The Systemic Market Risk Investors Won’t See Until It Breaks w Mike Green

We're getting very close to the point at which a crash of a magnitude that is, candidly, unfathomable is increasingly embedded within the markets. And the reality is regulators are largely captured. You can't imagine a regulator saying something along the lines of, well, we're going to restrict passive investing and force people to pay more to active managers. And you know, honestly, I can't argue that they should do that until the risk has actually been proven.

On the individual basis, there's good news and there's bad news, right? Like there are things you can do. Ironically, I think we're seeing some of that with the narrative around dollar debasement or gold, etc., which is really just a way of saying we want our way out of the system. Now, in the process of doing that, you will bid the price of gold up to the point that effectively it creates its own systemic risk, and I think we saw a small example of that in the past couple of weeks. So it really goes back to the same thing: like you can't get out. As a society, we are somewhat trapped by this dynamic. All I can really hope to accomplish is to make sure that people are aware of what is actually causing this, so that when the event does occur, we can start rebuilding in a more structurally sustainable framework.

Wow, that swings us in a direction I didn't fully anticipate. Look, the work that I'm most known for is my work around the impact of passive investing and systematic index-style investing, particularly market-cap weighted. What that's done is it's removed an element of information from the market. Historically, markets were a function of individuals conducting analyses of the value of the security, then comparing that against the price and using that distinction to determine whether or not they thought it was an attractive investment. That process is naturally mean-reverting. It encourages you to sell when prices go higher. It encourages you to buy when prices fall below your estimate of fair value. Now, it never worked that smoothly. Let's be very, very clear, right? As an investor, I can have my clients take money away from me. That removes my discretion, right? Likewise, clients can give me money, and in many ways that removes discretion as well. It forces me to consider where to put new capital to work. Even if I don't necessarily think it's a particularly attractive environment, I have the option in most situations of holding cash. But if I build a portfolio that's 50 to 100% cash, you know, you're not going to pay me for it, so you take the money away.

That has been lost with the shift to passive investing, passive index investing in particular, the allocation of funds through retirement accounts like 401(k)s, in which the money flows through automatically as a function of your employment and is allocated to securities on the basis of their market capitalization rather than a calculation around discounted cash flows. That means that the money has to be put to work. And the minute you recognize that, you recognize that you've now lost the information content about the value of the securities, and candidly, you've also lost the information content about the forward-looking prospects of the business because nobody is actually doing that calculation, or the marginal investor is not doing that calculation. That's kind of the biggest metagame that's going on right now, is that we have moved from a market in which information was largely about the cash flows associated with the underlying security to increasingly information about the character of those cash flows coming into the investment market.

The quick answer to that is there are definitely signals that we could look at. So, this is actually a slide I created, believe it or not, in 2017 as I began the process of doing this. None of these have been updated in any meaningful way with the exception of the last one: portfolio effects dominating cash flow and discounting effects. I can dig into that with a little bit of detail just to explain what's meant there. But the things we should be looking for is an increase in correlation between securities, an increase in valuation of securities regardless of the fundamentals as passive share grows, reduced market elasticity raising the risk of extraordinary price movements, an increase in market concentration as momentum bias leads to the largest companies becoming larger, a reduced ability for new companies to become public. And I want to put some caveats around that. There's actually some interesting stuff that's underway right now, of course facilitated by Elon Musk and SpaceX, etc. And then the last one, the portfolio effects dominating cash flow and discounting effects, that also should see a significant increase. And unfortunately, as you see with these, all of these factors increase the risk of investing in this manner. And unfortunately, at this point, the jury is really no longer out that actually all of these have now come to pass.

And so this was one of the primary contributions of my research, was identifying that most of the analysis that had been done on markets was largely a function of thinking about the difference between active and passive as a stock, basically how much was in each pool. There was no real consideration of the flow dynamics, meaning how much of the marginal capital is being invested in this manner. My contribution was identifying that it was really the flow that determined many of these components. The stock is an amplifying factor to it, right? And I just again want to emphasize, when I say stock, I don't mean stock price or stock market. I mean the quantity of active versus passive. And so unfortunately, you know, now a decade after I began this research, an increasing number of academics have come to the same conclusion.

