So, I feel like we could talk about

LTCM. We could talk about I mean, you

sense

>> Let's not Let's not do that. That's so

boring. I mean, everybody's sick sick of

LTCM. Yeah. Yeah.

>> So, what do you think the real lessons

are?

>> You know, I think the biggest lessons

are about personal risktaking. The first

big lesson has to do with skin in the

game. Maybe the next lesson is that

running a leverage pool of standalone

capital might be a bad business

structure. You know, it might be better

to do relative value trading within uh

larger institutions where it's a small

part of the activity and where it's not

exposed to, you know, to financing risk

etc. from all the counterparties that

are funding that uh that activity. So, I

think those are two things. I think

relative value trades tend to have

fatter tails than delta, you know, what

we call delta 1 trades, you know, that

that that's kind of natural. Something

that we knew about, but I think that was

more highlighted by that. I don't know.

I think those are like three really

really big important lessons from from

that. I think the main I think probably

the main uh difference is that they run

tight stop losses on all of their

strategies and so they are trying to

force all of their strategies to be

liquid enough that they can operate

tight stops. I think that's really

helped them. you know, I think that that

helps bring a positive exposure to

momentum into their strategies and um

you know, that's I think that's probably

the biggest divergence

between what they're doing and how

they've been more successful navigating

you know, a number of crises than uh you

know, than than what we've than what we

were doing back then. We didn't have

tight stop losses on our positions. you

know, felt like relative value trading,

it's hard to put tight stop losses

because they tend to be kind of illquid

and they tend to look more attractive as

they're starting to widen out. But, um,

yeah, and I think that probably the pod

shops have a greater a broader mix of

strategies than we were running at LTCM

and and, uh, you know, and that's also

helped. Um but you know I mean uh the

you know some of the pod shops that were

you know some of the hedge funds that

are have done successfully had really

big draw downs you know like existential

draw downs in in 20089 and and just

managed to survive them which is great

you know but but you know that that some

of them were vulnerable and and at other

times you know some of the basis trades

have looked a little bit dicey and put

some hedge funds in a precarious

position but you know they all worked

out, you know, and uh you know, again,

LTCM probably could have worked out if

uh if LTCM had not been so much the

focus of the financial markets at the

time like if LTCM had sort of been more

quiet, you know, had been uh quietly on

the side and people didn't know that uh

that we had had such a big draw down and

that we were likely to be unwinding a

lot of positions, you know, probably

LTCM would have survived as many other

relative value hedge funds survived

though with large losses in 1998 as

well. Joined today by Victor Hagani of

Elm Wealth. He is the author of The

Missing Billionaires, the author of an

upcoming book. He'll tell us about that.

Uh as well as he was the founding

partner of Long-Term Capital Management.

Victor, welcome to Monetary Matters.

>> Thanks very much, Jack. Co co-author by

the way with my partner James White on

that book and the fourthcoming one too.

[laughter]

>> Tell us about who killed the random

walk. What is the random walk? What is

the work that you've been doing that

shines new light on it? And why does it

matter?

>> Oh, thanks for asking that, Jack. This

is uh something I haven't I don't think

I've talked on any uh really publicly

about this except we've been talking at

a number of seminars about this paper.

It's a piece of research that we've been

working on for three or four years and

it just got accepted into the Journal of

Investment Management. It's available as

working draft on SSRN and um and and you

know basically the starting point is

that everybody who follows the stock

market uh sees a lot of behavior in the

stock market that is hard to reconcile

with the idea of everybody is a rational

fully informed agent making uh long-term

investment decisions based on expected

cash flows of the stock market um you

know which is the classical financial

economics description of the stock

market and asset pricing theory to begin

with at least. And um uh you know on the

other hand you know we have behavioral

economics that that came up relatively

recently. And uh behavioral economics

you know sheds a lot of light on the

ways that we make that people make weird

decisions but you know it tends in in in

its extremist form it doesn't really uh

give us much predictions or things that

we can test uh you know in terms of

market behavior. So what are these

puzzles I should say of start there what

are the different puzzles of the stock

market? I think the biggest puzzle of

all is that why is the stock market so

much more volatile than the volatility

of long-term earnings. Right? This is

the famous Schiller Campbell work from I

don't know the late 80s partly

responsible for Schiller's Nobel Prize

where he pointed out that like stock the

stock market is so much more volatile.

It's twice as volatile as as um expected

earnings are. um a little bit of a

tricky thing to exactly measure, but you

know, I think that he did that pretty

convincingly. And I think people kind of

feel that way and that's kind of become

accepted within

practitioners and academics alike as as

being the way things are. That stock

market's so much more volatile. And then

some people say, well, that's just

because the discount rate is also

moving. Not only are people's

expectations of earnings changing, but

the discount rate is too. But that

doesn't really uh answer the puzzle at

all. It's just reframing the puzzle. You

know, other puzzles that people think

about with the stock market, you know,

is why is volatility so so volatile

itself? Why do we go through periods of

of extreme volatility and then it kind

of stays that way for a while? It's

clustered uh and then we go to periods

of of peacefulness. Um why do we have

trends? You know, why has momentum

investing been such a good way to uh to

invest in the stock market? Why has

value investing not been so great been

so great? You know, when the PE is high,

uh if you reduce your exposure to

stocks, yeah, it tends to be okay

sometimes, but a lot of times the PE is

high and stock market just keeps on

going up. Why do we get booms and busts?

Maybe that should have been my first

one. You know, why do we get booms and

bust? This exuberance and and uh and

kind of depression in stocks, you know,

at different times. Um and um uh yeah

and you know and and several more well

uh our paper which which I should say

really builds upon a lot of previous

research that's been done uh our paper

uh is titled who killed the random walk

why extrapolators uh explain booms and

busts and uh and other stock market

puzzles and and anomalies. And um you

know our uh research has in this in this

field is uh is basically uh was was

developing what's called a um um a

multi- aent or heterogeneous belief uh

model where different investor types

come up with their belief about stock

market returns differently. So, you'll

have one group of investors, we'll call

them value investors, and they're really

thinking about the long-term earning

streams of equities and dividends, and

they want to own more equities when the

expected risk premium based on these

long-term cash flows is higher and vice

versa when the expected return is lower.

Um,

other investors, which is probably the

predominant investor class these days,

are static investors, which, you know,

they're just like investing in a target

date fund or a balanced fund that's

going to be 6040 more or less all year

long. And they're not going to change.

They just want to stay at 6040 and

rebalance there every month, every

quarter, whatever. And static asset

allocators are a huge component of the

market these days. It's not just um 401k

and IRA investors in these balance and

target date funds. It's a lot of

institutions. You know, the Norwegian

oil fund is pretty much a static asset

allocation

investor and uh and and these kinds of

investors have not been modeled very

much in this multi- aent um body of

literature. Um, finally, I mean, well,

we we've modeled a bunch of other

investor types, too. But the third type,

which is really the key one here, are

extrapolators or return chasers. And

what do they do? They basically come up

with their expected return for stocks

based on recent history, based on

returns over the last five years is how

we've modeled it with a kind of an

exponential decay. And the ex so when

when returns have been good in the stock

market, extrapolators get more bullish

about returns in the future. we dampen

it and try to be uh realistic about it.

