Preston Pysh  04:39

I think people need to put it in context. So I think Jamie Dimon’s net worth is just a little over a billion. I don’t know the exact number, but I don’t think it’s much higher than a billion. And so if he makes a $26 million acquisition of some common stock, that’s 2% of his portfolio, you know? So it’s not a big position. When you look at it from that context, I know it sounds like a lot, but it’s not that much money to his overall portfolio size.

Now, just kind of a piggyback question on that, Cullen. So, when you think of banking in general, when we look over in Europe, and we look at Japan, and now they’re doing all these negative interest rates stuff. How are these banks going to stay profitable? And more importantly, do you see that environment kind of coming to the US over the next call it, three years? Do you see the negative interest rate environment kind of coming this way? And why?

Cullen Roche  05:33

It doesn’t seem like Janet Yellen is on the negative interest rate train, which I think is probably a good thing. My view on negative interest rates is pretty simple. So I think of all of this through the operational side of the way that a bank works.

A bank, basically, the way that a negative interest rate impacts them is that what’s happening in the central bank is taxing their reserve account. So the way to think about the reserve account in a bank, think of it like this, we use the banking system. Okay? So the households and consumers use the banking system. And the banks have their own banking system, which is the reserve system. So the Federal Reserve runs the banking system for the banks. And JP Morgan and Citigroup and all these other big banks, they run the banking system for the rest of us.

So these banks have to have deposited at the Federal Reserve and what the Fed is doing, basically, when they implement negative interest rates, is they’re taxing that reserve account. Okay?

So the thinking here is that if they tax this bank account that all these banks have, that maybe these banks will go out and make more loans, or they’ll take a little bit more risk or something like that, and they’ll do things that could maybe stimulate the economy through that channel. And I just don’t think that’s right.

I view banking as something that is almost entirely consumer demand-driven. So the demand for loans comes from the household sector primarily in the corporate sector. And if there’s no demand for loans, for whatever reason, banks can’t force more loans on the rest of us. I mean, they can reduce credit quality and lending standards. But that’s not necessarily a good thing. I mean, that’s what we saw during the financial crisis, leading up to it.

So negative interest rates act as a tax on banks, and banks will tend to just pass that tax on to consumers in other forms: in terms of fees and things like that. So I view it as a negative environment.

Preston Pysh  07:40

So let me ask you this, when you talk about there not being a big demand presently for private individuals or companies that take out loans, would you attribute that to the fact that there’s just too much competition in all these different sectors because of low-interest rates?

Cullen Roche  07:56

No, I think that the low demand for debt right now is a function of just the lack of health at the primarily at the consumer level. I mean, if you look at household borrowing, I think we’re plumbing. We’re still in an environment where the year-over-year if you look at the… Federal Reserve has a dataset on all this stuff. I think if you type in *CM debt on the Fed database, the economic database in the St. Louis Federal Reserve, you can see this chart that I’m looking at right now. And it shows household and nonprofit organizations year-over-year change in borrowing. And we’re at 2.5%, relative to…

Historically this has been at like, 7% to 8%. So we are lower than any recessionary period and we’re seven years into recovery here. So something really, strange has been going on in the household sector, for the demand for debt. I think that’s a big cause of why the economy has been rather weak in the last seven years. And it’s why I think in general, just the demand for the debt has been low because household balance sheets just aren’t fully repaired from the credit crisis.

Stig Brodersen  09:14

So, Cullen, what you’re also saying here is that now that the ECB decided to buy back 80 billion euros instead of 60 billion, that’s not gonna have any effect because the customers or the households won’t be credit-worthy or simply don’t have an appetite for taking on debt?

Cullen Roche  09:30

Right. So that’s the problem with relying too much on monetary policy. So the central bank has been… I mean, central banks around the world have been the primary policy tool that we’ve relied on for the last seven years. And the thing about central banking is that all of the central banks are just a much bigger version of normal things. So the only way or the primary way that a central bank can impact the actual economy is through the banking channel. So they have to try to influence the way that we borrow money or the way that we use deposits or whatever.

And the problem with relying on that a policy during what is essentially still a credit crisis of some sort is that the central bank can’t force people to borrow. So as a result of that, I mean, reducing interest rates, it makes credit marginally more attractive. But I mean, gosh, when a man is bankrupt, and you offer him a 5% interest rate relative to a 10% interest rate, he still says, “I can’t afford to borrow at that rate.” So there’s just very little that the central banks can do around the world to stimulate the economy at this point.

