I just think that the current path that we're following, in which unbelievable amounts of money are being expended in pursuit of, you know, a TAM that is described as all of space and time, basically are highly unlikely to generate the returns for the current investments that exist.
- [05:38]
A
So help me understand the companies driving this AI boom. Nvidia, AMD Micron, they're reporting crazy earnings, they're reporting record profits, revenue. They keep raising guidance for the quarters ahead. Is that not something that reassures you about the build out of this or the market structure of AI here?
- [06:01]
B
Well, unfortunately it's become self reflexive in, in its underlying components. So if you think about Nvidia's margins effectively, what's happening is, is Nvidia is selling out its entire production. It's creating scarcity, it has scarcity for its chips, but it's manufacturing that scarcity by financing its customers. It's the same underlying phenomenon as the customer financing that existed, the vendor financing that existed under Cisco's build out in the late 1990s. Ultimately, what you needed if you wanted to launch a website and compete for the nascent online shopping experience or the online customer experience in 1999 you needed servers, you needed routers, you needed LAN equipment, et cetera, because you had to build that all yourself. Cisco was stood ready and willing to finance it. That meant that the customers that were being financed didn't have the opportunity to negotiate on price. Now that is really what has driven Nvidia's margins to such extraordinary levels. And when you finance your customer, you don't write down the margin that you're actually realizing on the credit riskiness of the underlying business. You simply book the sale and accept the fact that the paper that you issued is held currently at par. If it turns out that the opportunities don't generate the revenues and profits and cash flow that are necessary to service those obligations, there will be a write down in the future that will reverse those profit margins. But that happens often to the future. And so when we look at what's actually occurring here, I'd suggest that there's two real things that people should be paying very close attention to. One is, in the late 1990s, the US competitors to Cisco and Juniper Networks and JDS unifies, et cetera, were largely Canadian and Finnish companies, companies like Nokia or like Nortel. I'm much less worried about competition coming from Finland or from Canada than I am from China. And China, in part because of the policies that we've pursued where we've tried to behave in an exclusionary manner, has had an entirely different approach to it, which has been to focus on efficiency. How do I use less memory, how do I use less processing power? How do I do this more cheaply and more effectively? And that's always facilitated by the second mover advantage. We've forgotten the components of the dot com cycle and the insights that the second mover often has the advantage of not having to use the bleeding edge technology and incur the costs associated with it. Ultimately, we're now starting to see an explosion of the usage of those Chinese models. It's a little bit like watching Cray Microcomputer, which was the supercomputer manufacturer competing in Sun Microsystems or Intel, where the capacity and capabilities underneath in the lower end of the market were appreciating rapidly and effectively cutting off larger and larger share of the available market. The frontier labs are finding themselves in the same situation and ultimately are now taking actions that are designed basically to lock out the rest of the market, whether that's agreements with the US government or whether it's embedding within fable and mythos, the inability to work on competing front frontier models. These are all steps that are being taken by these companies because they have to protect their end market and the rationale for it simply because their valuations have become so absurd. That's very much a self defeating process. And so I think there's a very real risk that just like we saw with every other playbook that China has pursued, whether it's solar or nuclear or anything else, that the US runs a very real chance of squandering the lead that we've created because we're unwilling to actually experiment and drive competitively derived outcomes.
- [09:40]
A
All of that makes sense to me. I think the harder part still for me to wrap my head around is does any of that suggest investors should not be participating in the upside of the current bull market?
- [09:53]
B
Well, I want to be perfectly clear. I think that part of what is actually happening is that investors have figured out the game. So this is not dissimilar to the late 1990s when we had all sorts of theories around why is the stock market doing really well? Why were valuations rising? Jeremy Grantham, Warren Buffett, et cetera. WROT, you know, very profoundly in late 1999 about the exceptional margins that were being realized in US equities that were dead wrong in terms of the expectation for forward earnings, but they were very right in terms of the valuations that we were ultimately paying for those things. Now we're actually facing a much more complex situation where we're embedding extraordinary margins. The gross margins that Nvidia is generating under any reasonable model should attract tremendous competition and replacement, which is exactly what we're seeing from the Chinese models. But there's also no reason to recognize that because the vast majority of investors are simply buying the US Stock market right in line with what they're expected to do through their 401k. They're buying into a Target Date Fund. That Target Date Fund is allocating not on the basis of valuation or forward expected returns, but simply by using the historical return profile to suggest this is what we expect in the future. Every investment prospectus out there has the disclaimer, past performance is no guarantee of future results. And yet that's how we invest. And so, you know, you and I are very focused on this. We're very interested in this. 65% of American households that have 401ks should be very interested in the intricacies of this, but I'm going to guess it's about 5% that actually have any awareness of what is really going on.
