Vineer Bhansali: Physics, Tail Risk Hedging, and 900% Coronavirus Returns – #43

Steve and Corey talk with theoretical physicist turned hedge fund investor Vineer Bhansali. Bhansali describes his transition from physics to finance, his firm LongTail Alpha, and his recent outsize returns from the coronavirus financial crisis. Also discussed: derivatives pricing, random walks, helicopter money, and Modern Monetary Theory.

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Transcript

Steve: Corey, our guest today is Vineer Bhansali. I have known Vineer since we were both teenagers in Page House at Caltech. Vineer graduated from Caltech, did a PhD in Theoretical Physics at Harvard University under a very famous physicist named Howard Georgi. He was also in a way a disciple of another physicist named Sidney Coleman, who’s very famous. I think Vineer and I’ve written one paper together. Is it one or is it more than one? At least one, right?

Vineer: Yep. One.

Steve: And now, Vineer is part of the group of physicists who really pioneered quantitative methods in finance. I believe he left physics first to go to Citi, then he was at Salomon Brothers for a while, and then had a long run, I think as head of research and also a fund manager at PIMCO,

Vineer: Yep.

Steve: And now he runs his own fund, which is called LongTail Capital-

Vineer: LongTail Alpha.

Steve: Oh, sorry. LongTail Alpha. Excuse me. LongTail Alpha, excuse me. I hadn’t talked to Vineer for a while and I just saw him in the news because LongTail Alpha made some outrageous returns in the last month and quarter, really in a way because of the financial crisis induced by Coronavirus. I thought we’d get on a call to talk to Vineer, both about what it’s like to be a theoretical physicist who then transitions into a career in finance, but then getting into the strategy and how his fund works and maybe his views on what we have ahead of us in terms of more systemic risks, or just in general, more risk in the financial markets in the future. How does that sound, Vineer?

Vineer: That sounds fantastic.

Steve: I want to present to our audience a little bit of a personal portrait of Vineer, because he is one of the most fascinating guys in my whole life that I’ve met. I want to repeat, we’ve known each other since we were both teenagers. I just want to tease out a little bit of a portrait of Vineer before we get into the nitty gritty of what his fund does and what’s going on in the financial markets.

Steve: Vineer, you grew up in India.

Vineer: Yep.

Steve: Came to the U.S. to attend college at Caltech …

Vineer: On a one-way ticket.

Steve: One-way ticket.

Vineer: Only one quarter paid for.

Steve: I didn’t know that, but-

Corey: What part of India?

Vineer: From Rajasthan, northwest India, but my dad was in the railway, so we kind of lived all around the country.

Steve: I think the entire time I knew you, your dream really was to do theoretical physics, is that right?

Vineer: Absolutely.

Steve: Now we maybe had some friends, you may remember a guy called Cojot-Goldberg that we went to Caltech with, and he maybe knew that he was going to be in working in the financial markets even then. But I don’t think either you or I would have ever thought, at least I had never thought at that time that I would ever be working on Wall Street. Was that true for you as well?

Vineer: Absolutely. I actually, not only did I know nothing about it though, I knew negative about it because I willingly tried to forget everything I knew about finance. I had no intention, no desire, and as a matter of fact, Steven, you and I were at Harvard and move and we’d wrote that anomaly paper. That was when I was applying for, I think my first postdoc. You were a junior fellow and I was just finishing grad school and we wrote that paper and it got accepted. It was a pretty kind of formal paper for a student of an advisor who was a phenomenologist, but regardless, it got published and I think the fact that that paper, that paper got published more or less sealed my fate that I was not going to get a good postdoc.

Steve: Yeah, it’s all my fault.

Vineer: Exactly. Anyway, regardless of that, so what happened is I kind of decided to spend some time at Harvard, trying to do a little bit of an unofficial postdoc. And at that time, luckily enough, this was the second year that I got a call from a Wall Street firm and I can get into what happened. But yes, the short answer is that when I went out and interviewed at Wall Street, I had literally zero knowledge and zero desire for knowledge about finance and about Wall Street.

Steve: Right. So let me, let me tell a story, which it’s locked in my memory, but maybe it’s apocryphal. So you should correct me, but I remember you went to Citi and at the time, this is aged knowledge, Citi was not one of the leading, most prestigious firms like Goldman or maybe JP Morgan was more prestigious. But I remember your logic was they gave you the best comp offer and you were going to save up money because you thought, Oh, if I work there one or two years, I’ll save up enough money to do my entire postdoc from what I save.

Vineer: Exactly

Steve: Then get a faculty job in physics. So you, you were using Wall Street as a way to continue your physics career, at least at the beginning. Am I remembering that correctly?

Vineer: Oh, absolutely. So, when I was leaving grad school, I got this interview from Goldman. I went to Goldman, I sat across from an elderly gentleman who was taking notes, who was also a physicist at one point in time and I could read his handwriting upside down. It said, basically knows no finance, is extremely good at math. And I came home and I called my roommate who was a PhD economist at Harvard and I thought, I was at Goldman and I met this guy. His name was like Black, something like Fisher Black. I said, are you kidding me? You met Fisher Black? I said, yeah, Fisher Black. And they offered me a job and I turned it down because they weren’t giving me enough money compared to Citi where they wanted me to be a trader, which I had absolutely never traded before.

Vineer: I had no desire to trade before. And they were going to give me for extra money. And when I asked them, so wait, I can come here, work for a year, take this money, then leave and do my postdoc. Right? And they said, I mean this is a free country. You do whatever you want. But my plan absolutely was to go there and learn and have fun with like a sabbatical or a year off. And then after doing that, just go and do my postdoc. I think I had one at UT Austin and I had one in Marseille, France. I’ve been, I think I had another one-

Steve: Spain?

Vineer: No. Marseille, France. I think I had one in Salamanca. Exactly. I basically deferred all three and I said, I’m going to go do this for a year. And then the money that I’ll save up should be enough for me to survive for at least a couple of years. Cause Supercollider had just gotten shut down. So the chance of actually getting a faculty job was absolutely impossible. Even getting a postdoc was pretty much like a dream. Right? So I primarily took it just to have fun and save up, save a little bit of cash.

Steve: Now for our audience, Fisher Black is the famous co-inventor, or at least he’s credited with the code invention of the options pricing model. Black-Scholes model, which every finance student now learns in school. And so to be interviewed by Fisher Black, for someone who didn’t know anything about finance, it was just another former physicist hanging around Goldman. But for other people, that was amazing. And had Fisher Black lived somewhat longer, he would’ve won the Nobel Prize in economics-

Vineer: Absolutely.

Steve: Because Scholes did win later on. So at what point did you finally consider yourself a finance guy? So how long did it take?

Vineer: I still haven’t. I mean that’s as simple as that. [crosstalk] It’s very simple. Right? So Steve, so I am, I got, I kind of landed in this field with essentially no knowledge, no training and almost no desire to actually learn any of that stuff. So it was mostly learning by doing and I considered myself to be on a pharma sabbatical, like an extended sabbatical. And if you remember, Mark Wise who was my advisor, a [inaudible] advisor at Caltech. So Mark and I communicated when I was in New York, primarily about physics and we are very good friends as well. And when I came to PIMCO, I was head of research or head of analytics at PIMCO and a fund manager. And I basically wrote to Mark to start doing finance search. And he and I wrote 25 almost, 25 published finance papers. And he’s an amazing physicist as you know, right?

