We live in a fantasy world now. Reality has been destroyed. This is the time that you really need to pay attention. The probabilities are overwhelmingly on gold's side. That is the best environment to see gold increase its value.
Welcome to Palisades Gold Radio. I'm your host Tom Bodrovics. Joining me today is Michael Green. Mike is the chief strategist and portfolio manager for Simplify Asset Management. Mike, thanks so much for joining me today. How are you?
Uh, it's a pleasure to be here. I'm doing well.
So Mike, one of the big things that I first kind of heard you talk about and I think is really important to understand in this current environment and especially, you know, as a change that we've seen over, let's say, the last decade is this idea of passive fund flows and how important they've been to really building the market to the point that we've seen it get to and especially, let's say, the narrowness of where the market currently is. So, if you could, if we could start there by kind of getting an overview of what that really means for the market and how you've seen that change through your studies of it.
Sure. So, my work on passive really began in 2016. There was a paper written by another researcher, a partner at AQR named Lasse Pedersen. He was the first to really come at this from a more theoretical framework. So, there's been lots of complaints about passive as, you know, like why would you settle for average and passive is worse than Marxism, etc. Um, Lasse was the first one to actually challenge what the definition of passive was. And so, his paper in 2016 called Sharpening the Arithmetic of Active Management referred back to a paper by Bill Sharpe, the inventor of the Sharpe ratio, one of the founders of kind of modern portfolio theory, um, in which he described the rationale for passive. And the thought experiment that Bill Sharpe went through was pretty straightforward. By definition, all active managers own the market in total. Therefore, by definition, passive also owns the market in total. It's simply mirroring what the active managers are doing, and therefore the only difference between the aggregate of active managers on an asset-weighted basis and passive would be fees. And since fees are lower in passive, that would lead to outperformance in passive. Um, that was the rationale and thought process that largely underpinned the growth and acceptance of passive from roughly 1992, um, 1991, that paper came out in 1992, passive was about 1% market share. Today, it is north of 50% of all assets in US equity markets. And so, it's been an extraordinary growth over the last, give or take, 30 years in which passive has exploded onto the scene, and very little work was done saying how is this changing market structure until Lasse Pedersen's paper in 2016.
Now, my contribution to this was to look at this paper and say, "Wait a second." What Lasse identified was that during periods in which indexes rebalance, passive managers have to trade. And by Bill Sharpe's definition, that means they cease being active. Let me actually share a slide from one of my presentations that actually hits on exactly this point. So, according to Sharpe's definition, this is what passive investing actually is. A passive investor always holds every security from the market with each represented in the same manner as the market, in other words, market-cap weighted. Um, an active investor is simply one who is not passive. And Lasse Pedersen's key insight is in footnote number four, that there is a recognition that if you're always going to hold, that means you never trade. You cannot get into the market, you cannot get out of the market. In other words, it's magic. All right? Now, um, Lasse correctly pointed out that during periods of index rebalancing, that ceases to be the case. And so, during that time period, passive investors simply become systematic algorithmic investors who invest in a particular way given a change in the index constitution.
My key insight was that because passive investors receive flows, or passive funds receive flows every single day, inflows or outflows, that means that they're constantly transacting. And as a result, they're not passive at all by the own definition of passive proponents. What they actually are are simply systematic algorithmic investment strategies that operate off of basically the world's simplest algorithm. Did you give me cash? If so, then buy. Did you ask for cash? If so, then sell. And once you recognize that, then all of a sudden the analysis changes radically. Instead of saying, you know, well, passive comparison to active, you actually start saying, hey, wait a second, how does this emergence of the systematic algorithmic investor change market behavior? And that's really been the focus of my research. There's a couple of things that it very clearly does. The first is that because you're introducing investors who simply say, did you give me cash? If so, then buy. You've removed any filter in the market on something like valuation. And so, this was another slide from my research in which I asked a really simple question, um, how do active managers actually behave to inflows and outflows? And so, I was surprised to discover that nobody had really done this research. I went out and I surveyed investors and I asked a fairly simple question. You're a portfolio manager, you have 5% cash in your portfolio, so cash is not a meaningful constraint in either direction. You receive an inflow or outflow, what is the likelihood that you will deploy the funds or sell securities to meet a redemption given some type of valuation? And so these are the two best fit lines that emerge from that. The marginal propensity to buy, unsurprisingly, falls as valuations rise. Right? So valuations rising causes the marginal propensity to buy to fall. And the marginal propensity to sell rises. That should be somewhat unsurprising because for most active managers, the current level of valuation is somewhat determinative of future expected returns. And so high valuations, low returns. Therefore, you're more willing to hold cash than you might otherwise be. Um, that's not surprising. What was surprising is the intersection of these two lines at almost exactly 50/50, at exactly the market's historical valuation average. And the reason that's so interesting is cuz notice I didn't mention anything about interest rates, I didn't mention anything about business cycles, I didn't mention anything else. I simply said valuation. And if you build an agent-based model and you populate it with the responses from these surveys, and then you randomly add cash or take cash away, what you discover is that a market constructed of participants who behave in this manner exhibits valuation mean reversion. Right? As valuations rise, as you become less willing to buy, more willing to sell, that causes valuations to reverse. And so on. Right? This is actually what gave rise to the Shiller PE and the cyclically adjusted PE and why it, quote unquote, worked to explain historical behavior. Unfortunately, that research came out in roughly 1994 and 1995 just as passive was really taking off. And so the question becomes, well, what happens when you introduce a new participant that has a 100% propensity to buy or sell with no consideration for valuations?