If if you know, we know that if stocks

went up 25% the last year that people

aren't saying, "Oh, I expect 25% next

year." But they're more bullish. They

expect a higher expected return, a

higher risk premium, and they want to

own more stocks. And there's a ton of

survey data, etc. that shows that many

investors do behave this way. And um and

and anecdotally, I think we all see it.

and and uh and and depending on the

marketplace, it's stronger or weaker,

you know, like when it comes to

investing in cryptocurrencies, people

are very tied to history. When it comes

to investing in the two-year note, you

know, there's not too much extrapolation

going on.

>> So,

>> right. Yeah, I go ahead. Go ahead.

Well, anyway, so we take these investor

types, we put them together into a

hypothetical simulation, we let them

trade with each other to do to get to

where they want to be. We introduced

shocks to earnings. We put in some

noise, some um noise in that sometimes

people need to sell to sell some

equities to buy a house. Other times

people are getting compensation and need

to invest in equities. We try to create

a realistic environment where these

people can all trade with each other and

and voila, what we get at the end is

like all is an explanation of like all

these different puzzles that this

dynamic system gives us excess

volatility. It gives us stochastic

volatility. It gives us trends. It gives

us booms and busts. All these different

things. And um it does it with like a

reasonable set of of parameters. there's

a lot of parameters in this model. So

you could say, well, geez, once you have

this many parameters, you can explain

anything. And that's true, but it still

is kind of comforting as a framework for

thinking about things that this is

probably a reasonable description. And

you can ask a bunch of different

questions like

how inelastic

is demand as a function of price? Like

if if somebody comes in and needs to

sell a hundred billion dollars of

equities, how much is that likely to

move the price of the stock market

because these three investor types have

to adjust their holdings to absorb this

hundred billion dollars of supply or

demand that that comes to the market. So

it gives it's it's a really rich

framework for asking and answering

potentially a lot of questions. And

yeah, we've found it super exciting and

it's been gotten a good reception. And I

think we've given we've presented the

paper at about five different seminars

and we're super excited that the journal

of investment management is going to

publish it.

>> So many things I want to get into.

Victor, just starting with the title. So

the random walk theory states that asset

price change is completely random and

unpredictable, meaning past market

movements cannot be used to forecast

future prices. Are you challenging or

are you accepting that theory in the

paper to be clear?

I well, I'd say we're challenging it. I

think that, you know, the stock market

really doesn't feel like the classical

uh random walk um that,

you know, doesn't doesn't feel like the

classical random walk that we all

learned about in uh in in our finance

courses years ago. So, yeah, we're we're

challenging that the stock market

follows a random walk. Uh

>> and and the core a a core of that I

suppose would be momentum like Jim

Simon's rip that had phenomenal returns

like b best returns ever in their core

fund at at Renaissance of it was a it

was very complicated but essentially it

was a it was a momentum strategy right

and like a lot of a lot of incredible

returns hedge fund returns from a while

ago are from momentum of like if it was

up Monday Tuesday Wednesday it's a

decent bet to go bet that it's going up

on Thursday. It's a lot more complicated

than that, but like momentum is a giant

thing and that that that is one of the

things that

kind of disproves the random walk and

and you in your paper you have like

eight other puzzles other than momentum.

I think seven other puzzles and you're

you're trying to explain them. Yeah. And

I I think you hit on the one that

probably is the biggest challenge to the

random walk and it's the one Gene FMA

the father of the efficient markets

hypothesis, right? or one of the

fathers. Gene FMA says momentum is the

mother of all anomalies. It is an

anomaly. It is weird um that we see it

and we see it researchers um a number of

researchers have shown that like

momentum exists in everything. It's in

natural gas. It's in stock prices. It's

in 30-year long bond prices. It's in

Bitcoin. It's it's everywhere. It's it's

been everywhere. It continues to be

there. And what the heck? How can that

how can momentum be there? And and then

as I was was we were talking about

earlier that stop losses if you follow a

stop-loss program like investors that

are following a tight stop-loss program

are kind of like I don't want to say

they're closet momentum investors but

you know they are exposed positively to

momentum and it helps. So when you go

back and think about the turtles,

remember the turtles from the commodity

the the um it was kind of like the story

from trading places

>> where um these commodity traders, the su

successful commodity traders were like,

I bet we could just get some kids out of

high school or college and teach them to

be successful commodity traders. And

they hired all these people that do

nothing that knew nothing about

anything. And they got them to be really

successful by forcing them to just

follow a tight stop-loss. They could do

whatever they want, but they had to they

had to cut their losses and let their

profits run. And it was almost like

whatever they did, as long as they did

that, they made money. And that's

because those markets had momentum,

exhibited momentum over that period.

So why is it that momentum works? All

the quantitative geniuses from 40 years

ago, they said, "Okay, let's do

momentum." Why hasn't this been kind of

competed out of the market in the same

way? Okay, value was a thing. You could

make money in 1970 by buying giga cheap

stocks and now that strategy works a lot

less to put it mildly. Why isn't that

true for momentum? Why does momentum

still work?

>> It's a question of uh relative capital

sizes. [clears throat] So if the uh

momentum we believe is created by the

behavior of extrapolators, if the

extrapolators are much have much much

more capital at their disposal, if

they're if they're having much more

impact than the pool of capital that's

doing momentum

uh than momentum then the momentum

investors won't won't arbitrage or

compete away this momentum effect. And

you have to realize that momentum is is

a really interesting uh investment

strategy because on the one hand it's it

it um it has really good returns and

people love that. On the other hand, it

just seems like the dumbest thing you

could ever do. What? The market went up,

you know, I'm going to buy more. I'm

going to buy. The market went up. I'm

going to buy. Like, isn't the whole idea

of investing to buy low and sell high?

Well, what's momentum? Momentum is buy

high and sell higher. It's sell low and

sell lower. And um and it just is this

thing that um just seems so strange to

investors that it impedes or limits how

much capital is dedicated to it because

it just seems like such a a weird

investment strategy to most people. And

as a result, when momentum goes through

periods of time when it's not doing

well, everybody is like, I knew that was

a stupid strategy. Why did I ever invest

in that to begin with? and and people

just pull their money out of it so fast

because it's going through some some bad

period of time. So, I don't know. I

mean, I think we could get to a point in

time when everybody is thinking about

the market through this lens of this

heterogeneous belief model with return

chasers and so on and there's just so

much capital that starts to follow this

more binary momentum strategy that

momentum goes away forever. But uh it's

a as I say it's a question of capital

and I don't know I mean I think and in

our model if we give the momentum

investors in our model more capital than

the return chasers than the

extrapolators well then the momentum

guys don't do well and you know that's

and that's that you know so you can see

it immediately within our within our

little toy model

that yeah that that once momentum guys

get too big if momentum guys are just

price takers uh the world is happy for

them. When they start to really have a

lot of price impact, the world is not

happy for them. [laughter]

>> Yeah.

A and I think also on a fundamental

basis, momentum is also a thing. Like a

company that grows its earnings at 20%

and there's an acceleration is more

likely to do that than a company that's

their earnings are doing really badly.

>> Yeah. Yeah. I think there's also

momentum and fundamental economic

variables. I think is what you're

saying, right?

>> Yes.

>> Yeah. Yeah.

>> Um. [snorts]

Yes. Okay. So, I mean, in your you kind

of when you when you laid out there's so

many interesting things, but I I wrote

something down on it's funny. I like I

don't have a notebook in front of me,

but my notepad literally has this

Chinese I don't even know what it is.

Um, [laughter] probably my business

partner. But so so about we you said the

word static

investors that that to me that means

index investors, passive investors.