Vineer: A heavy court guy. And we also wrote a book together. And I still think of myself, I’m still involved with Caltech quite a bit. I still think of myself as a little bit of a misfit, physics, math, computer science guy who just ended up in finance and kind of learned everything backwards, like learned by reading the book from the end to the beginning. And I’ve written three books in finance myself. But if you open up those books and you start reading them, they’re still more like a, almost like a physic physics book to you or in many cases almost like a story of options. So I still don’t consider myself a finance person, but what has happened is that once you spend 25 years plus like I have done in the field, you basically learn a lot of tricks of the trade and people start considering you to be a finance person.

Vineer: But I mean I’m an empiricist, I’m a, if I have any skills a little bit, it’s perhaps thinking outside the box and being able to write a model that hasn’t maybe hasn’t existed before. And then, like many of us, I’ve used Mathematica and other symbolic programming languages and Python now as a basically a crutch as a tool to take these complicated imaginations that I’ve had and turn them into something that actually makes conceptual sentence. And when we get into what’s happened in markets over the last five or six weeks, you’ll see in spades that part of the reason that we were able to not only dodge it, this is the fourth or fifth time, knock on wood that I’ve been able to dodge these massive market avalanches. I think that is the reason is because I’m sort of not a mainstream finance person because I think more like a physicist or a math or a computer science guy than a finance guy.

Steve: Yeah. I think Fisher Black was famous for also being an out of the box thinker and he had all kinds of very fundamental questions, which were things which puzzled me too about the fundamental nature of money and the role of the Fed and banking and things like this which actually we maybe, if we get into the topic of MMT, we could actually get into some of those things at the end of this podcast.

Corey: Guys, for the audience, for their point of view, it’s easy to use the term out of the box, but can you give us a concrete example of what you regard Vineer as conventional finance thinking? And then a way in which one might think differently.

Vineer: Yeah. So that, that’s a fantastic question. So let’s go back to Fisher Black for a second and go back the famous Black-Scholes option pricing-

Corey: Yeah, so give us a finance 101 or a physics guy 101 turned finance person’s view of the [crosstalk] Black-Scholes-

Vineer: Yes, absolutely. So, that’s where we should start. So, let’s start from the absolute ground up. So, let’s say you wanted to buy protection, meaning some sort of insurance against the stock market falling. So the stock market just fell as you know, and you wanted to buy an insurance, but you didn’t want to sell all your stocks out. So instead of selling your stocks, you could just go out to a Wall Street dealer or go to the Exchange and buy what’s called an option, which essentially gives you the right, but doesn’t obligate you to sell your stock holdings at a certain price. So you can just say, look, I’m going to pay you an insurance premium of 1%, let’s say. And as the market falls 20%, then all I’ve spent at 1%, but I don’t lose more than a certain amount, maybe I don’t lose more than 3% or 5% so that’s what’s a typical option.

Vineer: That’s called a put option. And that insurance policy, will basically lasts for a certain amount of time. It could be a day, could be a week, could be a month, could be a year, whatever.

Corey: Okay.

Vineer: Now, it’s a very interesting question. So the question is, what should the seller of this insurance policy or option charge the buyer? What should it be the premium? So it depends on a lot of different things. Well, how high is the market? Where’s the market going to go? How uncertain is the market? Et cetera, et cetera. Just like a typical insurance policy, right? If you’re insuring your home against a fire, you need to know, well, how likely is a fire? How vulnerable is my house to a fire? Et cetera, et cetera. Am I an irresponsible person? Et cetera.

Vineer: Now, the beautiful thing is that about almost 50 years ago, a number of people, the most famous of them are these three Nobel prize winners, Bob Merton, Myron Scholes, Fisher Black. And even before that, Ed Thorp, and even before that, there were a lot of empirical people had come up with a formula, essentially. A formula, which is, I’ll describe the math of it in a few minutes in layman’s terms. But the formula basically gives you a simple way of calculating the price of the insurance policy, given certain input parameters.

Vineer: Okay. So a 20 or 25 years ago, before this formula came along and this formula is called the Black-Scholes formula, it used to be pretty much people would observe the enactment supply on this insurance policy. And based on the demand and supply, determine what the price of that option should be. But then there was a massive breakthrough by a bunch of physicists who said, look, this is a simple, what’s called a boundary value problem or, and you can actually solve this as if you were solving the heat equation in physics. The heat question is a simple equation that says if you heat, let’s say a piece of metal on one end, how will the heat transmit across the bar of metal over time? How would it actually diffuse? So the mathematics of what we’re trying to solve for the insurance policy is almost identical to the heat equation in Physics-

Corey: Why is that? What quantitative finance corresponds to heat? [crosstalk]

Vineer: So, right. So. It’s a little bit like the price, right? So, the where is the price and the distance away from where you’re hitting it is called the strike in the case of the option. And how much you, what’s the variation in the temperature of the heat is basically what’s called the volatility. So there’s one to one tera-volts. And you have to [crosstalk]

Steve: Sorry, sorry to interrupt. But Corey, one of the hidden commonalities between the heat diffusion problem and a stock price or option price is that there’s a random walk.

Corey: Exactly.

Steve: So in the case of the molecules that are being heated, there’s some random walk going on, of molecules bumping each other. And in the case of pricing the insurance policy, you are in a sense summing over all possible future paths of the stock price. And that’s a random walk as well. So, the underlying similarity in the mathematics is coming from an assumption of randomness underneath.

Vineer: Exactly. That’s exactly right. So this is where the fun starts, right? So if you’re a physicist, as many of us are physicists on this podcast, you know what the limitations are for applying a physics model like the heat equation to real world phenomenon like behavioral people. Liz. So when Fisher Black and Myron Scholes and others wrote the heat question down and solved it in a beautiful form, in the form of essentially a closed form solution for this problem. They also listed simultaneously what the limitations were, that this was a simple model. Now, as a physicist, I understand what the limitations are, but there are a lot of participants in the industry who basically take the formula as gospel truth and assume that it applies under all circumstances and it’s a completely ideal formula that has no exceptions. So they basically take what’s given in the marketplace, they cranked the formula as a machine and expect the answers to come out the same every single time.

Vineer: The big difference between physics and between finance is that finance is driven by people and behavior. And what Steve mentioned, what Steve just mentioned was the random walk. The random walk is a great tool in physics. And perhaps in mathematics to solve problems because it reduces everything to simple Gaussian integrals and so on. Well, real financial markets are not random walks or there’s sort of random walks, but there are times when they’re not random walks. They’re actually significantly auto-correlated and they have fact build meaning the underlying distribution are not Gaussian. They’re actually significantly fact built and levy distribution. So my specialty and my business is specialty. And this sort of explains what you were talking about before about our funding and our strategies and so on is that we specialize in thinking outside the box to identify how does the random walk actually, how do the markets actually deviate away from the random walk in a very systematic, predictable, not very predictable in 100% sense, but it’s probabilistic sense when large events happen.

Vineer: When large events happen, think about what just happened the last few weeks. It’s a little bit like, and a better analogy would be an avalanche. And I’ll tell you that story in a second as well, but you’re out there like I was in early January on the mountains and you’ve got fresh powder on the ground. The sun is shining and you feel great and you want to climb up this very nice, deep slippery slope. And I was ready to do that. I was getting up and at the end of December, that was one of my activities. I was getting up a mountain up in Mammoth and I suddenly realized that I am actually at the critical angle, right after a massive snow dump on a sunny day, which is when my activity can perturb this avalanche and bury me and dead, right? So I ran back and I read a book on how to survive an avalanche terrain.

