Pod Insights Invest Like the Best with Patrick O'Shaughnessy Chad Cascarilla – Update on Tail Risk - [Invest Like the Best, EP.165] About this episode My guest today is Chad Cascarilla, here to discuss some of the tail risks in the economy and markets as of March 24th in the midst of the Coronavirus pandemic. Chad was one of the most successful investors during the global financial crisis with a specialty in the banking and finance systems. He now runs Paxos, a trust company which trades and custodies unique products like pax gold, bitcoin, and other tokenized assets including simple pax dollars. I feel it is important to avoid confirmation bias in times like this and not just talk to people are optimistic or long, and while I still believe this is ultimately a positive and optimistic conversation, Chad acknowledges and outlines scenarios that few are talking about yet in the markets.
This episode is brought to by Koyfin.
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Show Notes
(2:04) – (First question) – Today’s market and the porridge scenario
(7:38) – Risks to the market that people aren’t focused on
(10:54) – What lessons from 2008 do we need to heed this time
(13:07) – How does he think about inflation on the other side of this crisis
(16:02) – What does a too cold recovery look like
(20:35) – Benefits of nationalizing the banks vs pumping liquidity
(24:13) – What does the just right recovery look like
(25:24) – Assets that might be ideal to hold in a too hot or too cold scenario
(29:00) – His take on how Bitcoin has performed during this crisis
(31:53) – The US’s inherent strengths compared to the rest of the global economy
(34:50) – Advice for people
(38:59) – Paxos.com
(39:48) – What is he monitoring to see which way things shake out
Learn More
For more episodes go to InvestorFieldGuide.com/podcast.
Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub
Follow Patrick on Twitter at @patrick_oshag
Transcript Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.
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1:28 Patrick O'Shaughnessy? That's P-A-X-O-S dot com forward slash Patrick. This episode is brought to you by Koyfin. I've become very interested in the best software tools in investing, and when I asked Twitter for the best Bloomberg alternative, the overwhelming winner was an excellent new product called Koyfin. It's a web-based platform that lets you analyze stocks, ETFs, mutual funds, and other asset classes in one place. I've been using it every day to track what's going on in the market, and I think if you try it, you will too. Koyfin has a ton of high-quality data, powerful functionality and a clean interface. The best part is that it's free. You can sign up at www.koyfin.com. That's K-O-Y-F-I-N dot com.
2:08 Patrick O'Shaughnessy? Hello and welcome, everyone. I'm Patrick O'Neal and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, methods, stories, and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfieldguide.com.
2:28 Speaker 01 Patrick O'Neal is the CEO of O'Neal Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Neal Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Neal Asset Management may maintain positions in the securities discussed in this podcast.
2:53 Patrick O'Shaughnessy? My guest today is Chad Cascarilla, here to discuss some of the tail risks in the economy and markets as of March 24th, in the midst of the coronavirus pandemic. Chad was one of the most successful investors during the global financial crisis with a specialty in the banking and finance systems. He now runs Paxos, a trust company which trades and custodies unique products like Pax Gold, Bitcoin, and other tokenized assets, including simple Pax Dollars. I feel it's important to avoid confirmation bias in times like this and not just talk to people who are optimistic or long. And while I still believe this is ultimately a positive and optimistic conversation, Chad acknowledges and outlines scenarios that few are talking about yet in markets. Please enjoy.
3:35 Patrick O'Shaughnessy? Chad, it's not that long since our last conversation, but the world has changed quite a bit. I thought it would be fun, given your deep expertise in the banking system, a deep history in sort of the big short trade in the last financial crisis, and a facility with looking through sensitive parts of the system in markets like this, that you'd be a great guest to have on to discuss where we sit today and where we go from here. So to level set with the audience, the S&P 500 is down about 35%, which is a no joke, and it's the fastest decline of that magnitude that we've ever seen. I'd love to begin with this porridge analogy that you mentioned right before we started recording and use that as a jump off point to discuss what the scenarios we may see from here, how you handicap those, and what you would recommend investors and maybe even business people do in those three scenarios.
4:21 Speaker 02 I think what's helpful is to come up with a couple of different ways in which the world could evolve. And then you could start putting probabilities on them and thinking about maybe what's the right strategy in those different scenarios. I kind of was describing it as it could be too hot, too cold, or just right. And that's really referring to the response from both the fiscal side and from the monetary side to try and address the crisis that we're having because of the coronavirus. And I think what's also helpful to do is to maybe step back and understand where we started from, which was, I'd say, a price for perfection moment. So the economy is running at 3.3x leverage, which is the most leverage we've ever had in the economy in history.
5:04 Speaker 02 And that's not just true of the US, but that's also true globally, the most leverage. It's a little bit less than we had in the US, but all the major economies are at least the same as the US. And at the same time, asset prices, as judged by the S&P, but probably across the board, from fine art to wine to cars to anything, were really priced for perfection, meaning almost the highest P/E's we've ever seen in the stock market, depending on different ways of calculating the P/E cyclically adjusted or just current P/E's. And I think maybe one of the most shocking things whenever I tell people is that pre-tax corporate profits in the US haven't grown in seven years. But if you look, the S&P had nearly doubled in the last seven years, or the markets broadly had almost doubled.