Tell me about the significance of those

of the rise of passive passive investors

who really just buy the index, the S&P,

the MCI world, whatever index you want.

How does that change the investment

universe? and be as provocative as you

can because I' I've got a lot of um

potential push backs and and challenges

and it's it's emotional to me. So, we'll

we'll get into it. Let's have a let's

have a fight, Victor. I want to I want

to have a intellectual cage match with

you.

>> Okay, let's do it. Okay, so I think that

it's really important to um distinguish

between two kinds of potentially passive

investing. Uh, one of them is um I'm

going to invest in the stock market and

rather than giving my money to somebody

that

decides which stocks to buy and owns a

subset of stocks, I'm going to give my

money to a market cap weighted index

fund. So that's um index investing as a

means of uh stock picking. Let's say in

other words, it's not stock picking.

It's just investing in all the stocks

when I decide to invest in that. The

other kind of passive investing is

passive asset allocation. And I think

that passive asset allocation is so I'll

just I'll just make my statement.

Passive asset allocation is really

problematic.

Um it doesn't make sense. Passive asset

allocation. It doesn't make sense.

Um modern portfolio theory never said

that anybody should be a passive asset

allocator.

the whole capital asset pricing model

was was um had this insight that people

are going to be wherever they want to be

based on their preferences on that

capital asset pricing line. Uh they're

not going to be passive. They're going

to make an active decision based on the

expected return risk and their risk

preferences. So passive

>> I'm just going to jump in and explain.

Sorry that so passive for stocks means

I'm not picking stocks. I just buy the

S&P 500 or some other index. Passive

asset allocation for overall assets is

I'm not going to choose my stock

allocation, my bond allocation, my hedge

fund, private equity, commodity

allocation. I'm just going to do what

some index told me. So, I'm going to be

60% stocks, 40% bonds. Or if you're an

endowment like 30% stocks, 10% hedge

funds, 20% blah blah blah blah blah blah

blah. And you're not

>> passive I think. Yeah. Passive. Yeah.

passive asset allocation means I'm going

to just choose some allocation of stocks

and bonds and uh and I'm just going to

stick with that despite the fact that I

can see that everything is changing all

the time that that real interest rates

are changing that

>> the um earnings yield the long-term

expected return if if the S&P if stocks

are super cheap and the S&P has a PE of

five so stocks are super cheap and bonds

are super expensive I'll be 6040 if

stocks are

expensive and bonds are super cheap.

I'll also be 6040. You're not making any

changes. You say that's

>> so I would call that static asset

allocation. But for the purpose of this

conversation, let's call that passive

asset allocation. I think it makes no

sense. I think it's I think that's

responsible for all the things that

people are worried about with with

respect to the word passive. I think

it's problematic.

On the other hand, I think that

investing in the stock market using

market cap weighted index funds is um is

mis is um is mistakenly criticized for

creating problems. I think that creates

very few problems. I think it's a good

thing for most investors. If you think,

you know, if you have some evidence or

belief that you can pick stocks, go for

it. But I think that investing in index

funds as a way to get stock exposure is

totally fine. And I think the criticisms

of it are mostly misguided, are mostly

coming from people that have had their

businesses hurt by that because money

has been taken away from them. And so

that's as provocative as I'm going to be

for now. I think that index funds as a

way to invest in the stock market is

fine. I think that passive asset

allocation where you're going to just

decide to be 6040 7030 whatever is

really a problem for our markets. uh and

it's giving us these booms and busts at

least it's giving us a boom [laughter]

hasn't given us the bust yet and uh and

I think it's problematic and and I think

those are two really different things

and I think that critics of indexing are

are missing the mark because they're

saying oh it's you know that uh when

somebody invests in an index fund look

how much uh Nvidia they're buying this

is a problem no I don't think that's the

problem I think the problem is passive

asset allocation not passive uh stock

picking you or no stock picking.

>> Okay. I um go for it. So I I I feel like

I

>> on the on the passive stock point, I

agree with you. I I think that a lot of

critics of passive investing, they say

by being a fundamental bottoms up

investor who focuses on value, who

focuses on quality. When I was growing

up with the business in 1994, in 2001,

that worked before the markets have been

perverted by the rise of passive

investing. And now what I used to do,

good investing, doesn't work anymore.

I h I struggle with that because to me I

look at the fundamental earnings power

and the companies whose earnings go up

the most generally their stock prices

have gone up the most rel relative to

the expectations that were baked in to

like to me the markets don't seem wildly

inefficient in terms of like oh the

market is we're all the the market is is

believing in lies like there's all has

been price distorting aspect like I the

if I look at the biggest stocks in the

market like their earnings have grown

tremendously and they're the biggest in

the market like with the exception of

Tesla now maybe you could say okay

Tesla's stock has been flat over the

past three years while its earnings has

gone down like in a proper market like

the valuation should have gone down and

the price should have gone down even

more because because earnings went down

but I don't really see like to me there

are distortions in the market that are

caused by 10 things and just by 10

forces that are greater than passive

like like for example stock promotion an

IPO comes out so everyone who wants to

unload their bags on everyone talks

incredibly bullishly on it um the the

the human nature to miss to to to

be overly optimistic on the upside and

overly pessimistic on the downside to me

those are the root causes of

inefficiency in the market not passive

investing so I'm I'm I'm a I'm

disappointed that I'm agreeing with you

as much as I I want to have an

intellectual cage match.

>> I'm so happy that we're agreeing. I

mean, I I'm so so happy that we're

agreeing on this. Yeah. I mean, I to

what you just said, I totally agree with

it 100%. There's there's, you know, it's

like the problem isn't that when it

comes to the when it comes to the

cross-section of stocks, when it comes

to the valuation of individual stocks, I

think the problem is not indexing, or if

it is, it's number 11 on on the list.

like okay maybe oh whatever like uh the

relative liquidity of some big stock is

less than the relative liquidity of some

other stock what fine but maybe but

those 10 things there's 10 things

exactly as you said I mean it's just all

this individual craziness like oh you

know I'm an all-in Tesla investor you

know I mean remember that guy that was

in the Wall Street Journal I think his

name was like u uh Mr. Vault or

something that was his last name was

like vault or Mr. watts, like wattage,

and he was an all-in Tesla investor

because his name had to do with

electricity. Um, [laughter]

well, yeah, I mean, if money comes into

the market and it's just buying the

market cap index, who's who's selling to

them? I mean, maybe it's just people

that own the market cap index on average

are selling. And remember that all

active investors combined have a

portfolio that is the market portfolio.

