Topics covered:

• Why AI can be both a transformational technology and an investment bubble

• The AI metrics Dan watches: token pricing, token growth, cloud revenue and operating margins

• What the Situational Awareness unwind showed about leverage, forced selling and semiconductor volatility

• Why hyperscaler AI revenue can accelerate even as free cash flow deteriorates

• How data center opposition, electricity constraints and politics could slow the AI buildout

• Where value may accrue across the AI stack and why Anthropic and Google could pressure OpenAI

• Why China’s memory chip expansion could bring semiconductor cyclicality back faster than investors expect

• How AI is reshaping software, including security, systems of record, gaming and usage-based pricing

• Why the shift from free cash flow to debt financing matters for AI CapEx, Treasury yields and credit markets

• Dan’s long-short investment process, Fed outlook, market risk framework and emphasis on downside protection

Timestamps:
00:00 Intro
04:00 The signals Dan watches to know when the AI bubble is peaking
09:12 AI ROI, hyperscaler profits and the problem with negative free cash flow
14:19 Why data center politics could become a major risk to AI growth
21:28 Why semiconductors are still cyclical and China could change the supply picture
25:47 Why smart companies still get bubbles wrong and agentic AI could extend the cycle
30:43 Is software the next major casualty of AI disruption?
35:04 Why video games may be one of software’s safer AI categories
39:23 Can markets absorb the surge in AI debt and equity issuance?
45:28 Dan Niles’ long-short investment process and approach to downside protection
50:45 Why Dan thinks the Fed could raise rates in September
56:38 Why buy-and-hold can fail and downside protection matters

Learn more about the Excess Returns podcast network:

https://excessreturns.co

No information discussed in this podcast should be construed as investment advice. Securities discussed may be held by the hosts and guests, their firms or their clients.

In my opinion, I think there’s a small handful of people we consider elite thinkers when it comes to the technology sector. And for a number of years, I’ve admired Dan and his work. He is founder of Niles Investment Management, has been portfolio manager at Niles Investment Management for two decades. And you have over 30 years experience in researching and investing in the technology business.

And it’s a very interesting time to be someone that has your views on tech, Dan. There’s a lot going on. And so, just thank you for joining us. We think this is gonna be a great discussion. A lot of it’s gonna be focused around AI, but we know you have thoughts on a lot of things when it comes to tech. So really appreciate you taking the time to join us today.

Dan: Oh, my pleasure, Justin. Thanks for having me on.

Justin: I wanna start with something that you said earlier in the year, and I think it was along the lines that, yes, we are 100% in a bubble — or maybe there was a specific pocket you were talking about — but that you specifically kinda keyed in on, you thought semiconductor stocks were gonna see somewhere in the range of 30 to 50% pullback. And since then, semis have pulled back quite a bit from June. So let’s use that as a starting point to where you think we are currently in sort of this bubble cycle, if we are in one.

Dan: Yeah. Maybe to look at a very big picture. So if you look at every great industrial revolution that we’ve had — and that’s whether it’s canals in the late 1700s, or railroads in the early 1800s, or radio, TV, fast-forward to electricity or the internet most recently — if you believe you’re in one of those revolutions that’s gonna reshape the landscape of the world, then by definition you’re going to have a lot of people chasing that opportunity, because they know if they’re the last company left, they’re gonna make an inordinate amount of money.

And so if you believe that AI is one of those technologies, which I do and I think most people do, then by definition you have overinvestment going on. Now, the thing is that that overinvestment doesn’t necessarily mean it’s a bad time to invest. In fact, it means it’s a great time to invest. The problem is when that eventually breaks, you know you’re going to have a much bigger than normal meltdown on the other side of it.

The good news about what’s going on today relative to the internet is valuations aren’t at these stratospheric levels that they were back then. If you take Cisco as a good example, which was sort of the Nvidia of its day, it was trading at a PE valuation of over 100 times earnings. Nvidia, in contrast, is at 15 times. So when the bubble does eventually break, you’re not gonna have the same kind of — or at least I hope you don’t have the same kind of — meltdown that you saw from the peak in March of 2000 to October of 2002. And that’s why I’m hopeful that any meltdown in semiconductors, which are sort of the tip of this AI spear, will be limited to 30 to 50%.

Justin: How do you think about... ‘Cause you hit on something interesting there. It’s still a great — even if we’re in the bubble, it doesn’t mean you go to cash or anything, because that bubble type of environment can last a lot longer than many people think. But what would be the things — and you kinda hit on valuation a little bit — but what would be the things you’d be looking at to make you question, “Okay, we’re more towards the end here of this bubble than not”?

Dan: Well, there’s two main factors, right? You’ve got the revenue picture, and within that you have two very simple things. There’s number of tokens being produced, and what you can charge for each of those tokens. And what you’ve seen since end of May is what you can charge for those tokens has gone down by about 50%.

Why? Because you have this thing called open source, or open weights, that are coming out with all of these cheaper models. So what you can charge for each token being produced, which is sort of the unit of currency for AI, has gone down 50%, which seems terrible — except that the number of tokens being actually produced is up two and a half times since the end of May. So I’m watching both of those things very closely to see, okay, is the dropping in costs being offset by a more than offsetting increase in tokens?

The second part of that is, how profitable is this? Because you may be generating revenues, but if you’re losing tons of money, it really doesn’t matter. The good news is profitability is also improving. And if you look at the big three public cloud vendors — so that would be obviously Amazon Web Services, Microsoft’s Azure, and Google Cloud Platform — all three of them saw accelerating revenue growth from the March to the June quarter, where revenues went from increasing 35% in March year over year for their cloud businesses to up 43%. But more importantly, the operating margins also expanded about two percentage points from March to June. And so not only were revenues accelerating, but the profitability of those revenues was also going up.

So those are kind of the bigger picture things that I’m watching to see when I really worry about, we’ve reached the peak of this bubble and we have to worry about the other side of it.

Justin: I was recently talking to a colleague who I’m texting here to see, ‘cause I thought he said — I wanna think he said he used, oh yeah, one billion, this is an individual, one billion tokens in 24 hours. So to your point, this token usage is certainly going up, especially with the guy I know, and Jack, you know who I’m talking about.

So anyways, I wanted to get at this thing you brought up with Situational Awareness. And what’s interesting is your take on how the failure of that fund actually kind of reduced some near-term risk. So can you just explain that?

Dan: Sure. I mean, there’s only two things that drive stocks, right? It’s earnings. It’s the multiple on those earnings. The multiple on those earnings gets overinflated because you have individuals as a group, or funds as a group, doing stupid things. And stupid things usually means you’ve levered up. And so you saw that with Korean retail investors who got absolutely destroyed when SK Hynix and Samsung imploded.

But you also saw that with funds such as Situational Awareness. And there were some other funds that I heard were in trouble as well. But luckily Situational Awareness being pushed into that fire sale with Citadel helped solve some of those issues, because the market obviously ripped the next day, especially in a lot of those positions that were getting unwound.

So with Situational Awareness, the problem wasn’t necessarily the positions they had. The problem was they were running it at 4X leverage. And so if you do the math and you say, well, if you have a 25% drawdown but you have 4X leverage on it, then you’re down 100%, at which point your fund’s liquidated.

It’s the same thing we saw with Long-Term Capital Management in the late 1990s, where they had a tremendous amount of leverage. At least in their case, they were trying not to have it be directional leverage. But similarly, if you have a lot of leverage and you have your shorts going up — in this case software was rallying — and your longs going down — in this case semiconductors were getting crushed — you have both sides of your book working against you. You throw the leverage on top of that, and you force this sort of cataclysmic bottom.

But remember what we just talked about. This is all going on, but the fundamentals are okay, because you’ve got a 50% drop in token costs, but you have a two and a half times increase in tokens being produced from the end of May till recently. And so at least the fundamental picture looked good. And so that’s why I felt like, okay, the timing was fortunate.

But I put out that note on July 29th thinking we’ve reached a short-term bottom, because I had been hearing about funds in trouble. I thought we were pretty close to getting something cataclysmic to happen. And in fact, it did, with the Situational Awareness fire sale that got announced the next day.

Justin: One of the big questions I think a lot of people are asking is, what is the ROI to the end user here in the use of AI? So how do you think about that? I mean, we’re all sort of benefiting from it, I think, in our work lives, right? But how do you think about the end benefit to users of AI, in terms of higher profitability or whatever it might be?

Dan: Well, it’s really a combination of all of the above. So if you look at the hyperscalers, part of the reason why a lot of those stocks have been struggling is because people go, “Okay, you are seeing accelerating revenues. That’s great. Your profitability is improving. That’s great. But unfortunately, your cash flows, which had been hugely positive, like for Google, are now negative for the first time since they went public.”

And so that’s the part that people are wrestling with. Because if you’ve been around the block a few times, and especially lived through the internet bubble — and I think we can all agree, right, the internet was a pretty good revolution. It’s not like things didn’t keep evolving in 2001 and 2002. But the Nasdaq went down 78% from its peak in March of 2000 to the lows in October of 2002, and it was a punishing, grinding beat down over two and a half years. The internet kept growing over that whole period of time. In fact, it doubled each of those years. But the problem was people were thinking, “Oh, well, it’s gonna double every three months or six months.”

And so that’s kind of what’s going on. And so there’s no one answer to this, because what’ll happen is eventually somebody will have an issue and then they won’t be able to live up to their commitments. And at which point you’re gonna see a slowdown in CapEx spending by one of the hyperscalers, at which point they’ll all probably go ahead and slam the brakes on at the same time, because they all kind of know they’re over-investing. I mean, you’ve had the CEO of Microsoft talk about that before. You had Larry Page say something along the lines of, “I’d rather go bankrupt than lose this race.”

But it doesn’t mean that... And I think we’ve got another year of pretty strong revenue growth and profit growth in front of us. And so those are kind of the interplay between revenues, profitability, but cash flow, and then obviously valuations, that I’m kind of looking at altogether.

Jack: I’m wondering, when you compare this to the late ‘90s, do you see... One of the ideas I’ve been thinking about is, are there more governors here in place that might prevent us from getting a huge bubble? And what I mean by that is, we don’t have enough compute, we don’t have enough electricity, and it seems like right now we’re kind of meeting demand, whereas in the late ‘90s we were building out in advance of demand. Do you think that fact that we can’t meet demand right now might prevent this bubble from getting as big as it otherwise could?

Dan: Yeah, no, I think that’s a great point. Because I put out a piece a couple of weeks ago and I said the one really negative development that surprised me is that data centers are getting pushed back on really hard.

And in the latest Gallup poll, I think when people were asked about having a data center in their backyard or nuclear, it was 71% against data centers and only 53% against nuclear. Like, that’s really bad, right? I couldn’t believe it when I saw it. And it’s like the Democrats and Republicans can’t agree on anything, but what they all seem to be agreeing on going into the midterms, which surprised me — especially from the red states like Texas — is data centers. They’re all pitching running against data centers. Which, by the way, I think is wrong, because I think it’s great for the communities that have gotten it. But the hyperscalers have not done a good job of doing PR around the benefits for these communities. And so the other side — and let’s call that the socialist movement, which by their own definition is against big business — has done a good job of kind of selling this as a bad thing.

And so that’s the part that really could cause a problem. Not so much, as you said, from the demand side, but from the ability of actually building these things. Which, you know, there’s enough people out there who’ve been negative on the whole AI build from beginning of last year that will jump on that as, “Oh, the bubble’s breaking,” et cetera. But I think, again, it’s something that should help prolong this build-out for even longer, because you don’t have the land to actually put these data centers on as we approach the midterms. And so that’s one of the reasons why, between now and the midterms on November 3rd, I’m pretty negative.

Jack: It does seem like, based on what you said here, the political risk is maybe the biggest risk here to AI growth. That’s a very high-level thing that could turn against AI. It already has turned against AI, and it seems like that might be the biggest risk. Do you agree?

Dan: Well, that’s a short-term risk. I always wanna believe that people will do the rational thing. And when you see the data coming out from the communities that have had some of these big data centers come in — the amount of jobs it’s created, the amount of tax revenues. They don’t use that much water at all. If you got rid of all the golf courses, you’d do a much better job with that. They put in their own electricity. A lot of it is they’re trying to make it renewable going forward.

And so I wanna believe with more education that that political risk, especially after the midterms are done, will hopefully die down. And now this is a big if. That’s assuming that you don’t end up with this huge landslide in favor of, in particular, socialists that want to make these companies forcibly give part of the share ownership to the government and all these other things. That, if by your own definition socialists don’t like big business, that’s not good for the big businesses that are involved in AI. And so that’s the part that I do worry about going forward. But I wanna believe rational thought will prevail. We’re gonna have to wait and see what happens.

Jack: How do you think about, across the AI stack, where the benefit will accrue? If you look at history, a lot of times the builders of these technologies have not been the ultimate beneficiaries, and it seems like so far here they have been. But how do you think, as you look up and down the AI stack, where the most benefits will accrue?

Dan: Well, it’s a great question, and you’re 100% right. How many railroads are in the top 10 market cap in the US? What about electricity companies? What about canal companies? What about fracking companies, right? And Cisco, which used to be the most valuable company in the world, just recently got back above its market cap from 2000, and that’s a pretty long wait.

So when I think about this, I do believe open source is gonna be increasingly used. I’m sure that person you talked about said he used a billion tokens in — what’d you say, a week or a day or something?

Justin: 24 hours, yeah.

Dan: 24 hours, in a day. I’m sure he’s not paying a dollar a token, right?

Justin: No.

Dan: So you’re going to have your costs continuing to collapse. And I always like to say, “You don’t need a Ferrari to go to the corner store to get milk,” right? A Ford will work just fine. And so people aren’t gonna be using Anthropic to go summarize their emails, right? They’ll be using some open weight, open source model to go ahead and do that. And they’ll use Anthropic or ChatGPT to do that front end replication of some software point solution tool that they don’t wanna pay all this money for.

And so I think ultimately the value’s gonna move from the model providers to the infrastructure providers, and then ultimately the companies sitting on top of that that create great businesses. Because if you think about the internet as an example, all that bandwidth and capacity that was put into place — when it collapsed, it imploded on the other side. It gave you the infrastructure necessary to have companies like Google and Amazon and Facebook, Netflix, all show up that were built on the back of all that cheap bandwidth. And I think on the back of all the cheap tokens we’re gonna have, you’re gonna have some really great companies coming around because of that.

Jack: How about within the model layer? I would think what you said is not great for OpenAI and Anthropic. And it’s been interesting — you’re seeing more and more usage, as you said, down at the lower-end models, but they still have captured most of the value with the high-end models despite usage coming down. Do you think that changes, and maybe the value starts to accrue away from them?

Dan: Yes, I do. And I worry more about OpenAI than I do Anthropic, because if you look at kind of the genesis of both companies, ChatGPT was launched for consumers. Anthropic started focusing on enterprise. And I’ve been saying this now for, I don’t know, a year or two at least, that I think Anthropic is gonna end on the enterprise side, and then Google on the consumer side, are gonna squeeze OpenAI between them.

Now, obviously OpenAI was much bigger than Anthropic early on. Now Anthropic is much bigger than OpenAI was early on. OpenAI has now switched from consumers, which — we’ve been all trained that, hey, we get answers from Google for free. So why on earth would you pay for it, right? And so that’s why OpenAI has switched to enterprises, where enterprises pay for their stuff. And so that’s why Anthropic’s going public first.

But I think as this continues to evolve, OpenAI and their ecosystem is what I worry about the most, because of the fact that if you look at the history of technology, you typically have a winner-take-most market, right? If you think about, well, who’s the market share leader in e-commerce? Well, it’s really only Amazon. Then you have a bunch of smaller players. Well, what about in social? Well, you only really have Meta, and then you have a bunch of smaller players. What about in streaming? Well, you really only have Netflix and a bunch of smaller players. So do you think you’re gonna have 10 models that are all thriving? I mean, anything is possible, but the history of technology tells you that’s probably not likely.

And so we’ll have to see what happens on the other side of this. But my belief is that, yeah, you’re going to have some — one of the large players, right? If you think about the internet era, I would’ve never guessed AOL would not have thrived. Or Yahoo! Or you can pick Lycos or Netscape. Like, these are all public companies that don’t exist. So when I look at today, just because ChatGPT is what started all this doesn’t mean that OpenAI is going to be ultimately the biggest winner. And I think most people would agree that Anthropic is already in better shape than OpenAI is.

Jack: I want to shift to semiconductors. And sometimes I ask a question that I know the answer to, and I’ll do that here. But you have seen a lot of talk about this idea that semiconductors are no longer cyclical. And I know you’re going to tell me that’s not true. But I am wondering, do we think about it differently in terms of that cyclicality? Do we think about that cyclicality in a much longer timeframe? Like, all the people that are saying semis are no longer cyclical will be wrong eventually, but this might carry on a lot longer than people on the other side think. Is that a fair way to think about this?

Dan: No.

Jack: Okay.

Dan: What I would tell you is it’s the same answer as the AI trade. When do you think the bubble breaks? Actually — you know what? I take that back. I’m actually starting to wonder if the semiconductor bubble breaks before then, for one simple reason. I think a lot of investors are vastly underestimating what China is doing.

And I hear these arguments and I go, this is what people were thinking back in the 1980s when Japan entered the semiconductor industry, and that was state-sponsored as well. And some of your listeners may not know, but Intel at one point had 75% market share in the DRAM industry. The US was the dominant force in that industry, and then Japan started, and they were obviously several generations behind, but they caught up. And then by the early 1980s, Intel was facing bankruptcy, and they switched to this thing called microprocessors, and Japan took over the DRAM market.

And then you fast-forward to the 1990s, and Korea, also state-sponsored, entered the DRAM industry. And the same arguments were made then. Now, don’t forget, you also had an internet build-out happening at the same time. But Korea entered that market, and then by the 2000s, you had the Japanese companies being driven out of business.

What you had recently is CXMT, which is China’s DRAM company, go public, and then YMTC, which is their NAND company, is gonna go public very soon also. CXMT plans on increasing their wafer starts from 300,000 to 500,000 by the end of next year. And YMTC, which is their NAND manufacturer, is saying they wanna be — or they plan to be — bigger than Samsung or Hynix in the NAND business by the end of next year.

Now, if you look at CXMT, they have about 8% of the global DRAM market, which is nothing, but it is ramping incredibly fast. And for commodity memory in particular, where a lot of people are making this argument there’s gonna be shortages through 2030 and all of this stuff, I go, well, if the Chinese meet the goals that they’ve set out for themselves, there’s very minimal chance you’re going to get there.

Because China is obviously a much bigger country than Japan or Korea ever were — in global GDP, population size, land mass size, ability to put up these massive factories relative to Japan or Korea. And from their perspective, unlike with Japan or Korea, they’ve been cut off from chips from the US. So from China’s perspective, having their own semiconductor supply is as important as having an aircraft carrier or nuclear weapons. It’s more of a defense technology in some ways even than a semiconductor technology.

And so this is why I look at semis. And the good news is, as I said earlier, Nvidia’s trading at 15 times. Not that I think Nvidia’s where the problem is. And the memory companies likewise are trading at valuations that the people who believe that this is no longer cyclical go, “Oh my God, they’re very undervalued.” But that’s kind of what I am thinking through right now, because the data — and you even saw it today, where CXMT said they had produced a high bandwidth memory that was actually yielding very, very well, and this one’s only like a generation behind. And as I said earlier, sometimes a Ford will work just as well as a Ferrari if it’s not the bleeding edge applications.

Jack: Yeah, one of the things I always have to remind myself about is, everybody gets caught up in these bubbles to some extent. And so one of the arguments you hear people make is, well, the people running all these tech companies are incredibly smart people, so they’re throwing these massive amounts of money for a reason. But you kind of have to take a step back and say, in the late ‘90s, those people were incredibly smart that were running those companies, and they were throwing the money for a reason. So I sometimes have to check myself and think that through.

Dan: Well, for anybody who believes that, they should go onto Cisco’s investor relations website, pull the earnings release from May of 2001, if memory serves me correctly, where the CEO of Cisco Systems says, “We’ve gone from 70% year-over-year bookings growth” — in several months — “to negative 30% year-over-year bookings growth.” And they were, at one point, the most valuable company in the world.

So yeah, to your point, these... Yes, are these really, really smart companies? Absolutely. Are they the best companies that we have right now? 100%. But do massively smart big companies get it wrong? Yes, all the time. And that’s the thing about bubbles — they’re great to be invested in. You can make a lot of money if you stay with them, but obviously you have to get the timing pretty well. Because you never know: well, is this the actual break, or is this just a pause that refreshes?

And when I put out that note on June 20th, I said, “Look, I think we have a short-term problem here. We have a speed bump.” And then I put out that note on July 29th saying, “Hey, I think we’re near the bottom. We should be able to see things starting to rally again.”

The backdrop of all of this is agentic AI is new. We first heard about this thing called OpenClaw being formalized on January 30th, right? That’s what, seven months ago. So it’s brand new. We didn’t have that with the internet, if you think about it. There wasn’t like a new thing that came out for the internet. If you look at AI, you’ve had kind of distinct phases. You had the training phase initially, then you had the inference phase, and then on January 30th of this year, you had the agentic phase. And the agentic phase uses 10 to 100 times more tokens than the chat-based AI phase.

And so I think you’ve got a long way to go, at least another year, for stocks to go higher. But I do think it’s getting — like what I said about the Chinese memory companies, I do think you’re going to have to get more selective, and then watch the data like a hawk to make sure that you’re not deluding yourself, either by being too negative or being too positive.

Jack: On that idea of watching the data — we don’t talk about individual stocks a lot, but I know in a period like this, looking at the reports of individual stocks can tell us a lot about what’s going on overall. And I’m just wondering, as an expert, when you looked at Nvidia’s report, it seemed like a blowout report. Was there anything you learned about what’s going on overall with AI that you think you would wanna communicate?

Dan: Not really. I mean, I thought it would be bullish. It was. Quite honestly, the only thing in that report I didn’t like is when they gave long-term revenue guidance. Because Nvidia, for its entire history, has guided out one quarter in advance. I know why they did it. I understand they’re really frustrated with the way their stock’s performing, with the multiple relative to other semiconductor names in the industry. And I think Jensen is amazing. He’s actually a great human being to boot on top of that. Visionary as well. But that’s the only part I didn’t like about it.

And I know they’re trying to give confidence by saying, “Hey, we think we can grow revenues at 70% in calendar ‘27, and we think demand is actually at 100%.” But at the end of the day, there’s a lot of other factors that’s gonna determine how fast AI’s gonna ramp. And that stuff evolves over time. I mean, Cisco Systems in 2000 was saying, “Hey, we think our revenues can grow 30 to 50% sustainably in the future.” And then two years after they made that proclamation, their fiscal year revenues were down for two consecutive years in a row. So things change.

And the Nvidia report made me feel good in that, okay, yeah, I do think there’s another year for this to run. But the magnitude, we’ll have to wait and see how that shakes out. But trading at a 15 times PE off of calendar ‘27 numbers with the S&P up at 19 times, you go, “This isn’t Cisco in 2000.” Even if they’re wrong, it’s not Cisco in 2000 in terms of the downside.

Jack: On the other side of that coin is software. How are you thinking about software? I know we have a tendency to overreact to things during a period like this, and maybe you could argue some people have definitely overreacted to software, or at least grouped everyone together. But on the other side, there are disruptive aspects of AI, certainly for the software stocks. So how are you thinking about software, especially relative to the decline it’s had?

Dan: So I think about it this way. No public company wants to miss their forecast. So if the combined annual run rate revenues for OpenAI and Anthropic was 29 billion to start the year, and now seven months later it’s 105 billion — that amount of money that is being spent with those two has to be made up somewhere else.

Now, if you look at software as a group, I put some numbers out on it this weekend on my Sunday post, but it’s a little over a trillion dollars. So you go, “Okay, well, it’s 100 billion annualized for OpenAI, Anthropic, only a trillion in change, a trillion two, let’s say, in software.” That could be a problem. Well, if you throw IT services on top of that, that’s even bigger than the software bucket. But then if you say, “Well, we really should think about it as some of that spending coming out of what is being paid to knowledge workers,” which is more like 35 to 50 trillion a year in spending, then you go, “Well, that ramp to 100 billion by OpenAI and Anthropic, you’re not even gonna notice it.”

So I’m trying to think through that myself, because the bulls will say, “Well, hey, agentic AI will access these point solution tools” — which is what people were very negative on — “10 to 100 times more than a human being.” But I go, “All right, so are you trying to say that software spending’s gonna go up as well? In which case, who’s gonna get hurt?”

So I’ve been a big believer that within software there are three safe spaces. Now, obviously they didn’t act safe until very recently, but those being security, system of record companies, and then a much smaller grouping, obviously, of entertainment, video game companies. And so those are the three that I’ve been like, “Okay, they should actually be fine ‘cause they shouldn’t get disrupted.”

But we saw recently with Atlassian’s results, which was supposed to be one of the names getting disrupted, the stock was up 35% the next day. You saw Workday, which I think was in some ways more interesting, because there was the news out that Silver Lake was looking to acquire them. And if private equity is looking to acquire a company, you go, “Wow.” They typically gotta hold these companies 7 to 10 years. They’re using some debt, and interest rates — obviously, 30-year Treasuries are at the highest levels since 2007. And they have to believe that there’s some terminal value to this out 7 to 10 years. So the bars they have to cross to actually want to do an acquisition of this size, which would be like 50 billion, is much higher than a regular equity investor who can get in and get out in a day. Like, these guys have to go, “Okay, I gotta feel good about this 7 to 10 years from now.”

And so I thought that marked the bottom in software to some degree. And then obviously Salesforce last week, where the stock was up over 20% in reaction. They obviously had that deal with Anthropic, which helped a lot.

It’s making me wonder if I can get more broadly involved in the group, because the good news is it has underperformed. As of today, it was up something like 4% year to date, and the semiconductor index was up over 60% year to date. And so that at least makes you feel like maybe there’s some margin of safety there. But security is still, I think, probably the safest bet in that group. But it obviously also has a pretty high valuation, because now that’s sort of become consensus.

Justin: So I do have a quick confession to make. And to the gaming thing — I did watch the Grand Theft Auto extended trailer on Netflix twice over the weekend.

Dan: I love video games. So I played the Atari when it first came out. I couldn’t afford it, so I would go over to a friend’s house who was better off than we were. And so I would play it there. And I remember playing Pong. And I played video games all going through Stanford for my electrical engineering master’s degree. That was my way to relax.

And I got my kids into video games. I think we’ve got every... Or we used to have. My kids are now in their mid-20s. But we used to have every game system that existed. Nintendo, Sony, Microsoft, we had it all. So I love video games. And you’re right, I love that trailer as well.

Jack: Do you still get to play some now?

Dan: Ugh, I wish I had time to. And unfortunately, the fun part of video games, at least for me, was playing with my children. And so I have some really great memories playing Super Mario Kart with them, and a lot of Mortal Kombat and a lot of other things. And then doing some of the Harry Potter and — there were so many. Kratos, whatever that... I forgot the name of that whole one. But that storyline. And so it’s not fun doing it by myself.

Jack: It was funny, I wanted my kids to see what it was like back in the day, so I got Super Mario Brothers, like, for the emulator, the emulator for the Switch, and I’ve been playing it with my son. It’s very, very cool. They obviously don’t like the graphics, but it’s still good to go back to what I used to play when I was a kid.

Dan: Oh, yeah, no. Those games were... And some of it’s just the memories you have, right? It’s the memories of playing with my kids, even as much as playing the game itself.

And so, yeah, I think Grand Theft Auto’s gonna do great. We’ll see what ends up happening. But people don’t want to program video games. They want to play them. They wanna have fun with them. And so we’ll see what happens. Maybe I’m wrong. And what I mean is high-end games, right? The low-end stuff, yeah, sure, you might go create something fun to do. But something with the quality that a Grand Theft Auto has, or you pick your favorite game, it’s Assassin’s Creed or whatever — yeah, you’re not gonna go and program that.

Justin: And the music in the trailer — like, whoever’s picking the music, I love it, ‘cause it’s kinda ‘80s. You know, the first one was, like, Tom Petty. Love Is a Long Road. But then this other one, you know. So it’s great.

Dan: Oh, yeah. I love it. And it’s nostalgic, too. And I’m sure it’s a lot cheaper than getting current music to put in there. But I love listening to ‘80s and ‘90s rock, so that stuff’s great.

Jack: Just one more on software before we move on. With Salesforce, what was interesting to me is they seem to be leaning into AI, which I think is an interesting play here, versus fighting it. They’re gonna allow people through, like, Anthropic’s interface to access their data, and it seems like maybe that’s the right play for a software company — rather than try to fight these technologies that are changing everything, is maybe to lean into it. Do you have any thoughts on that?

Dan: Well, I think all the software companies are trying to lean into it. It’s just, how are you doing it and managing through it? And part of it is you’re gonna need to have the billing models change, right? You’re not gonna charge a seat license anymore.

And Salesforce, that’s one of the things they’re doing. They’re switching from just a fee-based license to usage-based per token, as well as outcome-based around how much money does it save you, the corporation, or productivity improvements or whatever. So the contracts are gonna be a lot more variable, let’s say, in terms of you may end up with a lot more custom contracts based on whatever your customers are looking to do — versus in the past, where it was pretty much an enterprise license with seat-based licenses underneath that. You’re gonna probably switch to this more usage and outcomes-based fees in the future.

Jack: How do you think about all the issuance we’re seeing? There’s been a lot of talk in the wake of SpaceX that the market just can’t absorb all the supply. Anthropic’s coming, OpenAI’s coming. Some of the other companies are issuing. Do you think that’s a big deal for the market, that all these companies are issuing, or do you think relative to a huge market, it’s not that big of a deal?

Dan: Well, it’s a big deal in the sense that I am a big believer that credit is the lifeblood of the economy, right? Because the price of the 10 and 30-year Treasuries, that determines everything. You could argue that’s the most important price in the world, is the 10-year Treasury yield. And when you’ve got the 30-year up at the highest level since 2007, that’s a problem.

Now, why is that? Well, there’s a combination, obviously. You’ve got government debt sitting at $40 trillion. US GDP is $33 trillion. So that’s one problem. And you’ve got deficits at 6% of GDP, which is the highest levels outside of a major war that we’ve ever had. So that means the debt’s gonna keep growing.

In addition, it’s what you talked about — which is, in the past, you didn’t need to compete with AI debt spending by some of the biggest companies in the world, which in the past were massively cash flow generative, like a Google. And that’s the other reason why the 30-year Treasury is up as high as it is, along with the 10.

And so all of those things together bother me, because to some degree — and you can’t separate out what’s what very easily. I mean, one of the charts I look at every morning is the credit default swaps for the big guys, Microsoft and CoreWeave and all the rest of them, Nvidia, to see what they’re doing. What’s the cost to insuring that debt? And as you probably remember, credit default swaps were something that everybody was looking at during the global financial crisis to see, okay, which companies are potentially in trouble.

And when you’ve got some of the biggest, most cash generative companies in the world that have credit default swaps that are trading at premiums to the North American investment grade credit default swaps, that tells you something right there about the ability of capital markets to absorb this and what they’re pricing it at.

Because to some degree, credit investors are way smarter than equity investors, right? Well, why do I say that? Well, if Google goes from $100 to a billion dollars per share, the credit investor still only gets whatever they were lending out money to Google at. So they have to feel darn sure that they’re going to get paid back. So they have to do a lot more work.

With an equity investor, you go, “Well, yeah, if Google goes to zero but Meta goes up 10X, I don’t really care, because I lost 100% on Google and I made 10X on Meta.” And that’s the venture capital model. So equity investors, or venture capital investors, can go, “Yeah, I can have nine out of my 10 stocks in my portfolio go to zero, but that one stock can make it up.” That’s not the way it’s gonna work for a credit investor. They can’t afford to have even one of those companies go belly up.

And so there’s a lot more work done around that, which is why I spend a lot of time looking at the pricing of the debt instruments that belong to these big hyperscalers, to try to figure out what some of the smartest investors — because they have to be, because of that risk-reward structure I just talked about — how they’re thinking about pricing this stuff.

Jack: And it seems like so far those debt investors have been pretty happy to take on the debt related to this AI CapEx. But does that concern you going forward?

Dan: Well, they have and they haven’t, right? Because if you look at credit default swaps for all these companies, they’re at the highest levels they’ve ever been.

Jack: So does that—

Dan: They’re still at very low levels relatively. But as I said earlier, most of them, even Nvidia — I think when I looked this morning, their credit default swaps were actually higher than the average North American investment-grade credit default swap for five years.

Jack: So does that concern you? One of the differences with the dot-com here is at the beginning at least we were funding this through free cash flow.

Dan: Absolutely.

Jack: Now we’re starting to use debt. Now we’re starting to have some of the circular stuff coming in. Does that concern you more going forward?

Dan: Absolutely, because you know that what that means is on the other side of this. Because we had the same things during the dot-com build out, but it didn’t mean that you didn’t have... I mean, think about 1999. The Nasdaq was up 86%, and then at the beginning of 2000, Nasdaq was up another 24%. So even if you were right at the beginning of 1999 and you knew that the bubble was gonna break within the next 18 months, you forego — you missed out on so much profit by missing that last year of upward move.

And so you can have two things be true at the same time. You can know we’re in a bubble, but still have a lot of opportunity to make money before that bubble breaks. And that’s what I’m trying to say right now. Is it tricky? Absolutely. Because are we closer to probably the end than the beginning? Probably. But that’s what makes stock picking become much more important at this point, because this goes back to your earlier question, right? Like, well, who do you think is gonna be in trouble? Where’s the value gonna accrue? At the model layer? At the infrastructure layer? All these are things that you have to debate a lot more now than you did two years ago, three years ago, when this stuff all started.

Justin: I wanted to ask you about your investment process, almost like how you kind of think about investing, I guess. And specifically how you go about researching sort of the long positions or the short positions.

Dan: Well, the way I invest is, I have positions where I think are gonna go up, and I think I have positions that are gonna go down. So it’s a mixture of shorts and longs.

Justin: Okay. Give us some insight into, I guess, the investment process a little bit. Like, when you’re looking at a new name, kind of what you go through in terms of your due diligence and research process. One of the things I appreciate about you is it’s not, like, long only, so you also have to look at — you are thinking about things that could go down in value. And maybe you do more research for those, I don’t know. But I think it’d be interesting to hear how you go about looking at companies. I know it’s probably a different methodology for different types of companies in different industries, but just kind of walk us through your process. I think it’d be interesting.

Dan: Well, before I go through that, I’ll go through how I think about investing, ‘cause then that gets down to the process. ‘Cause everybody’s got a different view, right? Like I always say, Stephen Curry likes to score points a lot differently than Shaquille O’Neal used to, right? And so it really comes down to how do you think about it.

For me, my main thing is stocks can go up faster than you ever imagined possible, and then much like you saw in 2001, ‘02, they can go down more than you ever imagined humanly possible. And so I don’t wanna lose money. If you go down 100%, doesn’t matter if you’re up 1,000,000,000%, you still are wiped out.

And you just don’t know. Like, when I downgraded everything I covered when I was a sell side analyst at Lehman Brothers in 2000, I would have never in a million years thought Nasdaq would be going down until October of 2002 and be down 78% from its peak, when the internet was still doubling in ‘01 and ‘02, right? But that’s just the way it evolved.

So I always look at it as, I want to have excellent downside protection, and so it starts with that. So there are periods of time if I think things are massively oversold, I may have almost close to no shorts. And then if I think we’re in a period of time like we are now, where I think there’s a tremendous number of risks out there, I may have more shorts on than longs. And so it starts at the portfolio construction level, based on the fact that I know that stocks can get obliterated faster than you ever imagined. And I think some people learned that the hard way from June 22nd to July 29th. And so that’s where that starts.

In terms of the research, looking for longs and shorts is almost the same thing. Because as you’re looking for longs sometimes, I’ll run into names and I go, “Well, I thought this was a long.” But actually it’s probably better off as a short, because it is doing AI, but it’s actually probably one of the guys that’s gonna get displaced versus do well.

I mean, if you’ve been looking at any of my interviews over the last, I don’t know, one to two years, I’ve been pretty negative on OpenAI relative to Anthropic. And now you’re seeing it in the revenues. And profitability, by the way, right? Anthropic is very pro- — well, not very profitable, but they turned profitable in Q2. And OpenAI, I believe, lost even more money in Q2 relative to Q1. We haven’t seen the final figures yet.

And so it’s kind of the same process that you’re going through on the public market side, as you’re trying to come up with the names that will do well or not. And then in periods of time like June 20th, when I put out that note saying, “Hey, I think we’re gonna hit a speed bump,” you get really defensive. Because if there’s a fundamental thing that’s worrying you — in that case it was companies trying to minimize their spend on AI, open source, things like that, that you thought would have a problem, combined with valuations and leveraged ETFs getting out of control. And so you’re managing that at the top layer.

And I think the part that a lot of individual investors, or even some of the quote unquote “fundamental investors,” don’t focus on enough is, what’s the big picture? What’s the credit picture? If the cost of money is getting more expensive, and you’re having to fund a data center build-out with high-priced loans, and your credit default swaps are going up — like, that’s an issue. And that can cause some real severe problems.

And so it’s kind of a combination of all of that stuff: the macro, individual company fundamentals, and portfolio construction to control downside risk. That’s how I think about investing.

Justin: Do you have any thoughts on the Fed here, and any opinion on where you think rates might be going, or is that not something you kinda wade into?

Dan: Oh, no. That’s something I spend a ton of time on. I mean, my simple rule is don’t fight the Fed. Starts there.

And I wrote something on this on Friday, actually, off of Warsh’s speech, and that was what it was entitled: Don’t Fight the Fed. Because Kevin Warsh, the chairman of the Federal Reserve, came out at Jackson Hole at the economic symposium and said, “We’ve had 65 months of sustained elevated inflation, and that sits squarely with the central bank.”

So in my mind, he pretty much told me that he’s going to raise rates. Now, the question is when? Well, the next two meetings are on September 16th and then on October 28th, but the midterms are on November 3rd. There is no way, in my mind, that he’s gonna wanna irk the White House by raising rates less than a week before the election. So I firmly believe — and we’ll see what happens — that there’s a rate hike coming on September 16th. They’ll probably pause on October 28th, and then we’ll have to see what happens after that.

But he’s raising rates for a good reason, because inflation has been above that 2% target, as he said, for 65 months. And I have a really big problem with letting inflation run at those levels. Because the people that are gonna watch this podcast, they’re gonna own stocks. But there’s 40-something percent of the population that unfortunately isn’t in a position or isn’t owning stocks, and that don’t own their own homes. They’re getting killed by inflation running at these levels for over five years now.

And so I feel like it’s really important to get inflation back down to levels that work for everybody. And inflation is great if you’re a stock investor, right? ‘Cause it helps inflate stock prices, too, and home prices. But this is not a good thing for capitalism, because that’s how you end up with people saying, “Yeah, big business is terrible.” And those people come into power, and you end up with really bad policies that come about because of that. So yeah, I watch the Fed very closely, and my simple rule is don’t fight the Fed.

Justin: Is there a chance that the market — and it might go a little bit opposite than don’t fight the Fed, but I’m just curious — is there a chance maybe that there’s a positive reaction in the market to a rate hike?

Dan: Yeah, you could have that. The thing is that there’s never one factor that you’re looking at. So it’s that, which a lot of people are still saying, “Oh yeah, there’s no way. I mean, Warsh got appointed by Trump because he wanted a lower rate, so there’s no chance he’s gonna raise rates.” And so I think there’s a big contingency of people that believe that, and I’m not in that camp.

You’ve also got September seasonality that’s working against you, right? Since 1957, which is the inception of the modern S&P 500, September’s the only month of the entire year that on average is down, and it’s the only month of the entire year that the probability of it being down is more than the probability of it being up.

And then in midterm election years, the odds get even worse. Because the market hates uncertainty, and typically you have a big change during midterms, because politicians never live up to whatever they promised when they got elected, right? They’ll promise you the world. They never deliver the world, and then you end up with a change. And you’re gonna see that — unless the polling numbers are vastly wrong, you’re gonna see that as well come November 3rd. And so the market doesn’t like that.

Peak to trough losses, which I’ve written about, are 10% from July 31st through November 9th since 1990. That’s the peak to trough loss. The normal is five in non-midterm election years.

And so you put all of those things together, and then you have Iran. My firm belief is this is a lot like the Iran hostage situation back in the 1980s, where Iran held those hostages up until the few hours when Ronald Reagan got sworn in as president, and then they released them. Jimmy Carter got absolutely slaughtered in that election. It was 489 electoral votes to 49 or something, I think. And I think you’re gonna see a lot of flare-ups right up until the midterms, because if you end up with a change in the political climate, that’s much better for Iran.

And so I think all of these things — it’s not one thing. It’s not the Fed. It’s not oil prices. It’s not Iran. It’s not September seasonality. It’s not data centers getting in the crosshairs of politicians on both sides. It’s not any one of those things, but you put them all together with the valuations where they are, and you have to get somewhat concerned from a risk versus reward basis.

And that’s how I think about investing. I always think of it as risk versus reward, and where is it. And if I can stack the odds in my favor... On top of playing video games, I love playing Texas Hold’em, right? And when you know you’re gonna lose seven out of eight hands, it becomes very crucial to focus on, how much do you lose on the seven hands that you statistically should be losing? And a lot of investing is like that, at least for me. Other people look at it very differently. If you’re a venture capitalist, very different risk versus reward profile you’re thinking of.

Justin: So Dan, we have two standard closing questions we like to ask all of our guests. And the first one is, what is one thing you believe about investing that most of your peers would disagree with you with?

Dan: I believe saying there’s some stocks you just need to buy and hold is completely moronic. Because you don’t know that. You have a lot of survivability bias. You hear from the people who said, “Oh yeah, Apple was a buy and hold.” Well, you never have people on that say AOL was a buy and hold. Yahoo was a buy and hold. Nokia was a buy and hold. Cisco was a buy and hold. IBM was a buy and hold. The list is really long of market share leaders that then went into trouble.

And you always have some company that makes it through. Like Microsoft has done great through three different decades, right? But that’s one company. And so I think you have to have strong conviction, but loosely held, and that’s the way you wanna think about it.

And just because a stock’s down a lot — like one of my big disasters this year, we’ll see how the rest of the year plays out, is Nike, right? It used to be a market share leader. I don’t think the oil situation has helped it. Obviously other brands have come in. They had years of mismanagement. We’ll see what happens. Like Disney was another name, right? People were like, “Oh, you gotta put it away for your grandkids.” Well, that hasn’t worked out so well.

And so I completely disagree with that. I think you wanna have a very flexible open mind, and as the facts change, you wanna change too.

There was a second question. I forgot what it was.

Justin: Oh, yeah, the second question, which is the last one: based on your experience in the markets, what’s the one lesson you’d teach the average investor?

Dan: I don’t think there’s enough emphasis placed on downside protection, which is tied to kind of the first answer I gave — which is, you don’t know if you’re holding the next Google or are you holding the next Yahoo. You don’t know if you’re holding the next Apple or you’re holding the next Nokia. You don’t know if you’re owning Snapchat or you own Facebook. You don’t know. And the losses you can incur can be really steep.

And so this bubble is going to break, because AI is the most transformational technology since the internet, and some would argue it’s even more transformational. In which case, it means people are over-investing, because the profits you can make — as we’ve seen with Anthropic as an example, which should go public at close to 2 trillion in valuation — is just enormous. And so everybody’s chasing this. And so when this breaks, it’s going to be a bad break.

And so you need to focus on downside protection. And that also means don’t play with leverage, because if you get it wrong, as millions of retail accounts in Korea figured out — that could not only go on margin, but then invest in levered ETFs on margin — bad things can happen, and you never wanna put your family at risk.

And so I think that’s kind of the message I would leave with people. You know, Goldman Sachs has this great expression, which is, “Be greedy long-term.” And I think that’s how you wanna think about it, because as Albert Einstein said, “Compounding is the eighth wonder of the world.”

Justin: Excellent conversation, Dan. Thank you very much. We really appreciate it.

Dan: All right. Thank you.

Topics covered

• Why credibility is a teacup and why policy reputation is difficult to repair once it breaks

• How the Fed’s July rate decision changed the market narrative around inflation credibility

• The Four Horsemen: insurance and shadow banking losses, capital crowding out, the Iran war and oil inflation, and a stretched consumer

• Why insurer-funded private credit could become a systemic risk if fraud and losses reach major institutions

• How government borrowing and AI data center financing could push long-term interest rates higher

• Why fading fiscal stimulus, depleted savings and higher energy costs leave the consumer vulnerable

• What financial repression means and how the Fed and Treasury could try to cap rates and prevent major losses

• Why AI investment may be the key source of US economic growth if consumer activity stalls

• How Perscient tracks narrative regimes, virality and shifts in common knowledge across markets

• Why gold can act as an inverse measure of trust in central banks and how Ben is positioning around the risks

Timestamps

00:00 Intro: Credibility is a Teacup
04:00 How the July Fed decision damaged inflation credibility
08:21 The Four Horsemen that could threaten the financial system
14:00 Oil inflation, the Iran war and a stretched consumer
18:39 What financial repression means
23:20 How the Fed and Treasury could try to prevent a systemic crisis
28:21 Why AI CapEx may be the only major source of GDP growth
35:00 When lost Fed credibility became a confirmed market narrative
39:34 Narrative stock versus flow and how bursts can move prices
44:00 The return of bearish AI CapEx narratives
48:09 Why private credit may be easier to can-kick than the 2008 crisis

Learn more about the Excess Returns podcast network:

https://excessreturns.co

No information discussed in this podcast should be construed as investment advice. Securities discussed may be held by the hosts and guests, their firms or their clients.

Ben: Thank you, Matt. Great to be here, as always.

Matt: All right. You titled it Credibility Is a Teacup. Before we get into some of the slides, ideas, and everything else — what just happened in the last month that made you put this one together?

Ben: Well, this idea that credibility is a teacup is something I think is really important, not just for how I wanna talk about it — which is the credibility of Kevin Warsh, the Fed chair, the credibility of Scott Bessent, Treasury Secretary — but the role of just credibility and believability, reputation, in our business, our world of investing.

This is one of the first lessons I learned from my mentor, kind of the people who hired me when we got into this crazy business of investing other people’s money. And I know you know this, Matt, but in this business, your reputation is everything. It’s everything.

This is a wonderful career to have, in investing, in financial services, whether as an advisor like you are, or as an asset manager like I’ve been and I try to do. But through all of this, there will always be places where there’ll be a temptation to cut corners, or to just — we all know what I mean, right? And you can’t do it. You should never do it. There is no possible advantage on a trade or with a client or anything that should ever let you do anything that chips at your reputation.

Because once you crack your reputation, you can try to glue it back together. That’s why I use the analogy of a teacup. You break or you chip the teacup, and you can glue it back together, and it can still be a functional teacup, but it’s never the same. It is never the same.

So credibility — whether you’re a Fed chair, whether you’re a financial advisor, whatever you do here — credibility, your believability, your reputation is the most important thing. And you can’t put that ever at risk. And that’s what’s happened, right? So the teacup has been broken.