5:47 Speaker 02 And so you're really priced for perfection with high amounts of leverage, which means you just didn't have a lot of resiliency to deal with a 100-year storm, which is what we're dealing with now. And that's why you're having unprecedented fiscal and monetary responses. Now, at the same time, this is definitely not the end of the world. I think we've been through much harder times. I was going back and looking at other historical analogies, and there aren't really great analogies where you're priced for perfection and then you end up in this 100-year storm. But we've gone through a lot of storms that I think are worse, like the Civil War, 650,000 people died out of a 30 million population. I mean, that's unbelievable in the US, right? And you know what? After everything ended, the US went on and, you know, really became a great power.
6:29 Speaker 02 A lot of people died in the world wars. There was a great depression. You had stagflation in the seventies. These are cyclical things that happen. And in some ways, they can be good because they can clear the decks and actually create the foundation for some really exciting future times. So I do want to state, I don't think like this is the end of the world by any means, but it doesn't mean that it's necessarily going to be an easy scenarios that we go through. And there could be a lot of tail risks that happen that seem inconceivable because things have been really so good for so long here. A lot of people haven't even really lived through a recession before, which is hard to believe. Two thousand and eight, March of two thousand nine was the end. At least as adults, they haven't lived through it. So anyways, with that as like kind of a backdrop, I kind of think there's this too
7:10 Speaker 02 hot, too cold, and just right. And what we're talking about is how big of a hole is there? And is the response able to fill that hole? If you said, okay, what kind of hole could it be? So Bridgewater, Ray Dalio said $4 trillion, seen other estimates of five or more trillion dollars in the US. That means globally like a $25 trillion hole because the US is about 20% of the world. It might be worse outside the US. So there are pretty big holes to be filled. So far, the responses have been really aggressive. Fiscal stimulus of five to 10% of GDP, and then a lot of monetary stimulus. So we're throwing a lot at this, and it might
7:53 Speaker 02 be enough. It might be too much, might be too little. And so I think that what the hole looks like is a bit unknowable. There have been GDP estimates now from Goldman of minus 25, Morgan Stanley at minus 30 for the second quarter, and even James Bullard from the Fed saying minus 50, with unemployment hitting 20 or 30%. So really unprecedented. Now, that's because there's a second component of how big is the hole, how long does it last for? And then lastly, how fast can you fill it? And so you also need to be able to react quickly to fill it because otherwise you get feedback loops. And so when I mean by fast to react, in 2008, it took 60 days. Nearly two months for the IRS to send out checks to people.
8:37 Speaker 02 It took the ECB during the crisis 90 days to implement a corporate bond buying program. We don't really have those types of time periods. And so if it takes that much time, it doesn't matter if you're doing enough or you're even doing more than enough if it hits past the point when it's actually needed, which is right now. And so that's why there's just so many different possibilities here. It's really hard. This is a very complex equation then. And so I think that there is definitely a possibility that we could end up doing too much, but it's also not at the right period of time.
9:10 Patrick O'Shaughnessy? I'd love to talk through some of the deeper details about areas of the market that represent real risk, systemic risk that maybe people are not attuned to yet. We were talking about mortgage servicers before we hit record as one example, but any examples like that of kind of picking through the financial system where there are areas that this liquidity and cash flow shock you think represents a real acute risk.
9:36 Speaker 02 That's why I think it's so important that what needs to happen is the stimulus and the monetary response needs to happen now because, for example, most of the policy responses look like they're not going to cover mortgage servicers that are non-banks. Most people don't even know what a mortgage servicer is, but it's basically someone who makes sure that like they collect the payments and they make sure your mortgage payments are going to the bondholders. So they're kind of running the mortgages and the mortgage bonds. A lot of those are non-banks. They're not covered in any of this. And that's about 50 billion a month of liquidity they would need in order to defer people's mortgage payments. If they do defer mortgage payments and someone doesn't lend them money, then they can't make the bond payments on the mortgages.
10:17 Speaker 02 So you could have a real systemic problem in a month or two or three if you don't get that right. And so there's a lot of nuance in terms of how do you broadly get liquidity out there? And then how do you make sure that you're getting into the right places? And so certain intricate parts of the plumbing are not easy to get to because the Fed is really meant to help banks. The fiscal stimulus is really being meant to kind of bail out large industries, a little bit for small business, but also to send money directly to people. And so if those things don't get there in the right amount of time, or you don't have it in the right places, that could create its own type of tail risk where in essence, you filled the hole large enough, but not enough time.