Preston Pysh  10:45

And I think that that’s a concern is this rivalry between monetary policy and fiscal policy that you’re hitting at? And it comes down to there’s no friction when you’re talking about implementing monetary policy as far as Janet Yellen, if she wants to raise rates or lower rates, she can do it. She’s dealing with a board of, how many people are on the board? Like 10 or 15 people that are like voting members of that board. And then they just make a decision.

if you want to complement it with fiscal policy. And you want to do that, well, now you’re dealing with Congress, and the friction that occurs to implement fiscal spending. Say you want to build, you know, a new bullet train from Vegas to LA to spend money domestically, or whatever fiscal thing you want to induce domestically. The buy-in that you need, and the churn and the time that it takes to do that is just, it just can’t happen. And so what we’ve had is this total polarization to fix this monetary policy instead of fiscal policy. And I think that that’s breaking things. I think it’s like somebody is lifting weights and they’re only lifting with their right arm and not their left arm and they walk around and look ridiculous.

Cullen Roche  11:54

Yeah, well, I always say this with quantitative easing that people always talk about monetizing the debt and things like that and how this could be inflationary. And I’ve since the day the QE was implemented, I’ve been saying this policy is not going to do that much.

I mean, QE One, I think you have to make an exception for QE One, because QE One was different because they were making a market in bad securities that it definitely bolstered bank balance sheets, for instance. I mean, they were swapping bad assets for good assets. And that that was just such a unique environment.

But once we kind of transitioned out of that environment into a more normalized economy, quantitative easing, it just swaps good assets for good assets at this point. I mean, we’re swapping Treasury bonds now for reserve deposits. So it’s a good asset for a good asset, you’re reducing the overall interest income to the private sector, which means that in the long run, what we’re doing is we’re reducing aggregate income to the private sector, which means that there’s a chance that QE, unlike what a lot of people thought it would be, you know, either high inflation or hyperinflationary, QE is potentially deflationary because it’s reducing the aggregate income to the private sector.

But the kicker here is that QE and monetizing the debt always relies on a consistent deficit, basically. So Congress is still running the quantity that can be monetized at any point because they’re the ones that are running. I mean, if the Congress and this Congress decides to start running a surplus, there’s that much less debt that can be monetized every year, which means that Congress is running that train of policy and where it goes along the way. So I’ve always said that the focus, especially in a credit crisis like this, should always be on fiscal policy, because fiscal policy is the mechanism through which you can substantively change the composition of household balance sheets.

Preston Pysh  13:58

I immediately get sucked into it. Trying to understand the end state of where all of this is going. Because in the short term, I think all that stuff makes sense. But whenever I look at Japan, particularly, and also over in Europe, my personal opinion is that’s a precursor of what we’re going to see here. That’s my opinion. But whenever I look at those two locations, let’s talk about Japan. They’re at a point where they’re taking this liquidity, and they’re purchasing ETFs and common stock off the market. So what they’re effectively doing is they’re taking assets on the market, whether it’s bonds, equity, either one of those, and they’re nationalizing it. That’s crazy to me. This doesn’t end well.

Cullen Roche  14:41

It’s funny, I think that some of this has to be put in some perspective because I think that we’ve been spoiled by hyper-growth. So from the period of 1900 to the year, I mean, 1999 basically, we had had incredibly high economic growth, ranging from 3% to 4% per year at the aggregate level. We’re just maturing, and we’re developing into more of an economy where the growth is still going to be growth, but it’s just not going to be the type of growth that we’ve grown accustomed to over the last 100 years. So in my mind, it’s not necessarily a bad thing. It’s just that I think maybe we just need to get used to this world where we’re growing at 1% or 2%. And that’s okay, in my opinion.

Preston Pysh  15:35

So I got a point. And I like the discussion of the time frame that you’re talking about in the uncharacteristic amount of growth that we saw, where I would like to maybe scope the timeframe that you’re talking about is from 1940 to 1980, particularly. And if we look at the time of this, so the Fed gets stood up, call it 1914 or somewhere around in there. They’re kind of ensuring that the monetary baseline remains fixed at its starting value until 1940. And they’ve got to pay for World War Two.

So from 1940 to 1980, what you saw was a Federal Reserve that started acting in a little bit of a different manner where they didn’t want the downturn in these business cycles is what they’re commonly referred to. They never zeroed it out. Instead, what they were doing is they were increasing the monetary baseline just a decade after decade for 40 years straight. And when they did that, they’re adding more monetary baseline to the system over that 40 year period, without ever taking it back out.