The teacup got broken with Kevin Warsh for his press conference at the end of August — sorry, the end of July — where they didn’t hike rates. He was talking like he was gonna hike rates, and he didn’t do it. It would’ve been easy for him to do. And then if he had, we wouldn’t have any of this now. He would be cemented in everyone’s perception as, yes, you said what you meant, and you meant what you said about being an inflation fighter. And so now we believe you. And then that’s when the market does the work for you, as he likes to say is the goal here.

But when you come out and you say what he said, which was basically, “Ugh, new boss, same as the old boss. Lots of words, lots of talk, but they will never do anything to raise rates if they can possibly help it” — then that’s when gold skyrocketed. I’m gonna show you stuff on our narrative signals that shows just what a supernova this was at the end of July, when he basically broke his credibility as being an inflation fighter.

Now, he’s tried to reclaim the credibility at Jackson Hole with his speech last Friday, and the market correctly said, “Oh, this is a very hawkish speech.” But he’s got himself in such a bind now, because it’ll just be more words. It’ll just be more words if he doesn’t actually pull the trigger on hiking rates in September. And I’m telling you, for all the reasons we’re gonna describe here, no one in this administration or in markets wants him to raise rates. They really don’t want him to raise rates. But now he’s painted himself in a corner. He’s trying to repair his credibility, and it just makes it more difficult for him. It’s the problem of, you’re trying to glue the teacup back together, and it’s never the same.

Same thing happening with Scott Bessent. Oh my God, I mean, the last three weeks with Scott Bessent, with him threatening basically to do big buybacks of long-dated yields, to intervene directly in buying back our long-dated debt to try to put a lid on the ten-year and thirty-year interest rates. I get why he’s doing it, I really do, but they’re making all these same mistakes, because you can’t live up to it, and it just becomes words. And if you don’t follow up your words with action, and if the actions you’re taking are at odds with what your partner, Kevin Warsh, is saying, then nobody believes anything you’re saying.

All of his trolling around supporting the yen, all of the trolling around, “Oh, we’re gonna do this D-Day to put sanctions on Iran.” And then he gets up on the stand and says, “Well, we’re actually just trying to set expectations.” And there were no sanctions. No cudgel going against banks that are doing business with Iran. There was none of that.

And at the end of the day — and I can show you this in our results — you’ve got an enormous loss of credibility for the Treasury and the Fed. The teacup has been broken.

Now, that’s a problem today. It’s always a problem when you lose your credibility, because it makes it that much harder to take the actions. It’s the little boy who cries wolf. Once you cry wolf a couple of times and then you don’t follow it up with actions, you have to really yell wolf, and then you have to really do a lot of actions for people to start believing you again.

And that’s really difficult right now, because we’ve got four big problems that exist today where Treasury and Fed need all the credibility they can get. So that’s what I’d love to do in this call, Matt, is kind of run through: what are those four specific issues where God knows they’re gonna be a challenge for the Fed and the Treasury, and they need all the credibility they can get? And that’s why I think the next couple of months are gonna be so fraught for markets.

Matt: And not just fraught. In the presentation — and I’m going to say, when you lay them out this way as catalysts — you’re calling them the Four Horsemen. And that’s as poetic as it is important here, to say these are four big things that we’re watching coming in with big signals and big narratives tied to them. Why don’t you walk us through each of those four?

Ben: I’ll go through each of the four. And I call them the Four Horsemen because I think any one of these, if it burst onto the scene without — I’m not even gonna use the intervention word — but without action by the Fed and Treasury, any one of these four could spark a new great financial crisis. I really believe that. And I think you’ll see what I mean when I run through these four.

All right, here’s number one. So the first big problem that is now on the scene is fraud and unanticipated losses in the insurer-funded shadow banking system. So Mark Walter and Guggenheim, that’s the immediate place of this.

And you’re probably saying, “Well, Mark Walter, he’s the guy who owns the Dodgers.” Until a couple of weeks ago, he owned the Lakers. And it comes to light that he made those purchases by getting loans from, let’s call it a captive insurance organization. Captive insurers that he controls through Guggenheim Partners, one of the big financial firms that he controls.

And so this is something that’s been going on for a long time, not in as egregious a manner as Mark Walter did, where he’s borrowing from companies he controls to buy the Lakers and buy the Dodgers. But look, this has been something that Berkshire Hathaway’s done for a long time. They’ve got Geico as a source of permanent capital to fund what Warren Buffett does. This is what Apollo does with their captive insurer, Athene.

Something I’ve been writing about for a couple of years now — that we’ve developed this shadow banking system. It’s not regulated like the commercial banking system, but this is a source of funding for so much private credit activity, private equity activity. The money is coming from typically annuity contracts at life insurers that are affiliates or captives of these asset managers. And like I say, something I’ve been writing about for a couple of years, now it’s really coming into the public attention because it involves these amazing assets like the Dodgers and the Lakers.

So the thing that makes this go from a story into a really nasty event is if we have actual losses that get attached to one of these big insurance firms. That’s when this becomes not just a potential scandal, but becomes a Madoff-level incendiary event. So this is catalyst number one, that the Fed and Treasury have to pay attention to and say, “We cannot allow major fraud and losses to permeate our insurance system.” And there’s a real risk of that happening. That’s issue number one.

Issue number two. Both the US government, Japan, the UK, the EU — every government in the world needs trillions in capital to fund their growing deficits, US being prime example of this. But also the AI companies, the hyperscalers, they all require trillions in capital over the next couple of years to do this build-out.

We have a crowding out effect, as it’s called. It’s too many borrowers who need trillions, relative to people who will lend them money. And what always happens in this situation is the price of money goes up. That is the inescapable outcome of too little money chasing too many borrowers, especially when the borrowers are not optional.

I mean, it’s not optional for the United States to borrow money. It will borrow its money. It’s not optional for the hyperscalers to borrow the money that they need for this, because it’s Katie bar the door if they can’t. If they can’t, the whole economy blows up. It really does. So they’ve got to get their money, but that means there’s less money available for other corporate borrowers or any sort of borrowers. It’s a one-way bet on long-dated interest rates, which is what we’re seeing. So interest rates all over the world are going up.

And this is why catalyst number three — this war without end in the Persian Gulf. This disastrous Iran war with very few exit paths, exhausted inventories on distillates and crude all over the world. So in the same way that the demands for capital were creating a one-way bet higher for longer-dated interest rates, higher-for-longer oil prices means inflation and a one-way bet on higher-for-longer interest rates in the short term. That’s catalyst number three.

And finally, we’ve got catalyst number four, which is that the consumer is stretched again. Not just stretched, but in trouble again. We had an enormous influx of money, of liquidity, into the US economy in the first half of the year through the one big beautiful bill. All those tax rebates and reduced withholding, it meant there was more money sloshing around in the system in the first half of the year. Particularly in this most recent quarter, you had all the tariffs that had to be returned, those tariff rebates to corporates. That was a one-time deal as well.

All of that stimulus is now, if not done with, certainly fading, and I don’t see any chance of getting more stimulus coming in over the next quarter or two. So we’re back to where we were in terms of the consumer at the start of the year, which is not good. Which is really not good.

I mean, if anybody listened to the Dick’s Sporting Goods earnings call, where the day of that call they’re down thirty percent because people aren’t buying tennis shoes anymore — that was kinda one of the things they really pointed out to. Not just the cheap end or the high end. They’re just not buying. They’re just not buying.

And we’ve now got an all-time low in savings rate. We’ve spent our money. We don’t have our savings. We’re out of reserves — both in terms of reserves at a national level, reserves at a crude oil level, and now reserves in savings.

So all of these issues are coming together all at the same time. Any one of which could really spur a crisis in the financial system. And all we’ve got left to fight it is a broken teacup. So that’s the problem we’ve got. And that’s what leads to what I think is going to be the effort by Treasury and by Fed, which is going to be to address these four issues.

I don’t know what they can do about the Iran war, right? But for all of them, what they’ve got to do is keep the price of money as low as they can, which means keeping it artificially low. That’s why Bessent is talking about buying back bonds. That’s why they’re talking about all these things to try to keep a lid on the price of money, on interest rates, short-term and long-term.

It’s why I don’t think that Warsh is going to hike in September. I think he’ll find reasons still not to hike, and it’ll just mean that, well, it’s still just words. Still just words. They’ve got to keep enough liquidity sloshing around the system. I don’t know how they do that in terms of direct stimulus, but they’ll find some way to get more money into the economy.

You’ve gotta keep interest rates artificially low, you’ve gotta keep enough money sloshing around, and you’ve gotta find some way to kick the can down the road in terms of losses in that shadow banking system. You can’t allow a big insurance firm to take a big loss. You can’t allow a big data center project to fail. So what that means is, I think you’ll see loan backstops for the data center projects. I think you’ll see more efforts at keeping the interest rates artificially low.

I don’t know that any of this is going to work. And so long as they’re trying to do this, I think gold is a phenomenal investment, because all of these things I’m describing fall under the heading of financial repression.

Matt: I wanna drill into this word specifically. Because we talk about, maybe recessions really are over. Maybe there’s really no business cycle anymore. Probably not, but maybe. We talk about recessions, we talk about depressions. Very rarely does anybody bring up this word repression, let alone frame it as a strategy. So please unpack what you mean by this.

Ben: Well, all financial repression means is direct government intervention, principally on the price of money, on interest rates. So the whole idea of QE and expanding the Fed balance sheet and keeping interest rates artificially low — that’s financial repression right there. So this is just another version of that, to try to keep the flywheels turning, to avoid some big loss in the system.

The problem, though, is that unlike 2009 when we started QE and all those efforts, the problem today is we’re starting from a point where interest rates are — I’m gonna talk about short-term interest rates — the two years at four point something. It’s not zero. We’re not starting from 0% interest rates. We’re starting from a pretty high interest rate already. And we’re starting from enormous government deficits, much larger than we had before. We’re starting with a Fed balance sheet that’s already trillions higher than it was in 2009. So it’s just a lot harder to do the sort of actions that were done in 2009, ‘10, ‘11, ‘12 to try to come out of that great financial crisis. And so it’s a really tough row to hoe.

But we’re really trying to do two things at the end of the day, ‘cause I don’t know that you can stop a recession for the consumer. That’s gonna happen, and that’s a cyclical thing that we’ve avoided for a long time. I don’t know if it’s possible to avoid that any longer. What we’re trying to do is avoid some sort of big crack-up.

And there are two things that you gotta do for that. One is, you can have interest rates go up. You can’t have them go up quickly. That’s what kills the insurers, right? It’s not so much that rates are going up, but that they go up really fast. They get out of hand. And that’s what Bessent and Treasury are trying to prevent. Because when interest rates go up fast, that’s a real problem for these insurers, especially a reinsurance company. And we can get into the details of that, but that’s what creates real problems for them.

And you also can’t have one of these mega data center projects collapse, because that’s what hits the whole alternative asset manager, the shadow banking system. That’s what takes Blue Owl from 12 bucks a share to two bucks a share. We had what we needed to see happen for Blue Owl to go from 20 to 12, 20 to 10, and now it’s probably back up to 12. If you have one of these big data center collapses, that’s what takes all of these shadow banks, alternative asset managers — Blue Owl, I’m picking on them — but that’s what takes them from 12 bucks to two bucks.

So those are the two things you can’t have happen. You can’t have a rapid increase in interest rates, and you can’t have one of these mega data center projects not work. So you’ve gotta keep funding for that, and you’ve gotta prevent losses in any of these big projects, and you gotta keep interest rates from going up quickly.

So that, I think, is the goal of, again, what is called financial repression. All that means is you’re keeping an artificial lid on interest rates, and you’re keeping an artificial influx of money for things you want to support, like the big data center projects.

Matt: Talk for a minute about — because both Fed and Treasury have resources to apply here. There’s a reason these conditions can be thought to exist.

Ben: Yeah. So let me be clear: as much of a contrarian as I am, I don’t want us to go back to a great financial crisis. It pains me that the Fed and Treasury have done, I think, such a crappy job of managing their own credibility here. I don’t want this to blow up.

There’s no way, I don’t think, to have a small crisis given where we are. The goal, I think, is to try to grow your way out of this, to try to let some of the air out of the balloon, meaning asset prices. And we’ll talk about what I think this means as a trade. I think you can short a lot of things now that you couldn’t short in the past.

But everything I’m describing here — the absence of financial repression means that I do think that you have a crack-up that can lead to a GFC 2. And so I don’t want that to happen. I want Treasury and Fed to succeed in, I’ll call it limited financial repression.

But I don’t know that they can. They have enormous resources — enormous resources, even with diminished credibility, to take actions. It’s just, I think it’s gonna take a lot of actions to get to where they keep a lid on everything.

This is why I think gold works here, so long as they’re making the effort. I think the effort reveals itself as... In my model portfolio, I’m long gold, I’m long energy. I’m short the consumer now.

Matt: Well, let’s get into this. This is the hamster wheel trade, as you call it, right? This is your phrasing of this?

Ben: It is. Thanks for... Yeah. I’m calling it the hamster wheel because that’s where we are now. The Fed and Treasury are gonna have to run faster and faster on this hamster wheel to just try to buy some time. You’re not gonna be able to outrun this entirely, but they’re trying to prevent, like I say, interest rates from going up really fast. They’re just trying to make it go up slowly, and they’re trying to avoid a big loss, especially if it’s accompanied with fraud that sparks something like a Madoff, or something that really sparks a big sell-off in markets. They’re trying to let the air out of the balloon without letting the balloon inflate anymore.

And so I think you can absolutely be short the consumer, ‘cause I don’t know how you do more stimulus for the consumer at this point. And I think you’re absolutely getting higher for longer on gasoline prices. So yeah, model portfolio: I’m long gold, I’m long energy, I’m short the consumer. I’ve got small positions being short tech and small positions being short financials, in hopes that Fed and Treasury can get their act together and manage this, that they’ll be successful in running as hamsters on this wheel. But my fear is that they won’t be successful, and then I think you’ll want to have a big short tech position and a big short financials position. But right now, I’ve got placeholders there.

I am short consumer because I think that’s the casualty that — as loathe as they are to give up on anything — I think they’re gonna have to give up on the consumer. And we will have... I don’t know if we have an actual recession, but I think it’s gonna be really painful for the consumer over the next four months.

Matt: I’m gonna call back to something — you tell me if this is relevant or not — something you said before when we’ve talked about this. Typically, we talk about the US economy, 70 to 80% of GDP driven by the consumer.

Ben: Yeah.

Matt: But some of the data that you’ve been showing is also saying that the AI investment piece is probably taking up about... If GDP’s running a little over two right now, give us the math, give us the breakdown, and why some of this trade-off is already showing up.

Ben: The AI trade is where you get growth.

Matt: Right.

Ben: I don’t think anybody’s expecting to have growth in the largest part of the US economy, which is the consumer-driven economy.

Matt: Which is just what you spelled out with the savings rate, with debt, with all the other—

Ben: Exactly.

Matt: With the high gas prices, groceries, you name it.

Ben: Exactly. Look, I think that for the year we’ll have like, what, 1.5% GDP growth? The only thing that keeps that from being a recession is keeping the AI hamster wheel going. That’s the only thing, and that’s the place where you’re having growth. So it’s a triage situation, is what I’m saying.

And I think shortsightedly, they didn’t hike rates when they could easily in July, and now they’ve got damaged credibility, which means it’s gonna be that much harder to do the financial repression they need to do to keep this from only being a garden variety, inventory-led consumer recession. I think now they’ve got to really have concerns that you’re going to have a systemic crisis, which means a financial system crisis — which is what comes out of either the AI trade not working because you can’t fund it, you can’t finance it, or you’ve got problems in the insurance world. And that can come from one of two ways, either fraud and losses, or long-term interest rates going up rapidly.

They gotta focus on that to keep the whole ship afloat. And I think they’re gonna have to give up on, I’ll call it general economic weakness. I think they’d be thrilled to have one and a half percent GDP growth for the year. Thrilled. Because I think what that would mean is good growth on the AI trade, flat on everything dealing with the consumer.

Matt: Let’s talk about some of the narrative tools, because I think this is what sets your work apart from others — that actually tracking and scoring the density of these narratives as they’re shifting has been... This is why we’re having this conversation right now. You’re actually seeing this in the data. Walk us through that.

Ben: Yeah. So what I’m gonna put up as a slide here is — look, I’ll call it a breakthrough that we had in our technology, which is now we’re not just able to track how loud or how quiet a given narrative is, but we’re really able to track its life cycle. Because all narratives have life cycles. They have bursts where a new story comes on the scene, it’ll persist for a while, and then that burst may or may not lead to a change in what I like to call common knowledge. You know, what everybody knows that everybody knows.

And it’s totally transforming our ability to make actionable steps from our narrative analysis. Because if you know where you are in the life cycle of a narrative, then you’re much better off to be able to say, “Well, how does that impact prices or policies that have to come out next?”

Now, the slide I’m putting up is showing the life cycle of one half of the coin, the credibility coin for the Fed. We do this for all central banks. So this is central bank losing credibility. That’s the signature of the narrative we’re tracking, and we’re tracking it over the last five years, I’m showing in this chart. And it’s talking about the Fed. We’ve got this filter just on the US central bank.

And kind of as a backdrop, what we do is we’re reading all the news in the world, all of it overnight, and we’re looking for the presence of somebody saying, “Okay, the Fed’s losing credibility.” This isn’t word search, this isn’t sentiment analysis. We’re able to track the underlying — ten-dollar word alert — semantics. Any way that you might want to say, “Oh, the Fed’s losing credibility. Warsh is losing credibility,” we’re able to pick that up in all the news.

And so we’re looking for bursts of that story. We’re looking for the overall loudness or quietness of that story over time. And we’re looking for, what does that mean for what state of the life cycle we are in? Is this people arguing whether that’s true? That’s what we call contested. Is it possible or building? We’ve got that as a potential stage here. Or what happens when it gets confirmed? When, oh my God, we are in a confirmed state of everybody knows that everybody knows that the Fed has lost credibility.

And that’s what we’re able to show now in our different slides: the life cycle of a narrative, as well as the virality of it. That’s what we’re tracking when we’re tracking the bursts.

I mentioned earlier that when Kevin Warsh went and said, “Oh, I know I’ve been talking a big game on, we’re gonna be inflation fighters” — and then, oh my God, he didn’t do any of it. And so we saw an enormous burst, like a supernova of a burst, of stories and articles saying, “New boss, same as the old boss. Just like all the other guys. Talks a big game, but when it comes to it, doesn’t do a damn thing.” And so that’s what we’re seeing in our data and our charts here, is that you had this real burst of activity that transformed now almost immediately into a confirmed narrative regime of, the Fed has lost credibility.

Now, what I then wanted to do with that — ‘cause we were talking about what’s in our model portfolio — well, what does that mean? What do you do about that? I wanna show what we can do with that for thinking about gold. Because gold, I think, is a wonderful example of a thing you can invest in that is directly related to, or inversely related to, the credibility of the central bank.

In fact, I think that’s the meaning of gold. It was one of my very first Epsilon Theory articles back — God, that was a long time ago, thirteen years ago — when we were talking about, well, what does gold mean today? And what gold means today, it’s an insurance policy against central bank error. As my friend Brent Donnelly likes to say, the price of gold is one divided by trust. It’s the inverse of trust. If you trust the central bank to be large and in charge and to get the job done, the price of gold goes down. If you don’t trust the Fed and you don’t trust Treasury, and you’re worried that interest rates will go out of control, that they won’t do what they say they’re gonna do, they don’t mean what they say — well, then the price of gold’s going to go up.

So I think I can really demonstrate how that’s worked just over the last year here. Because what I’ve done in showing up the slides here, first you take the price of gold over the last year, and then what I overlay on that are the different states of the life cycle of that narrative that the Fed’s losing credibility.

Green is the confirmed up state. Yellow and orange — I don’t even know what that color is. It’s not really orange, but it’s—

Matt: It’s an orangey red. It’s an orangey color.

Ben: Yeah, not quite red yet. But that means it’s being contested. The regime is being contested. And the red is, no, it’s declining. Maybe it’s still louder than normal, but the rate of change is clearly on the downswing of that narrative that the Fed is losing credibility. So that’s step one.

But like I say, our technology is two things. It’s both what’s the life cycle stage, but also what’s the impetus? What’s the burst of activity of narrative formation? And you put that on top. That’s the next slide I’m going to show.

And what you see is that when you’ve got a positive regime — it’s either building or it’s contested or it’s confirmed — and you’ve got narrative bursts, that’s when the price of gold goes up. ‘Cause that’s showing narrative formation, these bursts, in a narrative regime that’s conducive to gold going up. And then when you’ve got it’s either contested and there’s no burst, or you’ve got the tail with the red when the narrative is on decline, then that’s when the price of gold goes down.

So it’s just an incredibly, I think, powerful tool now that we’ve got at our disposal, to look at not only how loud or how quiet is a narrative, but what is the state or regime of the narrative, and what’s the virality of the narratives that are actually coming up at the time.

Matt: When you think about these tools and the periods moving between the signals, the bursts, the framing — how do you think about those transition points? I think this is really interesting too.

Ben: Well, in investing we talk a lot about stock and flow, right? So what’s the total amount, and what’s the marginal impetus? What’s being added or subtracted to the stock? And I want you to think of narratives the same way. The narrative level is the state or regime that we’re in, and the flow is the narrative bursts that are coming out.

So when you see all these narrative bursts, it’s adding to the stock level of narrative, and that culminates in a confirmed, “Oh yeah, this is now what everybody knows that everybody knows.” And that’s where price goes up. Price reacts to that rising level driven by the narrative bursts. And then it tops over, and then it just goes down. And the level starts — that’s that red that we’ve got there — the level’s starting to go down. There’s no new burst to fill it back up again, and price just goes down with it.

What’s fascinating about this new state we’re in is that we went right into the confirmed reading. We went right from, “Oh no, everything’s fine,” to, “Oh my God, the teacup is broken.” And that’s what’s really interesting to me about this new narrative regime we’re in, and I think it’s why August was a crazy successful month for gold.

Matt: Talk — because I know people are asking the question, they’re already thinking about it — as this relates back to the tools you have built. We’re not gonna show any of those for sake of this, but just to talk through them for a second: the tools you have built to track those Four Horsemen that you laid out at the beginning. Because it’s not just gold where you can look at this.

Ben: Oh, no. I mean, we track nine thousand of these narratives now. More than nine thousand of these narratives.

What we try to do is... I think it’s pretty easy to see the relationship between narrative and gold. That, oh yeah, it’s one over trust, and as credibility collapses, then the price of gold should go up — if you’re in the right regime, if you’re in the right state of that narrative, which we are.

Matt: And this is about picking, choosing the vehicles to express the shared view with the narrative that’s on both sides.

Ben: Exactly. Exactly. So what are the narratives you wanna try to follow around consumer spending, or consumer confidence, or housing? What I try to do in my model portfolio is look at those where it’s a really clear relationship, like housing, for example. Housing, you’re getting this double whammy. You’re getting the stretched consumer, and you’re getting the impact of high financing costs, right? That’s like a slam dunk. And so, model portfolio, we’re short the home builders index.

That’s how you do this, right? Higher for longer on energy. You can track those narratives. The AI CapEx narratives, we track dozens of those. And we’ve talked about this before, the story here is that really until this summer, the bear case narratives, they went away. We were in that tail episode. And just as we’re describing for loss of credibility spiking up, you saw a similar spiking up at the end of June, an increase in the bear narratives around AI CapEx build. And sure enough, that’s when you see the price roll over here.

So dozens and dozens of examples, but that’s what we do. That’s what we’re trying to do, is to find those relationships between narrative and asset classes and sectors and securities. But now we’re armed with this new technology to track virality and regime of narratives.

Matt: We can edit this out if you don’t want to put this in here or not. We can land it here too. I’m going to ask the question, answer it if it feels right. If not, say, “Yeah, we’ll can it here,” and I’ll put an end on this thing.

Not for the portfolio managers — I have no idea how many of them, if they do watch this. I know some do, from messages we get. Policymakers. I look at all this, I think of the ads I’m already seeing pop up for midterms coming in. These are very big stories that affect how things are going to be positioned, how things are going to be talked about, and what the motivations are for Fed, Treasury, congressional approvals, all these other things to come. What do you think this does to the political conversation that we’re about to be steeped in all over the US for the next however many months?

Ben: Yeah. I mean, look, I think that any time that people feel stretched, it’s not good for the incumbent. I mean, period, end of story. So none of this is good for the incumbent. I think, though, that if there’s any political party that can find a way to screw up a good thing, it’s the modern day Democratic Party. But clearly when consumers are under stress, that’s not good for the incumbent party. So there’s that.

But I wanna flip it around, too — ‘cause we track a lot of these political narratives as well. There’s nothing about this election, I don’t care what your politics are, who you’re gonna vote for, or what your leanings are, we’re all going to feel miserable about the midterms. Because the campaigning is designed to make you feel miserable. And to make you feel miserable about the future, that, oh my God, if the other party gets the vote, then we’re doomed. To make you feel miserable about the present. It’s all designed to make you feel miserable. The Democrats are running on, you feel miserable now. The Republicans are gonna try to run on, oh my God, if you let the Democrats in, you’re gonna feel even more miserable in the future.

So we’re all gonna feel miserable, and that is an enormous negative on consumer spending, and again, why the short position I’ve got on in strength now for our model portfolio is being short the consumer. Placeholder on tech and financials, because if Fed and Treasury are not successful at limiting the damage to a garden variety recession — and I think it’s kinda fifty/fifty whether they’ll be successful — then Katie bar the door on a much more significant downturn.

Matt: I like, and I think it’s important that people hear the 50/50 odds on this, because in the negative scenario you’re just saying, “Look, there’s deeper negative skew to this case if we end up on that side of it.” But we’ve seen people run on hamster wheels before. And we’ve seen we might skate through with some nasty rotations and other things.

Ben: One thing that our world is really good at doing is can-kicking, right? And so this is gonna require some significant can-kicking. It’s gonna be difficult because we’ve broken a lot of our credibility. Would’ve been a lot easier with other policy choices.

But all of this stuff that I’m talking about — insurance world, private credit, the ABS — these are all private securities. There’s no mark to market here. So that’s an enormous advantage that the can kickers have relative to mortgage-backed securities in 2008.

So you’ve got a much more difficult starting position in terms of debt and leverage and lack of visibility. The Fed doesn’t have a lot of visibility into these alternative asset managers, not like they have into the commercial banks. So you’ve been dealt a tougher hand, you’ve still got a lot of cards to play, and what you’re trying to do is kick the can down the road.

Matt: Ben, if people wanna find you, if they wanna see more of this work, if they wanna go check out a subscription, where do you wanna send them?

Ben: Perscient. Go to Perscient. You can find me, you know, Epsilon Theory branded everywhere, Twitter, web, and the like. But the place where we do this work professionally is Perscient. Check it out. Love to show you what we do.

Matt: We’re gonna put a link in the comments.

Ben, I think you and I are gonna have a private talk about kintsugi, the Japanese art of putting teacups back together and doing it by hand, which—

Ben: Exactly. With gold. Yes.

Matt: Yeah, we’ll do that with some gold-based glue. It’ll be a good time. You know, maybe some policymakers will learn something from that exercise.

Ben: Just takes a lot of effort. It takes a lot of effort, and it’s expensive, but you can get it back.

Matt: It’s an expensive art project. It really is. Not so much a great reputation-building tool, and that is a metaphor I can get behind.

That’s Ben Hunt. You are watching Why Am I Reading This Now? right here on Excess Returns. Like, comment, subscribe, all the things below, and we’re out.

Topics covered:

• Why long-term bond yields may be more rational than alarming given stronger nominal GDP, inflation, deficits and heavy Treasury and corporate issuance

• How global fiscal expansion and the AI infrastructure build-out are adding to bond supply and upward pressure on rates

• Why suppressing market interest rates can distort an important economic signal and create unintended consequences

• How private equity became a lagged momentum investor and built massive exposure to software and healthcare technology

• Why recurring revenue does not make a business bulletproof, and how AI could challenge software economics that once looked untouchable

• Ian Cassel’s benchmarks for good, great and GOAT stock pickers, from 10-year outperformance to 20% annualized returns

• The five or six core investing skills elite stock pickers need, and why world-class investors become exceptional at one or two

• How AI CapEx can boost current supplier earnings while the buyer’s expense is spread over years through depreciation

• Why an AI earnings bubble could exist even if headline valuation multiples do not look extreme

• How futurism, expected-value thinking and confidence in AGI may be encouraging AI leaders to take enormous capital spending risks

Timestamps:

00:00 Intro: Kevin Muir, Dan Rasmussen and Ian Cassel
05:09 Why suppressing bond yields could create new risks
09:54 Private equity as a lagged momentum investor
14:15 Why investment committees chase three- and five-year returns
19:00 The skills that separate good investors from great ones
23:11 Why elite stock picking takes a decade or more to judge
27:18 How AI CapEx is changing cash flow, buybacks and earnings
31:47 Price bubbles vs earnings bubbles
36:00 Why AI leaders may be taking massive CapEx risk
40:49 AI adoption bottlenecks and the need for skepticism

Learn more about the Excess Returns podcast network:

https://excessreturns.co

No information discussed in this podcast should be construed as investment advice. Securities discussed may be held by the hosts and guests, their firms or their clients.

Matt: Hey, man. I’m excited to do this. This is, again, an embarrassment of riches. I don’t exclusively listen to our podcasts, or the conversations I have and then what else is going on. But I have to say, we get some pretty amazing conversations over here. And having Kai and you and all of us firing on all cylinders here, this is an amazing list.

Jack: Well, I am the editor, so I do have to exclusively listen to our podcasts. But you can’t necessarily judge the quality based on that, because I am forced to listen to every one of them. But I do think they were really good this week, as I always do.

Matt: So we got Kevin Muir, Dan Rasmussen, Ian Cassel — I mean, that alone right there. We have a giant macro conversation. We have the PE complex and everything that’s going on there, and then a microcap stock conversation with Ian. That’s not your average finance channel. I’m pretty damn proud of that.

Jack: Yeah, that’s the kind of balance we’re trying to create with the podcast. And the YouTube algorithm doesn’t love this, but we’re trying to do a lot of different things. We talk some macro. Ian’s thing is a very philosophical thing about a book that he wrote that’s really, really great. And then Dan inside of private equity. But also, because it was Kai’s episode, we tied a lot of it to what’s going on in the new economy. Because as we know, private equity — something gets big returns, they go there. They went to software. There may be some negative consequences to that. So yeah, we’re trying to mix all of this up, and we’ve got some really, really great clips today.

Matt: Yeah. And if you’re a professional, if you’re doing this, or if you’re a DIY-er and you’re just interested and you’re curious in all these things — if I was listening, my normal content consumption strategy, if I think about most of my life, this is what I would do. I would be dancing around all these different areas and gathering this. So, algorithms be damned. I love that we’re gathering these and putting them side by side to play them. And especially looking at these clips, because there is so much overlapping information in these that help you tell a more nuanced version of this weird story called reality we’re living in.

Jack: Yeah, and a lot of things people are thinking about a lot right now. So we’ve got some really great takes, and I know people don’t wanna hear us too much, so we’ll get right into it.

The first one is Kevin Muir. And this idea — obviously bond yields have been going up, particularly on the long end. Kevin has a little bit of a different take on that than other people. So here’s Kevin talking about that.

Kevin: So I guess I’m gonna push back a little there on you, Matt, ‘cause although it does feel like lots exciting is happening, it really is actually somewhat sedate in terms of its actual ranges. It’s not like we’re getting big, huge monster moves.

One of the things that I’ve been surprised about is how everyone’s losing their stuff over the fact that bonds have backed up over the last little while. And, you know, so what? The long end has gone from four eighty-five to five thirty or something like that, right? So we’re talking 50 basis points.

But let’s think about the environment that we’re in, okay? A year ago, nominal GDP was four and a half or four something. Today it’s six and a half, okay? In that period, we’ve also had the deficit continue to stay at elevated levels in terms of the US federal deficit, so the actual supply continues to be large. We also have record issuance of corporate bonds as we have this just huge ignition of animal spirits in terms of the AI build-out. You know, the largest infrastructure build-out since the railroads of 1850 or whatever it is. And even I’m not old enough to remember that.

And then to top it all off, we have a situation where Trump’s geopolitical — let’s just keep it neutral — positioning has caused the rest of the world to realize that everyone needs to put their pedal to the metal in terms of fiscal stimulus and actually spend as well. So in the past, three years ago or two years ago, the US had a seven percent deficit to GDP. The rest of the world was running two, two and a half in terms of the developed world. Like here, I’m a Canadian, we were running two, two and a half. Japan was two and a half. Europe was two and three-quarters or something. All of that is now being thrown out the window as we all scramble as the world order’s being redrawn.

And so when I think about this environment, we just have nothing but supply, and people are losing their minds because we have a nominal GDP of six and a half, and the long bond has gone to five thirty. So I actually will go take the other side and say, “I’m surprised it’s not a lot worse.”

And it just goes to show you, though, I think, how conditioned we’ve been to low interest rates. And to me, the real danger is that everyone is losing their minds because everyone has priced in a risk-free rate that is much lower.

And to me, I’m somewhat sympathetic to Drucken and Claude’s analysis, that the tinkering with the market is getting rid of an important signal that is actually part of the whole process upon which capitalism is based. And so once you start doing that, you’re gonna invite a whole bunch of different outcomes. And one of the things that — although I will make the case that it really wasn’t that big a deal what he said — I think that the gold market got the memo real quick and took off and ran like it stole something, because they see the writing on the wall. They see that although maybe this isn’t the actual mechanism that pushes us into the monetization of debt, it’s the first step into it.

Jack: This sort of ties into the Andy Constan conversation as well, Matt. Like, yields are up because they should be up.

Matt: Exactly what I was thinking about. Exactly the person I thought about.

Jack: Basically, if you look at the things Kevin talked about — he talked about nominal growth is up, real growth is up as well. Deficits are up. Inflation is up. You’d probably expect the long end to be up, and Kevin’s point is like it probably should be up more, maybe even.

Matt: Yeah. It probably should be up more given this. And he also pushed back a little. I was trying to tee him up with bond volatility, and he was like, “No, it’s not even that volatile.” It’s just been pushing higher.

And regular conversation, this is what we talked about with Andy — put your hand over the narratives for a second. Put your hand over all the headlines and just look at the underlying data. And the underlying data is, yeah, you would expect higher yields, maybe even higher.

The other point Kevin makes by the end of this, though — and this is the Druckenmiller thing, AI or not, it came out of Stanley Druckenmiller in one way, shape, or form, he approves of that message — was be careful tinkering. Because if you are going to suppress something that the data suggests should be higher, we don’t know what you’re gonna set off or screw up or break. And letting markets decide where that rate is, is probably better than a policy action that’s trying to boost some variation of those sub-component variables that are all the reason these rates are higher in the first place.

Jack: Yeah. This is Warsh’s opinion. He shares the opinion with you. He doesn’t want to intervene too much here. He kind of wants to let the market speak for themselves.

Matt: Yeah. And I don’t disagree with that sentiment, and this is one of the concerns when we see people trying to put their thumb on the scale to do stuff, especially around midterms or whatever it is. Not a political statement. Just expect this to potentially create some additional problems if somebody succeeds in putting their thumb on this scale. You can’t do this without consequences, and if we see a policy action, expect some consequence from that action.

Jack: But also understanding what’s driving this kind of helps me to get over the whole narrative — and we talked about this with Andy — that yields are spiraling out of control, or yields are at outrageous levels, that the stock market has to tank tomorrow or something like that. There are things driving these yields which make complete sense. Some of them are actually good in terms of real growth. So I think for me, understanding what’s driving this is really important in kind of putting it in context, and maybe getting some of the crazy takes on either side and getting rid of those.

Matt: Kevin does a great job of putting that into perspective. And part of it, and it’s in the bigger conversation, is just laying it out for people that we got really used to really low rates. We kind of forgot what some inflation and some growth looks like in combination. And when we look at these rates relative to history, it’s kind of like, all right, yeah, we’re still probably on the low side of normal for the most part here. But we have at least a couple of percentage points of inflation and at least a couple of percentage points of growth. So why wouldn’t we see bonds at four or five, if not five or six or seven, in this environment? It’s very compelling to see that data on the table.

Jack: Well, and the other good news is now that I’ve said the term “yields could spiral out of control,” now I can put it on the thumbnail. So even though we’re taking the complete opposite opinion of that, anything that’s in the transcript is fair game, Matt, so it’s going in there now.

Matt: Yeah. We are yields, and the hosts are officially out of control.

Jack: Yeah, the question is by the end of this, will we spiral out of control as well? And we don’t know that yet.

Matt: We gotta stay tuned to find out if we’re gonna spiral out of control.

Jack: I don’t even know what that would look like, but either way, let’s get on to the next clip here.

Dan Rasmussen. We always talk with Dan about private equity ‘cause he knows a lot about what’s going on behind the scenes with private equity. He’s obviously not that positive about it. But one of the interesting things — and this is how it fit into Kai’s show, the Intangible Economy — is private equity is up to, I think, like 40% in software now, I think Dan said in the podcast. So they’ve become big investors in software. So here’s Dan’s take on that.

Dan: Someone said that investment committees are momentum investors with a three-year lag, right? And so you see allocators and they basically say, “Hey, what has the best three-year trailing returns? Let’s add to that. And let’s take money from the thing that’s had the worst trailing three-year returns.”

And that actually is a good model, if you look at how the money gets allocated. Which is why private equity’s allocations are going down now. And I think you’re gonna continue to see that. The bloom is off the rose, and the trailing three-year numbers suck, the allocations are gonna go down.

But I think what’s funny is if you think about private equity firms, they are momentum investors on sort of a little bit longer timeframe, a four or five-year timeframe. And really the dynamic is that to make partner, you have to get a successful deal done, right? So you have to do the deal, and then you have to exit the deal. And if it’s a four or five-year horizon, that’s sort of the window in which that is gonna happen.

And so if you think about who on the investment committee has power at any given time, it’s the person who did the deals that four or five years ago now look like the fund’s biggest winners. So it has to mature. That maturity gives power to those people. And so what ends up happening is the people that did the bad deals four or five years ago get fired, so that when you go out and fundraise, you can say, “Hey, pro forma for those guys that left, the fund actually did really well. And if Ed and Harry hadn’t been here, look at what the fund would’ve been — even better.” And so it sort of cycles in and out like that.

And so what you saw, if you sort of trace that five-year history, is that in 2014 and ‘15, everyone was getting really excited about energy private equity. It’s kind of funny to think back, but that was the sexy thing. And people were saying, like, SCF and Lime Rock, “These are the best, smartest investors, and we need to go to the oil patch, we need to put money in shale.” Right? And then that blows up in ‘15 and ‘16. And so all that stuff gets deep sixed and, “Oh yeah, that was a separate energy fund, it was a carve-out, it was never part of the core strategy,” blah, blah, blah.

And then what people start seeing is — remember, software multiples had come way down during the financial crisis, and then as they started to come back, everybody started looking at Thoma Bravo and Vista in 2014 and ‘15 and ‘16 and saying, “Whoa, look at their returns, it’s unbelievable. Software is an amazing thing for private equity. We should do that too.” And so the software guys started to do deals. And those deals looked really good in 2018 and ‘19. More money was put to work at crazy prices. Then COVID hits, and COVID sends this stuff through the effing roof, and so more software deals get done.

By my estimate, probably 40% plus of private equity by 2021 or so was software or healthcare technology, which was basically healthcare software. And so you had, call it 40% of the money during that period going into software or healthcare software businesses, at crazy prices.

And there was this sort of new economy narrative that software’s eating the world, and so you can pay whatever you want for any software asset. But I think what’s sort of funny — I was keen to ask you about this, Kai — is these were always sub-scale software businesses. Private equity wasn’t taking private Salesforce or Adobe. They were taking private some company that had cornered the market on, like, car dealership software in the tri-state area or something, right? That was the stuff that was of the size range that they could buy.

And it’s unclear to me that there was all that much intangible value at these things. Like, yes, they were software businesses, but did they really have this IP moat? Did they really have a talent moat, or were they kinda just generic, kinda crappy software businesses that had captured a certain high market share in a niche?

Jack: My favorite thing about this, Matt, is like, individual investors get into all these traps about chasing performance and all this stuff. And when you hear stuff like this, you realize institutional investors do the same exact crap over and over again. Software’s got great returns, it’s got great recurring revenues. Private equity is going all in. Private equity’s gonna go way too far all in, then there’s gonna be problems. It’s the same thing that plays out for everybody. So it should make you as an individual investor feel better, because these people are doing the same exact thing.

Matt: It should make you feel better. And anybody who sits on an investment committee — what was the joke or the reference that he made? It’s three year, three year lagged momentum investors.

Jack: Yeah, exactly. Or five year.

Matt: But it’s perfect. And you have to think about this, and this is the great advantage for individual investors when they think about these problems. You don’t have the committee, you don’t have the performance reporting or benchmark that you’re supposed to be measured against or beat. You can let go of a lot of that stuff.

‘Cause the worst and the hardest part — and I’ve sat, at some point, we have our investment committee, I’ve sat on other investment committees, I’ve been a participant in a lot of these conversations for a lot of years at this point — one of the things that always hurts the most is you take all these managers, you take all this stuff, you create the deck. Here’s the quarterly review or the annual review or whatever the cadence is of this, and you’re gonna see, where are we at year to date, where are we at last six months, where are we at trailing 12. And you look at that and you’re like, “We’re all professionals. We’re not bothered by the price going up and down. We’re gonna zoom out and look at the three-year number and the five-year number.” And then people start making decisions off of those three- and five-year numbers. And that creates problems, and this is what he’s talking about.

Jack: Well, the good news is in private equity, the price is not going up and down, Matt. It’s just kinda staying right there, right? Just very steady.

Matt: It’s just quietly taking those stairs right up and saying, “Look at those returns. No volatility to see here.” Let your capital market assumptions speak for themselves.

Well, what I also love inside of this, though, is that stuff does well, it gets stable. Now it’s attractive for private equity to own. So when we think about the percent that’s in software, you think about where software was three years ago, five years ago, coming out of the pandemic. You think of how you’d roll all that stuff up. You might lever it. You’re looking for a five-year hold till you’re gonna flip it or do whatever with it. It’s a big, slow-moving ship that keeps getting bigger and slower moving. And it’s really interesting to look at the industry through this lens of, where is the sectoral composition in this otherwise private market? I think that’s actually a brilliant insight from Dan on this.

Jack: Yeah, the other thing is you have to be very careful about anything that seems bulletproof in investing. And software seemed bulletproof. This recurring revenue business — how are they possibly gonna be disrupted? And then AI comes and disrupts them.

And one of the things Dan said in the podcast is — ‘cause I put it on the thumbnail — he said newspapers were recurring revenue, which is very true. You could’ve looked at newspapers and looked at these recurring revenue businesses. They’re fantastic. And obviously, that didn’t end well. And who knew what was gonna come and disrupt software? But anytime anything looks like this sure bet, you’ve always gotta be so careful about that in the investing world.

Matt: It’s gonna come back to bite you, and it’s gonna come back to bite the investment committees and everybody else that is involved. Look, we love a good idea for a reason. We love returns for a reason. We are wired to chase our way into these things and probably hold on too long. So seeing this in private markets as well as public, and knowing that this is happening at the same time — Dan’s so important to listen to.

Jack: So one of the interesting questions in investing is what makes a great investor? And that’s something you got into with Ian Cassel. So here’s Ian talking about that.

Ian: A good stock picker would be somebody that can beat the S&P over a 10-year period. A great stock picker, the definition would be a 20-year track record of beating the S&P 500. How many make that cut? About 2.5, 2.7% of active managers. And then the definition of GOAT would be a 20-year track record of 20% net over 20 years. And that’s, I don’t know, it’s probably less than a half a percent or whatever. It’s a sliver.

And so that’s kinda my definitions of good, great, and GOAT. And obviously we can have conversations and people will push back on, “Well, what about so and so? They’re on TV a lot,” or this or that, and they’re good. And I’m not saying they’re not. But I’m just saying how I would benchmark good, great, and GOAT, and that’s how I would define it.

In the book I talk about Brazilian jiu-jitsu, and there’s a gentleman named John Danaher, who’s sort of seen as the Charlie Munger or Albert Einstein of Brazilian jiu-jitsu. He’s like a seven-time black belt in it, and he has a great past as well, which I won’t get into. But he’s a really, really great thinker. It’s almost like when you’re listening to him do interviews, it’s like you’re listening to Charlie Munger or some other really well-respected, intelligent human being. You just wanna keep listening to him.

And he was asked about how anybody becomes the best in the world at what they do. And he articulated that he believes in any profession or area of expertise, there’s usually five or six core skills that you need to learn and be proficient at to be good. And that’s where I kinda got the ideas of good, great, and GOAT. Then he said, to become great, to be world-class, you not only need to be good in all of those skills, but you need to be great, and the best in the world, at at least one or two of those skills.

So I size up this chapter in defining not only what good, great, and GOAT mean, but what is the difference between what’s allowing the good, great, and GOATs to beat average, and what’s allowing the great and GOAT to beat the good, and what’s allowing the GOAT to beat the great and good? Follow that frame of thought.

And I think it’s different for each category. But I think to be a good stock picker, to be in that top 10%, you do need to be good at those five skills I outlined earlier. And there’s certain ones that you’re gonna be good at just naturally, your strengths. And then there’s gonna be one or two that are naturally gonna be your weaknesses, and it’s your job not to look the other way on those weaknesses, ‘cause they will hurt you. But to fill those voids, either with technology or a team or somebody else, to get at least to good in a couple of those skills. And just their ability to then be that way for 10-plus years, I think, and do it consistently, is good enough to get you in that top 10% and become good. I think that’s the difference maker.

For the great stock pickers, I think they’ve evolved. To go for 20 years, I think that means they’ve had to evolve in small ways or large ways to keep that competitive advantage as an investor. And there’s different examples I talk about in the book. But the way to become great might not be the way that you were good. They usually probably had to evolve with different skill sets.

And then GOAT — this gets back to the point of John Danaher, that the folks that are world-class in a profession, a sport, they usually took an underutilized skill set, reinvented on it, and reintroduced it back into the game in a way that took their opponents by surprise. And I give a couple examples in the book about what that could mean in the investing lens. Whether that’s a deep value investor that’s only screening for tangible book value, caring about management quality, which isn’t normally what they would look for. They’re looking at assets. And I give a couple examples of deep value investors that do care about management quality, and some of them have outperformed greatly compared to deep value benchmarks. And I give some other examples there, as well as obviously Druckenmiller and Soros and Steinhardt and these guys that also have done well.

But I think the GOATs, they’ve evolved, and then they’ve also, like we talked about before, now they can paint with all the colors and they build a team around them. They go from having to really play every instrument in the orchestra to start leading the orchestra. They build a great team, and that allows them to just continue to compound at 20% net for long periods of time, which is really my goal. We’ll see if I get there.