11:01 Speaker 02 There's another problem, which is, hey, the hole ends up being a lot worse than we ever thought. That's still kind of unknowable because we don't know how long it's going to go for, and we don't know how deep this is going to be right now because it's completely unprecedented, what we're going through from modern times. They're historical analogies, but it's unprecedented for today. I don't think this is 2008, by the way. So 2008, it was a rolling crisis that was much less acute, and it was much less damaging. And you could see it kind of happening. As the prices were getting marked down, houses had been driven to real all-time highs, and you had a lot of leverage to people who didn't have the capacity to pay. And so that was kind of a conventional financial crisis. Whereas this looks much more like a war or like the 1918 pandemic.
11:46 Speaker 02 And the good news is that could end very fast. But if it doesn't end very fast, then it can seep into places that is really unexpected. Like another place where there was a lot of overlending in this credit cycle was in leveraged loans. The amount of leverage to corporate borrowers is the highest it's ever been. The leveraged loan market was done with what is so-called COV light or really light documentation, and they don't really have covenants on there. And so there is a huge problem potentially in what a corporate loan book could look like if you go through this type of kind of recession or even a potentially a depression. I mean, that's kind of what minus 20 or 30% GDP is. So there's these pockets. That you can't quite quantify.
12:26 Patrick O'Shaughnessy? I'm curious, before we leave 08, what lessons, you're one of the people that navigated that most intricately, profitably in your case, but also just deep analysis of the underlying businesses involved, what lessons do you think are portable from that period of time that we should heed either as policymakers today or as investors?
12:46 Speaker 02 I think the good news is the policymakers are heeding the lessons from 2008. And some of those were provide a lot of liquidity, whether that's a good thing or a bad thing, what they're doing is they're providing an unbelievable amount of liquidity now. So before we did QE, now we're doing unlimited QE. They rolled out all of these special lending facilities, basically in a matter of weeks, whereas it took months and months to be rolled out initially. So we took those playbooks of things that we learned, which is how can the Fed lend against good collateral in very large size as much as possible? Where I don't think the policymakers might, and by the way, I have to caveat this because the stimulus bill hasn't passed yet, so maybe they'll get it right.
13:30 Speaker 02 But it doesn't look like they're getting it right, is around how to help the non-bank participants in the markets. And some of them are providing bank-like services, but they're not yet going to be given the ability to access the Fed. Really, the way the Fed is set up is for large institutions and large banks, and it's not for mom and pop businesses, and it's not for smaller, non-bank financial participants. And I think that's really more where this problem arises. It's not arising from the financial system, it's actually arising from the real economy, because everyone has stopped working. All these businesses, like all the restaurants, all of the commercial real estate, it's actually
14:13 Speaker 02 hitting Main Street much harder than it's hitting Wall Street. And that's different from 2008. And so I think That that creates a whole new set of challenges for policymakers in ways they haven't thought because you can't just go apply 2008. It's great that they have because it's helpful. But you're kind of pushing things into into Wall Street as if that's the source of the problem. It's not. The actual source of the problem is Main Street.
14:38 Patrick O'Shaughnessy? There's another aspect of 08 that I remember so well around QE and sort of quote unquote money printing and the expectation from a lot of investors, maybe even economists, that all of this money printing would result in extremely high inflation, maybe even something like hyperinflation. And that just didn't come to pass. And I'm not an economist. I can't describe why exactly that happened. But I do remember that strong expectation where reality did not line up. How do you think about that now? So if we're going to throw an enormous amount of stimulus and print an enormous amount of dollars to try to solve this problem, with the experience from 08 in mind, how do you think about something like inflation on the other side of this crisis?
15:20 Speaker 02 I mean, this gets to some of these tail risks that no one can fully understand, which is, I think, part of the reason there wasn't inflation, there wasn't inflation in what's conventionally tracked in the CPI, goods and services. There was a lot of inflation in asset prices. And the reason was Fed was printing dollars and they were buying assets with them, buying bonds, that's feeding into stock prices, and that's feeding into like risk assets. And so you get inflation where the money goes. And so you saw it in certain areas, but not others. And that was also partly because of what we talked about last time, which is that by keeping interest rates really low, it actually incentivized a lot
16:00 Speaker 02 of investments. And you needed a lot of demand in order to fill the supply. So there was, it was actually somewhat deflationary for goods and services, but inflationary for assets in terms of how the money was printed and distributed in 2008. And so that brings us forward to today. Depending on how exactly the stimulus gets set up, if you do what is so-called helicopter money, which is you just start mailing checks to people. And if you started mailing a lot of checks to people and you came out of this faster than anyone expected, I think that would be inflationary. I think you get to that moment in time when it is inflationary and becomes hard to control. But we don't know because this is so hard to extrapolate because there isn't a lot of examples of this.
16:43 Speaker 02 All the historical examples didn't involve fiat money. So if you go back and people want to, everyone talks about the Spanish flu, or you talk about civil war, or Great Depression, whatever it was, there wasn't actual fiat money. So we haven't really had this capacity to print such unlimited amount of money and be in this situation. I think inevitably it would lead to inflation. We just don't know exactly when that tipping moment will happen. If you do helicopter money, that probably gets you really close. And so that's one tail risk, which is essentially the too hot, which would be sending a lot of money to people, printing money, and it's not, ends up not being that bad. And wow, the amount of stimulus just creates a red hot economy. And that could be destabilizing in its own way because you might have to come around
17:27 Speaker 02 to start raising interest rates unexpectedly or live with a lot higher inflation. Hard to exactly understand. It's definitely a possibility.
