It’s Worse Than a “Lost Decade” — 1987-Style Crash Almost Inevitable? | Michael Green

I think it's much uglier than a lost decade. I think it turns into absolute nominal losses before entities like the Federal Reserve or other regulators are pulled in to try to ameliorate the situation. The risks that I would highlight of a sharp correction have never been more significant, and American households and, candidly, global households have never been more poorly prepared to weather that sort of downturn. We have a flow-based system that is largely determined by the flow of retirement capital, and an increasing proportion of that capital being sent through passive vehicles that do not have the valuation filter.

It's a pleasure to be here. Thank you for having me.

Well, to be clear, I actually expect that the market will continue to be inflated by the manner in which we invest. So the primary thrust of my research around the impact of passive or index investing is that it removes the valuation filter from the equation, effectively forcing capital into the securities that have appreciated most, driving valuations higher until ultimately we encounter a regime in which the flows into those assets begin to reverse. That could be, as we saw in February of 2024 or 2025, I'm sorry, a tariff tantrum type framework in which Europeans threaten to take their money home. Or it could also be tied to a recession in the United States in which employment declines and contributions into retirement systems decline at the same time that the requirement for withdrawals increase. So the view that I would articulate most clearly is that we have a flow-based system that is largely determined by the flow of retirement capital and an increasing proportion of that capital being sent through passive vehicles that do not have the valuation filter. So I'm actually very much in the camp that says that markets will continue higher and in higher valuations until we reach the logical conclusion of that, which could be any number of what are called stochastic or uncertain events. So, you know, but when that occurs, my expectation is that the impact of it will be far more severe than the underlying fundamentals suggest. Those flows reversing could cause a catch-up and a sharper accelerated decline, what we call a crash. That's actually what I believe we are experiencing and what's underway. So, you know, it all depends on the time horizon in which you're actually referring to this.

Well, the quick answer is you probably shouldn't. If you actually believe that this is going to continue, if you believe that other people are going to continue to believe those truths that you articulated, then you should expect markets to move significantly higher and do so at an almost accelerated pace, what I refer to as an exponential valuation curve. I'm not suggesting that you should flip away from that. In fact, in many ways, I'm suggesting that we should embrace it within the market while understanding the societal harm that it is actually creating. And I think those are unfortunately two very different phenomena.

When you think about what are the alternatives, I do think that there are a number of areas that are experiencing neglect because it's not so much a thoughtful application of the investment principles that you're highlighting. It is increasingly a default setting within retirement services. The United States made this transition back in the early 1970s, the start of the transition from defined benefit plans or pension plans into defined contribution plans, where you move from receiving an income stream in retirement to accumulating a pile of assets that you hope you will be able to sell or harvest the dividends associated with those in your retirement. Those are two very different implications, and a move, you know, a defined benefit plan or a pension plan guaranteeing income allows the system to take advantage of what are called actuarial assumptions. How long is Vlad going to live? How long is Mike going to live? What should we expect on those for a population average split across a pooled portfolio? That's very different than in the process of retirement insurance in which I'm contributing to a 401k and I'm accumulating in an individual pool of assets to satisfy an individual stream. I have no idea how long I'm going to live. I have no idea how long Vlad is going to live. Statistically, if you group us into a pool of 100,000 people, I can give a pretty good articulation of what that group is supposed to be like, but I have no articulation for myself. And as a result, I have to accumulate far more assets to ensure against an uncertain retirement period than I would under the prior system, that has the effect of inflating the demand for financial assets, driving up valuations, and it's complementary to the approach that I described or shift towards passive investing, which simply allows people to invest without considering the underlying fundamentals and the valuations that they're paying. They're simply being told to trust the stock market, very much as you described. And because these are systems, particularly in the United States, but growing on an international basis, that don't ask any of those questions, don't consider those components, and simply rely on people doing what they've been told to do and pursue the limited number of options that are available to them.

I was saying as early as 2016, we saw asset allocators, very smart individuals like Jeremy Grantham at GMO, highlighting that the expected forward returns over the next seven-year period for US equities were sharply negative. Many people believed that. We've now largely seen that belief disabused, and people have been punished for that belief, and there's some evidence that they are trying to correct it after the fact by increasing their equity allocations or seeking out leveraged exposure through things like levered ETFs, which I think are really critical to understanding this last component of behavior. But the simple reality is, I think unfortunately, the evidence that this is increasingly tied to how we invest instead of our belief system is really the critical component in understanding the rising valuations and excess performance we've seen from the stock market.

So again, I think it's a little bit more all-encompassing than that. I, you know, we use the word believe. I'm not so sure many people spend that much time thinking about it. So, you know, you and I are a self-selecting crew by virtue of our interest in financial markets that we spend time thinking about this. But when you are talking about 65% of American households that are now investing through a 401k system, plowing those funds in one form or another into passive indices, either through target date funds or through low-cost brokerage funds, well, the simple answer is there's nothing that 65% of American households all believe. They're simply doing what they are told, not on the basis of a belief system, but because all of the incentives have been set up to ensure that they do this. The returns associated with investments that have employer matches to them, for example, are extraordinarily high. You'd be foolish not to take advantage of that. At the same time, the underlying principle and its exposure to the US equity markets and the risks that I would highlight of a sharp correction have never been more significant, and American households and, candidly, global households have never been more poorly prepared to weather that sort of downturn.