So, if you're if if an index fund buys

and it's just buying from a random

selection of active investors. If it's

buying from an index fund, it has no

impact. If it's buying from some random

selection of investors out there, well,

they own the market portfolio, so that

has no price impact either. So um yeah,

I think I but but I think that um I

thought maybe your question was even

going in a different direction which I

had never thought of before which is um

which is like why does the market kind

more or less for most stocks more or

less for most stocks? Why do most stocks

kind of look reasonably priced

in this world where there is so much

craziness going on where we have zero

commissions and tremendous volume and

all of this? And I think that I I hadn't

really considered this question before,

but I think the answer to that is that

um is that the

sort of the hype and the excitement and

everything of retail investors

is focused on just a very small fraction

of names. So we have a small fraction of

names that probably are misvalued by

fundamentals, but 95% of stocks are not

like they don't care about them. They

don't care about

I don't know they don't care about fizer

maybe I don't know they don't care about

whatever like they care about

>> they care about SanDisk they care about

they care about IBM they care about

Sandis they care about Micron they care

about Tesla they care about SpaceX they

don't care about [laughter]

>> Hilton

cares about Hilton and other investors

who whose names we do not know care

about Hilton

>> yeah no one else And so those prices are

kind of being set by uh fundamental

investors, you know, more or less by

stock pickers and by by sensible stock

pickers that are trying to figure things

out. And so um you know, I think in the

bulk of the market that the prices kind

of look kind of reasonable, you know,

and then, you know, around the edges, um

you know, around the edges there's some

craziness, but in aggregate it kind of

looks okayish. Um but it's the overall

level of the market that I think looks

kind of ridiculous right now. I mean you

know that that when you look at the

capital market assumptions of 20 uh

investment management

uh bank investment bank brokerage

Vanguard Black Rockck Goldman everybody

right the uh they're saying that the

expected long-term return for US

equities you know is like 6%. Well holy

cow you know uh 30-year treasuries are

around 5%. What? That's just 1% more.

That's that's our risk premium today.

And this is the consensus among a bunch

of people that are like have a business

have businesses that benefit from being

bullish on stocks. So I think you almost

have but as you know the real fees are

in hedge funds but but particularly

private equity and priv. So if you say

oh stocks are only going to do 2% a year

then you get your clients into the

private equity private credit and that's

where the real fees are. That's my

conspiracy theory. I don't know. Well,

except for the fact that that's not

Vanguard's gig. That's not Black

Rockck's gig. That's not Bank of

America's gig. You know,

>> it is a little bit Black Rockck's gig,

but the other ones I agree. Yes.

>> Yeah. Yeah. But I mean, it's just very

minor, you know. I think and and I think

this is like either if anything, okay,

maybe that offsets this bullish tint

that I would argue. So maybe this, you

know, maybe they try to say returns are

going to be worse to get people into

other things, but but on the other hand,

they also have businesses that benefit

from people being excited about stocks.

So

>> So the blue chip consensus long-term

forecast for stocks from this levels are

6% to be clear. Are you saying you agree

with that or that's too high or too low?

And why?

I agree that that's the appropriate

expectation based on where we are and I

think that's like um uh voluntary

financial repression and I think you

know it's like I mean I think that's a

shame. It really is going to make it

hard for people to grow their wealth if

stocks are just giving 1% more than safe

assets. So I think it's unfortunate. I

think it's realistic. I think it's and I

think that it's being caused by all of

this static asset allocation out there,

you know, that just people are like, I'm

just going to be 6040. It served me

well. I don't care that I'm just going

to get 1% more. Um, and so we have, you

know, Birkshire Hathaway is like, all

right, we're going to reduce our stock

exposure, guys. But nobody, but very few

other investors are willing to do that.

And anybody who has done that kind of

has mud on their face. And so you know

those those people you know is you know

it's like the J it's the widowmaker

trade they call it you know from you

know that's what they used to call the

Japanese interest rate trade where so

many people were shorting Japanese

interest rates at 1% and eventually

there was nobody left because everybody

lost their jobs who did it [laughter]

then so yeah I just think it's realistic

but but but unfortunately low and

meanwhile non- US equities at least are

offering better long-term returns Again,

our belief and the consensus belief is

that non- US equities offer healthier

long-term returns relative to safe

assets. But but here we are, you know,

with very elevated US stock prices. And

why, you know, why do we have that?

Well, I don't know if if you were going

to ask me why. Um, you know, I would say

why is because of we have so many

extrapolators and these extrapolators,

you know, are just more bullish than

ever on stocks. we have more leverage,

you know, through margin loan. You know,

you can see retail investors are so

bullish on stocks. This is typical after

a period of stocks doing well. And

meanwhile, up until recently, what have

we had? We've had companies buying back

over a trillion dollars of their stocks

every year. And remember our who killed

the random walk model says as others say

too it's not our novel view but you know

most practitioners believe that um that

that that the stock market is not

perfectly elastic that when you know you

need to buy you know that buying of a

trillion dollars of stocks if somebody

turns up and says I'm going to buy a

trillion dollars of stocks next year

that should move stock prices by uh you

know a pretty reasonable amount. you

know, we would estimate it from our

model, we would estimate it at like, um,

you know, would move the market up by

three or four percent. Um, uh, you know,

there are other, uh, other people think

it would be more than that. Some people

would think it would be less than that.

Most, uh, traditional financial

economists would say it's not going to

move the market at all. The market is

fully elastic. But that's ridiculous,

you know, I think, or or at least I

wouldn't call it ridiculous. I would say

I would challenge that, you know, I

don't believe that. Um, so you know,

we've had a trillion dollars a year of

these buybacks, almost no IPO calendar.

I mean, when we had a big IPO calendar,

it was spaxs, but spaxs are not IPOs.

Spaxs were just money that was going to

buy more stocks, you know. It was it was

it was like a kissing your sister thing.

It wasn't like real equity issuance at

all, you know. It was um, you know, it

was just,

you know, a net wash. So, so anyway, I

think, you know, we're here because

we've had these buybacks. We've had not

much IPOs. We've had businesses that

have been capital light for a really

long time. And we have extrapolators

that want to buy more stocks when they

go up. And we have static asset

allocators that just don't want to sell

their stocks unless they go up a lot.

And they and they need to rebalance. And

we have almost no fundamental value

investors anymore. So, stocks, US stocks

going up and up and up. and what's

happening now maybe um it's about to

change.

>> Okay. So, so Victor, the operating

earnings of the S&P have been growing

about 24% talking about blended

operating earnings and they're expected

to grow by 24% over the next 12 months.

That is a very rosy situation. So, so

the forward PE for the S&P 500 based on

that is 20 which is higher than average

but not what you have seen at bubbles

which is like 30 or something like that.

Why are you saying that the forward

expectations for the

S&P 500 are only 6% or in that modest

thing? Why? Like why is it crazy that if

the earnings are growing so much as they

are now this the the the stock should go

up and maybe the multiple should go up

as well. Sure. So um so first of all um

let's see. So okay so so first of all

why is it not first of all but your

question is why is it that we at Elm and

20 other market observers investment

banks investment managers think that the

long-term return expected return for the

US stock market is 6% just given that

we're seeing 20% plus earnings growth

recently and into the future

why what are they thinking What are we

all thinking? Why don't we just believe

that we're going to have 20% earnings

growth for a long time and so stocks are

going to deliver 15% returns? What are

we missing in saying that stocks are

only going to have a 6% return in in the

presence of tremendous earnings growth?

