He Invested Through Five Bubbles. He Wrote the Book on Them | What We Learned This Week

Fast forward a few years. Everybody is doing AI, aren't they? Everybody is paying for the service that they need. It is now in that point in the future the cost of doing business. It will not move aggregate profit margins or aggregate profits notably higher than they are typically.

>> Not only did they cut, but they did surprise cuts. And this is from the same guy who, you know, 40% ago had used the term irrational exuberance to describe the stock market. He was cutting into a stock market that was up 40% from when he made those comments.

One of the features of the of the capex booms is is that they as you know they they actually produce profits because if someone invests and the other person the buyer doesn't actually immediately depreciate what they're uh what what they've acquired then um they um then aggregate profits rise.

>> Welcome to the excess returns weekly rap. I'm Jack Forehand, joined as always by my good friend Matt Ziggler. Matt, we got we got some pretty good clips this time.

>> I am I mean I just can't believe like Jeremy Grantham. This is this is a mur I feel like we say this every week right now. This is like a murderer row of like holy crap going through this and I'm going I am embarrassed by how many cool people we've had on Access Returns this week.

>> Yeah, Grant's somebody we've like when you start a podcast he's one of the people like you're like I want to get him on eventually. Like we're six years in now and we got him. So, uh, that that was kind of fun. He he was a really nice guy. It was a lot of fun to do that one. But even addition to that, we got all kinds of stuff. We launched a new show with Andy Constant this week. Um,

>> Andy show is killer. Like, this is so cool. I'm so excited he's doing this. And that was what an inaugural episode. I mean, this is really cool.

>> Yeah. For anybody who wants to subscribe, it's called First Principles with Andy Constant. It's on our YouTube channel. It's also on any podcast platform out there. But like what was really cool about that episode is Andy has seen a lot of these bubbles firsthand. He's been investing. He was with Bridgewater. He was with Brevin Howard. He's been to like all the big names and like just the stories he has and like the details behind what went on that which you'll see in some of the clips here that I just didn't know. It it was really cool just to walk him through. Like we were going to do an episode on both bubbles and what to do about bubbles and like we decided sort of to do two-part series because there was so much in the first part just about his experience in the bubbles. So we're doing the rest the other one next week.

>> Andy in teacher mode. This is this is my favorite thing every time he's part of an interview or something else is when he goes into this teacher explainer from experience mode. So the idea that we're getting him to do this and yes please give me three episodes of the bubble conversation because this is

>> yeah we'll make it as many episodes as it takes I guess. And then and then on top of that, we've got Edward Chancellor who's I think like the world's foremost authority on capital cycles. At least that's how Kaiu did the interview. Uh this is Kai's show um explained to him. And then we've also got Mark Rubenstee who like knows the inner workings of the financial system like better than anybody ever seen. That was a really great episode.

>> Chancellor is amazing. So, I'm super excited that Kai sat down with him because the history lessons that he pulls from like he's up there with like a Grant Williams or somebody like that where it's just like they will tell you about a corner of history that explains something from a perspective where you're like I had I had no idea and now I am so excited to talk about you know railroads and canals and stuff like this and I want to dive into the history

>> and we will talk about railroads and canals in a little bit

>> and we will and same with same with Mark like net interest is one of the most reliably fascinating subst stacks. It's something that I feel like I shouldn't be interested in. And then he's another one who will explain the plumbing. Just the seat that he's had. The front row seat to covering the financials industry for like 30 years means much like constant with like bubbles. He just has this perspective on everything like down to how like payments work, where there's competition with like credit cards, at which scale, is it national, is it global, how to think about all this stuff. And nobody has financials knowledge like him. It's amazing.

So, let's get into it. We're going to we're going to start with Jeremy Grantham. And uh everybody kind of knows there's these been these big companies that have done a lot better than you'd expect big companies to do. They've defied what Michael Moes would call the base rates on this stuff. And there's been a bunch of explanations, but one of them we haven't talked about a lot in the podcast is this idea of monopoly. Um, so, here's Jeremy talking about that.

History was pretty clear. Asset classes mean revert. Sectors within an asset like small versus large, they mean revert. and even companies in the end mean revert. And then to be more detailed, mean reversion at the corporate level says if you make abnormal profits, you will receive competition. If you make obscene profits, you'll you'll get ferocious competition. If you're having a slump and you're not making much money at all or even losses, you will frighten away uh capital and you'll have no competition at all. And eventually as the market slowly grows or rapidly grows, you will reach a period of shortage and uh everything will recycle and your stock will go up, your profit margins will go up. And there was a very clear history of that happening. And in recent years, one has to say uh that is not as clear as it used to be. the the the m the bottom 90% of the market seems to fairly clearly still mean revert. And yet then you have a novel emergence of a kind of elite, a few handfuls of stocks that seem to have gone from strength to strength. And you have to ask the question, why isn't the money flooding in to compete these ridiculous returns and drive them down? And one is the winner take all nature of of software. The guys who who get there first have such an advantage it's hard to break in. The other is uh the attitude of the government of the administration to monopolies. And you can look back over this interesting different uh phase and of course this time is different. You look back to about 2000 and you say in what way is it different? And one of the ways at the top of the list is a steady concentration in every industry. There are fewer companies and bigger companies and more dominant companies in every industry. In most of them, it's not that big a deal. In some of them, it's massive. And what did the Justice Department etc. do about this? And the answer is uniquely in this time period, nothing at all. So companies were able to to quickly develop not just domestic monopolies but global monopolies. The mag seven were not universally seven global monopolies but there were several in that group that were and uh there is no better way to make money than to have a near monopoly or a complete monopoly to be a price setter. So ask yourself are are the MAG7 setting prices? Uh and the answer is mostly yes. They fulfill the characteristic of a workable profitable monopoly and they've been tolerated. In other eras the government get in there and say nah standard oil is too big. We're going to break it up into nine pieces and uh and so on. And um that's pretty effective. It's pretty effective at certainly breaking the monopoly. Then you have more competition from the pieces and uh the prices tend to be lower and the competition tends to be higher. The characteristic the unfortunate characteristic of increased monopoly is that the growth rate of the system tends to slow down. So the profit margins of the monopouists go up, the share going to workers goes down, inequality increases, but the growth rate of the GDP tends to slow down. So a lot of people think because there's so much profit being made by the top 20 firms that somehow everything in the garden is great and growth rate must be higher. No, it isn't. growth rate in GDP is actually slower for the last 20 years than it was the prior 20 and the prior 20 to that.

