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  • Bogleheads on Investing with Edward Chancellor: Episode 55

Bogleheads on Investing with Edward Chancellor: Episode 55

Post on: March 4, 2023 by Rick Ferri

For our 55th Episode of Bogleheads on Investing Podcast, host Rick Ferri interviews Edward Chancellor, a financial historian, journalist, and investment strategist.  Ed graduated with first-class honors from Trinity College, Cambridge, and later from Oxford University. He worked for the London merchant bank, Lazard Brothers, and was later an editor at the financial commentary site, Breakingviews of Reuters. Ed was also a senior member of the asset allocation team at GMO, the Boston-based investment firm.

In 2022, Fortune called Ed "one of the greatest financial historians alive". He is noted for his prescient warnings of the last three major economic bubbles in his published works: Devil Take the Hindmost: A History of Financial Speculation (1999), Crunch-Time for Credit? (2005) and The Price of Time: The Real Story of Interest (2022). 

Edward Chancellor

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Rick Ferri: Welcome to Bogleheads on Investing, episode number 55. Today our special guest is Edward Chancellor. He is a leading financial historian, journalist, investment strategist, and the author of two best-selling books, Devil Take the Hindmost and The Price of Time.

Thank you. Hi everyone my name is Rick Ferri, and I'm the host of Bogleheads on Investing. This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a non-profit organization that is building a world of well-informed,
capable, and empowered investors.

My special guest today is Edward Chancellor. One of the benefits of being a podcast host is I get to speak with some of the brightest people in the world, and as you listen to today's podcast, I think you will agree. Ed has studied economics and financial conditions in markets and economies going back literally thousands of years, and it's fascinating to listen to him lucidly talk through centuries of markets all over the world, picking out similarities that others have not considered.

Ed graduated with honors from Trinity College Cambridge and from Oxford University, worked as a mergers and acquisition banker for Lazard Brothers and later as a member of the GMO asset allocation team. He currently is a columnist for Reuters. He has written two books, Devil Take the Hindmost: A History of Financial Speculation, which was published right at the top of the dot com bubble; and, more recently The Price of Time: the Real History of Interest which ironically was published right at the top of the bond bubble. So with no further ado, let me introduce Ed Chancellor. Welcome to the Bogleheads on Investing podcast Ed.

Edward Chancellor: Thank you for having me Rick.

Rick Ferri: You've got such an interesting background. You've done so much and you've written so much. Could you tell us a little bit about maybe your schooling. How did you get into journalism? I understand your your family has a history in journalism.

Edward Chancellor: Yeah my grandfather was the Shanghai bureau chief of Reuters during the 1930s, during the Sino-Japanese war, and then he later went on to become managing director of Reuters. And then his son, my uncle Alexander, became editor of The Spectator magazine here.

I read history at University, decided not to become an academic after my postgraduate degree. I spent relatively little of my life in which journalism was my main or sole income stream. I made a mistake by going into the corporate finance side of things, in what you'd call now M&A banking, and that wasn't to my liking.

And so after a couple of years I quit. I sort of heard these stories about the speculative manias in the past, which I'd never heard about before going into in a finance job. I looked around and I read the available literature type: Charles Mackay's Extraordinary Popular Delusions, Charles Kindleberger's Manias, Panics, Crashes. And what I thought, being a historian, is that I could tell the story of the history of financial speculations that was more narrative driven than sort of Kindleberger's taxonomy.

Rick Ferri: So that's when you decided you were going to write a book, and you ended up writing Devil Take The Hindmost: A History of Financial Speculation.

Edward Chancellor: That book had fortuitous timing. I was working on it after I'd left the investment bank, Lazards, in about '93 and sort of finished it in late '98 just when the dotcom bubble was going sort of completely crazy. And it came out in mid '99. What was nice about the book, when it came out it got a good reception from the investment world. There were a lot of investors, in particular the quant investors, Jeremy Grantham the boss of GMO, Cliff Asness at AQR, Rob Arnett who was then at First Quadrant. They were all having problems at the time. This sort of historical account of expected manias which drew very strong parallels to what was going on in the U.S. markets in the late 1990s was catnip to the quant investment community. And that really was what introduced me to Jeremy Grantham. And then a few years later I started to work for him. So that, yeah, so that was my first book.

Rick Ferri: Just to clarify, in your own words, what's the difference between investing and speculating?

Edward Chancellor: Lots of people have had a go at trying to distinguish speculation from investment--some are quite boring and prosaic, the distinctions, so you might say that investment is posited on yield and value, and speculation as desire for capital gains not supported by yield or intrinsic value. Ben Graham put in the sort of margin of safety, that an investment should have a margin of safety. The definition I like distinguishing investment from speculation, is by Fred Schwed Jr. in his 1930s book, Where Are All The Customers Yachts, in which he says that speculation is an attempt, usually unsuccessful, to turn a little money into a lot. Whereas investment is an attempt, usually successful, to prevent a large pot of money becoming a small one.