Well, the answer is that um when

thinking about earnings, most people

think about cyclically adjusted earnings

because just as I mean, let's say that

um next year we're in a let's just say

that we're sitting at some point in time

like we're we're we're in the end of

2008 and and and last year's operating

earnings for the S&P 500 were like

negative. It's right. It's the end of

2008 and or early 2009 and we're like oh

my god operating earnings etc for these

companies was negative last year and we

expect next year operating earnings are

going to be negative again or they're

going to be close to zero. Why why is

anybody buying equities at all? I mean

clearly equities are worth zero because

next year's operating earnings are going

to be close to zero. Like why would you

buy any equities, right? And and so what

people realized is that you don't want

to base your valuation on equity of e of

the equity market based on last year's

earnings or next year's earnings. You

want to base it on some sort of cyclally

adjusted realistic long-term earnings

path. I mean if we get 25% earnings

growth of of the US stock market for

three or four years then GDP is

basically going to be 50% corporate

earnings where Historically, corporate

earnings have been 8% of GDP or

something or or 6% or whatever, much

much lower. So, the fact that we might

have some strong earnings growth last

year, next year, whatever, um shouldn't

make us think that earnings are on some

moonshot trajectory where the whole

economy is going to be corporate

earnings. That just isn't going to

happen. There's something called

competition

um where competition erodess margins and

u we won't go into like all the

different ways that sometimes in in

earnings in earnings bull phases

earnings tend to get a little

overestimated like we get a lot of a lot

of today's earnings are markups of

crossholdings a fair amount as markups

of crossholdings etc but you know we

won't go into a deep dive on earnings

but in general a pretty simple thing to

do is to say I'm going going to use the

last 10 years of earnings adjusted for

inflation, adjusted for

payouts.

I'll use that as my base case. And

that's what we do. And all of these

other uh 19 investment houses that are

saying, I think the returns are going to

be 6% over the next 10 years. They're

doing things differently than we're

doing it. They're doing things

differently than each other, but they're

all basically trying to think about

where are earnings I mean ultimately

everybody's like where will earnings be

10 years from now and what will the

multiple be on those earnings 10 years

from now and they're coming up with a 6%

return despite some tremendous earnings

momentum that we've had in the past few

years and that we expect to continue for

a while too.

>> Right. But but by forecasting 6% longer

terms, you are making a call that the

trend that has caused earnings to go up

so much which is five companies the

hyperscalers spending so much on

building out data centers and AI which

is flowing to mainly the semiconductor

companies the construction companies as

well that that is going to stop or it is

not sustainable and my my I'm not I'm

not like do you agree that you are kind

of making that bet and then that leads

leads me to say like what what are your

thoughts on this? Like do you think this

continues for 18 months, 18 days, 18

years? Like like I mean 18 years seems

unlikely it's going to grow. I mean I'd

say approximately zero that it grows at

at this rate but like Nvidia's revenues

are still growing at 70 to 80%

year-over-year and it's the biggest

company in the world.

Like just the the earnings momentum is

just so enormous.

It seems to me like the val if you say

they're overvalued like we can we can

catch up to fair value pretty quickly if

the stocks don't move and the earnings

just for 18 months if the stocks if the

earnings grow as fast they are now like

the stocks will be cheap.

>> Yeah.

>> Yeah. I mean look margins are very high.

We're already starting to see

competition

um within within the US within US

company between US companies and with

foreign companies as well. There's

always competition and as I say

historically look go look at look at

earnings in 2009 2010 2011 and you'll

see even stronger earnings growth over

those periods and did that could we

extrapolate that for how long? No, I

mean it it it kind of settled down and

it got into a more normal

pattern of of growth that was mostly

driven by um mostly driven by retained

earnings and share buybacks. And so, um,

I think that, um, look, I mean, we've

had tremendous technological

developments over the last

30 years, right? Go back to 1996. So,

from 1996 to today, I mean, think about

it. We have just massive

technological changes that were

tremendously positive for productivity.

We had the internet. We had fracking

that just created this huge windfall to

all kinds of energy companies. Um

we've had consolidation in the financial

industry where the financial firms have

been massively more profitable and

recently um we've had just tremendous

growth in the earnings of the of the MAG

seven or whatever. All different

business models just and tremendous

margins. Well, go back over that whole

30-year period,

earnings growth has been quite nice, but

it hasn't been

ridiculous. I mean, once you account for

share buybacks and retained earnings,

earnings growth, I don't know. I mean,

I'm just going to throw a number out

there. I think that earnings growth

adjusted for those for those things has

been a couple of percent per year

adjusted for buybacks and um and

retained earnings. So you've had

>> so so buybacks is is company takes its

its cash flow and buys back it its stock

in the market which boosts the earnings

per share because the shares outstanding

goes down. Retained earnings is just the

earnings that the company keeps. I

understand why

>> and they can invest it and that can grow

earnings too. So when you adjust for

those things, you know, and just think

about like core like core earnings

growth from productivity or from great

things happening to companies, it just

hasn't been that great over perhaps the

best period of time that any

that any economy, any country, any set

of companies has ever experienced. You

know, we're just at mega high margins on

a bunch of these businesses and you can

just see the competition. It's coming

from every direction. You know, I mean,

you know, everybody's competing with

Nvidia right now. You know, it's like,

oh, you guys make some really nice

chips. You mean you design some really

nice chips? [laughter]

You know, maybe we'll try to design some

nice chips, too. Um, and and so on, you

know. Um, you know, I mean, some of the

moes are bigger than other moes, but

there's there's, you know, no moat lasts

forever. Victor, why I understand the

argument that when a company buys back

its shares, it is boosting the argument

that it's artificially boosting its

earnings per share, but why is retained

earnings like why shouldn't that count

as earnings? I'm a little confused.

The retained earnings count as earnings,

but when you look at earnings growth,

you have to realize that the retained

earnings are getting invested

are being invested by the company in in

pro in um in output or whatever. And um

and that's growing earnings per share

too. So a company who retain forget

about buybacks for a second just say a

company that retains its earnings is

going to grow faster than the same

company that doesn't retain its earnings

that pays everything out as dividends.

So the retained earnings count as

earnings when they're earned. I'm not

saying that. I'm saying that the

retained earnings are also boosting

earnings growth

in a in a predictable manner. And and we

need to take that out when we're

thinking about like real earnings growth

just just come by businesses getting

better and better. So because if you had

paid me the earnings out as a dividend

instead of retaining them, I would have

invested them in the stock market or

whatever. And and so that that you need

to adjust earnings growth when you're

thinking about like how how great has

earnings growth been per share. you need

to adjust for retained earnings and for

buybacks.

>> That does make sense. Okay. So, yeah,

like in the 1950, you'd have a steel

company. It would pay out a lion share

of its income as dividends. It wouldn't

have that money to invest in its

business, which would cause earnings to

grow, or to buy back its own stock,

which would not cause net income to

grow, but it would cause earnings per

share to grow because the goes down.

Okay,

>> that that makes sense. And we we we

wrote about we wrote about that a while

ago when we started to use what we call

the pcape measure for cape instead of

cape pcape which adjusts for

payouts effectively you know or lack of

payouts sometimes in earnings growth.

>> Okay.

So V yeah Victor I think that the fate

of the S&P 500 over the next two years

it really does depend on is the spending

on AI capex going to continue and what

is the return on that capex and if the

return is bad and the spending goes down

I think earnings are going to be

negative perhaps massively negative at

least if you include like potential um

markdowns and the depreciation that's

kind of baked in. So I feel like Victor,

if I was you and I had a brain that was

as big as you, I would be spending like

80% of my time focusing on that question

rather than

finance questions that do matter but are

an indirect kind of output rather than

an indirect input, a direct input into

this. So like what what is your thoughts

on this? And if your thought is, oh, I'm

not spending that much time thinking

about it. I'm thinking about these other

things. Why are you thinking about these

other things?