Matt: Cannot plug this book enough. Stock Picker by Ian Cassel. He did an exceptional job by this. We have great people like Chris Mayer on the back of the book telling you, you will like this book. Chris has a great book out too.

Jack: I’m just happy you’re pitching a book that actually exists, Matt.

Matt: It’s a move in the right direction for us. We’ll get off topic sooner or later.

But one of my favorite things about this is, what actually makes a great investor? What makes a stock picker? And it’s the mindset, it’s the temperament, it’s the strategy, it’s all these other things that are drawn from your own life and your own experiences. Rarely do I see someone execute those ideas in a book the way Ian did with this one.

Jack: Yeah, and I like the idea. He did come up with some criteria. Good investors outperform over 10 years, great investors outperform over 20, and the GOATs are 20% a year returns. Now, obviously those are some very high standards, because even to get to good, you’re basically ahead of 90% of the people out there. And he mentioned that in the podcast. But 20% for a year is obviously — you can probably count on your hand the number of people you can come up with that have those kind of returns. But it’s a good way to quantify the whole thing, I think.

Matt: It’s a great way to quantify it, and it gives you something measurable to think about. I love this insight that you’re gonna have to do something that you’re really only gonna be able to measure over a 10-year period, to start. And that’s more than even the market cycle thing. Well, how’d they do over a market cycle? How’d they do over four to seven years? Because they’re trying to break out of the box that the investment committees are talking in, in their three to five-year windows. So it’s like, “Oh, let’s think over a whole market cycle.” And Ian’s like, “No, actually, if you’re gonna look, you’re gonna wanna look over a 10-year period to even self-assess: am I hitting this hurdle for where this should be compounding to go from good to great to GOAT?”

Jack: And I also know, since you were the person I was talking to here, and I know we like to get into the deep philosophy — getting the Brazilian jiu-jitsu into the clip was something I had to do. And that idea was really cool, though. The idea that you need to be good at five or six things, and you need to be great or the best in the world at one or two. I think that probably applies to a lot of different professions in terms of how you think about being a GOAT of that profession.

Matt: Yeah, because that becomes the differentiator. And it’s also who you surround yourself with. There’s all these factors that go into it. So yes, you’re gonna have to get really, really good, if not downright great, at a whole handful of things, and then there’s gonna be one or two it factors that are gonna push you over the line to GOAT status, if that’s even an option. And for most, it’s not. Ian breaking it down in this book is really cool to see, as much quantitatively as philosophically.

Jack: I just wish I’d met Ian before I bought that micro-cap garbage truck company back early in my career, ‘cause probably some of his tests would’ve kept me out of that thing, I would guess.

Matt: Might have kept you out of it? Are you saying it wasn’t... I mean, garbage is a great recurring revenue business.

Jack: I guess. I mean, I think there were probably some red flags I didn’t necessarily identify. I mean, it was like a tip from my old stockbroker or something.

Matt: Oh, fantastic.

Jack: There were probably some red flags that Ian’s analysis could’ve helped me to overcome there.

Matt: Well, maybe. You’ll have to check the book and see what you think. And if you find the time machine, let me know. I’ve got a couple things to fix, too.

Jack: So we’re back to Kevin Muir here, and this is something we’re talking about all the time — AI CapEx, how it impacts the market, but also how it impacts earnings. So here’s Kevin talking about that.

Kevin: So I’m kind of reluctantly having to understand earnings and explain why it matters from a macro perspective right now. But I’m gonna go to one of the guys who understands earnings much better than me, and that is Jim Chanos. And he has very eloquently talked about how this is an earnings bubble, and how the reality is that we have this situation where for every 10, 20, 50, $100 billion that Microsoft borrows to go and build out a data center, the benefits from that in terms of buying chips from Nvidia, buying Bloom Energy — the benefits are immediately felt, right? Those earnings are immediate. And yet the expense side of it is amortized over the next five, seven, 10 years, whatever it is.

So the larger this AI build-out becomes, the more earnings get bumped. And it’s fine if the benefits from that data center actually are what everyone assumes they’re gonna be. But, man, the reality is that as you’ve got Microsoft and everyone spending money, the analysts are also getting more bullish, so they’re increasing the multiples, and they’re assuming the earnings are gonna grow. So the earnings are growing on both sides of it as the bubble has grown out, and it’s just increasing the risk more and more.

And there’s a million things when you’re looking at and thinking about the dangers in this market. Everyone says, “Oh, it’s okay. The stocks are cheap.” And I’m like, “Okay, yeah, I get it. The stocks are cheap in terms of the multiples.” But when you think about this earnings bubble, and then you stop and think about the reasons that you bought these stocks way back over the last five, 10 years — one of them was, they were cash flow machines. That was what you’d always hear.

Well, guess what? They’re not cash flow machines. They’re buying back stock. Well, go look at a chart of Google in terms of the number of shares outstanding. It’s been going down for the past 10 years, and then for the first time it’s going up. They’re borrowing aggressively.

Matt: And throw free cash flow on top of that chart while you’re at it, because, yeah. Keep layering them on.

Kevin: And the numbers are just massive. And I think we’ve become numb to this, right? Like, we’re just sitting here and we’re tossing around these big numbers and — what’s the guy, the Leo...

Matt: Situational Awareness, yeah.

Kevin: He went and lost $30 billion.

Matt: What did you do when you were 25?

Kevin: Long-Term Capital almost brought the system down by losing $4.5 billion. And he lost 30 billion in the space of two weeks. And to be fair to the markets, they barely blinked, and it’s just continuing.

But all of this is based upon that earnings going up, and I am so scared that they’ve all become one huge monster bet, and that at some point it’s not gonna meet expectation. It’s not gonna meet the continued growth.

And I always say nobody knows when the dot-com bubble actually peaked. But one of the theories is, the Gartner Group, which was a very important firm at the time, they issued this report that said the internet was doubling every 270 days instead of every 180 days. And that’s all it took, was a slowing of the rate of growth.

But anyways, going back to your thing about the dangers from the earnings — I understand why they’re going up. I understand why people believe the stocks are cheap. But what they are missing is that this is not a bubble in terms of those prices that they’re paying in terms of multiples on the stock. What they are missing is that it is a bubble in terms of that actual earnings. The largest infrastructure build-out in history is getting accounted for in earnings, and we’re taking all the benefit right up at the front and then saying the stocks are cheap.

Jack: This is really important to keep in mind, what he says at the beginning here, which is the idea that when Microsoft spends money and buys chips from Nvidia, that’s income to Nvidia now, but the expense part of that kind of occurs over time. And this is something Chanos has been talking about a lot. You could have a bunch of behind the scenes accounting things going on that you have to properly understand to sort of understand what’s going on with earnings in a boom like this.

Matt: I also love that Kevin admits how frustrating it is to understand the accounting, and then points at Chanos. There’s a factor here of looking for somebody who’s achieved GOAT status in this area that you might be good at, not even great at, but people who are GOATs at it are saying, “Here’s what one of the problems is.”

The extrapolation that really is gonna stick with me from this conversation with Kevin was, this is part of his thesis on where stocks will probably go down before earnings go down. So this cycle, however it ends, however disastrously bad, or just, you know, garden variety rollover rotation — that could happen too. But whatever that looks like, he thinks stock prices will inflect lower before earnings, because of these mechanisms.

And this will be something else that’s the chink in the growth armor story. And he gives the Gartner example, I think, inside of that clip, where it’s just, the internet was expanding at a lesser rate than people thought. It was still a crazy expansion, but all of a sudden the rate of growth changed and the whole thing starts to implode. And with AI, at some point, we’re gonna have some doubt, some skepticism or whatever else. The way that the accounting is working, earnings might not be the thing that inflects lower before prices.

Jack: And this plays into that earnings bubble concept we’ve talked about a lot here, which is this idea — whether it’s the accounting, whether we’re spending way in advance of demand that’s not gonna come. You can have bubbles that are not bubbles in price, and you can have bubbles where things look cheap and then they end up not being cheap.

And so whether that’s the case now is beyond my pay grade. But it’s just important to think about that, because I think a lot of investors will think, “When I see bubble, I see outrageous valuations.” And a lot of these companies, the chip companies and stuff, they are not outrageous valuations right now. But that doesn’t mean that they are—

Matt: Because of the growth, right? They’re growing into this insane number, and that’s justifying it.

Jack: Right, exactly. So if the earnings represent something that’s unsustainable, then you could still have a bubble even though it looks cheap from a valuation standpoint. I’m not saying we’re there or we’re not there, but it’s just important to understand there’s two types of bubbles here. There’s a price bubble, and there’s an earnings bubble.

Matt: And the hard part is going to be if that price moves before... If you think the chip and the high growth stocks are relatively cheap or whatever it is, let’s say the market’s trading at 20 times earnings when that happens. Well, the stock prices go down, but the earnings keep going up or stay steady. Well, all of a sudden that multiple on even a little dip is gonna get way more attractive. And if that doesn’t create volatility when that starts to happen — if and when that starts to happen — I don’t know what does, ‘cause that’ll be really frustrating to see that start to occur out of sync with each other.

Jack: So something else Dan talked with Kai about is this idea that there are definitely some philosophical views among those leading AI that are driving their actions in terms of the actions they’re taking with their companies. So here’s Dan talking about that.

Dan: You have to look at actually the mindset of these people. What is their worldview and what is their philosophy?

And I think there are two elements to it. One is they’re futurists, right? So they believe that the future can come true, and that the future can involve things that you might be used to reading about in Popular Science magazine. Like, well, we’re gonna land on Mars and build colonies there, and we’re going to have robots that are smarter than people. And these things are normal, and they’re gonna come true, and we just should be building them.

And then second is this sort of rationalist, effective altruist type thinking, which basically says you should be evaluating everything statistically and rationally, and then you should just maximize expected return or expected value. And that often means taking a lot of risk. Like a huge amount of risk. ‘Cause if you wanna maximize expected value, you sort of know that the way technological innovations get pushed is that you take a massive amount of risk and, hey, even if 10 of them fail, if one of them succeeds, then the innovation comes true. And if one of them is worth a billion dollars, then your expected return for the nine that went to zero is, you know, whatever. It’s fine. So they’re thinking that way — rationalist, expected return maximizing, futurist. There’s this paradigm.

And so what are the actions that that leads them to take that we observe? Well, look at Sam Bankman-Fried. Look at Leopold Aschenbrenner, who worked for Sam Bankman-Fried. They’re all part of these types of movements. They’re all part of this current Silicon Valley, San Francisco thinking. And they’re making some of the same mistakes. They think that the future’s gonna come true, and they’re taking huge, huge risks on betting on that vision coming true.

And I think that if you look at the people that lead Anthropic or the people that lead most of these other big tech companies, they have some version of this thinking. They believe in artificial general intelligence. They really believe it’s gonna happen, that AI will be smarter than everybody at every task, that there are like 10 years left of people doing things before the robots take over. And then basically everyone’s gonna be on universal basic income if they’re not working at the Mars colony or servicing the data centers in space. And so they just need to maximize their expected return now. And by the way, they’re gonna give half the money away to save animals and stuff. So it’s all worth it.

And I think what is dangerous about this mindset, and to our view of the world, is we sort of know that world history doesn’t work rationally. It follows twists and turns, and it’s surprising, and things take longer than they should. And nobody’s using robot vacuums even though the technology is 20 years old, even if it’s a better model. And there are a lot of people that won’t wanna use driverless cars, they’ll just be afraid of them. Sometimes the better technology, even if it’s better, doesn’t get adopted, for whatever reason. And things happen that are slow or surprising, and there’s a populist revolt against data centers, or whatever it might be.

And I think that my bet is just that these people are taking massive, massive, massive, massive amounts of risk, and they’re all taking it because they all think the same way, and it’s gonna blow up in some way, just like Leopold Aschenbrenner blew up, just like Sam Bankman-Fried blew up. Like, the same people are running Anthropic, same mindset, same viewpoint. You think they’re immune from the probability of blow up? No.

They’re massively spending on CapEx. Massive. And what do we know about CapEx spending? Oh, everyone always over-invests. The returns are always lower than people anticipated. The returns always come later than people thought, and there’s this gap between the investment and the realization that’s always too long for most people to survive. These things are gonna happen again.

Jack: Well, first of all, Matt, before we even get into that, I will say that these people are not doing themselves any favors. These people that are running these AI companies — the PR war, they are not winning the PR war right now, in terms of when they open their mouth, bad things tend to happen.

I actually did watch, Sam Altman was on a couple of podcasts I watched recently, and he actually did a reasonably good job. It was much better than what I’ve seen in the past.

But this idea that we’ve got this philosophical view that basically the world is about to completely change, they’re about to unleash this world of abundance upon all of us, and it is like up to them to come up from on high and to properly determine how these resources will be allocated — that impacts everything they are doing. It impacts the way they’re running their companies. It impacts all of this stuff.

And I don’t know if you saw this, but Gavin Baker mentioned this and then Dario has since denied it — but Gavin Baker mentioned on All-In that he had from good sources that Dario said there will be one company left in the world and it’ll be his, it’ll be Anthropic.

So there’s definitely... It’s important though, when you think about investing in AI, to understand what’s driving these people who are driving these companies, because it’s affecting their decisions, and it’s making them take big risks and go all in on a lot of stuff because of the life-changing view they have on what’s gonna go on with this technology.

Matt: Yeah. People who speak in absolutes and grand statements are the people who can kinda lead you off.

I am gonna reference another book that may or may not exist. As Jason C. Buck writes in his excellent tome, Pimp of All, that now I wish I had handy — because he talks about, in the build up to the financial crisis, he’s in real estate. And he’s asking all these real estate developers and other people, “What’s going on?” And they’re all saying, “Nothing is wrong. There’s no problems.” And when everything goes off a cliff, he’s like, “Oh, because I was asking all the real estate developers. I was asking the people who are the most hardwired to be crazy and bullish and optimistic about this stuff,” and that’s their default wiring. So when the crisis happens, they’re gonna be just as shocked as anybody else, declare bankruptcy or whatever they’re gonna do, go out, start the next thing with a new name.

And so when I see the AI story, and the degree that we’ve carried this with some of these personalities — like the statement, “We’re gonna be the one company left in the whole world” — you start to go, there’s a blind spot somewhere behind that ego. And I know you think you can walk the giant dog off the leash, but the rest of the neighborhood would feel better if you would stop unleashing and at least leash your idea. Leash it a little bit.

Jack: Yeah, it’s interesting because the people, to an extent, you wanna listen to when you have a technological revolution is the people who know the most about the technology. But those are also the people that buy into it the most, and so they can be misled. Even though they know the most about the technology, they can also be misled about the technology and what it’s gonna mean for the world. And so it’s like this double-sided thing. I tend to listen to a lot of these AI people because I’m the opposite of that and I wanna learn from them. But you’ve gotta take it with a grain of salt and understand, they probably think this will be something bigger than it will be.

And also Kai made this point in the podcast. There are a lot of governors on this whole thing. There’s only so much compute we can buy. There’s only so much electricity. Your average person working in a random company — Kai’s point was, it took him a long time to adopt Excel 1997 or whatever. It’s gonna take them a long time to adopt this kind of world-changing technology. So there are a lot of governors between what’s going on now and even if they’re right about this vision, and us ever getting there.

Matt: Yeah. It goes back to Dan’s prior point with the investment committee talk. These are big slow-moving ships that think over these longer chunks of time, both for adoption and implementation and where it’s gonna go. It does take somebody at the front yelling out some of the craziness to get the believers and get the people on board and start the process of going, “Fine, I’m gonna use Excel 97 or whatever this is,” or, “I’m gonna move from my abacus to this spreadsheet. I guess it’s okay.” And then however long it takes for that to be normalized, you need the person to lead the culture to do that. But it doesn’t come without risks and consequences. And that’s where it’s just good to have a counterweight to that voice right now to say, “Yes, that’s right.” Every time historically, it helps to just have a few doubts on the table.

Jack: Well, and as we say this, I realize that I don’t use the current version of Excel or Outlook, because I don’t like change. I like my old versions so much.

Matt: Yeah, we get frustrated every time.

Jack: I’m probably part of the problem here, Matt.

Matt: We get frustrated every time. Why did you move that in the ribbon? I don’t know where that is anymore.

Jack: Yeah, I can’t find this thing anymore. I just don’t like it, so I just stay with the old one.

Matt: And it’s the same as when you love the new thing you have. You get a new computer, you get a new car, you get a new phone, and you’re like, “Oh my God, this is amazing.” And six months... whenever the shine comes off, you’re like, “Oh, this piece of crap. Ah, why?”

My beloved former Subaru Outback that I had for all these years — I had to keep a note in my phone, because after a while the window timers, something would get screwed up, and you had to do this Nintendo cheat code thing on the driver’s side door to get the other windows to go down again after the winter. And then it’s just like, “Oh, this is the stupidest thing ever.” I loved that thing once. And then slowly over time, you’re like, “Oh, the seven-year itch with the ownership of these things.” We’re gonna have the same experience with AI. We do with everything else in life. We’re curmudgeonly beings, we humans.

Jack: Well, that’s probably a good note to wrap up on. Matt, why don’t you take us out?

Matt: All right. Excess Returns over on Substack. Make sure you check us out. We’ve got all the episodes, all the links, all the stuff there. Wherever you are watching, thank you. Like, comment, subscribe, all the things below, and we’re out.

Topics covered

• Why ending Fed forward guidance could create more uncertainty around interest rate decisions

• Kevin Muir’s case that midterm election volatility is unusually cheap

• Why seasonal volatility, low implied correlation and election risk may favor owning protection

• Aahan Menon on inflation breadth and why 70 to 80 percent of PCE components are above the Fed’s 2 percent target

• Why demand-driven inflation may be stickier than supply-driven inflation

• How oil shocks can feed into core inflation and increase pressure on the Fed to hike

• Ben Hunt on the sudden collapse in the Fed credibility narrative and why gold has responded

• The four risks facing the Fed and Treasury: oil, fading fiscal stimulus, insurance and private credit stress, and the long end of the Treasury curve

• Brent Kochuba on why implied volatility and put positioning show a market with very little fear

• Nvidia options positioning, potential resistance near 250 to 275, and what dealer gamma says about the stock

• Stanley Druckenmiller’s AI-written Wall Street Journal op-ed and what AI-assisted writing means for investment thinking

Timestamps

00:00 Midterms, inflation, Fed credibility and options complacency

07:45 Kevin Muir on why midterm volatility may be underpriced

11:55 Why this midterm could be more volatile than the options market expects

16:36 Cheap volatility and how election risk could get repriced

20:39 Inflation breadth and why the headline numbers miss the bigger problem

25:43 Why cooling inflation data may hide persistent demand-driven pressure

33:31 Ben Hunt on why the Fed credibility narrative suddenly reversed

40:01 Four risks the Fed and Treasury cannot afford to ignore

44:43 What the options market says after Jackson Hole

49:10 Why Fed events can become an expensive options tax

53:14 Why falling volatility could help stocks push toward new highs

57:34 Druckenmiller, AI-written investment commentary and authenticity

01:01:53 Why writing is part of thinking in an AI world

Learn more about the Excess Returns podcast network:

https://excessreturns.co

No information discussed in this podcast should be construed as investment advice. Securities discussed may be held by the hosts and guests, their firms or their clients.

Jack: I’m doing good. Well, I realized, Matt, after we did this last time — like, we usually put clips at the front of this, and there will be clips at the front of this one. But I realized that when you put us in the private jet at the front of this thing, it definitely hurts the viewership, because I think people do not necessarily realize that that is an AI video and a joke. I think people might have thought we were like these hardcore traders who were showing off our wealth or something like that. So I’ve gotta kind of reverse this time.

Matt: We’re flexing too hard to start, and—

Jack: I think so.

Matt: I mean, what? I ran it by the Wall Street Journal op-ed committee. They had no problem. They were like, “This looks like straight out of The Odyssey. We love this.”

Jack: Well, I thought the ridiculous “Let’s go” I put in there from you at the end would probably tell people that this is not real, but I guess not.

Matt: A lot of people see me out there yelling, “Let’s go,” at them, so.

Jack: I guess so.

Matt: We’ve got great conversations. These are brand-new exclusive conversations for Excess Returns from some of our favorite people to talk to, on what just happened, what they’re looking forward to. We’ve got Kevin Muir with us today, Ben Hunt is with us, Aahan Menon, and Brent Kochuba. You’re gonna wanna hear what they have to say.

Jack: Yeah, and if you wanna look at the market through all the different lenses you can look at it through, we’ve got that today. We’ve got the macro, we’ve got data, we’ve got options, we’ve got narrative, we’ve got it all.

Matt: Let’s talk for a second before we start running these clips, because I think in context, what Warsh just said at Jackson Hole is top of mind for us as investors. This forward guidance going away thing is very, very real.

I appreciate the framing of — what was it? Play the ball, not the referee. That idea that’s been floating around some of the podcasts. I appreciate that framing. I want markets to function like markets and find their own prices here, but I still find this unsettling for some reason. What are you thinking?

Jack: Yeah, and I don’t know what it means, but it’s gonna change the way we’ve looked at these Fed meetings throughout our career, because the vast majority of Fed meetings in our career have been very, very high percentages in terms of what they’re gonna do, and they always did whatever the percentages said. And now the last meeting was not that way. This next meeting is not that way. I think Brent’s gonna bring it up when we talk to him, but I think it’s like 55/45 in favor of a hike right now at the next meeting. And so we’re gonna go into these meetings not knowing what’s happening.

And so we’re gonna have less guidance in terms of really smoothing this out, and we’re gonna have more volatility. And I don’t know what that necessarily means. I think it definitely means some more volatility around the short end. It probably means some more volatility in stocks too, because stocks obviously react to all this stuff with the Fed.

And it’s beyond my pay grade to think about whether it’s good or bad, and I know you guys on Click Beta dealt with this idea of whether it’s good or bad. But it is just, to me, very interesting that that tool, which has been a huge tool for the Fed, this forward guidance tool, is not going to be used anymore, and it just changes the way we look at all this stuff.

Matt: It’s Cameron, I think, was the one who laid it out on Click Beta as basically, this is probably good for short duration bond traders. This is good for people, because we’re gonna open up more uncertainty around this. Because if those are the odds, like 55-ish/45 in favor of a hike — that’s a touch better than a coin flip. That’s like you’re gonna have some spread going into this decision to see what happens. We saw that at the last meeting too.

I don’t know what the ramifications of this are yet for the modern market, where we over-communicate, where we have so much data available immediately to us. It’ll be interesting to see what happens if or when the market gets part of this wrong and what the ripple is. Because the thing with interest rates — and the reason we say that the bond market is smart — because anything that happens with bonds, what happens with debt, what happens with leverage, creates a ripple through every single other asset class and every other story we tell about the economy.

So that’s where I feel the most skeptical about, I wanna know what’s gonna happen with this. Something feels strange making this shift, because we’re doing it in a way that we didn’t do it before. And I don’t know what happens either, and that feels unsettling.

Jack: Yeah, I tend to be a more information rather than less type person. I like that. And so forward guidance was more information. But I also think about, on the other side of it, like Andy Constan brought this up — forward guidance really was a tool the Fed decided to use when it had no other tools. You know, if you go back to when rates were basically zero—

Matt: It’s not that old. It’s not that old.

Jack: There was nothing left to do. And so the question is, now they do have the other tools available to them. So could you argue maybe we don’t need the forward guidance as much now? Because if they wanna cut — they’re not gonna cut rates obviously, but if they wanna cut rates, they can cut rates. They have more tools available to them. So maybe that would be the argument on the other side, that that was a tool that was for a certain situation where the other ones weren’t working. Now that we have the other ones, we don’t need this one anymore.

Matt: That’ll be the test. It will be, can Warsh’s Fed assert confidence when this approach is tested? And I think that’s the part that I wanna see play its way out. I have no doubts that he will. I have no doubts that he’s gonna step up when this is tested in some way, shape, or form with a result, because this is the book that all the Fed people have to play by, especially since Greenspan. You’re placating markets to some degree.

It will be interesting to see, though, if this contributes to more volatility or more problems, especially if we get a new weird wrinkle or a new crisis or something that requires a different level of communication. How will Warsh step up in that environment? We’re gonna have to wait to see.

Jack: Also, if you look at government officials and you look at their track record on, will they give in when their resolve is tested by the market — it’s basically zero. I mean, the assumption is they will give in when they’re tested by the market.

Matt: This is what I’m betting on.

Jack: Yeah, this is what I’m betting on. And so that’s the question. This is all great—

Matt: He’s not gonna be quiet and be like, “I said no forward guidance.”

Jack: It’s great to give all these speeches at Jackson Hole. When the market’s tanking and Trump’s screaming and yelling at him, it’s gonna be a different thing. And you don’t know how people are gonna react until they get there. But typically, they have reacted by caving in and just doing whatever it takes to get the market back up. So we’ll find out. Hopefully we won’t have that situation where we have to find out, but if we ever do have that situation, we’re gonna find out what they really mean by this.

Matt: Ah, another responsible adult role model to look up to in government. I can’t wait.

So let’s start talking to some people. Our first person is Kevin Muir, Macro Tourist. We talk about — and this is extra relevant here — he thinks the midterm volatility is underpriced right now. He lays out a very compelling case. This was fascinating to understand historically. He didn’t have the numbers at the beginning of this clip. He gets them by the end. Listen to what Kevin’s saying about why we’re mispricing midterm election volatility.

Matt: All right, next up we have the Macro Tourist himself, Kevin Muir. Kevin, how’s it going?

Kevin: Good, man. Glad to be with you again.

Matt: One of my favorite things on the Macro Tourist is you’re all the way back — page 18, page 19, page 20. You’re sitting there looking at, “I’m gonna build a hovercraft.” “I’m gonna mail order a ray gun.” And you seem to find the thing amongst the hovercrafts and ray guns that then ends up on page one. You’ve got one of these themes right now that’s fast approaching above the fold on the front page. What are you looking at? What’s the story?

Kevin: So Matt, I feel like this one’s not even on page 18.

Matt: We’re behind the hovercrafts? Like after the hovercraft comes a coupon that says, “One more”?

Kevin: I’ve seen like one or two folks talk about it, and I’m shocked it’s not getting more play. And so what is it? It’s gonna be a little technical, but I think it is in essence buying forward volatility on the S&P 500, or the stock market, around the midterms. And I know that sounds complicated, and I’ll just walk you through the reasons.

Matt: Let me... time out. So are we — is this one of the classic buy vol stories? Are we buying volatility or is this something else?

Kevin: You probably could. See, that’s the problem. A lot of people are gonna be like, “I can’t do forward vol. That’s complicated,” blah, blah, blah. And I guess if you really wanted to, I think you could buy vol now. Today, buying vol.

And Matt, I just wanna say, I am not one to tell you to buy vol, especially short-dated vol. I love using long-dated options, but to buy three-month vol is very unusual for me. I cut my eye teeth on an institutional equity derivatives desk, and one of the things is I worked for a bank, and in general, implied volatility on indexes trades above the realized volatility. We had a balance sheet. I made a lot of money being short vol, and I like being short vol. It doesn’t bother me, especially when you’re working for a bank. And I hate being long vol, because the theta monster just eats you. You have to be so right in terms of your timing for the buying vol to work.

But let me walk you through why I think that this might be the time to be long volatility, and if you wanted to be more sophisticated, specifically long the midterm volatility.

One is, if you just look on a seasonal basis, this is the point upon which the vol rally starts. If you go back in time and look over the years, September is often a more volatile month, and we get a pickup in terms of volatility that way. So I think that we could get a situation where even without the midterms, even with nothing else, it’s just time to buy volatility.

And if you really wanted to get technical, the fact that implied correlation — which is the amount that the market is priced in terms of how much the stocks are gonna move within an index compared to one another — is at all-time lows. So correlation can only go to zero on an index. So we’re at a point where there makes a lot of sense. It’s very clear to me that the risk-reward favors owning volatility at this point.

But the real reason that I wanna buy implied volatility for the midterms is that, one, the midterms in general, even in the best of cases, are a more volatile period. So if you go look through time, the midterm years are more volatile.

Matt: How much more volatile? Give me some frame of reference.

Kevin: I can’t remember the exact numbers. And the other problem about this, Matt, is the option market hasn’t been trading that long, right? When you think about it, we haven’t had that many midterms. It’s every four years. So in terms of, you have the last 20 where there’s been a good option market, but before that, the option market was kinda sketchy.

Matt: This is part of my question. Like, we have a couple of decades, so it’s not a huge amount. Instead, you can look at price returns and infer.

Kevin: So unfortunately, I don’t have the number, but I’ve seen the stats and it’s more volatile.

But ultimately, one thing is that I believe that the forward volatility is not being fully priced in for just any midterm. There’s not enough midterm volatility priced in. The amount that they expect the market to move over the midterm is in essence almost the same as a regular curve, and that should be higher.

But I’m a big believer that this midterm will be different. And why do I say that? First of all, in terms of Trump, his approval rating is the lowest out of any president apart from Nixon three days before he resigned. So he’s in trouble in that way. We have this situation where if he loses the House, he’s gonna be subject to all sorts of subpoenas, investigations.

And people ask me, “Well, what does it mean in terms of passing legislation?” And I’m like, “It doesn’t mean anything. He hasn’t been passing legislation, apart from the one big beautiful bill. There’s been nothing passed. He’s done everything through executive order.” So it really has to do with the ability of whoever controls the House to issue subpoenas, to do investigations. And from that perspective, I gotta think that he’s not relishing the Democrats controlling the House. He’s gotta be sitting there going, “This is gonna be a disaster.”

At the same time, they’re not idiots. They see the same polls as everyone else. So to think that they’re just quietly sitting by and just gonna allow this to happen is, I think, naive. And the other day he had a prime time address to the nation, and if you remember at the time, there was some chatter that it might be him going to war with Iran. And then he got up there, and he just basically talked about election interference, started ranting about that for an hour. Even Fox was kinda confused, like, “What was that all about?” And to me, that was setting the stage for disputing the election.

And listen, I know a lot of people are gonna be like, “He’s got TDS, he’s doing this.” To me, I remember when he started talking about tariffs, and everyone said... I said, “Listen, he’s a tariff guy. He’s gonna do the tariffs.” And people say, “No, no, no, that’s just him negotiating.” And I’m like, “No, no. Go look in the ‘80s. You saw him. He talked about tariffs.” And he was very much a tariff guy.

And so to me, he’s given you the playbook already. He’s told you that this is gonna be contested. He told you that this is gonna be an issue. He set the stage for it. There’s no reason to do the primetime address otherwise. He’s in charge. If he was worried about it, he could go and actually tell the governments to investigate it. He doesn’t need to do a primetime address for it.

And so when I’m thinking about this forward vol, I’m like, the market is just ignoring the potential that this could get heated. And even if you disagree with me and think I am a huge panic mechanic, which is fine — that’s the beauty of markets, everyone has an opinion — one of the things that I think you could do, though, is that as we approach the midterms, I suspect that this risk will get more priced into the markets. Meaning that I don’t even need to be right about the outcome. You could just surf the wave that going into the election, we are gonna have increased worry about the midterm election.

Matt: The policy informing your investment portfolio. Part of this that I think is so interesting is vol is right now relatively cheap, and I’m trying to pull it up. So S&P 500, wherever we close out the month here, we’re looking at 12, 13% year to date on this. So you’ve got an above average return. You have below average vol, below average expected vol, and an event coming up on the calendar that seems to be... Well, there’s more coverage of the next Mag Seven earnings report that’s coming out than there is of what the impact of this is right now.

Kevin: Yeah. So it’s just an absolute no-brainer. It’s an awareness.

Look, actually, I’m pulling up some charts now as we speak. So implied volatilities for the actual period around the midterms — ‘cause you can isolate them by going long, short in front of it, and then long on the other side of it. We had, in 2022, they were expecting on the S&P like a 1.8% day. Right now they’re expecting a 0.9% day. In 2018, they were expecting a 1.25% day. Again, under 1% today. So 2014 was relatively low, but 2010 was the same as today.

I think today is a lot more dangerous than the other midterms. I think it should be at least as volatile as 2022, at least, with the outside chance that it’s much more volatile. And then most important, it just ends up being that even if I’m wrong and nothing happens and this is just me being a panic mechanic, I think that between now and then it’s gonna get bid higher.

One of my sayings that I used to love from the trading desk, Matt, was, you buy your straw hats in the winter, and you shouldn’t buy insurance when you have to, you should buy it when you can. And my advice — or not advice, at least for me — I’m buying my insurance today.

Matt: Never a panic mechanic, possibly a panic wildcatter. I mean, SPAC miner. What? I don’t know. We need a better Canadian metaphor for you than mechanic. That really undersells the work you’re doing here.

Kev, if people wanna bug you on the internet, where should we send them?

Kevin: They can send me an email, kevin@themacrotourist.com.

Matt: Thanks, Kevin.

Jack: So next up, we’re gonna stay in the macro world here. We’ve got Aahan Menon, and he has some just awesome data behind the scenes. And one of the things he’s seeing is, it’s great we see these high level CPI and PCE numbers, but there’s so much that goes into that. And behind the scenes, he actually tracks demand-driven inflation versus supply-driven inflation, and he also tracks the breadth of that inflation. So here’s my interview with Aahan, where he talks about what he’s seeing in that data.

Jack: Aahan, welcome to Last Call.

Aahan: Jack, great to be back.

Jack: Appreciate you coming back to do this. And we’ve got a great topic today because — I was just mentioning this to you before we started recording — I feel like we’re getting opinions all over the place on inflation. And I think even inside the Fed right now there seem to be pretty divergent opinions on inflation. And you’ve got some awesome data behind the scenes talking about maybe what’s driving inflation and what that tells us about whether it’s gonna be lasting. And so we’re gonna dig into all that today.

Aahan: Yeah, I’m very excited. It’s definitely one of those topics that’s extremely polarizing, right? Like, is inflation... the future of inflation? Is inflation being measured correctly? And then all the accompanying conspiracy theories with that. So it’s always a very polarizing subject.

Jack: Yeah, I feel like whenever anybody has a different opinion, they’ll find a measure somewhere, whether it’s the real-time, the Truflation or the PCE or CPI — they’ll find something that agrees with them. And it’s very hard to break down. And what’s cool about what you’ve done here, and in this first slide we’re looking at, is you’ve kind of gone behind the scenes and you’ve looked at the breadth of inflation, which is something you don’t see too often. Can you explain what we’re seeing here?

Aahan: Yeah. So I think everyone’s pretty familiar with the fact that we have elevated inflation readings, right? We have CPI that’s elevated, we have PCE that’s elevated. And you can look at those measures across a variety of manipulations when it comes to the look back. So you can look at a year, six months, three months, three month, three month averages, all those types of things.

But I think one thing that’s really important for people to recognize is that it’s not just the headline number, it’s the fact that all of the components under the headline number, which go into the headline number, are currently extremely elevated, and elevated in a way where they’re inconsistent with the Fed’s policy target.

And so what we’ve done over here is we’ve shown, in the blue line, a relatively fast manipulation of PCE inflation, which is the three month, three month, so it’s a three-month smooth annualized number. And then we’ve shown the breadth of that measure, which is really how many components are rising or falling. Importantly, we’ve done a little adjustment to this breadth number to basically say, are they above 2% or below 2%, rather than just rising or falling.

And when we look at that number today, what we basically see is that if we average out the last few months, basically you have about 70 to 80% of PCE components now above that 2% target. And usually when you have those types of dynamics, where you have a persistently high level of inflation on a broad basis, you usually tend to have much more consistent inflation when you’re looking forward.

Jack: Yeah, this tells me a lot more about what inflation’s gonna be in the future versus if it’s just oil driving it or something like that, right?

Aahan: Mm-hmm. Yeah, I think that’s definitely... And then there’s also — we’re gonna get into this I think in our next slide, so maybe we should take a look at that. It’s not just the fact that inflation is very broad-based. It’s what are the underlying drivers of that inflation?

And so when you think about inflation conceptually, there are really only two major sources. All inflation is driven by nominal demand — it’s nominal demand relative to the existing supply of assets. And so you can have demand-based inflation or you can have supply-based inflation.

And what we’ve done is we’ve created a quantitative measure for demand-based inflation and supply-based inflation, to understand the nature of the current inflation circumstance, and we can extrapolate that over time and understand how it’s worked in history. And when we look at that setup today, what we see is that the demand-based drivers of inflation are basically enough on a standalone basis to keep us above the Fed’s target.

Now, I think that’s really important to understand, because when you look at demand and supply-based inflation, which I’ve visualized in this chart over here, demand-based inflations tend to be slow and persistent. Supply-based inflations, on the other hand, over a six to 12-month period, tend to be very fast but mean-reverting. And so once you get into a situation where you have a demand-based inflation, particularly when the demand-based inflation is spread across all the components, you get an inflation that’s what most people would call sticky.

Jack: And so these numbers at the bottom here, this 3.31 versus .38 — that’s telling me that the vast majority of the inflation we’re seeing now is demand-driven?

Aahan: Absolutely. So even if we were to strip out all of the supply-based effects, which are really coming out of the Iran situation, we would still have inflation that’s materially removed from the Fed’s policy target of 2%.

Jack: So what are we seeing in this next slide? We’re seeing the same idea presented differently, right?

Aahan: So in the previous slide, we looked at the headline numbers and the headline decomposition of demand and supply inflation. What we can also do is break it down by the major components of PCE inflation. And when we look at that, we see — surprise, surprise — the biggest area of supply shock-based inflation is gasoline and energy goods today.

And so when you’re thinking about demand and supply inflation today, and you think about demand-based inflation being really persistent, if you were to strip out basically the majority of gasoline and energy goods inflation, which is driven by supply, you would still have a really elevated demand-based force in the economy driving inflation across categories.

And so in the visual, what you’re looking at is the contributions of demand-based inflation to each individual component are shown in blue, and in red we’ve shown the supply base. And what you can see, there’s a lot more blue than there is red.

Jack: So what are we seeing in this next one? This is again looking at another different way of this demand-driven versus supply-driven inflation.

Aahan: Right. And I think this is probably the most telling of the lot. We know that we have a big picture demand-based inflation, and we know that it’s pretty broad based. But I think what’s really important to recognize is that over the last few inflation prints, we’ve had an increased discussion around the idea that, oh, inflation seems to be falling off. You’ve probably heard that in popular media, that the latest inflation readings are much cooler than expected and things like that.

Jack: And you see that in Truflation, right? Places like that? Aren’t they showing that kind of stuff?

Aahan: Yeah, we see that in Truflation. We also see that just in the reported numbers for PCE and CPI, where we basically had a deflationary June and then we had about a 16 basis point rise in July, which relative to what we had earlier in the year, pretty meager.

But when we do this demand versus supply decomposition, what we find is that virtually all of the declines that have happened in inflation, or the slowing in inflation, is driven by these supply-based effects. And so when you look at the underlying demand-based trend, it’s still very, very much intact, which suggests that we’re gonna still continue to see persistent inflationary pressures from these demand forces over the next few months.

Jack: And this must be what the — I know there was a Fed governor who came out today and said, you know, we need to hike, and hike now. This is basically what they’re seeing, right? They’re looking through this high level data and they’re seeing this demand-driven inflation behind the scenes.

Aahan: Right. I think that’s very much the case. And like we noted at the outset, the people that are on both sides of the aisle — some people think that this is a totally transitory kind of situation. A lot of Fed governors are looking at this type of work. When the Fed does some sort of similar work, there are methodological differences in terms of how we approach it.

But I think, yeah, very much so. Intuitively, I think it’s something that’s very straightforward to understand, which is that there’s a lot of nominal demand in the economy right now. And given that we have a supply shock on top of a nominally hot economy, we basically have everything required for persistent inflationary pressures, and that’s what the Fed’s feeling.

Jack: So I guess the next question in terms of inflation is the pressure that’s putting on monetary policy, and that’s what you’re getting here, right?

Aahan: Yeah, absolutely. And I think this is a really important thing. Let’s just assume that, okay, you don’t buy any of the demand versus supply inflation work that we’ve done, and you’re like, “No, this is entirely an oil shock, and oil shocks don’t matter.” I think that if you were of that opinion, it would be something that would be largely inconsistent with history, which is what we’re trying to show over here — which is that persistent oil price shocks always tend to result in more core inflation over time.

And as oil price shocks make their way into core inflation, you begin to have more pressures on the Fed to hike policy rates. And so how that works is, you typically have a supply shock causing oil prices or commodity prices at large to rise. That slowly makes its way up the supply chain and begins to make its way into core inflation. In the interim between those two things, the Fed usually inevitably has to end up hiking monetary policy.

And so even if you don’t think that this is demand-based inflation, I think that you have to recognize that we’ve basically been in a six-month period now where oil prices are just going through the roof, and that is going to have an effect on monetary policy.

Jack: One of the cool things you do — and as you know, I’m a quant too, and I’ve always found in my quant career that a lot of times when I try to build these complicated models and then I just go back to the simple model, I realize the simple model works better. And you’ve got an awesome model here you’ve created for Treasuries. So can you talk about that?

Aahan: Yeah. This was something that we basically released in March, at the onset of the war, when oil prices really started to spike. And the idea was that there was a lot of debate about, oh, are we gonna have demand destruction by these high oil prices, which will result in Treasuries getting a massive bid? Or is the inflationary pressure gonna be reflected in hiking and the Treasuries get killed?

And so what we wanted to do is give a simple systematic tool to the majority of investors to be able to use to navigate all of this stuff. And all we said was this: look, inflation tends to be a pressure on bonds because it’s a pressure on policymakers to hike policy rates. And so all we do is we basically say, if our inflation nowcast — we have a daily inflation nowcast — if our inflation nowcast is above 2%, we avoid owning bonds. If it is below 2%, we own bonds. And we tested that over the period from, I think, 2000 to present. And what you can see is that you can actually get the majority of bond returns just by following that approach.

And so today, our inflation nowcast is actually running in the fours, and has basically averaged between 3 and 4% over the course of this year, and has basically indicated that you need to avoid bonds. And so that’s really what we’re showing here. We’re showing the summary statistics of the program that does that.

Jack: Yeah. I’m a big trend following fan myself, and I love these simple models. And you often find with these simple models that they outperform buy and hold, or at least on a risk adjusted basis, they substantially outperform buy and hold.

Aahan: Right. Absolutely. And I think it also gives you the opportunity to really know when you can overweight or underweight a position. So if you’re in a really good environment for bonds, maybe you want to overweight your bonds if you’re not somebody that can just completely exit the bonds.

Jack: Well, Aahan, this has been awesome. We really appreciate you taking the time.

Aahan: Likewise, Jack. Always a pleasure.

Matt: Next up we have Ben Hunt, and Ben, coming at us from Epsilon Theory and Perscient, is going to give us an update on narratives and markets. And boy, are there some doozies of narratives and markets that have been rolling over in this last year, especially as we rattle towards midterm elections. Take it away, Ben.

Matt: What is up, Ben Hunt?

Ben: It’s good to see you, Matt.

Matt: So it’s funny how quickly narratives change. That’s kind of the point of this conversation, because I think it was last month we were talking about, honestly, the credibility of the Fed.

Ben: The narratives we track on that, really since last summer, have just made kind of market improvements. It was really terrible last summer when Trump was going after Powell and all the Fed governors and all like that. It’s made this really incredible recovery since then.

Well, since Warsh’s press conference at the very end of July, and then followed up by a lot of the stuff that is not the Fed but Treasury has done, Scott Bessent — oh my God, Matt, the narratives around the Fed losing credibility have just burst and skyrocketed. It’s gone just supernova in a way that I really haven’t seen in looking at narratives in a long, long time.

Matt: What was crazy about this — we talked about this last time, let’s walk through this again for a second too — is Trump beating up on Powell was just diminishing credibility, kind of taking the stairs down, and you could just feel that building pressure. Then the shock was the recovery in Fed credibility once Warsh was coming in, and that pressure, that release valve came off, and it was just this remarkable climb that, holy crap, people believe in the Fed again.

Ben: ‘Cause he talked a good game.

Matt: He talked a great game.

Ben: About being, “I’m gonna be tough on inflation. We’re gonna let the market make the decisions. We’re kind of getting away from the forward guidance.” And people are going, “All right. I like that. That sounds good.” And then we get to the press conference at the end of July, and man, this is what I mean by the supernova of narrative explosion.

Matt: Well, this is an own goal. This is self-inflicted.

Ben: Well, it’s interesting, right? Because it wasn’t just that they didn’t raise interest rates. It’s what he said about it. It was meet the new boss, same as the old boss. And that was how the narrative shifted after this press conference at the very end of July and going into August.

And it’s not a coincidence. That’s when you see gold just taking off here in August, this big move we’ve seen in gold. Because that’s how really you think about gold. It’s one divided by trust, right? And when that credibility gets broken, it’s really hard to get it back.

Now, he’s trying to get it back — we’re recording this while he’s doing the Jackson Hole speech today. And again, it’s talk. It’s talk, talk, talk, talk, talk. I don’t think he’s gonna raise interest rates. I really don’t. And that’s what came out of the press conference. That was everybody’s reaction. Everybody. That was the narrative reaction, was that he’s just talk, just like all the rest.

And that’s a rough one, right? ‘Cause I liken credibility to being like a teacup. And once you break it — I mean, you can glue a teacup back together again, but it’s never the same. It’s always a broken teacup.

And people say, “Well, what difference would it have made if he had hiked interest rates by 25 basis points? It wouldn’t have really done anything.” And that’s not the question, right? It really isn’t. You hike then, like a lot of people kind of thought they would, or I thought it would’ve been smart for him to do it. Because once you hike by 25 basis points, you never have to hike again. You never have to hike again.

Matt: Just have to do it once.

Ben: You just have to do it once. Just have to say, “I did it.”

Matt: Just have to say, “I did it.”

Ben: And they say, “Okay, this guy means business. He didn’t have to do it. He did it. Man, he really says what he means, and he means what he says.” And that’s how you get the market to do your work for you.

Matt: That’s how you get the market to do your work for you.

Ben: It never comes up as an issue again. But now you’re gonna have to hike three times, not that one time, to regain that believability as an inflation fighter. And you can’t do that. He can’t do that, not without just tanking the economy. So he’s not going to do that. So it’s all just gonna be more of this talk, talk, talk, talk, talk, talk. Meet the new boss, same as the old boss.

Matt: Walk us through the graphic of this. Explain again just the narrative density, why we saw this come all the way down, then why we see this spike. And then I am curious, build on this — is there any reaction function? They’re aware that this is the corner they’re in. So walk us through what’s going on in the chart and why the chart tells the story first, and then tell us where you think this is going.

Ben: Well, what the chart is, is how loud or how quiet compared to normal. The horizontal line there is the average level of loudness for this story, that the Fed is losing credibility. That’s the story. We’ve got a separate story for the Fed gaining credibility. That’s what we were looking at the last time. This is the story that the Fed is losing credibility, and we had a multi-year peak in the summer of ‘25. That’s when every day Trump was going after the Fed. Every day there were stories about how he’s gonna take over, he’s gonna put his own people in there — which he kinda did. That was the peak of how loud that story was.