17:34 Patrick O'Shaughnessy? What would be the tail risk in, I want to come back to the hot tail risk and what kind of portfolio positioning you think would be appropriate in that scenario. But before we do that, what do you think the too cold scenario entails? Is it, is it simply the opposite, not enough stimulus?
17:49 Speaker 02 It's a couple of things. I think the too cold can actually cascade in a number of ways. The first thing is you have this hole and we don't fill it really. So we didn't get enough stimulus in, or we didn't get it enough time, and it begins to create a feedback loop. And that feedback loop is actually profoundly deflationary because people are defaulting, they're not spending money. You're in this depression of minus 20% or 30% or more in the second quarter. And it actually carries over into the third quarter and maybe potentially a little bit into the fourth. And so minus 6% first quarter, minus 30 or 40% in the second quarter, minus, I don't know, 15, minus 10, you know, that's a depression. And you can't fill that hole fast enough and you get a lot of defaults.
18:33 Speaker 02 And at the end of the day, the banking sector is holding a lot of these Main Street loans. Commercial loans, commercial real estate loans, what's called commercial industrial loans, working capital loans, and even like a bunch of consumer loans too. And so there's only $2 trillion of capital in the banking system. I say only, that's a lot of money. But surprising how it doesn't feel like a lot of money when you start talking about holes that are four, five, six trillion dollars. And it doesn't get there fast enough and it really creates a cascading effect, especially for smaller banks and midsize banks, not the big ones that are really going to be helped by the Fed here. So it's definitely possible in that scenario that you can end up with a banking holiday,
19:15 Speaker 02 where the liquidity in the banks and the capital losses create a need for a bank holiday. And that's not unprecedented. We had a bank holiday in the Great Depression. The stock markets were closed for, I think it was four or five months during World War I, and they're actually closed globally. So there's examples of having the banks close and the markets close. Because everything is inextricably linked now, you couldn't really have the banks close without having the markets close. If you wanted to close the markets, you have to close the banks. I know that sounds very draconian, but I mean, I can tell you factually, there's a lot of government agencies that are working on that contingency. Hey, how could we close the markets if we needed to for a week or two to give time for things to cool off? What happens if we need to close? You know, there's a bunch of banks that are closing. What will we do?
19:58 Speaker 02 And maybe close for two weeks, as an example, for a bank holiday. And that could lead to nationalizations of the banks. So you could keep going on. I'm not saying what the probability is here, but if you had a big hole, you had losses, the market isn't able to digest them, you have the markets take a holiday, you could begin to nationalize the banks. If you nationalize the banks, you could then reopen them. But you could get to a point where there's enough cascading effect in the economy that you said, you know what? We don't want to just shut the banks and nationalize them. We maybe should come out with a new currency, a new dollar, maybe one that's backed by gold or whatever it is. You could back maybe by gold and Bitcoin, or maybe just a new one altogether. I know that sounds really crazy to some people, but that's not unusual. It happens to certain countries.
20:43 Speaker 02 It's happened in a lot of Brazil or Argentina or wherever you want to look. There's plenty of examples of it even happening in modern countries like it happened in Germany. There's lots of examples of where you might redenominate, and you would do that when the banks are closed. Because that's the exact time when you would basically say, hey, you woke up and you used to have $100 in your account, now you have $20 and it's the new dollar, Zoller. Just making up a name here. So, oh, you now have $20 of Zollers in your bank account, not $100. And that's the same for all US-denominated government debt. And you just clear the decks of all the debt and that could allow you to do a lot more stimulus because you don't have this debt overhang. So that's a deflationary outcome that kind of really spirals. There's
21:26 Speaker 02 precedence for that. I do think that gets pretty far out there.
21:29 Patrick O'Shaughnessy? Meaning you think the probability of something like that is pretty small?
21:32 Speaker 02 I don't think the odds of a redenomination are high. I think the odds of us needing to have a market and bank holiday and having some bank nationalizations are decently high, like 25%. And the reason I'm saying that is it looks likely that we're in a depression for at least a quarter or two. If that went out for more than one or two quarters, I think you'd definitely have to have bank failures. And I think the market would have a real hard time digesting that. And if you need to try and fill a $6 trillion hole, I'm not sure if we could do that in time before the feedback loops kick in and you could end up with a bank holiday and nationalization.
22:07 Patrick O'Shaughnessy? Can you say a bit more about the first time I've encountered the thought in this cycle of something like nationalization? And I think it's good to explore these edges of the spectrum of potential outcomes. But given the signaling from the Fed thus far, their experience in '08, why would it not be the case that they would just continue to pump liquidity into banks versus nationalizing them? Like, what does the concept of nationalization buy you that just ongoing, effectively open lending and printing that goes into the banking system from the Fed? What's the difference between those two things?