And I think that alludes to both the sort of principle of safety in investment. But I think there's another aspect to it there which is the speculators are often trying to gain their fortunes fairly quickly whereas the investor, having gained a fortune, is trying to maintain a yield on it.

Rick Ferri: In your book you talked about signs of speculation, and you listed several of them: rumors fueling a boom; rapid growth of leverage; and to create the signs that there might be a speculative bubble going on.

Edward Chancellor: So what we find in the U.S. stock market in the 1920s there was rapid growth in margin loans. And then if you look historically the New York Stock Exchange produces data on margin loans, and outstanding margin loans tend to rise during the executive markets, or bubble markets. If you lever your returns you're getting higher potential return but you're also going to face greater potential losses.

So if a speculative market is characterized by both a sort of greed to enhance returns and an fecklessness towards risks, you would expect to find more leverage. I mean you can provide sort of checklists for speculative manias. Leverage would be be one of them, margin loans. The new entrance into stock markets of inexperienced investors. You saw that in the 1920s, Japan and 1980s, you see it--China in recent, in its recent sort of bubble episodes of 2005 and 2015.

Even more recent, our everything bubble, the surge of accounts at Robinhood Markets, the online broker. So there's new entrants and that's often associated with something, a call for the democratization of markets, and I noticed that speculative bubbles tend to appear at times when communications technologies are improving. The first stock market bubble in the UK occurs in 1690s, which is the same time when there's a proliferation of newspapers and journals and people are meeting to discuss investments in the coffee houses, London.

And then again, mid 19th century you get the railway mania in which the railway is not just an object of speculation, but the railways, and the telegraphs are means of transporting the speculative virus. And then you get into the 1920s and you get the telephone. Again it's both object speculation and means of communicating your orders to the broker.

Then you're going into the dot com era, get new entrants. If they're establishing stock market accounts with online brokerages, Charles Schwab, E-Trade. And E-Trade becomes both a big player in the day trading market, but also an object of speculation.

Rick Ferri: And it seems as though more recently using social media, a new app that you had on your phone, call Robinhood, which would allow you to discuss very quickly and easily. And that was adopted by these new entrants.

Edward Chancellor: What Robinhood did, which was novel, is it introduced the gaming techniques developed in Las Vegas for the gaming machines in Las Vegas, and introduced them onto an app for investing. But they also, as you're probably aware, they offer leverage, stock market loans at 2%. And if you had an account with Robinhood, the sort of premium account, you could get zero percentage cost leverage. So your margin loans were no interest charge on them.

And then you're probably aware that the state of Massachusetts launched a lawsuit against Robinhood Markets in I think 2020 or probably 2021, in which they accuse Robinhood of gamification. And you have this massive turnover trading of the these inexperienced investors. And so this rising turnover in the market is another sort of tacit, speculative feature, at least in stock markets.

And then this is more close to the subject of my book, is that you tend to find speculative manias occurring at times when monetary policy is abnormally easy and, really, as I point out in the new book, even the tulip mania in Holland of the 1630s occurred at a time when there was strong monetary growth in Holland, Dutch Republic, thanks to the establishment of a new Central Bank which attracted foreign capital inflows, and at a time of falling interest rates. And the Dutch, for that matter, the speculators in tulip bulbs, they were using derivatives to lever their returns.

I mean another feature, I think conspicuous consumption, luxury spending, that's the sort of social epiphenomenon of the bubble. Corruption in public morals or fraud is another common feature. And Walter Bagehot the Victorian journalist, says I'm getting--paraphrasing--that when people are most credulous when they are most happy. And so to speak, high markets at times offer opportunities for ingenious mendacity.

J.K. Galbraith sort of took the Bagehot insight and turned it into his notion of the bezel, the illusory increase in wealth that occurs during speculative bubbles, and the original term bubble is a fraud, a con, that's what it means. It's an illusion of wealth that is deliberately dishonest. And so the term South Sea Bubble, which was when it came into popular usage, referring to the stock market bubble of 1720, really means the South Sea con.

John Cassidy of the New Yorker wrote an account of the internet bubble, published after the bubble, but it's called "dot con c-o-n". And then looking forward to where we are today, you see the crypto market, the most speculative market ever created. It made the tulip mania of the 1630s look positively conservative. And you see the what looked to be possibly fraudulent behavior in the crypto world, and surrounding the collapse of the crypto exchange FTX.