And just for a little bit of context, where are we currently roughly for valuation right now in the market?
Uh, for valuation, we're at the highest levels in history. I'll actually show that chart in just 1 second. Um, but in terms of passive penetration, we are now just about 50%. All right, so slightly over 50% in US equity markets, a little bit lower in foreign markets. We can talk through the implications of that. But what happens when you introduce passive investors and you have them gain shares, what you're ending up doing is shifting the composition of the market away from a mean reversionary pool of managers towards a pool of managers who simply buy regardless of valuation. And in fact, because of market cap weighting, are biased to buy more of the stocks that have gone up and achieved higher valuations than lower valuations. In other words, a positive momentum loading. If you run that same model through showing passive share gain instead of mean reversion, what you get is mean expansion with valuations rising to levels we've never seen before, which unfortunately perfectly fits the actual data that we're seeing. And so again, here is the theoretical model, here is the actual data for the S&P 500 with valuations rising to extraordinary levels, skewed heavily. This should actually say median price to sales in blue and cap weighted price to sales in orange. So, the largest companies become more richly valued, but importantly, everything is rising in value. All right, so this is indeed the quote unquote everything bubble that is created by this framework. So, we're at the highest levels basically in valuation history even as more and more people are enthusiastic about the stock market because it has shown nothing but rising valuations over time. Um, the recognition of this is unfortunate that it effectively means that this is a function of passive share gain. And then the question becomes, well, what happens when a systematic algorithmic strategy like this eventually gets to the point at which selling occurs? And that's where it overlaps with a trade that I'm very well known for, which was the implosion of the XIV on February 5th, 2018. This was the inverse VIX complex that exhibited a lot of the same behaviors. So, it ended up, you know, we ended up seeing effectively the XIV rise and rise and rise with people's perception being that this made it more and more likely to outperform. And then in a tail of turkey type framework on a single day on February 5th, 2018, the entire complex collapsed, went to zero. I had a significant trade on at the time that ended up paying out, but this was the exact same analysis. Effectively, once these strategies get to sufficient size, that their flows are the dominant flows. When they try to exit the market or when an event occurs that forces them to try to sell, there can be no buyers below effectively that can handle the size of that type of transaction. And unfortunately, I think this is basically where we're getting to in the overall US equity markets.
So, basically when the, let's say, the end of that passive flow gets marked, as you said, there's no entity that can come in and buy that type of selling or that volume of selling that comes into it.