There are examples in which the fundamental narratives have had similar characteristics to it, but there has never been anything on this degree of expansiveness. So to put this in context, the crash in 1929 that led to the, you know, was part of the beginning of the Great Depression. I'm not sure I would agree that it led to it directly. I think there were a lot of bad policy choices and bad assumptions that really ultimately led to the Great Depression. But if we go back and we look at that time period, less than 10% of US households actually owned US equities. The overall exposure to the stock market was quite small. The crash in 1987, similar, far more, you know, far shorter in its duration, and I think largely improperly diagnosed in terms of its implications or rationale, was largely a mechanical component, and I think it was probably one of the first indications or examples of how systematic or mechanical strategies can cause adverse or cause surprising market outcomes, both to the upside and to the downside, leading up to the events of 1987. The existence of portfolio insurance and the belief that that would protect portfolios encouraged additional risk-taking, which drove markets higher and ultimately made the crash more severe. But ultimately, it was a very small fraction of the market.

Today we're talking about a much more broadly distributed framework. The closest parallels that I would actually draw are the period prior to 1907, in which European capital had broadly stormed into the United States pursuing the investment opportunities that people believe that the, you know, yellow brick road of the United States' ascension to world leadership provided, and 1907 was basically the liquidity crash associated with that. By 1913-1914, the concerns of European withdrawal of capital from US stock markets actually led us to close those stock markets for an extended period of time. That strikes me as the most plausible scenario that we've ultimately created a system in which the rest of the world is increasingly exposed to US investments as they gaze longingly on the performance of our 401ks and retirement assets and say, we want that for our citizens. You're seeing European countries increasingly adopt 401k-style systems. Those are investing largely to offset the home country bias that so many countries are concerned about. They're targeted at investing on a global basis, which then reallocates a sizable fraction to the United States. This is a tragedy for the European economies. It's a tragedy for countries that have broadly adopted it for the very simple reason that it's taking the retirement funds, the earnings of workers in those countries, and it's broadly shipping them abroad where the capital formation is going to occur elsewhere, leaving those domestic economies short on capital and facing far less productivity opportunities because they have failed to reinvest. These unfortunately again are byproducts of how we've... So the key to linking this to something like 1907 would be the flows of capital that are increasingly coming from the rest of the world into the United States. This is not at all dissimilar to what we experienced during that time period. And it's a real tragedy for Europe and other areas around the world that are adopting these approaches. They are increasingly sending the retirement funds, the earnings of workers that are being reinvested for purposes of future production, those are being sent abroad. That means that the labor-capital ratio is going to rise, which is negative for productivity and ultimately for living standards.

This is particularly true in places like the UK, which now in one form or another sends nearly 85 cents of every retirement dollar abroad. Denmark has actually just adopted legislation or regulations that will have a similar effect. It's a real tragedy for the young people in Europe who are seeing their earnings being increasingly funding the competitors to their own work capability, and unfortunately, I would argue, chasing after effectively a bubble. When you allocate on a global basis, you reward market capitalization because the United States is the furthest down this path. Its markets increasingly carry the heaviest load and becoming a larger and larger fraction of that global portfolio that European young workers are sending their funds to, or UK young workers are sending their funds to. It is really perverse. It's actually asking the, you know, the kid who's having his lunch money taken away to willingly give it to the bully. It's a very sad setup, and unfortunately, it's indicative of the poor leadership that we have in this time period.

Sure. So I'm going to disagree with Jim on most of these points. You know, look, first, I think that the Fed can absolutely save the nominal level of the stock market. Very simple example would be to print money, use it to buy stocks, which unfortunately or fortunately is illegal for the Fed to do, but that hasn't stopped them from changing their position in any number of crises. And ultimately, I do expect that that will play a role here. What that doesn't do is that doesn't increase valuations, because under those conditions, the Federal Reserve is printing money and effectively floating it into the stock market. Those funds should show up as an accelerating profit share and ultimately a reduction in the value of future earnings because they've been depreciated by the debasement that's described. That would be much more consistent with the behavior that we have seen in international markets in which valuations fall as the nominal price level is protected, what's called a rising cost of equity. Yes, we can be forced into those assets, and yes, we can believe that ultimately we are somewhat protected by the central bank and its monetary printing. But in the process of doing that, the currency loses value relative to all other sources of purchasing power, and valuation should fall. We are seeing the exact opposite, which tells me that the mechanism that Jim and others are highlighting is actually wrong.

The second thing that I would emphasize is that much of that narrative emerges more around the debt markets and the idea that governments around the world, but particularly in the United States, are going to be forced to print money to meet their fiscal obligations in the form of debt that is currently owed. Again, I just don't think that the evidence of that is particularly strong. And importantly, I would highlight that roughly 85% of the US government liabilities are actually inflation-protected assets. Things like Social Security and Medicare are benefits that are adjusted for the inflation that is generated. So it would be actually absurd for the government to try to create inflation, which would inflate the value of 85% of their obligations, in order to address the real quantity of the 15% that remain. It's just, you know, look, I understand the logic of it. I understand why they think it's true. There's just no evidence to actually support it. It's a thought experiment that people run, and it does certainly have an impact on how people choose to invest, but it doesn't actually hold up to the empirical evidence.