Vineer: And what you find is that there’s a lot of non-linearity in that system and once that avalanche starts, it’s the sand pile effect that we all know, suddenly the thing will just collapse up under its own weight. Financial markets are more similar to that then to an idealized random walk where things are very well behaved. So what just happened over the last three to five weeks was, as the market started to cascade down, it triggered a further action from participants that ended up triggering further action and further action. Put it into basically sand pile type of effect.

Corey: Sorry Vineer, so you’re saying there’s sort of a random walk and then, I’m trying to sort of interpret this for a late person, probably me. There’s some unpredictable events then after the unpredictable events happen, certain somewhat predictable events happen. Is that, right? So saying these things are auto correlated. Once you get correlated, once you get these kind of unexpected, but rather catastrophic events that are somewhat random, you can then predict certain events off these random events. Right? They are not quite deterministic, but they’re kind of expected.

Vineer: Yeah, it’s actually very interesting. You cannot predict the outcome very precisely. So just like, go back to the avalanche analogy.

Corey: Very precisely.

Vineer :
So just go back to the avalanche analogy, you cannot predict when the avalanche will start. You cannot predict the probability perhaps because it’s a rare event. But what you can say is that once it starts…

Corey: Yes.

Vineer :
… At a certain critical angle, then it’s almost impossible to stop it.

Corey: Okay. And do you know something of its dynamics once it starts?

Vineer :
So you don’t know its dynamics, but you can predict what the damage will be given the surroundings, right? So let’s say you were to have an avalanche and there’s nobody there. Well who cares because if the avalanche starts, nobody’s going to get hurt, nothing will happen, no damage will happen. But let’s say there’s an avalanche that starts next to a very highly populated area. Now you know there’s going to be casualties. So now think about that framework and bring it to the financial markets.

Vineer :
So what had happened, and this will probably find as a natural segue and after this conversation, is our belief for the last three years has been that the ecosystem of the markets had become extremely vulnerable because of certain actions by participants and by government policies that had resulted in, even though the phenomenon itself was unpredictable, once it started, it resulted in a cascade whose consequences are very predictable.

Corey: So what were these actions by government and individuals that you thought put the market at risk for? I assume not just unpredictable events, but for a large fall.

Vineer :
Yes. So that’s where we’re coming to. Okay. So what happened? You have to step back macroscopically and look at very long, very long at least 20 years history and say, how are the different pieces evolving over this 20 year history to create certain weaknesses of the system.

Vineer :
So let’s just go back. Not 20, only 15 years. So what happened in the global financial crisis of 2006, 2007, 2008, 2009, was there was a very large system of security, asset backed securities, which are basically linked to home prices, et cetera. Credit default swaps that you might’ve read about it, securitized credit. All these are buzz words. I can explain them to you if you’re interested, but a big ecosystem developed, which resulted in the global financial crisis of 2008-2009 now, it’s not very important for us to think about what actually happened in the global financial crisis. What’s important is just realizing that there was a reaction function from not just the federal reserve and the US but the European central bank, the bank of Japan, typically all global central banks in order make the system survive. Back starting in 2008, 2009 they cut interest rates down very, very significantly close to zero and they essentially made it impossible for market participants to generate any yield.

Vineer :
So right, if you’re a pension fund or you’re an investor, you need your terms, you need some return on your deposits. So instead of getting returns on deposits, the ecosystem actually got even more perverse.

Corey: They sought out more risk to get better returns.

Vineer :
Yes. So instead of seeing though, so let’s say you just want to get maybe 2% yield, 2% return, and you’re setting either in Japan or Europe or even in the United States. But the United States, you could have gotten 2% about two years ago. But if you’re sitting in Europe, the European central bank, which is like their federal reserve, they cut interest rates to negative territory, right? So here’s a great thing for a physicist though. You know, in physics, we don’t expect that a perpetual motion machine can be built, that’s really a perpetual motion machine. But in finance, if you create a situation in which you believe that you can take interest rates, negative meaning you give me your money, Corey as a deposit. And also instead of me paying you interest on the money that you’ve just deposited to me, you have to pay me more money every six months. You would say, well that’s silly. But that’s the situation that we were. And we still are on 20 trillion worth of bonds. Sorry, go ahead Steve.

Steve: Yeah, Corey, if I could just jump in. So typically when you’re comparing different asset classes, you have a risk issue and then you have a return issue and if the central banks are forcing interest rates to be zero or almost negative to generate any return, they’re forcing you into much riskier assets.

Corey: Exactly.

Steve: So many people have in the last few years have come to the opinion that these central banks basically inflated an asset bubble and a lot of people were kind of waiting around a lot of macro hedge fund managers thinking, Hey, this market is very vulnerable. It’s going to go, it’s going to go. And of course it’s very difficult to time the market to figure out what’s going to happen. But I think a lot of people have been just waiting for the pin to drop, the straw to break the camel’s back.

Corey: The exception was that people got out of effectively government bonds and savings then got into the stock market.

Steve: For example. Any kind of risky assets basically because you have to generate your return.

Vineer :
Right, but more perverse than that, and we’ll get into that question. Go ahead Steve.

Steve: Yeah. So let me, instead of focusing on that sort of general macro situation that’s persisted in the last few years. I want to just before we go further talk about the investment strategy of Long Tail Alpha, because it’s not just that you thought there might’ve been an asset bubble because there were plenty of other funds that have very different investment styles, few that also maybe thought there was an asset bubble. But I think you, and maybe Nassim Taleb as well, because I don’t know exactly what your investment strategy is for Long Tail Alpha, but you have set yourself, your fund up in a very distinct way from most other hedge funds. And so maybe you could just talk about that a little bit.

Vineer :
Right? That’s great. So let’s talk about that because that’s very critical. So there’s basically two opposing camps in financial markets, maybe not opposing camps, but two complimentary viewpoints. So the one viewpoint, which is the viewpoint that you sell insurance, you sell insurance to somebody who needs it. And they provide in exchange Steve, for that insurance that you’re selling some return or some premium, which is like an option, right? So that’s what’s called the generally called a risk premium harvesting or short volatility strategy. So that strategy if you think about it conceptually depends on mean reversion because it says that I’m going to sell an insurance policy and nothing will happen so I’ll get to collect and keep the premium that somebody else is paying me for. The second school of thought. And that’s basically based on random walks, mean reversions, et cetera. The second school of thought, which is what I subscribe to a little bit more, most of the time, not all the time, is that markets are inherently non random.

Vineer :
Over large time scales, you get audit correlations over large timescales the distribution is not mean reverting. It’s actually very, very fat tail, and I’m not the first one, I’ve been all [inaudible] abroad and others have written about this for decades and decades and decades. But the question is, that’s a philosophy. That school of thought says, that whenever you think that you’re getting paid a big insurance premium for selling something, be very careful because you’re probably missing something and typically, and then we’ll come back to this because there’s very, very important event that happened over the last four weeks is people confuse alpha or value added with selling what’s called liquidity. So selling liquidity is a classic example of selling insurance and saying, I don’t need the liquidity, you need the liquidity, so pay me for it.

Vineer :
Our approach is actually the opposite. Our approach is we value our liquidity and we believe that if liquidity is being given to you cheaply, you should take it. So Long Tail Alpha strategy and that’s why the firm’s called Long Tail Alpha. When I started the firm in 2015, I wanted to remind myself that we are always long the tails of the distribution, whether it’s on the left side or the right side.