And since that summer, it’s gone down, down, down, down, down, to the point where it never got quieter than average, but it was no longer a growing story. It was a declining story. Until Warsh’s press conference.

And like I say, it’s rare to find these bursts, these events where narrative explodes like it did, but that’s exactly what we saw. We saw hundreds of independent stories coming out in financial news after that press conference, and they all had the same basic gist. They used different words, right? We’re not looking at word counts or sentiment scores. We’re looking at meaning, at the semantics of something. Different words all to say the same thing: he’s just like all the rest. Talk big and actually do nothing about inflation.

And that’s just accelerated over this month with Bessent coming out and saying, “Oh, we’re gonna buy back the long end of the rates curve. We’re going to intervene by selling euros to buy yen.” All this financial manipulation to try to hold down interest rates, not let the market decide, but instead to jawbone these policies. And it’s all of a piece. Meet the new boss, same as the old boss. That’s what you’re seeing here.

Matt: Do you think we’re seeing a move in gold? Do you think any other asset classes respond to this? And is there almost an expiration date on some of this?

Ben: Hmm. I don’t think so, and I think that’s what we can talk about kind of more at length.

I think that what you’ve got right now is you’ve got four big issues that the US government, and particularly the Fed and Treasury, have to deal with. You’ve got an Iran war which has no easy exit and leads to higher for longer on oil prices, and so inflationary pressures. That’s one.

Two, you’ve got, I’ll call it the financial stimulus from the one big beautiful bill. That’s wearing out. That’s clearly wearing off now. Other policies like tariffs were a rebate for corporates in the last quarter. That’s going away. We’re getting the tariffs ramping back up again. So you’ve got problems on the consumer side. Stimulus has worn off, and you’ve got the pressures coming back. Not to mention — I don’t care what your politics are, everyone’s going to feel bad about the midterms. You just are. We can’t help it. It’s gonna be negative campaigning, and I don’t care which side of the aisle you’re on or who you’re voting for, we’re all gonna feel bad.

Matt: Bad and a little bit gross and a little bit frustrated.

Ben: And bad and a little bit gross. Exactly. So that’s problem number two.

Problem number three: you’ve got, I’ll say, systemic issues in the insurance sector, and this is the Mark Walter and the Guggenheim insurance policies and the like. You can’t have that blow up into being anything. You’ve got to prevent losses from being assigned in what looks to be, if not fraud, at least something we’ve talked about for a while — the use of captive insurers to fund a lot of the private investment world. That’s three.

And fourth is the biggest one. You’ve got real pressure on the long end of the curve, the 10-year, 30-year interest rates. You can’t let that blow out. You just can’t. It just is death, right? All of these things can spark another great financial crisis.

So you’ve got all these problems that the Fed and the Treasury have got to deal with, but now they’re dealing with it with damaged credibility. So it’s just hard. So no, I don’t think there’s an expiration date for this. I think that this effort to do, I’ll call it jawboning financial repression — that’s a technical term — I don’t see any end to it. I just see an acceleration to it. But that’s where we are right now.

Matt: That’s why you’re tracking the narratives. That’s why you’re giving us these updates. People wanna check out these tools, see more. Where should we send them?

Ben: So go to Panoptica. We do a lot of this stuff in public. And check out our stuff on Perscient. We do a lot there.

Matt: Thanks for joining us, Ben.

Ben: Thanks for having me.

Jack: As we wrap up, we always like to look at what people are actually doing, ‘cause we talk about what people are saying throughout these, but Brent Kochuba sees, in the option data, he sees how people are actually betting their money. And we talked about Nvidia here, we talked about what’s going on with Warsh and no forward guidance. We talked about a lot. Here’s Brent with behind the moves.

Jack: Brent, welcome to Last Call.

Brent: Thanks so much, Jack. I’m so excited to be here that I was in disco rave mood. I don’t know if kids these days still go to raves, but this background is lit, as the kids like to say these days.

Jack: Yeah, I like it. You chose, like, the wildest background Riverside has here. And it fits with Matt and I getting off the fake private jet at the beginning of the video, so it fits with the theme we’re trying to get across here.

Brent: That’s right. It’s one of your backgrounds, so, hey, this is how they... Warsh is today, so we could party for Warsh. Actually, you know what it’s like? Those MicroStrategy videos where they’re all doing, like, this weird thing. You know what I mean?

Jack: Oh, yeah. I saw that. That was very interesting — is that the word for that? I’m not really sure what the word was for that. That was, like, the earnings call they were dancing on or something?

Brent: They’ve done it a few times now. I think they call that the “we are diluting our investors” dance.

Jack: Yeah, I guess so. I don’t think anyone wants to see us dancing on this thing, Brent, though, so I think we should probably get into the options analysis, ‘cause that’s probably what people are looking for more from us than the dancing.

Brent: All right. Let’s get into it.

Jack: It is an interesting time to talk because Warsh is speaking, I think, as we speak right now. And I think the market is enjoying what he’s saying. We have this chart up in front of us here, and a lot of this is the different events we’ve had going on and sort of the volatility around those events. And people were worried about Jackson Hole, but it seems like it’s not gonna be maybe as big a deal for the market as people thought.

Brent: Yeah, right now it’s 10:45 Eastern Time. You see S&P’s reacting. The initial reaction here is up 30 bps. That’s pretty nice. The implied move for today was only about 38 handles, Jack, which is the 0DTE straddle. That’s not a lot of market movement on Warsh day, right? Certainly with all the conversations we had into this event, and what was looking like the implied pricing was gonna be higher. Things this morning were very, very quiet. You wouldn’t have even known that there was a significant thing happening today. So that’s a key thing to note.

And what you could see here again, markets starting to rally here. We’ll see how it ends up. But what we’re looking at is the SPX term structure. And this is today’s expiration, but look at Monday’s expiration, Jack. That’s a 7% implied vol for Monday’s options, 8/31. You may occasionally see a six. On Christmas Eve, you’ll see a four. But this is very, very low.

And the fact that this term structure — I’m looking at the darker green or teal line here — it’s at 90-day lows, which is that range. This is a market that has zero concerns right now. And so Warsh is just sorta like this speed bump. It’s like, “Hey, just get out of the way. Don’t spoil the party.” And then I have a feeling we’re gonna start to really move higher after Nvidia earnings, which we’re gonna talk about here in a second too.

Jack: Yeah, it’s interesting. It doesn’t seem like, to your point here, the market worries about anything. But I do wonder going forward, given the way Warsh is gonna run the Fed — and you kind of see a little spike here in the future on this — I do wonder, will there be more volatility around the actual meetings now? Because it doesn’t seem like we’re gonna know what’s gonna happen going into the meetings.

I feel like for most of my career, we’ve known exactly what’s gonna happen going into every meeting. Now, last meeting it was, what, 60/40 or whatever on what they were gonna do. I have no clue what they’re gonna do in the next meeting. And I don’t know — you might know what the market’s pricing right now — but do you think we’re gonna have more volatility around these Fed meetings now?

Brent: Yeah, there’s many dynamics at play here. There is, Warsh is new, and people didn’t like his guidance the first FOMC, so he’s supposed to say some more today. We’ll see how that goes.

And then what we have on screen here is, the lighter teal line is what we call forward implied vol. And what that does is it compares the vol between two expirations. And the value of that is saying, this is what the event is being priced at. And so when you see spikes in the forward implied vol, that tells us there’s an event. And so the big spike on the chart here is for September FOMC.

And so here you have non-farm payrolls. There’s a little consternation around that date. And then here is the bigger move around the 16th, which is also a very, very big options expiration. So the market is basically — we’re reading this thing — the market kind of only cares about that date. But ultimately, with term structure this low and implied vols this low, there’s really just not a lot of concern going forward.

Now, back to your original question. Oil is a big part of this, right? Oil’s been coming down as — I don’t even want... who knows about that situation? And then we have Bessent, who’s been jawboning, at least I would call it jawboning, rates lower. And so there’s this quagmire of events also involved with just whatever FOMC thinks is happening from a macroeconomic perspective.

So it’s a cloudy soup, but the thing I take away from this is implied vols do not care. People don’t own put options writ large. Put open interest is very low. It’s just a market that, in my view, just wants an excuse to rally. And so as long as these other risks stay kind of in their box, then the market seems just poised to kind of start to move higher into September expiration.

Jack: Do you know what the odds of a hike are in September? I don’t even know them off the top of my head.

Brent: Yeah, so this is the latest from the FedWatch. I know a lot of the kids these days like to use the prediction markets for this. But the FedWatch tool here says for the September meeting — and again, I’m not exactly sure what the pace of update is here, it says it here at the bottom, I guess — so 55% are saying hike for September. So that is still the case. But this is gonna be dynamic obviously, as Bessent does what he does, and maybe oil comes down, and who knows what non-farms and some CPIs and stuff do before the September 16th meeting.

Jack: Yeah, it’s so interesting to think about how this is gonna play out. Does this, for you as an options trader — if we start to see more volatility around these Fed meetings, is that something you view as an opportunity?

Brent: I generally feel like there’s a lot of event vol that comes with these events, obviously, ‘cause you have the extra implied vol pricing. And so I tend to not like these types of events, because the options get a little bit expensive because you know there’s the event. So if the event passes, then the options prices come in. It’s like a tax, right?

And to me, the tail risk in a market like this, where put options are quite cheap, implied vol’s quite cheap — if Warsh just says one sentence the market doesn’t like, since no one’s expecting vol, then all of a sudden, if you’re short options, for example, you can get steamrolled in these kinds of things. The odds of getting steamrolled are quite low, but at the same time, if you’re buying calls and the event rolls off, well, those calls pay a tax as well.

So to me, it’s sorta like you gotta wait for the event to pass and then kind of play the outcome, or try to play a trend that sets up after these types of events. So for me, I tend to kind of steer clear a little bit, because I just view these events largely as a tax.

Jack: Is the general rule with events that the market tends to overprice the risk of the event, but then there’ll be one-offs where it dramatically underprices it? Is that kind of the idea of how these things play out?

Brent: Yeah, and there’s sort of, I guess I’d call it an autocorrelation to these events. Because if you remember a couple of years ago, CPI would continuously price like 2, 3% market moves around the CPI print. And so sometimes the market gets so concerned that they greatly overprice risk, and then they’ll get stuck in these sort of regimes where they, I think, underprice risk a little bit.

And you wanna hedge out a new chairman coming in and saying, “Hey, I need to raise rates,” and the market wasn’t pricing that in at all. So I actually had on some very short-term put flies, which to me were extremely cheap today, just on a lotto in case he said something wrong. Now, that’s not paying off anything, and that’s fine. I thought it was low odds, but very high reward in that case, ‘cause the market’s just pricing in no movement.

And I think what happens is the market prices low risk into these events, then there’s a shock all of a sudden at one of the events, which then the next time or the next few times, the market goes, “Hey, last time I got ran over, so I gotta price more risk next FOMC,” for example. So again, traders need to get their hands slapped, and then they sort of reset and change the pricing regime in these events.

Jack: Yeah, it’s funny, in certain types of regimes, certain events matter. I remember for most of my career, the CPI print was irrelevant. And then we went through the inflation, and then CPI is the most important thing, and now that’s kind of becoming less important. But I have a feeling maybe in the Warsh regime, Fed meetings might become a little bit more important, just because we don’t know what’s gonna happen in advance.

Brent: Yeah, that’s exactly right. And another thing to toss on here, Jack, is the midterms. I think everybody and their brother’s expecting Trump to try to gas the stock market into midterms. I’m not gonna say that’s wrong. If any president or political regime thinks about the stock market, it’s President Trump. So there’s that piece as well, just to toss onto this quagmire, I guess we’ll call it.

But to your point earlier about people caring about CPIs, or suddenly people care about the unemployment data, or we were watching Treasury auctions not all that long ago ‘cause things were getting a little squirrely there — these things do roll in terms of what the market seems to really wanna pay attention to. And by and large at this moment, the data seems fairly benign. I think the unemployment data seems to be picking up a little bit in terms of importance here. But there’s just a lot of pieces to take into account now. Besides just pure inflation, there’s all these kind of exogenous effects that are a little bit tough to skate through.

Jack: And I know the viewers want a detailed political analysis from you and I on everything going on with midterms. So we’ll get an hour video out to them on that soon, Brent.

Brent: Yes, absolutely. We’ll bring back Brent and Jack’s macro corner for Sep OPEX, ‘cause that should be interesting.

Jack: It’d be the least watched video of all time for us.

Brent: But look, as it stands right now, from out of the options market, the market’s moving higher, vol’s starting to come down. That’s what we’re seeing in the term structures we just showed. We have Labor Day next week, which shortens time. Time is a tax on the options market. So with Warsh seemingly out of the way, I don’t see any reason for this market to not start to go higher. Sorry, trying to clean my language there.

Vol’s gonna crunch, I think, now. People, I think, will start thinking about midterms. Okay, nothing to worry about. Oil’s coming off a little bit, blah, blah, blah. And that time and vol coming down dynamic is just something I think can really help the market probably look at taking out all-time highs at this point, is what I’d be looking for. And next Monday obviously is the holiday again. That shortens the calendar. That adds options time decay, which I think lifts the market.

Also on this point, we wanted to end on Nvidia here, Jack, because Nvidia just reported earnings. They seemed like some of the best earnings in the history of stocks, right? And I don’t know if you dig into the depths of the fundamentals there if you get a different story. But on its face, the stock had a really great reaction.

And I wanted to show you this map, because this map is the latest in our options positioning. I think we’re really one of the only groups, banks included, that have this kind of data. And we are looking at where hedge funds are buying and selling options, and this is what we call calendarized gamma.

And why this matters is because if you see blue on this chart, what that’s telling you, like in this range, traders — that means buy side — are selling calls in that area. So this is looking at it from the market maker perspective. Market makers own calls in this blue zone, and they’re short calls in this red zone. Does that make sense?

Jack: Yes.

Brent: So the stock right now, last I looked, is around 225, 226. There’s a lot of long calls. You can see there’s a very clear band right at 250. You see that? Going out in time. So you can see how the colors change drastically on some days. That’s because of an expiration. So here’s Sep options expiration at 9/18. You can see the color blue drops sharply.

So what am I taking from this? Traders are short calls above 250, and they’re really short calls into that 275 area into September. And so when I’m thinking about the fundamentals and all this other stuff, I don’t know about that, but I do know that the Street is largely short calls above, call it, 250, 255. And so if I’m long that stock, I’m thinking that’s probably my resistance point, kind of in that 250 to 260 area, roughly.

Stock right now is at 225. So if I’m long, I’m thinking about, hey, this stock could rally through this red zone where the market makers are short gamma. And then around 245 or 250, I’d start to think about maybe I wanna sell some calls, or maybe I wanna try to monetize my position if we get that kind of a rally. Does that come across?

Jack: Yeah, it makes a lot of sense. It’s always so cool to be able to see what’s going on behind the scenes. You see these moves in the market, and then looking at a chart like this, I can understand better what’s going on, and also maybe what some of the pressures are going forward on the stock.

Brent: Yeah. And to the downside, there’s light positive gamma in here, light blue. Into earnings, there was a small short put position, meaning buy side was selling put options. They really weren’t worried about Nvidia into earnings. But the put skew in this name — the puts are cheap, and you’re just not getting a lot of value for selling those puts.

And so what you look out here is, there’s now a light long between now and September options expiration, what this red is. But that red is not a suggestion that people are really hardcore into puts. The put wing is pretty cheap on a historical basis, and it’s just kind of a non-event.

The big feature of this stock is traders’ long calls in this 225 to 240 band, and then this really big, heavy short call position in the 270 area, 260 area into Sep OPEX, is the real feature. So watch for that as a major resistance point. I also like to think about this as fair value for the stock, right? Because to me, this is traders saying, “Hey, stock probably not going over 275” really out in time, is what the positioning is telling me.

And so when you wanna boil down the fundamentals, you figure, hey, tons of hedge funds, tons of retail out there. Everyone seems to have this consensus writ large that the stock could move up to 250, but 275 seems to be over fair value, or fair value, based on where people wanna sell calls.

Jack: Well, thank you, Brent. I really appreciate you doing this.

Brent: Absolutely. Thank you, Jack.

Jack: So Matt, as we wrap up here, Stan Druckenmiller wrote a little something for The Wall Street Journal. I don’t know if you saw it this week.

Matt: Well, I guess the debate is, did Stan Druckenmiller really write something?

Jack: Yeah, I guess that’s the question.

Matt: Did he prompt something for The Wall Street Journal? Where are you coming down on this?

Jack: Well, what I first liked about this — we can get into the argument about AI, and you and I might do a different podcast on this. I did like that he owned the thing. So many people that get called out on this are like, “Oh no, I didn’t use that AI.” I mean, this thing scores 100% on Pangram, so clearly it’s 100% AI written. And he was like, “Of course I wrote it with AI.” He’s like, “It writes better than I do. It gets my points across better than I do.”

You could argue on both sides of this, but I do like that he came in and he owned the thing. And he was like, “I wrote this with AI, and there’s nothing wrong with it.”

Matt: A, respect for owning it. I think that that’s my favorite part about this story, that he pulled no punches. And I think he even went so far as to say, “You’d be an idiot if you’re not doing this too. Why would you even question this?” He was done with that argument the minute it came out of anybody’s mouths, and I do respect that from him.

The other part on this, and I am curious on your perspective, because when it comes to a lot of PR stuff, a lot of academic stuff, a lot of even kinda thought leadery things that I’m not reading like it’s prose — I don’t really care so long as I know that the thought is his. And this statement felt like something Stanley Druckenmiller’s been saying his whole freaking career and we have all been hanging over. So to me, I kinda look at it and I’m going, “I’m not bothered by him using AI for this, ‘cause this is still a Druck take.”

Jack: Yeah, and why this matters for investing is you’re seeing this on a lot of investing blogs. You’re seeing people giving actionable advice. You’re seeing people write things that are clearly AI. And so there’s so many different levels of this. On one level, Druckenmiller probably read this at least afterwards, and he believes every word that’s in there. And he’s also one of the greatest investors of all time.

On the other hand, you’ve got stuff from other people that you’re like, “Did they even read this? Do they actually believe this? Did they think this through?” Because so much of having an investing opinion is the process of thinking through that investment opinion. And I know, as you’re gonna say — and you’re 100% right about this — the process of writing that down is so much a part of the process of thinking. And if you’re not doing that, are you thinking? So even if it’s great and it represents their views, did the thinking go behind it that you want to go behind something you’re reading about investing? And I think that’s a really important question for all of us to ask.

Matt: I think that’s probably the most important question to ask. I think you framed it perfectly. I have an essay out. I’d love it if you read it. It’s not much to do with finance, but it’s related to these topics. It’s called More Eccentrics, Less Influencers. It’s out now on Panoptica. It’s a free read.

Jack: It’s great. So does that mean we can’t be influencers though, Matt?

Matt: Well, I gotta say two things about this. You can still be a finfluencer, Jack, don’t you worry your precious little heart.

Jack: Okay, good. That’s what I wanna be.

Matt: You’re still gonna be a finfluencer. The idea here is what you were just saying. There’s this common expression, “I write to figure out what I think.” And I agree with the sentiment behind that expression. I write to figure out what I think. That is part of why we like to do these things.

However, what’s important, and what the essay is about, is a covenant with yourself to write to figure out what you think, to explore what you feel. And that is the part that still changes the sensory input to the stuff we put out there in the world, that to me really breaks this line between what’s AI slop, or what lacks any taste or common sensibility, and what carries a piece of myself and how I’m interpreting something, which is feelings-based. It’s not logic-based.

And I will say, even with Druck, even with what he said in this — this is some George Soros twitch in the back in the middle of the night, change my position stuff. This was a felt thing that he used AI to help him organize and present. And that’s where I can look at it and say, “This still feels like an original thought from him that I think was communicated in a way that he wanted these tools to do.” And, fine. I don’t read The Wall Street Journal for Emily Dickinson. I read Emily Dickinson for Emily Dickinson, and she can use an em dash. So I don’t care. I’m not bothered by this, because I feel that that was a felt statement from Druckenmiller, and I don’t see what the real hubbub is about.

Jack: Well, you and I will do a whole episode on this at some point, ‘cause it’s such an interesting thing and there’s so much to talk about. I don’t know where we’ll put it, but we’ll put it somewhere. But on that note, it’s probably a good note for you to wrap us up.

Matt: All right. Excess Returns on Substack. If you’re not subscribed over there too, come check us out. Transcripts, episodes, all the stuff lives there, as well as our home on YouTube and all the podcast platforms. So thanks for tuning in. Like, comment, subscribe, all the things below. This is Excess Returns, and we’re out.

Topics covered
* Why stronger nominal GDP, large fiscal deficits and record corporate issuance are pressuring long-term Treasury yields
* How Scott Bessent's Treasury liquidity buybacks work and why investors are comparing them with QE and Operation Twist
* How replacing long-dated Treasuries with T-bills could ultimately force reserve management purchases by the Federal Reserve
* Why the Treasury General Account matters for liquidity and why attempts to manage the yield curve can distort market signals
* Jim Chanos's "earnings bubble" argument and how massive AI data-center capex can boost current earnings while costs are amortized
* Why stock prices can fall before forward earnings estimates roll over, and why retail investors may have an advantage over institutions
* How daily-reset leveraged ETFs create reflexive buying and selling and could amplify a semiconductor or single-stock selloff
* Why Kevin is bullish on gold again, the role of People's Bank of China demand, and how he combines fundamentals with technical signals
* Why platinum below production cost caught his attention and what rolling mini-bubbles in gold, silver and AI say about investor psychology
* What 2025 U.S.-Canada trade data says about autos, oil and gas, manufacturing, tariffs and the economic cost of policy uncertainty

Timestamps
00:00 Intro
06:31 Scott Bessent's Treasury buybacks and the bond market
10:39 How T-bill issuance could lead to debt monetization
18:25 The AI capex boom and the "earnings bubble"
22:27 The giant bet embedded in accelerating AI earnings
27:37 Why leveraged ETFs are changing market structure
32:00 How forced ETF unwinds can amplify a selloff
36:41 Why Kevin is bullish on gold again
41:57 Platinum, production costs and the precious metals trade
46:08 Sentiment extremes and why popular trades get dangerous
51:00 Globalization, manufacturing and America's distribution problem
55:00 Why oil and gas dominate the U.S.-Canada trade deficit
59:00 How tariff uncertainty can deter U.S. manufacturing investment
01:03:10 The trade math Kevin wants investors to see

Learn more about the Excess Returns podcast network:
https://excessreturns.co

No information discussed in this podcast should be construed as investment advice. Securities discussed may be held by the hosts and guests, their firms or their clients.

Kevin: Good, thanks. How about yourself, Matt?

Matt: I am doing fantastic on this lovely day that can’t decide if it wants to rain or be sunny or anything in between. So this is good to catch up. You’ve been on fire all summer with Macro Tourist things.

Kevin: Oh, that’s very kind of you to say.

Matt: And I keep flagging them and going, “This could be a whole episode. This could be a whole episode.” So starting off, I wish, I wish, I wish we were talking about Sean Connery or even Barry’s home run record, but alas, today we start with bonds. What the hell is the bond market doing? This is a wild one.

Kevin: It is fun, isn’t it, though? Like, bonds were so boring for so long, so we shouldn’t be complaining too much. And we have all the drama. We have Scott Bessent, who has worked with George Soros, who hired Stanley Druckenmiller. And we have Bessent doing something, and then—

Matt: Stanley Druckenmiller’s AI. Throw that in there.

Kevin: Yeah, Druckenmiller using AI. Who’d have had that on their bingo card, right? And what I liked about that though, Matt, was he was just like, “Yeah, of course I use AI. Why wouldn’t you? You’re an idiot if you don’t.”

Matt: I loved his response for that reason.

Kevin: I saw someone say the other day that, “I don’t pay for sex and I don’t let AI write my stuff.” So I’m gonna be in that same category. I think that Druck should write his own stuff and not let AI do it.

Matt: Yeah. The audacity by which he responded, though — clearly not considering anything else and just like, “Pff. This is who I am.” I mean, I’m not gonna borrow the prostitution reference, but we’ve seen other unapologetic behavior from people in power.

Kevin: Hey, that wasn’t mine. I just thought it was funny. It wasn’t mine.

Matt: All right. It was good.

So the bond market, like Barry Bonds, might be on steroids right now. It’s certainly bond vol. It’s been pretty crazy. When’s the last time you feel like the bond market was this volatile?

Kevin: So I guess I’m gonna push back a little there on you, Matt, ‘cause although it does feel like lots exciting is happening, it really is actually somewhat sedate in terms of its actual ranges. It’s not like we’re getting big, huge monster moves.

One of the things that I’ve been surprised about is how everyone’s losing their stuff over the fact that bonds have backed up over the last little while. And, you know, so what? The long end has gone from 485 to 530 or something like that, right? So we’re talking 50 basis points.

But let’s think about the environment that we’re in, okay? A year ago, nominal GDP was four and a half or four something. Today it’s six and a half, okay? In that period, we’ve also had the deficit continue to stay at elevated levels in terms of the US federal deficit, so the actual supply continues to be large. We also have record issuance of corporate bonds as we have this just huge ignition of animal spirits in terms of the AI build-out. You know, the largest infrastructure build-out since the railroads of 1850 or whatever it is. And even I’m not old enough to remember that.

And then to top it all off, we have a situation where Trump’s geopolitical — let’s just keep it neutral — positioning has caused the rest of the world to realize that everyone needs to put their pedal to the metal in terms of fiscal stimulus and actually spend as well. So in the past, three years ago or two years ago, the US had a 7% deficit to GDP. The rest of the world was running two, two and a half in terms of the developed world. Like here, I’m a Canadian, we were running two, two and a half. Japan was two and a half. Europe was two and three-quarters or something. All of that is now being thrown out the window as we all scramble as the world order’s being redrawn.

And so when I think about this environment, we just have nothing but supply, and people are losing their minds because we have a nominal GDP of six and a half, and the long bond has gone to 530. So I actually will go take the other side and say, “I’m surprised it’s not a lot worse.”

And it just goes to show you, though, I think, how conditioned we’ve been to low interest rates. And to me, the real danger is that everyone is losing their minds because everyone has priced in a risk-free rate that is much lower.

And to me, I’m somewhat sympathetic to Drucken and Claude’s analysis, that the tinkering with the market is getting rid of an important signal that is actually part of the whole process upon which capitalism is based. And so once you start doing that, you’re gonna invite a whole bunch of different outcomes. And one of the things that — although I will make the case that it really wasn’t that big a deal what he said — I think that the gold market got the memo real quick and took off and ran like it stole something, because they see the writing on the wall. They see that although maybe this isn’t the actual mechanism that pushes us into the monetization of debt, it’s the first step into it.

Matt: It’s a big step, and certainly gold seemed to catch that. So between GDP deficits, corporate issuance, the reality of nothing but supply — we have all that happening, and then we get the Bessent stuff. Contextualize what Bessent’s doing, how you’re thinking about the announcement. Some people calling it QE. You’ve got some pushback or some nuance there. Walk us through it.

Kevin: So if you go read what he’s talking about, it’s the liquidity buybacks, the increase that he’s talking about doubling. And so you might ask yourself, what is a liquidity buyback? My understanding is that it’s designed to encourage liquidity in certain parts of the yield curve.

And one of the problems is if you’re sitting there and you’re the US government and you issue a 30-year, and then two years later, that 30-year is now a 28-year and somebody wants to trade it, the reality is that that’s a very nuanced, specific issue, and not everyone has the ability or the desire to go buy that one. So often that’s called an off-the-run bond, and those off-the-run bonds will trade at a higher yield versus the on-the-run bonds.

So one of the things is, these liquidity buybacks are there to, in essence, buy back that off-the-run bond and then issue more of a new 30 that is more liquid, and thereby provide liquidity for the markets. That is the concept of it.

One of the pushbacks that Druckenmiller rightfully had was, you’re perverting what this liquidity buyback was supposed to be, right? It was supposed to be buying the off-the-runs, selling the almost equivalent tenor, and just making the whole market more liquid. What the concern is, is that Bessent is gonna go buy back a 28-year off-the-run bond, and instead of issuing more 30s, he’s gonna go and issue more bills. And so at first blush, it kinda looks like an operation twist, if that’s the case.

But here’s the nuance of it that, I think it was Cabana from Bank of America, very articulately described — the process upon which this could actually be monetizing the debt. If we get into a situation where the Treasury is buying back all sorts of longer-dated securities and replacing them with near-dated T-bills, we could get into an environment where that T-bill issuance overwhelms the amount of capital that is willing to be invested at that part of the curve.

And if that is to happen, what would occur is the primary dealers would therefore have to go buy the T-bills, and they would pay for them with reserves. And once they started paying for them with reserves, the amount of reserves in the system would decline. And as the amount of reserves in the system would decline, funding at the front end would increase. And then the Federal Reserve would be faced with a situation where they weren’t able to keep their funding in the range that they wanna keep it in, and then they would do RMPs, reserve management purchases.

And this is what we experienced last year. As the Federal Reserve was reducing the size of their balance sheet, they were feeling around for the point where they hit this minimum level of ample reserves. One of the things that’s kind of difficult about that is you don’t know it until you see it. It’s like, you know, like Justice Potter Stewart said — just to keep this off color once more.

Matt: Keep this off color. Pornography and prostitutes don’t factor in through this episode. We’ll lose the audience, clearly.

Kevin: So one of the things is you don’t really know what that level is. But if all of a sudden you’re issuing a whole lot more T-bills and all the funding increases, the Federal Reserve’s response to that will be to do more reserve management purchases, and those are, in essence, a permanent expansion of the Federal Reserve’s balance sheet, because you buy them and it’s increased.

So de facto, what will happen is Treasury buys back 30 years or 28s, they issue more bills, the bills become more expensive on a relative basis. The Federal Reserve realizes they’re running out of reserves. They increase the size of the reserves. The long and short of it is that we’ve had this situation where they’ve, in essence, monetized buying back the long end of the curve. And that is the plumbing behind the concerns.

Now, my pushback to that is, you go and you figure it out — there’s, I think, seven long end liquidity buybacks that they did, which, by the way, interestingly enough, are between now and the midterms. They somehow—

Matt: The dating on this one is definitely...

Kevin: Yeah.

Matt: I think Shrub had the best memes of encapsulating this, but yes, please go on.

Kevin: So there’s seven of them. Seven, and now all of a sudden they were gonna be $2 billion each. They’re now $4 billion, so we’re $28 billion of long end bonds that they’re gonna buy. When you go look at the amount of the balance sheet, it’s a tiny little portion of it.

One of the problems, though, is if you look at the amount outstanding, that’s like a stock versus flow issue, so you have to think about it more as flow versus flow. But even there, I think there’s two, $300 billion of 30 years being issued. So yeah, he’s monkeying with the curve, but it’s a small amount. It’s not really that big a deal.

To me, it had more to do with the signaling and the willingness to do it. And the comment the next day was actually much more worrisome to me. We had the initial reaction, bonds rallied, and then all of a sudden everyone realized, “Oh, this isn’t that big a deal,” and they sold off a little. And then he said, “Oh, you know what? And if we need to, we’ll use the TGA,” which is the Treasury General Account. And now that account is almost a trillion dollars. And if he starts going and doing that, that moves the needle. And to me, that was actually a more worrisome comment than the initial one.

Matt: I wanted to ask you specifically about that, because — Liz Ann Sonders is on here, and she says the other week, “You can’t jawbone the bond market.” It’s too big and too deep for you to just talk and think that’s gonna have an impact. It doesn’t mean anything for you to say this and then pour out your little bottle of Evian into the ocean and say, “Tides.” That’s not gonna happen. But when you invoke the... So explain what the Treasury General Account, the TGA, is. Explain why that actually kind of freaks you out that he would say this.

Kevin: And you brought up Liz Ann on purpose, didn’t you? Because you know how much I think she’s the greatest strategist out there, the most underrated strategist out there, and I am a huge fan. When she’s on, I end up clipping her stuff all the time.

The TGA is, in essence, the government’s checking account. And the new reality is, in the old days, we used to just leave it — just like if you were running your checking account, you, in essence, try to keep it as close to zero as possible, and that was the whole process of it. And then in the Obama administration, we started, for some reason — I think it had to do with them getting ready for one of the government shutdowns — they borrowed a bunch of extra money and increased the TGA. And from then on, it’s just been this whirlwind of up and down, up and down, and some really large numbers.

And one of the problems with it is if you think about the mechanics or the plumbing. It’s one thing if you go and borrow an extra couple billion dollars so that you have some spare change money in the coffers for the government. But they’ll go and borrow 100, 200, 300 billion and not spend it. So in essence, you’re withdrawing money from the system as you go and sell bills or issue whatever security into the system, and then there’s no benefit. There’s the liquidity withdrawal, and then there’s no actual economic benefit.

And increasingly, as the governments have become more sophisticated and understood this, they’ve used it in political means in terms of timing. Nobody’s gonna give the next administration a full TGA — or at least they’re not gonna do that anymore.

And so one of the things that I’ve assumed is that Scott’s gonna spend down the TGA in front of the midterms. You’d be dumb not to, right? It’s just the way it is. Game theory tells you to do it. The real question, I guess, is: how does he end up doing it? It’s kind of dumb to be issuing and then buying back your own stuff through the TGA, and it just shows you what a mockery of the whole financial system this has become, as people use these mechanisms for their political gains.

And I think that that was really also one of Druckenmiller’s main points — that, you know, stop monkeying with markets. Let us see where the prices are. The prices are an important signal. And I am definitely in that camp.

Like, one of the things that bothers me about MMT — and I am MMT sympathetic, so don’t think that I’m slagging on them — but they are willing to ignore the signals that the market is sending you in terms of what the bond yields are doing. And I think it’s important.

I don’t know if I’ve ever said it on this show, but I love telling the story about how Liz Truss went and made a budget and the long end of the UK gilt curve went no bid, and everyone said, “Okay, that’s the market telling you that that budget is not appropriate and it’s too much.” And everyone was very quick to take that signal and to say, “Oh, there’s the bond market telling the government how much they can spend.”

But yet we had this situation where yields went negative in the post-GFC world. And to me, that was also a signal. That was a signal that too many governments were either spending too little or taxing too much — you pick whatever based upon your political persuasion what you wanna do. But it’s a signal, and I believe you should let the markets give you those signals, ‘cause they’re important signals to take. The collective wisdom of the markets is better than any one individual, and especially one individual that’s running it with a political agenda.

Matt: Well said. Let’s get into some of the other things that are pushing growth and maybe having at least a shadow on some of these yield moves. I wanna talk about earnings. You were talking recently just about where we are for earnings in this cycle. We’re looking at the beats accelerating. We just had a big, big Nvidia earnings come out before this. This is feeling pretty wild. So what are the numbers saying? But then more importantly, what are the bulls missing about this earnings acceleration story?

Kevin: Yeah. So it is a tough one, and not only that, Matt, I’m an economics major, I’m not an accounting major. And when I did my CFA, the part that I hated the most was the accounting. Contrast the difference between American and German accounting, the depreciation of goodwill. And I’d be like, “No. I do not wanna do that.”

So I’m reluctantly having to understand earnings and explain why it matters from a macro perspective right now. But I’m gonna go to one of the guys who understands earnings much better than me, and that is Jim Chanos. And he has very eloquently talked about how this is an earnings bubble, and how the reality is that we have this situation where for every 10, 20, 50, $100 billion that Microsoft borrows to go and build out a data center, the benefits from that in terms of buying chips from Nvidia, buying Bloom Energy — the benefits are immediately felt. That money goes... that’s where earnings are immediate. And yet the expense side of it is amortized over the next five, seven, 10 years, whatever it is.

So the larger this AI build-out becomes, the more earnings get bumped. And it’s fine if the benefits from that data center actually are what everyone assumes they’re gonna be. But, ah, man, the reality is that as you’ve got Microsoft and everyone spending money, the analysts are also getting more bullish, so they’re increasing the multiples, and they’re assuming the earnings are gonna grow. So the earnings are growing on both sides of it as the bubble has grown out, and it’s just increasing the risk more and more.

And there’s a million things when you’re looking at and thinking about the dangers in this market. Everyone says, “Oh, it’s okay. The stocks are cheap.” And I’m like, “Okay, yeah, I get it. The stocks are cheap in terms of the multiples.” But when you think about this earnings bubble, and then you stop and think about the reasons that you bought these stocks way back over the last five, 10 years — one of them was, they were cash flow machines. That was what you’d always hear.

Well, guess what? They’re not cash flow machines. They’re buying back stock. Well, go look at a chart of Google in terms of the number of shares outstanding. It’s been going down for the past 10 years, and then for the first time, it’s going up. They’re borrowing aggressively.

Matt: And throw free cash flow on top of that chart while you’re at it, because, yeah. Keep layering them on.

Kevin: And the numbers are just massive. And I think we’ve become numb to this, right? Like, we’re just sitting here, and we’re tossing around these big numbers and — what’s the guy, the Leo...

Matt: Situational Awareness, yeah.

Kevin: He went and lost $30 billion.

Matt: What did you do when you were 25?

Kevin: Long-Term Capital almost brought the system down by losing $4.5 billion. And he lost 30 billion in the space of two weeks. And to be fair to the markets, they barely blinked, and it’s just continuing.

But all of this is based upon that earnings going up, and I am so scared that they’ve all become one huge monster bet, and that at some point it’s not gonna meet expectation, it’s not gonna meet the continued growth.

And I always say nobody knows when the dot-com bubble actually peaked. But one of the theories is, the Gartner Group, which was a very important firm at the time, they issued this report that said the internet was doubling every 270 days instead of every 180 days. And that’s all it took, was a slowing of the rate of growth.

But anyways, going back to your thing about the dangers from the earnings — I understand why they’re going up. I understand why people believe the stocks are cheap. But I think that what they are missing is that this is not a bubble in terms of those prices that they’re paying in terms of multiples on the stock. What they are missing is that it is a bubble in terms of that actual earnings. The largest infrastructure build-out in history is getting accounted for in earnings, and we’re taking all the benefit right up at the front and then saying the stocks are cheap.

Matt: You put it this way, and this is something I was feeling but I was having trouble articulating — that basically stock prices could actually decline before earnings do in this dynamic. And I think that is such an important observation here, because it actually says the prices of the general market might actually recognize this before we see earnings come down. And then it’s a whole other conversation about what does cheap look like in that reality. Why prices before earnings? Explain that.

Kevin: Well, if you go look at 2022 when we had the last earnings rolling over, it is very clear if you pull up next 12 months EPS, you will see that it continued to grow after January, February, March of 2022, as the stock market was rolling over. So we had a situation where — I can’t remember the specific numbers, but let’s say it was trading at 20 times earnings — and the stock market was declining even as earnings were increasing. And then eventually what happened was, when earnings finally rolled over, the stock market actually stopped going down.

And so one of the things we always need to remember is that the stock market is a forward-looking instrument. They are gonna anticipate it before the actual earnings roll over. At least I hope they do. That has traditionally been the case. So it’s just kind of the way this game works.

And one of the smart pod shop guys that I talked to, I remember him talking to me about the semis, and he’s like, “Everyone knows the semis are gonna roll over, and that you never wanna pay too much for peak earnings because the earnings are gonna collapse.” But this is all a game of just trying to figure out, maybe there’s one more quarter, and if I get one more quarter with this growth, then I can make a lot more.

And I get it. From his perspective, that’s the game he needs to play. He needs to be sitting there saying, “Is there one more quarter of growth?” But for a lot of those retail investors, I’m gonna push back and say, “This isn’t a point where the risk/reward makes any sense from a long-term perspective.” And you should be taking advantage of the fact that you do not have that same sort of mandate pressure that a lot of professionals have, and you should say, “I just refuse to play.” And I firmly believe that today retail is at an advantage over institutional, because they can choose to not play the game.

Matt: Well, I find that point hard to argue with for a whole bunch of reasons, and between earnings concentration and everything else. Think about it. If you don’t have an institutional mandate, this is your shot to think about this, ‘cause it hasn’t been this weird in a while.

Kevin: Yep.

Matt: It really hasn’t.

I wanna talk about another thing that hits retail that, A, you’ve got the background in ETF land, from market maker trading days. You’ve been writing about the systemic risk basically with these leveraged ETFs. You have some great points here.

Kevin: Yeah. So I don’t think people appreciate how much this is changing the nature of markets, these levered ETFs. And I don’t think they understand what they are, and I think that a lot of people own them for the wrong reason.

And all you had to do was look at that 7709 in Hong Kong. It was an SK Hynix levered ETF, three-time levered ETF. And I can’t remember the number. It went from like 2 billion to 30 billion. So at that point it’s tossing around $90 billion of SK Hynix or whatever the name of it is. The growth in these things has been furious. It was part of the reason that that Situational Awareness got crushed so bad.

And one of the things people need to understand is that they are very reflexive in terms of how they work. And let me just explain to folks in terms of the hedging of the underlying assets and why that is so important.

When you buy one of those, you are not buying a triple levered — let’s use the SOXX, ‘cause I like that one, the SOXL. You are not buying a triple levered of the SOXX return over the next month. What you are buying is a triple levered of the daily returns for the next month. And I know that sounds like, “Oh, that can’t be that much of a difference,” but it actually is a huge difference.

And you might say, “Why did they make it that way? That doesn’t make any sense. Why isn’t it just like you buy it and you get three times the leverage?” And the reason is, if you stop and think about it, if you go and open an account and you buy three times levered SOX index, and the price goes down, your broker either sells you out or demands more money, right? Obviously, if it goes your way, you’re fine. But your exposure to it is not the same. As it goes down, you have less equity in your account. Let’s just say you put 100 grand in, you buy 300 grand of SOXL, and it goes down 10% in a day. All of a sudden, your equity to position has increased.

So the way that the levered ETFs work is that they reset every night. They reset so that your equity to the position is proper. And what that means in practice is, as it goes up, the ETF is buying more every close, and as it goes down, they’re selling more every close.

And listen, when these things were just kind of a quirk and nobody was trading them, not that big a deal. But these things are huge. There are so many of them. And what it does is, when we got the rally in the SOX and the SK Hynix and stuff like that, every night there was more and more buying. And then people go, “Oh, look at how great this is behaving.” The reality is that the public is getting more and more levered to those instruments as it goes up. And this is way more dangerous than we are giving credit for.

And there was recently just a kind of a crappy little one — it was on Lucid. And Lucid, for those who don’t know, is this EV maker from way back when. And there was this levered ETF. I think it only had a few million dollars in it or something. It wasn’t very big. But there were rumors that Lucid was gonna go bankrupt. And all of a sudden the thing collapsed and it went down 45%.

And if you stop and think about it from an ETF provider perspective — this was a two-time levered one. So if they’re sitting there and they have twice the exposure to Lucid and it goes down 55%, technically they are negative equity at that point. So they need to make sure that they don’t get hurt by that. So what they do is they have the option to basically close the entire ETF. So as it gets close to the stop-out point — and this was what happened with XIV, the very famous thing, and nobody had ever thought about it back then, but now we’re a little closer and we understand it — we got to this situation where Lucid went down 45% and all the ETF providers said, “Oh gosh,” and they flattened it. So it went down 55% because they were busy selling off the position.

And one of the things that we need to remember is, as these things become larger, they become targets. And we have to remember this about Wall Street and about these hedge funds — there’s just a lot of sharks out there, right? And I could see a situation where if we got into some trouble in the market, we had some sort of event. Let’s just take the SOXL. It’s a three times levered on the semiconductor index. If all of a sudden one morning we get up and it’s down 25%, you’re sitting there and you’re some big huge hedge fund, you go, “Look, I can push that another 10, and then I can stop them out and I can buy it.”

And one of the things is, as these ETFs work today, all of the buying or selling happens at the close, because it’s based upon the closing price. But if we got in a situation where midday things were coming unglued, stocks will come unglued. All of a sudden we have the liquidity demand for that, and that ends up being one event, and then that pushes something else down more, blah, blah, blah.

So to me, I look at this, and one of the things that we just have to remember is that in crises, or crashes, it’s always something we haven’t considered or we don’t think can happen. In 1987, it was the portfolio insurance, and the problem with portfolio insurance was that they assumed as they could go down, that there was gonna be someone to sell to. And it just kept going and it fed upon itself.

This, to me, feels like it has the potential to create an event. And listen, I don’t wanna be the doom guy, doom at 11. I don’t wanna be that guy. But having said that, I think you should be aware that the market and the underlying structure is becoming increasingly fragile. And just put that in when you’re thinking about the risks out there in the system. Don’t just ignore them and say, “Oh, nothing’s gonna happen. There’s no way this is gonna be a problem.” These are products that are running amok, and they’re much too big for the underlying system.

Matt: In what may go down as the worst through line in Excess Returns history, it reminds me of the stripper in The Big Short with the houses. Where you have to remember, anytime there’s leverage, other people are impacted by the decisions made with the leverage.

Kevin: Right.

Matt: And I don’t think that that’s being discussed. When we talk about levered ETFs, we talk about the poor yahoo 60-year-old trading these things, presumably with his kids living in his basement or whatever, right? Like we talk about it like it’s his personal retail woe trading story of, “Oh, blew up another retail trader being stupid,” or like, “Oh, the crazy Koreans and SK Hynix and what.” We don’t talk about what that means systemically with the leverage around the product. And I see that as tying into what you’re talking about with earnings. We’re talking about where those earnings are focused.

Kevin: Yeah. And so we have this situation where we have an environment where the stock market is getting increasingly concentrated in terms of one theme, which is AI. So the stock market in the index itself is already getting dangerously concentrated, like the most we’ve seen since 1929. And then we’re going and applying levered ETFs on those things that we already know are fully priced and prone to disappointment.

Oh man, Matt, it’s scary. But in the meantime, you just look like that old man in The Simpsons yelling at clouds. And that’s unfortunately where we’re at.

Matt: Yeah. Except it’s not an old man yelling at clouds. It’s literally like degenerate gambling on bum fights or something. It’s just morally bankrupt.

Well, this isn’t gonna save us, but let’s talk about gold. You think gold is back, baby. What I love about this is you were actually talking about the toppiness of gold in 2025. The bottom buying was a little touchy. But you’re feeling pretty positive about it again. And this is interesting, and it felt very timely from when the most recent comments came out.

Kevin: So one of my heroes is Dennis Gartman, and for those who don’t know, he’s this famous Wall Street newsletter writer, and he has this saying that in bull markets, you should be either long, really long, or flat.

And I have been adamant that gold is in a bull market ever since 2022 when Russia invaded Ukraine. I think that the People’s Bank of China is the only player that matters, and that they’re gonna continue to diversify their reserves into gold. But yes, I was really long. I got a little less long in 2025 as we rallied, and then I got flat as the madness in late ‘25, early 2026 kind of enveloped everyone.

I was always joking because people would say, “You know, Kev, what do you think about gold here?” And I said, “My job is to tell you what’s on page 18 on the way to page 1. It’s been stuck on page 1 for the past two months, and I have no clue what’s going on now.” It was just complete and utter madness.

