This week, one of Dan's favorite guests returns for his fourth Stansberry Investor Hour appearance... Cullen Roche is the founder of portfolio-management firms Orcam Financial and Discipline Funds. He is also the author of two of the most widely circulated research papers in finance and a highly rated book named after his popular financial blog, Pragmatic Capitalism.
But first, Dan and Corey examine the biggest news events of the past week. And some have gotten a little too close for comfort to the extreme scenarios in the "Top 10 Potential Surprises for 2023" episode, raising questions such as: Who spilled coffee on the New York Stock Exchange's computers on Tuesday? What's the worst that could happen by "giving everyone fresh knives" in the Russia-Ukraine war?
As for our guest's economic outlook, Cullen discusses why disinflation could be this year's theme... why it's too early to be picking bottoms in the "huge, slow-moving beast" of housing... and why he thinks the Federal Reserve is likely to hike rates a bit more before adopting a wait-and-see approach...
Finally, Cullen explains why he builds "diversified" portfolios around his clients' "monthly liabilities," like mortgage or rent payments and credit-card bills. Simply put, unlike most asset managers, he focuses on specifying time frames for individual asset classes while keeping those liabilities in mind...
When you start to build in that component of time into your portfolio – thinking of things across time horizons rather than just "What is the best long-term-performing portfolio of cobbled together assets?" – break them down into specific time horizons. That way, you can afford to be patient with certain amounts of your money because you're impatient with other components of your money.
Founder of Orcam Financial Group
Cullen Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, personal advisory, institutional consulting and educational services. Prior to founding Orcam, Mr. Roche ran a private investment partnership in which he generated substantial alpha (high risk adjusted returns) with no negative 12 month periods during one of the most turbulent periods in stock market history. Before founding his own businesses, Mr. Roche helped oversee $500M+ in assets under management with Merrill Lynch Global Wealth Management.
Dan Ferris: Hello and welcome to the Stansberry Investor Hour. I'm your host, Dan Ferris. I'm also the editor of Extreme Value and The Ferris Report, both published by Stansberry Research.
Corey McLaughlin: And I'm Corey McLaughlin, editor of the Stansberry Digest. Today, Dan talks with Cullen Roche, CIO of Discipline Funds.
Dan Ferris: For today's rant, did two of our "Top 10 Surprises for 2023" already kind of sort of happen?
Corey McLaughlin: And remember, you can e-mail us at [email protected] and tell us what's on your mind.
Dan Ferris: That and more, right now on the Stansberry Investor Hour. So did two our top 10 surprises already kind of, sort of happen a little bit maybe?
Corey McLaughlin: I think they did.
Dan Ferris: All right. So the first one – I mean this one didn't happen, obviously, but it gave me some insight into how it might happen, and we're talking about what happened Tuesday morning on the New York Stock Exchange. Eighty-four stocks were halted for volatility just in the first several minutes of trading. The whole thing was over pretty quick, but what I found amusing about it was that in the end, after investigating, the NYSE said it was, "A manual error that caused a problem with their disaster recovery configuration." So, a manual error.
My first image in my head was somebody spilling coffee on a laptop. Manual error. Is that like somebody with really fat fingers and they hit the wrong keys? I mean, what is that?
Corey McLaughlin: That covers a lot. Yeah, that leaves a lot open for interpretation, for sure. They said it was manual error with the configuration in their disaster recovery program, which seems like some sort of technical error. But still, this is why we brought up these sorts of possibilities in the "Potential Surprises" episode, was talking about how stocks get dropped, individual stocks or indices drop 20% or more.
Dan Ferris: Some of them did drop 25%. Sorry.
Corey McLaughlin: Yeah, yeah, yeah. So if you weren't paying attention the first five minutes of the markets, it probably didn't affect you too much, but it could have.
Dan Ferris: That's the other thing. Manual error in the disaster recovery config, they use the word disaster, like the D word. Like I would have called it a hiccup. They could have said, "Hey, there was a little glitch in trading for a few minutes," and it was literally over like [snaps fingers] boom, really fast. It was done.
I almost didn't notice it. I wouldn't have noticed it if I weren't on Twitter way too much, and people posted charts of stocks dipping 20% real quick and recovering. But I thought disaster, wow. What happens if we get a real disaster? What happens if we get a repeat of October 19, 1987?
Corey McLaughlin: It definitely hit some alarm bells I think for a few people.
Dan Ferris: Yeah.
Corey McLaughlin: It also reminded me of, you know, a couple weeks ago. Do you remember when there was a manual error with the FAA's flight system?
Dan Ferris: Yeah.
Corey McLaughlin: That shut down, grounded flights for like – I don't know how long it was, one morning. But that turned out to be also a manual error from some contractors who were working in the FAA system. It was the same sort of thing... the flight-plan kind of system that used to be manually configured over like the phone. To me, this is what happened on the stock exchange in New York. It sounded kind of similar.
I think it just shows you that we have all of this technology these days. People talk about AI more now and all of that, the GPT-3. I haven't figured that one out yet, but there are humans behind all of this.
Dan Ferris: Exactly.
Corey McLaughlin: As long as we're around, there's going to be human error in everything.
Dan Ferris: Right. The thing about financial markets is like – you know, well think of it as like your car. I think the average car has like – I've heard 3,000 parts, individual parts. That probably includes every little screw or whatever, but there is, I don't know, maybe a dozen systems, right, but there's lots of stuff that can go wrong. It's fairly complicated. A modern car with a computer in it is really complicated. So you take it for granted.