Yeah, I mean, I can give a really simple example. Let me actually jump to just to compare what these funds look like. So, you know, this is the world's largest active fund. It's the Fidelity Contrafund. It's about $150 billion in assets. It's carrying about $4.5 billion in cash. Right? If they receive a redemption, they can use cash on hand to sell from that redemption. In contrast, the world's largest passive fund is the Vanguard Total Stock Market Index Fund. It's about $1.3 trillion just in this share class. It's got multiple share classes that take it up to about $1.8 trillion. But notice something really interesting. It's got negative a billion dollars in cash. In other words, it has actually had redemptions, and because it doesn't want to actually sell, it has been using levered funds to meet those redemptions. The only way that passive handles redemptions is ultimately by selling into the market. And the size of these sales, right? The size of these potential sales are so large that they dwarf anything that the active manager community can create. Now, we've been protected from this because passive has done nothing but gain share over the past 30 or 40 years. Even during 2008, you continued to have positive net inflows to passive. It was just happening at a smaller scale. It hadn't become the dominant feature. Um, and so, you know, now as we get closer and closer to the point where inevitably there will be selling events coming from passive, we're seeing everything basically echo that component, right? The passive share gain is causing valuations to rise. The values at which they're getting to are creating conditions under which most active managers have no interest in owning these stocks. And even if they did, a second feature that's playing out in the active manager space is that the active manager space is actually in net redemptions. Right? And so, what we're actually weirdly getting is more than 100% of the flows at this point are taking the form of passive investment. On net, we're seeing those managers who select on the basis of size or value trying to identify stocks that are undervalued, they're getting sold. And so, this is actually creating a negative loading for the value and size factors that is creating the behavior that we see in US equity markets where large caps run and small caps are underperforming or even declining in many situations. Russell 2000 has come nowhere close to its 2021 peaks 4 years later. Right? So, you know, we're looking at this. The other component is as that passive share gains, the quantity of trading that involves any sort of fundamental insight has actually collapsed. And importantly, this trading actually includes the redemptions that are coming in to the active managers. And so, perversely, that negative loading to the value factor is creating conditions under which we think that Apple and Nvidia and Microsoft are obviously the greatest companies the world has ever seen for the very simple reason that their stock prices keep rising. My work, unfortunately, suggests that that is a byproduct of how we've currently constructed the market. And before anyone, you know, jumps on you and says, "Well, that's because active managers outperform." You know, the simple reality is that what we actually have seen is a series of regulatory changes that have enforced passive dominance. Importantly, in 2006, we introduced something called the Pension Protection Act. The Pension Protection Act changed 401(k)s from an opt-in system in which you had to choose to participate in a tax-deferred savings plan to an opt-out framework in which you're automatically defaulted in. When you're automatically defaulted in, there has to be something they default you into. That's what's called a qualified default investment alternative. In 2006, those were first established as balanced funds, basically 60/40 type funds, a PIMCO bond equity combination. In 2012, under lobbying from Vanguard, those shifted to target date funds. And today, about 95 cents of every retirement dollar in the United States, in one form or another, is flowing into passive vehicles and target date funds. And so, this is really the true like crowded trade that exists. And the question becomes, what happens when they try to exit? My work, unfortunately, suggests it looks an awful lot like the XIV. But instead of happening in a, you know, give or take $2 million ETF, we're now talking about a $50 trillion market index.
I did it just, you know, when we look at it like that, it just makes it seem so looming and dramatic of a rebalance that has the potential to really rock all of, you know, as you said, this $50 trillion market, right?
Yeah, I mean, I think that's really the key component to it is this: in the United States, we've largely outsourced our retirement system to the market. We've presumed that that market continues to function, but our choices of how we allocate capital influence how it behaves. The same way, the rules that are put in place for how a Moroccan souk behaves or a Walmart operates, influences how they behave. Right? If you walked into a Walmart and, you know, the standard rule was everyone that walked in got hit upside the head with a crowbar, my guess is sales would collapse at Walmart, right? Or you'd get lots of headache sale medicine, you know, lots of aspirin would be sold. But the simple reality is the rules actually matter. And the simple reality is most people aren't studying them.
Well, and I think an interesting counterpoint to that, the idea that active managers have been far more, let's say, on balance in the redemption side. You know, thinking about that conversely with passive funds, obviously I think that rebalance we can kind of point to that as the reason for part of that, let's say, divergence between passive and active. But insider selling is also at all-time highs at this point again.
