Investing in a Crisis with Dan Rasmussen

Name: Investing in a Crisis with Dan Rasmussen
Uploaded: 2023-04-10T12:30:25.000Z
Duration: 2 h 4 min 43 s

Introduction

In this section, the host introduces the guest, Dan Rasmussen, and discusses his focus on investing through crises.

Investing Through Crises

Dan Rasmussen is a guest on the show.

Rasmussen's focus is on investing through crises.

The host asks if it's possible to time the market during a crisis.

Timing the Market During a Crisis

This section explores whether it's possible to time the market during a crisis and what indicators can be used to identify one.

Identifying a Crisis

It's difficult to know when you're heading into a crisis or in a bubble.

When high yield spreads rise above their 10-year median, it's a risky time.

When major indices are trading low and high yield spreads are over 600 basis points, there may be downside risk.

Knowing You're in a Crisis

You really know when you're in a crisis because major fund managers may shut down and asset classes may be blaring on the front page of newspapers.

High yield spreads over 600 basis points indicate real capitulation.

Conclusion

This section concludes the interview with Dan Rasmussen and summarizes key takeaways from his research.

Key Takeaways

Use rules like trend following to avoid selling at depths of crises.

Look for periods of panic as an indicator of being in a crisis.

High yield spreads rising above their 10-year median indicate a risky time.

High yield spreads over 600 basis points indicate real capitulation.

Understanding the High Yield Spread

In this section, the speaker explains what the high yield spread is and why it's important to understand it.

What is the High Yield Spread?

The high yield spread measures the difference in cost that risky borrowers generally small cap companies or companies that have borrowed too much pay to borrow relative to the equivalent treasury rate.

It's a wonderful indicator for two reasons:

These are borrowers on the margin, so if there's a material change in their borrowing costs, it indicates a change in default risk.

It tells us what banks and fixed income investors think about default risk.

Why Should You Care About the High Yield Spread?

Banks and fixed income investors are sophisticated and not thinking about hopes and dreams of the future. They're thinking about whether they'll get their money back on an investment.

When spreads rise materially, it means there's more default risk than before. This is not a good sign for businesses or consumers.

The financial accelerator happens when small shocks turn into big crises. Watching high yield spreads closely can help identify when this might happen.

Financial Accelerator

In this section, the speaker explains Bernanke's idea of the financial accelerator and how it relates to high yield spreads.

What is Bernanke's Idea of Financial Accelerator?

The financial accelerator happens when something happens (like Russia invading Ukraine or tech earnings coming in weak), causing people in financial markets to reprice risks.

Marginal borrowers may then invest less or hold off until markets clear. This can lead to job losses, lower consumer spending, and stock market declines.

Watching high yield spreads can help identify when this feedback loop might be happening.

How Do We Know When We're at Risk?

Spreads above 470 are not good and indicate that the financial accelerator is starting to see some pickup.

When spreads blow through 600, it's a real danger sign. If they continue to widen, lending may constrict and harm the US economy.

Analyzing High Yield Spreads and External Financing

In this section, the speaker discusses how to analyze high yield spreads and external financing in unique environments where external financing is shut off from the economy.

High Yield Spreads

The direction of the spread either rising or falling adds value to the strategy.

Paying attention to both the absolute level and direction of spreads is important.

Currently, spreads are wide and rising, which is a worrisome scenario for the economy.

Impact on Economy

When spreads are tight, it tends to be inflationary. When they're wide, it tends to be deflationary.

Rising borrowing costs are contractionary because there's less money to go around.

With high levels of indebtedness as a country, incremental increases in rates may have a greater effect than before.

Credit Driven View of the Economy

In this section, the speaker discusses their credit-driven view of the economy and how changes in debt prices affect market participants' actions.

Debt Prices

People buy things on credit deals happen because of availability of credit.

Changes in debt prices change actions of all participants in market economy.

Cheaper debt is stimulative while more expensive borrowing is contractionary.

Incremental Increase in Rates

In this section, the speaker discusses whether incremental increases in rates will have a greater effect than before due to high levels of indebtedness.

Rates

Incremental increases in rates may have a greater effect than before due to high levels of indebtedness.

Interest Rates and the Economy

In this section, the speaker discusses how interest rates affect the economy and why raising rates tends to be predictive of good economic outcomes.

The Relationship Between Interest Rates and Economic Outcomes

The Fed tends to raise rates when the economy is doing well, which can lead to good economic outcomes.