What they’re doing is they’re putting a loan into the system without any assumption for risk whatsoever. Now, you’re not having the monetary baseline being controlled or manipulated by the Fed. Instead, what you’re having is you’re having the banks controlling, that are driving those interest rates as they’re coming back down the hill to where we’re approaching right now is zero percent. Would you agree with that idea what I’m describing there, Cullen?

Cullen Roche  17:07

It’s tricky. I mean, when you have… I mean,  by definition, when you have a central bank, what you’re doing… I mean, if you look at what a central bank is, I mean, in the United States, all the Federal Reserve is a big clearinghouse. So if you kind of look at the history of banking, prior to 1913, the way that private banking worked was you were starting to see in the late 1800s, a national banking system.

What was happening was that all these different banks were working more as partners over time because you would have, for instance, Stig might bank at Citi Bank, and the Investor’s Podcast, LLC might bank at JP Morgan and if Stig makes a payment to The Investor’s Podcast LLC, well, they have to settle their bank accounts at the end of the day, basically.

And so what would happen? Before there was a Federal Reserve, these banks would all meet up basically, at the end of the day, they would settle in some private clearinghouse to settle all of their payments. And so you had these private clearinghouses that were run by the banking system, basically. But what would happen is because these were private run clearinghouses, during financial panics, the clearinghouse would shut down, basically, because then JP Morgan would look at Citibank and say, “Whoa, we don’t know what your balance sheet looks like. So we’re not going to accept your liabilities to clear this payment. So we’re gonna sit on this, we’re gonna let things settle down, and we’ll see if we can settle this payment maybe next month.”

And then all of a sudden, you’ve got this huge economic disruption, just because banks don’t trust each other. It’s almost like the plumbing in your house just shuts off because your bathroom doesn’t like your sink or something. And so that doesn’t work because that impacts everything else in the economy. I mean, all of a sudden, you’ve got industries that have nothing to do with a financial panic that is being impacted, because Citibank can’t settle payment with JP Morgan.

19:12

All Federal Reserve does or a central bank does is a central bank leverages the power of the government basically, or the aggregate private sector and comes in and says, “Okay, rather than have this clearinghouse be run by a private institution, what we’re going to do is we’re going to run this as a federal institution. We’re going to ensure that during financial panics, this clearinghouse will never shut down.”

And from that perspective, central banks around the world have worked beautifully for the last 100 years because, I mean, you saw this during 2008 when all the other banks wanted to shut down their businesses and JP Morgan thought that Bear Stearns and Lehman Brothers and all these other Washington mutual all these other potential banks were bankrupt, the Federal Reserve came in and said, “Hey, guys, calm down, we’re going to make a market in all this stuff. We’ve got your back, we’re going to support the whole system.”

And as a result of that, I mean, you had a situation there that was scary. I mean, General Electric couldn’t pay their employees potentially one day. I think they were the ones that called the White House and said, “Guys, if you don’t do something about this, we’re not going to meet payroll next week.” And the Federal Reserve came in and said, “Okay, that is not going to be a problem, because we cannot have credit-worthy companies that can’t settle payments, just because the banking system is shut down.”

So from that sense, the central banks have worked well. And by necessity, their involvement has gotten bigger just because the US banking system has gotten so much bigger and so much more complex. I think a lot of people have a tendency to blame central banks for everything and I just view it a little bit differently. I view central banks as  they’re just an intermediary to some degree mainly in clearing payments. And so I don’t think that…

20:50

I mean, for instance, let’s go back to the credit crisis. I mean, a lot of people blame low-interest rates on costing the credit crisis. But I hesitate to say that they had an excessive cause and effect there. I think that more had to do with just people speculating in a financial asset that ended up being I mean, God, that mortgage debt is something like 70% of all household debt in the United States. And so, add 10% to that, which is what happened during the credit crisis. And you take the most important asset in the world and the most important asset on the household balance sheet, and you make it potentially unstable. And so that’s all that happened.

That was, in my mind, that was just a speculative bubble that people bought into and the fact that interest rates were low or high before. I don’t think it would have mattered whether interest rates were 2% or 4%, I still think people would have been getting zero down and zero interest rate mortgages that they were getting before the credit crisis that ended up ultimately blowing up. So I guess I hesitate to blame things so directly on central banks.