Then one day the thing has a little glitch or whatever. So you don't think about it, you get it fixed, and then there's another and then there's another, and it's a 20-year-old car. Then before you know it, this thing is inconveniencing you horribly and it breaks down and you whole life is disrupted.
I feel the same way, except the financial markets are a car with like 100 million parts. It's just like insanely complex and insanely interconnected. At least in your car, whole systems can fail and you can keep driving the thing, right? But in financial markets, some part of it fails on one side of the world, and the whole world just swoons. It can be horrendous. We saw the interconnectedness during the Great Financial Crisis and actually a handful of times since then.
So when they're talking about these manual errors, a guy spilling coffee or fat-fingering the keyboard or whatever, I'm like, "Oh, wow." My big one-day 20% drawdown could come true for the dumbest possible reason.
Corey McLaughlin: And it might for the dumbest possible reason. I'm with you. These are why surprises are surprises. Mistakes happen. You can't exactly prepare for every single risk or, you know, unknown. That's why they're unknowns, but these things happen. We've got stocks in the airline system getting fat fingered all over the place. So beware.
Dan Ferris: Right, beware. So our other surprise we talked about was an escalation of the war in Ukraine. I think you and I were kind of on the fence about this. The U.S. has sent – I forget how many Abrams tanks to Ukraine, like 180. Maybe that constitutes an escalation of the war in Ukraine. I think it's different than what you and I were talking about, but I don't know. It sounds like an escalation to me.
Corey McLaughlin: Yeah. What did we say? NATO countries getting involved, more of them. But yeah, there is something about U.S. tanks being shipped overseas and rolling through Ukraine and/or Russia that scream escalation, to me at least. Something about seeing the tanks.
Dan Ferris: And oh, by the way, the U.S. is in NATO, is it not?
Corey McLaughlin: Right, right, yeah.
Dan Ferris: There's a whole lot more U.S. on the ground. It might not be people, but it's there.
Corey McLaughlin: Not to mention all the funding that's still going on.
Dan Ferris: Sure.
Corey McLaughlin: I don't think anybody really knows how this is going to end, the war in Ukraine I'm talking about.
Dan Ferris: Yeah. It doesn't seem to be ending soon.
Corey McLaughlin: I don't think. I think Biden said, oh, we're – you know, when they said they're going to send these tanks over, he said, "We want to end the war." OK. I don't know how this does that but –
Dan Ferris: Yeah. It's like ending a gang fight by bringing five fresh guys on each side into the battle. It's not going to end the war. You know, "Give everybody fresh knives." That's not going to end the fight.
Corey McLaughlin: Yeah. As long as Putin and the Russian military wants to keep fighting, I think is as long as this will go on, unless they get some sort of reason to stop. From my vantage point from across the Atlantic Ocean, it's amateur hour, you know, just seeing it, it's the only thing that makes sense to me, but I could be wrong.
Dan Ferris: My fear with this is that it goes on and on and that our surprise really does come true and it becomes like – of course World War III is the "glib" label I can throw on it. It doesn't have to be World War III. It can be a major European war and that would be bad enough.
Corey McLaughlin: Yeah. Then what impact does that have on the rest of the world and what we're talking about, the financial markets and inflation. You know, war is inherently inflationary. So it could all just kind of file into that whole story about higher inflation, higher interest rates, this new kind of era of the sea change, as Howard Marks said.
Dan Ferris: Yeah. That is one of the narratives that we're hearing. Inflation is over. Stocks will soar. Everything is fine. But I think a bunch of people, like we recently – well, we're going to talk with Cullen Roche. He's talking about things being different for the next 40 years.
We've talked with Vitaliy Katsenelson. He says take the last 20 years and invert it for the next 20. I picked up on this and written about it a bunch of times in the Stansberry Digest. Marks has his own view on it. He's like, "Well, do you think we're going to have these tailwinds that we've had for the last 40 years for the next 40?" It's highly unlikely. It's been Goldilocks time.
I still think there's too many people looking for a bottom. There are too many people like – I still think there's too many people looking for a bottom. It just strikes as the narratives are glib, I feel, and the glibness is dangerous.
Corey McLaughlin: I'm with you. I said last week that the quicker people get more optimistic, the more concerned I get. If we had the GDP – the fourth quarter number came out the other day, which is still growing. 2.9% I think it was. So I think people are still seeing – now people are talking about, "Oh, the soft landing, is it possible now?" after not believing that it would happen at all. Now it's turned the other way like, "Oh, maybe this can actually happen."
Honestly, I could see the argument for that in terms of the numbers with the job market and the amount of job openings that there are. We've talked about this before. There's still about 10 million job openings. So if you're saying those will go away and people won't actually lose jobs, but positions that could have been filled or have been productive are going away. That's still recessionary. It's just maybe not hundreds of thousands of people are losing their jobs.
Dan Ferris: Right.
Corey McLaughlin: In the meantime, you have the rising prices still going on. So it's not exactly rosy, but it might not be the worst case scenario that people may have thought about.
Dan Ferris: Yeah. It'll always turn out different than the extreme binary outcomes that are very easy. It's easy to sort of grip onto an extreme narrative, but life is more complicated than that.
Corey McLaughlin: It is until it isn't anyway. It is right up until, you know, September 2008, and then everyone is, "Whoa."
Dan Ferris: Right. But those moments are rare enough that it's foolish to get too much certainty about predicting anything, let alone something that rare. So we'll see.
I think different for the next several years versus the last several is enough for me. It's enough to say, whew, the tailwinds aren't there anymore, so be prepared. I think that's more than enough for me.
Corey McLaughlin: Yes, me too. That's enough of a starting point. And if you can get to that point, I think you're probably ahead of most people.