- [11:30]
A
So the passive bid on the market, can you talk about how that plays into maybe your views on the AI bull run right now?
- [11:39]
B
Well, what's really interesting about it is if you think about passive, it basically reinforces whatever the last price was, it accepts it and provides an additional bid. And so there's a theory under what's called the Grossman Stiglitz framework, that ultimately the active discretionary manager should be competing away those opportunities. The problem is because passive vehicles like 401s receive continuous inflows tied to the American retirement system, they effectively are able to exert continuous shocks. It's a little bit like fantasizing that, like a phenomenal right hook swinger can fight back against a guy who's an inside guy. But if that inside guy never lets up and never gives him a chance to draw back his punch, the game is over. The boxing match is going to be over before he gets a chance to take a swing. That's really the phenomenon that we're seeing in the market, financial markets today, which is an earnings report comes in, it's exceptional. That causes short covering from the skeptics. It causes enthusiasm and continued holding from the proponents of it. And into that changed price, passive has to step in to fulfill its fiduciary obligation to meet its allocation. It doesn't actually do any analysis. It's not thinking about it in the same way. It's simply reinforcing that price and effectively turning it into a higher floor. It's what's called idiosyncratic volatility and it reinforces it. This is actually a paper written in 2023 by Jang at Michigan State that highlights this component of idiosyncratic volatility. And we absolutely see that in the research that we do that once these sort of volume shocks occur, passive effectively becomes a propagation mechanism for it.
- [13:17]
A
One of the charts I published recently was about how the S&P 500 on a forward valuation basis is actually cheaper today than at the start of the year. And I saw that chart and I said, wow, that's an interesting counterpoint to the bubble thesis. My guess is you would disagree with that.
- [13:38]
B
Yeah, I think the earnings are wrong. I think they are overstated, certainly relative to what we are likely to see on a forward basis. But that's my opinion. That's not fact. What I would highlight on those earnings is there's no real mechanism for them to actually drive stock prices. A company reports earnings, that doesn't change the stock price. What changes the stock price is people's reaction to those earnings. And so there's still a sizable fraction of the investment public that responds to those earnings and says, oh my gosh, I got to get into this. I would suggest that a sizable fraction of those responding in that manner are actually people who are covering shorts. We've seen them taken out over and over and over again as they have confidently tried to express views on valuations being completely absurd. But eventually we enter into a regime and I'd suggest that we're there somewhat now where things like triple levered ETFs begin to emerge that reinforce and magnify the impact of flows and ultimately create the conditions similar to what we saw in the late 1990s in which narrowly focused, or with Cathie Wood and Ark, where narrowly focused funds are attracting extraordinary pools of capital and driving those individual securities to valuations that were previously unimaginable. I don't think anybody realistically expects Micron's or SK Hynix's margins to maintain at these levels for any period of time. Or anyone who has studied the cyclicality around these types of businesses expects them to be persistent and persistent and maintained. The question is kind of to what magnitude do they ultimately go? Because the corollary to Nvidia financing Your purchase of GPUs is those GPUs are useless without the memory to go with it. So of course you're going to pay whatever is necessary to get this. It also has become a somewhat convenient excuse for companies like Apple to announce price increases where they've more than doubled, effectively the price increase associated with the memory because they're unwilling to see the margins that they have begun to rely on. Increasingly. That in turn is creating conditions under which a growing fraction of people are looking at their iPhone and saying, I may not replace this next one.
- [15:47]
A
I'm definitely in that camp. When I saw Apple's price increases a few weeks back, I could stay with my current iPhone for years if I had to. So Mike, one of the things I know you're working on too is you've written about comparing this to 1987 as well as the 1990s. What's the connection there?