>> Yeah. I mean the I've kind of thought about this the other way. I've thought about like the nature of these businesses and and how they compound and how that's led them to be what they've become. But there's this other idea that you know they they have to some degree there's been some monopolistic type behavior here. And Jeremy's argument here is you know maybe the regulators should have been a little more involved in this than they were. I don't know if I agree or disagree with it, but I thought it was an interesting take. Um, and it's one I hadn't heard a lot.

>> I think it's a fascinating take, not just because regulator involvement and how individual sectors mean revert versus the whole system mean reverts. Like there's just all these fascinating layers with who's participating in what level. But, uh, yeah, it's this is a really interesting counter example that I don't really really hear anybody else talking about. and especially framing he broadens the definition of monopoly from the way that I would normally think about it.

>> Yeah. What do you do? I mean tech technology leads to monopolies to some degree. Um I mean was was Google search a monopoly? Not anymore. But was Google search a monopoly for a long time? I mean yeah it was I mean there was I mean they they got to that point because they they built a great search engine and they they outperformed everybody else. But at a certain point like that it's just so hard to figure out like what to do about this stuff. Like I I don't know if I have a view that like the government should have stepped in and done something about that or if I have a view like let the market work itself out and we're kind of seeing the other side of that now because Google search monopoly the government didn't do anything about it but the market is now doing something about it um with AI. So like to some degree letting the market do its thing does its thing over time but Jeremy's point is also true which is you know we did we did have a high level of monopoly in certain areas and that's certainly you know is part of why we haven't had reversion.

>> Yeah. Now the idea that like the technology becomes the new baseline and then that basically destroys the monopoly on its own from market forces. I don't think you can you can't say that reliably, but it is very it's a very very interesting thought exercise to think about how that draws competition in pursuing the profits or looking for a way to crack that. But also it just becomes a thing that everybody uses because nobody has done business in the last 10 years without relying on Google search for something. And that's that's a really interesting point to think of especially as we try to play AI forward. So our next clip is Andy Constant and people love to say we're in a bubble, we're not in a bubble, but what you don't see a lot of is the mechanics of what goes behind the bubbles, the stages of a bubble, what history, you know, how how the bubble has played out in various historical bubbles. And so here's Andy. This is kind of a long clip, but it's well worth it. Um here's Andy talking about the phases of a bubble.

These types of environments typically start with something new. And something new in the internet boom and the um and if we're in a bubble today uh the AI boom um were was technology was some new thing and you can look back to and again before my time you can look back to a variety of of industrial revolution technological advancements. You can look to the um to China where they took made a huge productivity move bringing people from the farms to the factories. You can look at major productivity changes as it tends to lead to some sort of bubble-like equity outcome. Um so there's a new thing that's technology. In 1982 through 87 the new technology it wasn't wasn't really new technology we just had ended a major inflationary episode we dereg the United States deregulated the financial industry in particular the savings and loan industry there was a small technology advancement which was the invention of Lotus 123 which allowed people to easily scenario analyzed companies And there was the innovation of of Mike Melin in terms of creating a market for high yield debt. And that kicked off the thing that was really new to the markets and that was the LBO. Um, and so when I think of the 1987 crash, I think it was impacted by lots and lots of things. And all bubbles have lots of things going on them. But in 1987, that bubble was driven a lot by a a trend toward the LBO. Um, we know what kicked off the something new in '95. In 2005 through 2008, where you had the housing boom, we had a period of time where globalization had essentially ended inflation. And with the end of inflation, financial conditions could be left very accommodative with no risk of inflation. And that created a levering up in banks and in the housing market. So the new thing was the end of inflation and globalization. And that was a driver for what ultimately turned into a bubble. And by the way, this is what I think. I could be wrong. This is just how I'm thinking through these things. Now, as I said, ZERP and QE drove a bubble in bonds, which ultimately peaked when the economy was shut down during CO. Um, and then today we have the chat GPT moment, which I don't remember what what you thought about it, but I thought on September on on January 10th of 2023 when Microsoft made its investment in Open AI, you know, for many of us, we'd been playing with the first version, first public version of ChatGBT. A new version had just come on. Um and for any of us who have done any sort of statistical analysis through their careers, there's been a slow burn of regressions leading to neural networks needing leading to uh machine learning all happening as compute power increased. that's been a 40-year slow burn in terms of what ultimately inflected with that pretty much one-off event when the the the AI trade has been one direction since then basically. And so I like to think of those as the precursor to the bubble behavior, which is either a significant regulatory change, a significant easing or a significant technological de development. And so or lastly, a significant exogenous event. the bubble of the um bond bubble would not have occurred without co um and then you have escalation events and that's that happens along the path of that framework and that's when you go into a bubble. Um, and for me, those things were just an explosion of deals in 1987. In 1989, the long-term capital easing ramped and escalated the tech bubble. In 2005, financial engineering in particular tanch cos tranched mortgage product double tripled xed the leverage, squared the leverage, whatever you might want to call it, and escalated the housing bubble. Um obviously the pandemic itself was the final thing that caused um the bond bubble to to go parabolic and then as I said I think we saw some unnecessary easing of financial conditions. Today we had a super hot inflation print. It's been I don't know 62 months since inflation is above target and in 2023 and even in early 2020 late 2022 before this whole SV this whole um um AI trade got started the central banks the in particular the Fed eased to deal with financial stability around the um banking crisis the small banking crisis we saw in the spring of 2023. three and they gave up on their inflation mandate and that escalated this thing. Um so those are the things there's the there's the root conditions which don't have to be a bubble but root conditions can become a bubble then there's the escalation events and then there's the peaking and I think we're in that phase right now we're in the peaking phase now how long that can last quite some time

>> so this idea something new escalation events the peaking phase and and you could watch the full episode to see we went that that exact thing for like all of the different things Andy has seen that he considered bubbles in his career. And it's just you do see these common things. You you something new doesn't as he pointed out it doesn't have to be technology. It can be something else but you usually get something new. You get these things that escalate the bubble and then you get this peaking phase. I I love the idea that it's you need the fertile soil for this thing to grow in. And that becomes something that's really hard to understand, but it's something where you can sort of understand in the new phase what's taking root and what that is and then how deep those roots are going to go and how much fertilizer proverbially is being thrown on this thing that determines the bubble. So, it's an it's an interesting construct to like kind of check back in to me with the earlier steps as you watch the thing advance.