Dan Ferris: That's right. All right. So our starting point will be a good ending point for our rant today. Now let's talk to a guy who hasn't been on the show for a little while, Cullen Roche, a very smart guy, a very good investor. Let's talk with him. Let's do it right now.
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Cullen, welcome back to the show. It's good to see you again.
Cullen Roche: Yeah, great to be back. Happy New Year.
Dan Ferris: Happy New Year to you too. It's been a while.
Cullen Roche: We're still saying that. How long can we say Happy New Year?
Dan Ferris: [Laughs] I don't know, maybe until the end of January.
Cullen Roche: I'm just going to say it all year. Is that all right?
Dan Ferris: It's still pretty new.
Cullen Roche: Is that cool? I'm into like September and then I'll be saying Happy New Year again.
Dan Ferris: Past the first couple of months, I think it's probably not appropriate, but it is still quite new.
I just want to dive straight into the reason why I asked you to come on, because we haven't talked in quite a while actually. That's certainly one reason, and I like to get you on here as regularly as possible.
The second one is this tweet that you recently put out, which kind of hit home for me because it's a question I ask a lot. You said, "Will the next 40 years of stock market performance look like the last 40 years? I say no. What do you think and why?"
Cullen Roche: I think that's right. Here's to kind of put some numbers to this backdrop. The last 40 years were really unusual, I think especially in the United States for two big reasons. You had a huge tech boom that I think created this divergence between foreign and developed equity market performance. Then obviously we had the big interest rate tailwind. So falling interest rates for 40 years are a tailwind to the stock market for so many reasons.
The tech one is almost more interesting. I mean when you look at the actual numbers, when you drill down into it, the U.S. stock market generated over 10%, so 10.1% per year since 1982, and did so with a lower standard deviation. So less volatility than the foreign markets, which averaged 6.5%.
To me, I think a lot of us who have studied stock market history, we kind of get these fake numbers in our minds about what the stock market will do on average going through history and going forward. I think that number of like 10% to 12% is kind of a number that a lot of people tend to think is really realistic and –
Dan Ferris: A huge pet peeve of mine, by the way. Continue.
Cullen Roche: Yeah. Well, mine too. I don't know. I'm a big proponent I guess of under-promising and hopefully over-delivering. But I think that in terms of building a portfolio, it's just super-important to have realistic expectations. So you get into this mindset of like the stock market is going to do 10%, 15%, 20% per year.
Well, you get into this mindset of anything that's less than that, you know, you could find yourself in a portfolio that's doing 8% per year, which is frankly fantastic. You'll still look at it on a relative basis and you'll say, "This portfolio sucks. I'm changing everything. I'm going to shift into the Cathie Wood portfolio because that thing has been doing 25% per year.
That's a lot of the mindset. People get these sort of unrealistic expectations built into their framework, and then they end up falling for what inevitably ends up often being a lot of behavioral biases across time.
So to me, when you look at the performance of aggregate corporate America, the performance has been actually on average, the growth of corporate profits has been closer to like 7% over the course of history. So if you think of corporate America as being an entity that basically paid out all of its profits every year in the form of like a dividend distribution, 7% is actually the sustainable figure basically, which is interestingly much closer to the international figure that we've seen of 6.5% and, frankly, seems like a much more sustainable figure on average compared to the American markets which have done so much better.
I know this has been a big theme for a pretty long time of people saying, "Oh, you need to be diversified internationally because of this reason or that reason." But I think over the course of the next 40 years, as this trend really plays out, you're going to see that at a minimum the divergence between that performance, which is – the difference between 10.1 and 6.5 over 40 years is a huge, huge amount of money.
Dan Ferris: Yeah.
Cullen Roche: I think it's going to converge more and more.
Dan Ferris: That makes a lot of sense to me. Of course, a big part of this argument is tailwinds, interest rates, inflation, et cetera. We got really used to that. I mean think of somebody who started investing any time in the last 40 years. They started. They just think, "Well, you can buy every dip because the market always recovers. It always goes up. The returns are going to be there."
They don't have any sense of like what my friend Vitaliy Katsenelson would call a sideways market or a range-bound market. The returns are there. They're like mid-to-upper single digits over maybe 10 or 20 years, but it's a brutal slog. I mean it can be a really brutal slog.
Cullen Roche: Yeah. It's kind of interesting that we're talking right now, because I kind of think we're in one of those markets. It's funny. I recorded something with TD yesterday on TV, talking about the market environment that we're in and what's the best analogy. History is never a perfect analogy for the future, but if you held a gun to my head and you asked me what was the best analogy for today, I would argue that the 2001 or 2002 kind of sideways slog of grind lower is a great analogy, where you had this big speculative fervor, huge premium in growth versus value performance.
Then the air is kind of coming out of this bubble and you had a lot of the underlying fundamentals for that big blow-off. They weren't there. That's actually one of the really interesting things about COVID. When you think about everything that kind of happened during COVID, I kind of think that when we reach the other side of this completely, 2024, 2025, I think a lot of us or maybe all of us are going to look back and be like, "Man, was that like a crazy dream that happened?" because I think everything is going to kind of just revert back to where we were, and life is going to largely return to what it was pre-COVID, and we're going to wake up and be like, "Man, that was a crazy couple of years. Why did the government print all that money? Why did inflation go so high? Why did I buy bitcoin at 65,000?"