So one of the things you should look out for in a bubble is evidence of corruption and malfeasance. We saw that came back to the 1990s that it was pretty clear that U.S. companies were misstating their earnings, and manipulating their earnings. And then after that dot com bubble burst, then you had these scandals that you remember at Enron, Worldcom, Tyco.

And then after that you get the liar loans that push up the U.S. real estate market in the bubble that peaks in 2006. So some corruption is an inherent feature of the bubble.

Rick Ferri: Let's go on to your latest book, The Price Of Time: The Real Story Of Interest. At the beginning of your book you go back to the history of interest.

Edward Chancellor: My opening with the book, was in the beginning, was the loan, and the loan carried interest. What I'm saying there is that right at the dawn of recorded history we have evidence of lending taking place at interest, so this makes interest, alongside the act of lending, the oldest financial practice, which Mesopotamians were lending at interest long before they'd invented the wheel, and a millennium before the Greeks had actually come up with coined money.

And then if we look into the etymologies of he word interest in ancient languages, they tend to be related the offspring of livestock. So there is a sort of what what you might call the fructification theory of interest. That some, rather lending an object, lending your capital, we know that in Mesopotamia there were loans of barley grain, and presumably there were loans of cattle and goats and sheep, and the idea was that some of the growth of the livestock, the offspring, would be returned to the lender.

The first law code we had, the Code of Hammurabi, is actually largely involved with financial regulation, in determining what maximum rates of interest, and when rates should be forgiven--and Mesopotamians also had these debt jubilees--which meant the debt was forgiven at the at the onset of a new reign. And the Israelites, they took a dim view of interest--that I think the ancient Hebrew word for interest is "nashak" which means the bite of a serpent--as we know the Old Testament forbids lending to each other at interest but not to outsiders.

To put this very succinctly, in a primarily pre-industrial, pre-capitalist economy, the danger is that farmers will borrow at interest and that the interest rate compound, the interest compounds at a high level, driving people into debt, into higher levels of debt, leading them to lose their farms, or even in cases, in the ancient world going into slavery. So I think that the ancient strictures against lend, against interest, or what was called usury, that continues into the Middle Ages by the Catholic Church, which sort of really takes the position of Greek philosopher Aristotle who complained about interest.

And so that continues through let's say the 15th, 16th century. But then as you come to a sort of more capitalist era--but then it's realized that capitalists need, the merchants need capital to trade with--and that they're not going to get the money unless they're offering to paid some interest, and that it's also seen as fair that the lender should have a share in the profits of the borrower.

And even in the Middle Ages before that was conceded, it was accepted that if the lender was taking risk, say for instance lending to a merchant who was going on a on a sea voyage, that and the ship might go down. That those type of risky loans would carry a legitimate rate of interest. In short, by the birth of capitalism, interest was grudgingly accepted.

And then there becomes a sort of new idea that comes in point with the justification for capitalism or a market system in Adam Smith, is that everyone should pursue their own interest. And the acceptance of interest by the 18th century is uniform, and as the title of my book says, interest is the price placed on time. And we need to put a place on time in the finance world for a number of reasons. Because all our actions take place across time, now what is a technically called inter-temporal--whether we're lending or valuing--and you need to put a price on time for capitalism to make sense.

We tend to think of capital being something solid, but in fact really capital is a flow of future income because you can have anything, any object, that doesn't generate income is not really capital from an economic perspective. It might have value but it's not capital. It's only when it's in an income producing function that it becomes capital. And the capital is the present value of the future income stream.

Now with this is pointed out by English writers in the 17th century, if you don't have a discount rate, if you don't use a discount rate, then it's impossible to distinguish the value of one acre of land from 20 acres of land, as everything has an infinite value. So if you think about it, the whole notion of capitalism is actually meaningless without its underlying foundational support of the rate of interest. That is the main underlying argument, my book is that we have really lost sight of the importance of interest and how it both affects valuation, risk assessment, allocation of capital, savings, and so forth. The system, our capitalist system, is only given some type of coherence by there being a rate of interest.

Rick Ferri: You talk, several places in the book about what is an equitable rate of interest. And you've already alluded to in your comments that there's a minimum rate of interest for what the lenders are willing to accept for the price of capital over time. But then you've also talked about interest rates that are too high. It ends up causing collapse. So there's some equitable rate.

Edward Chancellor: I think the interest rate sort of Goldilocks and the Three Bears, three bowls of porridge, one's too hot, the other's too cold, and the other is just about fine. If you go back to the era before the proliferation of banking, so in Britain say roughly 17th century, where an act of lending would be sort of the equivalent of me lending you a book. I'm actually lending you of in effect a physical object, that is a finite supply. The state shouldn't try and make laws about interest, but let the interest find its natural price or its natural level. So that becomes the first notion of a natural rate of interest.