- [16:09]
B
Well, I think that there's two connections to it. One is 1987. Part of the boom that was being driven was actually being driven by the false security of portfolio insurance. If you believed your portfolio was protected to the downside, you're willing to allocate more to a risky asset. 1987 was effectively the saturation of liquidity in those markets by these types of strategies. That's what Paul Tudor Jones really identified. If you ever watch the documentary Trader, you'll see all sorts of nonsense about him tracking each individual movement and comparing it to 1929. And I know any number of people have produced overlay charts since that are probably even higher fidelity in the world of computer replication as compared to the hand drawn charts that he was working off of that Peter Borschlin had created. But the simple reality is that isn't actually what happened. What really happened was that the liquidity in the futures market was exhausted by the size of the portfolio insurance need to sell. That overwhelmed the system. Specialists came under pressure in terms of their ability to finance the book, and that caused the ultimate collapse in liquidity that we think of as 1987. It wasn't fixed by cutting interest rates. It was fixed by Gerald Corrigan, the president of the New York Fed, telling all the chartered banks in the United States. Effectively, you will lend money to these specialists or you will lose your charter. Those were two choices, right? Obviously, the lines of credit reopened and liquidity was restored. This is a very similar setup where we have a relatively new technology index investing in ETFs that have combined with a general awareness and perception that the market never goes down for any sustainable period of time, that has led people to increase their allocations to equities so that today they represent a far larger share of total household wealth than we've ever seen before. The mechanism for that, and whether that continues, I would argue, is largely driven by the phenomenon of passive investing and how we've chosen to invest. And therefore it's subject to the flow components of the retirement of the boomers, the potential for an increase in unemployment, et cetera. There's a variety of components that could cause that flow to reverse. The question is, does that play out in the same fashion? And ultimately, I would suggest we may be even worse off because the liquidity provision in the market today relies on what are called market makers. Effectively, individuals who no longer have the obligation to maintain liquid markets that specialists had. A specialist could get fired by the firm that they specialized in. I worked for Spearleads and Kellogg, which was famously fired by Morgan Guaranty, a company now absorbed long ago. But Morgan Guaranty fired them for failing to maintain liquidity in 1987. They were incapable of putting up enough capital, but they still lost a business franchise because of it. Today's specialists have the opportunity, but not the obligation to maintain that liquidity. They can simply walk away with no damage to their franchise and their balance sheets held intact. That creates a risk that liquidity evaporates suddenly and quickly without the traditional warning signs.
- [19:17]
A
If we take those risks and put them to today, how close are we to something breaking?
- [19:25]
B
Well, I think we have evidence of many things breaking. The question is whether the aggregate system breaks. So we've now seen Korea closed multiple times in the past few days because the growth of capital into things like SK Hynix or the Korean memory stocks has actually created volatility that is candidly uninvestable. And that is actually one of the great ironies is unfortunately, in the pursuit of making the markets more investable and more accessible to the average individual. We've destroyed the underlying link to fundamentals that historically would have allowed us to properly price the cost of capital for public traded companies. Korea is just the most egregious example of that. I was looking at the SOXEL triple levered ETF referencing US semiconductor stocks. That was down 20% last time I checked. Right. That's not an investable framework. It's been up and down 20%. And because it is a levered vehicle, it actually creates its own endogenous flows, which is something that people generally struggle with to fully appreciate. But I'll give a really simple example. So let's imagine we have a 3x levered semiconductor ETF. We won't name it, but let's assume we've named it. You put $100 million worth of equity in there. It actually has $300 million worth of purchasing power because it's triple levered. If the Underlying index rises 10%, the total value of the portfolio has now risen to 330. But the debt outstanding was only the original 200. As a result, you have an additional 30 of equity. That means you actually need to go out and borrow an additional $60 million to buy the exposure that you promised your investors. So it can create its own endogenous flows. Those flows impact the securities, driving the prices higher and theoretically taking the demand even higher. The manufactured flows even higher. The next day it falls 10%. The reverse process occurs. You now actually have to sell an additional amount to maintain the 3x levered exposure relative to what you otherwise would have had to do. That type of volatility and that type of flow is actually exactly the sort of characteristic that you saw in events like 1987 in which selling begets more selling, buying begets more buying. And so those components, I think are very much in place in some areas of the market in which they're already I would describe as fully broken. I would also extend that analysis to things like the VIX pricing itself. Because if you look at the implications of large companies like Nvidia or Micron that are both in the S&P 500 and in the SoxL, if they continue to get their pricing behavior largely determined by this triple levered ETF, which in that example created $60 billion