Preston Pysh  22:18

I have one more comment but I’m gonna throw it over to Stig. So I’m glad you said it that way because I completely agree with you. I don’t think that Janet Yellen is out there trying to bring evil to the world. I don’t think that any one of these central bankers that have been in charge of the Fed over the last, call it 80 years, were trying to cause problems.

But what I do think that’s happened is that, in aggregate, they’ve made small mistakes. And that mistake is that they manipulated the monetary baseline without ever bringing it back to its most fundamental level. This is the money multiplier reserve ratio from 1940 to 1980. During that period of time, I think that if you added up all of those Fed chairmen’s in the decisions that they made. They made in aggregate, they made a bad decision in aggregate.

But as far as their decision on an individual basis, it probably didn’t seem like it was all that bad. But whenever you make bad decision after bad decision, and it adds up. I’m glad that you put it that way because I agree with you. I don’t think anybody is out there trying to wreak havoc and cause major issues. I think there have been mistakes and they’ve been made in an innocent manner, and they just haven’t been corrected.

Cullen Roche  23:33

Yeah, I think that’s right. I would say that there’s a difference between, I think, the central bank’s intended purpose as a clearinghouse and what we’ve veered into in the modern day of monetary policy where central banks these days are, they’re not just clearing houses. They do all sorts of funny things, whether it’s manipulating their currency directly or things like quantitative easing. Aa lot of that is, in my opinion, it’s just funny academic theory and stuff. I mean, a lot of these economists that run the central banks, are operating almost purely on a theoretical basis. I mean, nobody has any idea what negative interest rates even do. A lot of its just economic theory.

I mean, before quantitative easing was implemented in any mass fashion, nobody knew what it did. And I mean, I’ve got some of the most famous economists in the world on record, saying, basically, that QE was going to cause hyperinflation or that if all of these reserve dollars get out of the banking system, which is something that is quite impossible, then this would cause hyperinflation or high inflation.

So you had a lot of theoretical misunderstandings and policy being run by people who are essentially academics. I mean, Ben Bernanke, he’s a guy who was essentially an academic for his whole life, all of the sudden thrust into a central bank involved in the biggest crisis ever. And he probably managed it okay. I mean, all things considered, but at the end of the day, I think that the central bankers are a large degree, just theoretical academics who are implementing things that they don’t know if they’re going to do anything. So they’re almost throwing you know what at the wall and hoping that it sticks and does something. I don’t think you’re far off there.

Stig Brodersen  25:37

Well, we’ll come in so close guys to saying something nice about central banks, and then we’ll read it back to the fence. All right guys, so interesting discussion about central banks and QE and so on. And I think we were up to a good speed here. We have eight questions and we are done with the first one.

So the second question that’s about one of the most interesting currencies out there is the Chinese renminbi. And just a few months ago, IMF approved it as a reserve currency status. So we have seen a lot of volatility before and after. And just recently, the Chinese have pulled out capital that’s pressuring the renminbi. So, Cullen, how do you see the Chinese currency in the world economy the next step, a 12 month? But also, more importantly, in the decade to come?

Cullen Roche  26:28

Yeah, I mean, this is a great question, because I think I mentioned this last time. We talked that nobody knows what’s going on in China. I mean, I think there’s a lot of people out there, a lot of commentators who have opinions. And I mean, gosh, I’ve got an opinion on China. And it’s that I have no idea what’s going on because I don’t think you can trust most of the data that’s coming out of the Chinese government.

But regarding the reserve currency, this is a good topic to discuss because I think a lot of people misunderstand what it means to be a reserve currency. And the reason for that is that I think a lot of people seem to have this idea that the USA one day just  said, “Well, now the US dollar is the most important currency in the world, and it shall be bestowed upon us that we reap all the benefits of this.” And that’s not real, that is to some degree what happened. But the reason why we were able to say that in the first place was that we had become the largest and most important currency in the world by-product of our global output and our global importance to the global economy.

And so in that sense, reserve currency status is something that is earned and it’s earned through the hard work of the institutions and the firms that comprise the entire aggregate economy. So China’s situation is interesting because I think people look at, you know, like the IMF decision that you mentioned. And they say, you know, “Can the IMF bestow reserve currency status on China?” And that’s just not the way that it works. China has to earn its status as a reserve currency, they have to prove to the world that they produce the goods and services in the world that deserve to be held as a reserve, basically, for the rest of the world. Do we find the Chinese currency to be valuable enough in global trade and trustworthy enough in global trade for people to want to hold that currency as a reserve basically?

