Rebecca Hotsko (03:22):

I want to touch on a couple things you mentioned there. First is when you pick stocks, you are exposing yourself to those idiosyncratic risks, or company specific risks that you mentioned. And we know that the market doesn’t compensate investors for taking on company specific risk, because this can be diversified away by holding more positions, whereas when you hold an ETF, this risk is eliminated. So I thought that was a really great point. And another thing that you mentioned is that instead of having to be right about a specific stock, you just have to be right about the average, or industry, which to a lot of investors may see more manageable, especially if this isn’t something that they can dedicate a lot of hours to like stock picking often requires.

Michael Gayed (04:08):

Yeah. And it’s important to note, by the way, on that point that I think one of the nice things about not getting sucked into a specific stock story is results in you also by extension avoiding group narratives around that individual stock story. There’s a lot of behavioral evidence that suggests that the moment somebody buys a stock, they end up believing the stock’s going to go up even more because they own it. Then you pile on top of that echo chambers and other people that are big fans of that stock tweeting or commenting about that stock. And my point is that it’s a lot easier to get entrenched into investment thesis when it’s story specific, company specific, as opposed to average specific, which again, I think from a longer term perspective results in probably better returns because you don’t get sucked into a company specific narrative, which causes you to maybe overweight at the exact wrong time, relative to your risk tolerance. More of a side note.

Rebecca Hotsko (05:00):

So next I’m wondering if you can briefly talk about the different ways that an ETF can get exposure to the underlying index, and does this matter for returns?

Michael Gayed (05:11):

As far as ETFs go as there’s a lot of different ways that ETFs can track a particular index or benchmark, obviously the benefit of the ETF structure is that there’s no necessarily short term capital gains tax, unless you yourself obviously sell prior to a full year. And you essentially get exposure to a bunch of stocks underneath the service, as long as it’s not an ETF based on some derivatives or something like that. This is something that come across quite a bit. I think a lot of people confuse liquidity with volume when it comes to an ETF. So some people seeing exchange traded fund, if it’s not trading very actively, might say, “Well, this thing is illiquid. I want to be able to be in something that I can get in and out of easily because the volume’s already pretty high.” The problem is that that’s just a completely false construct, because it’s not about the volume of the ETF as a rapper for a bunch of investments, it’s about the underlying liquidity of the investments the ETF invests in.

Michael Gayed (06:06):

So I think ETFs are great for, using your very term, investors, even though a lot of people often actively trade them without any real rules based approach or methodology behind it. But you have to understand that ETFs are meant to be an efficient way of getting access to some part of the marketplace. It’s not necessarily meant to be an efficient way for you to trade in and out of that marketplace

Rebecca Hotsko (06:26):

In the past, we’ve had some guests come on the show and talk about how ETFs are a good choice for most investors. They’ve kind of become a go-to investment vehicle for many investors looking to just build low cost portfolios, but even for a seemingly simple strategy, like wanting to buy just a total US stock market index, there’s just so many ETFs out there now, and so I guess with the rise of all these new ETF products, what type of due diligence should investors be doing for ETFs? And I guess what are the most important things that investors should be comparing when ETFs have similar strategies?

Michael Gayed (07:02):

So this is a very good question, because you’re right, there’s a tremendous proliferation of the number of ETFs that are out there. Most are really largely doing the same thing, it’s really just a question of which is cheaper. And those that are more on the fringe, which I would consider my own ETFs, Rora and Jojo, certainly more on the fringe, can diverge very dramatically from other ETFs, but also have their own risks, as very evident this year, given away my own funds unfortunately have performed because of this strange dynamic of treasuries correlating into equities, which we’ll get into in the drawdown.

Michael Gayed (07:33):

But I think when you think about due diligence and deciding what to invest in, look, it makes sense if you’re going to be plain vanilla, you probably want to consider the Vanguards of the world with a very kind of cheap passive beta exposure and not worry about a product that is the S&P, but maybe on the periphery, does something a little bit different. Because at the end of the day, it’s all going to be within a plus or minus range of the broad stock market. I think for the more niche thematic ETFs, the best thing to do there is to look at the underlying holdings of those niche, thematic ETFs.

Michael Gayed (08:07):

Good example of this. I know there’s a lot of interest in ESG investing. There’s a bunch of ESG ETFs. When you actually look at the underlying holdings of a lot of these ESG ETFs, they’re really just large cap tech. Facebook, Amazon, Apple. That’s not really ESG, and that’s not going to differentiate itself against the S&P. My point is, if you’re going to go core basic, you want to go for the least expensive exposure to the quote unquote, “Stock market.” If you’re going to go thematic and satellite, make sure that whatever you were investing in, whatever that theme is, whatever the name of that fund is is actually matched logically with the holdings of that fund. Because a name alone doesn’t necessarily mean that it’s capturing a particular idea.