worth of flows. To put that in perspective, the daily flow associated with traditional passive is only 2 to 3 billion. So we're talking magnitudes directed at a much smaller set of companies that are not weighted on a market cap weighted basis. It's modified market cap weighting, equal weighting type framework to give a diversified expos so companies like Broadcom or Micron have massive overweights in those components. As that becomes the determining factor for that sub segment of securities, it loses correlation with the S&P 500. That drop in correlation then lowers the price of implied volatility. And the question is ultimately, do these triple levered or levered type vehicles ultimately end up the path that almost all levered vehicles do, which is that volatility drag that is magnified by the leverage ultimately drives them to zero, even if the underlying is actually going up. And I think this is the part that is quite most concerning about that is that ultimately we know that these pools of capital are not sustainable. The volatility drag associated with that. And just to identify what volatility drag is, if you think about it from an arithmetic average standpoint, if I'm up 10% today and down 10% tomorrow, or down 10% today and up 10% tomorrow, I'm flat. If I run that in a continuous series, if I'm down 10% today and up 10% tomorrow, I'm only I'm still down 1%, right? 1 times 0.9 times 1.1 is 0.99, I'm down 1%. That's what we refer to as volatility drag. You add leverage to that that gets even larger. And so these are largely self liquidating pools of capital that are currently causing havoc in the market. As they become less impactful, that implied correlation will actually reassert itself because we're seeing less impact from these external flows of capital that will cause a rise in implied volatility, potentially creating conditions under which people are forced to de risk because of the higher realized and implied levels of volatility.
- [24:09]
A
So my maybe perception from a non academic view is that most investors do not even know about levered products. Right? I think you have to be pretty in the weeds in markets or having conversation like this to even know you can get triple micron or something. And that also leads me to believe that passive flows would not be flowing into levered products. Is that the right way to think about it?
- [24:37]
B
Yeah, I would definitely not think of the products that are currently levered or the vast majority of them. And even I would extend this to things like a levered version of the S and P, it's critical to understand that those are magnifying the impact of the choices that you're making. And so exactly as I gave on the example of the triple levered semiconductor etf, it's generating flows that are far more impactful. When you think about a market impact formula, how much impact an order has, it is a function of the time in which the order has to occur. And so the more leverage you add, the more you're effectively jamming through increased Purchasing activity in a defined period of time, it's going to have a larger impact on the overall model or on the overall market. Again, these are unsustainable pools of capital. A 3x levered product on a 60 Vol instrument, the volatility drag associated with that is astronomical. There's an additional component in which this has actually driven an increase in what is perceived as lending activity and a pickup in credit activity. Because if I'm going to run 3x levered, I have to find that leverage somewhere because it's coming through effectively. An ETF trust, an individual financial company that falls into the category of what's called non depository financial institutions, which is where we're seeing an explosion of lending activity. Until very recently, that was going into private credit. Now it's simply going into speculation in the stock market, which is, I would argue, a poor productive use of credit.
- [26:10]
A
If all of this is happening largely in the background, almost no one I'm speaking with talks about these types of risks in the market. How does this end up stopping? Or is there anything that can stop these risks from proliferating into something catastrophic?
- [26:28]
B
Well, what you would hope is that ultimately regulators open their eyes to this phenomenon. South Korea's regulators have bemoaned the fact that they introduced levered ETF products. My hunch is at some point over the next couple of years these products will be banned in a variety of ways. As I highlighted, they're not long term investment products. There is a degree of leverage that is entirely appropriate. And many people are beginning to pursue strategies they call return stacking or capital efficiency in which they're marrying together two return streams that have negative correlation to each other, trend following in the S and P, for example, or bonds and equities under many frameworks. That was the original idea behind things like risk parity is effectively increasing the exposure of uncorrelated streams and maximizing the capital efficiency of the portfolio. Those are perfectly appropriate within their own limits. But at the same time, when you're effectively just magnifying a correlated strategy, if I'm going 2x in video or 3x in video or 5x the S& P, I'm introducing a degree of leverage that ultimately makes the product not a long term investment, that volatility drag I was highlighting before simply becomes overwhelming. And this is why things like the 2x leverage short microstrategy has not done any better meaningfully than the 2x levered long microstrategy. Right? They both have been hamstrung by the volatility that was revealed. They're terrible products. For the most part. They can be useful for executing an individual trade over a very short period of time. But we're seeing more and more evidence that individual traders are basically seeking that leverage as a lottery ticket to effectively try to escape the mundane nature of their daily existence. They want to get rich like they think everybody else is.