Corey: So Vineer, let me stop you for the audience, okay. Because when many people think of liquidity, they just think of cash and now can you explain to people in what sense you are selling liquidity, if people are often just thinking of cash and nice to be giving people more easily exchangeable assets. And then after that please go on to discuss the different tails of the distribution and what sense you are fat tailed and what that means to be right or left because that’s what [inaudible].

Vineer :
Yeah. So that’s actually an excellent way to look at it. So when we talk about liquidity, so like you just mentioned Corey, it’s liquidity in its simplest terms is having enough cash, maybe cash under your mattress or cash in your wallet. And that’s the kind of liquidity that will essentially keep you afloat or pay your bills when you need it. The problem is that that liquidity that you keep in cash most of the time can become very expensive because you get no return on it. Like we just mentioned in Europe, interest rates are negative and the U S interest rates are zero so you don’t get much return for it. So the trick, I guess the trade is how do you manage to keep liquidity, meaning have liquidity when you need it while at the same time getting return on it? And this is where, what we do, is use the derivatives markets and use all the different asset classes that exist, bond markets, currency markets, commodity markets, equity markets, to have liquidity you want, at the same time get some nominal return.

Vineer :
Now I just want to correct you on something. We’re not sellers of liquidity. We actually are typically buyers of liquidity and will willingly buy liquidity from somebody else who is wanting to give it to us when liquidity is cheap. Okay? So coming before entering this crisis back in January or February, liquidity was for sale. You could get as much money as you want. Rates were very zero, but people did not at that time show a preference for that liquidity. What people realized is in February and March that despite all this money that’s being printed by the central banks, there actually wasn’t much liquidity in the system because the system has gotten much larger over the last decade than they ever thought. And that’s kind of where I was taking the story while I was thinking about what happened post the financial crisis. Is this excess liquidity ended up in what we call an ecosystem of short option strategies.

Vineer :
So let me explain that for you and your audience a little bit. So as Steve mentioned before, one way to get return on your assets or on your securities is to invest it in an asset. Where you actually go out and buy a stock or a bond where you are getting some interest income. Another way of doing that is to suddenly imagine that you’re actually an insurance provider and you’re going to write insurance policies in the financial markets, and because of academic research that says that generally speaking, selling insurance is a positive expected return transaction, meaning you make money over time. A very large ecosystem of strategies developed there that were all simultaneously selling insurance. So you don’t need a license to sell financial market insurance. You can just go into the derivatives markets and to exchange and sell an option. And by selling the option, you earn a premium and you can think if you want, you can think of that premium as interest income or yield.

Vineer :
And everybody started doing it and that’s why the paper that I wrote in the Financial Analyst Journal is called, Everybody’s Doing It and it’s called them shadow financial insurers. And that system got so large that any small fluctuation, any small fluctuation would result in a complete implosion of the system as everybody rushed for the exits to basically control their own risk. So what has happened in the last week or 10 days or maybe four weeks we’ve seen is this massive exodus out of those shadow insurance type of strategies and everybody ran for the exit and that created a massive unwind of that ecosystem. I don’t know if that answered your question.

Corey: So when people unwound, so I guess I want to step back a little bit, right? You said you don’t need a license to sell insurance, but you have to have something to sell. So do I go out and buy insurance policy from somebody else and then try to sell it to another person? And then I’m going to become some sort of sales person and then I acquire these insurance assets and then I over the last month or so just basically liquidated my position. Is that…

Steve: If I could jump in. So I think what Vineer meant when he said sell insurance and he said you don’t need a license is that you can just go in the derivatives market and either buy or sell a derivatives contract, which is in effect granting some insurance to the counterparty and then you’re paid for that.

Vineer :
Correct.

Steve: That’s a concrete example of someone being able to sell insurance without being regulated. I mean, you have to be allowed to trade in the derivatives market. But that’s it.

Vineer :
But yeah, let me give you a very concrete example of it. So let’s say you came in January, you came and you were in the markets, the perception of risk was very, very low. Everybody felt that the stock market was going to keep going up and up and up and let’s say Corey, it was you and I, and I asked you how much Corey would you sell me a contract, with the following specification, that if the stock market was to move no more than 10% up or 10% down from where it was at that point in time, you would take this premium and keep it, but if it moved more than 10% up or down, then you would pay me any excess movement beyond that 10%. So that’s a specific contract and it’s basically called an option straddles, right? So I come to you and say, sell me this contract Corey, and tell me what your price is for selling me this contract, that essentially that the market is not going to move more than 10% either way.

Vineer :
Okay. Then let’s say you came up with the number and you said, okay fine, I’ll charge you 1%, and I’d say, okay Corey, great. So you sold me that contract, sold me insurance against the market moving more than 10%. And I paid you 1% upfront premium for every $100 I pay you a dollar. Now fast forward to middle of March. The market has moved 30% now you’re going, Oh my gosh, I said, if the market moves more than 10% I’m going to make Vineer whole, but it’s moved 30% so I got to pony up 20% and he only paid me 1% for this insurance policy. I’m in such a deep hole. So what do you do? Of course, you’re not going to wait all the way to the end. What are you going to do is as the market moves, you’re going to do something.

Vineer :
You’re going to try to either go and buy that same contract from somebody else, or you’re going to sell the stock market in order to manage your risk. That’s basically what’s called hedging activity or rebalancing activity. But that activity actually creates the value of the insurance policy now to go up from 1% which is what I paid you to 20%. So suddenly you are suffering a massive loss. And because I was lucky enough to buy it at the right price at the right time, I took my one dollar and it became $20. Does that make sense?

Corey: Absolutely. Yep.

Steve: Now the model Corey is just this crystalline mathematical thing that says, Oh yeah, there are fluctuations in the market and then the applied price of the contract goes like this and like that. But some of the things Vineer just mentioned are second order effects where you realize, Hey, the guy on the hook for the insurance policy, he has only a finite amount of capital and he has to start adjusting in real time to what’s going on. And a bunch of people are just like him. So you get these nonlinear feedback effects, which are like an avalanche.

Corey: Vineer, how do you take advantage of these nonlinear effects? I’m assuming you did somehow.

Vineer :
Yes. So, first, you need to know and you don’t always know. First you need to be able to enter this contract. In this case, I was lucky to buy this one from you when in my model I would’ve said the price should have been five. So you were selling it to me for one because you got so conditioned over the last five years with nothing bad happening. I’m going to collect that one and that’s good enough. The second is you just had need, you wanted to keep it because somebody told you, Hey, go and get the income because interest rates around the world are so low. So you’re like, sure, and I get 1% from this guy, I’ll take that. Now what we do is we eventually in this particular case we’re like counting cards, right? If you’ve read Ed Thorp’s famous book from…

Steve: Beat the Dealer.

Vineer :
… Beat The dealer, right? So we’re essentially, and every participant does this, so everybody counts cards. So we’re counting, we’re counting, we’re trying to figure out how deep is this ecosystem? Who’s involved? How strong are their hands? How weak are their hands? What is their reaction function? And every 10 years or so this cycle actually undergoes the same carnage and when it doesn’t, it actually emboldens people, which means on that table you’ve got a lot of very brave people now who have entered because they feel that they figured the market out and suddenly all the signatures, exorbitant elation, greed start showing up in various places and at that point even you don’t know. You definitely don’t know that taking the other side is going to be profitable.