Rebecca Hotsko (08:51):

I think those were all really good points there. And I guess in terms of, so cost liquidity are some main things you mentioned. What about tracking error? Is that something that we should be looking at and that we should care about?

Michael Gayed (09:05):

It depends on how you define tracking error. If you’re talking about tracking error against a benchmark like the S&P, assuming it’s a large cap strategy, it matters. Although for the most part, a lot of these passive vehicles track pretty tightly. Although it’s interesting though, because if you really want to have a diversified portfolio, you actually want things which have high tracking error, which sounds like a really strange concept. It’s like, why am I advocating that you should have tracking error? Tracking error simply means something that’s behaving differently against some benchmark, positively or negatively. Well, that’s pretty sure what you’d want with diversification.

Michael Gayed (09:36):

You want to make sure the tracking error is low in terms of the fund doing what it’s supposed to be doing, but don’t shy away from high tracking error strategies, which shouldn’t be benchmarking against the S&P and have a very different return profile, because you may actually want that in your portfolio for a more robust return stream.

Rebecca Hotsko (09:53):

So I guess one way to sum that up is you want low tracking error between the ETF and the benchmark it’s trying to track, but high tracking error on a portfolio level can be a good thing, because this just means that you are more diversified in your holdings.

Rebecca Hotsko (10:10):

So as I mentioned before, we’ve had a number of different guests on the show over the years. Some of them say that the average investor would be better off just putting their money in index funds, but on the other hand, over the past year or so, I’ve heard a lot more people say that this next decade is going to be a stock pickers environment. So I’m wondering what are your views on that?

Michael Gayed (10:34):

All right. So it’s important to first define what stock pickers market means, because you often hear that term. Stock pickers market presumably means that there were going to be some very clear identifiable winners that will drive returns for the average. I’d actually, oddly enough, argue it was a stock pickers market for the last decade, in terms of there were only five stocks to pick from. The fangs. Really wasn’t stock picking for small caps, because small caps relative to large caps have been terrible going back to 2012. If you look at the ratio of small caps against large caps, that levels back to 2002 levels, meaning that if you were thinking about stock picking with the smaller cap side, where there’s a lot more options to choose from a stock picking perspective, you did yourself with disservice with hindsight.

Michael Gayed (11:14):

Stock picking sounds like a great environment to choose winners from, but the reality is a healthy bull market should be one where it’s not a stock pickers market. Where all stocks are rising in a similar fashion. The rising tide lifting all boats so that it becomes easier to choose a stock. You need to have differentiation in a portfolio. You need to think about what positions are going to diverge from other positions. But the problem is if only a few positions are diverging, and that’s what a stock pickers market is, well that becomes problematic because then how in the world can you possibly diversify properly if only a few things are working, everything else is not?

Rebecca Hotsko (11:51):

I guess I’ll follow up with how should millennial investors think about properly diversifying their portfolio then? There’s so many theories on how many assets you have to have, or regional diversification, but what is your approach to that?

Michael Gayed (12:06):

Yeah, it’s funny, because I’ve been to a number of conferences where I’ll have somebody who’s younger come up to me and say, “Well, what do you think I’ve got? I’ve got Apple, I’ve got Doge Coin. I’ve got Qualcomm. What do you think of my portfolio?” And I say it to them, “Well, I hope you like concentration.”

Michael Gayed (12:20):

You have to think of diversification from the standpoint of are things moving differently against some core factor? And I’ve made this point many times before. Real diversification means you have to have a portion of your portfolio that you hate. Because think about it, right? Why would you hate a portion of your portfolio? Because it’s not working, because it’s not performing well, while other parts of your portfolio are. And if everything in your portfolio is working, you’re by definition correlated. And that’s not what diversification is.

Michael Gayed (12:48):

Real diversification has to mean investing in things. You actually don’t like, because one, you could be wrong in your dislike for that investment, but two, you actually want things to have different movements against each other. They might be volatile assets, but combined together, if the volatility happens in different sequences, that’s again, what gets you a better portfolio over time.

Rebecca Hotsko (13:08):

So a lot of millennial investors are likely in 100% equities, just given a higher risk tolerance, longer timeframe, but what other assets should we think about diversifying to? Would that lead us to stray away from that 100% equity allocation?