- [28:17]
A
They have to escape the permanent underclass.
- [28:19]
B
They have to escape the permanent underclass. That's exactly right.
- [28:22]
A
So Mike, if we have 1987 risks, we have.com risks and there is the ongoing risk of the passive bid in the market. If you were to help me build a brand new portfolio today, where would you start? I'm 29 years old, very long time horizon, high risk tolerance. What do we do?
- [28:43]
B
Yeah, there's this triple leverage semiconductor etf. No, I mean, look, my general view is that what you want to find in investing is areas of neglect. That's where the opportunities tend to be richest. It's either in the discarded stocks or in the discarded bonds that can no longer be held for fiduciary reasons by various strategies, bonds in particular tend to fall into this category. Bonds that have been downgraded often can't be held. This is what creates things like the risk of fallen angels in the high yield space. The most interesting space in the market to me are areas like long dated US Bonds and TIPS that are structurally ignored under most frameworks in things like target date funds. And so the, the mechanical representation of them within portfolios is radically reduced versus what they would represent on a forward expected return basis. While I'm not a big believer in the methodology, it's always instructive to look at things like GMOs 7 year asset class, 4 class. They currently project a negative 6% return to US equities. I believe if I look at tips, they currently project exactly as you would expect, somewhere in the neighborhood of around a 2 and a half to 3% positive return. Under a rational forward return model, we should be buying more TIPS and we should be buying less equities. But that's not how our investment systems are set up. That's not how our allocation schemes are set up. And it's made worse by the construction of the bond indices themselves in which the bonds that were issued at relatively low coupons between 2009 and give or take 2021 are now trading at significant discounts. Because passive bond indices are market cap weighted, that decline in price means that they receive less purchasing power, less directed flows than they did when they were priced well above par. And you can mechanically think about this in just a really simple framework. Imagine there's only two bonds in an index. There's a two year bond and a 30 year bond. They're equal weight. At the start of our experiment, Federal Reserve cuts interest rates. What happens to the two year bond? It goes up a little bit in price, but not all that much because it's what's called a short duration instrument. It's not going to benefit from the much lower interest rate environment relative to its current coupon for that long of a time period. The 30 year on the other hand is going to rise appreciably in price because it's a long duration asset. You've locked in a higher interest rate than is currently available for the next 30 years. That actually sounds relatively attractive. The price should get bid up. But now think of the composition of the index. It was 50, 50 before. Now the 30 year has appreciated a lot. The index is overweight. The 30 now raise interest rates. The two year falls a little. The 30 year falls a lot. The next dollar into the index is going to buy more twos and less thirties. And that I would argue is the phenomenon that we're experiencing right now. It feels like Nobody wants the 30 year bond because candidly, the area of investment that we have focused on passive bond indices when we choose to invest in bonds are ignoring those long duration assets because their prices have fallen so significantly. My estimates are the current weights in passive bond indices are about 35% underweight. Longer duration bonds, things 10 years and out. If I look at TIPS, it's even more extreme. There's very, very little allocation relative to it. So everybody's screaming about inflation. Everybody's saying they want inflation protected returns. That's why they're buying equities. And the reality is that there's an inflation protected tool that's out there that everybody is ignoring. On the flip side of that equation, you have to ask yourself how real are those claims about inflation? Because that's what people are using by and large to justify why the stock market is moving and why bonds aren't behaving. We actually have instruments that are traded on this basis. They're called inflation swaps. People have every incentive in the world to get the forecast correct. There's a profit incentive which is really what we're looking for. And those are currently telling you that next year's inflation is going to be in the neighborhood of 2.5%. That actually has to be priced at a premium to what we would actually expect to receive. And so that 2.5% level has been historically consistent with a 2% type level. They've done a far better job than surveys of investor expectations or anything else. Again, precisely because expectations to steal from the dude in Got it blanking on the name of the movie. Jeff Bridges is the dude in what movie? The Big Lebowski. Thank you. That's just your opinion, man. You didn't put any money behind it, you didn't do anything with it, et cetera. And so we have the market based tools that tell us inflation really isn't a material risk. Now people will construct a narrative about it. There's millions of participants