But when you get into a world where banks create money through the acts of lending and then you get into a world where money is no longer redeemable, or convertible into a precious metal, and you have a monetary system in which the central bank is in effect determining what at least short-term interest rates are, therefore on what long-term rates are, then the the interest rate is no longer so to speak market determined, or is no longer necessarily in line with the natural rate.

And what the central bankers have adopted over the last 100 years or so is a rule of thumb that says as long as there's no deflation and as long as inflation is kept around--it's what's now, the 2% target--then we have discovered the market's natural rate--and I argue in the book that this is mistaken because there are some periods when consumer prices are declining for particularly benign reasons, such as improvements in productivity, or falling traded goods prices as China starts selling stuff to everyone. And that these are not necessarily bad, and not necessarily an indication of where the natural rate should be.

You should look to other things too. You should look whether the strong credit growth or whether there's strong asset price bubbles, and whether the financial sector seems to be growing very strongly. Those would all be indications that lending is being done at what key players in the financial system would consider to be a very low rate, or at least a rate that's very favorable to them.

Rick Ferri: You also talk about ultra low rates, zero interest rates, negative interest rates created by central banks. They're trying to get the economy going and get people to borrow money but it causes unintended consequences.

Edward Chancellor: The preface my comments to--obviously first of all there, is a notion that interest actually emanates from within the individual in their so-called time preference--so you prefer to have which we express in with the phrase of bird in the hand, as worth two in the bush. You prefer, human beings by and large prefer, to have something now than at some date of the future. Therefore future goods and services are worth less due than your current goods and services. So the interest is the discount between the current and the future price.

And so according to some views is that interest, or in what Irving Fisher of the American economists call crystallized impatience, is an inherent feature of human psychology of mankind. So to set rates at zero is to suggest that mankind no longer has a time preference. To set rates at a negative level is to put the price of time in reverse. It's a concept that belongs to Lewis Carroll and Alice in Wonderland. It sets the position of normality back to front. So that I think is the sort of strangest thing about the era of zero negative rates. It's against human nature. As I mentioned to you earlier it undermines the fundaments of the capitalist system.

And in the late chapter of the book--I discuss in different chapters the role of interest--in valuation I discussed the role of interest in the allocation capital and interest as an inducement to save. Interest as a measure of risk, interest as a cost of leverage, or all the cost of finance for the financial sector. And interest affecting capital flows.

And all those aspects, all those different features of financial system were sort of knocked out of whack by near the end of 2021. Global debt levels have massively increased since the 2008 financial crisis. U.S stock market trading on record valuations, the so-called everything bubble. You get misallocation of capital into most absurd venture capital and technology ventures. Then you get the zombie companies. You get your legacy of decade or more of chasing yields. So the declining credit standards, of underwriting standards, and the growth of debt.

So I think you put all this together and you say the low interest rate immediately after the stock, after global financial crisis, it obviously lessened the impact of the crisis, mitigated unemployment and helped the financial sector hold together. So those are the plus signs. But then by continuing the same policies for a further - what, 13 years? - you then get these other problems.

And my main beef with the policy making community is they focus only on the immediate benefits of the low rate era. And the quantity of easing after the collapse of Lehman Brothers, where it averted--as they're keen to say--another Great Depression, and then they overlook the role of the very low interest rates after the dot com bust when U.S. fed funds rate fell to 1%, which appears to have contributed to igniting the, a major fact in driving the the real estate boom. And also the low interest rates encourage investment in in the subprime securities which had a higher yield.

So, and then after the crisis, then you have all these other problems that the policy makers, to my mind they don't pay attention to.

Rick Ferri: And it's one of our other interesting aspects of this, and we're seeing it, is a rise in inequality and social unrest comes along with this.

Edward Chancellor: Yeah, so I mean think about it. If you have some assets, a house, a stock market portfolio, bond portfolio, and the interest rates go down, everything else being equal, value of your house goes up, value of your bonds go up. So you you are richer, you're better off, at least into the current, and this is the valuation of all your assets. Whereas as you know, when valuations go up they're more expensive to buy. So a person trying to buy a house, get on the housing ladder, has more problems.

But obviously when the house price is higher, and actually you know valuations go up expected returns decline. So actually it's very good if you've got a fortune you benefit but if you're trying to acquire a fortune it's different matter. And then as I point out and perhaps I'm being a bit hypocritical because I've spent halfway in my life working in the finance area, but the very low interest rates benefit people working in finance, not your conventional banker because yield curves are flat and it's difficult for conventional banks to make a profit from their lending and borrowing.