>> Well, great question. Well, first of

all,

we at Elm, me, my partner, and me and my

partners, like we don't really think

that our brains are too big and that we

can really figure this stuff out. So, we

kind of feel like we're leaving it to

many many experts in the market to think

about what's happening with earnings, to

price these different companies relative

to each other correctly. And um and

actually and and um two other points,

but at Elm, we're like, okay, what we

want to do is is give you a really

lowcost

investment strategy that we make think

makes sense. And again, we were had a

team of people trying to figure out what

was going to happen with S&P 500

earnings better than everybody else. Um

we'd have to spend a lot of money on

that and charge our clients high fees

instead of the 12 basis points we charge

them. The third thing and maybe the most

important thing perhaps is that um let's

go back to who killed the random walk um

that we started with and I would say

that I guess our belief is that S&P 500

earnings kind of don't the next the next

two years

stock market performance is mostly going

to be determined by the behavior of

extrapolators interacting with corporate

equity activity. So if our belief is

that if we see a lot of issuance which

it seems like we might be seeing IPO

issuance, secondary issuance,

sales from insiders

of stock ownership like in SpaceX, a lot

of people are going to be selling SpaceX

and they're not going to invest all the

money in the stock market because they

have to keep some of it to pay capital

gains taxes. And so and and finally a

reduction in buybacks of the big buyback

companies. You put those things together

and if that's going to put one to two

trill if that's going to make a delta of

1 to two trillion dollars, we think

that's going to weigh on the market and

if the market gets weighed upon

eventually the extrapolators are going

to be like oh the the gig's up, the

party's over and and and we'll see

markets go down. So that's like a

scenario and and what S&P 500 earnings

are is like totally immaterial to that

that at the end of the day I think that

with the overall the overall market

level

is not being determined that much by

fundamental investors anymore because as

I said at the beginning the predominance

of asset allocators the predominance of

people that are deciding how much to

have in stocks how much to have in bonds

are either static investors tors passive

asset allocators or they're

extrapolators and the and the asset

allocators that are thinking about the

expected return are are like in a pretty

small minority these days. Yes, there's

Berkshire Hathaway. Yes, there's other

investors. Yes, there's GMO, but there's

not a lot. And a lot of the and and most

of those fundamental asset allocators

are like mostly out of the market

because they're seeing 6% returns

compared to a 5% long bond and they're

like h I don't need to own much equities

right now or I need to own as little I

need to own as little as I can get away

with. So they've already done their

thing. And so I kind of feel that um

that's where we've spent our time is

trying to understand the dynamics rather

than it just doesn't feel like earnings

that the next year of earnings is that

material. I mean it certainly gives this

it certainly gives this story to what's

going on, right? So, it's like, oh, the

stock market's up because earnings have

been so good. But it's kind of like

maybe the stock market's up because the

extrapolators are running the show, plus

companies are buying back their stock.

Maybe that's the whole story and um

and and the rest of the stuff. It's a

little bit but reminds me have you have

you um sorry you might well have you

read this um short essay by um Richard

Sutton called um the um

oh what's it called the um

what oh I'll come I'll come back to that

in a second I'm drawing a blank it's

like called the the

oh the bitter lesson the the essay

called the bitter lesson where he's like

It's it's it's a really fun short

article by one of the fathers of AI and

machine learning and he says it's kind

of sad that all of us machine learning

guys like we were trying to build these

smart AI models by trying to imbue them

with human thinking and it turned out

that all that we needed to do was just

throw a ton of computation. We needed a

few good insights but just the more

computation we threw at the problem the

better the AIS did and we didn't need to

model the way that humans think. And

like that's what he called the bitter

lesson. And it might be that like the

bitter lesson in finance is that um you

don't need to think that much about

earnings and stuff like that and

fundamentals because the market isn't

driven by fundamentals. It's just driven

by these static asset allocators, these

extrapolators and corporate supply and

demand and other shocks and other supply

demand shocks to the system.

>> I don't know.

>> Aha, Victor. Okay. Finally, we have our

intellectual cage match. I I So you

think earnings don't matter? Like I

disagree. I think you look at the stocks

that are up the most. They're the stocks

whose earnings have crushed the most and

whose forward expectations of earnings

have have risen the most. Those are all

in the semiconductor space. To me, that

seems like

um a little bit rational and it it makes

sense. Like why am I wrong?

>> You're you're not wrong, but we're

talking about two different things. I'm

talking about the stock market in

aggregate and I'm also exaggerating. I

mean I'm not saying that earnings don't

matter. Earnings matter a lot to us as

investors. Like I really care about

earnings. Our asset allocation depends

on earnings. So I care about them a lot.

I'm saying the market dynamics of the

market in aggregate but I don't think is

as affected by earnings. I don't think

the earnings is like the central thing.

I would stand by that. Not that it

doesn't matter. I agree with you that in

the cross-section

in the cross-section earnings matter a

ton the earnings of Nvidia and earnings

growth like like again we agree I agree

with you um that that more or less the

cross-section of stock valuations is

like reasonable and um

and earnings matter a lot and and and

the cross-section of stock prices is

like being driven by fundamental

investor investor tors stock pickers who

really dig into stocks a lot and and

they come up with reasonably good prices

except every once in a while for five or

10 or 15 different stocks where some

people are going bananas and then the

fundamental investors like kind of get

out of the way and say what will be will

be and they certainly don't go short

them but overall in the cross-section I

would agree with you that earnings

matter a lot and they seem to be

reflected earnings and earnings growth

expectations seem to be reflected in

individual companies fairly well.

>> So earnings and earnings expectations

matter a lot to individual companies and

perhaps sectors, but to the overall

broad market, you think they don't

matter maybe as much as they used to or

as much as people think. So if

>> yes,

>> perfect. That's that's what I think. So

to the S&P 500, the stock market, the

Vanguard total world market, the Msei

world, if earnings is not a a primordial

primary driver, what what are the top

drivers?

extrapolators, static asset allocators

and supply demand changes, changes to

shares outstanding, basically issuance,

IPOs, secondaries, stock buybacks,

um and and there are other shocks on the

demand side, right? like how much money

are are white collar invest how much

money are relatively affluent people

saving in their 401ks and then gets

rooted into the stock market. So it's

not all the corporate activities but

there's also flows there are also these

savings changes in savings flows year on

year that are also important. So if we

see we've seen a lot of net

contributions net contributions to 401k

and IAS in the US and that money's gone

into the stock market it looks the same

as stock buybacks in terms of impact um

and that changes or slows down or

whatever then that's another net change

to this number amount of equities and it

has a lot of price impact. We think that

that markets are not that elastic with

respect to changes in supply and demand

of of equities.

>> Do you think that those flows can be

forecasted and therefore you can

forecast proper asset values based on

those flows? Because to to me it seems

very hard being like, "Oh, in Japan they

have a bunch of old people, so they're

going to buy less stocks." Whereas in

the US we have a stock like it seems

very hard to like have that be something

that could generate a kind of a sharp

ratio. But I want I wonder if you can

>> I think it's I think it's hard. I think

in general the best estimate is kind of

what happened last year and then every

once in a while you might see something

that seems to be changing. So, I think

with respect to individuals, I think

it's it's hard. It's hard. I think with

respect to corporations, it seems a bit

easier because we hear about their plans

and they're like, "Hey, we're going to

we have a stock buyback program that

we're going to buy back hundred billion

dollars of our stock next year and they

tell you that

>> and then they start doing it." Um, or

they say, "We're not going to buy back a

hundred." So I think that different

components are

are h have relative difficulties of

predicting. I think the the um this um

investor side the demand side I think is

in general much harder than the

corporate side. Um

>> and [clears throat] does corporate

buybacks let's say there's like three

stocks in the S&P that are doing a ton

of buybacks and 497 of them are not

doing any buybacks at all. Do do the

buybacks boost only the three stocks

that are doing the buybacks or does it

boost the market in general?