Yeah. And he he used the word bubble regime, which I think is so important to use because he talked a lot about this idea. This is not like, oh, we figured out the stages of the bubble, so now we know where we are in the bubble and we're going to predict when it's going to end. Like it's none of those things. It's basically like in general, this is the way they work. When you're in a bubble regime, and we're going to talk in the next episode about how to invest in a bubble regime, you're in a regime, but you're not in something you can time. You're not in something you're going to be like, "Oh, here's the end coming, so I'm going to short the bubble or something." Like, that's not what he was getting at.

>> Yeah. that idea that idea of how unin it's not that it's uninvestable but it's like untimeable again. So humble yourself realize what this is and then understand that you may not you can experience this cycle super super fast or super super slow and you have to take that part out. You just have to accept that these bubble dynamics are at play and that that opens up a whole other way of thinking. Crazy how interconnected these these conversations this week. These four are because I feel like they all approach this from a different angle.

>> Yeah. And we're kind of with the next one. We're going to get into some other stuff related to bubbles and new technology revolutions. And this is Ed Ed Chancellor talking about this idea that people tend to overstate both demand and profits on the accounting side. um when we get into one of these phases

in these tech booms that people um overestimate demand and I think going back to the railways in in the in in 1845 capex spending at that time would have required you know within a spec there this someone's going to crunch the numbers would have required um passenger and rail traffic to increase by threefold over the next 5 years And given that that you know that there were fair number of railways already by that time in the UK it wasn't going to happen. During the um during the dotcom bubble, uh there was this sort of urban urban legend going around that um kept that data traffic was doubling every um every two months when in fact it was only doubling every um 6 months. And you know that that this little factoid you made it it actually originated in uh with some company that was uh later taken over by worldcom which later went bust and it was signed obviously everywhere you know all media say all the brokers picked up even the you know US government picked it up so everyone believed it but in fact we actually have data there's this guy I know called Andrew Oiko who was at the time at Bell Labs And in in in 2000, so just around the time that the tech bubble was peaking, he put out a you know a paper saying giving you the true um demand growth and um you know and no one so that so the the you know the the actual you accurate data was available in real time and um no one paid attention to it and The upshore was you welcome went bust and the host of those other um you uh so-called alternative telecoms carriers nets went bust and there was you know massive over capacity in fiber optic cable and all the um you know telecom's equipment suppliers like you know Nortal and Ericson uh and and Lucen you took took big hits um and actually you know there was a massive decline in you in um in in in profitability. So one of the features of the of the capex booms is is that they as you know they they actually produce profits because if someone invests and the other person the buyer doesn't actually immediately depreciate what they're uh what what they've acquired then um they um then aggregate profits rise. And so what you see in um you know in in the late 1990s going into 2000 mass search in reported profitability and then because that capital turns out to be misallocated then you have um uh then new capex is immediately cailed and then you have to depreciate past capex and so you have a collapse in profitability and something you know we're seeing something very similar today in that as as you know the depreciation schedules for these um AI chips GPUs has been extended and and um I think you probably know better than I but I think from sort of roughly an average of 3 to three and a half years to six six and a half years And I understand that they because if you buy a GPU and you know keep it in a warehouse because you haven't actually um um built your your data center yet. Uh you don't actually start depreciating the GPU until it's actually in the warehouse. But there is a sort of technological depreciation that is going along uh going on you know even before um you actually start using the chip. Um so yeah so um we'll see but yeah you know it uh that you know the market is being driven as far as I see um by um you know strong economy on the back of a lot of capex and very strong earnings growth but you know those are contingent on the investment turning out to be profitable and the demand being there.

So this is interesting from the perspective of there was a couple things in this. Um the one that was most interesting to me is so we've had this situation due to intangible assets where we've effectively been understating the profits of technology companies for a very very long time because we're expensing when when you invested in the tangible versus a tangible asset. We expense it. It brings down profits. And this clip was the first time I thought about the idea that when you have a massive capex cycle you kind of do the reverse, right? Um because you're not you're not taking depreciation right away. So you're actually overstating the profits at the beginning of this and eventually depreciation will kick in. But I hadn't heard it like presented that way and I I it just lead me led me to thought think like this is the opposite of what we've been seeing like with these companies you know for many many for like a decade here. It's re it's really really weird and it makes it really weird to play the AI cycle out forward because then to your point there's all these other weird knock-on effects that are occurring because of this like we're seeing you've been following this like Utah data center buildout thing between Mr. Wonderful and whatever else. Have you seen this?

>> Not a lot. I've heard about it peripherally but not as much as you have probably.