Michael Gayed (13:25):

I’ll frame this in the construct of risk on and risk off, because diversification means you want probably a blend of the two, except in years like this year where risk off looks like risk on. Most things in reality are variations of beta. Meaning they’re basically just going to move off of the broader risk on of equities, of S&P and then on the periphery of that, with different momentum, different acceleration rates. Which kind of makes sense, because progress happens by taking risk. So everything’s, in some way, shape, or form related to macro variables, related to growth, and inflation and all that is tied to broader beta, which is risk on. Lower volatility, progress.

Michael Gayed (14:03):

Risk off tends to be the things which benefit from volatility in stocks, and historically the only real risk off plays that are true diversifiers, and it’s an unpopular opinion, but this is fact when you look at correlations on average. Usually treasuries, especially on the long duration side. Why? Because during risk off safe haven moments usually yields drop. They actually act inverse to equity. So if you’re in long duration treasuries, you can actually make money as stocks go down/ not this year. So we’re talking about averages in terms of big declines. Two is gold. Gold does tend to act as a diversifier. Again, tends to do well when you have these high volatility pulses and equities. And then the third is the dollar itself, which on a side note, it’s amazing to me that the dollar ended up being the best inflation hedge you could imagine, with the way currency has behaved against everything else. Short the euro, short the yen.

Michael Gayed (14:56):

From that standpoint, the real argument would be that you want to have gold and treasuries. Now gold has done okay this year. Hasn’t really kind of provided any real significant benefits against just the S&P. Treasuries have been horrendous, in that we’ve never seen a draw down in stocks that was this severe, matched by an equivalent draw down in treasuries, as yields have spiked on the long end. That doesn’t mean that you should not consider having treasuries in a portfolio, just because it’s going through a wildly difficult period. By definition, the best time to buy anything, or the best way to avoid a draw down in any asset class is after one’s already taken place. So you have this tremendous draw down in treasuries relative to equities correlated in a very bizarre way. Now may not be a bad time to consider that. Again, to blend against an equity portfolio. Because as much as everyone talks about inflation, you don’t know. It could very well be that we have to worry about disinflation, or even outright deflation. Because somehow with this entire narrative around inflation people seemingly forgot that debt is inherently deflationary at these kinds of numbers. And if that is going to be deflationary as one of those possible outcomes, you probably want treasuries to play that.

Rebecca Hotsko (16:11):

That was a good segue, because the next things I wanted to talk to you about was your risk on/risk off strategy. So you kind of defined what it was there. I guess, for our millennial listeners that don’t know, what is a risk on risk off strategy?

Michael Gayed (16:29):

This is really important because the media often says that if the market’s positive it’s a risk on day. If the stock market’s negative, it’s a risk off day. It’s not about direction. Never was, never will be. This is just the media framing it based on how the markets close.

Michael Gayed (16:42):

It’s ultimately about volatility. Risk on is lower volatility, risk off as higher volatility. It’s as simple as that. Typically in higher volatility, regimes markets go down, but not always. So there’s one thing that you can say with some degree of certainty, which is that when you’re in a highly volatile state for the stock market, that’s where you tend to have accidents. That’s where you tend to have major crashes, corrections, and bear markets, because markets are already moving around violently and then you can have a massive decline just because you’re already moving around violently.

Michael Gayed (17:12):

Okay. So from that perspective, if you go with me that risk on is conditions, favoring lower volatility, risk off as conditions favoring higher volatility, the question then becomes, how do you define the opportunity set to benefit off of lower volatility regimes and equities, higher volatility regimes inequities on the risk off side.

Michael Gayed (17:29):

Now this is an important part of the discussion. People think that if you’re in a quote unquote “Risk off environment,” you should short the market, or you should take an outright bet on a decline in prices. But again, there’s not as clear of a correlation as people think between volatility and direction. The problem with risk off periods is that yes, you can make a lot of money shorting, but because you’re in a higher volatility state, you can also get whipsawed to death with that shorting. As opposed to, if you’re in a lower volatility regime where markets are going higher, whipsaw risk is less because you have more consecutive up days. You have a better trendy environment as opposed to the seesaw back and forth that happens in higher volatility states.

Michael Gayed (18:11):

In my world, I’ve got three funds. ATAC’s my mutual fund, goes back to 2012, Roro, Jojo. They’re all risk on/risk off strategies. They’re all predicated on this concept that, one, they’re leading indicators to volatility regimes changing. Again, risk on lower volatility regime, risk off higher volatility regime. But they also are predicated on the idea that the risk off side, the opportunity set behaves the way historically it does, which again goes back to treasuries as the safe haven. Why are treasuries a safe haven? Because risk off higher volatility correlates to rising bankruptcy risk among corporations. Credit risk, default premiums, they tend to increase when you’re in a high volatility state. So if you’re in a risk off period where volatility’s higher, there’s concern suddenly that the riskier companies can’t pay off their debts, there’s doubt around company fundamentals. So what does money do? It goes into the quote quote, “Safety of government debt, and of treasuries.”