22:42 Speaker 02 There's a couple of components here. One is liquidity and the other is solvency. So the Fed is in this position where they should have no credit losses. That's how they run everything. Like, the Fed is completely risk averse. So they want the banks to be the agents that take losses. And they'll lend against good collateral. If you began to have a solvency issue because you were in a depression and so loans started to go bad, therefore securities have to be marked down, all kinds of issues, you get these feedback loops going on, there can be less liquidity because there's less capital. If you don't have enough capital in the system, how do you get it in there? And so you either go to private markets and ask for capital. But if you're in depression, the private markets might not be willing to put capital in.
23:26 Speaker 02 Another way to do that is the banks have low on capital. You nationalize them and the government puts in the capital so that the banks can now be recapitalized to go out there and be able to lend. And so the banks aren't the only mechanism to lend into the economy, for sure. The capital markets are too. But you need to have good collateral. You have to have good loans. You have to have people paying them in order for it to work. And so that's why I think you absolutely can do a huge amount of fiscal stimulus and a huge amount of money printing. And hopefully you do it fast enough. And even if the hole is not four trillion, but six or seven trillion, they can fill it. And I think that's the more likely scenario. But I do think there is really a non-zero probability here of around 25% or so that
24:09 Speaker 02 we get caught into the defaulting deflationary trap. And that creates its own feedback loop or that's just bigger or worse. And then you need to nationalize the banks. And once you start getting down that road of nationalization, you could just nationalize them, put capital in and then refloat them. But it's also possible you got to that point where you have to do something else. And I think that's much smaller, which would be called redenomination. I think that's, say, a 5% risk or something or less. But once you start nationalizing and having a bank holiday and the market holiday, it can become really nonlinear how fast things move. Because it kind of goes impossible, implausible to its reality. Happening, yeah. And that's called jump risk.
24:51 Speaker 02 And the reason it's called jump risk is think about how fast this crisis unfolded. In a period of two weeks, it went from we're having a normal life to we're all bunkered down. That's really like, there was no time when that happened. And so I think we should be thinking about impossible scenarios to implausible scenarios. And just recognize that everything is on the table because tails aren't quite tails when you're in a crisis like this. It doesn't mean anyone should panic and, you know, this isn't the end of the world. But it does mean that you, there are strategies they may want to put into place that could protect and look like unlikely possibilities that could happen much more quickly than you could protect yourself with if you waited until it was obvious.
25:35 Speaker 02 And so this is a kind of a situation where... Try to plan because there's no real reason to panic. And if you plan, you could feel like you're protected.
25:44 Patrick O'Shaughnessy? So we've talked about, before we get to the portfolio side of things, the investing side, we've talked about the too hot and too cold. What does just right look like in your opinion? Is it pretty straightforward?
25:52 Speaker 02 Yeah, I mean, I think it's relatively straightforward, which is they get the money out fast enough and they get it out in the right size. And we're kind of all right that it's the middle of June when things can start to get back to normal or thereabouts. Or if it takes a little bit longer, the middle of June, that they can keep upping the stimulus enough to kind of end the monetary policy to fill that hole right. So that's Goldilocks. Obviously, that's the one we'd all hope that they were able to hit. But that's probably the hardest one to hit because it's so fluid with so many variables. Who could really prescribe exactly what Goldilocks looked like? It's changing on a daily basis. What we thought stimulus should look like a week or two ago was 500 billion. Then I went to a trillion. Now we're talking about $2 trillion. Who knows where it actually ends up? And the GDP estimates just keep changing, right?
26:37 Speaker 02 It was, you had someone who was minus six and that was considered, oh my God, so draconian. Then it was minus 12. Then it was Goldman at minus 25. And now it's Morgan Stanley at minus 30. And now it's James Bullard to the Fed saying potentially minus 50. That's so fast that these things are unfolding. Very difficult to manage that type of uncertainty.
26:56 Patrick O'Shaughnessy? Let's talk about portfolio positioning now. So we've got the big obvious asset classes, stocks, bonds, cash. I'd love to hear in, maybe we'll focus on the too hot and the too cold, since the just right is a little less interesting in this context. But on the two tails, what sorts of asset exposures or investing exposures that people could do relatively easily, do you think are interesting for people out there to consider?
27:21 Speaker 02 A lot of the ways you would protect yourself in too hot or too cold are relatively the same. And if things are just right, what's going to work is owning stocks, though undoubtedly do unbelievable in that scenario. You want to be really heavily weighted stocks in a Goldilocks just right scenario.
27:41 Speaker 02 On the other hand, if it's too hot, you're going to end up with a lot of inflation. If it's too cold, you're going to end up with a lot of default risk. And so what do you want to have if it's too hot or too cold? You really want to have assets that aren't going to depreciate. Either depreciate because of inflation or depreciate because their value is going down. And so that kind of looks like having an allocation in gold and having an allocation in other things like Bitcoin or whatever it could be that can't be printed or duplicated. So they have scarcity and when there's scarcity and you have a lot of money chasing, it'll go up. And on the other hand, if you had a deflationary scenario or defaulting scenario, you want something that can hold its value.