And so in that sense, reserve currency status is something that has to be earned. The Chinese can’t just say, “Oh, we want to reserve currency status, and now we’re going to have it.” People have to trust what is coming out of the Chinese government. They have to trust the currency and they have to want to hold that currency as a reserve and we’re not in a situation where I think that the Chinese currency is becoming increasingly important. But it’s still when it comes down to it. I mean, the dollar is just something that everyone has a lot more trust in when it comes to global currencies, just by the function of our economy is so dynamic and very transparent. I mean, our government and central banks are incredibly transparent relative to all others.

Stig Brodersen  29:29

So Cullen, let’s talk more about the relationship between the US dollar and the Chinese renminbi. So I think, as most of the audience is familiar with, the Chinese currency used to be pegged to the dollar, but now they’re pegged to a basket of currencies. And so for instance, they’re still pegged to the dollar but only by 26%. So what do you think would be the direct trade implication of this in the medium to the long run for the US?

Cullen Roche  29:54

So China is reversing years and years of valuation in the renminbi where now we’re going through something that’s unusual and something that is potentially frightening because… And I think this is what’s caused a lot of the turmoil in the financial markets over the last six months is that people don’t know what’s going on in China. They’re worried that now the world’s second-largest economy is going to go through its own version of a 2008 or something. And people don’t know how that’s going to impact everything. And what the Chinese government has started doing is they’ve started devaluing the renminbi, I think, to try to offset some of that domestic weakness. So they’re trying to make the Chinese currency more attractive relative to everything else, to bring in more exports, essentially, and boost growth. And so you’ve got kind of this situation where I mean, gosh, a lot of different governments are trying to do some version of this where they’re trying to devalue their currency relative to everything else.

In my view, it’s been potentially bad for the United States, because we’ve seen just a huge rally in the dollar in the last year or so relative to everything else. And that’s bad on a relative basis, it’s bad for primarily US corporations, and their potential profits going forward is the big hit.

So that, it potentially all boomerangs back to us in the form of this negative trade impact and negative corporate profit impact that hurts domestic companies and ends up potentially reducing domestic employment and things like that. So the kicker is that nobody knows exactly how bad things are in the Chinese domestic economy right now. So they’re doing things that look unusual and extreme. And I just, I mean, I wish I had a great answer for this, but I just don’t think anyone knows how bad things are in China. I think, I mean, gosh, I’m not bearish at all on the US economy right now. I mean, I think here’s pockets of weakness certainly. I mean, if you look at places like Texas and the Dakotas, and places that are oil-dependent, I mean, they’re in a full-blown recession right now. But at the more aggregate level, things don’t look that bad in the United States. But I just had no idea how all this stuff in China is gonna boomerang back to us.

Preston Pysh  32:26

So, Cullen, it’s interesting that you say your opinion on the US market not being that much of a bear. So one of the questions that we have here… So billionaire Ray Dalio, whom I know you’re familiar with, just released the white paper saying that there’s an asymmetrical downside risk to the US market due to prices, only offering about a 4% yield at their current market price. And this enormous currency pressures combined with no interest rates, kind of providing this thrust in this momentum to potentially push the US equity market and stock market lower. So you don’t agree with Ray. And I’m just kind of curious, where do you see things differently than him?

Cullen Roche  33:08

I would say that I see things. I mean, in terms of the way that the monetary system works. Dalio and I see things very similar because we… I think we view things through the idea that a modern monetary economy is just a bunch of balance sheets and income statements. I mean, that’s really, if you look at it, if you look at the US economy, the US economy is made up of a whole bunch of big excel spreadsheets, and that’s kind of all it is. To understand how all of that’s interrelated, it’s all about understanding assets and liabilities.

And so Dalio has this theory have a short term debt cycle and a long term debt cycle. And he says that we’re at the point in the long term debt cycle where we’ve exhausted all potential asset and liability growth, basically. And I just don’t fully agree with that notion, I guess of a long term debt cycle. I think that the economy has operated more of a steady-state and that you have… At times these unusual deviations that cause either recessions or in the case of 2008, you had an abnormal growth in balance sheets where you created essentially the environment for a credit crisis. And so you have potentially a lot of short terms debt cycle.

But I guess I don’t agree fully with his idea of a long term debt cycle and this notion that balance sheets necessarily have to become over-leveraged in the long term. I mean, you mentioned earlier that are we all heading towards the situation of Japan. And I just don’t I don’t think the world has to enter that an environment where we all become like Japan. I think Japan’s environment is unique to its own, you know, just being an island nation with a depleting population at this point.

