Research and Writing

Despite that inevitable outcome, the wisdom of the old gamblers had a lot more value than just supplying Kenny Rogers with his lyrics. I often think back to old poker adages when pondering over decisions at Avos. One such adage is “money you don’t lose still buys groceries.” The point is that you make money in the long run not only by scooping big pots, but also by losing the least amount possible when you lose.

For most investors, the biggest source of losing - by far - is taxes. So losing less to taxes means you can buy more groceries. But for some unfathomable reason, the tax code is written to punish diversification. For example, the US government taxes you more for lending them money than for holding equities. That leaves you with the choice of having a more diversified portfolio and paying more in taxes, or paying less in taxes and taking the risk of all equities. We have our own way of balancing those considerations in our client portfolios, but reasonable people can certainly disagree.

Right now we are seeing a very strong trend towards wanting more diversification…but trying to do it without paying heavy taxes. This trend makes perfect sense to us. In our investment systems that power our equity ETF, 29 of the 38 countries we trade have negative long-term value signals. Or put more plainly, for most of the world’s equity markets we expect the next 10 years to be worse than average. The flipside of that observation is that diversification is likely to be more useful than average over the next 10 years.

A strong demand signal from investors is, in turn, leading to an explosion in tax-advantaged products. Our 351 exchange ETF is one example, but there are many others, such as long-short equity strategies, PPLI, and exchange funds. As we look forward, we think this trend is likely to continue to pick up steam, and we plan on participating. So stay tuned. And in the interim, if you want help thinking about how to get more diversification in a tax-advantaged way, don’t hesitate to reach out for a chat.

In financial markets we don’t get many unsolved mysteries. Many, many things are surprising and confusing in the moment, but almost all of them can be unraveled in the post-mortem. There is too much data and transparency (at least to regulators) for big mysteries to persist. The Great Depression, the Tech Bubble, Black Friday, the GFC, all of these things were hard to predict but relatively easy to explain after the fact. We don’t have big head-scratchers from 50 years ago.

As I write this on the last day of May, I wonder if markets are in the midst of their D.B. Cooper event.

The closing of the Strait of Hormuz used to be a classic oil analyst thought experiment. How high would oil prices actually go? I’ll set the stage with a quote I enjoyed a few weeks back from Doomberg, a highly-regarded research shop with a specialty in energy:

"Had we been given the events of the past 75 days and asked to wager on front-month Brent crude at $150 per barrel, we would have greedily pledged our homes to take the over. While we wouldn’t be the first to be made homeless by the brutality of the markets, anybody who claims to have correctly predicted how oil prices would unfold is, well, almost certainly lying."

Normal stuff, in the sense that markets are surprising. So let’s do what we always do and look at what the data tells us is keeping the lid on prices. SPR releases? Sure that helps some. Demand destruction? Yeah, there is some, though even the highest credible estimates don’t get you anywhere close to bringing the market in balance. And then there is this chart:

Whoa. Depending on where you want to draw the starting point, that’s a 3-4 million barrel a day drop in imports. To put that in perspective, that is as much oil as Germany, Spain, and Italy import…combined. All economic activity - and really all of modern civilization - is just the translation of energy from one form to another. That much missing energy should leave a mark. Let’s go back to the data.

Is the Chinese economy collapsing? No.

Have visible Chinese oil inventories been collapsing? They’ve fallen a bit lately, but on net they are up since the beginning of this conflict. So no.

Have they stopped exporting refined products (gasoline, jet fuel, diesel)? No.

Have they stopped manufacturing petrochemicals? No.

So how are they doing this? A lot of ink has been spilled by analysts with theories that are all over the map. But here’s the thing - many of those theories, if true, would be considered “state secrets” for the Chinese government. That means we may literally never know. It’ll be D.B. Cooper all over again.

While we have also been surprised by how long the status quo has been maintained, we continue to believe that the pressures are building for a resolution - one way or another. This has us paying a bit each day in option premium for a large payout if things radically shift in either direction. While we don’t have an edge in forecasting the results (or lack thereof) of the negotiation, we believe that markets are meaningfully underpricing the probability of big moves regardless of how the war proceeds.

Memorial Day is a day to remember that the same thing is true for our very way of life. The comfort we enjoy in the US required a lot of shooting and dying to establish, and we should celebrate and honor those who died to make it happen.