28:24 Speaker 02 It might go down, but it wouldn't go down nearly as much as, say, stocks or other assets. So I think gold and Bitcoin can actually work in either one of those two hot or two cold scenarios. And then the wild card is cash. So cash obviously doesn't do very well when there's inflation. Cash can do really well when there's deflation and defaulting. But how do you manage the risk that a bank might default or get nationalized? Because I think it's definitely possible that, and there's examples of this in Greece and Cyprus and other places, that large time depositors took haircuts in the defaulting scenario. So this wasn't actually that long ago. This was just a couple of years ago, where in Cyprus and in Greece, the large depositors took losses.
29:09 Speaker 02 So above $250,000, you don't have FDIC insurance. Below it, you do. So you're essentially depositing money with the US government if you have FDIC insurance. But above it, you're actually lending to the bank. And so if a bank was to default, you have bank risk. You're actually a lender to that bank. You have to see what your recovery is. So cash can become problematic in a defaulting scenario, just like it is in the inflation scenario. If you're in the Goldilocks scenario, you probably don't want to have that much cash either. You want to own stocks. So in some ways, cash is, is an okay asset. But ultimately, you have to move out of it. You do have to move into stocks or you need to move into something that can protect value like I think gold or Bitcoin. It really just depends.
29:54 Speaker 02 One way you could protect your cash is to hold U S T bills. So you could say, oh, I'll own T bills. I don't think the government's going to default, but I think the banks might have a haircut. You have more than $250,000, I would say you need to own T bills. You need to make sure you own them in a segregated way. And so these are different ways of protecting these scenarios. And I think a lot of that risk is just about having the portfolio that's diversified. That's how you manage these situations because you just can't tell where we're going to end up. Whereas before, those tails probably felt like tails. I think that the possibilities are almost equally distributed in a weird way.
30:32 Patrick O'Shaughnessy? What do you make of the performance of something like Bitcoin? Obviously, where you were a very, very early participant and miner, the earliest days of Bitcoin. What do you think of its performance thus far in this period where at times it's it's looked almost like an S and P 500 proxy? Now it seems to have done a little bit better in the more recent week or two. Any surprises from you as a longtime participant and watcher of that asset class in terms of how it's performed in this crunch so far?
30:59 Speaker 02 Firstly, absolutely surprised at how much it went down from like 10,000 to like, I think 3,900 or something it touched. I'm surprised it went down that much. I'm not surprised it went down. I'm just surprised it went down like 60%. And I think there's a couple of reasons for that. The first thing is people own Bitcoin because they think it will become gold. Bitcoin is not gold, that it will become gold. And so that means it's a speculative asset. The second thing is there's an enormous amount of leverage that's got put into the Bitcoin and crypto markets in this bear market where people are trying to figure out ways to create higher returns, come up with new ways to be able to make money. And there's actually been a lot of options that have been put in there. I think the Bitcoin price started going down for the same reason the market crashed in 1987.
31:42 Speaker 02 People were selling puts all over the place, thinking that it wasn't going to be that volatile and it created all kinds of implied leverage in the price. And then, and the last reason I would say it went down is gold was going down too. You have had liquidation happening in all asset classes because people are getting margin calls everywhere. You're getting margin calls in your S and P positions, you're getting margin calls in your bond positions, you're getting margin calls even in gold. And so, a lot of players in the crypto markets are cross asset players. They own Bitcoin as part of a portfolio. And so, your portfolio starts going down, you gotta sell a little bit of everything. And so, I think all of those are contributing factors to why Bitcoin
32:25 Speaker 02 went down. But at the same time, I think the fundamentals still hold just like they hold for gold. So, gold went down several hundred dollars from the highs. There were a couple of days when the market went down and gold was down like $75 at the same time. And I was scratching my head, and I realized, this is not risk off, this is liquidation. They're different. You think they're the same, but they're not. One is risk off, oh, I'm worried about like the economy or something, I'll go buy some gold, versus, I just gotta sell everything. And you know, if you looked at the markets today, it's really interesting because there's been so much QE announced. Gold is now up $80 or something today, or whatever it is from yesterday, $90. It's gone up a lot, even when the market was going down. And Bitcoin went up yesterday too, even though market was going down. Hard to
33:09 Speaker 02 draw a trend from one day. But I do think, a lot of this was, everyone getting washed out, and then now you're kind of like resetting into a different scenario, which we're still trying to figure out what that is. Is this inflation? Is this deflation? Could this be Goldilocks?