>> Yeah. I mean not enough. And so there were like some Gallup numbers that people are citing in some reviews and everything else. So there's a lot of push back against like this phase of the buildout. And it's interesting because if the AI super cycle or whatever we want to think about it is going to keep if that bubble's going to keep on blowing, we need more data centers and we need more stuff to do it. We need more capex to then be expensing and go through this. But now all of a sudden like there's this Gallup pole that's like seven out of 10 people would rather live next to a nuclear power plant than a data center. And it's this is the the bubble regime at play because if there's like a political will and a push for this other stuff, I don't think the demand for AI goes away because of all the business adoption in the new way that we're considering this tool becoming like baseline again. So, it's these counter trends really kind of help frame out to me just how long and how unpredictable this cycle could be because it could pop tomorrow or we could be six years forward and going well we just bottleneck this stage of the growth but since the demand didn't go away well we had to build those data centers I don't know in outer space or something and that sort of indirectly plays to what he was saying at the beginning which is this idea that people tend to overstate the demand at the beginning of a bubble um which is very true and I've been thinking about that a lot because on one hand that's that's been true in all these bubbles like we tend to overstate what the eventual demand is going to be, but we seem to have limitless demand right now. And so part of you says AI is different. Like this is intelligence. We have limitless demand. And the other part of me says, well, that's exactly what everybody else was saying in all these other bubbles. So I I don't know the answer to that, but it's just it's a really interesting thing like back and forth, right? You don't sell you don't raise money in any of these businesses without being optimistic about the future. And definitionally, you have to be overoptimistic about the future to get the commitment. I think the question here is how transformative is the baseline technology as it gets adopted into all these different businesses. And even if we even if we restrain some of that demand by like holding back on some of the supply or the buildout, maybe that just ex maybe that just extends how far we have to go with this because well it also could extend the optimism and there's lots of problems with this too. But I I'm fascinated by this applied to right now.

>> Yeah. Yeah. And the more I talk to small business people, like the more I realize there are a lot of people out here who are using this technology in in many many innovative ways. And maybe your average person still is not, but it just makes me think maybe the demand is going to be stronger than it has been in the past. Like this this demand seems to be like it's going to be going on for a very long time because this is just this can have transformational effects on like almost any business. And think about think about the adoption cycle of the fax machine versus the internet and email. Just just the advantages that email had over the fax machine for sending information and then internet access and download speeds and all the other stuff as it moves it forward. Think about how long that grew and became embedded again as this like baseline technology. So it's really interesting to think about this. If this demand isn't going to go away or this is the way this is going to be, there's still a lot of strength and desire to do this and it's immediately applicable by everything from the diner down the street and how they're I don't know ordering they're ordering materials, they're ordering the stuff for the stuff they're going to make in their supply chain all the way up to like a JP Morgan or whatever else. So this baseline technology being being adopted, it doesn't really feel like this is a that part of the demand is just going to go away. It's kind of insatiable until we've established that new norm. And that feels like it's a way off.

>> I'm just happy the fax machine is mostly gone because I freaking hated that thing. Um, nothing ever good happened with the fax machine. It's always broken. Like it's just waiting for the paper to come through. Like I'm just happy it's done. I'm dealing with like a nightmare estate situation with with like a transfer agent and almost all of it has been able to be accomplished via attaching documents via email. And it's I'm I'm just waiting. Like I know the fax request is still going to come because it's it's such a painful process that I know it's it's waiting for me in there. But like every time I correspond with these people and we move the ball the next step forward, I'm like I know you're going to ask me to fax something. Like it's just a matter of time. I'm so scarred. A traumatized child. At least they have eax now. So can that can be done electronically as well. But uh Exactly. Exactly. So getting into the next clip. We've talked about private credit a lot with a lot of different people on the podcast, but but Mark had had a unique take and kind of a unique inside look in what's going on. So here's Mark Rubenstein talking about private credit.

Reminiscent, isn't it, of subprime being contained, but they know that. So they are not going to be making as bold a statement having not done the work. And I think on this occasion what they are saying is that the amount of money ultimately that's invested in private credit on terms that limit redemptions is tiny in the context of the overall financial system. And the fact that these gates are in place, that these redemption limits are in place, it creates headline risk, it creates reputation risk for the providers and we can talk a little bit about that. Potential liability risk for the providers. We can talk about that. But it serves a purpose which is unlike deposits. you cannot get a run on the private credit firm and therefore the risk is largely mitigated. Um now if the holders of these private credit funds are institutions then who cares right? They are big enough to read the small print. They are big enough to withstand redemption gates. The question, what kind of makes it a bit more topical over the past couple of years is that a lot of the holders of those funds are increasingly retail investors. At least not not at least affluent investors. no longer just high net worth but increasingly mass affluent investors um who in many cases have been put into these funds by advisers and there are various incentive structures around that who probably should have read the small print but more likely outsourced it to the financial adviser and have ended up locked in these funds that they now they want to be getting out of. Although it kind of feels watertight from a legal perspective, the you can see I mean we'll go on and talk about Blue Owl which was one of the first private credit firms to put up gates, but you can see the impact it's had on their share price and on their reputation um and on the financial flexibility of their owners, of their founders who in at least two cases put up stock in Blue Owl as collateral for loans. Stock price collapsed. That created some problems for them. So, there are knock-on effects. They're not systemic. They're not the sorts of things that the Fed should get involved in, but they do create questions uh and at the margins they represent risks.

So, I'll throw this one to you because you did the interview. Um like what were your what were your most interesting take on this? I think so. Mark's got the most credible nuanced view on this private credit thing that I've seen. That's not there's the whole you have where you stand as a function of where you sit thing. So like when you read the KKR or the Apollo or any of the private credit providers, when you read their self assessment of the system and why they're not going to cause the next GFC, you have to kind of read that with the expectation of you're paid to have this opinion. like you you have to have this is like the people raising money for AI data centers. You have to be over optimistic or else nobody's going to give you money. So you better turn up the charisma a little bit too much so that you can get to your your goal so you can maybe stem these redemptions, stem some of this other stress. What Mark's saying though is not on the opposite side either. We're like this is the next global financial crisis or this is a disaster. So thinking in layers of where are the various bottlenecks in these redemption pieces where it could get somebody into trouble or where it might be a moot point. So thinking through like does this roll up to some insurance companies? Does this roll up to somebody else? And he seems to think that like we can navigate through this without a giant GFC size disaster. However, the contingency is, and this is whatever the reverse bubble or the bubble popping scenario is, is if something else is going wrong at the same time as you're in this redemption gating problem where there's either a combination of like fraud in some of the cases we've seen so far, or there's people who need money and now there's a regulatory intervention that can turn into something else that's worth fast. It needs something else that it would have to combine with it. So that's that assessment of private credit feels like one of the most like genuine we don't really know what's going to happen, but here's the things to watch for that I've seen anybody seen outside of the the major private credit pushing firms.