But if you're more on Wall Street, if you're helping companies do their leverage stock buybacks, or leverage buyouts, or if you're just if you're running an investment firm, and your markets are going up and you're being paid a percentage of that, then what you see after the global financial crisis is that despite the fact it was a financial crisis you see that the role of the financial sector in the U.S. actually increases, and contributions to profits rise to a record high. And I show a chart in the book showing that the share of wealth owned by the, I think it's the top one percent of the population seems to track the inverse of the long bond yield, so as long bond yields come down the wealth of the richer section of population rises.

As you're probably aware there was this book came out, I think 2013, by the French economist Thomas Piketty, where he said that when rates of return were higher than growth and inequality increased. But I say when the rate of interest is below growth then actually inequality rises. Historically the Gilded Age, which was a period of these great trusts being put together by JP Morgan, funded with debt, creating the robber barons. It's no coincidence that this occurred at a time of very low interest rates. Just like the great financial fortunes for recent years.

Rick Ferri: What you're saying does make the case for a market timing strategy. But we know that that's very difficult to do and you have to make two decisions when you do market timing. You have to decide when it's time to get out, and then you have to decide when it's time to get back in.

Edward Chancellor: I agree. And obviously if one comes from the sort of active investment, market timing side, everyone's always going to look for arguments to justify that position against the passive investment. If you pay taxes on capital gains that's an extra problem. What worries me in particular about passive investment, all the growth for passive investment over the last decade, I mean in some parts perhaps has to do with growth of ETFs and technology.

Another thing that I think was probably pushing it was that when you move into these bubble markets created by the ultra low interest rates it becomes extremely difficult for the active investor with a value bias keep up with markets, particularly when those markets as happened in the U.S. become heavily concentrated in a relatively small basket of stocks. And so you get this sort of negative Alpha drawdown going on year after year after year. And then it becomes a simple decision for the risk-averse investment committee to say hey active doesn't work so let's take our money from active put it into passive.

And as you make that shift, you're selling the active position, the active, so value stock positions, which is everything else being equal lowering their price, and then you're putting it into market cap weighted positions in the index which reinforces the demand for the large cap stocks that have already increased their position. So you get a lot of, if you will, blind capital going around. And I see this as indirectly related to the easy money conditions.

There is--I didn't include it as a chart in my book--but there is a a chart which I saw that Nomura, a Japanese broker, put out in 2016 which showed that the active with Alpha and negative Alpha, roughly tracked the course of interest rates. So that as interest rates were falling this was a very bad time in aggregate for active

Rick Ferri: The markets are cap weighted and most active managers tend to be equal weighted. and because of that they're investing the money more broadly across the market. So they may have 50 names in their portfolio, but it's closer to an equal weighting rather than a cap weighting. So as you get lower and lower interest rates pushing up particularly in the U.S. market these large cap growth stocks, then you've got--not only is it a value/growth issue for them--but it's also there's no breadth in the market. So that their names are not benefiting.

Edward Chancellor: I've seen research from the quantum shops, AQR and Research Affiliates, and they both argued that value, U.S value, but also value in other parts as well- but that stick with U.S. valuation was at not at a record discount, but a close to record discount by the late 2020, when value rebounded.

Now the value was the greatest discount at the peak of the dot com bubble, when long-term valuation measures like Schiller PE or Tobin's Q, were at its highest level ever. And then you go to 2020 U.S. market, on Schiller PE is its second highest level with the exception of the dot com bubble and value is once again at a discount. And I imagine that active managers in the U.S. are looking at early retirement.

Rick Ferri: No not this year. Quite frankly what has happened in this last rally, I think, is you look back over the last six months and active managers have outperformed because of the breadth of the market.

Edward Chancellor: Active managers tend to sit on a bit of cash.

Rick Ferri: Well that too, the the bit of cash, but also because of the higher interest rates, and the valuation equation of long-term, way out there future earnings of large cap growth stocks, they came down a lot and the breadth of the market broadening out into other names, and particularly value names, and value industries like energy and materials have caused the active managers to outperform.

Edward Chancellor: I was saying that in 2020 that that was a nadir. Obviously 2021 market is a very strong market too. And so last year heralds the return both of value and active management and if the sort of new mirror correlation between interest rates and alpha hold -- I did a talk at some investment conference in Germany last summer which I showed the Nomura charts to the value investors, saying that all hope was not quite lost.

Rick Ferri: Again getting back to our discussion about market timing, very difficult to do it and even if your data says okay now the market is overvalued you should begin to pull back. You could be much too early and that causes other problems, not only for the professional managers but for individuals, who now have to figure out how to get back in. But should you invest in growth, should you go to a value tilt. Again if you're going to do that you can't time it. It's very difficult to time these things. So just going down the middle of the road is really what the Boglehead philosophy is.