Well, that's one of these really, really interesting things, right? So, um, you know, insider selling traditionally has been thought of as a signal that you should be exiting, right? Um, and the simple reality is nobody cares anymore for the very simple reason that nobody cares at Vanguard. Right? There is no consideration of this. Um, to give you some idea how extreme this is in terms of its impact, I actually just want to share one screen for my Bloomberg shot. So, this is looking at the relationship between small value and large growth, right? And historically small value has been an outperforming factor. This is the Fama-French work with Dimensional Fund Advisors. And literally almost to the day that we adopted the Pension Protection Act and established the QDI as the default investment vehicle, it just turned. Right? And so, like this is one of these really crazy things where we can actually point to a regulatory change. And these happen all the time, by the way. My firm Simplify is a byproduct of a regulatory change that was introduced in September of 2020 that facilitated the inclusion of derivative strategies, what I'm historically known for, into ETFs, creating the opportunity to launch new ETF firms. Um, you know, these types of regulatory changes really, really matter, but this is one that is so big and so important and so unknown. Right? It's, I used to use the analogy of the David Foster Wallace "This Is Water" speech, right? The graduation, commencement convocation at Kenyon College that he gave back in 2014, I think it was, in which he describes a scenario in which, you know, two young fish are swimming along, pass by an old fish, the old fish shouts out, "Hey boys, how's the water?" And they look at him kind of weird, they swim on a little bit further, and the young fish turns to the old fish, he goes, "What's water?" Right? And so this is part of the challenge. This is the medium in which we're swimming. We presume that the swimming pool is unchanged despite the fact that we've got the heater going, right? And so, you know, like we are unquestionably boiling the water at this point.
Yeah, that's a great speech. I'll make sure I include a link to that in the show notes. But Mike, when we think about the, you know, as you mentioned, this rebalance of the markets, what do you think could act as a catalyst to reverse it? To reverse this action.
Yeah. So there's a couple of things that matter here, right? So once you change the system to one in which is very simply tied to do you have a job? If so, then you are contributing, right? One of the obvious links becomes, well, um, a factor that you have to consider is employment. And you know, I've written on this, I know you read my Substack, which is Yes, I Give a Fig, um, and you know, I've highlighted some of these in my writings over time in that, but one of the key factors that has occurred is in that mean reversionary market in which active managers are theoretically looking at stocks and making forward projections and building a discounted cash flow analysis and saying, do I think the stock is overvalued or undervalued? If it's overvalued, I'm going to reduce or sell my position. If it's undervalued, I'm going to buy it, right? A recession is a signal that your cash flows are going to deteriorate in the future and therefore it should be worth less. So, you start reducing positioning ahead of the recession occurring. But if you have a system in which the allocation of capital is simply a function of do you have a job? Well, employment is a deeply lagging indicator. It doesn't start to fall until the recession is already here. And so, one of the things that becomes very perverse is that markets move from discounting mechanisms that effectively can tell you what is happening in the future by virtue of the wisdom of the crowds to a system that is now a lagging indicator tied to employment. And so, one of the most important things we're watching for is a deterioration in employment, which in turn will lead to a decline in flows. We're starting to see some indications that that's happening. The second component though that is also, you know, worth highlighting is that there is a feedback loop that is created by valuations themselves. And so, the second thing to remember is that 401(k)s or systems of retirement are designed to fund retirement. At some point, you start taking withdrawals. Um, withdrawals are always going to be a function of asset level. So, the total value of the asset is going to be a key driver of how much you're withdrawing. Uh, 401(k)s, for example, have what's called required minimum distributions. Those required minimum distributions are set by your age as a percentage of the assets held in your 401(k). So, if [asset values] get higher and higher and higher, eventually the withdrawals will overwhelm the contributions. Again, we are seeing some indications that that's happening and that's deeply facilitated by the retirement of the baby boomers, which is an inevitability, right? They will not work forever. They've stuck around for a very long time. They've worked longer than we would have anticipated. We've repeatedly changed the rules around 401(k)s to encourage assets to remain there and in the Trump one big beautiful bill, we actually go a step further. We introduce the idea of baby, you know, credits that are going to be invested, $1,000 invested in US equities. Now, that's actually a relatively small sum, right? There's roughly 3.6 million births in the United States. So, even if everyone got $1,000, that's only in the neighborhood of 3.6 billion dollars, right? It's just not that much money in a flows determined market in which we're talking tens of billions of flows in any given month. Um, but you know, that's an example of another rule change that's basically designed to get people in early, keep them in for their entire lives, basically turn us into a whole bunch of Bitcoin hodlers. Um, the system eventually fails, but one of the other challenges is that increasingly we have outsourced decision making by our policy makers like the Federal Reserve, for example. They increasingly rely on market derived measures to determine should they hike interest rates, should they cut interest rates, etc. And as we take away that forward-looking capability from the market, we turn it into a lagging mechanism. That means that inevitably the Federal Reserve and other policy makers are going to be driving using a rear-view mirror that basically only tells you where you are once you've already crashed into the tree.
Well, you know, as you're explaining that, it just obviously to simplify it a little bit, almost seems like a literal Ponzi scheme as you were explaining it to me.