33:24 Patrick O'Shaughnessy? How do you factor in what I would call the relative advantage of the United States in terms of its, I don't know what to call it, like horsepower, productive capacity, natural resource advantages? You know, some of the examples that you've laid out, a Greece or a Cyprus, it's true what happened there, and maybe a Germany, and you know, the hyperinflation in Germany is a bigger country example historically. But it just strikes me that the US has unbelievable relative advantages lying beneath financial systems and everything else that we're talking about. How do you factor that sort of thing, given that this is a global crisis and everyone is sort of in the same boat facing this challenge? How do you factor in the United States's relative underlying advantages, to the extent you believe that's there, like I do, into portfolio positioning?
34:08 Speaker 02 Well, first of all, I completely agree with you that the US has an unbelievable position. And we have an unbelievable position for a number of reasons. There's a distinction between the real economy and the nominal economy. Meaning like the nominal financial economy versus the real economy. U.S. from a real economy perspective is in an unbelievable position. You have a continent that we basically more or less control. We have the best waterways in the whole world. Our shipping costs are like a fraction of what they are to get around anywhere else. The Mississippi Basin is unbelievable. You could go on and on about like the number of deep water ports the U.S. has on the eastern seaboard is more than all of South America. Like we live in the best place in the whole world and we have the best form of government in the whole world.
34:49 Speaker 02 So I'm unbelievably bullish on America and I actually think some of the bigger risks are outside the U.S. What a tragedy in Italy. It's unbelievable what's happening there. Who's going to save Italy? That's the third largest sovereign bond market in the world. It's because U.S., Japan and Italy. And it was already in a really difficult position. And now you have just what looks to be potentially the worst hit country, even though it's so much smaller than say China or the U.S. or anywhere else. And Europe itself looks to be really hit. And so I think Europe is actually in a much worse position because they're in the Euro and yet you have different countries have different amounts of debt. So I actually look out and I see huge problems.
35:32 Speaker 02 I think the Chinese have done a good job of trying to lock this thing down after not doing a good job initially and like kind of really leading to where we're at. But they have problems with their system of government. So I look out and you know, where are these great places that you would rather invest in than in the U.S.? I think absolutely the U.S. is the place you want to invest. It's about figuring out what's the right entry point? What's the way to protect yourself so that you have capital? When you go through the crisis to be able to take advantage of what will be unbelievable buying opportunities and unbelievable businesses that are going to get created. And so to me, it's just managing these tail risks isn't because you're negative on America. It's because you're negative on where the world is right now relative to price. And so I think that's a big distinction to make. Absolutely, this is not just a U.S. issue.
36:17 Speaker 02 We just talk about it because we're here from the U.S. I think it's worse in other places.
36:21 Patrick O'Shaughnessy? Can you say a little bit about tactically, the notion of T-bills and segregated accounts? How you might consider owning gold? People are familiar maybe with some of the major options like a GLD or something like this in the ETF market. Any sort of nuance around tactically, if someone were to sort of adopt your view and create what I'd call like a tail risk aware diversified portfolio? Sounds like that would include stocks to cover that middle, the just right territory in some decent or large weight, but also some of these other things that you've talked about. Any tactical recommendations for people out there that might consider your advice?
36:55 Speaker 02 Everyone can put their own percentage weights on too hot, too cold, or just right. And then figure out what percentage stocks I want to have versus say cash versus say, let's call it scarce asset or an outside asset is what we were talking about it last time. And so we've actually at Paxos, set things up very specifically to try and create financial market infrastructure for a more open financial system. And part of doing that is to really create assets that are highly reliable. So for instance, at Paxos, our dollars are only backed by US government risk. There's no commercial bank risk. We're not backing our dollars by loans. So they're all held in T-bills or through FDIC insurance.