Raising rates tends to predict good economic outcomes until the end when they raise too much.

Falling rates tend to occur when the economy is doing badly, but there is little correlation between interest rates and any asset class in a predictive way.

John Taylor's rule suggests that the Federal Reserve rate should track nominal GDP. If GDP is rising, then the Federal Reserve rate should also rise.

Concerns About Current Interest Rate Policy

The Taylor rule broke down in February/March of last year, and the Fed didn't start raising rates until GDP had already started slowing.

When there is a wide gap between where the Taylor rule says the reserve rate should be and where it actually is, it tends to foreshadow bad things for fixed income markets.

When spreads go above 600 (a standard deviation about long-term median), it's considered a major economic event.

Why Interest Rates Matter

In this section, the speaker explains why he cares about interest rates relative to where they are compared to where they should be according to John Taylor's rule.

Why Interest Rates Matter

The speaker cares roughly where interest rates are relative to where they should be according to John Taylor's rule because if those get way out of whack, it's a cause for concern.

The speaker looks at the 10-year median to determine where the current cyclical average cyclically adjusted average would be. This is useful for giving you wide or tight.

When spreads go above 600, it's considered a major economic event.

The Problem with Discounted Cash Flow Model

In this section, Dan explains why the discounted cash flow model may not be a reliable method for forecasting future cash flows.

Limitations of Discounted Cash Flow Model

The discounted cash flow model relies on accurate forecasts of future cash flows and risk assessment.

It is impossible to accurately predict future cash flows and risks, even with extensive research.

The model replaces uncertainty with certainty and can lead to overconfidence in forecasting.

Garbage in, garbage out: the model's assumptions are often driven by biases and trend extrapolation.

Creditism vs. Capitalism

In this section, Trey and Dan discuss Richard Duncan's theory that we are no longer in capitalism but creditism, where credit and liquidity drive asset performance more than earnings.

Creditism vs. Capitalism

Richard Duncan believes we are now in creditism rather than capitalism.

Credit and liquidity have a greater impact on asset performance than earnings.

The Federal Reserve's tightening policies may have a greater weight in decision making than a company's earnings.

Understanding Market Volatility

In this section, the speaker discusses the excess volatility in markets and what causes it.

Excess Volatility Explained

The actual S&P is about 20x more volatile than the theoretical right answer for the S&P.

At any given time, there are multiple potentially accurate forecasts of what might happen that fit historical facts but are impossible to disprove.

When the future unfolds and a large percentage of people were wrong, they have to readjust to a new set of historical data. This creates excess volatility in markets.

Cash flows and interest rates would only explain one twentieth of market volatility.

Tools for Understanding Market Volatility

Short-term tools like trending markets or high yield credit spreads can be useful for forecasting.

High yield credit spreads are a better source of discount rate than the actual fed reserve rate because they provide much more real information on the economy.

Market valuations like GMO's cape ratio may also explain some market volatility but none of these tools really explain all that much.

Humility in Forecasting

We can't predict the future with accuracy so we need to be humble about what we can know with confidence and less confidence.

Crisis investing is an example where we isolate periods when markets were panicking as opposed to trying to define bubbles which is an impossible problem to solve.

Introduction to Four Quadrant Approach

In this section, the speaker introduces the four quadrant approach and how it can be used to understand asset prices.

Understanding the Four Quadrant Approach

The four quadrant approach is a matrix based on growth and inflation.

It connects where you are in that four quadrant grid with how asset prices do.

Most asset classes have multiple drivers, for example, bonds have a growth bet and an inflation bet embedded within each bond.

Equities are really a growth bet more than they are an inflation bet.

Linking Asset Classes to Growth and Inflation

Commodities like oil and copper are very growth dependent so they do well when growth is rising. They also work best when inflation is rising.

Bonds and stocks are inversely correlated absent inflation because they have opposite linkage to growth. However, adding in inflation could screw it up.

Challenges of Using the Four Quadrant Approach

It's hard to say what is growth and inflation today. Understanding where we are in that four quadrants requires retrospective analysis of periods when growth and inflation were both down or up.

Conclusion

In this section, the speaker concludes by summarizing the key points discussed in the podcast.

Key Takeaways

The four quadrant approach helps structure your view about multi-asset or cross-asset class correlations and relationships.

Most asset classes have multiple drivers which makes understanding their behavior complex.