Edward Chancellor: I'm aware of the timing issue. Obviously having worked in an investment firm when our models were not necessarily producing in a timely or even very accurate forecast--having said that to go back to what I as mentioning earlier about you the credit cycle model or even our general understanding of the impact of outflow of interest rates, which is what my book is about, I think it's important for an investor, even if they're committed to only using index products for asset allocation purposes, to understand the environment in which they're operating.

Let's take the most extreme example, and say we were Japanese investors in the 1980s. Obviously it wouldn't have been very good idea in December of '85 to taking your money out of the Japanese stock market. However what you would observe during that period. First of all you'd see interest rates kept low, and you'd see following from that strong credit growth and a real estate bubble and rising valuations in stock market. And you'd have seen this phenomenon of "zaitech" [application of financial engineering techniques in Japanese financial markets since their deregulation in 1984], or financial engineering, which profits are really being created speciously through direct and indirect exposure of Japanese corporations to the stock market, or the real estate markets, which are being put through the P/L, sometimes goosed with a bit of extra leverage. So you see the "zaitech", and then you notice towards in the latter years you'd see inflation coming back in the system and you would observe the Bank of Japan tightening and putting it up interest rates very sharply in late '89 and into 1990. You'd have heard the governor of the Bank of Japan saying expressly that his desire to bring the real estate bubble to an end.

And if you knew your financial history you'd be aware that the end of periods of asset price bubbles, the real estate bubbles, after strong credit growth were likely to be fairly calamitous, as turned out to be the case in Japan. Now given that the Japanese stock market was trading on a price earnings ratio around 75 times at the time, and now you know we're speaking what 33 years later, the stock market still hasn't returned to the Nikkei peak of December 31st 1989. That is a strong case. I think it's probably the strongest case you can make, because I'm obviously giving you an example where we actually being out of the market for a long time has paid off. And at least getting out close to the top. I think that it behooves one to understand the environment in which you're investing.

Yeah and and I suppose I would say quite strongly to adapt your asset allocation at least to extreme divergences from normal conditions.

Rick Ferri: I also interviewed Antti Ilmanen from AQR and his book Investing Among Low Expected Returns. Basically said the same case in the extreme if you we're to do a little market timing. You may benefit, in fact there's a video out there by Jack Bogle talking about his own portfolio and how he incorporated this.

Edward Chancellor: Bogle slightly--he tempered his U.S. exposure in the late 1990s.

Rick Ferri: Correct, by quite a bit. Now realize he says in the video that he did it in 1995 when he was having some very big health issues. And then he had to have his heart transplant in January of 1996. So that had a big factor on him trying to prepare his portfolio. If he didn't make it, he did say that in the video. But he did make the case that things were getting to an extreme. Now remember he was four years early on that call and was out of the market generally. He said he was at 25% equity-- went from 75% to 25 for four years, while the market went up.

And it does create problems for investors, watching the market go up and up and up, and maybe believe they make a mistake and get back in at even a higher price. My problem with market timing is: market timing. If you're not right on your timing it could lead to exponentially larger errors in your timing.

Edward Chancellor: Hey, look, I understand that. Are you familiar with the work of Andrew Smithers who's an English, it's a British economist sort of city of London economist, now retired, came out with a book roughly the same time as Robert Shiller's Irrational Exuberance, called Valuing Wall Street. And Smithers uses replacement cost and the idea being that the market U.S market has traditionally traded, I think it's like discount to its replacement cost valuation, otherwise known as Tobin's Q. And you can go to Smither's website and you can download his Tobin's Q. It tells you the same story as the Shiller P/E but from a different angle.

But Tobin's Q or the last 28 years has hardly hit fair value and the GMO methodology which is not quite similar in its way to the Shiller P/E, but works on a mean reversion of valuation and profit margins. That it was early, the forecast with its negative signal in the late 1990's, when it was developed. But then it produces outstanding rankings on investment returns in 2000, the 10-year forecast, the rankings of value and emerging and U.S broad stock market. And either those--I mean if you look at them it's almost it's sort of spookily good-- it's so spookily good it might almost persuade you to believe in forecasting.

Forecasts that were then made by GMO and the team I was part of in 2009--over the next 10 years were decisively inaccurate--so that that moment of glory didn't last.

Rick Ferri: It's the old saying that it works until it doesn't.

Edward Chancellor: Yeah. And I think that's true, within I have to say, I think that's an investment truism. And I think, I reckon sort of, Bill Bernstein would agree with me on this. Is that there's no sort of permanent investment truth, and therefore really one sign of a good investor is a sort of flexibility to adopt different methodologies, or different ways of looking at the world. Think of it this way. You know you had Ben Graham with his sort of, if you will, hard value methodology, and it's a price to book and earnings. And then you have Warren Buffett adapting that into a sort of more of a sustainability of return on equity, or what we would now call a sort of quality focus, moving from Ben Graham pure value to a sort of quality value proposition.