We still remain uncertain about what the future holds. But unfortunately, my most recent work is actually suggesting that we are very rapidly approaching a point of terminal decay in which all of these factors are representing a very significant risk. The easiest math to think about is we're about 53, maybe 54% passive in market capitalization at this point. My model suggests if that number crosses 80%, regardless of the flow characteristics, we effectively enter into a terminal event. And you know, as many investors may know, my initial work on this back in 2016 led to the creation of a trade around the XIV, which was an inverse volatility ETF in which all of these factors had coalesced to the point that we exceeded 70% of the daily volume coming into a systematic strategy. My analysis back then was this would result in a terminal event. I ended up being right. We did very well on the trade. And what we're really seeing now is effectively the extension of that into the S&P 500 or a total market exposure. So the quick answer is we don't know exactly when it happens. It is going to be flow dependent. Again, that contribution versus withdrawal component is going to be critical. But regardless, we're getting very close to the point at which a crash of a magnitude that is candidly unfathomable is increasingly embedded within the markets.

Unfortunately, there are actions that individuals can take. But in aggregate, anytime you sell, you're selling to somebody else, right? So as a society we cannot diverge, we cannot hedge against this risk. We can accept it and we can start to change our behaviors to ameliorate it. That was the original impetus for me actually going public on this initially after the XIV and my work was proven to at least have some value. I largely approached the regulators and said this is an issue. Unfortunately, the lobbying activity of the passive complex, the Vanguards, BlackRocks, etc. of the world is far more powerful than Mike Green. You know, it seems like an unfair competition. And it is. It's an unfair competition. The reality is regulators are largely captured. You can't imagine a regulator saying something along the lines of, 'Well, we're going to restrict passive investing and force people to pay more to active managers.' And you know, honestly, I can't argue that they should do that until the risk has actually been proven.

The scary story I tell around this is soon after the XIV, I went to the Bank of International Settlements, spoke with them. They came back and said, 'Yeah, we largely agree with your conclusions.' And my reaction was, 'Oh, that's fantastic, right? This is 2018. Like, we can do something about this.' And their response is, 'Yeah, no, you don't understand, and there's nothing we can do because of the regulatory framework that I just articulated.' The only outcome of them raising the alarm would effectively be they would be targeted by the passive complex. They would lose their jobs, and as a result, they just have to wait for the event. The BIS has actually added to the literature at this point, having written similar concerns to mine. But the simple answer is that regulators are not going to do anything about it.

On the individual basis, there's good news and there's bad news, right? Like there are things you can do. Ironically, I think we're seeing some of that with the narrative around dollar debasement or gold, etc., which is really just a way of saying we want our way out of the system. Now, in the process of doing that, you will bid the price of gold up to the point that effectively it creates its own systemic risk. And I think we saw a small example of that in the past couple of weeks. So it really goes back to the same thing: like you can't get out. As a society, we are somewhat trapped by this dynamic. All I can really hope to accomplish is to make sure that people are aware of what is actually causing this, so that when the event does occur, we can start rebuilding in a more structurally sustainable framework.

Well, the really simple answer to that, unfortunately, is just that everybody owns assets in relation to other people, right? So, let's say you put 100% of your portfolio in gold. Other investors start to figure this out and start bidding up the price of gold. Do you then sell your gold for US dollars at a time period when liquidity facilitates that exit, or do you wait for the event and suddenly wake up and discover that nobody else has any money? Right? And if that's the case, then your price of gold will fall. That unfortunately we've seen play out repeatedly in 2008, for example, on the liquidation of Lehman Brothers. We discovered that there were lots of levered holders of gold who needed to raise cash to meet debt obligations. In crypto, you see this as repeated liquidations that occur against levered positions. Whether you're levered or not, the simple reality is somebody else is. And that person is the marginal capital that'll define the price action from that point. So this is unfortunately the definition of systemic risk. You can't actually diversify away from it.