In the aggregate, I don’t think the global economy has to look like that. So I guess that’s the big point where we disagreeing is that I just don’t, I don’t know how to digest the idea of a long term debt cycle and something that occurs over the course of in his model, it’s 75 years or something like that because we just don’t have any data on anything like that. I mean, the economy in a modern state hasn’t even existed for more than I mean, 100 or 150 years? You could say that we’re operating in just the post war period in terms of how the modern economy is operating. So there’s just no data supporting the idea of a long term debt cycle, I guess.

Preston Pysh  35:55

So I see a completely different than you, Culdifferents interesting because whenever I look at interest rates, and you just kind of look at since, call it 1942, where we’re at right now, you can see this long term debt cycle. I mean, it’s really, in my opinion, it’s very clearly defined. When you look at, call it the 10 year Treasury, you can see it go up and you can see in 1981, it peaked and then it’s come down ever since. If you go and you look at PE ratios on stocks from 1940 till now, during 1980, when interest rates were sky high, the multiples that people paid on equities or stocks were extremely low comparewereo what it’s been in the last 10 years because interest rates are now low. So for me, I see it. I completely agree with Dalio’s position that in his opinion in that article is that the Fed is missing the long term cycle and they’re just looking at the short term cycle and that’s going to cause their fatal mistake in the long run.

Cullen Roche  36:51

I’m glad you brought up PE ratio because I think that kind of dovetails nicely with this that people sometimes I think look at things like the Shiller CAPE ratio And they say things like, “Well, this is high relative to its historical norms.” And I just, I don’t know how to put that in perspective, because I don’t think that there’s any reason why can’t a PE ratio of say, I don’t know what it is today, the Shiller CAPE is at something like 16 or 17, I think something like that. And it’s usually it’s historical averages something like 12 or 13, I think.

So people say the market is vastly overvalued. And I just, to me, the concept of value is something that is it’s so dynamic, it’s so subjective, and I don’t see why. I mean, 50 years ago, we might have thought that to use beauty as  an analogy, we might have thought that this fashion trend was beautiful 50 years ago, and today it’s something different. And I kind of view stock valuations as being something  similar that why can’t the public perception have what is valuable today just be different than it was in a different era.

And in that thinking, there’s no reason in my opinion, why a PE ratio of 16 today, why can’t that be just the new normal or so relative to 12, but the way people perceived it 50 years ago. So I just, I guess I don’t always look back at these historical data sets in and say, “Well, historically, these have been mean-reverting. Therefore, this has to revert back to the mean, which means that we’re in a state where we should all be either bearish on stocks or expect stocks to fall by, you know, 30, 40 50%, or something like that.” Just because people’s perceptions are not changing is what the theory would say. And I don’t know if that’s right, I guess.

Preston Pysh  38:52

So I kind of see it the way that you’re talking. I think that there’s a qualitative piece to it. But at the same time, I think that there’s definitely a mathematical piece to it. So one of the things that we did whenever we built the website, BuffettsBooks.com is we created this discount cash flow calculator. So I wrote the math behind this thing to try to understand it myself and you know, post it on the website. And when we’re doing that you play around with all the different numbers and things that you get. If you got a fixed amount of cash flow, let’s just say it’s $100 from now into infinity, and you’re going to discount that back and an appropriate discount rate. Warren Buffett always says to us, you know, the 10 year Treasury is kind of the ruler or the benchmark for that discount rate. So let’s just say we were using 10%. We’re going back a couple of decades, and we were using 10% is that 10 years Treasury yield that years get. So we’d be using that as our discount rate. So not adjusting the future cash flows of company x, okay? And qualitative all stays the same as interest rates change the multiple that people are going to pay over or below that 10% is I think the key starting point and that’s where you have to look at it from that mathematical standpoint.

If the 10 year Treasury is now at 2%, the premium or the discount that people are going to pay over above that is drastic, in my opinion, it drastically impacted by that change on the interest rate scale. And so whenever I look at this Ray Dalio you know, 70-80 year cycle, that’s why I’m saying you go back to the 1980s, the premium that people paid on a stock is significantly lower than it is right now. And you if you plotted that PE ratio from 1940 to present-day today, I think you would see a pretty strong… Now, the premium the discount would kind of change as the business cycle that’s, you know, riding on this long term wave, it would fluctuate but in general, you would see the lowest premiums people pay for stocks, definitely in the 1980s. And I think it’s completely based on those interest rates. So I guess I’m trying to sell you on this.