Understanding where we are in the four quadrants requires retrospective analysis of periods when growth and inflation were both down or up.

High Yield Spread as an Indicator

In this section, the speaker discusses how high yield spreads can be used as an indicator for inflation and growth environments.

Using High Yield Spreads to Indicate Inflation and Growth Environments

High yield spreads provide a good indicator for inflation and growth environments.

When high yield spreads are wide, it tends to be deflationary. When they are tight, it tends to be inflationary.

Falling spreads tend to indicate rising growth environments while rising spreads tend to indicate falling growth environments.

The speaker notes that the current high yield spread is above its 10-year median at 470 basis points while the 10-year meeting is about 420 basis points. This suggests a deflationary environment.

Implications of Rising Spreads

Rising spreads suggest slowing growth in the economy.

The credit markets are tightening, which puts us squarely in quadrant four where there is falling inflation and falling growth. This quadrant is characteristic of recessions.

The speaker notes that every single 30-drop in the S&P 500 has come after high yield spreads went above 420 basis points.

Managing Data While Solving for Confirmation Bias

In this section, the speakers discuss how data can be managed while solving for confirmation bias.

Limitations of Data Sources

The amount of data we have on the US economy is not enough to tell anything conclusively with a degree of confidence needed for physics or other sciences.

Working with imperfect and incomplete data makes it challenging to figure out the best way forward.

Managing Confirmation Bias

It's easy to cherry-pick data based on timelines or other factors to see what you want to see.

The interpretation of data can be subjective, making it challenging to limit confirmation bias.

The speaker notes that their quantitative approach helps manage confirmation bias.

Developing Frameworks for Thinking

In this section, the speaker discusses how quantitative investors develop frameworks for thinking and make them explicit. They test these frameworks by using large datasets and statistical tests to determine their reliability.

Making Frameworks Explicit

Everyone has a framework for thinking that they use to interpret data.

Quantitative investors make their frameworks explicit in order to test their reliability.

The biggest dataset possible is used to throw at the framework and see if it tells us something useful.

Statistical tests are run on the data sets to determine confidence intervals or logit regression.

Finding Simplicity in Frameworks

Simple things tend to be more robust than complex models.

Credit spreads are a powerful indicator across various asset classes.

Trend rules can be significant indicators of market trends.

Complex models increase the likelihood of subjective biases.

Settling for 60% Accuracy

In this section, the speaker talks about how well-defined, well-tested frameworks produce results that are right at best 60% of the time. He emphasizes that settling for this level of accuracy is necessary in order to avoid random subjectivity.

Well-defined Frameworks Produce Results That Are Right 60% of the Time

Even with well-defined, well-tested frameworks, results are only accurate around 60% of the time.

Settling for this level of accuracy is necessary in order to avoid random subjectivity.

Investing in Crisis

In this section, the speaker discusses how growth stocks like Amazon performed best during the crisis territory and ways to diversify investments.

Growth Stocks Perform Best During Crisis

High yield spread went to 10 10 and a half, well into crisis territory.

Growth stocks like Amazon perform best during crisis territory.

The high yield spread started dropping on March 23rd, indicating a switch from recessionary period into recovery period.

Diversifying Investments During Outlier Events

Ways to diversify include focusing on small cap and protecting against outlier events that might be almost Black Swan.

When liquidity freezes up in markets, less liquid things such as small cap micro cap sell off worse than large caps.

Micro cap did better than small caps which did better than mid-cap which did better than large cap.

Value factor worked remarkably well over the subsequent year or two after spreads went wide.

Tech Bubble Hangover and Diversification

In this section, the speaker discusses the aftermath of the tech bubble and how diversification can be achieved through small cap value investing in international markets.

Small Cap Value Investing Across Markets

Buying cheaper stocks that people are pessimistic about tends to work better than buying expensive stocks that everyone is optimistic about.

Small caps matter because there are many more small caps than large caps, making it easier to find every value stock in a market.

Small cap value investing allows for choosing not just cheap stocks but also really cheap ones.

Tech Bubble Hangover

The tech industry had an unbelievable year during COVID-19, leading to a massive acceleration of digital growth. However, this has resulted in a big pull forward or acceleration of growth which will lead to gross lows or even declines in growth.

As people start going out again, tech stocks are seeing a massive deceleration and drop in their multiples due to less optimism.

Diversifying Through International Markets

Value tends to replicate well across markets and can be done in emerging markets, Japan, Europe, and the US.