On the way back down, I did give a shot at trying to buy it. I was right for about 10 minutes, and then the decline kept going again. I did a couple weeks ago step back in, and it was one of these cases where, if I’m thinking about it from the People’s Bank of China’s perspective — and that’s what I always try to keep in mind — their goal is to buy as much gold as they can for as little as possible. Not today, not this week, not next week, but for the next 10 years. And if I’m thinking about it from that perspective, what do I do as the market gets frothy? I walk away. I don’t go and chase it and let all these guys that have run the price up on me sell it to me at a higher level.

So I’ve just been waiting for the signal to go back and buy gold. Now, I know a lot of folks have been focusing on real rates or the US dollar, and ever since 2022, I’ve been telling everyone to put away their multi-regression linear models and just forget about that, because that isn’t what’s been driving gold, and it won’t be what’s driving gold. So I’ve just been sitting there going, “The People’s Bank of China are gonna come back. I just gotta wait for them.”

And I’m kind of embarrassed, but I was just letting the crayons tell me when to buy it. And one of the things was there was this really nice 50-day moving average that it kept bumping up against, and it was overhead resistance. And I just sat around saying, “One of these days that’s gonna get broken, and we’re gonna see it go.” And while everyone was kind of nervous about it because the US dollar was doing something, and oil was going up and traditionally oil recently has been negatively correlated with gold, I said, “I’m not gonna overthink this. This is a bull market, and I’m just gonna do my Dennis Gartman, and I’m just gonna pull out the crayons, and I’m gonna go with something as simple as technical analysis.”

And I do have a funny story about this, because I’ve been lucky enough, like you, to interview some great people and some terrific traders. And you think that there’s always this sophisticated analyzing things, putting it into their models and things like that. You’d be shocked at how many of them are just crayon chewers and just chasing charts. Like, you’d be shocked.

And I know I told this story. I got a buddy that reached out to me and he says, “Kev” — and I’m not gonna tell you the name, but it was somebody very, very famous. And he said, “This guy, I’m sitting there. He’s presenting to us.” I can’t remember if they had money with him or whatever. And at the end, he said something like, “Up to 50% of my trading is technical.” And the guy was like, “What? Did he just say that he’s basically using charts for 50%?”

And unfortunately he didn’t get a chance to follow up. But I firmly believe that it wouldn’t surprise me at all if you went and did the Market Wizards guys, that at least that amount is just pure technicals. And for me, I’m not a true technical guy. I have to have the fundamental story. So I know my fundamental story. I use technicals as the trigger. That was the trigger. I still think it’s behaving well. I still like gold, and I think it’s gonna continue to surprise to the upside.

Matt: One of the other facets that’s interesting whenever you’re writing about gold is you talk about the other players in and around it. You’re talking about platinum again. I’m curious at the non-gold other metal things that we only understand abstractly in our financialized world, but actually have a purpose.

Kevin: So I was mad at myself, because I happened to miss the platinum rally last year. And one of the things about the platinum was it was trading below the cost of production. And any time a commodity is below cost of production, it just piques my interest. I’m like, “That can’t go on forever.”

Matt: And back to the story idea. You want the fundamental story. Below cost of production is a compelling story for, this has to get righted.

Kevin: Right. And I’m lucky enough — you mentioned Shrub, so I’m lucky enough to be friends with Shrub, and I remember him pitching me and somebody the platinum story. And I thought to myself, “Oh, I gotta make sure I get long this.” And then something happened, some personal stuff in my life, and I missed it.

Matt: You were busy in your platinum mine? Is that what happened? Be honest.

Kevin: Be honest. And so when this gold came back and I got another shot at it, because I wasn’t gonna chase it with everyone else... If you stop and think back to late 2025, early 2026, when we had silver at like 100 bucks, and it felt like it was never gonna go down.

And actually, we should talk about this, because I’m a firm believer that — I came up with this thing about the series of rolling bubbles, and I wrote that way back when. Actually, Matt, I went and found it. It was 2014 I wrote about that. And for those who know me well, they’re gonna get a big kick out of the stock when I wrote about this. I said, “You know, I think there’s a chance that we could get a little mini bubble here. And if you’re looking for a flyer, I got this stock that you should try. I think it might double. Might even triple.” And the stock was Tesla.

Matt: You Tesla bull, you.

Kevin: I know. There it is. For those who don’t know me, I can’t stand Elon. So it just goes to show how long ago it is.

Matt: No kidding.

Kevin: But one of the things that I do believe is that it’s only gotten faster since then, and these mini bubbles are occurring with increasing speed, increasing ferociousness. And I think that gold and silver were just one of them. And one of the things that I just want to remind everyone is, think back to how good it felt at that point. It felt like it would never go down. And I wanna remind them of that when they’re thinking about AI today. These little mini bubbles are occurring over and over and over again.

But anyway, so back to platinum. I picked some up because I think we’re going into another precious metal bull market, and I didn’t wanna miss it. But I don’t know enough — I have a nice big theme for gold that I truly believe in. Platinum was a cheap asset versus the cost of production. At the same time as well, I understand that the whole EV push was kind of overstated at the time, so it kind of felt like nobody was ever gonna build another catalytic converter. And I think the reality is that the hybrid cars are winning. Those were getting built.

Matt: You can blame Tesla for that. It’s okay. If you wanna blame Tesla, safe space. Safe space.

I think it was — it might’ve been Rich Bernstein, could’ve been David Rosenberg, somebody like that, somebody who would get invited to speak at a gold conference — basically said one of the worst sentiment indicators for stuff like the price of gold is when you’re at the gold conference and all these people are coming up to you ‘cause they wanna ask you about how much silver they should own.

Kevin: Yes.

Matt: And I feel like that same with the AI stocks and whatever. Or else Mag Seven — it’s like, “Uh, yeah, I don’t wanna talk about Mag Seven. I wanna talk about how much of this weird cloud computing company no one’s ever heard of.” And it’s a different form of a derivative way to talk about it, where it’s like, “I want more juice than the already amazing juice that I have.”

Kevin: Yeah, 100%. You know, Bill Fleckenstein, he was a newsletter writer. He famously has his hate-o-meter. ‘Cause he was perpetually bearish, so he said when he got lots of hate mail—

Matt: Haters are gonna hate, Bill.

Kevin: Haters gonna hate. He said, “When I got lots of hate mail, I knew the top was in.”

And one of the ironic things about writing a newsletter is that you wanna present ideas that are hopefully gonna be good investments. But the reality is that if you present an idea that gets a lot of applause, in terms of everyone says, “Yeah, you’re so smart to own that,” chances are it’s not gonna be as good of an investment as the idea where everyone says, “Mm, I think you’re wrong, but I’ve never thought about that. That actually might happen.”

And the reason is because — I think it’s Jim Grant has a famous line, “Good investing is having everyone agree with you... later.” And that is in essence the problem. If you go and you write stuff that’s popular, then it’s already in the price of the market.

And so the inside joke between us newsletter writers is that when we write something, we ask each other, “What was your feedback?” And if people tell you you’re an idiot, you double it, because it means that it’s not in the market. And that is actually kind of one of the funny little side things in terms of how markets work. And it’s just the reality of it. And I think that your Rosenberg story about the silver, everyone asking you one thing, is just another derivative of that same story.

Matt: Right. So I brought up PUP the band in the intro because I am trying to manifest another US tour, ‘cause I missed them on the last US tour. So I want Canada to export PUP tour dates back to me, because I haven’t seen them in like five years and I’m fiending.

Inside of that, though, you’ve been talking about the Canadian story. Certainly all sorts of trade stuff is back in the headlines. You actually were looking at some of this data. I think this is so important and so interesting as neighbors. As neighbors, as fans of the movie Canadian Bacon, on both sides of the border, we can all agree.

Kevin: I was gonna bring it up. I’m surprised you did. I was like, “I’m gonna bring up Canadian Bacon, and Matt’s the only guy I know that’s gonna appreciate that reference.” And everyone else is like, “What? There’s a mo—”

Matt: Oh, put the subtitles in French below us as we talk through this. Somebody please. Gotta do both languages.

Kevin: One of the best. Yeah. I’m gonna have to go watch Canadian Bacon again.

Matt: You and me both, my friend.

Kevin: Yeah. You know, it was funny, because Idiocracy was the documentary that we should all have watched for last year. So maybe this year the documentary is Canadian Bacon.

Matt: I’m ready to celebrate some John Candy with you, I’ll tell you right now.

Kevin: We’ll do a live stream.

So, Canada. Go Canada. So first of all, I’m gonna say some things that are bad about Trump. So let me get a couple things out of the way first, and one of them is Canada has been negligent in terms of our military spending. We deserve all the criticism that was leveled towards us in terms of not fulfilling our commitment. We promised we would do that, and we didn’t, and Trump was right to call us out for that. And I am, for one, super glad that we are stepping up and doing what we said we were gonna do. We shouldn’t have had to be bothered for that.

Next up with Trump. His stated goals are actually noble, or at least admirable, in terms of when he starts talking about the problems that middle America has faced in terms of losing jobs with manufacturing. He’s spot on correct. There’s no denying it. Globalization has crushed mid-America, just absolutely crushed it. We lowered all these trade barriers, and in essence what happened was every single manufacturing job was outsourced to China, India, Vietnam, wherever it is. And mid-America has been left behind with nobody to go fix it.

And one of the things I always kind of push back on when people say, like, “Everyone’s taking advantage of America,” I’m always like: what do you mean? You guys are like the wealthiest country in the world. You have nailed globalization. The amount of wealth that you have created through globalization is monstrous. You don’t have a wealth problem. You have a distribution problem. It’s just that instead of it being shared equally around amongst the country, it’s being increasingly in just a few hands.

So having said all these things — one, that Canada is not blameless and deserves a kick in the ass in terms of military spending, and two, that Trump’s stated goals of trying to fix mid-America’s jobs are actually quite admirable — I’m about to say why picking a fight with Canada is just dumb.

And it’s important to realize — and I don’t wanna seem like I’m coming off as sour grapes as a Canadian that’s mad about this, because Matt, I’m actually super happy with what Trump has done in terms of our country, because we’ve finally gotten shaken out of our economic slumber and are doing some things that we should have been doing ages ago. So I am ecstatic. I’m actually worried we are gonna come up with a trade deal, and we’re gonna somehow slip back into our old coma. So don’t take this as sour grapes. It’s nothing but. I’m very happy with how everything’s going from that perspective.

But what I think it’s important to analyze is, you’re trying to figure out what is Trump doing, why is he doing it, and will it be successful in terms of America’s economic stance? And when you think about it — if his goal is to try to return manufacturing to mid-America, to return the jobs that were lost...

When we had this breakdown in terms of our trade — I guess it’s a trade war now — I decided to go and get the numbers. Instead of just listening to what everyone’s claiming, I’m like, “I’m gonna go grab the numbers.” So I went to the US Census Bureau, and I grabbed the numbers for 2025.

And one of the first things I did was, okay, automobiles. Trump is saying how Canada’s ripping off the US. So I took automobiles, and then I realized that there were multiple categories, because you have this situation where we build a part, we send it to you, you guys do something, and then you send it back and stuff like that. So I got all the different categories, put them all together. Lo and behold, Canada has a $7.2 billion deficit, meaning you guys have a surplus to Canada in terms of the entire automobile section.

So I thought, “Okay, well, maybe Trump’s got that one wrong, but we’re ripping you guys off supposedly on other things, so let’s pull up every single category.” I pull up all the categories, and there’s just this one that’s just massive, and it’s oil and gas. And then — I can’t remember the number, $82 billion or something. And the reality is the other ones are like fives and tens and twenties in terms of net surplus or deficit. So when we’re looking at the deficit that we have with you guys, the vast, vast majority of it is from this oil and gas.

So I thought to myself, “Okay, well, oil and gas is actually a globally traded commodity, and you can buy that anywhere. Let’s take out oil and gas. Let’s just assume that you don’t buy any oil and gas from us.” Because let’s face it, it’s not like us pumping oil and gas is making tons of jobs. It’s making some jobs, but on the whole, we’re just pumping it out and sending it to you guys. In fact, you guys are the ones refining it and sending it back to us, so the value-added jobs are actually on your side.

So you take that out and then look at the trade deficit. Well, that trade deficit we have all of a sudden turns to a surplus. You have a surplus with Canada. So we actually buy more finished goods from you guys than the other way around. We are your best customer. We are selling you raw stuff out of the ground that we don’t do anything on, and then with the money, we’re buying it back from you guys.

So in terms of actually trying to fix the manufacturing jobs that were lost, picking a fight with Canada makes absolutely no sense. And not only that, man, it’s even worse. We were foolish enough to trust to sell you guys our energy, and we haven’t bothered to make pipelines to our shores. So we are landlocked. We can only sell to you guys. So we sell our oil at a discount, because we’re so stupid that we don’t go and open up markets, and we don’t go and put it on a barge because — well, it’s a long story of environmental crap and stuff like that. But you guys are buying our oil at a discount, okay? And then we’re sitting there buying all your goods from you, and then he’s saying, “No, no, that’s not good enough. You’re ripping us off.”

And I’m just at this stage where personally, it’s frustrating. You don’t hear Mark Carney talking about nasty Americans. He talks about the Trump administration. And then on the other side, we’re getting nasty Canadians. We’re getting attacked.

I’m increasingly of the opinion that we just kinda have to get on with our lives. I kind of view this whole thing as like, you’ve had a partner that you thought you were getting along with, everything was great, and then one night, in the middle of the night, they just punch you in the face. And then you’re like, “Hey, wait. What’s going on?” And then they go, “Oh, I’m sorry about that, but not really. And if you do it again, I might have to punch you again.” And you just kinda go, “Okay. I think I should just go find a new partner.”

And one of the things that I just wanted to make clear was, when you go look at who Trump is attacking in terms of us — and don’t forget, I believe that in some ways this is making us better — but when attacking us, it’s very clear that he’s not trying to achieve what he says he’s trying to achieve. And if he’s trying to achieve what he really wanted to achieve, which is put people back to work in mid-America, which is a noble cause — one of the things you can’t do in terms of having tariffs is to put them on, take them off, put them back on, change them, negotiate them.

If you’re sitting there and you are a business owner thinking about, “I wanna make a plant in the US,” what you want is the certainty that that tariff is gonna stay consistent. So if you wanted to do what he says he wants to do, then what you would do is you would pass legislation in that you would increase tariffs over the long run, and you wouldn’t turn them on and off. There’s no point in turning them on and off.

And so you have to really ask yourself, what is he trying to accomplish? And it’s not what everyone thinks it is. And not only that, here’s the real big takeaway that I have from it: I think it’s hurting America way more than people understand. And I just go back to that business owner that wants to potentially build the plant. With that sort of economic or policy volatility, he’s not gonna do it.

And people are gonna go, “But, but, but,” and they’re gonna say that, and I’m like, “I have no problems.” I think that if I was an American congressperson, I’d be like, “Let’s do tariffs. Let’s just do 10% to Canada across the board, and let’s just leave it, and let’s not negotiate it, and let’s just do it.” But these things that are happening are just introducing volatility, which is reducing economic certainty.

And it’s one of these things that when you make presidential policies, it’s often difficult to judge how good or bad it is. Like if we go back — was it Roosevelt that did the New Deal? I get your presidents confused. So he did the New Deal or whatever. I think you felt the benefits of that for decades to come. And if you think about Eisenhower putting the GIs back to work, building the interstate highway system, that was felt for decades. It was one of the reasons America was so great for the longest time. They had this terrific highway system.

Matt: We still feel it. These things have far, far, far-lasting—

Kevin: Right. And I think that you’re gonna be feeling the negative effects of the current administration’s economic policies for a long time to come.

Matt: I think it’s important apolitically — and we’ve talked about this before, and this is where I come down personally on this stuff, where it’s like I have to talk to people with all sorts of random views. I don’t wanna talk about politics, I do wanna talk about policy. What you’re laying out is a policy issue that introduces market volatility. And so no matter what you think about it, play this forward. Because this doesn’t have a good natural conclusion for either party at the table, and there’s bigger ramifications of playing this game out. And therefore you have to discount this into all the other things that feel positive about this market or positive about this economy, or just number go up in your brokerage statement.

Kevin: Yeah, ‘cause EPS go up. And to me, the fact that he’s picked on Canada — and again, I am happy he’s picked on Canada ‘cause it’s awoken us from our slumber, so do not take this as sour grapes — but the fact that he’s picked on Canada shows you that he’s not really truly trying to put people back to work. ‘Cause let’s face it, Matt, Canada has suffered from the same hollowing out of the manufacturing jobs that America has suffered from. It’s not like the American Midwest lost their jobs and they went to Northern Ontario. That’s not where they went. They went to China. They went to India. They went to other countries. They did not come here.

We are suffering from the same thing America is suffering from, and we would be so much stronger together, coming up with plans to push back against that and to make a system where we can all trade for the lowest amount and share all of our things. And instead, he’s picking a fight with us instead of going after the real problem.

Matt: There’s one thing you’re unlikely to hear from me, it’s surrender pronto, Orwell level Toronto. So again, save face, Kev. Save face.

I approve of this rant. I think the policy implications of this are still well, well under-discussed. I was super impressed when you did the math on that, because I don’t see the argument with the math accompanying it, and that was a really interesting walkthrough of all these steps.

Kevin: I appreciate that, Matt. You know, I almost didn’t write anything. I almost thought, “Here’s a story in picture terms,” and was just gonna post this and let you people decide. But then it’s like, “Oh, I better actually write something.”

Matt: Yeah, I better actually write something. Sometimes you actually have to not just ChatGPT it to The Wall Street Journal, and you gotta do the work.

Kevin Muir, people wanna bug you on the internet, find more information, where should we send them?

Kevin: They can send me an email, kevin@themacrotourist.com. And listen, I’m happy to send people that latest piece, so just send me a note and I’ll pass it along, and you can see the numbers for yourself. Matt, it’s always a pleasure being on the show. Thank you very much for the opportunity.

Matt: Kevin, we love having you on. We love the takes. Big fan of The Macro Tourist stuff. Make sure you check that out. Take him up on this. You wanna see the math. There are policy implications that, again, nobody’s feeding this through ChatGPT and sending it to the Journal op-ed page, clearly. At least not yet.

So Excess Returns right here on Substack. We’ll have transcripts, notes from this episode, much, much more. Like, comment, subscribe, all the things below, and we’re out.

Topics covered:

• Why private equity became a consensus trade and why exits are now clogged

• How leverage and high debt costs threaten private equity returns

• What publicly traded private equity funds reveal about true volatility and NAV discounts

• How private equity shifted from old-economy buyouts into software and healthcare technology

• Why AI may have erased code as a software moat while strengthening other intangible advantages

• How ARR lending helped private credit finance software buyouts and created an obsolescence mismatch

• What AI is doing to hiring, junior roles, productivity and the composition of work

• Why the AI CapEx boom may be a crowded, path-dependent overinvestment cycle

• Why traditional value metrics work better in Japan than in the intangible-heavy U.S.

• How Tokyo Stock Exchange reforms, buybacks and dividends can unlock value in Japanese small caps

• How R&D spend, specialist ownership and short interest can help quantify biotech value

Timestamps:
00:00 Intro
04:03 Why private equity’s debt burden changes the equity math
09:24 How private equity became a software momentum trade
13:29 Why code may no longer be a durable software moat
17:48 How private credit enabled software buyouts through ARR lending
23:56 AI productivity, jobs and why displacement is slower than expected
30:23 Why the AI CapEx boom may be the market’s most crowded risk
34:29 Rational overinvestment, leverage and the timing risk in AI
38:46 Why consumers may capture more of AI’s value than investors
44:07 Japan’s below-book-value reform and the return of old-school value
51:03 Quantifying biotech value with R&D, specialist ownership and short interest
55:08 Dan’s non-consensus views on private markets and Japan

Learn more about the Excess Returns podcast network:

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No information discussed in this podcast should be construed as investment advice. Securities discussed may be held by the hosts and guests, their firms or their clients.

Dan and I actually go way back. We were classmates at Harvard, rowed crew together, and later independently found our way into the esoteric field of quantitative investment management. Dan, it’s great to see you, and welcome to the Intangible Economy.

Dan: Thanks, Kai. Delighted to be on. This will be fun.

Kai: Yeah, I’ve been looking forward to this. So we’ve done a couple chats together over the past year. And I know going back even further, you’ve been a really early skeptic of what’s going on in private markets, private equity, private credit. And it took some time, but over the past year or so, things are really starting to change.

And so I’d love if you’d start off just with a quick update on where things stand. We last spoke in January, so about six months ago. What material developments have unfolded since then? What should listeners be aware of in terms of where we now stand in the cycle?

Dan: Yeah. I think the private markets story is sort of a classic one in markets. And I think you and I, Kai, both love studying history to try to learn the lessons that it can teach. And I think one of the lessons is that investment fads rarely end well. When everyone agrees on things, you can almost bet that those things they agree on will be accompanied by future subpar returns.

And private equity became the ultimate consensus trade. Every endowment, foundation, RIA, family office said that private equity was the best performing asset class, and therefore you needed a very large percentage of it in your long-term strategic asset allocation. I mean, you could literally parrot the kind of BS talking points that got fed to everybody from this sort of herd mentality, groupthink propaganda.

And so the money flowed in. And how do those things typically end? Well, people pay too much. The asset prices get inflated, and then those inflated asset prices take years to deflate, and that deflationary process is very bad for returns, and that’s exactly what happened.

So purchase prices in private equity reached almost probably 20 times EBITDA when public markets were trading at probably 15 and small caps at 12. And now multiples have kind of come in from there. And as long as money was flowing into private equity, you could sell to the next fool. But when money stopped flowing in, you had to sell it to somebody real, and turns out nobody else wanted to pay those crazy prices.

And so now there’s a massive backlog. They can’t sell the things they bought at those prices, so they’re doing continuation vehicles and all other weird financing tricks to try to hold onto the assets that they can’t sell. And everybody who invested in private equity during those peak years is stuck in it and can’t get out, ‘cause the private equity firms can’t exit their companies, and so you can’t exit your investments. And I think the whole thing has become a massive train wreck. And I think it was eminently predictable, although highly, highly non-consensus.

Kai: So you’re saying that things are starting to unwind, but the industry is doing its best to slow things down — continuation vehicles and such. As an observer to the industry, how would one go about trying to assess what is the true mark that these assets should trade at? How do you see the cycle unwinding? Obviously they’ll do what they can to slow down the bleed, but at some point you would assume that these vehicles have to end, and the investors have to get back their money.

And so both from a standpoint of markdowns, but also in terms of liquidity and distributions, how do you see things playing out? And again, where are we in the cycle? How much more time do you think it’ll take for things to get back to equilibrium?

Dan: Yeah. Well, I think one big problem, Kai, is the amount of debt on the balance sheet of these companies. They didn’t just pay 20 times — they paid 20 times, and half that was debt. And so you’ve got this huge private debt stack that the equity is subordinated to, that’s often paying interest at 10, 12, even 14 percent, depending on how risky the asset was. And there are not that many really small micro-cap companies that are earning at 10, 12, 14% return on assets. And so these capital structures are just inherently problematic.

And so I think what’s gonna happen in more and more cases is that private credit... You know, private credit gets so much criticism, and deservedly so. But if I had to bet which is gonna do better over the next five years, private credit or private equity, I’d be putting my money in private credit. I think it’s a better investment, because at least they’re getting cash flow back. And at those rates, it’s really hard to see how the equity survives and grows.

And so I think really what I’m watching is some of these debt servicing, how that’s developing, whether you’re starting to see creditor-on-equity violence, as it were, and how these refinancings go. And again, my money is that the debt side has the leverage right now.

Kai: Yeah, you had done some interesting work — I think we talked about it a few months ago — on the publicly traded managers of these funds and the listed funds themselves, which kinda give you a cleaner proxy, I guess, for what’s going on in the underlying assets. What’s the latest there?

Dan: Yeah. That was a fun one. The essential argument is that one of the reasons everyone liked private equity was that they report on a quarterly mark basis, and so they never had some sudden shock drawdown. They never were down more than the market. It always seemed manageable. And by the way, they reported a month after your reporting to your boss was due, and so you could always say, “Hey, we don’t have fourth quarter marks yet.” So there were always all these benefits to owning PE in that sense.

And one of the other striking things is that when you looked at the volatility of private equity on the reported numbers, it looked about as volatile as investment grade bonds, which is why everyone thought it was so safe.

And so we just did a simple fund analysis — Richard Ennis and I did this together — which is that if you look in London, there are a bunch of basically LP interests in private equity funds that are publicly listed. So HarbourVest has one, and Partners Group has one. And these are direct fund investments, right? It’s not the manager. It’s not like Blackstone or KKR where the management company is listed. These are fund interests that are listed.

And so what you can do is you say, “Well, how volatile are those?” Those are mark-to-market PE funds. How volatile are they? And it turns out their volatility is like, eh, twenty-four, twenty-five percent annualized, which is just a little bit more than small cap. And so you’re basically like, what a shock. Turns out private equity is a little bit more volatile than small caps, which makes sense ‘cause it’s levered micro-cap, so it should be a little bit more volatile. And so I thought it was a really clever, simple argument. And of course those vehicles are doing horribly this year, along with private credit.

Kai: Right. It’s not only a way of looking at the volatility, but also the discount to NAV, right? So you can get a sense of what do people really think about the true quality of the underlying assets.

Dan: Exactly. And basically, for a long time, they traded pretty close to par. And now they trade like closed-end funds with a 30, 40% discount to NAV, which is probably where private equity should trade in aggregate.

Kai: Got it. So let’s shift gears now. Let’s talk about the underlying assets. And given the theme of the show, the intangible economy, I wanna focus in particular on a transition that we’ve seen in terms of the sector mix of these assets.

So when people think of private equity, they probably think of LBOs and buyouts of old economy industrial businesses, car washes, dental practices, veterinarian clinics, right? The interesting thing is that the world’s quite different now, and that picture is somewhat obsolete. And you talked about this on our last chat — that over the past one, two decades, there’s been a pretty marked shift in terms of the focus of these companies, in terms of moving from your mature old economy businesses to what’s basically software, or software as a service, SaaS companies.

And so I’m really interested in this migration. Maybe you can walk us through the history and talk a little bit about the magnitude and the extent to which this has happened, and the effects on valuations and other components, and just the shift in the private equity business model that has come hand in hand with the transition from private equity being kind of a small cap value play to a more midcap, or whatever, growth technology play.

Dan: Yeah. I mean, I think that someone said that investment committees are momentum investors with a three-year lag, right? And so you see allocators and they basically say, “Hey, what has the best three-year trailing returns? Let’s add to that. And let’s take money from the thing that has the worst trailing three-year returns.”

And that actually is a good model, if you look at how the money gets allocated. Which is why private equity’s allocations are going down now. And I think you’re gonna continue to see that. The bloom is off the rose, and the trailing three-year numbers suck. The allocations are gonna go down.

But I think what’s funny is if you think about private equity firms, they are momentum investors on a little bit longer timeframe, a four or five-year timeframe. And really the dynamic is that to make partner, you gotta get a successful deal done, right? So you have to do the deal and then you have to exit the deal. And if it’s a four or five-year horizon, that’s sort of the window on which that is gonna happen.

And so if you think about who on the investment committee has power at any given time, it’s the person who did the deals that four or five years ago now look like the fund’s biggest winners. So it has to mature. That maturity gives power to those people. And so what ends up happening is the people that did the bad deals four or five years ago get fired, so that when you go out and fundraise, you can say, “Hey, pro forma for those guys that left, the fund actually did really well. And if Ed and Harry hadn’t been here, look at what the fund would’ve been — even better.” And so it sort of cycles in and out like that.

And so what you saw, if you sort of trace that five-year history, is that in 2014 and ‘15, everyone was getting really excited about energy private equity. It’s kind of funny to think back, but that was the sexy thing. And people were saying, like, SCF and Lime Rock, “These are the best, smartest investors, and we need to go to the oil patch. We need to put money in shale.” Right? And then that blows up in ‘15 and ‘16. And so all that stuff gets deep sixed and, “Oh yeah, that was a separate energy fund. It was a carve-out. It was never part of the core strategy,” blah, blah, blah.

And then what people start seeing is — remember, software multiples had come way down during the financial crisis. And then as they started to come back, everybody started looking at Thoma Bravo and Vista in 2014 and ‘15 and ‘16 and saying, “Whoa, look at their returns. It’s unbelievable. Software is an amazing thing for private equity. We should do that too.” And so the software guys started to do deals. And those deals looked really good in 2018 and ‘19. More money was put to work at crazy prices. Then COVID hits, and COVID sends this stuff through the effing roof, and so more software deals get done.

By my estimate, probably 40% plus of private equity by 2021 or so was software or healthcare technology, which was basically healthcare software.

Kai: Wow.

Dan: And so you had, call it 40% of the money during that period going into software or healthcare software businesses, at crazy prices. And there was this sort of new economy narrative that software’s eating the world, and so you can pay whatever you want for any software asset.

But I think what’s sort of funny — I was keen to ask you about this, Kai — is these were always sub-scale software businesses. Private equity wasn’t taking private Salesforce or Adobe. They were taking private some company that had cornered the market on, like, car dealership software in the tri-state area or something, right? That was the stuff that was of the size range that they could buy.

And it’s unclear to me that there was all that much intangible value at these things. Like, yes, they were software businesses, but did they really have this IP moat? Did they really have a talent moat, or were they kinda just generic, kinda crappy software businesses that had captured a certain high market share in a niche? And I don’t know what your research shows on that, when you go down into small caps and how software scores in intangible value. I’d love to hear what your research says about this.

Kai: Yeah. So I’m not an expert on private markets and this tier size of companies. I can see how it fits the narrative really well if you’re selling to an LP and say, “Hey, look, we roll up car washes. Why not roll up the software that the car wash uses?” And that makes a lot of sense. It seems like a natural extension of the business, and to this extent that, yeah, they can’t take private Oracle, so that kind of is within their realm.

In terms of where we are today — I mean, this is kind of the next question, I guess — which is, with public software stocks like Salesforce you mentioned, Adobe, these stocks are down fifty to eighty percent, right? And those are the big boys. These are the guys that presumably are the most well-positioned.

I think that it does beg a lot of questions. So the research I did in May was around the question of the software sell-off. Obviously, there’s gonna be a huge amount of dispersion. There’s gonna be a lot of value traps in what otherwise looks like cheap stocks, and then some companies that will likely recover, and it’s probably overblown. And if they survive, just based on the amount of their drawdown, they likely are pretty good investments.

And so then the question became, what is the moat of these companies? And my one-liner was, “Look, if your moat was your code, that’s gone.” AI has basically obliterated that moat, so forget about that. But if your moat was being kind of IBM in its heyday, when, you know what, you didn’t get fired for hiring IBM — if you had your tendrils in enterprise America, then maybe you’ll survive on the back of the customer relationships that you fostered over the years, your reputation, et cetera.

So I think when it comes down to the intangible moats that companies have, obviously it’s very nuanced, and there’s a lot of different layers. But I’d say the one-line answer is, if your moat was your code, then I’d be worried about you. And if your moat was something else — in the case of some of these smaller, more niche vertical plays, maybe it is like a regulatory moat. They just spend so much time lobbying and kind of building out regulatory capture that they will be hard to displace, and that is what it is.

But I would go through this case by case and ask that question. I do think all else equal, the extent to which you as a software company are serving the biggest companies in the world, the enterprises where the workflows are deeply embedded, it gives you a bit more safety than, say, a consumer app on iOS or something that anyone can kind of vibe code in a day. So I’d say all else equal, the bigger companies are likely more safe. And that’s something that’s a principle in general, right? Not just in software. When there’s a recession like in ‘08, generally the small caps are the ones who get hit first. But yeah, I’d be a little bit concerned about some of these names.

Dan: Right. So then if you think about that and you think, okay, if the public software companies are down fifty to eighty percent, and these private equity backed things are 50% levered — if you do the math, that means annihilation. That’s bankruptcy, basically, right? Which is why I think actually private credit is better positioned than private equity right now on the same assets. You’d rather own the debt than the equity. Because I actually think there’s a chance the cash flows are fine for some of these businesses for a while. It’s just the equity value and the valuation multiples have gotten absolutely smoked.

Kai: Yeah. I’m fascinated by the whole role of private credit. So let me run this by you. You tell me what you think. And I know this is gonna be an oversimplification.

So, okay, so intangible assets, right? We know that one challenge of intangibles, like think of IP, is it’s hard to use them as collateral. No one’s gonna lend against your patents — or sometimes they will, but generally not — your human capital, your brand. These are just intangible assets. And so traditional banks, they’re not going to do a ton of debt financing for these kind of intangible intensive businesses like software.

And there are many reasons why private credit emerges as an asset class, including the GFC and changes in regulations there. But I wonder to what extent private credit played an increasingly important role in making happen the migration we just discussed, the move of private equity into software, because they couldn’t have done it with traditional banks. They needed someone who was willing to lend against what at the time seemed like stable recurring revenues. Obviously, in hindsight, it’s not as clear how stable that will be moving forward. But does that narrative play out, or is that just an oversimplification?

Dan: Totally. No, that’s exactly right. The private credit lenders, one of the tip-of-the-spear products was ARR loans, annual recurring revenue loans, where they said, “Hey, you can’t get lending against your software business, come to us and we’ll lend against it.”

Now, I always like to say that, well, newspapers were recurring revenue. It didn’t stop them from blowing up. I don’t know, just ‘cause it’s recurring and you sign an annual contract, I don’t get what the difference is. People can cancel contracts, or not pay if they don’t want the product. But that’s not how they viewed it.

Kai: Yeah, it’s really interesting because the problem is almost more of a mismatch, right? Between a sector for which technological obsolescence is a major risk. Yes, the revenues may seem stable, and they likely will be stable moving forward. They might slowly bleed out is kind of the worst case. They’re not gonna go away overnight in most cases. But the question is, it’s kind of masking the underlying dynamics of the business. The technology industry is kind of by definition the frontier of innovation, and is by definition exposed to obsolescence risk.

And so a mismatch between debt capital, which is kind of by definition meant to be seeking stable, predictable cash flows, and an underlying asset where the underlying dynamics are inherently volatile — I think that’s a really interesting problem, I guess, just a structural issue. Put aside whether this works out. Maybe everything will get bailed out and we’ll look back and be like, “Oh, that was just a false panic.” But just structurally, the way that finance is supposed to work is you’re supposed to match the risk profile of the underlying assets and the capital providers.

Dan: How do you evaluate obsolescence risk, Kai? Is there a way to do it quantitatively when you’re evaluating a company’s intangible value or intellectual property, to know whether its risk of becoming obsolete is high or low?

Kai: It’s really hard. I mean, I spend a lot of time doing it. In some cases it’s really obvious. Like any, I don’t know, any ChatGPT wrapper, right? Those companies, they could go away in one day. I’ve been using a lot of Wispr Flow. I mean, Wispr Flow could be a feature on iOS. So a lot of these things are obviously competing for the new technology. And when 100 auto companies launch to take advantage of the new invention that is the car, 99 will fail, and that’s just obvious.

The question of the disruptions whereby newspapers were disrupted by the internet, those are a little bit harder to find. And I spend a lot of time trying to figure out how do we quantify that. So you can look at, for example, what the CEOs of newspaper companies were saying during the internet. But the problem is that it’s not that reliable, because many CEOs just refuse to acknowledge it, and that was kind of why they ended up being disrupted in the first place. So you have to go outside to third-party research, sell-side research, news — what are people saying outside the confines of the company themselves around which companies may or may not have exposure to a given sector.

And then from there, I think the next step becomes, okay, so you know that newspapers are exposed to the internet as a category. That can be determined quantitatively. Then the question becomes sorting through all the different companies in that sector, which ones are acknowledging some of the issues and which ones are not.

So in the piece I wrote on disruption, I mentioned The New York Times, which managed to obviously survive the wipeout of most newspapers. How did they survive? It was that they had a strong brand. They were one of the top three or four or whatever papers in the world. They changed their business model somewhat to adapt to the internet, through the games and things like that. But there’s a bunch of different stories. Ultimately, they had the preexisting intangibles required to potentially survive, and then the management did a good enough job to navigate them through the period.

And so those are the two questions you would ask. I think you’d first say: can we identify ex ante, or at least in real time, which sectors we think are exposed? And I think the answer is yes. It’s pretty clear that if you are doing web development, you’re a freelance web developer, or you’re an outsourced IT firm in India or something, you’re obviously in the crosshairs of the AI wave. And then if you’re laying cement, probably less so. I think that’s pretty clear.

And then the harder part, I think, is just saying, “Okay, so I know that these 10 companies are exposed. Who will end up being survivors and winners, and who will end up going out?” And that’s something that changes rapidly over time, because maybe Company X in the beginning of the internet was a little bit behind, but then they kind of caught up and then they ultimately survived. Like Walmart’s a good example there, with e-commerce.

Dan: And probably those companies that are able to pivot need to invest to do that, right? There’s sort of this moment where if you’re not investing to deal with the new technology, you’re screwed. And again, that doesn’t bode well for private equity-backed companies, ‘cause if you’ve got a massive amount of debt, where’s the money gonna come from to build new AI tools? You just don’t have it.

Kai: Yeah, that’s a really good point. You need to invest to adapt. One thing we do look at actually is job postings. So there’s pretty clean data on job postings where you can say, for a given company through the internet — there’s two types of jobs. There’s what you would call substitutable jobs and then complementary jobs. Substitutable jobs are those that basically the internet can do better, and then complementary jobs are those that actually benefit from having the internet around.

And what you can do is you can look at their job postings through time and ask the question of, is the mix shifting in such a way that Company X ceases hiring people who are in the substitutive category and instead moves towards the other one? Again, that’s not gonna guarantee you success, but I think it’s definitely a good sign that a firm is looking to adapt to whatever disruption’s on the horizon.

Dan: Yeah. It’s been interesting. One of the things I’ve been thinking a lot about in trying to process the AI question, which I think we’re all trying to work through — I think you and I have talked about this before, with these technological innovations, that the innovation has to benefit the consumers of the innovation. You’ve written about this in some sense more, right? ‘Cause you have to pay for the profit margin of the producer of the innovation. This is a classic Kai Wu model.

And so one of the things that I think about is, well, in theory, the benefit of AI is that it’s gonna replace people, and thus take out cost at the end consumer of the technology. And I think one striking thing is that we just haven’t seen any AI-related job losses yet. And I’m sort of wondering when and if that will happen.

And I think that you can say, like, on one extreme, take Waymo, which has gone from like 0% of car rides to like 20 or 30% of car rides in San Francisco for Uber-type rides. And clearly, some Uber drivers have gotta be out of business. They’ve taken a lot of market share. On the other hand, look at something like call centers, or people cleaning with vacuums that have just not been displaced by robot vacuums yet, or call center employees who have not totally been replaced by chatbots. We just haven’t seen a decline in call center employment yet.

So it’s sort of interesting to reflect on, when you think about the job listings, when will AI start to have the theoretical impact on employment that its boosters say that it will have, and that economically, to justify the CapEx that’s being spent, is gonna have to happen?

Kai: Yeah. So my understanding of what you are seeing in the data is you are seeing a shift, as I described, away from jobs. So companies are cutting back on hiring jobs that AI can do and towards those that AI cannot do. So you are seeing that.

There’s also some evidence — I think there’s some conflicting results, but I think directionally, you’re seeing a shift away from the more junior roles, where unfortunately, people who are earlier off in their career, that’s where the cuts are happening. Whereas the more senior people, the companies are like, “Well, whatever, we got the senior person.” Now they can command some AIs and get more leverage.

Dan: Right. That’s interesting.

Kai: And that’s something you’re seeing as well. I think the challenge is this, which is AI is pretty jagged. It’s very uneven, where it’s really, really good at coding and a few things that are adjacent to coding, and pretty bad at some other things. Like, robot vacuums are pretty bad technology still. I have one. It’s horrible.

But here’s the thing. Coding is an area where, yes, I use Claude Code and Codex, and I can basically have at my fingertips like 10 junior developers. That’s fantastic. But here’s the thing. I have so many things I wanna do code-wise that I wouldn’t really want to outsource, either for IP reasons or just don’t feel like the hassle of managing a team of outsourced developers, and I don’t have the budget to say hire a bunch of Meta engineers to come over to my firm. So I’m doing all these new things that would literally be sitting on a shelf otherwise.

And so I think the same thing with call centers — maybe wait times go down from one hour to one minute because you can talk to an AI for the first 59 minutes. And so maybe the work expands to somewhat absorb the efficiency gains that we’re seeing. And the efficiency gains are concentrated, of course, in certain industries. And so we’re not really seeing it, aside from the tip-of-the-spear things like the software engineers. I don’t think we’re seeing it through the data yet.

And likely we never will. Look, you look at the historical labor force participation rate and unemployment rate — it’s been very stable through time. Through massive changes of technology, like the agrarian revolution, the Industrial Revolution, the internet, through the addition of globalization and Chinese workers and female workers into the workforce. It’s been remarkably stable, because we’ve just managed to find other things to do.

It was the MIT economist David Autor who found, I think it was like 60% of jobs didn’t even exist in 1940. Like airline pilot, or whatever. Things in that category didn’t even exist. So I think we’ll most likely find ways to keep ourselves busy. But there will be obviously a massive disruption in terms of the composition of the workforce. A lot of things will... Uber drivers will likely eventually go away, and we’ll have a whole new category of people whose job is to be personal security for Elon Musk or something.

Dan: Right, right.

Kai: But yeah, so let’s step onto the next bit then. We covered obviously software and what AI’s done to software, and how that’s impacted of course the private equity and private credit industry. Let’s look at the other side of the K now, which is the hardware side, the AI CapEx, which I know we’ve talked about a bit in the past.

Trillions of dollars are of course flowing into AI data centers, and that money downstream is benefiting everyone from SK Hynix and Micron to Nvidia and other chip companies, to utilities and power, and anyone involved in this infrastructure complex. And so that’s the other part of the K. So we’re seeing the software index is down 50% or whatever, and relative to the market, the semiconductor index is up by 200%. So technology’s become a K-shaped economy.

You and I were actually talking about this — we were talking about Situational Awareness, the San Francisco-based hedge fund that was not only long chips, but they were also short software. And so they weren’t really hedging their bet. They were doubling down on the same trade, which is being super long on this bet. And pretty much the entire industry’s in it. It’s not just them. You look at the Goldman Sachs VIP index. I think the portfolio is like 90% correlated with the AI trade. Basically everyone is in on the same bet. It’s becoming very, very crowded.

So as someone like yourself who tends to be a contrarian and lean against consensus, I’d love to hear your thoughts on what you think is going on, not just in software but on the other side, on the bullish side, in hardware and AI CapEx.

Dan: Yeah. I mean, I think that you have to look at actually the mindset of these people. What is their worldview and what is their philosophy?

And I think there are two elements to it. One is they’re futurists, right? So they believe that the future can come true, and that the future can involve things that you might be used to reading about in Popular Science magazine. Like, well, we’re gonna land on Mars and build colonies there, and we’re going to have robots that are smarter than people. And these things are normal, and they’re gonna come true, and we just should be building them.

And then second is this sort of rationalist, effective altruist type thinking, which basically says you should be evaluating everything statistically and rationally, and then you should just maximize expected return or expected value. And that often means taking a lot of risk. Like a huge amount of risk. ‘Cause if you wanna maximize expected value, you sort of know that the way technological innovations get pushed is that you take a massive amount of risk, and, hey, even if 10 of them fail, if one of them succeeds, then the innovation comes true. And if one of them is worth a billion dollars, then your expected return for the nine that went to zero is, you know, whatever. It’s fine.

So they’re thinking that way — rationalist, expected return maximizing, futurist. There’s this paradigm.

And so what are the actions that that leads them to take that we observe? Well, look at Sam Bankman-Fried. You look at Leopold Aschenbrenner, who worked for Sam Bankman-Fried. They’re all part of these types of movements. They’re all part of this current Silicon Valley, San Francisco thinking. And they’re making some of the same mistakes. They think that the future’s gonna come true, and they’re taking huge, huge risks on betting on that vision coming true.

And I think that if you look at the people that lead Anthropic or the people that lead most of these other big tech companies, they have some version of this thinking. They believe in artificial general intelligence. They really believe it’s gonna happen, that AI will be smarter than everybody at every task, that there are like 10 years left of people doing things before the robots take over. And then basically everyone’s gonna be on universal basic income if they’re not working at the Mars colony or servicing the data centers in space. And so they just need to maximize their expected return now. And by the way, they’re gonna give half the money away to save animals and stuff. So it’s all worth it.

And I think what is dangerous about this mindset, and to our view of the world, is we sort of know that world history doesn’t work rationally. It follows twists and turns, and it’s surprising, and things take longer than they should. And nobody’s using robot vacuums even though the technology is 20 years old, even if it’s a better model. And there are a lot of people that won’t wanna use driverless cars. They’ll just be afraid of them. Sometimes the better technology, even if it’s better, doesn’t get adopted, for whatever reason. And things happen that are slow or surprising, and there’s a populist revolt against data centers, or whatever it might be.

And I think that my bet is just that these people are taking massive, massive, massive, massive amounts of risk, and they’re all taking it because they all think the same way, and it’s gonna blow up in some way, just like Leopold Aschenbrenner blew up, just like Sam Bankman-Fried blew up. Like, the same people are running Anthropic, same mindset, same viewpoint. You think they’re immune from the probability of blow up? No.

They’re massively spending on CapEx. Massive. And what do we know about CapEx spending? Oh, everyone always over-invests. The returns are always lower than people anticipated. The returns always come later than people thought, and there’s this gap between the investment and the realization that’s always too long for most people to survive. These things are gonna happen again.

Kai: Yeah, no, I think to be a little bit more charitable to that point of view, I’d say that even if you’re purely rational, you have no choice but to invest. If you’re sitting on top of one of these big tech companies and Sam Altman’s putting a trillion dollars into play, what are you gonna do, sit around? You’re gonna be fired instantly.

And so it’s a bit of path dependency as well, where there is a perception — I don’t know if this is actually correct or not, but there is a perception — that AI is like social networking or Uber, where there’s network effects, and therefore the first mover who can move to capture the market will lock the market. I don’t know if that’s actually true, but that is the belief. And so everyone’s saying, “We need to buy more GPUs. We need to invest more and more.”

But I think the problem is, obviously that leads to a collective over-investment even if the individual is rational. But I think also to your point, Dan, this is a really important point, which is the world’s path dependent, that you can be right in the long run but maybe be carried out in the interim. That’s the definition of—

Dan: Like Sam Bankman-Fried. All of his bets were right. If he just held onto his bets, all the FTX bets worked.

Kai: Yeah, he had a problem. He’d be the world’s best VC. Exactly, right? I mean, LTCM, same example. All these hedge funds. And that’s the danger of being either over-levered or over-concentrated, which are kind of two forms of the same thing — which is you make a massive bet on something, and if you’re right, you’ll make more money, and you’ll be more successful, and you’re more likely to capture the market. But if you’re wrong, or if it just takes longer, that’s the thing.