Michael Gayed (19:07):

This year has been a notable exception, and it’s not my opinion. I put out this tweet many times, you look at the top 50 draw downs for the S&P, peak to trough, going back to 1961, usually treasuries either make money when stocks are in those big declines, or are at least down a lot less. This year is unequivocally an anomaly, and people seeing that would say, “Well, it looks like your approach forgot to go risk off, but you’re in a weird anomaly where treasuries and stocks are basically acting the same. And you’ve seen those stats just like everybody else. One of the biggest yield spikes in history. By some metrics in terms of centuries, literally for the 10 year treasury.

Michael Gayed (19:43):

So I say all that, because one thing I find with younger investors that they have a problem with is they assume the most recent past can be extrapolated out into the future. The problem with that is that what if the most recent past is the anomaly? If it’s the anomaly, then you want to actually bet that things get back to some degree of normalcy in terms of asset allocation, trading, diversification. If the anomaly persists, well then we’re all flying blind because if it’s an anomaly and things have dramatically changed in terms of the way the system works, and maybe it has, how do you know what to compare that against? How do you know what the playbook is if it’s never been written?

Rebecca Hotsko (20:19):

You made a lot of great points there. I think too often investors don’t look far enough back on the history of global markets, as you mentioned, and many can fall into the trap of assuming that the next decade will look like the last, which just might not be the case, and that’s why I like having people like you on the show to help us learn about strategies that will work in environments that maybe don’t follow the same pattern as the last 10 years.

Rebecca Hotsko (20:47):

So I’m curious to know, how are you thinking about reallocating your portfolio during this time, given those views?

Michael Gayed (20:57):

I talk about this on Twitter spaces, on Lead-Lag Live, my own podcast too, but there’s a well known phenomenon called the morning Morningstar curse, which basically says that if you were to take the top performing funds, top performing strategy over the last three years, the five star funds, and then look at how they behave the next three years, it ends up being that those top performing funds end up being among the worst performing funds in the next three years.

Michael Gayed (21:20):

Conversely, the same is also true. Meaning that the worst performing strategies and funds over the last five years, or three years end up being oftentimes in the top decile for the next three, five years. In other words, there’s a degree of mean reversion that happens with strategies which are hot for a moment, and then go cold, and then cold goes to hot, back and forth, back and forth, back and forth.

Michael Gayed (21:40):

In many ways, sometimes the best investments are the ones that have done the absolute worst over the last several years, which is basically just another way of framing buy low, sell high. The problem is FOMO often screws with people’s heads. They want to chase that which is going up, and they think they can trade it and get out just as the turn’s about to happen. And all the evidence suggests that’s not true, but you have much more room for error, you have much more cushion obviously with things which have already done so poorly where not too many people are trying to chase. It’s a long-winded answer, but my point here is that sometimes I often advocate that people should consider allocating to that which has not done well at all. By the way, like energy stocks, which have been on fire, they’ve done poorly for a decade. But if you followed that suggestion that maybe the best thing to do is buy the biggest laggers over the last cycle, over the last several years, well at some point mean reversion kicks in, at some point you end up having that which is last become first and first, last.

Rebecca Hotsko (22:40):

I want to circle back quickly to the risk on/risk off topic, because I’m just curious to know what indicators are you looking at to decide whether we are in a risk off or risk on? Is it just the volatility index? Is that mainly what you’re watching?

Michael Gayed (22:58):

I always liken the VIX index to the mile marker that a crash happens. It doesn’t necessarily tell you the weather. It’s much more reactionary than anything else. I’ve got these five different research studies. They won these different awards going back to 2014. It’s what my own funds are largely based off of as derivations of the approach. But broadly speaking, that which has some degree of predictive power when it comes to this risk on/risk off dynamic, these indicators all relate to interest rates. The utility sector. Historically utilities are the most bond like sector of the stock market. Historically when utilities on a short term basis are outperforming, up more down less, average stock market volatility is likely to rise on a go forward basis, not my opinion, by the way, it goes back to the 1926. You can download the data, you can run the metrics and see that very transparently.

Michael Gayed (23:44):

Why would utilities warn you of higher volatility risk off regimes? Because utilities benefit from rates being lower. Interest rates being lower. Well, why would interest rates be lower? Because demand for money is falling because you’re in a slowdown. And utility companies are very highly leveraged, so they benefit more from the cost of capital dropping than from revenue increasing because they’re highly regulated. So that’s the utility sector.