>> Yeah, me and my good friend Claude had to have a little battle about that episode because Claude was basically like, "We're doing the over the top private the private credit title and thumbnail for this." And I'm like, "No, we're not. We're not doing that. We don't do that." It's like, but that's what you see like on YouTube all the time. Like everybody is selling into like private credit is the next catastrophe that'll destroy the economy. And there there's a middle ground which is there's problems in private credit. It probably won't bring down the financial system. Like that that middle ground does exist. Now that's not a good YouTube title. There's problems in private credit and it will probably not bring down the financial system. But nonetheless, that probably is the truth here. And it's fascinating when like listening to Ben Hunt and talking to him as we've had him on multiple times talking about this specific topic. He's looking at what are the knock-on effects inside of other industries and then how can this turn into a problem. Again, not necessarily GFC size in proportion, but from the context of what does all what do all these middle market companies do who have become dependent on private credit for financing in the last 10 years. And Mark goes into great depth with this in the interview where he talks about the evolution of private credit as an industry postregulatory change in the GFC. So that this cottage industry like springs up and grows over time and now you have these you have these floating rate loans where you apply some leverage on the top and here's all the various structures and all the ways that businesses and entities and now regular people can access this stuff. And he's like this is still solving a lending problem. And one of Ben Hunt's questions is effectively, okay, so what happens to the middle market companies who depend on this for financing if all of a sudden they can't get financing? How do we understand what the knock-on effect of that is? Where does that consumption go? What happens to a supply chain if they get pulled out of it? And that's the part here. The nuance is in the combinatorial effect of some of these things. And if something else is going wrong, nothing else goes wrong. this probably just slowly rotates its way out of being an issue and the industry is fine. Something dreadful goes wrong or six things happen at once. Now we could have a big problem and a lot of headaches and a lot of frustrated people and probably insurance companies.

So we're back to Jeremy Grant again and we we asked him about the impact of AI and particularly the impact of AI on margins and on companies across the economy and here's what Jeremy said.

When a new technology comes through the early adopters often make considerably more profit than normal. their profit margins become wider than normal. The medium adopters maybe have a slight edge. The late adopters bring the market in into balance again. And uh if I go back and look at at prior cycles, what I have to conclude is that when the smoke clears, any new technology is merely a cost of doing business. Let me focus on the asset management business which I know a lot about. I remember not so long ago when we had to dig deep and buy our first prime computer, a mini computer. It filled the room the size of the one I'm in. It generated enormous heat and and it processed the data pretty quickly and we had a competitive advantage for two or three years until everybody gritted their teeth and and paid up for their mini computers and then it became a cost of doing business. Everyone in the investment management business had a computer, right? I can assure you everybody was not having higher profit margins than they used to. the profit margins settle back down to normal. The return on capital, which is the central driver in capitalism, how much money do you make on your investments, has been remarkably stable for a couple of hundred years. And after the computers had all been bought, all you got was a modest return on the cost of the computer. That was it. You had to put more assets into the game of money management. you made the same average typical return on it and the early adopter thing was God. Well, think of AI. The guys who adopt it professionally first have a huge advantage. But fast forward a few years. Everybody is doing AI, aren't they? Everybody is paying for the service that they need. It is now in that point in the future the cost of doing business. It will not move aggregate profit margins or aggregate profits notably higher than they are typically. Only in the early adoption phase where we are now does that effect occur. Once everybody has settled in, this is just another cost of doing business. It's obvious. I think it's incontrovertible, but you would never guess it from the conversations of the day. There are many other problems and possibilities with AI that we we haven't talked about, but uh that's the one I think I understand the most.

So, this is this is interesting because it is what's happened with some of these past things. like if if you end up with some sort of technology or some sort of product or something that gives you an edge, you can have a short-term edge, but over time it becomes I think he called it a cost of doing business, which is once everybody gets it, then basically everything kind of comes back down to where you were. And that that is a I think a fair take on how this might play out.

>> I think this is great. I love that he connects this to basically like the product adoption life cycle because I I always think of everything in terms of like who are the early adopters, who are the midcycle adopters, who are the late adopters and then where are we in that process and him mapping this adoption cycle on to like profits and who gets the benefit totally checks out. I've also been I think I've mentioned it here before Dennis Taylor the Babaverse series. Um I'm caught up on the current iteration of this. So, in this series, there's a lot of AI. There's a lot of it's a lot of science fiction takes place in the future. But one of the things that keeps happening is you develop a new technology, then you have a slight edge until you discover a more superior technology, which is like running into a wall. It's like over and over again. It's you have something, you have a temporary edge, it slowly depletes as everybody adopts it, and then everybody runs into a future wall. And I keep looking at this and thinking that's a great metaphor too because even when the late op adopters finally catch up now the whole system is just waiting for the next disruption. And that's where we're going to end up here. I'm convinced. I think it's kind of the same thing with data sources and alpha like in the in my in our industry. Absolutely. Like the idea that like if I've got if one hedge fund has pictures of the Walmart parking lot from satellites or whatever, they get an edge, but then eventually the person who has the the data on the pictures from the Walmart parking lot sells it to every single hedge fund and we all end up in the same place. But now we're just paying more money. We've got the cost of the uh the data of the pictures of the Walmart park.

>> Yeah. And we're not even getting good like Walmartian material out of it. If nothing else. Yeah. Don't don't send me to Reddit for my Walmartians. Like use that data for sources of good, please. Hedge fund data analysts.