I personally am a believer in AI. I do think that we’ll get from point A to point B. It’s just a question of how long it takes and how the path unfolds. If there’s a crash in the interim — like the Carlota Perez model, or pretty much every single historical example you can find, there’s always been a crash that punctuates the starting point and then the ending point of a technological deployment.

There’s that, and then I think it was even Sam Altman who came on some podcast, I think it was last week, or I just saw it at least, where he was saying he underestimated the inertia of society. Why isn’t society just automatically adopting my technology? It’s so amazing. Why wouldn’t they just do it? And it’s like, have you ever worked at a big company where it takes 20 years to use Excel 2007 or whatever? That’s just the nature of the world, that people are kind of stuck in their ways for better or worse, and sometimes better.

I was on a podcast a little while ago, and people were really worried about this doom loop scenario, that if AI happens too fast, people get fired, and then there’s no income, and then we end up in this negative spiral — the Vestrini thing. And the point I was making is, look, there’s all these natural governors against AI accelerating that fast. There’s the compute constraint, there’s the institutional constraint, there’s labor unions, which most people don’t like them, but they have a purpose, I guess, which is to slow down the pace of this deployment. If the deployment happens fast, things can be bad. If it happens slow, it’ll be like anything else.

And that’s my base case of how this unfolds, even though I am myself very kind of on the frontier and very active in AI. The median person is not super AI pilled. They just will slowly adopt it over time, or maybe they’ll die off, and then their kids will get really into it. I just think it’ll take a lot longer for these S-curves to unfold than it seems like the people who are super in this bubble seem to think.

Dan: Right. Well, I think part of it though is really smart people live in this highly verbal world of ideas, right? And AI is really good at meeting those people where they are. It’s really good. Like, you’re like, “Hey, I really wanna know about the history of the Ottoman Empire in the 12th century.” AI can tell you. You wanna rapidly switch and solve some Erdős problem, and it’s gonna do that too. And then you want it to vibe code you an app, and it does that. And then you wanna take photos of your garden and have it tell you what plant you should plant in your garden. It can do all of it. Everything that you as an intellectual wanna know about and learn about, AI is there to talk to you about it. And so you’re seduced by it — this is great.

But then have it actually reliably do something like answer calls at a call center twenty-four seven for two weeks, processing insurance claims, and you’re gonna go off the rails with disaster very, very quickly. And I think that it’s that gap, which is exactly what you’re talking about, that is gonna create the delay.

Kai: Right. And I think you wrote about this in your piece on this topic recently, and you said something along the lines of, look, if there is a crash, there’s better times to get in. You can still be long AI, but you just don’t have to be long today. Which I thought was a really interesting point.

And this accords with what we were just discussing around consumer surplus. That historically, most of the value, if not all of the value that’s been created by technological advances, has actually gone as consumer surplus to the corporate adopters and the individual users of said technologies. And so I do wonder if the investment we’ve seen, all this CapEx spending, is perhaps a gift, a transfer from the folks making the investments day one to those of us who may survive and be able to enjoy the fruits.

Dan: Yeah. Kai, you and I are gonna do so much with all that excess data center compute supply when the prices crash to zero. It’s gonna be amazing.

Kai: It’s gonna be... Fable tokens will be so cheap too.

Okay, Dan. So let’s shift gears now to just a broader topic, something that’s central to both of our work, which is of course the evolution of value investing. You pointed out that the severe underperformance of the value factor has been concentrated mainly in the US, while value’s continued to work pretty well abroad — international, small cap, emerging.

Now, I’ve thought about this as well, and I wanna run this by you. You probably heard me say this before, but I wanna get your take, which is, is it possible that one of the explanations for why value has struggled so much uniquely in the US really is that the US is the world’s most intangible intensive economy? It’s one where the most successful companies are technology, healthcare, consumer brands — these sorts of very asset-light businesses for which the traditional accounting-based metrics, like the price-to-books of the world, are uniquely poorly positioned to evaluate these companies. Do you buy that argument? And feel free to push back if you disagree.

Dan: No, I’ve been thinking about that recently, Kai. I was actually looking at, by region, what percent of book value is intangible. And then, of course, there’s the things that aren’t in book value that obviously you’ve documented.

But what’s sort of funny — and I specialize a lot in Japan — in Japan, book value is basically tangible book value. There’s almost no intangible assets in the balance sheet in Japan. And so if you’re buying something at half book, you’re literally buying a building that cost a hundred dollars for fifty dollars. And you’re buying investment securities worth a hundred dollars for fifty dollars. And it turns out that book value is a really good predictor for returns in Japan, because it’s like an entirely tangible economy.

And then you go to the US, and it seems to be completely bonkers and doesn’t work at all. And is it any surprise given that the US is the most intangible economy? So I think that there’s a lot of truth to that.

And I think that your work on trying to figure out a new way to calculate intangible book value is brilliant. It’s the answer to the question that other people have thought of as the problem but not identified a solution. And obviously, it’s hard to come up with a solution. You have to come up with all these new methods, which are so creative. But I think that’s the path to making value investing work better in the US.

Because what you end up seeing, if you just run a pure value screen in the US, is that pure value screen routes you into a lot of old world or cyclical businesses. It’s like every shoe retailer, and then every commodity producing, you know, supplier to every commodity producing industry, or chemical refineries. And you’re like, “Yeah, I get this is all value,” but it’s all got this kind of flavor of being quite cyclical actually, and quite asset dependent.

And I’m just not sure that that’s really what I’m trying to bet on. I’m trying to bet on expectation errors, systematic expectation errors. And I actually think these things are kind of priced fairly. And I think that’s really been one of the problems. Value isn’t leading you to expectation errors in the US in the same way.

Kai: Yeah, I like the way you framed that. Expectation errors are what you as a value investor are seeking, but the extent to which a given accounting metric actually takes you systematically in that direction versus just encodes a different bias. Like, oh yeah, we just wanna be long asset heavy businesses and short asset light businesses, which is itself a different factor and is a negative factor, by the way. That’s just kinda taking you in the wrong direction.

Dan: Exactly.

Kai: So yeah, let’s talk about Japan, ‘cause I know that you’ve been on the record saying this is one of the big bets you’ve made as a firm. And congratulations, by the way. I’m sure you’re doing pretty well in that.

Talk to me about the thesis around Japan, both obviously the valuations, but also what are the catalysts to realize the value? I know there’s a lot of stuff around governance reform, which maybe is kind of intangible governance reforms unlocking tangible value. I don’t know if that’s the way you would put it. But obviously Japan can be cheap and it can be cheap for a long time — why now? Why is it positioned to outperform moving forward?

Dan: Yeah. So I’m a skeptic of governance mattering, mostly. Like, okay, who the shareholders are, who’s on the board — I don’t know how it matters. It’s too airy-fairy. I just don’t get how it matters.

In Japan, it’s a little bit different. It’s actually really quite tangible what they’re doing. The headline reform, and this is a value investor’s dream, is that they’ve said that the primary thing that has to happen is that every company that trades below book value needs to get to book value.

And now that sounds crazy at face value, but when book value is tangible book value, what you’re basically looking at is companies that trade below book value have overcapitalized balance sheets. They generally have a mix of cash, investment securities, and real estate. And so what the government is saying is, “Hey, you gotta return the cash, you gotta sell the investment securities, and you have to divest non-core real estate. And then you have to return that money to shareholders, and basically buy back shares or do dividends until the investor money rises and the balance sheet assets fall.” So it’s a very mechanical, tangible intervention.

Kai: They’re almost forcing you to par, basically.

Dan: Forcing you to par, right, by asset transfer. And it’s brilliant, it’s simple, and it’s happening. All these things are lining up.

And if you are willing to go down cap into pretty illiquid stocks, you can build portfolios that trade at like 0.5 or 0.6 times book that are actually profitable, cash flow generative, and growing, that are just massively overcapitalized. And basically the trade is that you buy stuff that’s really cheap on book. It’s old school, like ‘60s style value investing. And you let the government and the Tokyo Stock Exchange pressure these companies into divesting their non-core assets and returning them to you as a shareholder.

It’s so classic and brilliant, and it’s so simple. It’s such a dumb trade. But it’s a great trade. They literally have the cash, the investment securities, and the real estate on the balance sheet, and all you need to do to earn a pretty darn good return over the next three or four years is wait for them to return it to you through buybacks and dividends.

And it’s happening. Massive increase in buybacks, massive increase in dividends, decreases in long-term investments, decreases in cash on the balance sheet. And so it’s a wonderful, wonderful trade that I am trying to be as long as possible on while it lasts, because I think it’s pretty rare that you see something this clear of an opportunity existing.

Kai: Yeah, I like that you’ve brought in the analogy of 1960s style US investing. It’s like if we had the ability to take what we know about investing and go back in time to when the economy was still industrial, when Warren Buffett and Ben Graham were able to use price-to-book to pick stocks. That’s Japan today. I think that’s a really compelling visual.

So one question I have there is, obviously what you’re doing is active. You’re looking specifically for the underpriced stocks, things that are trading, say, below book value. What would happen if you just bought TOPIX? Like, you just bought the Japanese index? How important is the value tilt as opposed to just being long Japan from a macro standpoint? I assume pretty important, but I’m just kind of trying to decompose the trade.

Dan: Yeah. So there’s a lot to like about Japan macro too. But the specific exposure to the governance reform as a tailwind is basically zero in TOPIX. All the things that trade below book are small cap, and therefore are a tiny, tiny percentage of TOPIX. I mean, there are a few companies, maybe like a dozen, that are large cap that are below book. But you kinda know what they are. It’s Mazda, and it’s Nissan, and it’s like, fine, take those bets. But they’re below book for a reason. Versus you go down cap, and it’s a bunch of random normal companies that just massively overcapitalized themselves.

But I think the other sort of big story recently has been the yen, where the yen is at 40-year lows. And people are sort of at this point panicking about what’s gonna happen with the yen. Is it gonna fall further? The entire time, as long as I’ve been investing in Japan, the yen has been going down. And I’ve been fine investing despite it, so I’m sort of less worried.

But I think the yen is probably at bottom as well. And I think there’s a lot people don’t understand about the Japanese economy. People are very focused on debt to GDP, without realizing that actually Japan has massive assets on the balance sheet. So you’re looking at a gross debt number — it just doesn’t matter. Because if you subtract the assets, then the debt’s only 100% of GDP. Well, then it’s totally fine and normal.

And actually, the Japanese government has basically been running a carry trade where they borrow with 0% JGBs, and then they go buy foreign equities. And so it’s been a great trade. You should have done that too. And I think people miss that. And so it’s one of the only countries where the fiscal situation is improving, not deteriorating. And where the currency’s probably at all-time lows. And where a lot of things that they specialize in — the very advanced manufacturing, really high-end intellectual work — I think are only gonna benefit in this AI world. And I think as people turn away from China and want an alternative, I think Japan’s a clear beneficiary.

Kai: Yeah, I agree with that. And I’m obviously concentrated in the larger cap space, but I also see that in Japan they’re leading in robotics and precision manufacturing. It makes sense. And culturally also one that’s more open to this, and a friend of the US, of course.

If you look outside of Japan at just microcaps in general — so there’s a couple different layers to your trade. Let’s say microcaps in the US, microcaps in Europe. Are you still seeing similar discounts? Is it just the discounts without the catalysts, or are the discounts also not as deep outside of Japan?

Dan: It’s basically like Japan and Korea are at one extreme. Europe is getting pretty close to that level. And then US, there’s still a big discount, but the stocks are less crazy than Japan, Korea, or now Europe.

So I’ve always been, because of my career, that’s always been the case to some extent. I’ve been much more focused on those international markets than on the US for value, because the discount’s been so much bigger. But I think that probably, if you look at the universe of things that trade below book as a crude approximation, it’s probably 30% of them are in Japan, 20% of them are in Korea, another call it 30 or 40% in Europe, and then the rest in the US and Canada and Australia. I’m excluding EM. But that would be the universe.

Kai: Interesting. Wow, okay.

All right, so now switching gears real quick. Another piece of research that you’ve been doing — and we talked about this a little bit last time — was in biotech. And I think of biotech as a really interesting foil to what you’re doing in Japan.

‘Cause let’s step back and — interrupt if I’m not being fair — but we as value investors face a problem, which is that at least in the US, and at least in large cap technology-oriented domains, traditional value has been challenged due to the rise of intangibles. So we have two options. One is you could say, “You know what? Let’s just go elsewhere, where the economy is like the 1960s US. Let’s go to Japan. Let’s go to Korea. Let’s go to Europe.” That’s one approach. The other approach is to say, “Why don’t we adjust our metrics?” And obviously that’s the tack that I’ve personally chosen to go down.

But it feels like in biotech, that is you also going down that path, saying, “Look, value metrics don’t work in biotech.” But it turns out that all this interesting data exists around the IP of these companies, that we do feel confident that we can quantify “value,” in air quotes, for these sorts of companies. Is that a fair assessment?

Dan: Totally. I’m drinking the Kai Wu Kool-Aid. I’ve been reading enough of your research over the years, Kai.

That’s totally right. And biotech is kind of an extreme example, because there’s no traditional metrics. There’s no assets. There’s no revenue. It’s completely intangible. That’s all there is.

And so we’ve come up with some Kai Wu-light type metrics, nothing as sophisticated as what you do. But the ones that we look at are the value relative to the historical R&D spend. Just add up all the historical R&D spend and how does that compare to the current market cap? Or specialist ownership — take all the people who specialize in evaluating biotechs, and what percent of the shares are owned by those people versus are owned by tourists in the biotech sector? Short interest, which is similar to the previous one.

And then we’ve been working really hard to construct other types of intangible value metric for biotech, but that’s all harder and less far along. But those three alone provide actually a really good way of sorting the biotech universe. And you see that the companies that are owned by specialists, that are cheap relative to their historic R&D spend, and that have very low short interest, massively outperform the ones that are the opposite. And so it’s our way of trying to proxy for intangible value in a very specific universe where there’s nothing else to rely on.

Kai: Yeah. And I will say, R&D divided by market cap is a pretty obvious, easy to construct proxy for intangible value, and it works pretty well, and it’s public. It’s been in the finance literature now for many years. It’s not a secret.

And what’s amazing is not only does it work on average, but also what you’re describing is spot on. Where does it work better? It works better in the industries that are more intangible intensive, like biotech being at one extreme. And it’s not as important or powerful in certain industries. There are some industries where the average company doesn’t even report R&D at all.

Dan: Right. It’s just not an important line item for them.

Kai: So I think it says something when even what you and I would both agree would be a simple metric works that well. It’s almost a robustness check. If the basic stuff is working pretty well, that’s a good sign, because then you’re willing to go deeper.

Dan: Right. Then you go deeper.

Kai: Go as deep as you want, and hopefully that’ll only add incremental value. But even just doing something very naive, it works. That’s good, right? That’s again price to book in the 1960s. When I was at GMO, we had a much fancier model that Jeremy used to run through the ‘70s and ‘80s, and it was better than price to book. But you could even have just run price to book. That would’ve been fine too. So it gives you a margin of safety just from a modeling standpoint, to know that that works.

Yeah, that’s super interesting. I like the synthesis there, that there are different paths to respond as value investors to some of the changes that are being wrought by technology and the intangible economy. That’s really interesting.

Dan: Trying. Trying to learn from you, Kai.

Kai: Well, I learn a lot from you too, Dan. Whenever I talk to you, I learn something.

So all right. Well, look, we have a few minutes left. I don’t wanna keep you too long. So I’m gonna just jump now to our standard closing question. And this is the one that’s basically purpose-built for you, because you are a contrarian. So I’m just gonna go ahead and ask it. What is it that you believe that your peers do not?

Dan: You know, I would like to say, Kai, that my views on private markets are happily becoming more consensus. I feel like this has been a year in which I’ve had a few big non-consensus views that, I think the market is moving towards them, honestly. I think I’ve been very bearish on private markets, and I think consensus is moving towards me. And I’ve been very bullish on Japan, and consensus is moving towards me. So I think I need to go refresh my arsenal of non-consensus opinions, because I think those ones might be tapped out.

Kai: All right. Well, we’ll do this again next year, and you’ll have a new one for me by then, right?

Dan: Excellent. Perfect, Kai.

Kai: Awesome. Well, thanks so much, Dan. I appreciate you taking the time.

Dan: Thank you, Kai. This was fun.

But then he added his own spin on it. The longer something takes to happen, the larger the outcome can be. And that is why he thinks the frustration value investors have lived through is “setting up an abnormally exciting period of time.” Bob founded Robotti & Company in 1983, and he joined Matt and our good friend Bogumił Baranowski of Talking Billions for an hour that ran from Tweedy Browne to what AI spending means for cement (a topic our value investor viewers will know is near and dear to our heart).

Lesson 1: Never Bet Against the Guy Who Keeps Showing Up

Bob’s origin story starts with a bad report card. “I failed my way into success.” He goofed off at Bucknell and graduated with a C in accounting, and no big eight firm would hire him. But a small firm took him on because one of the partners grew up with his dad, and the partner “realized that I wasn’t as stupid as my grades were.” The internship put him on the Tweedy Browne audit in 1975, right after the 1973 to 1974 crash. So he watched what Tweedy did, talked to Walter Schloss, and absorbed value investing just as it was being rediscovered (a process all of us value investors hope is about to happen now too). And he had never taken the class that said markets were efficient. “No one ever told me that, so I couldn’t be misled.”

He then ran Mario Gabelli’s operations for three years while the firm grew from $7 million to $77 million. But Bob wanted to pick stocks, and nobody was going to hire him as an analyst. “The only one foolish enough to hire me was me.”

For ten years, he made no money.

He tells aspiring managers almost nobody can copy what he did, because the real edge wasn’t stock picking. He lived with his parents for a decade after college, his expenses stayed near zero, and his capital compounded through the lean years. “Most people don’t have 20 years to be able to do that.” His investors are the same story. “Extremely patient money. That’s hard to get.”

And that is the real lesson here. Nothing about Bob’s start suggested he would last. But he kept showing up, decade after decade, while his capital and his experience compounded. And more than 40 years later, he is still compounding money for his clients.

Lesson 2: Bad News Today Is Good News in Three Years

Bogumił asked about what Bob calls grassroots macro, built from individual businesses instead of economies. His firm are business analysts hunting for “substantial latent earnings power,” and the way that gets created is really just Economics 101. When an industry performs badly, capital leaves, weak players quit, and the survivors consolidate. He calls it the cathartic effect of poor performance.

I see a news piece and there’s something negative, and the stocks trade down, and I look at that piece of news and I say, “That is a great piece of news.”

Every discouraged competitor is one more exit, and the business that remains gets more interesting three to five years out. Mr. Market, he said, “is more manic depressive today than he was in the past.”

His story to prove his point is Builders FirstSource, bought in May 2009 after housing starts collapsed from 1.7 million to 500,000 and most competitors went bankrupt. The recovery took years longer than he expected, but that turned out to be the good news. The industry stayed difficult for so long that four of the five largest companies eventually consolidated into one, and the survivor came out with earnings power the old fragmented industry could never have matched. As he told the chairman, the best thing that ever happened to the business was how long it took to recover.

Lesson 3: No Moat Is Permanent

Bogumił asked Bob how intangible assets have changed his thinking. Bob answered with an analogy you wouldn’t expect.

If you go travel around Europe, you’ll see all the castles that had moats around it. And people figured out how to get over moats. No moat is permanent.

A great business, he argued, wears a mark on its back, because everyone who sees those returns wants in. And plenty of companies get classified as better businesses off their historical results rather than their current economic model.

His favorite illustration is from 1975, when he interviewed with a railroad company and thought, “Wow, railroads, what a horrible business.” If you had to pick which business would still be great fifty years later, you almost certainly would have picked The Wall Street Journal, a company with more pure intangible intellectual property. “There was no across the street from The Wall Street Journal.”

But today the Journal is, in his words, a vanity project for a billionaire, while the railroads turned out to be natural monopolies that have generated excess returns for over a decade, because nobody is going to build a second track. So he hunts for what he calls halo stocks (heavy asset, low obsolescence), growth companies hiding in industrial places nobody researches. He also thinks investors confuse asset light with capital light. One energy services company he follows spends every year buying and creating new intangibles, and the dividend is about all it has returned in a decade. “It may be asset light, but it’s not capital light.”

Lesson 4: The Dog Is Inflation, the Tail Is the Fed

Bob’s pet peeve is how much time investors waste on the Federal Reserve, which he called much ado about nothing.

The dog is inflation. The tail is the Fed. So watch the tail. It doesn’t tell you anything other than where the dog’s going.

In his view, the Fed doesn’t control interest rates. Inflation does. What worries him is how many assumptions hardened because the trends behind them ran so long, until low rates felt permanent rather than cyclical. Bob thinks the world remains extremely cyclical. If inflation is a recurring fact of life and runs at 4, 5, or 6 percent, the 10-year treasury needs to yield 5, 6, or 7. And if that happens, what’s the cap rate on anything? What multiple do you pay?

Today’s valuations look reasonable only if you assume we stay in a 2 to 3 percent world. To be fair, Bob conceded materials and energy are a much smaller share of the economy than 50 years ago, and oil “ain’t going back” to a quarter of the S&P 500. But smaller is different from irrelevant, especially with the technology build-out demanding cement, steel, copper, and aluminum from industries starved of capital for a decade. A repricing to that world “is assumed that’s not gonna happen.”

Lesson 5: The Worst Losses Don’t Show Up as Losses

Bogumił brought up the biggest loss of Bob’s career, which came from a winner he sold too early. Bob agreed to reopen the wound. The company was New Market, the old Ethyl Corporation, controlled by the Gottwald family, smart capital allocators who had consolidated the engine oil additives industry down to four players. The family bought back stock at $45 without selling a share themselves, so when the market offered it to Bob at $35 a year later, he jumped on it. But then the Asian crisis hit, new capacity came online, and two big customers merged and squeezed every supplier. The stock went from $35 to $4, where the market cap was less than the annual R&D budget. When Bob told the CFO the company would soon generate $4 a share in free cash, he got back one of his favorite lines.

Bob, from your lips to God’s ears. Two, three years ago, I was concerned that it was gonna have a bankruptcy, so all I see is trees. I can’t see the forest, ‘cause every day I run into a new tree.

The forecast came true. And that is where the real mistake started. With the stock at 39, Bob decided the business wasn’t good enough to deserve the price and began selling. The company bought back stock at 48. He kept selling. It bought back more at 62. The consolidation he had bet on was finally paying off, and he was handing away his shares. He collected a $25 dividend on his $15 cost and sold his final shares at $275. So the stock he rode to near zero cost him far less than the winner he couldn’t hold. And unlike a loss, that mistake never appeared on any statement.

The Bottom Line: No Substitute for Thinking

Two years ago, Bob hosted a dinner he called the Restoration of the Fallen, named for the Horace line that opens Graham’s Security Analysis, that those who have fallen shall rise again. His case is that stock picking is the fallen thing, and that even Templeton’s axiom about doing something different from the market got thrown away after a decade of underperformance. That’s why he tells students they’re lucky, because security analysis is now a skill almost nobody practices. We can’t tell you whether the restoration Bob sees coming will arrive on his schedule (nobody can). But his advice works no matter when it does. Look at actual companies and do the analysis. Even if you pick badly, you’ll learn something. His final words were the shortest version of the hour. “Data and information is no substitute for thinking. Think.”

Watch the full episode here:

Stock Picker: How to Develop the Mindset, Temperament, and Strategy to Outperform Wall Street
https://amzn.to/4hU28Im

Topics covered

• How an investor’s motivations change as ambition gives way to family, legacy and the scarcity of time

• How Ian turned $20,000 into $120,000, then watched it fall to $8,000, and why that early win permanently shaped his risk tolerance

• Ian’s four-part survival framework: recession-resistant growth, strong balance sheets, conservative valuation and signs of intelligent fanaticism

• Why balance-sheet strength is not just defensive and can let great companies act aggressively when competitors are forced to retreat

• Why Ian targets roughly a 25 percent CAGR without relying on multiple expansion

• The Judas goat lesson, talking your book on social media and why investors still have to do their own work

• Why comparing short-term returns can corrupt an investing process and why Ian measures himself against the S&P 500 over a 10-year horizon

• The five core stock-picking skills: identifying, analyzing, buying, selling and holding, plus why selling matters especially in microcaps

• Why position sizing should account for initial excitement, and why Ian now starts much smaller than he did earlier in his career

• Active patience, expanding your circle of competence and the difference between good, great and GOAT stock pickers

• Why temperament evolves with experience, why leverage can destroy otherwise good investing, and why the best investors keep sharpening their edge

• Why Ian is willing to back repeat-winner management teams before every piece of the business is fully in place

Timestamps

00:00 Intro
06:58 The $20,000 to $120,000 win and 90 percent loss
11:02 Ian Cassel’s four-part survival framework
15:02 Why strong balance sheets create offensive optionality
19:03 The Judas goat and social media stock promotion
23:18 Why comparison is the enemy for stock pickers
29:39 The five core stock-picking skills
34:43 Active patience and knowing what you are looking for
39:28 Good, great and GOAT stock pickers
47:02 How investor temperament evolves over time
52:03 Leverage, situational awareness and surviving to compound
57:24 Betting on repeat-winner management before the numbers arrive

Learn more about the Excess Returns podcast network:

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No information discussed in this podcast should be construed as investment advice. Securities discussed may be held by the hosts and guests, their firms or their clients.

Ian: Thanks for having me. This is a pleasure. Appreciate it.

Matt: You did a great job on this book. I’m gonna say that in the extra earnest, complimentary way. Does it feel good? Did this book feel good to get out of your head?

Ian: It did. Yeah, I never really thought I was gonna write a book, but something about hitting the age of 40, or going over the age of 40, and then having written so many articles, and some of them connected more than other articles did. And some of the things had a shelf life to ‘em, my thoughts at that point in time, and others didn’t.

But it felt good to get this out on paper, and it was kind of a mix of my personal narrative with some stock picking lessons and some other weird quirky stories that I could somehow relate back into stock picking. So it was really fun to kinda get this out there. Not to say I was looking to bookend the first half of my investing career, but it kinda felt that way. And it was, not a relief, but it felt good getting it out there on paper in a way that didn’t read like an instruction manual or a “ooh, look at me, I’m a guru, now invest exactly like me” type of book. It’s meant to be kinda find out how to invest like you book, more than me.

Matt: You did a good job of it not being, A, a checklist. There’s checklists in there, but the book is not a checklist. B, you didn’t just give us a bunch of the same old tired and trite business stories or whatever. People sometimes get in that Gladwellian trap of being like, “I’m gonna tell you this amazing story about something that I have no personal attachment to, but I thought was curious, and I looked it up on Wikipedia” or whatever. And here you go too. And it’s like, well, why? Why are you doing this to me?

So you figured out a way to balance the checklists, the cool stories that you have a personal tie into, and then all this personal narrative, which was really truly endearing to get out of these pages. So thank you for writing this book.

Ian: No, thank you. Thanks for reading it.

Matt: I wanna open with this part. You start with what is chasing you. There’s 300-odd pages here of answering the question. But for professional investors — we’re gonna keep this investor education focused for this conversation, Excess Returns people, stick with me on this one — why is what is chasing you such an important question for people to ask?

Ian: Well, I think that initial chapter was probably one of the most fun ones for me to write. And even though it leads the book, it’s a chapter that couldn’t be written until after the journey. And I think we’re all chased by different things at different seasons in our life, and it fuels us and our ambitions, our goals, and those types of things.

And I had a weird goal at the age of 20, and that was to be a full-time kind of private investor, or stock picker, if you will. And that dream’s a rather lonely dream. It’s something when you tell somebody that at the age of 20, “I wanna be a full-time private investor,” they kinda look at you cross-eyed and wonder if you should be in a loony bin, and most of them don’t even understand what that means.

And so that just means you have to go it alone. And there’s a lot of people saying that you shouldn’t do it. You should just get a normal career path, work for your dad, in my case, all of the above. And so those people, the people that say you can’t do something, it’s kind of what fuels you, what chases you to continue after that goal.

But there’s also the negatives of negativity from others fueling your goals too. And that’s when you finally do hopefully reach that goal, you kinda just wanna — I can’t think of a better way to phrase it, but you kinda wanna give the middle finger to the world. Be like, “I did this. I showed you.” And you express that in different ways. And for me, not all of them were positive ways. I went out and bought a new Porsche, bought a new gold Rolex, all those funny things. And started driving the Porsche around a small town, and that caught a lot of attention. And you realize after a couple months, it’s not the attention you want. It’s not the person you are or how your parents raised you to be.

And then other things start to chase you. You get married, you have kids, which means you can’t really fail anymore. You could fail if it was just you, but you can’t fail when you have your family on your back. You can’t do that to them. And so that kind of fear starts to chase you.

And then after a while, I think your legacy starts to chase you as well, after you build some success. You wanna start building something bigger than yourself. You wanna start mentoring along other younger people and either build a business, build a philanthropy, whatever the case may be. But you’re looking to build something that can last.

And then I think last but not least, time starts to chase you. And you start to see that through your kids getting older, your parents getting older or passing away. And you realize every second matters. The present matters. And it’s not what you do for yourself but what you do for others. And that starts to impact you more, and that starts to chase you. Your legacy starts to chase you alongside that.

So that’s kind of the CliffsNotes version of that chapter, and just how that changes throughout the maturation of an individual person as well as a career as an investor.

Matt: Part of what I loved about that too was you’re starting without it just devolving into memoir. You’re starting from this place of explaining the different seasons of the professional investor’s life, and that comes in seasons. We talk about markets and macro regimes and all this stuff all the time, and we rarely step back and go, “Oh, you’re a different person for this part of whatever else is going on in the world.”

Ian: Yeah. No, exactly. And it’s a topic too, I think Morgan Housel and other writers have hit on before, where you kind of are what your circumstances were in those early years. Whether you were brought up in the 1940s in the US, or you came from a wealthy family or poor family, whatever. All those circumstances play a role into your personality, your temperament, and your investing and your risk tolerance.

So I am completely open-minded to the fact that I kind of started my investing career during the dot-com bubble. And during that time it was a great time to invest, and my cat, whose name’s Skyler, could probably pick winning stocks during 1997. And that just happened to be when I got started, and I had a big first win, and that kind of helped pave the way for my investing as well.

Matt: Well, let’s talk about that. Not everybody can say they had the experience of $20,000 turning into $120,000, so that’s an exciting thing to experience. You were a genius tech investor, as you just said, you and your CIO Skyler. Revisiting it now, framing it for the book, what’s the actual lesson to take away from 20,000 to $120,000? You can say where it went afterwards if you want to.

Ian: Yeah. I think first, I’d just like to say I got lucky when I was starting out, in a bunch of ways. First, I got lucky where I had great parents who saved for me $20,000 to even give to me. That’s number one, luck number one. And second, I was lucky because my parents gave me control of that money at the age of 16. I could’ve just as easily incinerated that capital or spent it on a car, or whatever it is, instead of multiplying it right out of the gate.

And I also got lucky because I invested, like I said, during a roaring bull market in 1997 when I got started, and it just so happened a lot of other people could two or three or five X their money over the next three years as well, and I was just one of them. So that’s how the 20,000 turned into 120,000.

But that big win I think was really instrumental. A lot of people, including myself, you learn from your losers and your losses. That’s kind of the definition of experience. But I think in this case it was the big win really allowed me to make different choices than if I didn’t have a big win. It impacted the college I decided to ultimately go to, the part-time job I took. I had an Edward Jones office, so an RIA here locally. Looking back, that win put me on a different trajectory in my career than if the first investing experience would’ve been a loss.

And I would have losses. The 120,000 turned into 8,000 after the dot-com bubble crashed, and I learned lessons from that crash as well. But I would say the biggest impact looking back at that experience was the first big win, because it gave me that kind of misguided self-confidence, and enough self-confidence that when I did lose 90% of my portfolio, I still had enough self-confidence in the tank that I knew I could come back. And I did. And I don’t think if it weren’t for that, who knows where I would be. I don’t know if I’d be in a career somewhere working for my dad or what have you, but that first big win was really instrumental.

Matt: Did base rates make a lot of appearances in this book? Do you wish you had any knowledge of base rates, or any real understanding of base rates, at the onset? Is it only valuable to learn about base rates after you have either some dopamine-inducing experience or the opposite? When should base rates enter into the equation for a young investor?

Ian: That’s a good question. I don’t know. I think I tend to have taken the other side on many things when it comes to investing, such as being just super concentrated in my stock picking approach — which I don’t tell anybody else they should do, but it’s just how I learned, and kinda learned the hard lessons faster and felt the emotions even more just being that concentrated.

I probably think of the base rates now, but not as much in the beginning, ‘cause I think it’s just about finding your path, finding your strategy, your temperament. And quite honestly, if you’re following the path of somebody else as an investor, if you’re just looking to clone somebody else, you shouldn’t be looking to outperform the market. I’m a competitive spirit. I’m looking to beat the market. I’m not looking to hug the market. I think to do that, you can’t be doing what most people are writing about. You have to find your own way.

Matt: Chapter 15, called “Survival.” Not typically an investing book chapter title. Would’ve also accepted “Eye of the Tiger,” something like that, if you wanted to go there. You had Munger and Thiel both make cameos. I loved seeing both of them, quotes stacked in a chapter like this. Explain what survival looks like in concentrated microcap.

Ian: Well, survival’s kind of a broad topic. When it refers to a business, I think survival is the ultimate quality score of a business. For a business itself to survive through 20, 30, 50, 100 years, it has to be a special business, given the base rates, which we just talked about, of small business or large business success over a longer period of time.

And yeah, I think there’s also a survival characteristic to being an investor, and remaining an investor in your strategy. So I think those two kind of go hand in hand. And I gave a four-part survival guide, if you will, in the book, that outlines both on the business side and investing side a framework that’s worked well for me. Doesn’t mean that I won’t evolve and look back on this conversation in five years and say, “That was dumb.”

Matt: You will look back on this conversation.

Ian: Oh, absolutely.

Matt: Big mistake.

Ian: Yeah. For different reasons.

Matt: But wait, wait, wait. The four parts: grow through recession, great balance sheet, valuation that can double in three years without multiple expansion, and intelligent fanaticism.

Ian: Yeah. So, like, the first one, and this is one I believed for a long time, is trying to find businesses that can grow through a recession. And obviously, when you put 10,000 stocks in North America down that funnel, there’s not many that come out the bottom of that funnel. There’s certain industries that are completely missing, and there’s certain industries that would be more prominent. But I think that’s a first really good hurdle, is think about a business that, if the unemployment rate ticks up to 6% or interest rates go to eight, what businesses are still gonna be growing and earning more money year over year?

And I think that’s an approach that I’ve tried to use with my investing, too. So even when I look at the portfolio of my fund today, every single company that’s in there I feel can do well even if the macro side went against me. Doesn’t mean that risk off in small and micro-cap equities, that headwind won’t impact me. But the businesses themselves I think will do well.

Matt: It could hit the share price. It doesn’t necessarily destroy the fundamental.

Ian: Exactly. Yeah, and we’re talking about stock picking here, so you don’t have to be invested in the market. You can pick and choose the ones you want, and that’s what I do. I’m trying to narrow the universe of, well, 30,000 microcaps globally down to a dozen that I connect with that are meant for me.

And then the second one I think you mentioned there was invest with businesses that have a good balance sheet that can weather a storm and act with occasional boldness. And I think having invested through a couple bear markets, or three bear markets so far in my career, you see the value in a good balance sheet. It’s not only to survive that recession, but also be aggressive when competitors can’t be. And nothing pulls in the spectrum of outcomes in a negative way more than a highly levered balance sheet when everything gets worse.

And I think Peter Lynch had a great quote about, it’s very hard to go bankrupt when you don’t have any debt. And I think Morgan Housel said something similar about, as debt increases, you narrow the range of outcomes that you can endure in life too. So I think it kinda has a personal finance lesson as well as a business lesson. So I try to find companies where they have good balance sheets. And then the third one—

Matt: Wait, before that. The boldness. Explain the boldness term, ‘cause I think that’s a really important part of that balance sheet explanation too.

Ian: Yeah, I think during bear markets and recessions in particular, a lot of companies, they’re spending less, they’re doing less. And the best companies have a balance sheet that can act — maybe take out a competitor, maybe be more aggressive while everyone else is pulling back because they don’t have the resources to do so, because they didn’t take a long-term approach with the business.

I think those are the qualities that you find in enduring businesses that survive. When they’re playing a long-term game, they know what a strong balance sheet means. They also know what growth means too. It’s kind of a barbell. They wanna grow, but they also know the importance of not over-leveraging to get that growth.

Matt: Keep going on the valuation double idea.

Ian: So the third one, which was invest at a valuation that could conservatively double without any multiple expansion — I think that’s something that I still do today as well. And for me, I think we all know the double lever of returns when it impacts a company, when you can grow a business and then also the multiple expands.

And obviously in the market environment we’re in now, where I don’t know what the S&P PE is, maybe 25 or 27, something like that, people are saying, “Well, we can’t get any more expansion.” But you can still find these small companies that are organically growing 25, 30%, where you can find them at reasonable PE ratios, where even if the multiple doesn’t expand over the next three years, but they continue to grow the business at that rate and earn more money every year, that equity should CAGR at the similar rate of their organic growth rate. And then if they do get multiple expansion, then that’s just an added cherry on top.

And so for me as an investor, I’m usually targeting every individual investment, kind of benchmarking it to a 25% CAGR. That’s what I’m looking to achieve on an individual level. And so that’s the valuation metric that I would say is more geared towards survival of an investor — not overpaying for a business as well.

The fourth thing: invest in businesses with a leadership team that shows signs of intelligent fanaticism. I co-authored two books on the topic of intelligent fanatics with Sean Iddings. You can’t really find them anymore. We took them off Amazon. They’re kind of turning into these scarce little assets. I think it was like 500 bucks on Amazon to buy one. We might bring them back out, produce a few more copies.

But we spent three years looking at intelligent fanaticism, which is a topic that Charlie Munger first brought up in one of his speeches. Trying to find these great business builders that can not only grow a business into something sustainable and something that dominates a niche geography or industry, but can do so for decades, that can remain in a dominant competitive position across decades. And then pulling out what were those leadership attributes and characteristics that were prominent across those types of leaders — the Sam Waltons of this world, and you go down the list of those types of businesses.

And so once again, trying to find businesses that show signs of intelligent fanaticism. A $50 million microcap company with what you think is a good CEO is not an intelligent fanatic yet, until they grow up and out of the gravitational force of microcap that pulls them down. And so that’s why I say we’re trying to find the signs of intelligent fanaticism, not that you’re finding intelligent fanatics. That’s a label that is earned after hopefully 50Xs.

Matt: It’s a nice thing to achieve such status.

Ian: Yes.

Matt: It’s nice to be there. Getting there takes a few more lumps.

Can we talk about the Judas goat for just a second?

Ian: Sure.

Matt: Explain the Judas goat. Let’s just get this on the table. What is it? Why is it there?

Ian: It’s one of my favorite stories.

Matt: It’s poetic.

Ian: It is. So back in, like, the meatpacking days, like 100 years ago, they would use a Judas goat to lure sheep to slaughter, up this ramp. I think it was usually six floors, and the only way they could get sheep in unison to go up the ramp was to follow a goat they found. I don’t know why. It’s just what they did.

And so these Judas goats would lead the sheep to slaughter at the top of these slaughterhouses, and the fix, or the compensation they would give the goat, would be a cigarette, usually a Lucky Strike or something like that. And so it would give the goat a nicotine fix, and then that would incentivize the goat to continue to lead more sheep to slaughter. And it’s just a great visual and true story of the past in the meatpacking industry.

But in that chapter in particular, I’m mainly talking about watching how you communicate if you’re an investor, especially in today’s day and age with Twitter — well, now it’s X — and Substacks and all of these things. A lot more people talking their book, coming into stocks confidently, trying to get more and more people to buy those stocks as they rise, and a lot of times they are simply just leading sheep to slaughter.

And so it’s kind of a warning to not only the people that are trying to build a reputation, just like I was, or am, over the last 20 years, to do it with grace — and there’s certain ways to communicate how you’re investing and communicating a story on a stock, and then there’s certain ways not to. And then also for the investor that follows people, just to be careful who you’re following and to do your own work, and not place blame on whoever you’re following. The blame certainly is just on you for making that decision.

Matt: Lucky Strike optional.

Ian: Yes.

Matt: Lucky Strike optional.

Comparison is the enemy — another chapter. I love this on so many levels, especially this age we’re in of leaderboards, performance updates. What does it actually mean? Define comparison the way you’re thinking of it, and why that’s such a challenge that we need to put on the table as professional investors.

Ian: Yeah. I think in that chapter I led with a story of Steve Stricker. I believe it was like 1996. Steve Stricker is a PGA Tour professional. He was in his late 20s. He was coming off the best year of his career, I believe. And in one of the first rounds of the 1996 season, he was paired with the 22-year-old phenom named Tiger Woods. And at the time, Steve Stricker’s caddy was his wife.

And I found an article where his wife was retelling the story, or the conversation that Steve had with her as they were playing a round of golf there that day. And basically, Tiger was driving the ball 50 yards past Steve on every hole, which meant he probably had a pitching wedge into the green where Steve Stricker would have a five iron.

And after that round, he just kinda came off the course wondering, like, how is he ever gonna compete against somebody like that? It completely destroyed his self-confidence, and so much so that it led to a 10-year slump, that he would eventually lose his tour card at the end of it.

And luckily, that wasn’t the end of the story for Steve Stricker. He would ultimately end up coming back, and he did so by focusing on his strengths, which was his putting. And he stopped comparing his driving distance to somebody like Tiger Woods, which was arguably his worst skill in golf against the best of somebody else. And then after that, he ended up winning nine more times on the PGA Tour, 18 more times, I believe, on the Champions Tour, and had a very illustrious career. And you could argue that he got better as he aged, which I believe you and I are too, Matt. We get better as we age.

Matt: Like fine wines.

Ian: Yeah, exactly. Fine wines.

And I think as investors and stock pickers, we tend to do this quite a bit, comparing ourselves to other investors, which is just silly, because we all invest differently in different ways, and we all win in different seasons and lose in different seasons. And it’s too easy for us as human beings to get despondent in the bad times when we’re having a losing season. We’re comparing our year-to-date return that’s down to somebody else that’s having probably their best season in investing. We’re comparing the worst of who we are against the best of everybody else, and that in itself can be very, very toxic.

And kinda the lesson of that chapter — there’s a few more stories in there too, as well as some personal ones — it’s just to focus on your own game, and that the competition isn’t other players. The competition is your long-term performance. And that’s something that we get into in later chapters, about what I benchmark myself up against over the long term. But it certainly isn’t other people or other investors, ‘cause that’s gonna be a distraction to you.

Matt: I like the way that you compartmentalize it. I like the way that you break apart, here’s where it’s important to think about base rates and relative comparisons, but then here’s where it’s important not to do that. The Stricker story does it really, really well. Parse that nuance just a little bit for me, ‘cause there are times when you wanna compare, whereas there’s times when, please hold on, don’t do that.

Ian: Well, you usually wanna compare when you’re doing well. You like to compare yourself to other people when you know you probably beat them year to date, and that obviously makes you feel good in the ego when you look at your performance last year. ‘Cause it’s always the last year or the year-to-date performance that’s the most front and center, because that’s what you’re going through right now. And you’re comparing that against somebody else. And so, oh boy, I’m up 54% and Warren Buffett’s only up 12, or whatever it is. You’re just like—

Matt: What a chump.

Ian: Exactly. What a chump. Well, look at me.

But there’s so many nuances with the comparison. I think there’s some you have to watch until you’re at a stage where your self-confidence — it’s not a distraction to you. Because you’re always gonna have people like a Tiger Woods, or whether it’s a Soros or a Druckenmiller, that it is a competition. He is looking to beat other investors, but he has such a hold over his own skill set when he’s not letting what they’re doing impact what he’s doing. It’s at a completely different level, and I think you can have that mentality. Certainly some people do, some of the greats. But you don’t have to. But if you are gonna have that mentality of always looking at somebody else and seeing how you’re doing compared to them, I think you just have to go into it knowing that you have to be in complete control of your game before you even start to let that infiltrate your mind.

Matt: There’s also the time horizon aspect of this too, where you’re thinking in pretty decent sized chunks of time for when you’ll even allow some of these numbers, performance statistics, whatever, to bubble up to mattering, to be separable from noise. How do you think about that?

Ian: Yeah, I look at performance on the fund and investing performance in a 10-year kinda horizon. My goal is to beat the S&P 500 over a 10-year period.

And that’s another topic we could get into as well. There’s a lot of active fund managers or stock pickers that don’t like to use the S&P 500 as a benchmark. I think if you truly wanna be the best, you compare yourself against the best performing, cheapest option that’s available to anyone, and that’s the S&P 500. Because the S&P 500 is the ‘92 Dream Team. It’s Michael Jordan, it’s Larry Bird, it’s everyone there. It’s Nvidia, it’s Microsoft, it’s Google. It’s the Dream Team.

And in my case, it doesn’t matter that I don’t invest in the S&P 500, any constituent there or anything. It’s a goal of my no-name roster of microcap stocks to beat the Dream Team. That’s my long-term goal. The way we get there, yeah, I’m gonna probably lose to it a few years and then hopefully crush it a couple other years. So in any given year, I might look like a hero or an idiot, but over the 10 years, the goal is to beat it.

Matt: We are all chasing that ‘92 Dream Team now. If you were a small country anywhere in the world going up against them, what country would you pick? I can’t remember if anybody... I know nobody actually gave them a run, they just thrashed everyone in that cycle. Give me a country. Pledge your loyalty to some obscure nation for a second. If you were playing this on a video game, who would you pick?

Ian: Which Eastern European countries do a lot of the NBA talent come from now?

Matt: All’s I’m trying to think is, it’s gotta be something weird like Croatia. You need somewhere where you’re hardened and chiseled.

Ian: Yeah. Well, that’s why I think it’s awesome — like even the Winter Olympics, you have Norway. What does it have, a population of 6 million people, like half the population of Pennsylvania, and they won more medals than anyone else in the world. It’s pretty cool, actually. As an American, I think that’s pretty cool.

Matt: Yeah, the per capita adjustments of some of these countries are just staggering.

Ian: Yeah, it’s crazy. I started thinking about it like that when I was looking at the countries. I’m like, “Wait a minute, they have a population of 6 million people.” Like, how are they going up against us with 340 million? You can’t tell me that we can’t produce athletes that, in some way, shape, or form, just by the law of averages, we can compete better.

Matt: Yeah. Or should we be registering some random part of Iowa as its own country to go compete? Because who knows, maybe that’s the talent pool that could be America’s Cape Verde.

All right, seven skills. So in section four, you go through this full framework, and this is the identifying, analyzing, buying, selling, holding. I would venture to say from many conversations, people will talk about maybe two of those in their process. So explain these as a unit. Why is it so important to see cohesively?

Ian: Yeah, and this is where I bring the book together, in these five core skills. Identifying, analyzing, buying, selling, and holding. And I think there’s so many different variations of stock picking, from day trading to coffee canning, and technical analysis, fundamental, hyper growth, deep value, shorting, activism. There’s so many different flavors.