Vineer :
But just like in the counting cards example, the odds start to tilt in your favor. That’s essentially what we do. We just say, what is the asymmetry for us? How much can we lose if we take the other side and how much can we make? If what we think is likely to happen happens, and if the asymmetry is good enough, then again as a quantitative or maybe just like the poker player in that example that I gave you, you are playing the same odds over and over and over again. So statistically if you played long enough and the odds are even slight amount in your favor, sooner or later you’re going to win. And that’s what we do. Yep.

Corey: One of the great memories from the big short was that a couple of the guys who made a lot of money had this basic theory that people underestimate the probability of rare events.

Vineer :
Correct.

Corey: You know, and so just like you said, someone thinks it’s quite unlikely this is going to happen. You’re pricing it at 5%. Basically you thought it was a little more likely than I did, and priced it only at 1%. But I’m curious about, you’re saying when you’re trying to count cards, there are millions of people in this market, right? When you’re playing poker there is like four. Are you simply looking at the largest actors, the central banks? You know, when you’re trying to figure out how much risk these people are willing to take. So who are they? Are they large institutions are they individuals? How do you do this on a macro scale? That is, how do you scale up a poker game? Just where there’re millions of participants.

Vineer :
So that’s the beautiful thing. Again, coming back to thinking outside the box, right? So in physics, we have this, and maybe I just got lucky because I came to this field from physics, so you know, and then…

Vineer: Field from physics. So condense matters theorem many body physics. You don’t need to know what each atom is going to do. All you need to know is statistically what the collective system is going to do. So from a macro level, if you know that I’m good… And that’s in one of the papers that I sent Steve. If you know you take a pot of water which has millions of molecules and you start heating it, at some point you’re going to have a phase transition and it’s going to convert. Go from water to steam. So I don’t really need to know what individual atoms are going to do. All I need to know is some microscopic characteristics of the system.

Vineer: Now, in this simple example that I gave you, what we found by our own research and by talking to people and reading people and so on, is that everybody for very valid responsible reasons was conditioning their portfolio construction on a very simple parameter, which in the markets we call volatility or implied volatility of options. Goes back to black short. That is where we started. Everybody, the black shows most important parameters. What’s the level of volatility or uncertainty? So different participants at different macroscopic scales all the way from lowest timescales to fastest timescales. We’re conditioning their decision making process on the same parameter called volatility, but at the same time they were telling each other or they believed that they were actually not doing the same thing. Sorry, go ahead Steve.

Steve: So Veneer, I believe what you’re saying is that in the derivative’s ecosystem or just an actually larger ecosystem, there were a lot of people whose strategy was essentially short volatility is that fair? [crosstalk]. So they wanted… They were banking on low volatility in the markets to make-

Vineer: Correct.

Steve: … spread to make their money. And so you became aware of this and you thought, “Oh, the returns will be X size will be extremely outsized if in fact there’s a spike up involved.” And so that was your… The result of your research and your research had nothing to do with Corona virus, right? You didn’t actually have a view on what was going to cause the spike in fall. It was just that you wanted to be prepared for a spike in fall. Is that fair?

Vineer: Absolutely correct. And as a matter of fact, in my year and my review, which I wrote in January 2020 on my look back at 2019, I wrote about that and I picked up on a book by Robert Shiller who is a Nobel prize winner out of Yale and Robert Shiller’s books called Narrative Economics. He actually describes how just like the pandemic spreads, how fear and greed spread. So he’s basically is a dependent model for fear and greed. And it’s a model called the S-I-R model of how many people are susceptible, how many people that are infected and how many people are recovered. And it’s a very simple three differential equation model that was written out in 19 hundreds by Kermack and somebody else, the second author. I read this thing and I go, “Oh my gosh, this is incredible.”

Vineer: So when I wrote my retrospective in January of 2020, I actually referred to the fact that look, Avalanche has happened the rhetoric can change in a second. And if you haven’t been rented, go read Robert Shiller’s book. This was like early January. I had absolutely no idea that COVID or coronavirus would actually do anything. But the fact of the matter is that, even though this is a disaster medically and so on, if it weren’t COVID 19 it would be something else that would start this cascade. That is my firm belief. And that’s how it always is. Over the last a hundred years, whenever there’s been a market crash, the last straw that breaks the camel’s back is the one that you don’t expect. And then retrospect, if people say, “Well look, it was that unpredictable disease that did it or the Archduke was shot before the world war or something like that.

Vineer: And then people start fighting the last Wars and the last battles. So this is not the last time my market crash is going to happen. In the next crash that will happen, will happen because of unforecasted reason. But will happen because of the same fear and greed taken to its extreme. And maybe in another decades time.

Corey: Maybe is it a question I’m always want to ask him. You’ve made a lot of money through a certain strategy. What would have to happen for you to lose a lot of money with this strategy. So I assume that the markets would remain fairly stable for one or two years. You lost a bunch of money. Is that correct?

Vineer: Exactly, that’s not a bunch of money. So that’s where the asymmetry comes in, right? So that’s the fantastic question that this question comes up over and over and over again. So let’s say you buy a… You live in a nice house and you’ll have a home insurance policy, and let’s say you pay 1% for protecting your home against a fire.

Vineer: If 10 years pass by and your house doesn’t burn down, you’re going to lose 10% but you’ll still be pretty happy that you got to live in that house and protect yourself. So the way we think about it is that you allocate the amount of premium and you increase and decrease it based on your forecast and so on. But at the same time you have to be okay with having multiple years where you lose a finite predictable amount of premium. But at the same time, when the inevitable event happens, your payoff is some significant multiple of the premium that you spend. So you’re absolutely right. In the last five years or so, we and other people in this space bled some fraction of the money that collectively all made. And that was okay because that was a planned expenditure and could’ve gone on for another five years and it would’ve been another five years of planned expenditure.

Steve: Now Veneer, in order to get LPs limited partners to invest in your fund to do this, did you find you had to find LPs that were fairly smart, fairly quantitative, who understood your strategy, who weren’t going to get mad at you after three years of small losses and they had to really deeply understand what you’re trying to do. Right?

Vineer: That’s so. We have multiple strategy. I can’t talk about our fund, but we have multiple strategies and that described in the articles that you read about us. So there are certain strategies where you have to be very upfront and tell them that you’re spending premium, but you’re getting a levered exposure to the left there, right? All right there. So they are… They have to come in knowing that they can lose that 1% premium or whatever the number is. But if the event happens, they might make a very significant multiple. [crosstalk] We’ve got others where we also do other things.

Vineer: We tried to make back some of that premium, but generally speaking, most of our strategies are such that if the markets took bump around or are stable, we actually underperform the others. Right? So in last year when the stock market was up almost 30% we absolutely underperformed. No question. But that’s okay because hopefully everybody has plenty of stocks and they don’t need us to act better. So we had our diversifier and our LPs are those who are now painting us because when the stock market’s down 20 or 30% they need something that actually creates a diversifier for them and that’s what we’re doing for them.

Steve: Now, as I mentioned at the beginning of the podcast, you popped into mind for me because I read an article reporting on your ginormous returns in the last month and last quarter.

Corey: Let’s not be vague about this. What were the returns over the past month?

Steve: Yeah. So in the articles I read numbers like 400% return in a month through in a quarter where I think what they said and I think there was even one number for I think return on invested assets, which was something like 900%. Yep.

Corey: Can you confirm Veneer?

Vineer: I can point to the numbers as reported in articles are accurate. Yes. So you’ll have to go look at the articles with actual numbers. Yeah. That’s Right.