Rick Ferri: But that that's all great for people who do this maybe for a living, and I would say that people who do this for a living may be the top 1% of those people could actually do that. The other 99% basically have the title of portfolio manager, and they're pushing buttons and following some model, but you know there is the 1% of the professionals who have this belief.

The problem with individual investors is they're always going to be late to the game. They're the ones who pick up the model right at the end when it's got its last, maybe correct forecast in it, and then it all goes haywire and then they wait for the next model to come along that has worked for the last 10 years, and they they jump on that model which is right at the end of it. Individual investors have this problem.

Edward Chancellor: I know I mean it is and you see it and I guess, I think you know, I think I've even seen reports in the Wall Street Journal over the last couple of years with retail investors piling into the market in 2020 - 21 and then the market cracks and then suddenly they're getting out of the market just before the market's about to rebound. So I think that if you're going to do market time you not only need to understand the valuation aspects, you need to understand certain extraneous other factors that might influence, be a help market timing work.

Of which I think the monetary situation probably is fairly important one. And then you need to have confidence in your position, and you need to have a strong contrarian aspect to be willing to go against the market. And I think you probably also, you know, getting back to your question whether you're out of the market, you also need to be able to reassess your decisions and if necessary overturn them. Are you asking a lot from the typical individual investor, or quite a lot.

Rick Ferri: Or you could do the Boglehead version of it, which is to come up with an asset allocation, call it 60 stocks/40 bonds. Be super diversified into global equities on your stock side. You know, U.S index fund, international index fund, be diversified on the bond side as well.

Do an occasional rebalancing, which does pick up these valuation differences over time and then stay the course and it ends up being the default model that ends up pushing these individual investors who actually do this model up into the 90th percentile as far as rates of return. So you're never going to be number one, but you're going to be up there in the 90 percentile.

Edward Chancellor: And it's always quite dangerous to make generalizations of investment based on sort of a back testing of the positions. I'm not saying the Boglehead portfolio-

Rick Ferri: But no, I just wanted to explain what the Boglehead kind of what how it ended up defaulting to that-- in other words the people who are the Bogleheads are very intelligent. They study everything. They read everything. They're they're going to read your books if they've not already read your books. They are into everything. We're talking some of the smartest people I know, much smarter than me. They've come to the conclusion that yes there may be people out there who can do this, but it isn't me. And so what do I need to do for me, that works for me, and that's where you end up with this the Boglehead philosophy.

Edward Chancellor: So, and we come off this period of very strong U.S bull market and reasonably strong but obviously not quite so good global markets, with the U.S market ending up at a close to record high valuation in the end of 2020. You've also had this period in which you this 40-year bull market in bonds, in which nominal bond yields declined around the world to their lowest level in history, and negative in some countries. If you remember 18 trillion dollars worth of bonds cited by Bloomberg with negative yields.

And during this period is the correlation between bonds and stocks is not stable at all times historically. But there seems to be the case that since we moved into the recent bubble era which we might take collapse of the Long-Term Capital Management hedge fund in September '98. That was a period in which there was quite a strong inverse correlation between bonds and equities. So that as you were losing value on the equity side you were getting something on the bond, and that was may have been due to the fact that the markets were aware of the sort of deflationary risk from all the debt and the bubbles that were being created.

And perhaps they were also where that whenever the markets faced travail the Fed was likely to cut rates that would be good for bonds, and they were, and the markets were aware that inflation pressures would appear to be in abeyance, and therefore there wasn't much of an inflation rate. So that was a very nice period on the whole to have your classic automated 60/40 portfolio.

But you're aware of the 1970's. You have a positive correlation between the bonds and the equities and then inflationism permanently eroding the value of the bonds and temporarily depressing the valuations on equities.

Rick Ferri: But that let me stop for a second if that is a good point. You see where we are right now in history, and we've been here now for well since the financial crisis, is bonds have given us a negative real return, and that's before taxes, and we all eventually have to pay taxes. This is a real dilemma. We are losing purchasing power with every bond that we hold, unless you're going to buy triple B or double B rated bonds where you get a high enough yield, or you buy treasury inflation protected securities, where there only recently the interest portion of it has been high enough so that maybe after you pay your taxes, maybe you break out even. So bonds are a real dilemma right now for people who are actually trying to grow real wealth after taxes and inflation in their portfolio.

Edward Chancellor: First of all if you think it's difficult to time equities, try timing bonds. That's another project I had at GMO. I looked it up. One focus, I back tested it over the previous century and found that it was, it had been right on about three occasions, and it would often be wrong for sort of multi-decade periods. And then you actually realize--and if you ever move in the circle of fixed income investors--is that they never, they really don't talk about market time. Equity guys do talk.