I mean, the quick answer is yes, we are absolutely seeing that, although I don't think it's for the same reasons that we were discussing on an individual basis, right? China has recognized in the aftermath of the US's restrictions on Russia's access to their reserves that holding their trade surplus earnings in a treasury account, you know, in treasuries, exposes them to the same risks, right? They don't want to have that exposure, and as a result, they have done things like diversify into gold. With again, they are playing the same underlying game. If everybody figures out that we need to rotate into gold, we drive the price of gold really, really high. People use leverage to increase their exposure to it. And as long as the systems remain in place to enforce debt collections, which mechanically have to remain in place in a financial market, you know, you will be subject to the same underlying phenomenon as it relates to gold, etc.

What you can't guarantee in those regimes is whether it is a good outcome to remove the restrictions of US influence on them or whether it is a bad thing. Right? In many ways, what most of these countries are doing is not dissimilar to choosing to join the ruble block in the post-World War II era as compared to the US dollar block in the post-World War II era. They're effectively saying, I want the freedom to operate as I see fit. And so the Soviet Union provided that benefit to various countries that chose not to embrace American hegemony. You know, it can be the right answer, right? I just want to be very, very clear, like you could be better off going with China. I would push back against that analysis, though, because we actually know that China's behavior around the world has in general been far less munificent and benign than has the United States.

The Soviet Union's model was ultimately flawed because of its focus on command and control. Command and control is an inevitable feature of any government system, right? That's what a legal code is, is you can do this, you can't do this, right? It's much more focused on the can't do. You know, removing those restrictions against governments like China, etc., and removing the limitations that the US system of, you know, global order, right, a laws-based framework. It's hard to argue whether that's good or bad because we don't know how it plays out. It again depends on the actions of the players going forward. So, you know, my hunch is that China has such inherent contradictions embedded within its own economic model. People by and large are ignoring those in the hopes that they can avoid the influence of the United States. I don't think that it's going to play out that way.

The second thing that I would emphasize is that, you know, part of the description of flows moving to the United States or away from the United States, increasingly the world itself has adopted these types of investment strategies, and this actually has created some really perverse consequences. I would highlight that the UK's adoption of some of these frameworks has actually set conditions under which the default allocations in retirements in the United Kingdom are such that only 15 cents of the average retirement dollar actually is retained within the UK. If you mechanically think about the implications of that, that means that the UK is going to receive far less investment than it otherwise would receive. And I think unfortunately that is another predictable impact of this, that what we end up seeing is more and more money effectively driven into a malinvestment frame, to use an Austrian term, in which we're simply chasing the relative price, the market capitalization of companies around the globe as the first-mover advantage towards passive that pushes up those valuations.

It means the United States has become more overvalued than the rest of the world. And perversely, the rest of the world through its retirement approach is increasingly subsidizing that. So, you know, you're damned if you do and you're damned if you don't. Again, this is the definition of systemic risk, and in an increasingly integrated world, or a world that is heavily integrated regardless, there's no escaping the Spanish Inquisition.

Well, I think competition in the capitalist sense, right, competition that spurs innovation, that lowers costs, that drives innovation, is always a good thing. Right? When you talk about competition within the base layer of monetary systems or of trading relationships, that's actually inherently restrictive, and so it drives everybody to a lower global maximum even as candidly it does introduce some elements of diversification. Right? So there is actually value in having multiple computing systems even though they reduce the aggregate output if those systems reinforce anti-fragility, to steal the frame from Nassim Taleb.

There's also another component, though, as economies become less integrated and as the costs associated with that loss of integration, that loss of efficiency that I highlighted, if that translates to less adequate outcomes or more stress on sovereign balance sheets, it can often lead to conflict. And conflict is inherently a destructive act that lowers everybody's aggregate output in a meaningful way. And I think unfortunately we're seeing elements of that play through.