Steve: Now. When I contacted you I was thinking to myself because I basically went through this process when I was learning about the Corona virus. When it was still just happening in China, but I was very convinced it was not going to remain bottled up in China. And then so I started looking at my own investments and so around, I guess it was late February, I went all basically all to cash in my own portfolio. And later on I was thinking to myself, well, back in the day when I used to actually do derivatives trading on my own, I probably would have made a bundle of money, but I’m so out of practice.

Steve: I didn’t even have a brokerage account for trading derivatives a couple months ago. And so I just ended up going to cash, which was good enough. But I thought to myself, “Hey, a bunch of these smart hedge fund guys were probably thinking the way I was thinking and they must’ve made some just incredible outsize returns.” And so when I contacted you, I thought you were going to tell us a story about spotting the Corona phenomenon and then making the trades, but actually you are just prepped for this catastrophe already. You had nothing to do with reasoning about Corona. Is that right?

Vineer: Exactly right. I never told… I mean I have a firm rule. I find the temptation having done this for now, 30 years, goof forecasts, unpredictable thing. I know I can’t do it. I don’t focus the market. I think part of the reason perhaps maybe that I’ve been able to survive so long in the markets is that I actually don’t even work out the probabilities very much. I only look at the severity, right to any gains or losses in any contract or any transaction or any security. It’s the product of the probability of that event happening and conditional on that event happening. What is the gain or loss, which is called the severity. So I always focus on the consequences and I try to kind of hold my own ego at Bay when it comes to forecasting. So if you’d asked me back in January, what do you think of this coronavirus thing?

Vineer: I probably would have said that, “Ah, is going to blow away.Nothing would happen.” Because the whole global health system and the global economies shut down because of a virus. Impossible. It just cannot happen. I mean in this day and age of technology and medical research. I sometimes feel like I… And obviously Steve like you perhaps that I’m living in a novel like in fiction here, but I absolutely did not forecast the concept of the coronavirus but once the signature, the telltale signatures of the consequences on the Dervish markets, which is basically the illiquidity if I can get into that on how we actually started to kind of gauge the temperature of the markets do then say, “Wait a minute, this is the event and this is going to get ugly.” At that point in time we knew that, this was it anyway, but I did not forecast it just to be very clear.

Corey: So when it’s quite interesting that you say this is the event because we’re in the middle of it and it’s not clear what the event is, whether it’s going to end soon, whether the markets are going to go back soon. I know you can’t disclose the details of your strategy, but it’s curious when something like this happens, you change after the event happens or you just keep kind of maintaining a pretty stable approach rather independent of events. Because again, you can’t predict the future now anymore than you could probably four months ago.

Vineer: Yeah. For you, I took it not predictive and I don’t know how long it takes. I hope it’s over soon. But I’ll tell you what started to happen. So the atomic building blocks or financial markets are a couple of futures contracts that everybody trades. And let me tell you why there’s atomic losing building blocks. So over the last decade I told you the story of how this incredible ecosystem of what we call short volatility strategies started where everybody is telling an auction. Now, what theory tells you is that if you are hedging an option position, then again going back to Black-Shcoles and assumptions of continuous transactions and no transactions cost, you are able to trade the futures contracts and equities called the mini futures contracts that trade on the Chicago mercantile exchange. Is the deepest single market in the whole world and it is the atomic building backup option traders because at any given point in time you assume that regardless of how big you are, you’ll be able to buy and sell enough of these futures contracts to locally make our position unexposed to the markets called delta hedging.

Vineer: Now what we started to see, and the same thing with the treasury market, something called the treasury futures market. Very big market. Literally Trillium’s grade on an average basis when things are liquid. Now coming into February, what we started seeing is a very critical telltale signature, which is that the liquidity, the total amount of size that is shown in the exchanges basically went by a factor of one 20th okay, so let’s assume that a hundred is your normal size. What was being showed in the futures contract, which you see in real time flash and all day long went to five. Okay, so one 20th. So on the one side what you have is, as I said in my hypothesis an incredibly large ecosystem of people who all have to Delta hedge or hedge or sales or buy futures contracts. And on the other side, the liquidity one 20th okay?

Vineer: So at that point, my visual is a big elephant and that very tiny needle. The elephant is 10 times larger than I have ever seen in my career, including the four crises I’ve lived through; 1994, 98, 2000, 2007, 2008. So I know just by counting cards, counting participants that the size of their derivatives markets is between five to 20 times larger. And in front of my eyes, I see what everybody’s banking on. The futures contract, it’s liquidity is one 20th you multiply 20 by 10 tells you things are 200 times likely to get worse order of magnitude 20 maybe 2000 who knows? Nobody knows. When you have a system where there’s a dislocation that’s a hundred to 200 times larger than you ever seen before, you know what to do. You know what’s going to happen. And that’s because the market makers are electronic. Sorry, go ahead.

Corey: This is really fast. And you basically got unpack all of that. Used a lot of terms. I think many people are not going to understand what’s a deep market, right? Delta hedging what… many of our listeners may understand this, but explain how you actually hedge in such a way that you may limit your risk and what it means to have this asymmetry between essentially the size of the driver’s market and what you’re saying futures. Just when you say futures of one 20th people are not selling and buying futures at that point in time. Is that correct? So anyway, just you unpack that member back to kind of finance one on one level.

Vineer: Absolutely. And I apologize because I went to a lot there. So okay, so let’s go back to where we started. Option. So go, are you solving an option? And I bought that option. You sold it to me for one dollar and I owned this option. Now not the market starts to go against you and you know that you’re losing money. So what you do is you plug in all the parameters, the current stock price, the volatility interest rates into your handy dandy Black-Scholes calculator. And out pops a number, which is basically the local derivative, the derivative, the price, the underlying, which is a stock B price. The option B underlying which is called the Delta first derivative, and that says, “Corey, if you want to not have a market exposure right here, right now, you have to go out and sell X number of futures contracts or stock market.”

Vineer: You have to sell this many stock to actually be locally neutral, meaning have no exposure to the market because that’s where you want to be. You always want to be, if you don’t have a view, you want to be what they called flat. You don’t want to have any effort. So you say, “Okay, great. My formula tells me go ahead and sell X number of contracts.” Well, let’s go back to the ecosystem now as you’re doing it, so as everybody else who’s got the option that they’ve sold to their class customer, they’re doing exactly the same calculus and they’re saying, “Let’s go sell too.” So you’ve got a line of people who are lined up into the exchange, all wanting to sell. Now on the other side, somebody has to buy them. So in the old days, the buyer used to be a video or a Corey or Steve who would say, “Sure, I’ll buy it from you at the right price.”

Vineer: But because of the technological improvements we’ve had in trading over the last 10 years, the person on the other side is not a person. It’s a machine. And the machine’s masters, I’ve told it when Corey comes to sell and a million other Coreys come to sell to you, just say no, just turn the switch off. Okay. Say, “I’m not playing.” That’s what I call illiquidity. So you come in and you say, “Hey, my model said that there was going to be this person, they’re willing to buy. Where is he?” Well, he’s not there because he’s a machine and the minute he saw you coming, he said, “I’m not there.” So suddenly you thought there was all this work on market depth. You saw… You expected somebody to take the other side and bail you out. But 99 point X percent was a robot.

Vineer: Somebody, the algo that turned off and then there was one human there who said, “Oh my gosh, Corey is going to come and run me over so I’m going to back off.” So you suddenly go to zero essentially, except for somebody who is required to make markets that make more sense. So Steve was a wrestler. This isn’t like mano-a-mano man on man wrestling. Okay. This was like the audience. Right?