Dan Ferris: Yeah. I think a lot of people are already asking that one. You put out a video recently that I kind of breezed through earlier. I noticed that you talked about a couple of things that Jeremy Grantham just wrote about in a recent note, and one of those is housing. His point was housing is like – it's still really highly valued in terms of like house price to income in the U.S., where it's 6 or so, up from about 4.5 maybe 11 years ago, 12 years ago. But he says the rest of the world, London, Paris, Vancouver, Sydney, all these places, they're between 10 and 20 times income.
Now look, real estate markets are local. They're different. I get it. But still, those are pretty extreme numbers. You could just stay focused in the U.S. and say, "Wow, this thing might have a long way to go." But what are your thoughts about housing right now and in the next maybe few years?
Cullen Roche: Again, the COVID boom kind of throws everything for a loop here. The old rule of thumb used to be that in terms of your disposable income, you spend something like 25% to 30% of your income on housing or shelter. So what happened though, with the current cost of where mortgages are and rents and everything, the cost of that now is closer to like 40%. That's if you're rolling into a new mortgage from your old one. A lot of people are kind of locked out of, I think, transitioning from a new house at this point, just because they're locking into the golden handcuff of the low mortgage rate that they locked in back during the pre-COVID period.
Those numbers are interesting because you have to ask yourself – COVID made houses obviously much more valuable, the main reason being that for a lot of us, your house became your office. So in a certain sense, the sort of premium that we're seeing in terms of the way people are valuing homes makes sense because if your house is now your office, you obviously are willing to pay a lot more for that thing.
But the question is: is this going to sustain itself? Is the "work from home" here forever? If it's not, does that mean that there is potentially a lot more downside in housing than people think?
It's crazy to look at how far and how fast the real estate market came, because that 40% jump during COVID, what that means basically is that if we were to have a 25% decline in housing, which is a really substantial decline in housing, that would only take us back to 2020.
If you remember the pre-COVID period, people were already looking, especially in those foreign markets, like the crazy Canadian markets and a lot of the foreign markets, they were already saying, "These houses are totally unaffordable. This market is a crazy speculative fervor. It needs to collapse," and everything kind of just kept rolling, in large part because of the – I think largely because of the stimulus from COVID and all the complexities of everything that was going on.
But that's crazy to think that a 25% decline just takes us back to where we were in 2020. And what does that do? If that actually happened, which would not be crazy at all I don't think, it's an outlier outcome probably, but would really not be that crazy. What does that do to everything else? I think that's a really rational, realistic risk to talk about.
The other crazy thing with real estate is that real estate is a huge slow-moving beast. Nothing fast happens in the real estate market. I think it's funny, especially right now. This month I saw that Redfin came out this morning and said, "The real estate bull market is back," and it's like we've only been in a real estate bear market – prices, first of all, are down like – I don't know. The national Case-Shiller is down, I don't know, maybe 3% to 5% or something like that.
When you look at past bull and bear markets in real estate, we are potentially so early in the way this is all playing out that I kind of think it's crazy to look at this and start picking bottoms so early into something that is probably, in my view, going to be like you said, kind of a slow grind, either at a minimum, I think, sideways, with all probability, probably a grind lower.
Dan Ferris: Yeah. Even though the events may be different, pre-financial crisis, it was like the peak was in 2006. The bottom was in 2011. It's just like, whoa.
Cullen Roche: Yeah. That's just how real estate works. I live in the worst state for this, California. It took me 18 months to get a permit when I remodeled my home. Granted, we did a lot and we had some weird environmental stuff because I have a creek on my lot, which I'm the biggest idiot in the world for buying an environmental hazard in California. But still, 18 months.
It's like as I was going through this process, I was going down to the building department at times and being like, "Are you people out of your minds? Why can't someone review this and just put a stamp on it, because this is so obviously done at this point?" It went on and on. It went to the state. The state bounced it back to the city. It was so dysfunctional.
Then you get into the actual building process and it's like the developer says, "Oh, this is going to take nine months," and you're like, "You're full of it. This is going to take 12 months, right?" and he's like, "Yeah, probably," and then it takes 15 months.
Dan Ferris: Yeah, that's how it works.
Cullen Roche: But that's how real estate is. You're talking multiple, multiple years for everything to play out. A lot of the inventory issues and stuff that are going on right now, that's builders who started building these homes two years ago. That inventory is just coming onto the market now. So this I think is going to play out over a much longer period than people think.
Dan Ferris: Yeah. Then on the other side, we were talking about people working at home, changing the dynamic a little bit. On the other side of that, the commercial structures that they're levered up for 100% occupancy, and they're like 50 occupied trying to roll these loans out. I feel like that's going to get really ugly.
Cullen Roche: Yeah. That's a really interesting one. In the last two or three years, I have been relentlessly bombarded by real estate investment trusts, the private REITs that were coming at us, and some of them are actually publicly listed, but they don't – a lot of the ways these things work is they don't actually mark their valuations to market because they really can't. It's crazy though because some of these firms would send me their pitch decks and you look at the net asset value of these mutual funds or their product, privately listed REITs in a lot of cases, and it is – I don't want to say it's Bernie Madoff.
I don't know if you remember the Bernie Madoff chart, the performance of his fund, but man, that thing was just like – it was a straight line. It was most likely looking at –
Dan Ferris: A 45-degree angle, up and to the right forever.
Cullen Roche: Yeah. It was perfect. It was the perfect, perfect performance chart.
Dan Ferris: No matter what –
Cullen Roche: Yeah. But when you look at a lot of these real estate funds, they look really similar.
Dan Ferris: Yes.
Cullen Roche: The pitch decks sound the same. They're like, "You generate 6% tax advantage with a standard deviation of two," and you're like, "What?" That thing – I'm sorry, maybe that thing can exist for five- to 10-year periods when markets are just the way they were sort of pre-COVID, but man, I don't know. Maybe I'm jaded by having lived through a few big bear markets, but I feel like these things never last.