Well, I mean, this is one of the interesting features is that equities in this framework do become a Ponzi scheme. All right. So, uh, my good friend David Einhorn whose discussion of some of my work in, I think it was 2022, you know, really raised awareness of this. David is obviously far more famous and more successful as an investor than I am. So, I'm quite happy that he chose to do that. But, what David highlighted was the difference between endogenous cash flows and exogenous cash flows. An exogenous cash flow is one that is Ponzi-like. It requires somebody else to give me cash for the asset for it to have value. And the vast majority of equities, because they have very low dividend yields, very low return of cash on a net basis, even the largest stocks, Nvidia, for example, didn't start returning cash on net to shareholders until around 2023, give or take 30 years into its life cycle. Um, but those assets rely on exogenous cash flows, things like fund flows that we're talking about. Um, what David was highlighting was the opportunity to invest in companies that have endogenous cash flows, in other words, are buying back their shares or paying a high enough dividend to give him the expected return that he requires without relying on other investors. As I pointed out, all valuations are rising. David will now concede that it's become almost impossible to identify even those securities. He finds almost nothing undervalued at this point. Um, but bonds actually are a very different asset because their cash flows are deeply endogenous. All the cash flows that I get from bonds, particularly a short-dated bond, are going to be a function of cash that is paid either in interest or in return of principal. Um, if I think about a longer-dated bond, there's certainly the potential for prices to become influenced by passive behavior during kind of the center of its life, right? But at the terminal value, it's going to be worth the principal. Right? So again, it has a largely endogenous characteristic. I actually think I have a chart on that that's worth just highlighting. Okay, so this is a messy chart and I apologize. Um, but hopefully I can explain it well enough. So this is looking at exactly that type of characteristics you're referring to. The path, you know, if I invest $1,000 in equities, the path of possibilities is, you know, determined by an upward slope. We expect stocks to rise over time and ultimately return more than bonds. But it can have a high return framework in which valuations rise, it can have a low return framework in which valuations compress or earnings are disappointing or whatever. But ultimately, this final price is determined by somebody else, right? Who wants to buy it from me. Right. In bonds, they have a totally different cone of possibilities. They basically have the same feature. You have a positive expected return associated with it. There is a low interest rate environment in which it modestly diverges, but then comes back to the same point. There's a high interest rate environment in which it falls and then climbs back to the same point. I draw the analogy. A bond basically looks like an American football in upward flight, right? It can have a low return framework, it can have a high return framework, but at the end of the day, you get the exact same back. Now perversely, what this means is that a passive impact on equities is that rising valuation over time as it pushes it towards the top end of that distribution as passive gain share, the bond actually looks quite different. In a perverse way, it can't be nearly as influenced and actually as you get into what's called the belly of the curve, the tail of the curve, the duration end of the curve, it actually becomes undervalued in most situations. And so I actually think that part of what's happening in the bond markets today is the impact of passive. It's roughly at that stage of penetration that it was in equity markets around 2016 where it really began to influence this. I've actually been talking with Secretary of the Treasury Scott Bessent about exactly this topic. I think it is one of the things that we should expect to see is a greater awareness from Treasury around how passive is impacting the US Treasury market.
I think that this is absolutely fascinating to kind of wrap our heads around and especially the part that this ends up affecting the bond market. So, has this really, because of this market condition of passive taking over so much of the market, has that changed in some ways the role of the Fed as well as, let's say, the data that they depend on?
It absolutely has. The question is have they yet realized it? Right? So it's a little bit like, you know, driving with the idiot light on in your car, right? It tells you something's wrong. We all know something's wrong. The question is now do I want to take the time to pull into a service center and get it serviced at potentially high cost while losing access to my car. A lot of people simply decide, you know what, the car still runs. I don't care about the red light being on. Um, that doesn't sound like a great strategy from policy makers, but that's currently where we are. And so like I would argue that the Fed is being misled and candidly I think most market observers spend the vast majority of their time trying to interpret the economic data in the context of the stock market, you know, presuming that the stock market is actually telling you something about the future as compared to what my analysis suggests it's doing, which is just telling you, "Hey, you've got a job." You already knew that. Right? Um, it only reacts once you don't have a job and you stop the contributions or you start withdrawing in an emergency framework from your 401k or in retirement from your 401k. And so this is the part that is hypothesis at this point, right? We have models of what behavior of what happens, we have models of how it impacts it, but we don't know because we've never seen it before.