Corey: But, doesn’t standard supply and demand theory say there’s going to be somebody out there who will take it? Then might give me much money for it.

Steve: That’s a theoretical abstraction, Corey. But when there’s actually a crisis situation, those approximations may not hold. So you may not find people stepping forward or that there may be a huge imbalance of people wanting to sell and only a few people wanting to buy. And so then it becomes an illiquid market.

Corey: Got it.

Vineer: So this is more similar to the picture you should have in your mind and not the picture of a stock market or financial market, but of a big sword or knife as we call it, falling from the sky.

Steve: Catching the knife.

Vineer: And you want to… Are you going to… You knot that somebody should catch it. But do you want to be the one catching it? Probably not and so then the nobody wants to catch it. Yeah.

Corey: But this confuses me because I’m thinking of your statistical analogy, right? And there was a million molecules out there, some of the molecule out there that’s going to catch this thing if there’s so many of them, it’s just a matter of probabilities. And shouldn’t this all just smooth out eventually given that, the prices change enough to make it appealing?

Vineer: Absolutely. And that’s exactly right. That is the key word. The price has to fall to a point where it’s either appealing or somebody like the federal government has to come and say, “We will catch the falling knife because we have an infinite printing press. So come on.” Right? Now they came on after a while, but until they came on, there are a number of people like myself who have tried to catch the falling knife. When I first started in 1991 I tried to catch it all at night and I won’t use the proper French for it, but when you realize what happens to you, you just, “Sorry not doing it again.” So what ultimately happens is you end up finding a price level at which somebody says, this is the greatest discount that I’m ever going to get. And that happened about two weeks ago. And I can tell you some examples.

Vineer: … I’m ever going to get. And that happened about two weeks ago, and I can tell you some examples of stuff that was creating what we call “money good.” You’re going to get your money back on this stock, that was trading at 20, 30, 40% discount to its fair value. At that point, somebody said, “Okay, enough,” let’s step up and spend our dollar, because we don’t care.

Vineer: Now, one other problem is that there are lots of regulations, for good reason. They’re called circuit breakers, which don’t allow the markets to fall or rise beyond a certain amount, only 5%, 7%, 10%. Something like that.

Corey: Does it applied to rises too, Vineer? I thought it was just falls.

Vineer: It applies overnight session and also applies to rises in the futures markets. But there’s limits on both sides because they will just want you to cool down basically and to not get panicked, which is a very good thing by the way. But those circuit breakers were set when that so-called knife used to be a Swiss knife. And they’re not set up for today’s world. and that, you know, it’s like King Arthur sword. So you know, so you’ve got a massive 20 X bigger ecosystem and the circuit breakers are like this. And that’s what you saw in the two or three weeks ago is every day you would come in and the market will do a limit down, meaning it can’t move anymore, or limit up, limit down, limit up, limit down, limit up, which basically means that the markets are not allowed to move. So ultimately, the markets were completely dysfunctional. It was complete structural breakdown of the markets doing that one week period.

Corey: Sorry, Steve. Just one question. Had the regulations kept up with increase in size of the market, where would these cutoffs occur now?

Vineer :
That’s a very tough question. I’m not a regulator. I probably shouldn’t opine. I’m sure people who know about this have thought about this and they’ll come in. But all I can say is either the size of the cutoff should have been larger or there should have been, in my view, some other mechanisms through which the system should have never been allowed to get so out of control where this kind of event were to happen. We basically had a 10 times or 20 times larger market getting through a 20 times smaller needles hole. And that imbalance essentially is an imbalance that should not have been allowed to happen, I guess.

Steve: So Vineer, are the markets restored now that the helicopters have been dumping money on us and the printing press is running overnight? Do you see these liquidity problems solved now? Are the markets back to normal or are you still seeing some dislocations?

Vineer :
No. So the short answer is, it’s been a big help, but the true answer is that it’s a fix in the wrong places. Whenever a regulator… and I’m not a complete free market, do whatever you want, believer, at the same time, I do think that central banks and federal governments have to pick and choose, and they’re picking and choosing winners. What we saw in the last couple of weeks are unprecedented actions where the central bank of the U.S. is buying private market assets. They’re buying corporate bonds now, they’re buying high yield, they’re buying ETFs, people in the market are front running them. You’ve read about that. So what’s happening is that the markets have two functions as you know, markets, both, store wealth make people get wealthy or not so wealthy. But markets also signal the state of the economy, and yes, you can pump in liquidity to boost asset prices, which is what has happened perhaps permanently, perhaps temporarily.

Vineer: Nobody knows. I don’t know. I can’t forecast it. But the signaling component of the markets, and I’ve written a lot about this and I have no problem talking about it even on the podcast, the signaling component has been massively distorted. So, negative yields in Europe, for instance, are a function of the massive amount of liquidity, almost 8 trillion worth of liquidity, that the Japanese and the Europeans have printed that’s created negative yields. But this distorted bond markets, the current inflow of capital that has come in has distorted capital markets in the U.S. Now one cannot judge and say, well they shouldn’t have done it. You know when you have an accident on the freeway and the ambulance comes, it doesn’t say, “were you drinking or were you not drinking?” Their job is to actually save the person who’s an accident. That’s their first- that’s where we’re at right now. But I do think there’s a massive amount of moral hazard, and I do think that this is probably not over yet. Maybe we could push it further out, but I think we’re not yet at the end of this particular event.

Steve: After the last financial crisis in 2008, I think that the U.S. added, was it about 4 trillion to its balance sheet in the wake of that? Maybe more, I don’t know. But at that time I remember a lot of people saying that, “Hey, there’s going to be some inflation as a consequence of all this printing.” And it ultimately didn’t really materialize. And now we may have added, I don’t know, could it be another 10 trillion before this is all over? To our balance sheet. Do you have any- does your crystal ball say anything about what’s going to happen here with inflation or the value of the dollar, et cetera?

Corey: Vineer doesn’t forecast Steve.

Vineer: Yes.

Steve: I know, but yes?

Vineer: I can tell you my odds.

Steve: Yeah, go ahead.

Vineer: I can tell you where the severity is. Right? Corey, thank you for reminding again before I made a forecast there. But yes, you are right. So the state today compared to 2008, 2009 is very different. In 2008, 2009 yields were at 5%, we went down to almost zero. Right now we’re at zero or negative. You’re absolutely right. There was no inflation at that point in time, but there’s no inflation right now. But we have a very different situation today, which is the global economy shutdown. And at some point in the supply chain as they call it, can become restricted because if people are not making stuff and people cannot transport stuff and other people need to consume those things, food, oil, whatever, and money is much more available now, 10 times more available now, probably biases you in favor of inflation rising and central banks would like nothing more than inflation to rise.

Vineer: But having said that, my bias is that, yes, this is more inflationary than it was back in ’08, ’09, but I’m not going to bet on it. But let me go back to the severity component, where I do make bets, if inflation were to rise and I don’t know if it will rise. Let’s say the probability was 10% that inflation was rise. What are the assets that will do really well? What are the assets that will do really badly? I do have a list of those, so all else being equal, conditional on that event happening, I know what I need to do. But if that event doesn’t happen. I don’t get hurt very much, but if that event happens, I get an asymmetric risk return profile. So that’s how we position our portfolios and our clients portfolios.

Corey: So now here’s a question about inflation. Many people did predict inflation after the 2008 and 9 financial crisis and didn’t happen, so soon people had to revise their model of what caused inflation modus in with their empiricists. Did your theory of what would likely be the cause and consequence of inflation change? I mean, there are may be attempted explanations, right? Globalization pressed down labor costs and the cost of goods, et cetera. But how did your theory of inflation change from 2008 and 9 how has it informed your current view as to what might be the consequences of renewed inflation and the likelihood of a renewed inflation going forward?