I don't know. I know some people who are rolling money out of those funds, and I'm like this is a great time to take a breather on stuff like that, and just step back and let this thing play out and see. You know, hey, you had a really good run, but those charts that go 45 degrees from bottom left to top right with no volatility, whew, those don't stick around for long.
Dan Ferris: Right. This reminds me of something else. I saw a little blurb somewhere today that talked about – I think it was on Twitter. The guy was talking about fraud. Every time I say fraud I think of the up-and-to-the-right Bernie Madoff returns. It's like a major red flag, and the fact that it was delivered to the SEC 10 times is another thing.
But the real point he was trying to make was frauds in public markets, he said there haven't been a lot of them recently, like Autonomy. HP bought Autonomy. That turned out – and in Wells Fargo, that whole thing with lower-level employees committing fraud on these accounts that they were bringing in. But he said nothing else really big in the past several years.
Then I thought of the recent ones. They're all private market, FTX, that company that JPMorgan bought, Theranos. It's all private. They get to say whatever they want. They can mark anything wherever they want it. I feel like, OK, this is where the wave of fraud is going to come from because they're the up and to the right. That's the up-and-to-the-right valuations and things.
I don't know. I always wonder what's the connection to public markets.
Cullen Roche: Yeah. And what's lurking? The crazy thing – I mean I think for sure you can look at the last two years and just say this was one of the stupidest environments we ever saw. All the stuff that has been going on, whether it was like – like I remember when Gene Fama and Richard Thaler used to have arguments about like efficient markets. They would be sort of like strange things that would happen, like funds that – you know, somebody mentioned something idiotic on CNBC and the stock goes up a million percent and it stays there for a few days.
Thaler would say, "See? Markets are inefficient," and Fama would say, "No, let it play out because markets are efficient, and it'll right itself in the long run." Thaler is a famous behavioralist who would argue that markets are driven by irrational behavior and prone to inefficiencies, and Fama is the opposite, who is kind of like, "No. Markets are perfect and they get everything right in the long run."
The truth is probably somewhere in the middle, in my view. But the last few years, I mean you can look at some stuff and just – and this is still going on, where things like GameStop and AMC and a lot of these stocks that really just had no fundamental basis for making the moves that they made are still really high compared to where they were.
I don't know. And there are so many more examples outside of – obviously, you could look at almost 99% of the crypto market and make basically the same argument. How much of that was just silliness that is still kind of playing out and being digested by the market over time?
I still think five years out we'll look back and there's – I don't want to say there's certainly some sort of like humongous fraud lurking, but the FTX thing is interesting. People were talking about it like it was such a big deal at the time. In inflation-adjusted terms, FTX was not a big fraud. It was an important fraud because they defrauded a lot of people who couldn't afford to be defrauded because the average account value there was something like, I don't know, a thousand bucks or something.
But in terms of like big corporate frauds historically, especially in inflation-adjusted terms, FTX was just not that big and the crypto market is not that big. So it is interesting, especially in the context of looking at something like real estate, which is the biggest asset class in the world by orders of magnitude.
What is lurking out there? It's weird going through this sort of grinding process that we're going through now, because oftentimes you don't actually see the skeletons in the closet until you start opening up the doors, and you have to start wondering at this point like how many doors have we actually opened and how many doors are left to be opened.
So I don't know. Predicting fraud is obviously like a haphazard way to sort of manage your investments. I think realistically, I mean looking at just the amount of sheer craziness we saw in 2020, to see nothing on the other side of that in terms of like a really big fraud would be – it would be really surprising.
Dan Ferris: Right. The point is not to predict it. It's like a characteristic of these kinds of aftermath grinding periods, and I just wanted to throw that in there.
Cullen Roche: Yeah.
Dan Ferris: The other thing about the most massive asset class, real estate, is like substantial leverage is just de rigueur. We don't even think about not using substantial leverage. It's like, whoa, when things go south, poof, they go south in a bigger way because of that.
Cullen Roche: And especially related to the way that credit cycles work. I mean this is I think really important to understand in the context of what's going on now, because the Fed just moved really fast, the fastest they've ever moved, and in such a big move relative to the timeframe over which they did it.
A lot of the refinancing that needs to be done – the mortgage market is a lot healthier than it was in 2008. So I don't know how much of a worry, like a repeat of 2008 is, but I think in the corporate market it's probably a much bigger issue. Probably on the consumer household balance sheets it's a much bigger issue, too, where people now have to refinance everything back into a totally different rate structure.
I mean we basically had – for 10 years, the whole economy became built on like a 0% interest rate structure, which was equivalent to a 3% mortgage rate and super-low ability to borrow, you know, to purchase new vehicles and to run lines of credit, corporate credit, so on and so forth. And now we've only just adjusted upward into this new normal.
I don't know. How long is the Fed going to stay where they're at? I think they're at least going to stay where they're at through this year, but that means that you've got like a full year of refinancing going on across all of credit. Again, this is something that – this is not going to happen quickly. We're not at the end of the tunnel here in terms of how this is all played out.
Dan Ferris: Right. Are you telling me you think like rates could be higher for longer? A lot of people are talking about the Fed even cutting this year, by the end of this year, inflation higher for longer. Tell me how you feel about each of those.
Cullen Roche: Here's the interesting thing about this. In my full-year outlook I said that 2023 was going to be the year of disinflation, which basically means a positive rate of falling inflation. So it's like going from 5% to 4% to 3% to 2%, is what economists call a disinflation. So you still have increasing inflation year-over-year, but relative to where it's been declining.