Michael Gayed (24:07):

Lumber, which goes into my Roro ETF, which again has had unfortunately very ugly draw down, because treasuries are not acted the way historically they do. Roro uses lumber. Now I have a lot of people on Twitter on at Lee Lag Report who say to me, “I don’t understand why you look at lumber so much. Why do you talk about lumber? Why do you have a picture that’s got lumber and gold eyes?” Because it’s about your home. Again, it’s not an opinion. The average home has 16,000 board feet of lumber. So you’ll often hear people talk about copper as a tell because of industrial activity, but it’s really lumber that everyone has to focus on because it’s a tell on housing starts. So if lumber’s weak, what does that mean? It means probably demand for housing’s weak. Well, if demand for housing is weak, what does that mean for interest rates? Probably means three year mortgage rates have to respond by dropping, because demand for mortgages drops.

Michael Gayed (24:52):

So again, I go back to this, it’s really all about interest rate movement. Even a moving average. A lot of millennials I’m sure are looking at moving averages. It’s probably the most popular, important way of looking at a trend. Moving averages also tell you about volatility and interest rates. Why? Because usually if you’re below 200 day moving average, again, not my opinion, markets are more volatile. If you’re below 200 day moving average, you’re probably in a recession. What does that mean for interest rates? It means they’re likely falling.

Michael Gayed (25:18):

I’m very basic in the way that I look at things, even though people think of the indicators I often cite are complicated. They’re really not. They’re all just variations of the same story. What are the early warning signs of a change in the demand for money? Whether it’s utilities out performance, lumber weakness, moving average, it’s all trying to get to the same place, but using a different indicator in each case.

Rebecca Hotsko (25:39):

I really liked your paper on the utility sector and the beer beta rotation approach. And I’m just curious for our listeners who haven’t read it, can you walk us through this beta rotation strategy, and what are the practical takeaways from this?

Michael Gayed (25:58):

The paper which is available on the Social Science Research Network, ssrn.com, basically it’s very simple. And I’m a huge fan of simplicity when it comes to back testing and strategy development. If utilities are performing the stock market on a rolling four week basis, go into utilities. Risk off. Otherwise, if utilities are underperforming the market, the relative momentum’s weak, go into the market. So it’s literally just look at the relative performance and chase utilities on a relative basis, or chase the broader market on a relative basis. You can think of it like a beta of one in the case of risk on market, or a beta of less than one. Because utilities are less volatile just given the nature of their price movement.

Michael Gayed (26:36):

Using that rotation, going back to the late 1920s, and across every single rolling decade, rolling 10 years, every single period you can imagine, that strategy generates real significant alphas. Remember it’s like 420 basis points of out performance. Now it’s interesting, because that out performance simply chasing utilities are chasing the S&P, flies in the face of, let’s say, the CFA curriculum would argue, I’m a CFA charter holder myself, that the only way to get more return is to take more risk, which I think probably a lot of millennials also have heard. But it’s not about taking on more risk, it’s about taking the right risk at the right time. Oftentimes the best way to generate longer term returns over a long period of time is to just not be down more than the broader stock market, on average. Again, a year this year, been very hard to do that if your opportunity set was treasured to risk off. Although if you used utilities as your risk off play this year, you actually did a hell a lot better, given the way utilities have so dramatically outperformed. I’d argue that this year was unbelievably spot on if you use utilities as the expression of risk off, as opposed to treasuries.

Michael Gayed (27:42):

The point here is that … And the paper again, it’s back tested, it’s not my opinion. This is all just what history shows. History shows that utilities are the most differentiated sector of the stock market on average, and perhaps the most important to tell you about risks rising for equities.

Rebecca Hotsko (27:57):

So as investors, we’re often told there’s no way to time the market perfectly and consistently. In your paper, you kind of mentioned that there’s signaling power of the utility sector. Would you say that the utility sector can be a way to maybe time investment purchases?

Michael Gayed (28:18):

Yes. But there’s a caveat there. Why is it that market timing doesn’t work? Let’s take a step back, because there’s a lot of studies around that. And I agree with those studies by the way, and some people would scratch your head and say, “How could you say you agree with market timing when your own funds do market timing?” Because there’s a nuance there again, and this is always the important part. It goes back to the opportunity set. The reason why market timing doesn’t work in all these studies is because the risk off play is cash. It’s either the asset that has the risk that you’re trying to time into, or cash to wait. The problem there is that cash doesn’t allow you to be wrong and still make money. You have no chance with cash. Again, it worked this year. I get it. But the idea here is that market timing doesn’t work because with any signal, you have false signals. You have times where you play defense and the market runs away from you, and you’re defensive in your posture. Well if you’re in cash, you don’t have a chance of getting any benefit from that. If you’re shorting and you’re wrong, it’s even worse, because the market goes higher and you lose money because now you’re making it directional.