But I do believe each one of those flavors executes on these five skills. Identifying is finding actionable ideas before others, and the pursuit of active patience. Analyzing just means due diligence and valuation. Buying is just sizing your conviction — how big of a position size are you making it when you make an investment? Selling just means limiting your losses and capturing gains. And holding, which is just maintenance due diligence, knowing what you own at all times. And so I think every kind of flavor of stock picking executes on these five unique skills.

Now, each one of those flavors might focus on one or two more than the other three. But that’s actually another area I get into in the book, where even in those cases where a certain flavor of investing might not look at selling that much, the people that are actually outliers that outperform using that flavor of investing probably are using that underutilized skill more than the others.

But yeah, I think everyone uses these skills. I dive into each skill in the book, and I think each one is important. For me, being a microcap investor, I would say the ones that are more important to me are something like selling, because the shelf lives of these smaller, more emerging companies are shorter in general than if you were gonna compare my type of investing to mid-cap or large cap. There’s just less blowups in mid-cap or large cap. Selling is more of an important skill down here in microcap, because the turnover by nature is gonna be higher in a portfolio of microcaps than they are in mid-cap or large cap.

It’s really almost impossible, I think, to do well coffee canning — which we talked about when I was on with Chris Mayer and you the other week. It’s just hard to coffee can a portfolio of microcaps. It’s a pretty easy way to go broke. Most of these companies, they have a shelf life. They have a season or two where they do well, and then reality catches up to them. The product that ascended the business stops ascending, and they need to scramble to find another product to replace that revenue. You see that time and time again.

So the seasons of winning a microcap are usually one to two years, and that’s usually the holding periods of even the winners. And then obviously you’re gonna have outliers that you are able to hold over a longer period of time, but those are the outliers. They aren’t the reality of microcap investing. Like, I have one company in my portfolio that I’ve held for five plus years out of probably 80 or 90 companies that I’ve owned over five or six years. So it’s hard.

Matt: How do you think about the combinatorial aspect of these? Because when I think about buying and holding, or selling and holding, I think about increasing or changing a position size as part of the maintenance due diligence, and how these are very related. You talk about them separately. You talk about the nuance of each.

Ian: They are very related.

Matt: But they’re so, so very related. Think through that for me.

Ian: Yeah, and some of them are kind of the counter. Obviously if you’re not holding, you’re selling. So that’s the other side of it.

So yeah, it gets into your flavor. And even sizing your conviction and the buying part of it, I’ve evolved quite a bit on. In my early days I was in three or four companies at a time, which meant you’re taking 25% at-cost positions or more. Then I went to like seven to eight positions, then I went to 12. Now I have around 12 to 15 positions.

And what I’ve found over time is I think the skill of buying and sizing it correctly is a skill that probably a lot of folks don’t talk about more than they should. Just sizing it right in the beginning. And a lot of times for microcap investors, it quite honestly means just sizing it smaller than what you want to do.

Matt: That initial excited expected value calculation.

Ian: Yes. Let the euphoria and infatuation wear off for a week or two, and just put a portfolio sizing limit on yourself of, whether that’s 3% or 4%, doesn’t matter. But give yourself some time, because the truth is, in 90% of the things you buy, you will like them less in six months, not more. And so I think to reframe things that way, it kind of resets reality when you’re looking at something new that you’re obviously excited about.

Matt: Say a little bit more about active patience, because I think this is a really valuable term. And not that you would miss it going through this, but it is a term that... This is one of the words from this book that’s gonna be with me for a long time. Explain the term for people who haven’t encountered it.

Ian: That was maybe another fun chapter to write, because it’s one that I couldn’t have written until after probably 20 years of investing. But active patience is something that occurs only after 10 or 20 years, when you develop into the stock picker that you were meant to be, where you can just kind of sit there and wait for the opportunities because you know what you’re looking for.

And I think a lot of people overemphasize identifying companies or finding great ideas. Well, getting more idea flow means nothing unless you know what you’re looking for. And so the whole role of active patience is, it takes 10, 20 years to finally fine-tune your lens into what type of company, what type of leader, that you wanna invest in.

It doesn’t mean that you are slow to react. It actually means that you can be very quick to react when you find something. You can react within hours, not weeks. It doesn’t mean you’re slow to do due diligence. It means you know exactly what you’re looking for.

And you can draw some comparisons to someone that’s been an art dealer for decades and looking through an art auction catalog and just flip, flip, flip, flip, and probably goes through like 10 or 15 catalogs, and all of a sudden just stops and they’re, “Oh, there it is, and that’s what I’m getting, and this is what I’m willing to pay for it.” And you become more of an art collector, kind of adding prized assets to your collection, I think, once you fully develop that active patience in your portfolio.

And a lot of that, the first few years is just developing your temperament and finding out what type of investor you are, when it comes to position sizing, your risk tolerance, valuation, all of those things. And that just takes reps and time to figure out what that temperament is.

Matt: And I’d tie that back to, as well, this is part of the learning process, of you have to learn how you’re wired to identify. You have to learn the way that rhymes with your processes in each of those categories.

Ian: Yes.

Matt: Let alone what the combination’s going to eventually emerge as.

Ian: Yeah, exactly. And the hard part about investing is it’s just hard to speed up time. You can do little tricks and techniques, which is what everybody should do, like journaling everything, and having your watch list, because that gives you at least mentally more reps in investing than just what you own. There’s little tricks that you can use to mature or evolve quicker.

But it’s hard, because investing — depending on which style of investing you are, if you’re longer term — it can take you a year or two years or five years to know if you’re right or not. If you’re a trader, it’s easy. Probably in three seconds you know if you made a mistake, and you learn from it and you don’t do it again. But if you’re more of a longer term investor, those feedback loops are longer, and that makes it even difficult.

So a lot of investing is just taking the time to go through the process to be the investor that you were meant to be, and then not just sitting on your laurels and being okay with it, but continuing to evolve, continuing to push out that circle of competence.

Matt: Do you think about it in those terms, pushing out the circle of competence? How does that come through?

Ian: Yeah. I look at it as almost more of an artist, where my first five years I was a story stock investor, which meant I cared nothing about fundamentals. I just cared about the story. Then I was a resources investor. Then I was life sciences. Then I turned into GARP later. And in each one of those seasons, you tend to overemphasize what you’re focused on. So when I was investing in resources, I was probably 80% resources. When I was in life science, I was probably 80% life science.

But then over time you realize that you don’t need to overemphasize any single area. You have this palette of all these colors that you’ve painted with before, and now you can paint with all of them, and you express that in the portfolio in the same way. And it takes 20 or 25 years to figure out how to paint with all the colors.

And that’s why the GOATs of investing, whether it’s Buffett or Druckenmiller — they don’t paint with one color either. They’re not just long only investors. They also short, they also are macro. They also do credit. They have all the different types of colors in their arsenal. And that’s what the GOATs do. They just continue to push out that competence.

Matt: Well, let’s talk about that. Let’s talk about good to great to GOAT. Can’t double dip on the Judas goat here, but good to great to GOAT.

Ian: Yeah, so the good to great to GOAT — and we talked about a little bit of this already. It was a fun chapter. But how do you define good, great, and GOAT stock picker?

And I start off by talking about, I could see a lot of active managers potentially being annoyed with this chapter because of how I define it. But I do qualify it by saying this chapter is meant for absolute return stock pickers, not capital preservation stock pickers, not somebody that’s looking to invest 100% of somebody’s net worth, and obviously some S&P index funds and stuff like that. They’re different. I’m just talking about folks that are looking to invest and their goal is to crush the S&P 500. So that’s what these definitions are about.

And we talked about the S&P 500 — I think it is the benchmark, and it should be the benchmark for anybody that’s an absolute return stock picker, even if they don’t invest in large cap companies.

So I define good stock picker as having... And I think how you grade a stock picker is over performance and time. It’s obviously easier to get really good performance in a short period of time. It is harder to get good performance over a longer period of time. And so those are the two levers that I used to define good, great, and GOAT.

On the good side, a 10-year track record of beating the S&P 500. And so how many make the cut? About 10% of active managers. And that just shows how hard the S&P 500 is to beat over 10 years. And something you already know — it’s just amazing, if you turn on to CNBC, probably 90% of the people on there can’t beat the S&P 500, and yet they’re on there.

Matt: Oh, but they can talk like they can.

Ian: Yes, they can. Yeah.

And so that would be a definition of good. A good stock picker would be somebody that can beat the S&P over a 10-year period. A great stock picker, the definition would be a 20-year track record of beating the S&P 500. How many make that cut? About 2.5, 2.7% of active managers. And then the definition of GOAT would be a 20-year track record of 20% net over 20 years. And that’s, I don’t know, it’s probably less than a half a percent or whatever. It’s a sliver.

And so that’s my definitions of good, great, and GOAT. And obviously we can have conversations and people will push back on, “Well, what about so and so? They’re on TV a lot,” or this or that, and they’re good. And I’m not saying they’re not. But I’m just saying how I would benchmark good, great, and GOAT, and that’s how I would define it.

In the book I talk about Brazilian jiu-jitsu, and there’s a gentleman named John Danaher, who’s sort of seen as the Charlie Munger or Albert Einstein of Brazilian jiu-jitsu. He’s like a seven-time black belt in it, and he has a great past as well, which I won’t get into. But he’s a really, really great thinker. It’s almost like when you’re listening to him do interviews, it’s like you’re listening to Charlie Munger or some other really well-respected, intelligent human being. You just wanna keep listening to him.

And he was asked about how anybody becomes the best in the world at what they do. And he articulated that he believes in any profession or area of expertise, there’s usually five or six core skills that you need to learn and be proficient at to be good. And that’s where I got the ideas of good, great, and GOAT. Then he said, to become great, to be world-class, you not only need to be good in all of those skills, but you need to be great, and the best in the world, at at least one or two of those skills.

So I size up this chapter in defining not only what good, great, and GOAT mean, but what is the difference between what’s allowing the good, great, and GOATs to beat average, and what’s allowing the great and GOAT to beat the good, and what’s allowing the GOAT to beat the great and good? Follow that frame of thought.

And I think it’s different for each category. But I think to be a good stock picker, to be in that top 10%, you do need to be good at those five skills I outlined earlier. And there’s certain ones that you’re gonna be good at just naturally, your strengths. And then there’s gonna be one or two that are naturally gonna be your weaknesses, and it’s your job not to look the other way on those weaknesses, ‘cause they will hurt you. But to fill those voids, either with technology or a team or somebody else, to get at least to good in a couple of those skills. And just their ability to then be that way for 10 plus years, I think, and do it consistently, is good enough to get you in that top 10% and become good. I think that’s the difference maker.

For the great stock pickers, I think they’ve evolved. To go for 20 years, I think that means they’ve had to evolve in small ways or large ways to keep that competitive advantage as an investor. And there’s different examples I talk about in the book. But the way to become great might not be the way that you were good. They usually probably had to evolve with different skill sets.

And then GOAT — this gets back to the point of John Danaher, that the folks that are world-class in a profession, a sport, they usually took an underutilized skill set, reinvented on it, and reintroduced it back into the game in a way that took their opponents by surprise. And I give a couple examples in the book about what that could mean in the investing lens. Whether that’s a deep value investor that’s only screened for tangible book value, caring about management quality, which isn’t normally what they would look for. They’re looking at assets. And I give a couple examples of deep value investors that do care about management quality, and some of them have outperformed greatly compared to deep value benchmarks. And I give some other examples there as well, as obviously Druckenmiller and Soros and Steinhardt and these guys that also have done well.

But I think the GOATs, they’ve evolved, and then they’ve also, like we talked about before, now they can paint with all the colors and they build a team around them. They go from having to really play every instrument in the orchestra to start leading the orchestra. They build a great team, and that allows them to just continue to compound at 20% net for long periods of time, which is really my goal. We’ll see if I get there.

Matt: So inside of that progression, there’s an idea that you really make me think about, which is how the skills evolve. They’re either learned internally or they’re learned externally, and those skills go through all these different iterations and developments, and that’s a big part of being the GOAT — you figure out how to dominate in different... You know, when King James comes to play for the Sixers. Is he gonna figure out the way that he has to play now? It’s very much not the way that he had to play 10 years ago or longer.

Ian: Yeah, or Jordan developing his jump shot when he couldn’t jump 12 feet in the air anymore. It’s all those things.

Matt: Right. The Wizards era. Or him even going to play baseball. It’s interesting to think about.

The part that has limitations, though, is this temperament idea. So what’s that relationship between skills and temperament over time?

Ian: I think your temperament evolves, too. And all this, it’s not a science. We’re all different, and then we’re all changing in ways. Like even me talking about position sizing — I used to take 20% positions, now I take like 4% positions, because I found that actually works out better in my area of microcap investing. Because when I’m investing in something that could be a multi-bagger and it does, it quite honestly doesn’t matter if it’s an eight or a four. If it’s gonna work, it’s gonna work. If it doesn’t work, it’s not gonna work. So I’ve given myself more chances to win by taking the positions from eight to 14, more chances to win, and just being more cautious on the at-cost capital I’m putting into individual companies. And so that’s an area that I’ve evolved.

But I think the temperament, a lot of it is generated in those early years. Like even today, drawdowns or volatility in the individual stocks that I’m in doesn’t bother me, because at least one time per year I wake up to a position down 35% pre-market for some unknown reason. And that’s just part of it. You just get used to that volatility. And I think depending on what your area of investing is, whether it’s microcap or large cap or whatever, you just get used to those nuances. So I do think the temperament’s kind of set in motion in the direction in those early years.

Just like my first few wins got me further up on the risk curve than if it would’ve been a loss, it would’ve been down the risk curve. Maybe I would be a deep value investor if my first investment was a loss. But it wasn’t. I was investing in story stocks and I won a few times, so now I think I can win in those types of equities. And so that just got me on that different trajectory.

Matt: Yeah. It’s very interesting to think about that, where temperament and skill just evolve on two different tracks almost. And as we age, mature, gain those experiences, those linkages are gonna mean different things as you look backward and forward in time.

Ian: Yeah. Exactly.

Matt: The secret to compounding — spoiler alert, let’s spoil this. What’s the secret to compounding?

Ian: It’s one sentence. No. Actually, it probably could be.

Yeah, this chapter was something that I was reflecting on just more so thinking about my kids, believe it or not, less about investing. But I think it’s a lesson that can be applied to your personal life, your business life, and your investing life as well.

And I think it’s really just living in the present more than we wanna live in the future. I think as a stock picker, especially somebody that’s always looking out two, three years ahead, trying to guesstimate at what a business is gonna look like, what they’re gonna earn, and what multiple should be applied to it — I’m always looking out three years. I’m always hoping for the next quarter to come here because I think every company I own is gonna crush it. I’m always looking to get tomorrow’s gains today. I can’t wait to get those achievements I get when I get those gains from my LPs. I can’t wait maybe to spend some of that money I get after I make the money a year or two years out. You’re always living in the future.

And I don’t think it really hits home when you’re younger, because you feel like time is in abundance when you’re in your 20s. But when you’re in your 30s and then your 40s, you realize time becomes the scarce asset. And you start to realize the way to achieve your goals, your dreams, whether that’s on a personal level or a portfolio level, is to really pay attention in the present, to today.

And the way we get off center on achieving our goals on the investing portfolio is not doing the work today that we should be doing. The way we let our relationships get off track is not doing the work with them today, not saying, “I love you,” to your spouse today, not hugging your kids today. That starts, and then you don’t pick back up on it, and that’s what leads to things. So the whole point of the secret to compounding is, the way you take care of tomorrow is by taking care of today.

Matt: You just can’t look at tomorrow all the time.

Ian: Yeah, exactly.

Matt: The great irony in both of these things—

Ian: That the Phillies winning the World Series. No, I’m just kidding.

Matt: From your mouth to John Kruk’s car insurance commercials.

No, it’s the great irony that is the very recent rear view mirror disaster that was Situational Awareness. And this is what you’re describing. You actually need that situational present awareness of, what do I have to do today that ties into the tomorrow that I’m trying to connect, that I can control in some positive way to just not screw it up?

Ian: Yeah, exactly. And I don’t know how old he was at Situational Awareness.

Matt: 25 or something insane.

Ian: 25, something insane. But I’m sure he’s gonna come back even stronger and crush it again. ‘Cause everything he was in did well, just not for that two-week period, right? In hindsight.

Matt: Which is part of the interesting thing on the age adjustment, and your total points to this. So I know we’re talking about two entirely different spaces that you guys are operating in, but you look at a situation like that — and I might be getting this wrong, I do think at least when the fund started, he was mid-20s somewhere, 25 is in my brain. You’d look at somebody like that and you’d go, “Holy crap. That’s a lesson.” But because you delivered these results, odds are you’re gonna come back with some hard-won battle scars to figure out a better way to do this the next time around.

Ian: Yeah, I would think so. He now probably won’t over-lever like he did, ‘cause he would probably be really crushing it if he just wasn’t as levered. And I have no doubt he’ll be able to raise just as much money or more, probably, the second go around.

Matt: It’s also interesting too — and I think this was a Kris Abdelmessih-ism — he was talking about, he likened it to the croc’s eyes coming out of the water. It’s like the Ken Griffins and the other people. The people who think about not just what the returns are going to be, but they worry about the existential questions like, “Will the markets open tomorrow?” And when they see somebody over-leveraging, they’re the crocodile whose eyes come up. And I think a lot about what it means to mature into that state, which I also grasp you—

Ian: With the active patience. They’re just kind of waiting for some asset that they wanna own and the opportunity to buy it at the price they want.

Matt: Yeah. I use this in something I wrote about one of Kris’s pieces on this. It’s this fascination with — we make fun of the dinosaurs, the big dumb dinosaurs, that the meteor came and wiped them all out. And then you remember that there are birds, and there are alligators, and there are crocodiles. The dinosaurs walk amongst us in the most literal sense. But they’re the ones who just kept compounding in some weird way, shape, and form. They’re not gone. They have a bunch of strategies that you can kinda look at and say, “All right. This is better than one meteor kills you all.”

Ian: Yeah. No, absolutely. There’s a whole other rabbit trail we could go on that topic too, of evolution and these different areas of the world that then all of a sudden evolve very quickly compared to the other side of the world where the same species is. Anyway, that’s a whole other topic.

Matt: The Galapagos Island small cap edition is coming.

I wanna hit a couple more quick things with you. This idea of how edges dull if you don’t keep sharpening them — I think this was when you were talking about mentors. Say a little bit more about that.

Ian: Yeah, I saw it with one of my mentors that I had earlier. He just didn’t evolve, and that’s partly why we sort of still were in contact, but we didn’t invest together anymore after a certain period of time.

Matt: Was this Skip or was this somebody—

Ian: Yeah, yeah, exactly.

Matt: Okay. Great story.

Ian: And I think that it is important just to continue to not be happy with where you are in your skill set. There’s always a better investor inside of you, and that’s something that continues to drive me too. Like, where am I?

Even the portfolio I have today — it’s funny, every year you start out and probably your biggest position you have, you think it’s gonna be up another 100%, and everything else you think is gonna do well. But in reality, fast-forward 12 months, probably half of them you’re not gonna own anymore because they underperformed or something changed with the thesis. And then usually the one that does the best is your smallest allocated one, because you thought about it less, you didn’t overthink every little thing. You let it four or five X out of nowhere. All of a sudden that becomes your largest position.

We like to think that we can control the future with our position sizing. And that’s one of the areas that I’ve had to evolve. I take a much lesser angle that I know I’m gonna be right in the beginning, by limiting my position size with it. And it’s actually helped my returns since I’ve done that, where I’m gonna make this thing a big position at cost, and it’s usually the small thing that then outperforms. So I’ve taken that out of it, which is an ego hit, ‘cause I like to think I’m right all the time, but I’m not. History has shown. My wife tells me that too.

Matt: Well, she’s not on this interview, so history will be adjudicator of that fact.

Closing question: what is something that you think one of your peers doesn’t understand, still gets wrong, especially as it relates to microcap and the space that you operate in?

Ian: So would the question be, what do a majority of my peers think differently than me on?

Matt: Yeah. Or disagree with you on. We’ll go with majority, but if you wanna group this down smaller to people who think about microcaps — you’re an odd lot, but you have a thing with your club and community where you run into more of them than the average bear.

Ian: I would say probably an angle that I express my portfolio that is different — and at the surface it might not seem like it’s different, like everybody says they would invest in great leadership. But it’s kind of on that great leadership angle, where I’m willing to invest in a management team that has been a repeat winner, that has had previous success, when not all the pieces are together yet in the business that’s publicly traded. It might be this shell of a thing that they’re bringing the team together in. It might even not be making money.

But I meet with them, I understand the vision of where they’re going, and I’m willing to say, “Okay, I don’t know if I’m gonna make money in this this year, next year, or the year after that, but I’m willing to bet eventually I’ll make money and it’ll catch up to the CAGR I’m looking for.” We’ve had a couple of experiences of that in the portfolio, where we made a direct investment into a small microcap company late ‘23. Literally went nowhere for two and a half years, then it went up 400% in a quarter. And it definitely took a little bit longer than I thought and the management thought, but I knew they would figure it out because the management quality was very high.

And I would say that’s probably a nuance where I’m probably different. Other than that, I think it’s less about where I’m generally in big ways different, and more of how you bring all the pieces together in your strategy.

Matt: Well, I will say it again, this book, Stock Picker, does an excellent job of putting all those pieces together and not getting stuck in all sorts of the normal places. I don’t think it’s common either to get a book like this from somebody in their mid-40s at this level of the journey. I think we get a lot of the after 40 years, here’s principles — when you write that, I don’t know if we’re having this conversation. But here on the way up, it’s a really interesting place to stop and pay some respects to the things you’ve been through, but also say, “Here’s where I’m trying to go.” So thank you for writing this book.

Ian: No, thank you. Thanks for reading it. I hope other people enjoy it as well.

Matt: If we wanna have people bug you on the internet, where should we send them?

Ian: You can find me on X, my handle is my name, Ian Cassel. You can find me on microcapclub.com, which is an online community that I created 15 years ago for wackos like me that invest in microcaps. You can attend one of our events at planetmicrocap.com. And that’s where you can find me.

Matt: There you have it. That’s Ian Cassel. You wanna get a copy of this book, Stock Picker, wherever fine books are sold. Thank you so much for doing this, Ian. You’re watching Excess Returns. Like, comment, subscribe, all the things below, and we are out.

Timestamps:
00:00 Intro
02:15 Why rising rates and record-high stocks can coexist
07:30 Rolling recessions and why the economy isn't moving in sync
11:57 Labor vs. capital and the rise in corporate profit share
17:39 Why the biggest AI beneficiaries may be cement, copper and natural gas
25:26 Could the bond market really lose control of the long end?
30:22 Where to find episode notes, transcripts and more

Learn more about the Excess Returns podcast network:
https://excessreturns.co

No information discussed in this podcast should be construed as investment advice. Securities discussed may be held by the hosts and guests, their firms or their clients.

Matt: Nothing. Nothing says live from vacation like I’m recording a podcast.

Jack: Well, I figured the backdrop, which you’re gonna comment on at some point, so we might as well get it out of the way — with these nice photos I have behind me, would probably give it away.

Matt: They are... This is a lovely representation of nature and natural art. I assume they’re from a very fancy collection.

Jack: I got some coral or something. It’s kind of a good fit for, like, I’m at a beach location, so the coral, it all fits in.

Matt: This fits. Joseph Mora, I’m coming for you. We’re gonna critique Jack’s wall art together and find out what vintage of reefs and sea anemone and other structures are behind him.

Jack: Yeah, I mean, I barely got dried off. My kids were splashing me about five minutes ago, and so I’m like, “Oh crap, I gotta get up here and film with Matt.”

Matt: No live from the pool? The Jack Forehand... It’s like the MTV Beach House, but it’s the Jack Forehand Beach House.

Jack: If it would get the views, Matt, I would do it, as you know. Anything for the views. But I don’t think that would get the views, nor would... the people at the pool would probably wonder what’s going on here with this guy.

Matt: I want the meta joke of, basically, for the two people who understand the reference, of the time that Radiohead played at the MTV Beach House, and you had pasty guy in his striped shirt sitting next to the pool. It could just be you doing the podcast instead of them doing Creep. I can see this in my mind now.

Jack: I will get us off track, but I remember that MTV Beach House. That was like a huge thing back when I was younger. Everybody was all excited about that.

Matt: You gotta sell spring break to the kids, you know?

Jack: I guess so. So anyway, we probably should get into... We have some great clips today, so we should probably get into them. We’ve got Andy Constan, we’ve got Liz Ann Sonders, we’ve got Bob Robotti, and we’ve got a lot of stuff like we always try to have. We have things that we learned when we listen to these things. And, you know, we do a lot of podcasts, so when we’re learning something, it’s usually something pretty new and interesting. So we’ve got a bunch of stuff like that today.

Matt: Yeah, these are great clips. I mean, these are S-tier guests, if I dare say it myself. Lots of cool stuff. Lots of counter perspectives that... or just ways to think about stuff better. And Andy — I know we’re leading off with Andy here. Andy has such a way with being able to do this. You wanna intro what’s in this first one?

Jack: Yeah, there were like four things in this episode where I kind of asked him about a myth or something people misunderstand, and he broke it down perfectly. So I would highly recommend people listen to the episode.

But what we started with is a question I’m getting a lot, and you might be getting a lot from clients too, which is rates have been going up a lot recently. The 30-year, I think, is at near multi-decade highs right now. And a lot of people are like, “How is that happening?” At the same time, the stock market — although it’s pulled back a little bit recently — the stock market’s near all-time highs. Like, that doesn’t make sense to me. So we asked Andy about that.

Andy: I think markets are basically acting internally consistent at this stage. It’s not like there’s things that are saying, “Wow, that really makes no sense to me.”

Interest rates going up is often confused. I think even our president is confused about the idea that real growth, particularly productivity growth, also population growth, but that’s not a factor today. Real growth, by its very nature, pushes interest rates up because people prefer to spend their cash to build a data center that has great potential for earnings than buy bonds. And so the data centers are selling the equity and things like that. The investors are saying, “Well, I’d much rather own equity in that than own bonds.” And so that presses up real yields, and it’s consistent with an economy that’s running very hot. So I think that’s internally consistent in the rearview mirror. Higher interest rates, driven by higher growth expectations.

Down a level, interest rates are also a little higher because there’s a temporary period during which all this financing is being done, where there’s a new corporate bond issued every day, often many per day. The government continues to run a large deficit and continues to need to issue its own debt. And so there’s a little bit of what I would call risk premium expansion that’s going on that’s driving longer-term interest rates higher.

A lot of people, when thinking about the bond market, are making a lot of premature, in my view — but based on like five years of history, so sensible — assumptions that the Fed just doesn’t care about inflation, and the administration wants to run the economy hot. So there are people that are selling their bonds because credibility matters. I think that’s less of an issue than just very strong growth and quite a bit of bond supply.

And the equity market makes sense in the context of, interest rates are high, but they’re not restrictively high or not seriously high. The central bank isn’t really making... Even the most hawkish central banks are modestly hawkish. So there’s not a lot of restriction going on, and there’s strong growth, so equities do well in that environment.

Jack: This kind of gets into what we talk about all the time, Matt, which is the question is always why. You can never say in the markets, you know, this thing is happening and it’s good or it’s bad. Well, with some things you can, but with something like this, the question is why. Are rates going up because we’ve got a crazy inflation shock like 2022, or are rates going up because we’ve got real growth like we have now? Those are two different scenarios, and one is a pretty good scenario for stocks and one is a pretty bad scenario for stocks.

Matt: I love what Andy always makes me do when I listen to him, is it’s just put your hand over the narratives. Put your hand over the narratives, look at the data, and now think about what story is the data telling you without seeing the headlines that are tied to them.

And when I hear him breaking this clip down and saying, “Here’s different reasons that we can think of the long bonds moving up and seeing yields move up” — let go of the current narratives that are everywhere and look at the underlying data, see what’s pushing those, and get your brain thinking from that level. Self-discover this from what’s inside of the data, not just from all the media headlines that are being thrown at us on this topic, because they are very, very competing.

Jack: Yeah, he made the point that obviously, if rates go up a ton, you’ve got a problem for stocks. But even if you look back to the ‘90s, Matt, rates were not low in the ‘90s. We had strong growth. We had a tech situation. We had something very similar to what we have now, and rates were not low. So we kinda got used to this period of low rates. I think a lot of us sorta forgot what normal rates look like, because normal rates in my career have been so much lower than what normal rates over a longer period of time look like.

Matt: Yeah, because we haven’t had growth and we haven’t had inflation. Which makes it really interesting to say, “Okay, we actually have some version — from wherever it’s coming from — we have some version of economic growth, and we have some version of inflation happening at the same time,” which produces higher rates, higher real and nominal yields. So you put your hand over all those stories again, you look at this data and it says, “Yeah, this is not surprising,” and it’s a lot like the rest of history.

Jack: So this next one, Matt, is from Liz Ann Sonders. And this gets into the vibecession here, which — we should always credit Kyla Scanlon. Whenever that word is used in a podcast, Kyla Scanlon must be credited, so we will credit Kyla Scanlon.

But this idea that people expect unemployment to go up, but people also expect the stock market to go up, and that’s not something you typically would see in history. So here’s Liz Ann talking about that.

Liz Ann: Well, I think, starting with where we are in the economic cycle, we can’t think of this cycle in linear terms. Not that there’s really a true normal cycle, but typically you come out of a recession, you go through the recovery phase, and you have an expansion phase, and then a slowdown phase, and then the recession. And certainly when there’s a credit crunch involved or a financial system collapse, like in the case of the global financial crisis, it tends to happen in that linear fashion and in the aggregate.

Anything but that has been the case in the post-pandemic era, all the way back from during the pandemic, where the goods side of the economy boomed, along with the stimulus, given services were shut down. Manufacturing then rolled over when we got the vaccine, and services opened back up, and you had pent-up demand there, pent-down demand on the goods side. So you went into a manufacturing and goods recession for a few years, offset by the services side. Now, services has rolled over a bit, but manufacturing has picked up.

And I think that ties into the much more rotational nature of the market right now. That is the connection point: sectoral recessions and expansions in the economy happening at different times, and that, to some degree, is leading to some of these rapid-fire rotations, exacerbated by the key players in the market right now, in many cases having time horizons measured in nanoseconds. And you can pull on any of those threads, but that’s the broad-brush look at not just the economy and the market, but what the connection points are between the two.

Matt: I love her response to this, because this is what it’s like — and we get into this in the interview — this is what it’s like talking to real clients. People come to you, and they say these two things next to each other, and you have to help them understand these are kinda competing, and one of these could catch up, and one of these could catch down, and here’s the different outcomes that can come from this. But this is really, really happening. People are trying to hold these thoughts at the same time in their head, and there is true cognitive dissonance here between these narratives.

Jack: Yeah, and I feel like in my career, there’s been nothing like this before. There’s been nothing where people are thinking the economy is really bad, or not happy about the economy, but they’re optimistic about the stock market, and the stock market’s doing really well. And it’s gone on for a long period of time. I remember — I don’t know if you remember — when this started out, people were like, “This can’t continue.” Like, you’re not gonna have these two things simultaneously existing. But they have simultaneously existed for a long time now.

Matt: I think about this too, in the terms of, she breaks down the economic cycle here. And you think about the way that we move through that economic cycle from recession, recovery, expansion, to a slowdown, and that’s that clock. What’s fascinating here, as she explains it, is you can really see the rotational reality of different parts of the economy seem to be in different parts of the cycle, and that’s showing up in different stories that we’re telling each other as investors, as people.

That rotational aspect is probably one of the things that keeps me the most optimistic right now, because those cycles aren’t all lined up. And I think that’s a really interesting detail here — that without these cycles lined up, it gives room for certain things to zig and other things to zag. And I’m not convinced that it has to end badly until everything lines up. That’s when I get freaked out, when I see all these things telling the same story.

Jack: Yeah, this gets into that sector-by-sector recession thing, which is basically what we’ve been having. People talk about we haven’t had a recession in a long time, but we’ve had lots of rolling recessions in different areas of the market.

And it also makes me think about Jim Paulsen’s point about tech and everything else, because everything else is more tied to your average person in the economy, and tech is not as tied to that. And so you can get the feeling that the tech is doing really well. Your average person’s not gonna feel as great about the market when the other stuff is not doing as well as tech.

Matt: Yeah, and we’re seeing this across not just sectors of stocks. We’re seeing this across the different sectors and breakdowns inside of the economy. We’re seeing it between consumers versus employees, across demographics. It’s very interesting how deeply this runs, and also very important to revisit that vibecession term that Kyla came up with, where something can look one way and feel another way, and that does have ramifications.

Jack: So our next clip — you might say, “Jack, did you come up with a perfect next clip to follow this with?” And I’ll say, “Matt, yes, I did.” Because behind this whole idea is this idea of labor versus capital. So here’s Liz Ann talking about that.

Liz Ann: Let’s just explain the concepts here, because — and in fact, I know the chart you’re talking about, and if you don’t pay attention that there’s a scale on the left and a scale on the right, it makes it look like corporate profits are a much larger share of GDP than labor, which is compensation costs. That’s not the case. Compensation as a share of GDP has always been much, much larger than corporate profits as a share of GDP. It’s the direction of each of those.

So in the 1970s — since we’ve already talked about Great Moderation versus temperamental era — in the 1970s, labor was, I’m guessing and rounding a little bit, you might have the chart in front of you, I do not — but 65-ish percent of GDP was labor compensation. That’s now down to about 54, 55%. Whereas corporate profits have more than doubled. I think it was like 5 or 6% of GDP, and now like 11, 12% of GDP.

So there’s another sort of K. But I always am quick to point out, if you’re looking at that data, understand the two different scales. But I don’t really see a near-term catalyst to start to see convergence there, where labor starts to pick up share and corporate profits come down. Because corporations, courtesy of profits and this sort of low hiring, low firing, for lots of reasons, employees are not demanding compensation above the rate of inflation. The latest wage data, actually the growth rate is lower than the rate of inflation. That may be a positive longer term for inflation, notwithstanding the other forces that are not driven by that.

But I also think it means that labor is unlikely to wield power again, certainly relative to the 1970s, when it was a much more unionized workforce. That was a big part of it. So I think the only thing that would potentially shift that is if we started to see a significant deterioration in corporate profits, where that gets dragged down just because of normal cycles. I don’t think we’re imminently facing that, and absent that, it’s hard to see how labor would wield a pickup in share of the economy.

Jack: Yeah, so Matt, first of all, she made a really good point on this, talking about the idea that with these charts that have two sides, you’ve always got to look at the percentages on both sides before you comment on it.

Matt: Careful with those squiggly lines. They will throw you for a loop.

Jack: While it is very true that corporate profits have been rising as a percentage of GDP and employee compensation has been falling as a percentage of GDP, employee compensation is still a higher percentage. So that doesn’t mean it’s not a problem. It just means, when you look at it this way on a chart, you would think one has crossed and surpassed the other, and that’s not the case.

Matt: It’s also fascinating to me to think about this in terms of, if 70 to 80% — or a very high number — of GDP is just consumption. So a lot of that is earnings, labor, the money we take in as individuals, we go out, we spend money. That consumption is what drives the bulk of the GDP statistic.

What’s interesting here is with the AI build-out, with the CapEx boom — I know that’s not corporate profits, but we are in a part, as that’s been increasing and the labor share has gone down as a percentage of GDP, we’re in a different type of pathway here than we can see anywhere else on this chart. It’s another part that says, not necessarily that this time is different, but there are different implications on how this chart is going to look in the period going forward.

Because I see a good justification of a lot of the growth arguments right now for what AI is doing for growth in the economy, and I also see a good argument for some policy initiatives that are probably not far around the corner, like, hey, corporate taxes. If this chart goes through the political circles, they’re looking at you. As the rest of that tax revenue starts to drop, this becomes an interesting place to tax, especially on the tech growth, the places these profits are mostly accruing, ‘cause they’re not accruing to a lot of the smaller or necessarily other companies outside of natural resources. I don’t even know how to think about that in this one.

Jack: And to my earlier point, this plays to the vibecession. Because if you want to have people not feeling good about what’s going on, well, have a lower share of labor and a higher share of corporate profits, and have that changing over time. Because part of this too is not absolute levels, but relative levels. If they see the Elon Musks of the world continue to get richer and richer and richer, they’re gonna look at that on a relative basis relative to themselves. And that just doesn’t make you feel good when you see that type of thing, when you see all this stuff with tech. And this is a part of the AI thing, I think, in terms of why people don’t like AI, among other reasons. But people just don’t like seeing this. This is not good for society, for this share to be going the direction it’s going.

Matt: When you start to carve out the social programs and the other things, which is what we’re seeing right now, it’s charts like this where that starts to get felt and that starts to show up in other areas. Which is, again, I think some people are gonna look at this and say, “I see future policy ramifications from an image like this.” I hadn’t quite seen it painted this way. It’s a really cool graphic.

Jack: So our next one, Matt — I don’t think I ever thought I was gonna use the word cement in a YouTube thumbnail, but this was my opportunity. I did get an opportunity to use cement, actually successfully too, ‘cause the video’s doing very well. But this was Bob Robotti talking about this idea that the AI trade may not be AI itself, it may be something else.

Bob: What we would note is that we think the application of all the data applications in artificial intelligence, clearly we see is driving demand for a lot of things that we think have been underinvested in forever. And so we think it’s a consistent theme that we’ve expressed three, four, five years ago, when people start to talk about de-globalization, right? The view I had was, well, it really is the evolution of globalization, and who plays what role will be different.

And clearly, as an energy investor, I looked at North America as a place that is long natural gas. And so that means that we have natural gas prices, energy prices that are disconnected from the rest of the developed world, and that’s a sustainable competitive advantage. So as opposed to when I graduated college, we were not competitive. We were importers. Many things we were not competitive, and over time we’ve lost industrial businesses. But three, four, five years ago, it seemed to me as if, well, we have a key ingredient. Industrial businesses are energy intensive. We have a much lower cost of energy. We will have competitive advantage. And so therefore, for industrialization to come back to America is logical and intuitive, because you can’t move natural gas and you can’t build the infrastructure as fast as we can increase the production of it. So therefore, we have this huge competitive advantage.

Another factor on top of that is artificial intelligence and all the demands that it’s placing on the physical world. So the technology needs all kinds of issues and materials that have been underinvested in. And of course, they’re concurrent, right? ‘Cause as an energy investor, again, renewables is definitely a growing field and a growing component. And the current events in the Middle East and attacking Iran, and therefore the problem with the flow of energy out, tells every country in the world, if I have wind that blows in my country or I have sun that shines in my country, I have secure energy. And so the idea that energy security will accelerate renewables makes sense.

But renewables, what do you need? So, I chair Pace University’s endowment and pension committee, and the students and the faculty and the administrators have a task force and have come to us and said, “We want you to change the policy and restrict certain industries you can’t invest in,” and one of them is fossil fuels. And so I met with the provost the other day, and we had lunch and I spoke with her and I said, “It’s more complicated than, you know, you get rid of, you don’t burn fossil fuels.”

And then I sent her an article that was the aluminum plant in Brazil, they had to shut capacity 50% ‘cause the natural gas isn’t there. They don’t have the supply of it. And so you need the natural gas to make aluminum, and if you don’t have aluminum, well, you don’t have renewables, because it’s a critical component in solar and wind and electrification and all these other — light-weighting, all these things. So the world’s interconnected, and so therefore the demands on things are growing.

And there’s a capital cycle even in the asset-light businesses, right? ‘Cause that’s one of the advantages that these guys have had. They’ve been asset-light forever. At least temporarily, they’re not so asset-light anymore. There’s a huge capital spend they’re doing, and that capital spend is I need cement, I need aluminum, I need copper, I need all these materials. And so... Or is it ahead of itself? Did it get built out too much? Maybe. But it’s one extra call on things that have been underinvested in for over 10 years, maybe 20 years even.

Jack: So yeah, this is the hope, Matt, for us value investors like me. This is what we wanna hear. We wanna hear that the beneficiaries of AI are not gonna be all the high-flying tech people who have been making all their money. We want cement. We want steel. We want whatever it is. We want that kind of stuff. When that stuff wins, we love it, Matt. So hopefully that’s what happens here.

Matt: I mean, it might. So Bob paints a very compelling picture in this conversation. It was really interesting to talk to him about it. It’s also a zoomed out mega theme, super theme, I don’t know what the right word is to describe it or what word Bob would use. But this idea that you have the underinvestment in all these sectors creates a constraint that, if this is where the growth is, all these places are gonna need to catch up.

And we see this over and over and over again at all these levels through history. There is no reason to think this time would be different when it comes to figuring out where are those natural constraints. And if it’s in a place like cement, what an interesting way to frame — here’s where the underinvestment’s been, here’s what creates that opportunity. It’s now going to take multiple years, if not multiple decades, to rightsize this imbalance if this is what the driver of growth is. It’s a really brilliant framing.

Jack: Can you imagine if the rockstar investors become the investors who are investing in cement? I’m gonna be so happy, Matt. It’s gonna be like my dream.

Matt: It’s gonna be your dream, but I also think it’s going to be... It’s right now figuring out in suburban America that the guy with the most money isn’t a CEO of a tech company. He’s the guy who had the HVAC company, and he sold off the unit to private equity or something like that. I feel like this will mint a bunch of interesting investors their wealth, and they will continue to be as uncelebrated as the HVAC guy with the really nice pick ‘em up truck and a sports car in the garage.

Jack: By the way, a couple points on that. Private equity definitely figured that out, by the way, because private equity is rolling up every kind of business, like plumbers and HVAC people. Whatever private equity can get their hands on, they figured this out, that these people are making a lot of money. And I guess whenever private equity figures out anyone’s making a lot of money, they’re gonna go head on in there.

Matt: They’re gonna go do it with size and scale. And I wonder with this too, all those cement companies, all the other people who play part of the input engine to the AI story, if we’re going to continue to see some of those get remade in the next, whatever, three, five, 10 years. And it wouldn’t surprise me if they do.

Jack: Just the last point. It’s important with all these tech revolutions to keep in mind that it always goes down. You always need the basic stuff at the base of this thing. So he made the point about renewables, I think, there. Renewables need a lot of traditional materials and energy. And all this tech stuff does. And so obviously at the beginning of a tech revolution, people aren’t gonna care about any of that stuff. They’re not gonna be thinking that through. They’re gonna invest in the tech stuff. But as it actually happens in the real world, you need this stuff. So as much as I’m a value investor, it’s a very, very fair point to make.

Matt: We get into it in the interview. There’s a whole sub-discussion around — it’s not directly ESG, but it’s a mandate in one of the schools where he has clients or advises on capital, and it’s a conversation about some of this stuff of saying, “Oh, we wanna divest of or not be involved in fossil fuels.” And let me come in, let me talk to you about what that statement actually means and where the line might exist for this institution.

Part of the underinvestment that we’ve seen in these areas has been driven by different types of policy statements. Not saying if they’re right or wrong — your personal preference is your personal preference here. But it is interesting that the allocation of capital has gone around a lot of these sectors for the last however many years, and now they’re just being revisited, parsing some of the nuance with renewables, with alternative energy, with the ways that these things can be done. That’s part of what likely helps extend the capital cycle in this area.

Jack: So one of the things I love to do, as I mentioned with Andy, is myth-busting. And so I asked him in the podcast, ‘cause it came up — you hear this thing all the time that we’re gonna lose control of the long end of the curve, and basically rates are gonna spiral completely out of control. So I asked Andy if that was possible.

Andy: I think you have to think about who the natural buyers and sellers of Treasuries are and where the demand comes from. And I’ll tell you, if I saw twos-tens at 200 basis points — 10-year yields 200 basis points over two-year yields — I’d load the boat. That’s a point where, on a duration neutral, interest rate neutral position, you get to make 200 basis points of positive carry. You don’t even need much leverage with that.

So I think there’s just incredibly deep demand at a price for duration. The question is, are you comfortable at five and a half, 6% long-term interest rates with three and a half, 4% short-term interest rates? Are you comfortable that that’s okay? I think it’s very normal and would be easy to continue to roll and finance, and healthy for an economy, great for banks. A little expensive for mortgagees and for corporations issuing debt. But a disaster? I mean, I’d imagine a world in which they went up 500 basis points. The only way I see that is if inflation goes through the roof. And that’s not in my crystal ball at this stage.

Matt: I love the lose control narratives just in general. I love the idea of, like, anything in markets where we—

Jack: They play. People love those.

Matt: They do.

Jack: If you go talk on CNBC or on a podcast about that, people love that stuff. Like, this thing’s gonna spiral out of control. People love it. Unfortunately, it’s not true most of the time.

Matt: The podcaster has lost control of the podcast. That’s a problem.

Jack: Oh yeah, I’ve been known to do that as well. I’ve lost control of my share of podcasts.

Matt: I love these myth-busting things. I love that you do that with Andy, because again, back to it — Andy knows how to put his hand over the narratives and say, “Let’s just look at the data. Let’s just talk about this this way.”

This one made me think of natural habitat theory, and this idea that, hey, there’s different people who hang out at different parts of the yield curve for all their own reasons, and you have to understand who’s buying and selling at each point in time, and who wakes up when something is going on and says, “Oh yeah, I’m an active buyer again. I’m over here ‘cause I need this for this purpose.” And other people are like, “That’s too much. This is outside of my circle of competence or outside of my need.” And so long as the bond markets are big and deep, the lose control scenario doesn’t really make sense.

Jack: Yeah, that’s the point. This doesn’t exist in a vacuum. As yields start to go up, certain people say, “Oh, this is attractive to me. I wanna buy this.” And Andy said he would be one of those people. I don’t know if it was 50 basis points higher or something like that. And so that plays against the whole spiraling out of control — these are complex adaptive systems. As rates are going up, people are gonna make changes. There’s going to be buyers out there. In something like the Treasury market, it’s very hard to have something completely spiral out of control, like it is in all parts of the market, which was the point you made at the beginning.

Matt: Yeah. Assuming there’s still a Treasury market, Jack.

Jack: Yeah, exactly. Well, we can take it even further, right? How can it spiral out of control, Matt, if there’s no market?

Matt: If you need a thumbnail for the episode. If the market doesn’t open tomorrow for Treasuries.

Jack: Right.

Matt: Right. Yeah. It’s not in a vacuum, though, so you have to look at it this way, and you have to paint in the other scenario that’s gonna create that situation before you’d say, “We’ve lost control,” or, “This market no longer is existing or functioning in some meaningful way.” I think his explanation’s really intelligent, and I think his background in this area is also part of what’s informing this.

Jack: Well, I’d recommend people watch all three of these interviews, ‘cause they were all really good. I shied away from saying, like, “We brought in the heavy hitters this week,” ‘cause I say it in every episode and I’m like, “I gotta stop saying that.” So I’ll say it at the end when nobody’s left anyway. But they were really, really good episodes, and I recommend all three.

Matt: I recommend all three, too. Heavily endorse. You even get a Nantucket cookie recommendation in the Liz Ann episode.