at the BLS who are simply lining up to lie to their friends, neighbors and citizens about what's actually happening with inflation. I simply don't believe that. I've written about this extensively. I've highlighted the misunderstanding that exists between economists and the average American who is pointing correctly to the price level and saying, man, I can't afford these things. But that's not the same thing as inflation, which is the continuous change in that price level. The change year over year in that price level is how it's typically presented to us. That actually is pretty modest. And if you actually think about the mechanics of we just had a war in the Middle east that created an unprecedented disruption to the supplies of oil, impacting gasoline prices, by far the most volatile component of the basket. And we got to 4.2% inflation. This is pretty incredible when you actually think about how little impact that ultimately had. And so I think people need to be very aware that if the theories of the productivity associated with AI are correct, if the opportunities that people are highlighting existing, the odds are almost certainly that we're looking at a deflationary future as compared to an inflationary future. And that's further exacerbated by the simple fact that population growth, which is by far the best predictor of inflation over time, has actually slowed materially. And we're looking at a decline in the number of consumers. We're seeing that overtly in places like China, in which consumer spending have been extraordinarily weak. They've made up for that by exporting the vast majority of their products. We've inflated those costs through things like tariffs, et cetera. But the simple reality is China is desperate to sell what they're producing, and by and large, we're ignoring it. Whether that continues to play out or not is anyone's guess. My hunch is that there will be political interventions going forward that may very well create inflationary conditions. But for those to take place, I think you actually have to see the deflationary shock first. So if I'm building a portfolio for you, it's going to be more fixed income centric, it's going to be less credit centric, it's going to be more duration exposed than almost anything else. With the full recognition that what I'm looking for is ultimately that correction that then drives the response. It's that that the order of operations, the path is ultimately going to matter. My hunch is I'm early on that. Right. I don't see any real material signs that this is evaporating other than the obvious component being that things like the highly levered ETFs are self liquidating enterprises that ultimately will undermine the bid that we're creating for this narrow group of companies in addition to the passive component. So as that begins to evaporate, I think that there is short term risk in equities. It becomes a real question of does it arrive at the same time as the long term risk which would be things like baby boomer liquidations, et cetera.
- [36:25]
A
Wow, I did all that without a breath.
- [36:27]
B
Yeah, that was pretty impressive.
- [36:29]
A
I could follow up in so many ways. But Mike, I want to be conscious of your time here. Before I let you go, I want to ask you about an essay you wrote over the July 4th weekend. Tell me about why you wrote the essay and the insight that you think people should take away.
- [36:46]
B
Well, so the essay was called the verb, and it's about a component of the Declaration of Independence. As I was thinking about what we were actually celebrating, which was increasingly centered around around an individual, I wanted to draw people's attention to what I think is truly unique about the Declaration of Independence and its follow on documents, the Constitution of the United States, preamble to the Constitution of the States, the Bill of Rights, et cetera. To me, the most important thing about the United States is that we declared in the Declaration of Independence that government exists for the protection of life, liberty and the pursuit of happiness. And that pursuit of happiness is very different than almost anything else. It's not guaranteeing you happiness. It's not that the government is there to provide you with happiness. The government is provide you with the protection that allows you to pursue that happiness. And that's defined on an individual basis. The Greeks called it eudaimonia, which is effectively what is your life's purpose and life's meaning. I personally found that in being a parent changed my life In a meaningful way. I've devoted my life to my children. I've been thrilled that my career has enabled me to provide them with resources far above most people should expect. It's certainly not billionaire sort of status by any stretch of the imagination. But they have been given the tools and those were provided at no recourse to them. They graduated without student loans, they were free to pursue careers that they saw fit. And by and large they've capitalized on that. For most people it's going to be their own choices, right? It can be. You're incredibly passionate about xyz and we corrupted that and basically told people, hey, go study whatever you want. We took away the price signals associated with is engineering superior to underwater basket weaving as a degree? As I like to joke, underwater basket weaving combines my