Michael Gayed (29:20):

If you are long utilities instead, you could be wrong being defensive, but you’re still equities. You’re still going to go up presumably if you’re in a false signal and the market ignores it, as far as defensive posturing goes. Same deal with treasuries, because you have yield. Treasuries are not perfectly inversely corollary to equities, but on average they tend to be in these high volatility equity thrusts.

Michael Gayed (29:42):

I mention that because I think too many people get stuck on market timing in terms of timing, the thing that they want to go up, which is the true positive. In other words, the fact that the signal actually end up being right, whatever signal you’re following, they don’t think about the false signals. And my point is that you need to have an opportunity set to time your risk on with a risk off investment that can at least give you a chance to make money if you’re wrong in your signal. So yes, I do think you can use utilities to help determine when to take a more offensive or defensive stance, but don’t view defense as cash, because again, if your utility signal is wrong or if the lumber to gold signal’s wrong, you at least want to have a chance at making money, which of course doesn’t guarantee that you’ll make money, but over time hopefully gives you better odds.

Rebecca Hotsko (30:28):

I’ve looked into a lot of research on market timing myself. I’m really curious about the topic, and it just seems like investors make a lot of mistakes because their decisions are driven by emotion a lot of the time. So they wait too long, they get out too early, and then they just don’t get back in. It’s that emotion. So if you kind of take that emotion out of it and follow a rules based strategy, like you mentioned, where the alternative isn’t just sitting in cash, but it’s a rotational strategy between different yielding assets, then timing the purchase of your investments could potentially improve returns in that context.

Michael Gayed (31:05):

And on that point, emotion is very hard to model. Your own self emotion is hard to model. And this is why I’m a fan of rules based approaches, which are not … You take the emotion out, because it’s based on some formula, some set of variables that you’re following on a regimented basis. But it’s important to note that whether emotion plays into an investment return stream or not, you will still have draw downs. You will still have periods where you’re de-synced. I’m living this myself with my three funds. Everything I do is rules based. It has nothing to do with my opinion. And those rules unfortunately use treasuries as the risk off play. And with this tremendous yield spike in all this dislocation that’s happening in the bond market, it’s been extraordinarily difficult to rotate, and it’s been extraordinarily difficult to play stock market volatility when treasury volatility is more than stock market volatility, even though treasury is historically benefited from stock market volatility.

Michael Gayed (31:52):

Believe me, I get emotional based on that. Doesn’t have anything to do with my decision making, because it’s all rules based. But you will have, no matter what, declines. The point about the emotional aspect of investing is important from the standpoint that because emotion can be variable, and can be somewhat random, depending upon how you woke up in the morning, or depending upon you looking at the screen at a certain moment in time, it just creates a variable you don’t want to have to deal with.

Rebecca Hotsko (32:17):

That brings up a really good point. How can investors implement more rules based approaches to their own strategy?

Michael Gayed (32:26):

I encourage anybody and everybody that wants to invest to not look at a chart. Don’t look at a chart. Look instead at actual data, and actually do some back test.

Michael Gayed (32:38):

Now, back testing is interesting cause I do a lot of presentations on the road and at CFA chapters, and some people like back testing, some people don’t. Although it’s funny, because those that don’t like back testing seem to love buy and hold, but buy and hold is a back test. It’s a back test with one trade. Nobody ever thinks of it like that, but everything’s a back test. And sometimes back tests fail in real life when they’re implemented, like the back test of buying whole for Japan, going back to 1989.

Michael Gayed (33:04):

So everything in markets is a back test, number one. But for those that want to be active or tactical, take a more proactive stance on their portfolios, you’ve got to actually look at the underlying data of price movement, look at the sequence of returns in different regimes, and create essentially if/then statements, if this happens, then you do this trade, and here’s what the historical return tends to look like. There is so much nonsense in financial media, and so many things that are said that if you just did a very, very rudimentary excel data dump and did a back test on what people are saying has predictive power, you’d see that it’s all nonsense. The reality is there are very few true predictive things. I would argue utilities are one of them. I’ve proven that. Same thing with lumber, even though it’s not working this year, on average it tends to.

Michael Gayed (33:49):

But you can’t really get a handle on your potential future investment success if you don’t know what the past looks like in terms of your strategy. And if you don’t on top of that, test that thesis across multiple cycles, and then do auto sample testing as well. I can’t tell you how many people on Twitter are banging their chest around some trade they made on some cryptocurrency. “Oh, I bought here. My indicator’s perfect.” And it’s like, it’s a sample size of one. How do you know if that’s luck or randomness? You don’t. The only way to do that is to actually do some real hard data work and look at the sequence of returns and study. And it doesn’t mean you have to be a quant or a PhD. You can do this very basic rudimentary back testing with even just Excel, but the problem is that takes extra effort, and it’s a lot easier to simply look at a chart and extrapolate the most recent pass, goes back to the earlier discussion, into the future.