Jack: Oh, that’s right. Yeah. You gotta stay to the end for it, too.

Matt: You gotta stick around to the end for it, but it is in there, and I am tracking down what apparently is this loaf-of-bread size of raw cookie dough.

Jack: Yeah. And she eats half the dough and cooks the other half or something like that for the cookies? It’s a good plan.

Matt: This is the kind of math I can get behind. I’m actually gonna whip up one of those charts where the X and the Y axis, you know? I got the double axis on the side of amount of cookie dough Matt consumes versus amount that goes into the cookie. And that way I can paint the statistics in a confusing way.

Jack: With the intersection there? I like it.

Matt: I’m all about this. I’m all about this.

Jack: Well, on that investing note, Matt, you probably should take us home.

Matt: All right. Make sure you check out the Excess Returns Substack to get all the notes on these episodes, transcripts, and more. Meanwhile, wherever you are watching or listening, thank you. Like, comment, subscribe, all the things below, and we are out.

Timestamps:
00:00 Liz Ann Sonders on the unusual 2026 market and economic cycle
05:49 Portfolio construction, diversification and volatility-based rebalancing
11:39 Immigration, labor supply and the new payroll breakeven rate
17:38 Why long-term Treasury yields are rising and what the Treasury can and cannot fix
22:07 Corporate profits versus labor compensation as a share of GDP
27:37 Attitudinal versus behavioral sentiment and lessons from 2022
32:13 The vibe session, consumer confidence and conflicting investor expectations
37:14 The Neural Nine, widening stock dispersion and rotation as the new momentum
41:21 Margin debt, leveraged speculation and where the real risk may be
45:52 S&P 500 earnings growth, concentration and the sell-side versus buy-side gap
50:27 Hyperscaler AI capex, debt financing and signals from the corporate bond market
55:05 IPOs, FOMO and why investors should be careful about chasing new issues
60:05 Where to follow the real Liz Ann Sonders and avoid impersonator scams

Learn more about the Excess Returns podcast network:
https://excessreturns.co

No information discussed in this podcast should be construed as investment advice. Securities discussed may be held by the hosts and guests, their firms or their clients.

Liz Ann: Hi, guys. It’s so nice to be here. But next time you gotta get a Led Zeppelin song in the tease. That’s my request, all right?

Matt: Will the bond levee break? I’ve got you.

The market’s confused a lot of investors in the recent past year with stocks near record highs. You got the 30-year at multi-decade highs, inflation stuck above 3%, depending who you ask, or somewhere in that range. How do you think investors should possibly make sense of where we are August 20th, 2026?

Liz Ann: Well, I think, starting with where we are in the economic cycle, we can’t think of this cycle in linear terms. Not that there’s really a true normal cycle, but typically you come out of a recession, you go through the recovery phase, and you have an expansion phase, and then a slowdown phase, and then the recession. And certainly when there’s a credit crunch involved or a financial system collapse, like in the case of the global financial crisis, it tends to happen in that linear fashion and in the aggregate.

Anything but that has been the case in the post-pandemic era, all the way back from during the pandemic, where the goods side of the economy boomed along with the stimulus, given services were shut down. Manufacturing then rolled over when we got the vaccine, and services opened back up, and you had pent-up demand there, pent-down demand on the goods side, so you went into a manufacturing and goods recession for a few years, offset by the services side. Now, services has rolled over a bit, but manufacturing has picked up.

And I think that ties into the much more rotational nature of the market right now. That is the connection point: sectoral recessions and expansions in the economy happening at different times, and that, to some degree, is leading to some of these rapid-fire rotations, exacerbated by the key players in the market right now, in many cases having time horizons measured in nanoseconds. And you can pull on any of those threads, but that’s the broad-brush look at not just the economy and the market, but what the connection points are between the two.

Matt: So the market, dare I say, sounds temperamental, and last time you told us about the temperamental era, but then you wrote a note saying this changed a little bit. Explain what you’re seeing.

Liz Ann: All right. So a lot of focus, for good reason, on the now in the rearview mirror Great Moderation era, which, depending on what metric you’re looking at or who you’re talking to, there’s different start points. But essentially, it goes from the period from the late 1990s up until the 2022 COVID-related inflation spike.

And there were a lot of facets behind why Ben Bernanke, who coined the phrase, called it the Great Moderation. There was moderate volatility and inflation, generally a disinflationary backdrop fueled in part by massive globalization and the cheap and abundant access to goods, to labor, to energy, China joining the WTO in 2001. So you had a fairly benign interest rate backdrop with the exception of 2008 and the oil price spike.

The most important component of that as it relates to what matters to investors is that bond yields were keying more off the growth side of the equation than on the inflation side of the equation. So in that Great Moderation era, bond yields and stock prices were positively correlated, which means their prices were inversely correlated, meaning that kind of classic, whether it’s sixty/forty or sixty/thirty/ten, at least on paper, made a lot of sense because you had that inverse correlation between bond prices and stock prices.

You go back to what we termed the temperamental era, from the mid-sixties to the late nineties, and almost that entire thirty-plus year period of time, bond yields and stock prices moved in the opposite direction, and that’s because bond yields, most of the time, were keying off of the inflation side of the equation, not the growth side of the equation. So inflation rearing its ugly head without the attendant benefit of stronger economic growth, not great for the equity market, and vice versa. And of course, that meant that you had a positive correlation between bond prices and stock prices, and a bit more of a difficult environment to get that traditional diversification in the two simple asset classes of stocks and bonds.

We’re back in negative correlation mode right now. I think that’s probably a secular shift. That does not mean that equity investors shouldn’t have fixed income exposure and vice versa. The good news is that there’s been so much democratization of access to other asset classes for individual investors that the ability to take maybe a more endowment-like approach from a diversification standpoint is there, unlike it was during the temperamental era.

But I think inflation volatility — maybe not high inflation in perpetuity, but more inflation volatility — more monetary policy uncertainty, probably a bit more economic volatility, more geopolitical uncertainty. I just think this also is an environment where it’s less about uncertainty and it’s more about instability. So I think unstable is the better word to describe the current backdrop than the more simple word of uncertain.

Matt: With unstable as the thing we’re gonna anchor on for a second. Portfolio construction — what else does that mean? You’re a stock investor. You’re investing for growth. You want some ballast in your portfolio. You’re thinking about other low volatility or less volatile asset classes than the stocks you own. How much is that alternatives versus just a money market or something where you accept the returns low?

Liz Ann: It depends on who the investor is. So any answers... I bristle when I hear cookie cutter answers to a question that is about how should investors be positioned. I know you didn’t ask me directly for how much exposure to X asset class versus Y asset class, but it really comes down to the investor. And all of the stuff that frankly, if we didn’t have an hour, I’d say it’s too boring to talk about, but it is really the stuff that matters. Diversification across and within asset classes, and periodic rebalancing.

I think some of what can be done in an environment like this is on the rebalancing side of the discipline. And I’ll get to the diversification part shortly. But rebalancing is often done based on the calendar. If you’re in some sort of structured program, or if you’re looking at the traditional fund complex, they do their rebalancing — in the case of mutual funds, final week of every quarter. Many of the structured programs for individual investors might do annual rebalancing or semiannual rebalancing, which means the decision point is based on the calendar.

I think portfolio or volatility-based rebalancing is what gives you an edge in this environment, because it maybe ups the frequency, assuming you can handle the turnover and the tax implications associated with that. But it forces investors to do a version of buy low, sell high, which is add low, trim high. Really basic stuff to talk about, but for many investors, when left to their own devices, they do precisely the opposite, and they let portfolios get more concentrated.

Now, in terms of what to do in this environment, I am a believer in the broadening out trade. Not every single week, not every single month, but in general, the broadening out trade. That’s borne out in terms of equal weight relative to cap weight. Small caps doing quite a bit better than large caps. International doing better than US large caps. So that broadening out trade, I think, really has legs.

I think prices are getting reconnected to fundamentals, and I think the days of monolithic investing, whether it’s in the Mag Seven or some other cohort, those days are gone. Even among the Mag Seven — and I added recently Micron and Broadcom to that list and called it the Neural Nine — you go everywhere from Micron being the number one contributor to S&P performance by virtue of its cap size multiplied by huge price gains, all the way down to Tesla, which is ranked dead last in terms of contribution to the S&P. That’s a pretty wide dispersion array, and I think investors are learning the lesson about concentration and about looking at the market in monolithic terms.

The AI story is not dead, but it’s being found in other areas. You’re finding stories, you’re finding shiny new objects down the cap spectrum, into other areas within the market like industrials, like materials. And the beneficiaries, not just the creators or providers of AI. So I think that it does mandate a rethink. We had the best start of the year in many, many years for active relative to passive. That doesn’t mean both don’t deserve a home in a portfolio.

And then to your point, you’ve got the private markets, private credit, private equity. There’s other less traditional asset classes, the commodity space, real estate, precious metals. It’s all a function of what your goals are, what your time horizon is, if you’re looking to hedge something, where the cross-correlations are in building a truly diversified portfolio. There’s no one simple answer for that.

Matt: I think it’s important hearing you say this too, because — and let’s be clear, if I’m asking a cookie cutter question, there’s gonna be a cookie recipe involved. I wanna save that for maybe like the end of the show. But the idea here is understanding, if you’re going to earn that excess return, or you’re going to earn the bulk of your return from the rebalancing strategy, you also have to be managing liquidity preferences. And that works on both the personal financial planning needs of the clients, and it also works on the selection of what’s in that portfolio.

Liz Ann: Hundred percent.

Matt: And this is a different calculation because of the tools that people have at their disposal than it was five, 10, certainly 20 years ago.

Liz Ann: Yeah. So it’s not just access to a broader scope of ways we can invest, but it’s knowledge around that and education associated with that. Unfortunately, I think there’s a lot of money in the market right now that is not endeavoring to understand that, and is jumping right into the gambling side of the equation and really conflating gambling and investing. And aided certainly by the marketing from many of the betting platforms and prediction markets that are blurring the lines between investing and gambling. And that, by the way, I think is a less discussed serious risk for investors. I think it almost could be some sort of financial literacy crisis in the making, even if it’s not imminent.

Matt: Completely agree with the gamification concerns. I wanna take us back to economics. I wanna talk about, because of the way you’ve been covering this, the net migration information and data series that we’ve been looking at. We saw a spike. We’ve now seen a really dramatic shutoff. Describe what’s happening here, and then describe what you think this means.

Liz Ann: Well, we’ve choked off immigration. And the demographic profile in the United States, inclusive of immigration over the last many years, was a relatively healthy demographic profile relative to many other parts of the developed world, like a Japan or like a Germany or like a France. Absent that flow of immigration, our demographic profile when looking at sort of just the native population is not that great. So we’ve dented the beneficial demographics by not just reining in immigration, but sort of cutting it off at the knees.

And that’s part of the reason why, even though inflation is still sort of the bugaboo out there — for small businesses, the NFIB has its monthly index that comes out, and there’s lots of sub-questions that they ask their small business members on a monthly basis. And one of the questions is just: what’s your single most important problem? It’s a multiple choice, so they give you options, and inflation has been running at one of the highest ones. A year ago, it was actually taxes, and that’s because they don’t have a tariffs category, and tariffs are taxes on businesses — notwithstanding the way they’re often billed as China’s paying us more in tariffs. No, it’s the US company that pays the tariff. It’s the US company that’s importing the goods from wherever it is, China, fill in the blank.

But the latest reading on that particular question is quality of labor. We know that was a huge problem coming out of the pandemic, when there was such a demand for labor and there just weren’t the skilled people available. That’s starting to come back to the top of the list now.

It also means that the break-even rate of payroll growth — and estimates vary, but most that I see from economists are somewhere between no payroll growth to, at best, thirty thousand, in terms of not causing an increase in the unemployment rate. And then the constraints are obviously greater at a more micro level, depending on what region or county in the country is at the mercy of a major drag. So it’s obviously having an impact on the agricultural economy, in some segments of healthcare.

So we really have to stop doing apples to apples comparisons on anything that brings in the size of the labor force relative to the past five years or the past 10 years, or even the past 15 years, because we have just completely changed the math associated with the crackdown on immigration. And to me, I think there are more negative consequences of that than there are likely to be positive consequences.

Justin: There was a really interesting article in the Washington Post, I think it was, like last week, talking about how 2030’s sort of like the fiscal cliff for the US, whether you agree with that or not. But one of the statistics that really stood out to me, and it’s on this point — I think it made the point that in like 1960, there were six workers for basically every senior in this country. By 2030, there’s basically gonna be two and a half workers for every senior. And that just really was stark to me, seeing that long-term decline in terms of number of workers, and it kind of played into supporting Social Security and the solvency of the trust fund. So to your point, that was really kind of mind-blowing.

Liz Ann: Yeah, and by the way, there’s obviously these days, especially in very recent days, a heightened focus on the deficit and debt, and we can talk about that. But I think the most important thing to consider, for all the talk about the perils of a high deficit and an ongoing, ridiculous growth rate in debt and the cost of servicing that debt, is the only way to start solving this problem is to make some sort of adjustments to entitlements. Maybe I’m exaggerating a little bit, but we could probably raise taxes to 100% on everybody and everything and cut spending on everything, and we still couldn’t tackle this problem without some look at entitlements.

You know, I get asked questions about the deficit and debt all the time. It’s the number one theme of questions I get from our Schwab clients anytime I do a client event, and this has been years. This is not a brand-new phenomenon. And I think that’s because the investor class cares really deeply about this, and increasingly cares even more deeply about this than they have in the past.

I think the average constituent cares about it in the abstract, but it’s hard for them to quantify $40 trillion of debt and what that means. When you get down to the brass tacks of, will you vote for less spending on the things that you need, take advantage of, services, transfer payments, whatever it is, and/or are you going to vote for having your taxes go up significantly? And the answer is going to be no.

So if there’s one thing that both sides of the aisle do really well together, it’s just ignore this, essentially, give it lip service, and kick the can down the road. And we may be at this moment now where it is in the spotlight to a greater degree than anything I’ve seen in a really long time. Save for maybe the ‘90s, when it was in the news and in the zeitgeist for the opposite reason, because of the move eventually into surplus territory. Now we’re obviously in the opposite situation.

Justin: And I think maybe it plays into, at least to some extent, what’s going on with the thirty-year right now. So I want to ask you about that. What in your opinion is driving that? And then two, the headline of the day is, with the Treasury’s intervention yesterday buying long bonds, what generally do you think of that move? And there’s different reads. The White House is saying that they have plenty in their toolkit, Bessent’s out. But then you get a lot of these strategists that are saying it’s the fundamentals that are driving it, and that Treasury sale just kind of—

Liz Ann: I think it is the fundamentals, and I think what the Treasury announced yesterday was an attempt at jawboning. It worked for a day, working less well today, and I think it is because of the fundamentals. You can’t jawbone this problem away. And I think what Treasury is doing maybe is they’re attacking the symptom, not really the problem.

And I think it was in some sort of speech today or comment to the press today by Bessent, maybe more bluntly acknowledging the need to start to rein in the deficit, but then just said, we just need strong global growth. Well, yes, that is the ideal way you start chipping away at this problem, is if you have the growth rate in debt be lower than the growth rate in the economy, and that’s how the math starts to work in terms of chipping away at the problem. There’s just no plan on the table to change that relationship between the growth rate in debt and the growth rate in the economy.

We’ve got much more competition for capital on the fixed income side, massive issuance on the part of the AI space and the hyperscalers. You’ve got Japan recently further diversifying away from Treasuries, actually catching down to China, which has been diversifying away from Treasuries for about twelve years now. So that’s not a sudden thing. But now you have other foreign creditors, and now foreign private investors, which have been big investors in our Treasury market, now look at higher yields in their own home country. And then just the more esoteric concern about debt levels, and the term premium going up as investors just demand higher yields to commit their money for longer duration. So it’s a confluence of things.

And then the last thing I’d say is, part of the discussion of Treasury announcing what they were going to do is to maybe put some downward pressure on the dollar. And it’s not all a good news story when the dollar goes down, all a bad news story when the dollar goes up, or vice versa. I mean, there’s pushes and pulls in both directions with the dollar. But a weaker dollar arguably accrues to the benefit of S&P earnings, because a large share of those earnings come from overseas sources.

But here’s an interesting rub right now as it relates to a potential weaker dollar. If it has the effect of boosting exports, that would be a good thing. But there’s a unique reason why that is maybe needed right now. The AI spending boom is extraordinary. We’re looking at about a trillion dollars annualized this year on the AI build-out. That means that the business investment, or the non-residential investment line item within GDP, is absolutely booming. But we’re not seeing commensurate GDP figures that show that, and that’s because a lot of the spend associated with the AI build-out is on imports. We already import more than we export. We essentially always have. And so you net imports and exports — that’s the math that goes into GDP.

So that’s why I got a lot of questions: “Explain to me why we had weak second quarter GDP when we had this massive business capital spending.” Well, if it’s spent more on imports and you don’t have the offsetting improvement in exports, that accrues to the downside in terms of the GDP print. So there’s so many more interesting things happening in our economy, in the financial system, in our markets. It does require peeling a layer or two of the onion back. And unfortunately, in this day and age, with everything being sound bites, I think there’s not enough of that happening.

Justin: One of the other charts that really stood out to me, and you kinda mentioned S&P 500 earnings — but you have, going back to 1965, corporate profits as a percent of GDP versus employee compensation. And it’s just kinda crazy how... Maybe it’s an all-time high, how much corporate profits as a percentage of GDP relative to that employee compensation percent. What do you think? Is that gonna revert and hurt margins, or is it gonna continue?

Liz Ann: Well, let’s just explain the concepts here, because — and in fact, I know the chart you’re talking about, and if you don’t pay attention that there’s a scale on the left and a scale on the right, it makes it look like corporate profits are a much larger share of GDP than labor, which is compensation costs. That’s not the case. Compensation as a share of GDP has always been much, much larger than corporate profits as a share of GDP. It’s the direction of each of those.

So in the 1970s — since we’ve already talked about Great Moderation versus temperamental era — in the 1970s, labor was, I’m guessing and rounding a little bit, you might have the chart in front of me, I do not — but 65-ish percent of GDP was labor compensation.

Justin: That’s about right.

Liz Ann: That’s now down to about 54, 55%.

Justin: Yep, exactly.

Liz Ann: Whereas corporate profits have more than doubled. I think it was like five or 6% of GDP, and now like 11, 12% of GDP. So there’s another sort of K. But I always am quick to point out, if you’re looking at that data, understand the two different scales.

But I don’t really see a near-term catalyst to start to see convergence there, where labor starts to pick up share and corporate profits come down. Because corporations, courtesy of profits and this sort of low hiring, low firing, for lots of reasons, employees are not demanding compensation above the rate of inflation. The latest wage data, actually the growth rate is lower than the rate of inflation. That may be a positive longer term for inflation, notwithstanding the other forces that are not driven by that.

But I also think it means that labor is unlikely to wield power again, certainly relative to the 1970s, when it was a much more unionized workforce. That was a big part of it. So I think the only thing that would potentially shift that is if we started to see a significant deterioration in corporate profits, where that gets dragged down just because of normal cycles. I don’t think we’re imminently facing that, and absent that, it’s hard to see how labor would wield a pickup in share of the economy.

Justin: Just one last one for me before we move to your sentiment piece with Kevin Gordon. It’s early reads. We haven’t got much from the Fed so far, but just generally with the idea of less guidance, shorter statements — I mean, he was even floating maybe two public press conferences a year. What’s your sort of read so far on Warsh and what he’s trying to implement?

Liz Ann: I think the pressure is on, and I think will continue to be on, for him to say more than he’s been saying, especially given that other Fed members, that there is a cacophony of them out speaking. So their bullhorn obviously becomes a little bit louder in the absence of direct communication on a more regular basis from the Fed chair. So whether it’s surrounding Jackson Hole or at the presser with the September meeting, I think you’re going to continue to see that pressure bear down on him.

The one thing that’s been floated that there’s an interesting idea behind is to go from eight FOMC meetings a year to six. And I think there’s some validity to the assumed rationale, which is you get another month’s worth of data, labor market data, inflation data, in between each of the meetings. Not that they make decisions solely based on the most recent print on any of those. They are looking at aggregate numbers, or looking at trends and moving averages.

But I don’t know that the market would go into freak-out mode if that was one of the decisions. But I think if it’s in conjunction with much less commentary, and much less forward guidance, and not a lot of detail on the reaction function — frankly, I think that that’s part of some of the skittishness in the market lately. So it’s not just about the move up in yields. I think it’s all tied into concerns or uncertainty with regard to monetary policy under this new chair, who is clearly going to do things differently than his predecessors, not just predecessor.

Matt: Let’s jump to that piece with Kevin Gordon. Why don’t we start with — and I know we’ve talked about this before on the show — but attitudinal and behavioral sentiment. Give us the difference.

Liz Ann: Yeah. So traditionally — and I started in this business in 1986 working for the late, great Marty Zweig, who was just a pioneer in sentiment analysis. He coined the term, the trend is your friend, and don’t fight the Fed. He invented the put/call ratio. He was steeped in sentiment analysis, so I really learned from the best early in my career. And the important categorizations back then, to your point, were attitudinal and behavioral.

So attitudinal measures are the survey-based sentiment measures. So AAII, American Association of Individual Investors, is a longstanding one that dates back to 1986 or 1987. You’ve got Investors Intelligence, which is looking at advisors and newsletter writers, so that’s an attitudinal measure. Then you have the behavioral measures, so things like fund flows, the put/call ratios — what’s actually happening, what are people doing with their money?

Even within some broad sentiment measures, you get a combination of both. I mentioned AAII, which since the mid-’80s have been doing a weekly poll of their members, asking three really simple questions. Are you bullish? Are you bearish? Are you neutral? They track it on a weekly basis. They give you a reading. You see extremes of optimism and pessimism, but that’s purely attitudes. AAII also tracks the invested exposure of their members, and there are times where the messages, even from the same organization doing a survey and doing a tracking, send two completely different messages.

A somewhat recent example would be in 2022, the last bear market that we had. You may remember that the market sort of started its swoon earlier in the year. You had a big move down into June. You kind of hit lows. You had a bounce back before you rolled over. You retested those lows, and you ultimately bottomed in October. Well, that first whoosh down — my technical term there — you saw a move to a record high percentage of bears and a record low percentage of bulls in the history of their data. That included the COVID period, it included the entire global financial crisis, and it included the immediate aftermath of the crash of ‘87. However, equity allocations at that time were only 1% off an all-time high. It wasn’t until we retested that you finally sort of saw those measures match each other. So what investors were saying and what they were doing had some common thread to them.

So that’s an example of why you have to look at both attitudinal and behavioral measures. The rub more recently is it’s not just the buckets of attitudinal versus behavioral. Particularly with the behavioral side, it’s what cohorts are we talking about? So you could have a sentiment reading from systematic funds, long-short hedge funds, commodity trading advisors, the retail trader, the longer-term, more traditional retail investor, that are all over the map, in part because they’re playing off each other’s sentiment and positioning with kind of blinders on to the bigger picture macro forces. And the shelf life of narrative changes has just collapsed.

So it’s important to still look at sentiment, but I will say it’s much more complex and less likely to send what at times have been fairly clear signals in the past of either extreme optimism or extreme pessimism. The last thing I’ll say on that is, even historically, when you get to extreme levels of optimism — that is, all else equal, a contrarian indicator, but with no time specificity. Greenspan made the irrational exuberance comment in 1996, and we had three and a half years left before the bull market ended. So you can get frothy sentiment that gets more frothy and totally ridiculous and really absurd before the market rolls over. There tends to be a bit of a narrower window around inflection points when sentiment gets to the extremes of despair. So that’s just kind of a lesson around using sentiment as a timing indicator, which it’s not great at.

Matt: So this hits into the anecdotal side of this, and I know because you’re talking with clients of the firm, and you’re talking to real people. There was a chart that you highlighted in here about how the majority of consumers expect stocks to rise over the next year, and a majority also expect unemployment to rise at the same time. We’re seeing cognitive dissonance in areas like this just everywhere right now. What do you say when somebody holds both of these views together?

Liz Ann: Well, it’s sort of the vibecession, that is a term increasingly being used. There’s an aura out there, there’s a perception out there that has clouded the attitudinal measures more so on the consumer sentiment side than on the investor sentiment side.

You have metrics like consumer sentiment put out monthly by University of Michigan that recently hit a record low, and they’ve been putting out that index since the 1950s — so a record low. You didn’t quite get there with consumer confidence put out by the Conference Board. And it’s important to understand the questions that underlie those metrics as well, because consumer sentiment, based on the questions that they ask, tends to gear more toward what’s going on in the inflation environment, and consumer confidence tends to gear more to what’s going on in the labor market. So we’ve also been in periods where the labor market has been fairly healthy, like in 2022, but you’ve had this disaster from an inflation standpoint, so you get this crush in consumer sentiment, less so in consumer confidence.

So there’s this vibecession in terms of the economic data, hence people thinking the unemployment rate is going up, yet much more optimism in terms of the equity market. So if this were pre-pandemic and we saw that phenomenon, it would be a much odder set of circumstances. These days, I look at something like that, and I say, “Yeah, that tracks,” given the big spread between the soft economic data and the hard economic data.

Matt: Yeah, it can rhyme with so many different levels of experience for each individual. I feel morally and ethically obliged — it’s the Kyla Scanlon vibecession. She still gets credit for that word.

Liz Ann: Oh, absolutely. That’s right.

Matt: And we gotta make sure she still gets it. People can’t steal it.

All right, AI momentum. You showed this chart of the trade just unwinding in crazy speed. I think it was the Ned Davis Research ETF Speculation Index. The AI momentum trade changed course very, very quickly, very, very sharply. This feels like a sentiment indicator in its own right. What sense of that do you make?

Liz Ann: Well, I don’t know that we saw some sort of major change in enthusiasm around AI. It was just the aperture got widened in terms of where investors were looking for that exposure, understanding the peril of concentration and making monolithic investment decisions, and looking elsewhere for that broader exposure, because we’re in the cascade phase of the AI build-out right now.

So this is not just about the hyperscalers, it’s not just about memory and semiconductors. It’s broader. It goes into the industrial space, it goes into materials, it goes into energy, and it goes down into the cap spectrum. It goes into the beneficiaries side. So I still think that there’s a tremendous amount of enthusiasm about AI, most of which is justified, but beneficially from a concentration within the market standpoint, just the aperture having been widened.

And I think there’s increasingly being looked at, from investors’ perspective, that if you’re still in a small cohort of names, even if some of them are still doing well, it’s an increasing opportunity cost of not getting exposure in areas that have been less popular over the last several years.

The good news is that down the cap spectrum, you did see decent performance in an index like the Russell 2000 last year, but the non-profitable stocks within the Russell 2000 had double the performance of the profitable stocks. So it was kind of a, you know, the crap within the Russell 2000 did well. This year, we’ve actually had most of the year the profitable stocks outperforming the non-profitable stocks within the Russell. Right now, they’re about neck and neck on a year-to-date basis.

But I do think it was a knee-jerk, the Fed’s gonna ease — that ship sailed. The Fed’s going to ease, rates are coming down, that accrues to the benefit of small caps, and we’re gonna see an inflection point in earnings, and so let’s go down where the leverage is great, which is in that zombie category, non-profitable. Largely, I think that ship has sailed, and now I think there’s a more discerning eye on where opportunities lie when you exit the monoliths of whether it’s the Mag Seven or what I’ve been calling the Neural Nine.

Justin: Yeah, and the dispersion has gotten a little wider here recently, right?

Liz Ann: Oh, way wider. Yeah. Micron is the number one contributor to S&P returns this year, and that’s by virtue of... It’s not the number one best price performer. I think it’s ranked third in price performance. But it’s the number one contributor because you’re multiplying very strong price performance by large cap size. But Tesla’s literally dead last in terms of contribution to S&P returns. So number one to number five hundred — you don’t get a wider range than that.

And I post this on my X feed every single day. It’s a chart of the Neural Nine. It looks at performance rank, it looks at contribution rank, and it just reinforces that we’re not in a monolithic, the tide lifts all boats. And investors are increasingly aware of that. It’s also one of the reasons why I’ve been saying for a while now that rotation is the new momentum trade.

Justin: Rotation is the new momentum. So as the market rotates into these different areas, that is basically like short-term momentum, so that’s the momentum trade. That’s what you’re getting at with that.

Liz Ann: And a lot of investors understand there’s a lot of rapid-fire momentum. Now, some will say, “I’m gonna try to get ahead of that, and sort of trade in anticipation of what the next move is going to be.” I think the better tack for individual investors to take goes back to that rebalancing. If you have volatility or portfolio-based rebalancing, you’re gonna be somewhat regularly adding low and trimming high, and staying in gear by letting your portfolio tell you when it’s time to do something. It does go against the grain, but that just has to do with changing our mindset.

In fact, speaking of mindset, and this is slightly tangential, but let me share an anecdote that I think really framed, in my mind, the way our emotions sometimes play tricks on us as it relates to things like taking profits and trading.

I was at a client event in the Bay Area, it was probably a year and a half ago or so, and there was a client that either had been an Nvidia employee — I don’t know if it was a prior employee — but had a ton of Nvidia stock, huge concentrated position, was working with his Schwab financial consultant. They were developing a strategy. The financial consultant had said, “We think you should probably trim 10% of the holding. We’ll manage the tax implications associated with that.”

And the client said, “And I kinda fought him and I fought him. We decided to split the difference, so I sold 5% of my very large position. And then the stock went up by 20%, and I’m not really happy.” And he wasn’t coming up to complain about his financial consultant. He did it in a very lovely way. But I paused and I said, “Would you really have been happier if the 95% of the position you still own went down by 20%? Because you could say, ‘Man, I nailed that trim at the top.’”

And to his credit, he said, “You’re absolutely right. That’s how I should think about it.” But unfortunately, the way he initially thought about it is the more common way, I think. So there’s this aversion to taking profits, just as there is an aversion to add to something that is underperforming. That’s inherently what rebalancing is. It goes against the grain, but it helps us along the way.

Justin: Maybe this is a new ETF idea for someone, Liz Ann, that listens to this. They’ll come up with a monthly rebalance momentum ETF. I don’t know.

Liz Ann: Well, ETFs have rebalancing strategies.

Justin: Sure. Yeah. Is there anything in the margin debt levels that sort of concerns you here? It’s interesting, I’ve never bought on margin, but it seems like this is something that I know the market looks at a lot. I know it’s one of the indicators you look at. So what are you thinking here?

Liz Ann: I think it needs to be on everybody’s radar, but in ratio terms, margin debt tends to track what the market is doing, and if you track it against overall market cap, it’s not in egregious territory. My concern is a little bit more what investors are then doing when they go on margin. Going on margin is one thing, but then if you’re going way, way, way out the risk spectrum in leveraged ETFs and inverse, that’s where I think the bigger problem is. So I think you both have to put margin debt not in level terms, but in relative terms, but also assess where that money is going and how it’s being invested, or maybe gambled, in the market. So I think it has to be a double-pronged analysis.

Justin: One of the things that you’ve written about, and I think this is very important for investors to think about and understand, is you’ve written that the wealth effect has become this economic risk. So with more and more people in this country having stock portfolios — and listen, the market’s done extremely well. If you take out the COVID decline, we’re coming up on maybe 20 years of a bull market. There’s been corrections and shallow bear markets in there, but not a sustained bear. So just flesh that out, ‘cause that’s very important, if most of people’s wealth is either in their stock portfolios or investment portfolios. And obviously people that do own houses, they have probably equity in there too, but that’s not necessarily liquid. So how do you think about that when you look at statistics like this?

Liz Ann: Yeah, so households’ exposure to equities as a share of their total financial assets is by far at an all-time high, well eclipsing what we saw back in late ‘99 or early 2000. I don’t remember the exact point it peaked in that era.

All we have to do is look back to what happened between 2000 and 2001. So obviously, we know with the benefit of hindsight that we had an internet bubble, a dot-com bubble. It started to collapse in the early part of 2000, brought on what became a two-and-a-half-year bear market. We had a recession in 2001. It wasn’t a very long-lived recession. I think it was 10 months. It was concentrated within calendar year 2001, and it wasn’t a severe economic contraction or dislocation. And that’s because I think if we didn’t have the bear market in stocks happening, I don’t think we would’ve had a recession. There were no major economic dislocations. There wasn’t a serious problem within the financial system. We didn’t have a serious credit crunch. It wasn’t that the Fed had to ramp up interest rates because of a dramatically overheating economy or a runaway inflation problem. I think the economy just kind of toppled a little bit under the weight of the weakness in the equity market, and I think that that is something we need to be mindful of.

And to some degree, it’s a little bit chicken and the egg. So you could envision a scenario where you see problems erupt in the economy first, and then that finally leads to less enthusiasm around the stock market, which then becomes a loop. And it almost doesn’t matter where it starts, but I think the interconnectivity is probably greater than it has ever been in the past. None of which suggests an imminent problem. I just think at a point we inevitably go into the next corrective phase. I think we have to maybe look at the connection points to the economy a little bit more closely than we have in the past.

Justin: Probably highlights the importance of asset class diversification as well. And to the point about the Nvidia holder, a lot of individual investors I think are still loaded up on the biggest stocks, just like the indexes are in the market.

Liz Ann: Right.

Justin: Talk about this massive growth in earnings that we’re sort of seeing and expecting. I think that’s one thing that a lot of people point to in supporting the market, is that we’ve gotten this really impressive earnings growth. And I don’t know what the consensus estimate is for next year, and it’s hard for me to determine how much of it is... I thought I saw one statistic that because of the SpaceX IPO and maybe something else, it was driving up this earnings growth. So it’s hard to parse that, at least from my perspective. But how do you kind of look at this growth in earnings?

Liz Ann: Well, that’s where I think the concentration problem is still alive and well, even if it’s lessened within the equity market. So if you look at the consensus expectation for calendar year 2026 S&P earnings relative to 2025, and then you look at the top 10 stocks in terms of their earnings growth rates — Nvidia accounts for 18% of overall S&P 500 year-over-year growth expected in 2026. Micron adds another 14% on top of that, so cumulatively you’re up to 32% for two stocks, the two chip stocks.

If you take it all the way out to the top 10 — and it was Leuthold very recently that did a really fascinating study on this, I just wrote an internal note on it, so I can’t immediately point you to it in any of the public sites — but if you go out to the top 10, and 9 and 10 are actually not in the tech or tech-adjacent space, it’s Chevron and Exxon, the top 10 earnings stocks are 65% of overall S&P 500 earnings.

So there has been breadth in earnings. I think all but one sector saw an improvement in estimates throughout the course of reporting season. Throughout the course of this reporting season, which of course was just for the second quarter, you went from beginning of the quarter expectation of 24% growth, and now the blended growth rate, inclusive of consensus estimates for those companies not yet having reported, is more than 50%. So that’s a huge, huge surprise factor. And there has been breadth, because I think it’s 10 out of 11 sectors saw an improvement. But there’s still massive concentration, and I think that’s another reason why you’re seeing some of these rotations, is concern about that.

There’s also a case that we’ve never seen a parabolic acceleration in the growth rate in earnings and the growth rate in the surprise factor like we have seen now. The only two times where it’s higher than what we’ve seen now was coming out of the COVID recession and coming out of the global financial crisis, and there it was about math. It was about the math of the compression in earnings that meant the base effect — the base from which you were then doing year-over-year estimates — was a big spread. That’s not the case right now. Last year’s earnings were quite strong. It’s just this surge.

The concern, of course, is that this is not permanent, that this has a lot to do with the massive AI spend. We can’t keep setting the bar higher and higher and higher. So far analysts have been wrong to not extrapolate, but at some point depreciation is going to catch up, and we’re going to have an inflection point in the growth rate. And that is part of the reason why you’re seeing stocks get punished, like Samsung, which ended up causing what I think a 40% drawdown in the Kospi, because Samsung and SK Hynix represent like half that index.

And that was just an example. I don’t have an opinion on any stocks. I don’t cover individual stocks. But that was sort of an example of another phenomenon that I think we’re seeing and will continue to see during earnings seasons going forward, which is Samsung beat the sell-side consensus by a pretty handy margin, but they essentially underperformed the buy-side expectation. And I think there’s a wider spread now than anything we’ve seen before between the sell-side consensus published and the unpublished buy-side expectation. And so that’s where I think volatility could kick in, whether it’s at the individual stock level or at the industry level, or maybe even to some degree at the sector level, and has been driving some of these rotations. Where does a report fall in that span between sell-side consensus and buy-side kind of hope and hype?

Matt: I love that you said it that way, because I think we also forget how far and how fast so many of these companies have come with those reported results. So how many analysts can look back and say, “Oh, I remember the last time a company quintupled earnings in the last three years, and this is how I updated my...” Like it doesn’t exist.

Liz Ann: There’s no precedent. Yeah.

Matt: Hyperscalers — the hyperscaler CapEx I think is really interesting because of that depreciation cliff, but also I think we’re pointing at something like 900 billion next year. Put this into context.

Liz Ann: Nothing like we have ever seen in the past. Just leapfrog over anything that happened in the late 1990s.

I think that maybe one of the more important differences between the spend now in the build-out of AI and the spend back in the late 1990s in the build-out of the telecom network associated with the internet, is back then it was a little bit more of a build it and they will come. The build was tied to estimates for future demand. This time, the build is associated with current demand, and it’s undershooting current demand.

But that doesn’t mean it lasts forever. And obviously there’s a lot of concern now, and there has been for a while, in terms of the circularity of financing. It was less of a concern when most of the build and the spend was financed out of cash flows. That’s not the case anymore, so you’re seeing massive debt issuance. There’s still a tremendous amount of demand for that. In fact, I’ve talked to a number of equity investors that are getting much more interested in the corporate bond market and getting exposure to that space on the fixed income side, as opposed to just the equity side. That’s further exacerbated the concerns in the Treasury market, because we’ve got that competition for demand in the corporate space.

You ended up with Oracle as a poster child for when things maybe got a little bit out of hand and concerns about that debt financing. But that was more of a one-off than anything in the aggregate. Spreads are fairly tight, so we’re not really seeing any flashes of warning signs. But I know I’m keeping an eye on that, because there’s always a feeder between the corporate bond market and the equity market, and sometimes you get some of the most powerful signals about the equity market from the bond market. In this case, probably the signals will eventually at some point come from both the corporate bond market and the Treasury market. As well as maybe private credit, but that’s not my area of expertise.

Matt: But fascinating to stitch them together. What do you think — because of that stock-bond relationship, because of the circular financing, we know it’s there. Different people are showing us how deep it may go, what the ties to private credit are. I’m not asking you to go into places you haven’t closely studied. Marty Zweig looks at this. Does he look at this circular financing and see something different? What do you think he would say?

Liz Ann: I remember talking to him a lot about the internet boom in the late 1990s, and he was really good about not getting enthralled in sort of these narratives. He was a, “What does the data show? What do the indicators show? What does the sentiment show?” So he was pretty good at putting blinders on to what impacts, I think, us and markets so much more now. In part because of the speed of information flow, the fact that there was no social media back then. The internet was in its very early infancy. So he really was just — he used to keep all of his indicators on that green kind of grid paper that accountants use, and he did it in pencil. So he was really old school.

I would be fascinated — I often think, what is he, from up above or wherever he is, what is he thinking right now? How would he look at a market like this? Whether it’s the sentiment environment, not just being the buckets of attitudinal versus behavioral, but just the different cohorts that have different views on the market at any given time. Valuation, which has just perpetually gone up, maybe not fully unjustified, maybe not just frothy and bubble territory, because our economy has become more and more innovation oriented, and that’s why the US market gets a higher multiple than, say, Australia, which is a mining industry, or Germany, which is basically an auto ETF.

So I think it is much more difficult for those sort of traditionalists, pure technician or pure sentiment watcher, to get an edge in a market like this. He would’ve figured it out, ‘cause he was so brilliant in understanding markets, but what he would be doing right now is probably so different than what he was doing in the ‘70s, ‘80s, and ‘90s when he became the guru that he did.

Matt: What about — and this is for you, you can channel Marty if you want on this one — the IPO cycle. What are you telling people now, because we made it through the first one. There’s supposedly two more in the oven ready to come out. What should we be telling people? How should we be framing this conversation for the average investor?

Liz Ann: Be careful about chasing. And that’s a lifelong lesson about IPOs borne out by history, so that’s not some new warning on my part based on some prescience I have of what’s going to happen.

Where I think the skeptics about where this places us in the market cycle have — I don’t wanna say are accurate, because I don’t try to time the market — is when you do see an environment like this where there’s a huge surge in issuance on the debt side, where you’ve got these massive companies bringing IPOs, they’re basically selling to the public. What is the message that comes when there’s a big increase in the desire to sell to the public?

It used to be considered going from strong hands to weak hands. I think that’s maybe too insulting a moniker now, frankly. Just like you don’t really hear much reference anymore, rightly so, to smart money versus dumb money as it relates to things like sentiment indicators. Because frankly, what used to be called the dumb money, which was a lot of the retail traders and individual investors, they’ve been pretty darn right for a really long time, and they’re much more educated than they’ve ever been before, and they have the tools to continue to increase that education and knowledge. So it’s not me saying these are the smart guys that are now selling to the dumb people, not at all.

But we’re still in kind of a FOMO market. There is a lot of really short-term money, more gambling-oriented money. And I think for investors, they need to come at this with a rational approach, understanding how it fits into a portfolio, what the parameters are around how much you’re willing to pay, what rebalancing strategies would be.

So I’m not gonna express an opinion on any of the stocks that are set to come public, nor on the big one that already came public. That’s not what I do. And even if I wanted to, Schwab compliance would say, “You can’t say anything.” So I have to zip it, with that very broad set of comments.

Matt: Zip it with those comments. I’m gonna take you to cookie cutter advice now. You have a good summer cookie? What’s your summer cookie of preference?

Liz Ann: Well, I spend a lot of time on Nantucket. It’s my favorite place in the world. That sometimes generates a lot of, “Oh, aren’t you chichi?” And Nantucket is a really special place, not just because it’s a fancy place for rich people to go, but it’s a wonderful community with a lot of hardworking people. I am vice chair of Nantucket’s Boys and Girls Club. We do an incredible amount of work for the children on the island. I have great admiration for our teachers and our doctors and our firefighters and our police officers and our hardworking people. So sadly, this island gets a really bad rap sometimes, and it’s unfortunate, because it’s a broad brush that does not capture the island. All that said, I felt like I wanted to plug that.

There’s a sandwich place on Nantucket called Something Natural, and they have chocolate chip cookies, and they now sell the dough. So it’s not a fancy cookie. Their dough is — it’s a roll, like the size of a loaf of bread. I could probably eat half of it raw and then cook the other half. I mean, most cookie dough is kind of as good raw, but man, this is the best chocolate chip cookie. So, Something Natural.

Matt: Okay. I don’t often come to Nantucket just for cookies, but this might be it.

Liz Ann: Well, if you come to Nantucket, you should come for both the sandwiches and the cookies at Something Natural. No, it’s not a paid advertisement. I pay them a lot, because I get food there a lot, but that’s my favorite cookie.

Matt: Okay. We like the sound of that. I got one more for you. You referenced, “If you build it, they will come” — baseball movies. Field of Dreams? Is it better than Bull Durham? What’s the top of your top?

Liz Ann: I’m not a baseball fan. I find it a little bit too boring a sport. I just don’t have the patience.

Matt: Well, it was really a movie question.

Liz Ann: Can I show my age?

Matt: Of course.

Liz Ann: Bad News Bears.

Matt: Perfect choice. There you go. Perfect choice.

Liz Ann: Walter Matthau. OG Bad News Bears.

Matt: Walter Matthau.

Liz Ann: Charlie Sheen.

Matt: Gods amongst men. Fantastic answer. We’ll take that every day of the week.

Liz Ann, thank you so much for joining us. People wanna bug you on the internet, where should we send them?

Liz Ann: My pleasure. Yeah, so I’m on LinkedIn and X. On X, it’s @LizAnnSonders. Make sure you’re following the real me. An absolutely ridiculous number of imposters over the last couple of years, and it gets worse and worse. They actually have developed scams. There’s been money that has been taken. Apparently, some versions of me say I have a private stock-picking club. I have a private crypto-picking club. I don’t do any of that. The money grab happens through WhatsApp. That is not me. The latest ones have been setting up a handle that has some form of, like, Liz Ann’s assistant or Liz Ann’s research associate, and it’s just nonsense. So please make sure to follow just me.

And it is one-stop shopping, because I post everything that not just I write, but we write — my close colleague, Kevin Gordon, and I, and other colleagues. And it’s a daily rash of charts and data. And I say when I’m gonna be on TV, and I post my reports and videos, so it is nice one-stop shopping.

Matt: Best feed on the internet. Liz Ann, the real one, in all the places. You’re watching Excess Returns. Make sure you look at the Substack too. We’re gonna have the transcript, key lessons, other stuff on this very video. Thank you so much to Liz Ann. Like, comment, subscribe, all the things below, and we are out.

Topics covered

• Why rising long-term interest rates can be consistent with strong economic growth and record stock prices

• Why Andy does not see higher government interest costs creating an imminent U.S. debt crisis

• The “script to kill inflation” and why reducing the wealth effect may require lower stock, bond and asset prices

• How the Fed, Treasury and other policymakers have suppressed long-term interest rates and risk premiums

• Why Kevin Warsh’s comments about the Fed balance sheet and letting the bond market “do the work” could signal a policy shift

• How Treasury bill issuance, coupon issuance and the quarterly refunding announcement can affect stocks, bonds and financial conditions

• Why the AI CapEx boom is shifting from cash flow funding toward massive corporate debt and equity issuance

• Andy’s “hamburger thesis” and why the ability to finance AI infrastructure may matter before anyone knows the ultimate AI ROI

• Why capital markets can suddenly close after issuance booms and what that could mean for the AI investment cycle

• How Nvidia’s $500 billion financing structure expands the pool of capital available to data center projects

• The “not enough pie” problem: why projected corporate earnings may require extraordinary GDP growth, productivity gains or a larger corporate share of the economy

• What Andy watches in new stock and bond deals for signs that investors are becoming unwilling to absorb more supply

Timestamps

00:00:08 Why stocks, long-term yields and inflation can all rise together
00:07:18 The “script to kill inflation” and why short-term rates may not be enough
00:12:48 How policymakers have suppressed long-term interest rates
00:16:53 The Warsh “drumbeat” and a possible shift in Fed balance sheet policy
00:21:56 Why markets may be underestimating Warsh’s willingness to fight inflation
00:26:27 Treasury bills versus coupons and the limits of current financing policy
00:31:33 The “hamburger thesis” behind the massive AI CapEx funding shift
00:38:41 Why AI financing may matter more than AI ROI in the short run
00:42:55 Breaking down Nvidia’s $500 billion data center financing structure
00:47:51 The “not enough pie” problem for AI earnings and economic growth
00:52:03 Demographics, productivity and the limits on future GDP growth
00:56:14 What issuance prices reveal about capital market stress

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No information discussed in this podcast should be construed as investment advice. Securities discussed may be held by the hosts and guests, their firms or their clients.