Cullen Roche  41:02

So I like, I guess here’s the thing, I guess maybe I’m the one thinking too much in extremes because I feel like what I tend to see, people will look at current PE ratios, and they say 2008 is coming back. And I think that that’s oftentimes the implication that a lot of people have that because stocks are at a, you know, whatever 30 or 40% PE ratio premium to what they have been relative to the historical norm that people then say, “Oh, well, the S&P 500 has to fall back down to 1000 or 1100,” or something like that.

When PE ratios are high, we tend to have lower future returns. And when PE ratios are low, we tend to have higher future returns. And that’s just  I think that that’s just sound operational thinking. I mean, the way that I think of it is if you took a zero-coupon bond, I mean, take a treasury bill for instance. And have you ever…  A treasury bill that’s at 2% today, if that bond, if that bill, this is the second after I buy it, if that bill shoots up to a 3% interest rate, what happens is the future value, the future return of that treasury bill, it has to increase.

So someone who bought that bill tomorrow, or a minute after I bought it when interest rates jumped up, they’re buying something that will generate a higher future return. And if you think of the stock market in the same sense, the exact same thing happens when the stock market rises and falls in value. When the stock market rises in value… I mean, years like 1999, what’s essentially happening is you’re pulling future returns into the present. And so the future returns are there just mathematically have to be lower because the stock market cannot sustain 50% returns because corporate profits don’t grow at 50 percent.

Corporations, literally, they cannot pay out those types of returns with any consistency. So that’s what tends to happen when you see these huge bull markets is people excessively pull future returns into the present, which means that it just means that the future returns are going to be lower. So I guess what I’m saying is that I just think of things more in terms of PE ratios are high, which means the future returns are going to be lower, but it doesn’t mean that the PE ratio has to go back to 12. Does that make sense?

Stig Brodersen  43:33

Yeah, I think it makes a lot of sense. And Preston and I have discussed the PE ratio a lot of times in the podcast, and I definitely see where we’re coming from terms of saying that value is like a relative thing. And it’s definitely influenced by the interest rate. But I think the way that… I want to say we but I don’t want to pull Preston into this. I guess I kind of disagree with you, Cullen, in this sense that basically, the value of any asset is the cash flow produces. So it is mathematically restricted by how much cash is going to the spin-off. And if you look at the value of a stock, it’s like, basically, you’re just discounting that cash flow. And if you look at the value of the stock market, you’re thinking, “How much could I make if I owned all the stock in the market?”

So I definitely like the notion of thinking of the new normal. But if it only has that increase it only has to the interest rate, it’s just not sustainable the way I see it, because whenever the interest rates will go up whenever that will happen, you will simply see that the dropping your yield anyway. So I’m trying to politely say that I disagree with this. But I think it’s interesting because we had brilliant people like Jeremy Siegel, who’s saying exactly the same thing as you are. So you might be right, he might be right too.

Preston Pysh  44:54

The thing that I will say, Cullen, that I do appreciate that I think a lot of people don’t have is the appreciation for the qualitative piece. And they immediately say, “Oh, it’s a PE of 25, it can’t go higher.” Well, and that’s a bunch of bunk because you could just go back to like 1999, you can see, it can go a whole heck of a lot higher, because of this qualitative dot-com boom that happened during that period. So I think I do believe that you have to have a balance of both the qualitative and the quantitative, and how you look at it. And I’m glad you brought it up. There’s definitely validity in what you’re saying.

Cullen Roche  45:33

I feel like we maybe agree more than I’m leading everyone to believe. I mean, I’m certainly no Jeremy Siegel.  I’m critical of extremist thinking of any type. And I think that Jeremy Siegel is one of these guys that he will advocate 100% stock allocations for most people most of the time, which I just think is crazy. And I guess that’s  the thinking that I’m trying to avoid with a lot of this stuff is, you know, just because PE ratios are low, it doesn’t mean that you should be excessively bearish about stocks.

Even though I agree with you that I think future returns are going to below. I mean, my equity model outputs about a four and a half percent 10-year average return on US equities going forward, which is low relative to historical norms. So I’m not this you know, raging crazy bowl that maybe I’m coming across as, but I’m also not this doom and gloom jump in your bunker type of thinker where I say, “Oh, well, just because the average historical PE ratio was 12. It doesn’t mean that your returns are going to be lower.” But probably in the next 10 years, you’re probably almost with 100% certainty going to do better in an aggregate stock market index than you will in an aggregate bond market index or certainly an aggregate cash index. So that’s, I guess, kind of where I’m thinking.