37:39 Speaker 02 So if someone has a dollar with Paxos, you know, the dollar isn't tied to the performance of the banks. Now, if you thought the US government was going to default, different thing. Then you know, you have problems owning dollars in general. But when you just hold T-bills, that means the dollars are extremely safe. They're put in a bankruptcy remote, fully segregated account for our customers. So you know, the dollars are always only backed by government risk. The other product that we created is a goldback token. And that's backed by bars down to the serial number in a Brink's account. And so that token always relates to bar. And the key thing here is this is different from an ETF or futures because if you had a problem
38:21 Speaker 02 in the banking system or you had a problem with the futures exchange, there's like, I think, 15 to 20 different intermediaries between you as ETF holder or you as the futures holder and the end gold. And so you're really holding a synthetic gold product. Whereas if you came with us, it's not gold that's sitting in your hand, but it's the next best thing, which is that you have a token, it is a bearer receipt on an allocated bar to the serial number in a Brink's vault in London. Very safe. It's not tied to any of the banks as a result. Another thing that someone could buy is Bitcoin or other types of crypto assets. I was mentioning this before about why is it so volatile? It's more speculative. People buy it because they think it will become gold. It's not gold today. It has attributes that make it better than gold,
39:04 Speaker 02 but those still take time to develop and for adoption to happen. And I do think that you're going to see a lot of adoption of crypto because of this crisis, because of what's going on. It was literally, in many cases, created because of this exact situation. And so I think that adoption curve will actually accelerate over the next year or two, but it's still more speculative. And so if you said, hey, what type of safe assets would I want to own? If you want to own cash, in my opinion, you don't want to have cash more than 250K because it's not FDIC insured. Something like a Pax Dollar gives you a lot more assurance. If you really want to hold gold, but you don't want to own physical gold, I would say an ETF is fine, but Pax Gold really
39:45 Speaker 02 gives you a level of confidence that you couldn't have anywhere else. It's a regulated gold token from the New York Banking Regulator, just like our dollar is. And then lastly, if you want to own something that's a little bit more speculative, a little more jiggy in terms of what it could do on the upside, I think that's Bitcoin. So you have to kind of pick it and I would put that in a portfolio with stocks. With maybe conventional cash, but it creates this capacity for you to be able to manage these risks that are very unpredictable right now. And you know, the advantage is they can always be unwound. You know, there's no, there's not like a permanent position that anyone needs to have, but it's a question of what do you want to do now in case the tail risks really begin to materialize and that jump risk happens. And so these things are all
40:29 Speaker 02 available at Paxos.com. They're also available through some of our partners like Kraken, where you could, you know, go buy Pax Gold. So I mean, I think this underscores the value of being able to maintain your capital at a time like this, to be able to get to that other side that we were talking about, which I know is going to be bright. And all these crises end up creating the seeds that, just like any fire, creates the capacity for you to have new growth and new opportunities. I think that's exactly what this is going to create. So I, I think it's just about how to make sure you're, you get through in the best possible position.
41:00 Patrick O'Shaughnessy? I certainly understand everyone's in an interesting position, especially financial market participants of being, you know, you've done a great job of treading around recommending what you do in your company. I do the same thing with, you know, our equity strategies. I mean, it's, it's one of those interesting times when I think, I think balance of perspective is, is really important, which, which I think we've gotten today from you. So I appreciate that. I'm curious in closing, what things you are watching most closely to try to remove uncertainty in your mind around where we're going to be going. So these outcomes, you know, we have to assign probabilities to them. Who knows what they are. There are certainly possibilities today more than probabilities, but as you try to sort of adjust those relative probabilities of the, of the hot, too hot and too cold, what are the specific things
41:43 Patrick O'Shaughnessy? you're watching most carefully on a daily basis?
41:46 Speaker 02 Yeah, well, there's a number of things because there's kind of three categories we talked about. How long could this go on for? How much stimulus is there? And what's going on in the markets? So, you know, you're really looking at case counts on a daily basis. It's hard to tell from one day what's going on, but what's the case counts looking like? What's the fatality rates? How is this progressing? Is it burning itself out? Is it subsiding enough so you can get a sense that we could go back to like normal life? Still too early to draw any conclusions, I think, at the moment. Definitely looking at that. Second thing is trying to understand what's going on in markets. And so there are some esoteric areas you can look at like overnight spreads, off the run treasuries. They should theoretically be priced really closely to on the run treasuries.
42:30 Speaker 02 But sometimes they get out of whack. That means there's not enough liquidity. What's going on in the muni market? What's going on with corporate bonds? What's going on with commercial real estate bonds? Being able to track spreads of theoretically bulletproof bonds. One example I heard was there are some cat bonds that are rated AAA. They mature in May. They only had to pay if there's a hurricane. There's not going to be any hurricanes in May. It's never happened before. And they went from trading at like a almost a zero yield to like a 10% yield. You know, that's a real sign of stress. So really trying to make sure you understand, is there liquidity risk? And then also being able to track what's going on with the economy in terms of like solvency. So one is liquidity, one is solvency with the markets.
43:12 Speaker 02 And then the last thing is trying to understand politically, what are the programs that are being put into place from a fiscal perspective and liquidity perspective to help fill the hole? So you're trying to figure out like, how bad is the hole? Is the market think it's being filled enough? And then what is the policy response? Is it effective enough? So there's a lot of things that need to be weighed. And that's partly why it's so unpredictable right now. Man, it's really hard for the markets to know all these answers. I mean, I can't tell you the answer to them. And I think, I don't know anyone who thinks they can actually. So you have to try and just position yourself to weather the storm.
43:46 Patrick O'Shaughnessy? Yep. Well, Chad, this has been informative and interesting for me as always, you know, always pushing me outside my sort of Overton window or spectrum of beliefs. I appreciate the insight and all the information. Thanks for your time.
43:57 Speaker 02 That was great talking with you. Thanks for having me on again.
44:01 Speaker 03 Hey, everyone. Patrick here again. To find more episodes of Invest Like the Best, go to investorfieldguide.com/podcast. If you're a book lover, you can also sign up for my book club at investorfieldguide.com/bookclub. After you sign up, you'll receive a full investor curriculum right away and then three to four suggestions of new books every month. You can also follow me on Twitter, at Patrick underscore Oshag, O S H A G. If you enjoy the show, please leave a quick review for us on iTunes, which will help more people discover Invest Like the Best. Thanks so much for listening. [Music]
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