But again, we cannot take our hard-fought accomplishments for granted. Democracy is a system designed to follow Darwin’s rules and adapt. That why it can work when the country was run by dudes in wigs writing with quills as well as today. But it is not infinitely adaptable, and is the most important thing to not take for granted. I believe one of the best ways we can avoid taking it for granted is to study and learn from the mistakes of those who have given away democracy, and in doing so doomed their freedoms and quality of life. Memorial Day seems like a fitting day to do that.

And before I continue, let me just be as clear as I possibly can: I am not saying Trump is Hitler, or that we are on the verge of a fascist takeover, or any other politically charged subtext. Republicans are not Nazis and Mamdani is not Marx. I am just saying we are all better off for having studied the mistakes others have made. If a thing is important to you - and it is fragile - it’s useful to know what causes it to break. And AI has brought to light some new data that we can use to do that study.

With that as context, some researchers at Harvard used AI to read and digitize the membership cards of over 10 million Nazis, increasing the sample size for study by 200x. It’s incredibly cool. You can read the full paper at NBER. But a few things I took away from it:

1. The original Nazis were “true believers” with radical ideologies. By the time WWII came around, the Nazi party pretty much just looked like Germany from a demographics perspective - with one big exception (next bullet).

2. Something like 40% of municipalities in Germany had no recorded Nazi membership at all. It was red state/blue state on steroids. Digging into that, it appears community leaders - teachers, doctors, police - had a huge influence on whether Nazism took hold in each town or city.

3. Antisemitism was described as a factor in joining the party by only 26% of the sample. And even that number is probably too high given how the researchers calculated it. The top two causes were “national renewal/order” and “social belonging.” In other words, most Nazis weren’t cartoonishly “bad people” but just normal people who wanted what was best for their lives and their country but made bad decisions.

4. The heroes that Germany needed weren’t the ones that shoot bullets, they were the domestic leaders that never materialized.

I hope everyone has fun this weekend, but also takes a minute to be grateful.

The defense attorney, with no real alternatives, relied on random distractions. “Why did the hospital intake form say the defendant weighs 190 when his driver’s license says 270?” “She had 5 minutes alone with the security camera footage, how do we know she didn’t monkey with it?” “The dictation software the doctor used made some typos, how do we know any of it is true?” They flew in an “expert” (read: mercenary) from Kansas who testified that the forensic nurse took the evidentiary photos in an unusual order. That was the entire case. The defendant never testified and they never disputed any of the core assertions.

Imagine my shock and horror when we got into the deliberation room, and the first vote was 5 guilty, 5 not guilty, 2 not sure. The vote was roughly split by age - us old-timers voted guilty, and the twentysomethings voted not guilty. It took us 8 hours to convince the young folks that the victim was not a Keyser Soze-level mastermind who had manipulated everyone and everything to frame the defendant for his 6th domestic violence charge.

I’ve thought about nothing else since, and here is where I land: if you are young, and your entire life has been spent bathing in Twitter and TikTok and Snapchat and Memes and AI deepfakes…it’s not surprising you might have trouble separating signal from noise, or truth from nonsense. How would you know how to do that? And it is only getting harder! I went from anger towards them to something more akin to pity and/or fear.

As Benjamin Graham famously said, in the short run the markets are a voting machine. I will remember this experience the next time I see MicroStrategy or GameStop and think “that makes no sense.” Most of the voters in those things are not like me, and whether it makes sense or not doesn’t actually matter.

It’s also true that age and experience doesn’t immunize any of us from the same challenges. Our species evolved to trust our senses to process reality. That’s not good enough anymore.

So with that in mind, here are my “big picture” beliefs. I find these things act as a useful anchor when I am sifting through the noise to build durable investment portfolios:

1. The world we have lived through is not the world we are entering. For a generation, we had disinflationary growth achieved through cooperation and globalization. That is reversing quickly.

2. For the last 25 years, growth in the developed world was largely accomplished by shuffling electrons and didn’t rely on physical stuff, and the physical stuff that it did need was adequately or over supplied. That is changing as militaries, supply chains, energy and mining infrastructure, and data centers get built from scratch.

3. Because of 1 and 2, in the medium term it will be better to be an owner - of businesses and real assets - than a lender being paid back in nominal dollars.