>> So this next we're back to Andy Constant and this is what I was referring to earlier, which is his unique takes having been inside of some of these things. So here's him talk about long-term capital and how that served as fuel for the bubble in the late '90s. There are a couple of things that happen during a bubble. You always look for what I call contagions for that could cause that could either cause the bubble to extend or are consistent with the sort of postbubble world. um long-term capital had it's interesting. One of the contagions you can have in a bubble is those who are fighting the bubble being bankrupted. But generally those don't have meaningful contagions because whatever they have to dump they dump and whatever unwind there's so much liquidity around there's so much available capital around that losses can be absorbed by the system. So, a cont a a a inflation bubble, the period of time when a bubble is inflating, you rarely have contagion. So, I don't think the long-term capital thing was a was caused by the stock market rally. There's some tweaky little stuff about their evolve position that probably had some impact, but it's not really there. long-term capital was overlevered in primarily fixed income instruments and um got a margin call. The problem is that the central bank massively overreacted. This is what they did is they arranged for the entire fund which by the way the numbers are laughable how small they are right now. They forced the I believe the number was they forced 13 banks or 11 banks called the consortium to come up with 1.3 billion. That's B for billion, not T for trillion.

>> That's crazy.

>> Nothing. $1.3 billion to buy the positions that long-term capital had and assume their positions. So there was it was nothing. But they still cut significates significantly to make sure this didn't become a a a financial crisis. It wasn't going to become a financial crisis. it was taken care of. That was that. But they still did these, not only did they cut, but they did surprise cuts. And this is from the same guy who, you know, 40% ago had used the term irrational exuberance to describe the stock market. he was cutting into a stock market that was up 40% from when he made those comments. I think though

>> and so that was like adding rocket fuel to the bubble.

>> This is one of the things like Matt I was saying like I I didn't know this exactly like I mean obviously long-term capital was a major issue. First of all like I don't know if you watched the whole clip but the the idea of like how big it was is insane. Like it was nothing. Like what was it 1.3 billion? It's like this massive bailout and then it's like it's just like some crazy low number relative to what we

Think about today. I remember I went and I reread the book. What's what's the title of the long-term capital management book? You know what I'm talking about.

The smartest guys in the room or something, or is that a different book? I forget. I'm trying to remember if that's the Enron book, or maybe that's the Enron book. Yeah, but I don't remember then. Whatever the long-term capital management book is, which is exceptional and great. And I remember like, so I reread it either just before the pandemic or like during the pandemic as a fun, like, you're moving a bookshelf and you're like, "Oh, I love this book. I should check it out again." And I got to that part on like the dollar amount. And I was like, "This is awful how like laughably small this feels because this is not that long ago." Like, even like my student loans when I was in college, like from a similar era, I look at and I'm like, those feel more terrifying than the bailout of long-term capital management.

Like Nvidia has that hiding in his couch cushions basically these days. Like it would be like, "Oh, yeah, no problem. Like, we would even notice it's gone." Every one of the Mag Seven stocks basically has that in their couch cushions right now. And yet, this almost destabilized the global financial system. It is pretty crazy. And Andy, in the clip, talks about the idea that he didn't think they needed to be bailed out. But what was the more interesting part is like, we were kind of pretty far into the bubble at that point, and like this was fuel. So we had a series of cuts because of this, like pretty far into the situation. And Andy's argument was, this made the bubble be a lot bigger than it otherwise would have been. This linkage between contagions, and this is where it was really interesting having like Mark next to Andy playing back through some of these clips. And we're going to get more into some of Mark's stuff in a minute, but it's this idea like Mark talked about the extended, the extended cycle that we've been on basically since the GFC. And we haven't had like a real recession, like COVID, yes, to a degree, but a real recession or a real credit boom bust cycle basically since the GFC. We've had some slowdowns. We've had an earnings recession. We've had whatever you want to label the pandemic in the sense of what happened. But it's like we've just engineered new ways to do different forms of stimulus all along the way that at some point, it's got to create a problem. And I know, I mean, make your YouTube titles out of this. Make your thumbnails. At some point, the crisis is coming. It's the worst crisis ever. It's worse than it's the greater Great Depression. Like, I don't know. But this idea of contagion will infect these things all the way along, and we will do our best job from a policymaker standpoint and whatever else to try to fight it in the other direction, and it doesn't feel good on the other end when you start to zoom out and think in these terms.

When Genius Failed, then that's the book. Thank you. Roger, I believe. It was Roger Loans. So for whoever's typing that comment right now and saying, "These two idiots don't even know the name of that book," you can stop typing the comment because we finally figured it out. We're still two idiots, but I appreciate. That's true. So, you can stop at the two idiots and then hit submit. But, you know, Smartest Guys in the Room and Geniuses, like I see. It's close. Yeah, I was like, in the vicinity. Smart genius. Yeah. I mean, that could have worked as the title for that one. Um, it would have been an okay title, but so anyway, back to back to our clips here. Uh, this is what you alluded to earlier, which is uh, Edward Chancellor studied like all of these booms historically, and we're in the 1850s right now, and we're talking about railroads and canals. So here's Edward talking about that.

Sometimes the new technology doesn't attract too much attention in its early years. I'm thinking, for instance, of, you know, when the railways came to Britain in the 1820s. Um, 1825 was the launch of the first passenger railway in the UK, which is called Stockton and Darlington. And that the first few railway companies had a, um, had dominant positions, no competition, they were pretty profitable, and their technology was proven. Uh, and then we had two successive waves of investment. One a decade later, sort of 1835-36. Uh, that led to boom in the stock market. A bit of overbuilding came down, but it wasn't too much damage. The real problem, or mania, came in, um, sort of 1843 to 1845. And and that is really the, um, a period in which there was a massive, the launch of many, many railway schemes across Britain. And the, in terms of capital employed, capital expenditure, I think was running to about 10% of UK GDP. So actually much higher than AI today. And there, there were too many, as a result, not all the schemes got actually went ahead, but the upshot was far too much duplicative investment. And you famously, as I say, you know, three railway lines between London and Peterborough, which is in East Anglia. Three railway lines between Leeds and Manchester. And obviously, if you have three lines running between two places, they're going to be less profitable than if you have one line. And the upshot of that is that the railway index, I think, lost about 60% of its value. And ironically, I just looked at this the other day, you know, canal stocks, canals were the most obvious losers from the railway mania, and they did lose in the end, but actually, you did better investing in canal stocks between 1845 and 1850 than you did in railways.