Michael Gayed (34:39):

But again, you don’t know if the most recent pass is an anomaly unless you back test to see if the current environment really is abnormal, and if there were prior periods like what happened, where it ended up reverting back to normal. I wish people would spend more time actually looking at historical prices, as opposed to just looking at a chart and drawing indicators on a chart. Actually create buy and sell signals and see the power and impact of compounding, and full signals within that compounding to really have a sense of what’s really happening in markets.

Rebecca Hotsko (35:10):

For the average investor, do you recommend this approach for them? A more tactical approach? Or would you suggest just a buy and hold strategy for those investors?

Michael Gayed (35:22):

It depends on temperament. If you’re going to back test and spend the time and effort to actually see what works and what doesn’t from an active perspective, well the next part of that is you have to make sure you stick to that. Because otherwise if you do a back test and then you have an emotional period where you simply override a particular signal, then what’s the point of doing the back test? Because you’ve now introduced the element of you into the investment decision making process. The emotional aspect goes back to that conversation.

Michael Gayed (35:47):

For those that actually want to do it, it’s not just a question of back testing. It’s a question of can you actually stick to whatever rules based approach that you back tested? If you can’t, just simply do a traditional asset allocation and close your eyes, don’t worry about the noise. Don’t worry about the here and now. And this is an important point too. If you don’t need the money tomorrow, if you don’t need the money imminently in your investment portfolio, why do you care if you’re down? Money is always moving. Your net worth is always changing, second by second. It doesn’t matter though, unless you have to use that capital for some emergency in the here and now, or for some expense in the here and now, because you then basically pull money out at what could be the exact wrong time in a draw down. But with enough time, you have to assume, hopefully, things come back. And if that’s the case, being passive does make sense for a lot of people. But if you’re going to be active, my point is be active in your own self education and make sure that you are not overly active to the point where you overrule your approach.

Rebecca Hotsko (36:42):

I want to move on to some of your tweets. I’ve been following you on Twitter for a while now. I recently saw a tweet about you talking about phoenix rising. Can you explain what this is?

Michael Gayed (36:56):

Yeah, it hasn’t been rising yet, unfortunately, and I don’t mean Phoenix, Arizona, which has been going through a pretty bad period in terms of home prices. When I say phoenix rising, what I’m referring to is the relationship of treasuries against stocks. That you end up having that inverse correlation kick in where stocks go down heavy, yields on the long end for treasuries also drop, and you get back to that kind of safe haven status of US treasuries. By the way, that’s important to note that that’s very different than saying bonds. Yes, treasuries are bonds, but treasuries are unique in the bond market, in that they don’t have that credit risk. Because at least in theory, US government can print dollars to pay off and make bond investors whole.

Michael Gayed (37:30):

The problem is a lot of people have basically written off treasuries as the quote unquote “Safe haven,” and I get it. It’s because it did not do what a historically tends to. It ended up being as bad, if not worse than buying holds on the way down in equities. Again, what I’ve called many times, my hell.

Michael Gayed (37:47):

Now if, and this is the big question mark, and this is what selfishly I hope is the case, if housing is in a bear market, if you’re going to have disinflation because housing is in a bear market, that means demand for mortgages drops, so you’re seeing a lot of data around that, pretty aggressively. That probably means that liquidity comes out of the system even more, which should be negative you would think for stocks, and again, housing [inaudible 00:38:11] tends top precede stock weakness, and probably means that treasuries again act as a risk off safe haven. The phoenix rising, that inverse relationship, that diversification benefit that comes from holding long duration treasuries against your risk on basket.

Michael Gayed (38:24):

At least I hope the phoenix rises, because if you are in this world where yields keep rising, interest rates, treasuries keep selling off, while stocks themselves keep selling off, it’s not to say that it can’t happen, but think about the implications when you have such a highly leveraged society of collapsing asset values with higher cost of capital. You’re talking about an explosion of deficit, in which case you and I have bigger things to worry about than the value of our portfolios, because I would argue if what we saw the first six months of 2022 were to repeat on and on and on, that feels like an apocalyptic end of the world type of situation for the entire system.

Rebecca Hotsko (39:06):

That kind of jumps into my next question here. You had another tweet that said the movement in the dollar over the last few days should scare you, and the dollar is acting like a sovereign debt crisis is imminent. I guess I’m just wondering, what do you mean by this, and how should investors think about this impacting their portfolios?