So, Michael, moving from this idea into basically what everybody's worried about and what the Fed is seemingly worried about right now as well is this idea of if they drop rates, inflation going to be returning. So, I like to try to separate this out and try to understand, you know, let's say the monetary stimulus that they embarked upon with that combination of the scarcity of goods after COVID seemed to be, you know, a good explanation for, let's say, CPI type of inflation that we saw over the past 4 years. So, if they go back to cutting rates in reaction to whatever they finally decide that they're going to react to and they went back to a fiscal type of stimulus only, would this result in the same type of inflation, let's say, asset type inflation that we saw after 2008?
Um, well, I think that there's a couple of things that are worth highlighting, right? So, one is, you know, there's this general idea that cutting interest rates is going to be inflationary. Um, it can be. It can also be contractionary. And so this is worth emphasizing. When you look at an environment like we have post 2020 in which there is an extraordinarily high level of assets invested in things like money market funds. It's about 7 and a half trillion dollars that's invested in money market funds at this point. And very little financing is happening on the corporate side or on the household side at the short end of the curve, right? So there's very little adjustable rate financing. There's very little commercial paper in use as compared to what we had going into 2008. And so when the Fed hikes interest rates, perversely the impact that it has today is to raise incomes for those who have short-term assets, things like either a money market fund or savings in a bank, etc. Their incomes are going up. And the fiscal transfer component of that interest expense is actually now probably the single most sizable component of the US budget. Um, it is now past defense in total spending and is rapidly approaching that of Social Security and Medicare combined. If we cut interest rates, that fiscal transfer falls. And so it actually becomes theoretically contractionary. Um, I think I have a chart on that. You know, so if I do a balance sheet analysis and I basically look at the effective rate, this is actually a couple of months old now, um, and the quantity of corporate debt, the quantity of that that's floating, um, the quantity of CRE debt that's floating, etc. You know, if I cut interest rates by 50 basis points, it basically lowers the interest expense by about 37 billion dollars on the private side. On the flip side of that equation though, remember that all that debt is somebody else's asset. So things like bills are sitting in money market funds. There's reserves at the Fed that are paying. There's CDs at banks, etc. And the combined floating rate on the asset side of the equation is actually almost twice that of the liability side of the equation. And so if the Fed cuts by 50 basis points, the risk is actually that you're lowering fiscal transfers, you're reducing income to the private sector. All else equal, that actually is disinflationary, not inflationary. And um, you know, there's another component, right? Which is just looking at things like stock market wealth. Well, the marginal propensity to consume out of stock market wealth is really low. It's about 2 to 5%. The marginal propensity to consume out of interest income is incredibly higher. So, it's 50 to 90% is the typical marginal propensity to consume that's associated with interest rate impact. And so again, when we run through this, we're like, "Look, the stock market doesn't really explain the consumption behavior we're seeing." The increase in interest income that's flowing through to the private sector does a much better job of doing that. And so like I, you know, I just keep coming back to the same place as I say, "Wait a second, there's this presumption through what's called the Euler coefficient that by lowering interest rates, we're going to spur credit and lending activity." I just don't see that. I just, you know, the vast majority of the activity that we're looking for is refinancing of existing securities, not new investment or fantastic, you know, new spending activities. It's simply paying down the debt. And so those lower interest rates are not particularly stimulative until you get back down below the levels at which the old debt was last financed, you know, which happened in 2020 and 2021 when interest rates were effectively zero. So, you got a long way to go before these interest rates become meaningfully stimulative. Right. Um, the second component is that if you actually think about what drives inflation as we saw in the 2020 time period, there's two factors that play
through this, the supply side of the equation. And hiking interest rates is certainly not going to help you on the supply side. So, cutting interest rates could theoretically stimulate investment that causes supply to expand. That would again be deflationary or disinflationary.
But on the flip side of that, if I think about the demand side of the equation, you know, is cutting interest rates going to affect that? Again, I come back to, well, it's actually possibly going to reduce net income levels. And so, you know, that becomes a negative. Then the last component is this really what is the underlying driver of demand-based inflation. And the most important factor that plays through in demand-based inflation is simply population growth. It's really more accurately labor force growth.