Vineer: So I don’t really have much of a theory cause I’m not an economist and again, inflation to the very slow moving process, but I do say, I believe one thing and, and that comes back again to linking various aspects. We all know that we have an incredible amount of debt globally. And the way you deal with debt generally is either by defaulting and you refuse to pay it back, devaluation, meaning you devalue your currency, or inflating it away. So there’s basically only three choices. My theory of all, they’ve been, “Okay, are we going to default? Are we going to devalue or are we going to inflate?” So what do they mean if you unpack it a little bit more? The big thing that drives inflation is a management of expectations.

Vineer: So it’s not locally what’s happening today, but where is that longterm expectation in people’s minds, where inflation’s going to go? And that depends on the credibility of the central bank. So let’s go back to our three pronged equation. Will the U.S. default? Absolutely not. Because we have a printing press. We can print as much money as we want. Japan won’t default. Europe can’t default, nobody will default. None of the major countries. But throw that one out. I should never say never, but most likely not. Okay. that could be a tail risk and you’ll probably remind me of it when I said nobody will default, so maybe they can, but I don’t think they will. Can everybody de-value all at the same time? No, because currencies, whenever there’s a currency, there’s a counter currency dollar, yen, yen, euro, dollar, euro, so that’s not going to happen most likely because everybody will race to the bottom. So there’s only the third option, which just to change people’s expectations of what money buys, which means recalibrating the anchor, recalibrating longterm prices.

Vineer: Okay. That’s the way we’re going to pay the debt down. Now I know Steve’s going to bring an MMT into this. Maybe that’s never going to happen, but I would say that the market and market participants are completely and thoroughly unprepared for a recalibration of anchor and everything that I read, everything that I see is leading me to believe that government authorities would like nothing more at this point in time than the inflation anchor to actually move up a little bit because that gets them to go out to spend. When you know that prices are going to go up in the future, you go and spend, and right now one of the only ways to get the consumer out of their homes when the economy recovers is to have them go and spend. So I do believe that all else being equal, the risk is that inflation rises and hopefully the consequences won’t be too bad for anybody.

Steve: Yeah, I think it’s often said that the moment before the bubble actually pops is when you start to get the craziest theories for why there is no bubble. And so when people trot out MMT, it makes me wonder if that’s like the last moment before we realize, “Oh, this debt is actually unsupportable and we’re going to have to inflate to deal with it.” But who knows? Maybe, maybe we’ll go through a decade of people accepting the idea that Keynesian stimulus is great and governments can run up debts and it doesn’t matter, et cetera. So it’s very hard to know.

Vineer: So when I came to the U.S. in 1982, this was right after the big inflationary spike. Treasury yields were, I think, in the mid-teens, interest rates had just broken 20 you could go to a bank and you could get a 15% deposit. Right? And nobody wanted to believe that interest rates would ever, ever, ever come down. The anti MMT was a popular then, which is, “buy gold, inflation is never coming down. You can do nothing about this.” And then you saw a couple of years ago the exact mirror image of it and exactly to your point, Steve, people’s views and justification in hindsight can be completely rational. But when you look back at it a decade, you say, “what was I thinking?” So anyways…

Corey: Okay guys, we got to roll back a little bit because most people don’t know what MMT means.

Vineer: Sorry.

Corey: Monetary theory, so lay it out in simplest terms if you could and why you think it’s maybe outdated in the current environment.

Vineer: I don’t know if I can lay it out in the simplest terms because if I do something, some economist was going to correct me with a lot of nuance, but I’ll just tell you the way that I think that Steve and I think about it, perhaps I think about it, is that if you are a sovereign nation, you can print as much money as you want and it has really no inflationary consequences. I mean that’s the simplest way, the gist of it. Hence, you should print as much as you want. And so far we have seen a test of one as they say, right? Economics and financial markets have only had one history. And as a physicist you would never take that as proof that it works. But as an economist or a finance professional, you could just say, “Hey look, we’ve been printing 20, 30, 40, $50 trillion in negative yields. There is no inflation. Hence it works.

Corey: Hold it. But we’ve got lots of examples of governments printing money and leading to massive inflation.

Steve: He means recent evidence. So yeah. I think many people who are skeptical of MMT would say, “well if you, if you look at historical examples, this is all going to end in tears.”

Corey: Yeah. As it has for many countries throughout history.

Steve: Yes. So I think MMT could very well be that last crazy, the theory before the bubble finally pops, this bubble being the idea that sovereign debt is unlimited without consequences. That MMT could be the sort of last weird theory that tries to support that before it becomes completely unsupported by reality.

Vineer: But, there’s another aspect of it, right? I’m a big believer in invested interest and, and I just finished reading a John Kenneth Galbraith’s, one of his books and I’ll remember the title in a second. But when somebody said that MMT works versus somebody who says empty doesn’t work, they have some ends for which they’re using either one of the two hypotheses. I’m not sure where I am, I don’t really have a particular view. I don’t really know. So that’s why I won’t say it works or doesn’t work, it’s a crazy theory or not a crazy theory. B.

Vineer: ut if you believe for a second that we-, the pendulum is swinging again from an extremely capitalist friendly, corporation friendly, maybe three or four decades to a people friendly, liberal, social type of environment, then the proponents of MMT are basically arguing for an incredibly large amount of fiscal stimulus to bring up the people who’ve been left behind. So they’re the best in interest here, which is print money and bring the distribution on the left side of the wealth distribution back up. So that’s why they’re using this theory. I think maybe one aftermath of this financial crisis will be that, perhaps social programs become a lot more accepted, and maybe money printing to do helicopter drops becomes a lot more accepted. I think if you understand the motivation of the people, like the Paul Krugmans of the world and so on, then maybe it’s better, easier to understand.

Steve: Yeah. [crosstalk] I would say there’s one flavor of MMT that I could kind of accept, which is that if the money is printed for the purpose of infrastructure investment, or maybe investment in human capital, that eventually that could pay off enough that it is a legitimate, reasonable expenditure for the government to run up a huge amount of sovereign debt. Building the super fast trains in China, for example. Maybe it’s ultimately really going to pay off for them. And I think that isn’t as implausible to me, but just the general idea that sovereign debt doesn’t matter seems very crazy.

Vineer: Yeah. I mean, we’ll see. The great amazing thing about financial markets is that they will tell you, you just have to wait long enough. This is my fifth crisis and I think I’ve survived this one so far so good. But we don’t know. Maybe the next one will take me down. But I just tell you this one thing, that before every single crisis, the story, the rhetoric, is always exactly the same. And like you just said, it’s when people start saying this time is different, right?

Steve: Yep.

Vineer: Know that we are reaching the eighth or ninth, maybe the overtime innings of this game. So you got to get very cautious. If you do believe that you can’t make perpetual motion machines and you can’t build something out of nothing, then it tells you, and coming back full circle, it tells you, you can’t forecast it, but you know where you want to be.

Steve: Well, we’re over time, so let, that seems like a good place to end it. I want to thank you veneer for being on the show. I’m sure listeners are really going to enjoy it and I hope to catch up with you before too soon.

Vineer: Likewise, guys, thank you very much for your questions and I hope there wasn’t too much jargon that I slipped into, but thank you for asking the question. Take care guys.

Steve: Okay. Bye. Bye.