So I think that over the course of this year, I mean just the year-over-year comps and the normalization of the economy, supply chain, things like that, it all to me points to the year-over-year comps are going to lead to lower rates of inflation. So I think that core personal consumption, expenditures, inflation, which is what the Fed cares about, that's the indicator that they care most about, I think that's going to end the year at 3%. It peaked at like 4.5%, and it's been ticking lower kind of continuously throughout the last few months.
So even if we get to three though – the Fed's target is 2% – so even if we end the year at three, we're still way above the Fed's target rate, which to me, that translates into a situation where the Fed is going to – I think over the course of the next couple of Fed meetings they're going to move the rate to five. I don't care how they get there, whether they do 50 – people have all these debates about 50 dips versus 75 or – [crosstalk] – we're going to get to five.
Dan Ferris: Exactly.
Cullen Roche: We're going to get to five and I think they're going to kind of hold it there for basically the whole year, and they kind of wait and see what happens with inflation.
Honestly, the other big debate that people have been having is: is the Fed going to pivot? To me, they're not going to pivot. They're not going to make this like big, glorious pivot at some point. I think the only situation in which they sort of start to move the opposite direction really quickly is if things start to go south really fast if the unemployment rate starts to tick up a lot faster than they expected. In that scenario, you won't even get a pivot. They're going to be backpedaling basically. They're going to be backpedaling, back to where they say something like two to 3% overnight rate.
But I don't think the – the likelihood of that happening this year, I don't peg that as being very high. I think they're going to remain at five for basically the whole year. You're going to be able to buy a 5%-yielding Treasury bill in a few months. It's going to be one of the best deals that we've seen in decades. I mean not since like the beginning of my career were we able to buy 5% Treasury bills.
So I think the Fed is going to sit tight and inflation is going to remain higher than they expect, which means that everything in the credit markets is going to remain tighter than markets are probably pricing in even right now.
Dan Ferris: Yeah. As soon as you told me – let me just go back a little bit. As soon as you mentioned getting to about 3% inflation by the end of the year, my first thought was this sort of what I think of as a double-lag effect in Fed policy.
They come up to a certain moment in time. They look backward. It's backward-looking data that they're using, so call it a month or three or something. Then the policy is executed and the effect of it lags, some they say six or so months into the future.
So I think if they're looking at all these numbers that we're discussing and they come up with 3% in December let's say, are they ever going to begin to appreciate the lagging nature of the policy execution? Are they going to say, "Well, it's three now, but we're at five-plus maybe when the Fed funds, so let's just take a breather."? That sounds like you are confident that they will finally sort of figure that out. They don't seem to have figured it out yet.
Cullen Roche: I don't know. The outlier scenario is: does 5% on the overnight rate cause a lot more problems in credit markets than they expect?
This debate is weird. I try to be at least somewhat understanding of the Fed. Their job is impossible and I think what they're really, really worried about is they're worried about a return of the 1970s. So they want to get ahead of that, the cart there, but I don't know. To me, the risk of the 1970s and the wage-price spiral and a lot of the dynamics that you had in the '70s, to me they're not there. This is not an environment that looks a lot like the 1970s, and I think that is starting to kind of play out in the data now.
All the Fed officials, everyone in the Fed, they lived through that era. They're hyper-worried about it. To their credit, I mean a 10-year – we lived through one to two years of pretty high inflation, which is sucky in a lot of ways, but imagine 10 years of it. I mean 10 years of 10% inflation is – it's really horrible, really catastrophic.
Dan Ferris: And again, at least the first portion of that period, the Arthur Burns portion, it ratcheted up and down. That was the nature of his widely touted failure, was that when inflation numbers sank he said, "We licked it. It's done," and it was not because –
Cullen Roche: Yeah. That's exactly what they don't want to do in this environment.
Dan Ferris: Right.
Cullen Roche: They don't want to cut rates down to three and then get a big surge in demand that causes another big jump in inflation. So they're hyper-worried. That's part of why I think that the really likely scenario going forward is that they're likely to stay higher for longer and keep rates 5%-plus for at least this year, I think.
It's weird, because if I'm right that this is not the 1970s and that this is more analogous to – I don't want to say 2008, but say 2001 or 2002, where corporate credit is pretty fragile. You get lower inflation than you want and higher unemployment than you want, which creates kind of the exact opposite of what the Fed is really positioned for. I think they're cognizant of that risk, but it certainly does not seem to be the consensus view that they are more worried about that than, say, the return of the 1970s.
Dan Ferris: Yeah. Let's look at inflation from another angle that you looked at in your recent video. You talked about something that's become important to me, the dollar index. I don't want to spoil it. I want you to tell it. So why don't you tell our listeners the scenario that you kind of – it seemed like that was the bigger one you were discounting.
Cullen Roche: Yeah. The dollar is another sort of huge tailwind, especially for U.S. markets. It's really interesting to look at the dollar relative to everything else, especially in the scope of COVID. You could have gone back to 2020. I remember when we talked back during the earlier parts of COVID and I was – a lot of people know me for being sort of a – not a deflationist, but a disinflationist for like 10 years coming out the financial crisis because I was basically saying that monetary policy and quantitative easing doesn't cause inflation. Fiscal policy is the thing that causes inflation and we haven't had huge, huge fiscal policy.
So the government spending just wasn't there to cause a really, really high inflation coming out of the financial crisis, whereas with COVID I was like, "Holy cow. We're spending an incredible amount of money," and inflation went higher than I expected it to, but still, I expected inflation to be much higher than I think a lot of other people expected, certainly the Fed.