love of manual dexterity and the water. And so of course I'm going to pick that over electrical engineering. And the government was willing to fund it and finance it with no difference in interest rate. No message to me that hey, that's actually a pretty risky degree. The end market demand for underwater basket weaving is effectively limited to Jacques Cousteau's children. It just doesn't really exist. And as we steal that information and prices away from people, they lose that capacity to make those informed judgments. The piece that I was actually highlighting is that we've systematically replaced that. Providing people with the tools to succeed and the tools to pursue their happiness, and largely providing those on a non recourse basis. I didn't have an obligation to support the transcontinental railroad. I could buy a ticket to it if I wanted to travel to California. I didn't have to pay for the interstate highway system unless I chose to drive on it and take advantage of its resources. And then I paid in the form of gasoline taxes, usage taxes. When you think about what's increasingly happened, we've tried to provide that happiness. You're not making enough money. Here's money, we'll give you some more money. You fall below this certain threshold line, we're going to take care of you, we're going to provide you. If you're above that threshold line, you're not of interest to us. Make it on your own. That sort of disconnect has actually fractured the American story and fractured the perception that we're all in this together, trying to work together to accomplish our own objectives without necessarily impinging upon others opportunities. When you think about what capitalism really is, it's the coordinating mechanism that allows millions or billions of people to pursue their own self interest. And as long as they follow the laws and they're not impacting other people's rights to do the same. The system slowly coordinates through what Adam Smith described very well as the invisible hand. We've increasingly tried to replace that invisible hand with a very visible hand. And when government tries to intrude and give you outcomes as compared to opportunities, it also has to be able to take those away from you. It has to be able to monitor whether you're receiving them. And that intrusive government is what I would by and large argue that most Americans and most people around the world, I'd focus on the UK and Europe actually, or Canada for that matter, before I'd focus in the United States on these subjects. But the simple reality is government is increasingly perceived as intrusive in that process. The reason it ties back to AI is AI is going to be that ultimate tool. It's a little bit like eyeglasses, right? Eyeglasses don't. If I have eyeglasses doesn't mean you can't have eyeglasses because they're so cheap and readily available. Nor does your perfect vision corrected by eyeglasses impinge on my perfect vision uncorrected by eyeglasses. It simply gives you the opportunity to participate. And under a networked social economy, the more participants we have, the richer we are. That's the theory of networks, right? It doesn't matter the quality of the individual node. It doesn't matter if the incremental person being added to that node is operating at the 85th percentile of intelligence or the 15th percentile of intelligence. They're bringing something incremental in terms of the transition of wants and interests. AI as a broadly distributed tool becomes a phenomenal opportunity to do the same thing. It effectively raises everybody's iq. It raises everyone's potential in terms of the ability to transfer and obtain knowledge. But the minute we actually turn it into a rental service in which people have to pay a disproportionate amount potentially to the frontier AI companies that have locked down access to anyone other than their models, then it effectively becomes like sharecroppers on land that is leased from a landlord. And it's a very different world and it's not one that I think we want to inhabit.
- [42:19]
A
Mike Green, you always bring fire and you are certainly welcome back on the show anytime. I think that you're a three time champ here on the show, so always a pleasure, always learned so much from you and we didn't get time to cover it but you do have a book coming at some point. Can you give us one minute on that?
- [42:39]
B
Yeah. So the book is actually on the subject of passive investing. I've received edits. I'm desperately trying to find the time to do those, as those who read my substack know, this weekend, power went out in the Poconos and I completely lost access to my computer. As it was, I had to go to a Starbucks to actually publish the substack. So I am being somewhat lazy in addressing this and getting through it. We're likely to slip, unfortunately, on our publishing deadline, and I'm frustrated with that. I hope it doesn't mean that we move beyond the point at which it has the impact that I hope it to have, but it is out there. It is written in the classic sense. And now the editing part, which is a lot of fun. And as we were discussing, I'm simply struggling with the number of hours in a day.
- [43:20]
A
Well, it's called the Greatest Story Ever Sold.
- [43:22]
B
Correct.
- [43:23]
A
Fantastic title. I'm looking forward to reading it. And, Mike, thank you for your time.
- [43:28]
B
Thank you for having me, Phil.