I mean, this gets at the idea that a lot of people say, which is that there's a different thing between the performance of the companies and the actual technology, and you have to separate those two things. So he's talking about this idea that the railroads were the new thing, but ultimately, if you just bought the canal stocks, like you would have ended up doing better than if you bought the railroads. It's it's really it's so amazing. And I think with part of this too, were there a lot of railroad tracks around where you grew up? Did you grow up on the wrong side of the tracks too, Jack?

Yeah. Well, we have, you know, the railroad in New York City, so it's like a huge thing here. Like tons and tons of people commuting every day. So here's here's the interesting thing to me is you grew up on like commuter rail lines, and I grew up on all industrial rail lines. Yeah. We don't have any of that. Yeah. So railroads to me, and it's crazy, even where I live now, I'm not far from basically an industrial rail line that basically connects a bunch of plants and other things together. So in coal country in northeastern Pennsylvania, it was all about the way that you got, it's like, okay, the coal comes out of the mountain here or out of the hole in the ground. Then you take that coal and then you put it on here and you take it over there to sort and filter. Then you take it and all the way down to like Bethlehem and Allentown where you're making steel, and then the steel's coming back up to basically get on the train in Scranton and go out across the country to build it. So rail for transportation was like a part of it, but the real money maker was this supply chain expansion between these factories. Saw the same thing like in Connecticut, used to live there's a whole canal system like between Hartford and like Springfield. That's fascinating. I lived on that for a while, and it's just thinking about these canals ran and they connected all these mills for all these industrial uses. You don't have to do the same amount of maintenance on the canal. Like it's really interesting to think about the companies who did this, how you would have invested it, what those returns would have been, and how back to the table stakes idea again. There's companies in 2026 who are still using the rail for transporting stuff between shipping facilities like blocks from my house, twice a day, they go by. It's the worst train if you're trying to get somewhere and you have to wait because the amount of those giant like storage container things that go by. It's like a 15-minute wait for that train to pass you by. What's funny is with the commuter rail growing up, like that doesn't really exist. Like where I am, like railroad crossings aren't really a thing. Like it goes over the road or whatever. And then when I would go down to Georgia growing up, you'd be like, "Holy crap." Like, "When is this train going to stop going by?" Like, it's just going, it's just going like forever. You're like sitting there for 15 minutes. You're like, "How could they even pull this thing with like with an engine? This thing's so long." It's it's amazing to think about and it's really I love zooming out the way that he zooms out here to think about them as businesses, how they were financed, and then why different aspects of basically like moving stuff around would mean totally different things and people in different locations would have a totally different understanding of it. It's a really cool piece of history. So our next clip is back to Mark Rubenstein, and you asked him at the end, I put this in because I thought it was good. You kind of asked him at the end to sum this up, like what is his take based on the overall situation and kind of what is he positive about and what is he negative about. So here's Mark talking about that.

The market overall is confusing, right? I mean, people I speak to, you know, I regularly speak to people still managing money, and many of them say that they don't recall a time when they've been as confused as currently, against, you know, a tide of bad news. This is all quite well rehearsed. But against the tide of bad news, the market just powers ahead. And many explain it away through market structure, role of passive, for example, more retail investors. Um, obviously AI has a huge influence on market internals right now, and allocations. So it's just really confusing. Against that, financials become kind of questionable. So against that, financials, they're never a safe haven because that playbook is still there to be pulled down. But and Europe, Europe in particular, I would say, you know, Europe, we've seen this huge divergence between US and Europe over many years. Um, like a lot of trends, so many trends have accelerated over the past few years. You know, we spoke about this in the context of private credit growth, but just, you know, the AI trade, US analysis is Europe, you know, anything that was totally along in a linear fashion on a chart has just tipped up over the past couple of years. And US versus Europe is another example of that. And Europe's not spanners, he's fee. We've spoken about Revolut, probably they'll list in the US, doesn't really matter where they'll list. You know, DeepMind is a UK company listed in the US, inside of Google Alphabet. You know, we talked about Jane, one of its largest competitors, flies under the radar company called XTX, which is London-based. Revolut is another, is another, could be one of the biggest beneficiaries of a change. I mean, it's again, traded in the US, could be a beneficiary of change in free float rules that NASDAQ is introducing for its indices recently. So, lot of innovation in Europe. It's not that bad. Uh, and so, yeah, I would say long Europe versus the US, financials versus the market.

A piece that I just feel like people don't know about Mark, and there's a great, we did an intentional investor interview where I got to talk about a lot of these career milestones with him that's worth checking out. If this intrigues you, you should check it out because like he talks about, he ends up running a financials focused long short book through the GFC, like through the worst, the global financial crisis. He's running a long short strategy through it, and they survive and do they do pretty well. They do pretty well. So he does okay for himself through this period, including the recovery on the other side, which is really interesting to talk about. So what he was pointing out is there's a whole bunch of things in. So number one, this idea. Did you? This is I think in the longer interview where he's basically like, growth is the enemy of financials.

Yes. Yeah. Growth is bad. That's my thumbnail actually that that I've got up right now. That guy, like, what an amazing idea in the era of like scale that like growth is bad, and it's actually a red flag when you're looking at these companies because you don't want to see them trying to grow too much because that always begets problems when you're in financial services. You want more of a utility actor than somebody who's chasing growth. So inside of all that, he's looking at all the things that have sort of quietly been built at lower valuations that are doing like interesting global stuff, not only outside of the US but like in Europe that are plugged into these systems. So a more stable growth path, a much lower valuation, and a whole different opportunity set that people don't seem to understand the size. His story about Revolut, namechecking like XTX, the Jane Street competitor, a bunch of these entities, DeepMind outside of the US. Not a take I was expecting, and very, very intriguing. I'm very excited to run this past some other international investors and just say, do you agree with this, or is there a hole here that you see because I'm intrigued. The pixie dust is on me. So, as we wrap up, we're back to Jeremy Grantham for our last clip. And he has this, GMO has this thing called the bubble detector, which we talked about in a different clip, but I hadn't heard this other thing he has in terms of this thing that's happened at the top of every bubble before it's popped. Um, and so here's Jeremy talking about that.