But the interesting thing with that is that even in the context of that, you could have looked at all of the relative currencies and said, "What's going to happen to the dollar in that scenario?" The scenario where the dollar rallies against everything I think shocked a lot of people.
That's just the fact that the dollar, even with this crazy high inflation that we've had the last few years, everyone else had higher inflation basically. So the dollar was still the strongest currency in a horrible neighborhood of fiat currencies.
But I think the worm is turning on that though, especially on the relative interest rate dynamics. I think what's happening is that the Fed, even though they're not going to move to a lower rate position, the Fed has been much more aggressive than a lot of foreign central banks. So on a relative basis, the dollar has rallied in large part because the interest rate dynamics have been so much more aggressive in the USA.
We've started to see that already in the reversal of the dollar index in the last months, few quarters. But I think it's going to continue for this year, maybe a couple more years.
Dan Ferris: The reversal?
Cullen Roche: Yeah. I think foreign central banks continue to be really aggressive in fighting inflation, and the Fed, I think the Fed's mission is done. Even though they're going to stand pat with where they are, I think that the Fed's battle against inflation is over, whereas the risk of inflation, especially in places like Europe where they have the huge energy exposure and so many of the mishaps with policy there, they have a lot more inflation risk that's going to be a persistent type of inflation risk relative to the United States.
So I think they're going to be fighting a different battle for potentially much longer. That's assuming you don't get that outlier scenario where things sort of get really crashy in a lot of other markets. But even in that scenario, I think inflation is going to be high on a relative basis in foreign markets versus the USA.
Corey McLaughlin: OK. So let's talk about what to do about all this. Your model that you use at Discipline Funds is in major "risk off" mode. It seems to be all the way down at the bottom of the graph that you published, in risk-off mode. But I thought you had an interesting idea that I hope you'll talk about, which is diversification across time. What do you mean by that?
Cullen Roche: It's interesting. I basically use a countercyclical approach to asset allocation. I like owning stocks and bonds and other asset classes, but I think the thing that always struck me as being really strange, especially with a lot of big index funds, the way they rebalance is that they always rebalance back to a fixed rate.
What's weird and the thing that lot of people don't look at is that the relative market caps or the stock market versus the bond market, it changes a huge amount every year. So if you were following like a really efficient market hypothesis approach to asset allocation, well you would track those actual market changes.
But the weird thing is that behaviorally that's the exact wrong way to manage money, because what typically happens is the market cap booms during periods like 2007, 1999... big, big bull markets. That's when the stock market capitalization, the percentage of the stock market's value relative to the bond market, it booms. So the bond market typically doesn't grow very much, so the stock market tends to cause these big gyrations.
Interestingly, when you look at the data, it kind of moves and the stock market is typically – like in the early '90s, it was 35% of market cap. It grows to 50% by 1999. It crashes back to 35% by 2003. It grows back to 50% by 2007. It crashes back to 35% in 2009. Then it kind of grew back to 50% by like 2016 and sort of stayed pegged there.
So behaviorally, the right thing to do, if you're trying to navigate all the volatility of the stock market, is basically to do the opposite of what the market cap of the stock market booms and busts are over time. That's kind of the approach that I take because I'm just hypersensitive to people's worries about this. I think the stock market is what drives the majority of people's concerns in the financial markets over the long term because the stock market is just so volatile relative to everything else. So if you can kind of throttle the stock market's volatility, you can create a much more behaviorally robust asset allocation.
Right now we're still in one of these environments, where the model was very bearish coming into last year, and it hasn't really changed that much coming into this year. So still in kind of a risk-off mode.
But the more important thing is that we use that model kind of as like a core position for a stock/bond multi-asset allocation. The much more important, I think, component of asset allocation for me is that a lot of asset managers, really the whole industry, we talk about when we build portfolios we typically – we'll run like a back-test of different asset allocations and look at like it spits out the best risk-adjusted asset allocation.
Then you say, oh, you're 50 years old and you've got this risk tolerance, so the best risk-adjusted portfolio for you is 50% stocks and 25% bonds and 10% gold, yadda, yadda, yadda. Then you slap that together and the person ends up holding this sort of mish-mash of different stuff.
The problem with that is that none of us live our lives in this sort of risk-adjusted asset allocation model. We all live our lives based on the way that our liabilities change across time. So we all have monthly liabilities, a mortgage, your rent, your credit-card payment. If you've got kids planning for college, you've got five- to 10-year expenses. If you're planning a down payment on a house, let's say you've got two to three-year money that you need.
This is how actual life works across time. We have all these liabilities across all these different time horizons. When you take a portfolio that is just a mishmash of all this stuff, well when you need the down payment for the house and the stock market is down 50% or the bond market is down like it was last year, well this mishmash of assets causes what's called an asset-liability mismatch, basically, where you've got short-term liabilities that need to be funded, but your assets are all down in value.
So I've become a big advocate. I wrote a paper called "All Duration Investing." It's sort of the methodology that I use now, where instead of looking at diversification across the best risk-adjusted asset classes, I try to apply actual durations to every asset class that we have.
So in terms of the actual figures, a Treasury bill is basically a – think of it as like a zero- to one-year instrument. That's your cash-like instrument that you know that across certain time horizons, even if inflation is raging, in nominal terms that principal certainty is pretty clear.
You can look at something like a short-term government bond fund, something like the Vanguard short-term government bond fund. It's basically like a two-year instrument. The aggregate bond market is like a six-year instrument.