Small cap value investing allows for finding tiny little things that may not be found otherwise.

The Negatives of Small and Micro Cap Stocks

This section discusses the downsides of investing in small and micro cap stocks.

Volatility and Bankruptcy Rates

Small and micro cap stocks are much more volatile than large caps, which means there is a big drawdown when investing in them.

Bankruptcy rates are materially higher for small companies than big companies, making small caps riskier to invest in.

The Benefits of Extreme Investing

This section discusses the benefits of extreme investing.

Small Cap Value Investing

Small cap value tends to work really well across most major markets.

Japanese small cap value is particularly interesting because Japan has a big small cap market, is super cheap, and has almost no bankruptcy risk.

Why Things Are Cheap for a Reason

This section discusses why things can be cheap for a reason.

Cheaper Stocks Have Worse Growth

Cheap stocks tend to have worse revenue growth and earnings growth than expensive stocks on a one-year forward basis.

However, over time, cheap stocks that didn't grow as much tend to see their multiples go up while expensive stocks that did grow better see their multiples come down.

Exceptions: Distressed Debt and Bankruptcy Risk

When companies get strapped during recessionary periods, distressed debt may seem like an attractive investment option. However, bankruptcy risk is not compensated so buying things that look like they're going bankrupt will result in owning many bankrupt things.

Buying small cheap stocks that are not going bankrupt is a good value strategy. Quality screens can help identify these stocks.

The Importance of a Systematic Approach to Investing

In this section, the speaker discusses the importance of having a systematic approach to investing and how it can lead to positive outcomes.

Having a Framework for Investing

A systematic approach to investing is important because any framework about how the world works is wrong sometimes.

Consistency is key in investing, and having a systematic approach can help achieve that.

The advantage of having a framework is that you keep repeating it, and if you're right 60% of the time reliably over the course of your life, you can end up with very positive outcomes.

Avoiding Human Bias in Investing

It's important to be aware of your human biases when making investment decisions.

When coming up with an idea for an investment, it's essential to ask yourself why you want to invest in it and whether that logic makes sense.

By broadening out individual decision-making processes and making them more explicit, investors can avoid idiosyncratic elements that could drive them towards poor investment decisions.

The Pitfalls of Creating a Swiss Army Knife Approach to Investing

In this section, the speaker discusses why creating a Swiss Army Knife approach to investing may not be effective.

The Problem with One-Size-Fits-All Strategies

One-size-fits-all strategies may not work because they do underperform for periods of time.

It's tempting to create a Swiss Army Knife approach where you have specific strategies for different market conditions or quadrants. However, this may not be effective because momentum shifts quickly in markets.

Staying Rigid and Systematic

Instead of shifting gears based on market conditions or quadrants, staying rigid and systematic may be more effective in achieving positive outcomes.

By avoiding human biases and sticking to a systematic approach, investors can achieve consistency in their investment decisions.

Avoiding Idiosyncratic Elements in Investing

In this section, the speaker discusses the importance of avoiding idiosyncratic elements in investing.

Making Individual Decision-Making Processes Explicit

It's important to make individual decision-making processes explicit by asking why you're making a particular investment decision and whether that logic is sound.

By doing so, investors can avoid idiosyncratic elements that could drive them towards poor investment decisions.

Consistency is Key

Consistency is key in investing, and having a systematic approach can help achieve that.

By broadening out individual decision-making processes and making them more explicit, investors can avoid idiosyncratic elements that could drive them towards poor investment decisions.

Investing in Fixed Income

In this section, the speaker discusses the relationship between growth, inflation, and fixed income investments.

Treasuries vs Credit Spreads

If both growth and inflation are going to come in lower than expected, treasuries will do well because they are a bet that growth and inflation will be worse than expectations.

Credit spreads indicate that growth and inflation will be worse than expected, making it a great time to buy treasuries.

The Taylor Rule

When the Taylor rule is wide (like it is now), fixed income investments tend to perform poorly because the Fed has to raise rates more than necessary to bring down inflation.

Eventually, raising rates causes the economy to go into recession, which is when bonds work.

Timing

It's difficult to predict when bonds will start performing well. It could happen if things continue trending worse or if there's a soft landing.

Balancing these two scenarios, relying on spreads is more reliable since periods where the Taylor rule is wide are rare.

Recession Predictions

In this section, the speaker talks about their predictions for whether or not we're currently in a recession.

There's a 45% chance that we're currently in a recession.