And most people think about labor as being a disinflationary impact, right? If I have more labor, that actually reduces my cost to manufacturing stuff. But let's forget that the reason why people labor is because they want to consume. The statement of joining the labor force is possibly the single most inflationary statement you can make. I don't have enough. I want more. Right? Do I become immediately productive and do I begin contributing? No, first you need a suit and you need an office and you need a computer and you need a car to drive to it and you probably want to have a dishwasher to do the dishes you didn't have time to do because now you're working. Right? All of these factors end up driving effectively an outward shift in aggregate demand that hits before the supply response can emerge.
And so, periods like the 1970s that saw persistent inflation, we use the term stagflation all the time to describe the 1970s. That's absolutely ridiculous. The 1970s had the most rapid rate of job growth in any decade in US history with half the population levels that we have today. Right? That's an extraordinary recognition that what we actually saw was simply a population driven boom in which women and minorities entered the labor force, formed their own households, demanded cars and dishwashers, etc. That outward shift in aggregate demand is really what caused the inflation of the 1970s.
And so we actually look at that inflation of the 1970s, I mean, it just matches up perfectly with the labor force growth components, right? Now, what happened in 2020 was totally different. We shut the world down, we reopened it. Was it tied to labor force growth? Well, definitely a component of it as people reentered the labor force, they had new jobs, they needed new capital equipment, they needed home offices, they needed all sorts of stuff. Right? And that contributed to an outward shift in the aggregate demand function, but the simple reality is we are now going back to labor force growth that is in the neighborhood of sub 1%. It's about 0.4% is what we're running at currently.
This is not an inflationary environment unless we choose to make it so. And choosing to make it so would be much more like the Biden era stimulus in which we decide everybody should have whatever they want, regardless of whether they've earned it. We should suspend student loan repayments. We should not report buy now, pay later to credit agencies. All those sorts of things that manifested themselves that allowed that aggregate demand to be both significant and credit enhanced. Those are now all gone. And it's heading in the opposite direction.
And so, you know, if we look at what is actually transpiring right now, I'm not the least bit surprised that we suddenly disinflationary pressures PCE, you know, if we properly adjust for the housing component is now printing right around the 1% range. This is the market derived measures that Powell has begun to refer to. It's just not a crazy runaway inflation environment. Can that change? Of course. Can we make bad policy choices? But man, I'm not really that worried about the interest rate cut. What I'm much more worried about is the fact that Powell was late to hike interest rates and then hiked them far too far. Right? So we now have amongst the most positive real interest rates that we have in living memory. The absolute level of real interest rates is very, very, very high. That's creating conditions under which we're experiencing increased credit distress both at the household sector and at the corporate sector. And if it's not addressed in relatively short order, it would just pull forward a lot of the concerns that I have around job loss and everything else.
And again, just to kind of reiterate the importance of the jobs numbers, it seems like this is again all about jobs. And what are there any metrics that you're particularly looking at to kind of understand that as that catalyst that we went over?
Well, there's two or three factors that are playing into the jobs story, right? One is the fact that we have the tremendous uncertainty around both interest rate policy, what is the Fed going to do? And then we also have the uncertainty that's introduced in the technological sphere by the growth of AI or LLMs and the potential for services automation. This is creating an environment of uncertainty and the response to uncertainty is not to fire people, right? You don't walk into the office and you're like, 'Gosh, I really don't know what's going to happen over the next 6 months. I should just fire all my employees, right?' Like that's not your reaction function. Your reaction function is to begin preparing for that, right? You start saying, 'Okay, how many people can I cut? Can I rank my people on the basis of performance? Can I identify my top performers and retain them, etc.'
Which is everything we're hearing from all of the large companies at this point. Can I also adapt to the new systems that are coming into place that don't cost me necessarily as much as these high-dollar, high-value employees? Absolutely correct, right? And so the payback and it becomes particularly intense at the starting end, right? Do I hire a new crop of interns or a new crop of college graduates given my uncertainty about how my business is going to develop? No. Right? And so what we have experienced is the highest levels of unemployment in a non-recessionary environment for new college grads we've ever seen. The general oversupply of knowledge workers who are directly affected by things like LLMs and AI has exploded. You know, I'm quite a bit older than you. I'm in my mid-50s. I actually just turned 55. When I graduated from college, less than a quarter of the US population had a college degree. Today it's 50%. Right? And so there's far more people who are competing for these knowledge worker jobs and presuming that they have earned a place in society as a skilled worker, right? And incurred the costs and debt associated with that that requires them to participate. That has led to an increase in the unemployment rate for college grads to the point that there's very little of a college premium that exists.