Rick Ferri: It's interesting. You're absolutely right about that. That's interesting you say that.

Edward Chancellor: There are no value investors in the bond world. Anyhow. But the thing is we all sit now and we--let's throw ourselves back in time to the previous period in which interest rates in the let's take with the U.S. interest rates were kept at an extremely low, manipulated down to very extremely low position during the Second World War, where, I can't quite remember, but I think sort of T-bills were fixed at some 25 to 50 basis points, and a handful of basis points about that for the Treasuries. And the yield curve was manipulated.

And then you come out of the Second World War, pent-up demand and you get a surge of inflation. It's only there for a year or so, but then the inflation comes down and you could say there are certain similarities to today, although I actually think that the U.S, from an investment perspective and an economic perspective, is in a much better position after the Second World War because the debt has been paid down to the Great Depression. There's a lot of sort of suppressed consumer demand and valuations quite low on the equity side.

So it wasn't sort of post bubble valuation problems to deal with. Anyhow if you were a treasury investor, then you actually have to deal with 35 years of rising yields until they peak in the early 1980's, and by the end of that period bonds are known as certificates of confiscation. If you and I went back in a sort of time capsule and someone to argue now here a balanced portfolio would be having 60% equities and 40% nominal treasury bonds they would think you were completely mad.

I haven't said that we do know that there are historically these bond markets and their cycles have gone in roughly three to four decades, sometimes five decades. The bond bear market of Second World War lasted 35 years. And then the bond bull market that followed it lasted 40 years. We know now that there is a strong incentive, as strong if not stronger incentive for governments to push for keeping interest rates below the level of inflation, if only to facilitate the reduction in the real burden of government debt.

Rick Ferri: The the idea of negative real interest rates is here to stay for a very long time. It becomes policy going forward and this is a real dilemma for investors who are on fixed income, and we have this saying here in the U.S., as you get older you should buy more fixed income, your age in bonds. And I'm not so sure that that's true. That's just maybe a bad idea given this world that we're in.

Edward Chancellor: From a sort of practical investing perspective compared to where we were at the beginning of last year, is that the TIPS, that Inflation Protected Treasury Securities now have a positive real yield. At the beginning of last year they were in negative territory, or at the end of 2021, and they took quite a big hit, the TIPS. Te yields, real yields moved with nominal yields.

Rick Ferri: Yes that's true. But now as we stand today they are at--short-term TIPs are at 2% percent-- like a one-year TIP for us here in the U.S. are at 2% yield and longer term TIPs are at 1.5%. So you could actually invest in TIPS today and you will have a real return on your fixed income portfolio.

Edward Chancellor: One of the arguments of my book is that the ultra low interest rate environment has created a bubble economy and contributed to misallocation of capital, whether it's in your pie in the sky venture capital investments or in your zombie companies. And it also contributed to a lot of financial engineering and companies, particularly in the U.S., having levered themselves up, and obviously a great private equity boom, and then a decline in in savings, in actual savings, discouraged by the low interest rates and also savings discouraged by frankly the extraordinarily strong position returns in the market.

If people are getting seven or eight percent real returns from a balanced portfolio there's less encouragement to put money away. And so I think the upshot of all that is that it will probably--so there's not a forecast--but it's there's a reasonable chance I would say that we're about to go through a period of continued low growth--bear in mind that since the global financial crisis U.S and European GDP growth has been at sort of near record low levels- and I argue in the book that the accommodating managed policy and the resistance to allowing the market to clear by monetary policy has contributed to that.

If this were to continue at that low growth, or even exacerbate that trend over the next decade. And if, as we've already mentioned, the authorities have a strong incentive to keep interest rates below the level of inflation, policy of financial repression, as we had after the Second World War, then I think your one and a half percent on TIPS today will look like an outstanding bargain. You know, for U.S. retirement investors I think TIPS should be a core holding, and probably to my mind, probably bigger than the 40% allocated in the average portfolio.

Rick Ferri: Thank you so much Ed for being on the show. So we've talked about a lot of things, a lot of concepts. Oh, I think I've learned a lot today, and I hope all the Bogleheads have also.

Edward Chancellor: My pleasure.

Rick Ferri: This concludes this episode of Bogleheads On Investing. Join us each month as we interview a new guest on a new topic. In the meantime visit Boglecenter.net, Bogleheads.org, the Bogleheads Wiki, Boglehead's Twitter. Listen live each week to Bogleheads Live on Twitter Spaces, the Bogleheads Youtube channel, Bogleheads Facebook, Bogleheads Reddit. Join one of your local Bogleheads chapters and get
others to join. Thanks for listening.

About the author 

Rick Ferri

Investment adviser, analyst, author and industry consultant


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