Good question. Um so

um let's see. So the you know I think

the the first order thing is it's sort

of boosting the market in general. Um

the

the um the index funds you know the

index funds are going to be kind of

passive with respect to this flow. So a

company comes to buy back its shares and

now the number of shares that that

company's going to have outstanding go

down and the index fund is going to say

okay I am uh uh I'll sell you those

shares. I mean they might not you know

meet at the exact same moment in time

but let's say they do. They're like oh

sh I'll sell you those shares because I

need to have less shares of you in my

index. And then they turn around and

what do they do with that cash? They

have to buy all the other companies. So

um you know so it could so if everybody

were an index fund you know I would say

that the buybacks actually could have

the impact of raising counterintuitively

of raising all the prices of all the

other companies

and leaving the price of the company

buying back its shares unchanged. Um

maybe I've got that wrong because it

does seem pretty counterintuitive but I

think that might be how it goes. I think

that might be how it goes. But the

overall effect, right, is that it's

lifting the the whole market. You know,

it's lifting the whole market. But I

think the mechanism could well be I'm

sorry. It again, it depends because then

So that's so sorry. So that's the index

fund. So if everybody were an index

fund, I would say, oh, it's raising all

the other stock prices, which is weird,

but I think it's correct.

Or maybe it's not, but I think it's

correct. But then, uh, let's put the

index funds aside, and now we have

everybody else, you know, just regular

people. And now whoever owns this

company that's buying back its stock

like likes this company. They they chose

it. They're a stock picker. They bought

that company. Company's buying back its

stock and they're like, "I don't want to

sell you my stock. I have a capital

gain. I don't want to pay capital gains

tax or I just love this stock. I don't

want to sell it." And and that pushes

that stock price up.

And eventually they're like, "Okay,

fine. I'll sell it to you know and so

the buyback is pushing up the stock of

the company that's buying back its stock

with respect to you know uh uh you know

people who are not index funds people

who are like care about the valuations

and so on. Uh and then when uh but then

when they do get that money you know

when they do eventually sell that stock

they buy some other stocks and you know

that pushes the other stocks up but the

big impact but it but that doesn't have

much impact on all the rest of the

stocks there there needed to be quite a

lot of impact on that stock to get that

marginal person to say okay fine I'll

sell it I'll sell it back to you Mr.

company and I'll um

and uh I'll pay my capital gains tax or

I'll find something else to invest in.

Fine. you know you've pushed the price

up far enough where I accept that and uh

of course there's a lot of you know

closet indexing which is more like the

index funds you know where they they do

that so net net I think uh the whole

market is pushed up and depending on

who's do you know who's depending on how

big the buyback is

sorry depending on the relative weights

of kind of indexers and closet indexers

versus fundamental guys you know it's

going to you know is going to ch um is

going to deter determine what that shock

is, you know, but I would say the

company that's buying back its shares,

that stock price goes up, everybody else

goes up, the whole market goes up.

[laughter]

>> That that makes sense. Victor, remind us

what extrapolators do and why are they,

as you say, the critical ingredient in

your model.

>> Yeah. So, so within our model, we have

different investor types that come up

with their expected returns for stocks

in different ways

and and then when they have their

expected returns, that drives how much

they want to own of stocks. So,

extrapolators are are people who

estimate the future return of the stock

market based on its past return. They're

extrapolating the past return into the

future. We model them as doing that in a

dampened way. We don't say whatever the

return was last year over the last five

years is their expectation for the

future. But when it's high, we make that

expectation higher. When it's low in the

past, we make it lower. We use it. We

dampen it a little bit or a lot. And and

that's what they do. And that's how they

set their asset allocation. So they they

kind of create a bit of reinforcement

for bull markets and a reinforcement for

bare markets. So Victor, I am someone I

look at the extraordinary earnings

growth in the semiconductor space, the

extraordinary stock performance. I do

think it's going to continue. So yeah, I

just I I will go on the record, you

know, at in in late July, July 21st,

like I'm I remain bullish of

semiconductors. I think they're going to

do. So basically, I'm an extrapolator

and extrapolators can be right and they

can be wrong. Why on average have you

found that extrapolators tend to have

submarket performance? And how does

extrapolators differ from momentum

people? Because it sounds like moment

momentum is such a positive way of

putting my view of semiconductors are

positive momentum whereas extrapolators

is such a you know more a less positive

view to put it. And what's the

difference between extrapolators and and

momentum people? And if you were to to

determine Jack, you're an extrapolator

or Jack, you're a momentum person, what

questions would you have to ask?

>> Sure. I think this question of what's

that that an extrapolator or return

chaser, gosh, it just sounds like the

same thing as a momentum investor. What

the heck? How could it be that return

chasing or being an extrapolator is bad,

but being a momentum investor is good?

They sound like exactly the same thing,

don't they? I mean, what the heck? And

we think this is a fantastic question

and puzzle, something that we've thought

about and written about for more than 10

years. And um first of all, I would just

say, look, we have a hypothesis. We

don't have an answer. It's something

we've thought about and written about a

lot, but I just want to start off by

saying I'm not really sure. Our working

hypothesis is that the difference

between the the what does a momentum

strategy look like? A momentum strategy

is that when momentum is positive, when

today's price is higher than last year's

price or the moving average price, when

momentum is positive, I I overweight my

position by X. And when it's negative, I

underwe my position by X or by Y or

whatever.

>> And that can apply to prices. It also

can apply to fundamentals like earnings.

Go ahead. Sorry.

>> Well, you're not trading earnings. So

you you could say that but but that's

not that's not a price that you know

like um

applying it to earnings is fine but you

have to look for what's the action

you're taking in the marketplace if you

want to test it as an investment

strategy

>> data points four times a year instead of

250 times a year how many trading days

there are

>> sure but you know I'm saying you could

uh

>> yeah I mean you could follow a strategy

that's based on earnings momentum uh and

and that Um, that's something we haven't

looked at. And again, you know, okay,

sorry, let's just forget I said that.

Sorry, I don't want to derail you. Go

ahead. Go ahead.

>> And and also there's like the again that

sometimes you're talking about the

cross-section. You're talking about

individual stocks. We're talking about

the market. But anyway,

>> um, so let's go back. So momentum means

that when moment the momentum strategy

is implemented by going overweight or

underweight, a fixed amount of of

exposure

when when momentum is positive or

negative. um respectively. And so you

could really think of it as this binary

operation, this binary trading strategy.

So I'm sitting there, I come, I look at

some asset, momentum goes positive. I

normally am 50% exposed to the stock

market. I'm a momentum investor,

momentum's positive, I go to 75%. As

soon as momentum's negative, I go to 25%

exposure, and I stay there until

momentum goes positive, and then I go

back to 75. And that's a momentum

strategy. Um that's well defined. That's

everybody agrees what is a momentum

trading strategy. There's literature,

there's everything like everybody knows

what a momentum strategy is. There's

nothing nobody has,

nobody has defined

there. Sorry, there's not agreement on

what is a return chasing strategy.

There's not really any agreement on

that. There's not a consensus.

Partly there's not a consensus because

when people are testing for strategies,

they they test strategies that have done

well historically and momentum's done

well. So there's a whole literature on

what is it that we're testing. It's this

momentum strategy and that's what it

looks like.