I think we have probably hit a local peak, and again, defining it as a good thing depends on the outcome, right? It actually turns out, so I mean, one of the things that I would just emphasize is that, you know, there's the very famous quote, right, 'practical men who fancy themselves exempt are slaves to a defunct economist.' By and large, I would argue that the West in particular has become slave to the teachings of Milton Friedman, which have almost no empirical basis whatsoever and candidly have very caustic implications to society, which I think unfortunately we're seeing now manifest in an increasing manner.

It actually turns out that this is a variant of a Minsky-type framework, right? That move towards globalization encourages fragility in the system in favor of optimization or quote-unquote efficiency, that raises the risk of exactly what you highlighted. Modest disruptions or major disruptions can effectively put us all in the soup together for greater risk. But the bigger issue is actually what you're doing when you optimize for efficiency is you are exposing yourself to another factor, which is volatility, and that really sits at the core of it. The tools for analyzing volatility are very poorly fleshed out within traditional economics. We tend to think about things as settling in an equilibrium. The reality is there is no equilibrium, right? There will be constant disruptions and constant new signals that are received. And so the question is how effectively can you navigate from point A to point B? That turns out to be heavily influenced by your resistance and your robustness against volatility.

So, you know, the answer is no. I don't think we've hit peak globalization. If I project us forward 500 years, my guess is we will be a radically more integrated society across the globe than we are today. But if we hit a local maximum, I think the evidence is pretty clear. Yes.

Well, first of all, you know, I think demographics are actually incredibly important, so I can't overemphasize that. Secondly, I think that they are a very slow-moving phenomenon that unfortunately forces us to only consider things after they have gone to an extraordinary degree. Right? Many people have focused on Japan's demographics. For example, Japan, because of the surplus that existed in their country and because they did not have to defend themselves operating under the US umbrella, they were largely able to harvest a significant fraction of the wealth and investment that they made around the world. Today, a country like Japan is uniquely exposed because so much of their investment post-1990 has flowed into China, which is unaligned with the United States, Japan. And this raises a very real prospect that the assets that Japan has accumulated over the past 35 years in places like China actually don't belong to Japan. Right? So it can lead to nonlinear outcomes that change very, very rapidly, unfortunately looking a lot like that XIV chart that I highlighted. If, you know, China were to invade Taiwan and nationalize all of the assets that Japan or the United States has in China, the United States would be fine. Japan would be in the soup.

My hunch is that it's going to be proved to be somewhat nonlinear, and there's a variety of factors that are hitting there. One is, you know, particularly for things like agricultural foodstuffs, those largely exist to, as I described in one of my pieces, feed human beings, right? There is an element of agriculture that has been repurposed for feeding machines in the form of ethanol, for example. As we shift away from fossil fuels, which is somewhat inevitable in our transportation sector, that demand for agriculture will disappear, right? Likewise, a sizable fraction of agriculture goes not to feed people, but to actually feed other agriculture, right? It takes about 16 units of grain to produce the same caloric output in beef as it does in actual grain content itself, right? You know, there's this thing called manure that comes out the other side of a cow that is wasted, quote-unquote, caloric energy.

My strong hunch is that we will discover as we move forward in innovation that not only will we see fewer mouths to feed, but we will ultimately come up with solutions that prove to be superior to nature's production of proteins, that ultimately mean we will use far less agriculture for those purposes as well. So my analysis is that agricultural commodities in particular, broadly what I describe as human food, which would include oil, for example, for transportation, to a certain extent natural gas for heating as compared to electricity generation, etc., that we are probably very close to, if not past, the peak of those demands, whereas the demand for what I call machine food, which is really electricity, steel, copper, etc., could have a very different trajectory as we radically increase the number of machines that are designed to complement humans within the system. This shouldn't be a surprise. We've broadly seen this play out throughout history. Wheat has done a very poor job of holding its purchasing power. Copper has done relatively well.