The stock market in my model ends up being basically an 18-year instrument. Things like gold and commodities end up being basically 30-year instruments. I actually like to think of gold and commodities as more like they're insurance. They operate like – I mean if you think of what an insurance contract actually is, an insurance contract is typically a very long-term instrument that generates a negative return on average actually, but in certain environments it will generate very, very high sort of asymmetric returns.
That's what gold and commodities are really similar to. They're instruments that they don't generate consistent cash flows like stocks and bonds do, but in certain environments they'll outperform for very specific reasons that are generally operating like insurance relative to stocks and bonds.
So I've become a big advocate of building portfolios, working mainly from the liability side, looking at someone's financial plan based on how they spend their money, and then saying, "Look, I know that Treasury bills right now are only yielding 4.5%, which that sucks compared to the long-term average return of stocks over the course of time, but this is a financially appropriate holding for you, for x amount of dollars for you, because when the stock and the long-term bond market are doing terribly, that Treasury bill position will give you the peace of mind to know, hey, I've got this amount of money laid out for this number of years, and I don't have to sweat what the stock market is doing because I know that the stock market is an 18-year instrument that you just let it ride." You don't worry about what it does over the course of 18 minutes or 18 months.
Dan Ferris: OK. Folks who want to find out more about you and about these ideas can go to DisciplineFunds.com and find you on Twitter @CullenRoche.
Cullen Roche: Yep.
Dan Ferris: We've come to the moment when I ask my final question, which is the same question for every guest no matter what the topic. You have answered it once or twice yourself and here it is again, if you could leave our listeners with a single idea. If you already stated it, by all means just say, hey, that was it. But if you could leave them with a single idea today, what would it be?
Cullen Roche: Do you want an asset allocation idea or just a general philosophical idea?
Dan Ferris: You can go anywhere you want with it.
Cullen Roche: I think I said something similar in a previous episode, where I said patience was really important. But speaking of this sort of all-duration framework, I'm so much more convinced now than ever, especially after having gone through COVID, that managing your assets and liabilities and accounting for time is the crucial aspect of good financial planning, in my opinion.
That approach is so different than the way that a lot of portfolio management is done, where so many of us look at things like stocks and bonds, and we talk about stocks for the long run or gold for the long run or whatever it much be, and the reality is that none of us really – we don't have a long run for all of our assets. We have all these different time horizons.
I think when you can introduce the aspect of time, you're kind of solving for the last big problem in portfolio management because building a really good risk-adjusted return portfolio, that concept may put together a portfolio that has a lot of great aspects that might be appropriate for a certain risk profile or risk-adjusted style return over the long-term, but it doesn't help you plan for time.
I think when you start to build in that component of time into your portfolio and thinking of things across time horizons, rather than just what is the best long-term performing portfolio of cobbled-together assets, break them down into specific time horizons. That way you can afford to be patient with certain amounts of your money because you're impatient with other components of your money... because that's the way we all live our financial lives.
We're inpatient with certain liabilities, and if you take care of those liabilities by matching them with certain assets, it gives you the ability to live through periods like COVID, where you can afford to be patient with other money because you know that you've got impatient money to kind of offset it.
Dan Ferris: Nice. Yeah. I like the way you talk about time and patience. That's awesome.
Cullen Roche: I've got young kids and I'm getting old and I'm running out of time, so it's something that I'm becoming obsessive about.
Dan Ferris: I can see it, yeah, but you're something about it. That's great.
Listen, thanks for being here. It's always a pleasure to talk with you. I'm sure our listeners got a lot out of this.
Cullen Roche: Yeah. Well Happy New Year, everybody.
Dan Ferris: All right. Thanks a lot, man.
Cullen Roche: All right, Dan, great talking.
Dan Ferris: Many mainstream analysts are predicting that stocks will recover soon, but I say we'll instead witness a cash frenzy unlike we've experienced in 21 years before stocks recover, and I'm urging Americans not to buy a single stock until they see it. I predicted the Lehman Brothers crash in 2008 and I called the top of the Nasdaq in 2021. But this, this is the No. 1 most important thing to pay attention to for 2023.
I'm not talking about another market crash or politics or inflation or any of these other things. As all this unfolds, the financial consequences of what I'm talking about could last for several decades if you don't understand what's happening. There will be winners and losers and now is the time to decide which one you'll be.
This is why I strongly encourage you to read about my warning, totally free today. It's all spelled out in a free report we put together. Get the facts yourself. Go to www.stockdeadzone.com to get your free copy of this report.
You can learn how to get my four steps to prepare for what's coming. Again, that's www.stockdeadzone.com for a free copy of this new report.
Hey, how about that. That's like the third or fourth interview we've done fairly recently, where the issue of time has been really important. When I think about just sort of the typical mistakes that investors make, as Cullen was talking I was thinking about it.
He was talking about the way we live our lives and how people need more patience, and they need to match their assets and their liabilities. I was thinking, yeah, one of the big mistakes that investors make is they're not patient enough. They're not patient enough with their stocks.
Like he said, it's an 18-year asset class in his view versus shorter-term bonds or something that makes more sense to liquidate in the shorter term. So I think that was a really great discussion with him, for that reason alone, let alone all the other insights he had about housing and the Fed and so forth.
It's always a pleasure to talk with Cullen, a really smart guy, really sort of conservative-focused, risk-adjusted thinking kind of investor, and just an all-around smart, good guy, and that's why we check in with him on a regular basis. I don't think we'll wait so long next time.
All right. That's another interview and that's another episode of the Stansberry Investor Hour. I hope you enjoyed it as much as I did. We do provide a transcript for every episode. Just go to www.investorhour.com. Click on the episode you want, scroll all the way down, click on the word "transcript," and enjoy.
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