Return chasing you're it's kind of up to

each researcher a little bit to define

what it is that we mean by return

chasing. So when I say return chasing,

we have defined it um very specifically.

We've defined it within our multi- aent

model, who killed the random walk. We've

defined what the returns tracing

strategy is. And that return chasing

strategy is when returns have been good

historically, the the better that

returns have been historically, the more

we expect returns to be good in the

future and the more equities we want to

have. So you can see that the big

difference between return chasing and

momentum is that return chasing is not a

binary strategy as so imagine stocks are

going along a little bit and they're

doing well. So now all of a sudden

momentum has gone positive. So I say

okay I'm going to be 75% in equities

because momentum is positive. That's the

momentum strategy. The return tracing

strategy is like, oh, stocks have been

doing well the last year or so,

whatever. I'm more bullish on the

future. I'm going to go from 50 maybe to

55% in equities. Then if the market goes

up some more and the returns

historically have been even better, I'm

going to say, "Oh, they've been even

better. My future expectation is even

better. I'm going to go to 60% in

equities." And eventually when returns

for the last year have been 20%, I'm

going to say, "Oh, that's that's like

wonderful. I'm going to be at 75% in

equities. So, it's kind of this the way

that we're defining it is this slowm

moving

the slowmoving pattern

of the extrapolator getting more and

more invested in the market. Then the

market starts going down or whatever and

they're kind of slow coming out. So, the

way that we've modeled it is that that's

what we've that's how we've defined what

a return chaser is or an extrapolator

is. Now, other people have thrown out

other ideas for it. So, um I think Cliff

Asnice at AQR has said a return chaser

is somebody who's doing a momentum

strategy but with a five-year look back.

Okay, that's that's also testable, etc.

We've kind of looked at that within our

model. We've looked at it with

historical data. It's not as good. It

doesn't it's not as good an explanation

in our opinion as what I just described,

but that would be another way of

defining a return chaser.

That's what I was thinking while you

were talking of a momentum person tracks

what happened last day, last week, last

month. A return chaser is someone who

looks at the last year, the last three

years, the last five years. And it

sounds like that's kind of what you're

saying, but you're also saying that

>> Yeah. Not really. Yeah. We don't think

it's Yeah, we don't think it's as much a

horizon thing as it's this binary thing.

So, it's the

>> So, so momentum is binary and Go ahead.

Sorry.

>> Yeah. and return chasing is this more

continuous thing like we think that's

more at the heart of it but there's a

lot of debate and I don't want to say

that we're right and anybody else is

wrong that's how we look at it and then

so you said how can I tell if you're a

return chaser what questions would I

have to ask you and I guess what I would

say given what I just described is I

would say to you

do you kind of take your dynamic asset

allocation as like a binary chunk like

when you get bullish you go from 50 to

75 five and stay there or are you a

little bit more slowm moving? You're

like, "Ah, this feels good. I'm going to

get a little overweight. Oh, markets

have been even better. I'm going to get

more overweight. Oh, markets have even

been better. I'm going to get more

overweight." And vice versa, if you're

on this more continuous move as a

function of past returns, we would say

you're a return chaser. If you're more

of a binary chunky, like if you're this

chunky thing, do this chunky thing, then

we would say you're a momentum investor.

And what we find is that that once the

that that historically and in our model

that the way we've modeled return

chasing and the way we've modeled

momentum, momentum does really well.

Return chasing does poorly.

That's a good question. I would say that

I don't weight

like stock prices that high. I say I

look more at earnings, forward earnings,

and if I think earnings are the forward

earnings are too high or too low. Like

to me, at least the earnings that I have

on my fiscal AI terminal. I don't have a

Bloomberg terminal, but at least what's

available to me, like the earnings

estimates and the revenue estimates for

Lamb Research are just too low. Yeah.

>> And and if Lamb Research only earns how

much the analysts expect, even the high

high estimates, then memory prices are

going to be as high as they are now.

they're not going to come down which

means that Micron is trading at eight

times earnings that it's not going to

change. So so to that that's just a

little bit more but I'm I'm I'm more

curious about you know

>> you you are a you are really a

fundamental investor. That's what you

are. You're a fun you're a value

investor. You're a fundamental investor.

You're thinking about cash flows. You're

trying to estimate cash flows. You have

a model for how earnings work. You're a

cash flow fundamental investor. I'm

talking about the market and aggregate.

And when I talk about momentum and

return chasers, they don't care about

anything except for price. They don't

they don't even know what earning they

don't even know what any of they don't

even know what any company

>> they don't know how to spell earnings.

Yeah. Yeah.

>> They don't know how to spell earnings.

They don't know how to spell

fundamental. They're just looking at

last year's price. And it turns out

that's pretty good if you're a momentum

investor. And it's pretty bad if you if

the way that you incorporate returns is

as a return chaser. It's pretty bad. And

by the way, I just want to say that we

haven't really talked about this, but

within our framework, we also

substantiate what Cliff Asesses and

others have said, which is perhaps the

best investment approach is this

combination of value and momentum, where

you're looking at long-term return,

long-term um cash flows. You're a value

investor. you're a long-term expected

return investor and you're also

incorporating momentum either as a risk

signal or whatever, but you're putting

when you put momentum and value

together. I think as as others have said

that's the most robust approach to

investing in any market and and that's

kind of what we've modeled our approach

at Elm on is this val this combination

of value and momentum trying to get like

the best of passive and active put

together. Um and we were really

influenced by this very seinal paper by

Cliff and and his co-authors

co-ressearchers called value and

momentum everywhere. I think for me that

was probably the biggest thing that

changed my mind about markets that I

read in in that I've ever read as a

single thing and it was fantastic great

great paper. So in addition to your

paper, who killed the random walk, we'll

also attach that that Cliff A's paper.

Victor, why is it that having a static

having a binary zero or one if momentum

is of of a certain quality and and

vigor, you you increase your allocation.

If you don't, you you don't. Why is it

that that works so much better than

having a modeled gradient thing? To me,

it's not obvious that that would work at

all, but you you're clearly you've done

the work, and it it is true. Why? Why is

that the case?

>> This is so much fun, this conversation.

You know, you're like just asking these

these great questions um which, you

know, I think are really like uh

kind of hard questions, you know,

without being able to go back and sort

of have a little bit of a model in mind

of things. So, um uh so, you know, why

is it that one does well and one does

poorly? Well, um, as I said really early

on, um, you know, I think that it just

depends on the relative capital of the

two investor groups. So, if, uh, there's

a lot of capital that is doing this

return chasing, then their activity is

going to impact prices. And if the

momentum guys are like kind of price

takers and not impacting prices at all,

you could really just think of these

momentum investors as as frontr running.

I mean, not in the legal sense, but

getting ahead of the the uh expected

behavior of the return chasers. So in a

world in which these extrapolators are

impacting prices because of their

activity that we've described as such,

it's going to be a world in which

momentum investing does well because the

uh return chasers are impacting prices

in a certain way. There's still a lot of

risk. I mean it's not like the momentum

guys are getting a sharp ratio of two or

anything like that. They're just getting

a little bit better sharp ratio. But

it's nice. It's really really nice. and

um because there's still a lot of

uncertainty and a lot of shocks in the

system. But you know that's what's

happening is that you could think of it

as the return chasers are kind of

impacting prices and the momentum guys