Preston Pysh  47:03

All right, so we’re over the hour mark. We got through what was it three questions, Stig. Yeah. And we were forcing it. Let me tell you we were forcing three questions.

Stig Brodersen  47:14

Yeah and we wanted to put in the extra question because we were talking back and forth before the interview was like, “Hey, listen to this too because we have plenty of time, like an hour into, right?”

Preston Pysh  47:24

We got to wrap this up.

Cullen Roche  47:26

I talked too much. I’m sorry, guys.

Preston Pysh  47:29

That’s not it. So here’s the thing I know anybody who listened to this conversation can have a deep appreciation for how smart Cullen Roche is. So one of the things that we talked with Cullen before recording this episode was syndicating his blog posts on our website. So if you don’t go to the Prag Cap website, we’re also going to have it, his feed of the articles that he writes. And how many articles do you write a week, Cullen?

Cullen Roche  47:54

I usually try to publish one thing a day, basically.

Preston Pysh  47:58

Awesome. Awesome. Okay. Some of the articles that he’s publishing, we’re going to try to syndicate that onto the blog tab of our website. And if you don’t go to our blog to see some of the differences because we’re different going to publish every single one that he writes. But if you do want to get his feed and see what he’s writing every day, you can go to pragcap.com, and you can see what he’s talking about. And some of his articles. I know he’s also on LinkedIn, and I see a lot of his feed through LinkedIn. So you might want to add him there as well. If people want to know more about you, Cullen, where can they go and, and learn more outside of Prag Cap?

Cullen Roche  48:30

Well, Prag Cap is the best place to start. So actually, if you go on the Prag Cap website, and you click on the tools and resources tab, I’ve got a tab for education, which is probably the thing that would be most useful to people and that will link it to my corporate website where I have a page called Understanding Money. And that link is I mean, it’s hundreds of links to just basic understandings a lot of things that I was going through today where, you know, talking about the basics of central banking and understanding what the reserve system is, and getting into kind of the operational things.

I think that I tend to view things sort o  almost from the perspective of like an engineer, where I view the whole monetary system is this system that you can understand how the pieces all kind of fit together. And if you can kind of understand think of it like a car, basically, you can look at the parts of the car and understand well this is attached to that, and this is attached to that. And if I push this nozzle, then this will do this, and that will do that. And if you can kind of then just understand the behavioral piece of it, which is the person that you put into the car and understand kind of the almost the behavioral finance side, you can get a sound understanding of how the financial system works and how the economy works.

Preston Pysh  49:56

So we will definitely highlight that link to the resource page that you have in our show notes, so if you can’t remember what it is just going to our show now is just going have a link to it. And I’ve been on this page that he’s talking about, and it is beyond in-depth.

Cullen Roche  50:10

I just published a free new white paper called Understanding Modern Portfolio Construction. And that kind of dovetails with my paper Understanding the Modern Monetary System, because it’s the financial explanation of why we allocate assets. Whereas my monetary system papers, it’s a lot wonkier. It gets into central banking and banking and things like that. And I think your listeners will probably find them the modern portfolio construction paper a lot more useful and a lot more applicable because I just go into again, some of the operational aspects behind why we allocate assets, where returns come from why certain assets generate the returns they do. And I touch on stuff like the discussion we had earlier where, you know, thinking of returns and where returns come from and putting PE ratios in perspective and valuations and things like that, and trying to understand how all this is applicable in a real-world setting.

Preston Pysh  51:12

Fantastic. So, folks, that’s Cullen Roche. Cullen, thank you so much for coming on our show and taking time out of your day to have this discussion with us. We have a blast when we talk. So thank you for coming on the show, Cullen.

If anybody out there wants to sign up for our newsletter, where we read our different books, go to theinvestorspodcast.com, and then you can subscribe to our email list. Also, to you’re wanting more information, something that comes out twice a month, and you want to get our blog posts, and you want to try to follow the show a little bit closer. Go to Facebook type in “We Study Billionaires” and you’ll see our fan page pop up. And that’s where we’re going to be posting blog posts and you might see some of Cullen’s articles being popped up from our Facebook page. So go ahead and like that and we’d love to have you as part of our audience on Facebook or on our email list. So thank you guys so much for your time and we just want to thank Cullen Roche for coming on the show. We’ll see you guys next week.

Outro  52:05

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