We had every condition of a bubble in place, including my very favorite rule that I could or could not describe to you, which was flashing brightly. Um, and that rule only occurs at the top of 1929, the Nifty Fifty of '72, and the tech bubble of 2000. It had only occurred three times in history, and in the fourth time was late 2021. And that is when the market leaders of the second to last year, where they're all up 70, 80%, the market leaders start to go down as the market, the broad market, the S&P, continues to go up. So in 1929, the S&P was up 40%. But the S&P had an index there called the Low-Priced Index, which were, you know, $5 flaky fallen angels typically, and they had been up 80% in 1928, and come January '29, they started to go down. And before the market broke in October, they were down 40%. They were actually down 40% with the S&P up over 30. Oh my. That was what I call the biggest scream from the stomach of the market in history. And nothing like that happens again until 1972, where you get a significant, but only a faint echo in comparison. The S&P goes up 17 in 1972, and the average of the S&P goes down 17, so that I can remember it forever. And nothing like that happens again until 2000. As the tech bubble begins to break, growth stocks go down 50%, the S&P continues to go up. The balance goes up another 14%. So that you have the same level on the S&P in September 2000 that you had at the growth stock peak of March 2000. Why does that happen? I think it's because the players, you know, Mr. Prince once said, "If the music's playing, I've got to keep dancing." And that is ultimately important statement of how the professional money management business works. You cannot fight a major bull market. It is ruinously unprofitable. It's not optimal behavior at all. So the big companies never fight the market and never tell you to get your ass out of the market, and they never have. They never will. If you are waiting, dear listener, to be told to abandon ship by the Goldman Sachs and the JP Morgans, you will have a long wait. They have never told you. They never will tell you because it's simply bad business for them. They do very nicely being bullish all the time and trying to be a little quicker and slicker on the execution on the way up and the way down, and it works very well. Thank you. Yeah.

So I mean, I probably knew this, but I never thought about it this way. This idea, like obviously the highest beta names start to roll over way before the market is. So his detector is the high beta names are rolling over or the names that have been leading up the bubble. But the other important part is the market is still going up at this point. Um, and he saw that like in all, and he definitely saw that in 2021. Um, and he talks about 2021. It's funny. It's like somewhere else in the interview, but he talks about 2021 and how AI ruined his perfectly good bare market when it came to 2022 because he was all excited about his bare market, like he was right about it, and then AI had to come and destroy the whole thing.

Yeah. I'm not saying that I loved hearing about him getting his heart broken by his precious bare market getting interrupted, but it is it's really interesting to think about back to the bubble regime idea. You can kind of have multiple bubbles like existing and new fertile soil being created all at the same time. And here's Jeremy Grantham also pointing out, he gets one good pot shot in at like, you know, the major banks, at JP Morgan and Goldman or whatever, in this. And you got to love that coming from. Yeah. They're never going to tell you at the top. The people who are in the business of like raising money and financing these things and being over optimistic are always looking for a new place to raise money and be over optimistic and do this.

They're going to tell you the opposite at the top, right? They're basically going to be like, "Yeah, we got all these amazing opportunities." Yeah. So you have to act in the construct of like knowing new bubbles are could be starting every day. There's new fertile soil. There's people who are going to try to chase this stuff. And it makes a whole different system to navigate around. The humility in here is really interesting to me.

And it's interesting because I asked him like, "Are we seeing any of that today?" He said, "Absolutely not." But what was interesting is like before we had Claude Methos, we were sort of seeing some of that, like some of those high beta names were starting to roll over relative to the market. You'd seen value come back. You had seen a lot of the types of things he was talking about. The market was still going up, but some of these leading names were underperforming. And then you had like Claude Methos or whatever it was, you know, bet good earnings from semiconductors and all that stuff. And like that's completely reversed now. So, uh, he's he's right, right now, we're not seeing any signs of this.

Yeah, it's it's really interesting to see him think through this in real time. That was a really cool question. So, that wraps it up. Uh, we we had some really good stuff today, so hopefully everybody enjoyed it. Um, Matt, I'll let you take us out.

Well, first off, whoever has to dust those shelves behind Jeremy Grantham, like, God be with you. All those wood slats and those angles, I'm glad that's not my job. They were perfect, though, weren't they? They were immaculate. I'm pretty sure I paused and zoomed in on a screenshot just to see. But yeah, I was almost like, is this a fake backdrop? Because this is if we had a backdrop award between our various guests. I mean, they they would be they would be right up there, right? GMO? Well, and let's just say Chancellor, best chair in any, like, what was he sitting on? Like, did the hair coming off of that thing? I don't know if it was like, like a bear rug, like some kind of like I had a dog who had weird hair like that for a long time. Best chair I think I've seen in any podcast where just most questionable amounts of fur coming out from behind. We're gonna see now, we're gonna have to do backdrop awards because Mobison wins most appropriate for the guest because literally like piles of books on the floor behind him, just going up. So like now we're gonna have a whole, a whole backdrop. I want to do the backdrop awards. Award watch us doing this for an hour and I don't care. But we'll put it, we'll put it somewhere else. I want to do the honorary backdrop awards. Yes. That's what I want. All right. All right, enough shenanigans. Excess Returns on Substack. Make sure you go there. We're doing top lessons from these investors. There's show transcripts. Train your LLMs on this website. We are building this as a resource for us to use. It's right there for you to use, too. Come subscribe. Check out what we're putting out alongside every single one of these episodes. If you're watching this on YouTube or your podcast app, you know what to do. Like, comment, subscribe, all the things below, and we are out. Thank you for tuning into this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio platform or on YouTube. You can also follow all the podcasts in the Excess Returns network at excess returnspod.com. If you have any feedback or questions, you can contact us at excessreturnspod@gmail.com. No information on this podcast should be construed as investment advice. Securities discussed in the podcast may be holdings of the firms of the hosts or their clients.