4. AI is a unique development in the history of our species, and no one has any clue what the ultimate impacts will be. That means that the ability to change your mind is as valuable as it gets, favoring liquid vs illiquid assets.

5. Dominant US companies juiced earnings by expanding global market share and leveraging a lack of competition into fat margins. AI and protectionism are likely to eat into both tailwinds.

6. Governments don’t want vulnerabilities that can be leveraged against them, and that includes reliance on the USD.

For all of those reasons, our clients with a long-term investment horizon are positioned to be globally diversified, liquid, and overweight real assets. And we hold on to that approach, regardless of the latest tweet, “news” story, or distraction.

So why is cheating so rampant? A big part is that the consequences of cheating are hilariously tiny relative to the reward of getting away with it. If you are from East Africa and can win 10x the GDP of your village by doping…I mean, is it even more immoral to cheat or not to cheat? And to get a chance at that reward, the risk you take is that you will be caught (hardly a given) and suspended from competitive running, which stinks…but not that much. For a first offense you can always come back.

Having consequences that adequately deter bad behavior is an important part of the glue that holds civilization together. Just trusting everyone to “do the right thing” is a ludicrous recipe for disaster. If the punishment for murder was a stern rebuke, there would be more murder. It’s not super complicated.

Markets work the same way. To function, participants have to believe that markets are fair. Why don’t investors from the largest economy in the world invest much in the stock market of the second largest economy in the world? Because, rightly or wrongly, a large swathe of US investors (and frankly Chinese investors) don’t think they are going to be treated fairly in the Chinese stock market. And because of that, the Chinese stock market suffers from much weaker demand. Over the last 10 years, the Chinese stock market has cumulatively grown less than the Chinese economy. Good luck finding another country with that badge of dishonor.

It is obvious that there has been rampant insider trading going on in oil markets since the start of the war. Here is one article if you aren’t up to speed on the lore. This week, the DOJ and CFTC said they are going to investigate. What will be the consequence of a 9 or 10 figure score? Will it be enough to deter this from happening again? I’m not holding my breath. Instead, I expect another small erosion in confidence that US markets are fair. Of course, this by itself isn’t going to cause a cataclysmic unwind of confidence in US markets. But we’ve already seen a piling up of reasons for investors - US and otherwise - to spread their bets more globally. Adding another to the mix is not helpful.

This “lag” dynamic happens all the time in markets - an event happens, but then it takes time for the event to actually change outcomes in the real world. And most of the time, most markets are pretty efficient at sniffing it out. Central bank policy is famous for this. At the moment the Fed lowers interest rates, nothing changes in the economy, but the market reacts and prices in the things that will eventually be changed by a lower interest rate. You also see it when there are public market proxies for private market investments - public markets will mark down a troubled REIT or private credit fund, even if the sponsor hasn’t yet marked down the underlying private assets.

Which is why we find what is happening in markets today so bizarre. Instead of light coming from the sun, we have oil (and fertilizer and helium and LNG) coming from the Middle East. And instead of 670 million mph, those huge oil tankers travel around 15 mph, or about the same speed as a very fit person can travel on foot. A catastrophe is slowly moving through the system, as tankers finally reach their destinations…but without another tanker behind them.

The chart below from JPM shows the picture. Lack of incoming supply is being replaced by drawing down inventories, and global oil inventories have rolled over and are falling off of a cliff.

“But wait Josh, we still have roughly 8 billion barrels? That doesn’t seem so bad” is a thing you could be forgiven for asking. The problem is that you don’t get to draw all 8 billion, or even anything close to that. You need some minimum amount of oil to keep tanks, pipelines, etc functional. It’s impossible to know precisely what that number is, but the most credible sources peg the amount of oil that remains actually available at meaningfully less than 1 billion barrels. We are not far away from needing to defend tank bottoms through soaring prices.

Iran seems to believe that if they block the Strait, eventually the pain for the rest of the world will be too great and the US will cry uncle. The US seems to believe the opposite, that it is Iran that will cry uncle first. This has spawned one of the dumbest and most destructive games of chicken in human history. A lot of humans, particularly in the poorest parts of the world, have already experienced the equivalent of the sun exploding. The more this thing drags, the more the blast radius will spread. We see incredible value in betting that even the damage already done implies a resolution will not be as smooth as markets are discounting - with more damage still likely to be done.