Michael Gayed (39:28):

That’s not meant to be hyperbolic or anything like that, when I say sovereign debt crisis incoming. But factually, most sovereign debt crises you see it first in currency volatility. So the dollar has been unbelievably strong, especially as we’re speaking, last couple weeks have been unbelievable in the surge higher. Why is that problematic? Because you have a lot of foreign entities that whole dollar denominated debt. So as the dollar goes up, it becomes harder and harder to get dollars to pay off that debt. When I say sovereign debt crisis, you never know where it comes from. You only figure out the narrative after the fact, but this movement in the dollar is disturbing, because if it continues at this kind of a speed and holds at this level, there’s very real stresses on the global system because of this.

Michael Gayed (40:10):

Now let’s take it a little bit further. What would normally be the response to a strong currency? You lower interest rates. Well, that’s not going to happen with inflation as high as it is. You’re in this really strange spot where you have something that could be a real problem for foreign dollar denominated debt, and for possible defaulting on that debt by some entities or some countries, whatever it be, and you don’t really have the ability for the federal reserve to counter it because them countering it then means inflation goes higher. This is a really nasty spot to be in. And my only point in referencing this is, from a portfolio perspective, from a practicality perspective, that’s another diversifier. I go back to, what are the three diversifiers? The risk off plays are treasuries, gold, and the dollar. It’s not a very popular opinion, but if you have stocks, you may want to own the dollar itself, which basically means short euro, short yen, because that can provide some very differentiated return streams in the event that the dollar is indeed telling you you have a sovereign debt crisis, which would be very negative for equities and may even be more bullish for the dollar.

Rebecca Hotsko (41:08):

So just circling back here then, if the dollar continues to strengthen, you mentioned a play would be short yen, short euro. Does that give a more bearish case then for an investor trying to diversify two emerging markets or developing economies in the near term, given that you would be long their currency by buying those equities?

Michael Gayed (41:32):

Usually emerging markets in particular do well when their currencies are rising against the dollar, which has not been the case. Again, I go back to that point. The best time to buy or to avoid a draw down is after one’s already taken place. Let’s say the dollar were to surge and you wouldn’t have a sovereign debt crisis. That’s going to be very nasty for emerging markets. That’s going to be very nasty for any foreign investing, and for domestic investing, because everything will correlate in the extreme. But there’s going to be a moment, there’s a price for everything where if that happens and there’s a real nasty sell off, you probably would want to buy into that capitulation for those stocks that are outside of the US. I don’t think it’s here just yet, unless the dollar were to start reversing, in which case you’ve taken off the sovereign debt crisis pressure, so to speak.

Michael Gayed (42:12):

But I do think it’s looking at emerging markets, looking at European markets, I would say even more so emerging markets, that’s going to be a really interesting place to just maybe consider allocating to in the event that there is an event, obviously waiting for the event to take place. Because that’s an area of the market also that hasn’t done anything for a decade. And I go back to that point about the Morningstar curse. You don’t know exactly when the cycle is going to favor, from a secular perspective, of emerging markets against the US. You just know that every day that goes by you’re closer to it. I know that doesn’t help anybody, because that could be closer to it meaning three years from now. But if you are going to be a true investor, who cares? That’s fine.

Rebecca Hotsko (42:47):

Okay. I think that I’m going to end it here today. I want to be mindful of your time. Thank you so much for joining me today, Michael. Before we close out the episode, where can the audience go to connect with you and learn more about your work and everything that you do?

Michael Gayed (43:04):

I appreciate it. The main thing is Twitter @leadlagreport. I mentioned I do these Twitter spaces, these live conversations with different thought leaders. That’s on an edited basis on a podcast I call Lead-Lag Live, also available everywhere. Twitter is often the best way, and you will see that my Twitter persona is very different than my podcast persona right here.

Rebecca Hotsko (43:22):

All right. I hope you enjoy today’s episode. Make sure to subscribe to the show on your favorite podcast app so that you never miss a new episode. And if you’ve been enjoying the podcast, I’d really appreciate it if you left us a rating or review. This really helps support us, and is the best way to help new people discover the show. And if you haven’t already, be sure to check out our website, Theinvestorspodcast.com. There’s a ton of useful educational resources on there, as well as our TIP finance tool, which is a great tool to help you manage your own stock portfolio. And with that, I will see you again next time.

Outro (44:00):

Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by The Investor’s Podcast Network. Every Wednesday, we teach you about Bitcoin, and every Saturday, we study billionaires and the financial markets. To access our show notes, transcripts, or courses go to theinvestorspodcast.com.

Outro (44:21):

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