When it comes to the question of whether the economy affects the stock market, it’s not about whether the former is in a good or bad state, but how that relates to what the market was expecting. In today’s episode we get into predictions about labour economics during COVID-19, the relationship between the market and the economy, and how to make decisions that suit your risk tolerance. We kick things off by reviewing insights Edward Lazear and Gerard O’Reilly gave in a recent webinar. They spoke about how the current crisis relates to past events from the perspective of labour economics, and what empirical data is saying about stock returns and the economy. A talking point here is the idea that recessions are defined by committees, and always long after they have either begun or ended. This leads to the topic of whether there is a relationship between economic data and stock market performance. We find many examples of cases in the short and long term where no correlation can be found between the two, and cases where the market starts to recover before the economy. We discuss how this speaks of a fundamental difference in the analytical methods of economists versus investors, not a rigged market. The first group assesses past information while the second invests based on where they think things will go. We talk about what happens when GDP is good but not as high as expectations were, and how per-share earnings growth can only keep up with GDP if no new shares were issued. We then switch to the concept of risk aversion and discuss the differences between system one and system two thinking, before moving into a comparison between two methods of analyzing risk. Tune in for your weekly reality check!

Key Points From This Episode:

•    Having a baby and getting a drone license; updates from Ben and Cameron. [0:00:18.2]

•    Great new Netflix shows and books Cameron has been getting into. [0:03:44.6]

•    Predictions about labour economics during COVID in Lazear’s webinar. [0:06:28.3]

•    Implications around recessions being defined by committees after the fact. [0:10:35.2]

•    Predicting future growth based on great performance in financial markets recently. [0:13:45.8]

•    Pent up demand post-crisis; why the government should keep businesses afloat. [0:16:25.0]

•    Gerard O’Reilly’s observations about financial markets in recessions. [0:21:51.2]

•    Lazear’s stabilization predictions, and why inflation isn’t a threat in slack markets. [0:26:09.1]

•    State Street’s ETF rebalance and failed hedge fund rebalancing bets. [0:28:40.6]

•    Is the market rigged? Forward-thinking markets vs backward thinking economies. [0:33:30.7]

•    Market expectations and the effect economic news has on future stock prices. [0:38:21.8]

•    Lead vs lag in when recessions get defined compared to when they begin. [0:38:46.2]

•    How component-based vs automatically rebalanced portfolios are faring. [0:43:44.1]

•    Why yield curve inversions forecast economic activity but not equity premiums. [0:44:25.7]

•    Research that compares GDP growth and stock returns long term. [0:48:01.9]

•    Slippage: per-share earnings growth can only keep up with GDP if no new shares get re-issued [0:54:00.0]

•    How efficient the market is in pricing new information, not the other way round. [1:01:50.3]

•    Determining risk tolerance; unintended consequences to risk avoidance. [1:02:41.2]

•    Why using a GMO point is more effective than psychometric risk profiling. [1:06:18.5]

•    The dollar terms and percentage terms shown on the Riskalyze risk slider. [1:09:15.7]

•    Five methods of appraising one’s risk tolerance. [1:13:02.2]

•    Bad advice of the week! Rebalancing your portfolios. [1:15:36.2]

Read the Transcript:

Benjamin Felix: This is the Rational Reminder podcast, a weekly reality check on sensible investing and financial decision-making for Canadians. We're hosted by me, Benjamin Felix and Cameron Passmore.

Cameron Passmore: This is Episode 94. And, speaking of episodes, I think you have something to share.

Benjamin Felix: Yeah, we were expecting a new baby, and she arrived at 2:20 AM on Friday. So, we were hanging out in the hospital until 3:30 AM, the following day, because they made us stay for 24 hours. And, as soon as 24 hours was over, I was, "All right, let's go." Do the test we have to do and then when all that was done, went home. And, they're like, "Are you sure, it's three o'clock in the morning?" Like, no, no, we're going home.

Cameron Passmore: So, that's when you came home?

Benjamin Felix: Yeah. The doctor's like, "Well, why don't you just sleep and go back in the morning?" I'm like, "No."

Cameron Passmore: So, what is it like in hospitals now?

Benjamin Felix: Well, when you go in, there's an entrance specific, not completely specific, but intended for the maternity ward. You go in, there's a screening. So, at the very front, they make you sanitize your hands. I don't know if they're giving out masks or not. I had a mask on when I went in. And, then they asked you, do you have a cough? Do you have a sore throat? Have you traveled? Have you been with anyone has traveled? No, no, no, whatever. And, then they'll only let you in if you've been called. So, Susan had to go in by herself, first. I couldn't come in with her. And, so she goes up, the nurses assess her. And, then once the nurses say, yeah, baby's coming, then I was allowed in.

So, when I went in, they did a screening, but they also made sure that I've been called up. And, then once I was in the maternity ward, they screen again. So, I get there, the nurse asked the same questions, takes my temperature. And, then once all that is done, they escort me into a room. And, then you're not allowed to leave that room.

Cameron Passmore: At all, until you leave? So, you have to bring your own snacks, etc.

Benjamin Felix: I brought snacks, but they were actually pretty good about giving, both, the patient and the partner, me, in this case, meals. Usually, they would just give it to the patient but because of what's going on, they gave meals to both of us.

Cameron Passmore: Wow. So, your house is busy and your mom was there? Listeners know your mom.

Benjamin Felix: Yeah, that's right. They do. Yeah, my mom started staying with us at the beginning of the month. So, almost two weeks, she's been here now.

Cameron Passmore: Amazing.

Benjamin Felix: Yeah.

Cameron Passmore: So, Susan's feeling good.

Benjamin Felix: Yeah. Everything's good.

Cameron Passmore: Awesome.

Benjamin Felix: Typical, just had a baby stuff, but all good all around.

Cameron Passmore: So, as you know, I shared with the group, I'm now a pilot. I got my drone license.

Benjamin Felix: Oh, I didn't know that. I missed that.

Cameron Passmore: You missed that on Teams. So, yes, I'm officially a drone pilot. Got my registration. And, I even registered my drones. I'm by the book. I have not flown since the rules changed in Canada, so I've always been by the book. So, it was fun to get out yesterday and do some filming yesterday.

Benjamin Felix: Oh, when the virus is over, we should get the drone out, and you can film the RC trucks doing some big jumps.

Cameron Passmore: That'll be so cool.

Benjamin Felix: That'd be so cool.

Cameron Passmore: I've got to figure out how to get the drone to follow things. We get the drone to follow the trucks around. I'll be a blast.

Benjamin Felix: That'd be awesome.

Cameron Passmore: So, my daughter, last week, get this, as people know, she was let go by the restaurant until things get back to normal. So, she applied last week for the Candidate Emergency Response Benefit, the CERB benefit. And, it went through so fast and so easily. I got to hand it to the government, it's well done. Very well done.

Benjamin Felix: Wow.

Cameron Passmore: She did not have a CRA account yet. You don't have to wait for the password that you normally have to, it just went right through. Both of us cannot believe how short and how easy it was to do.

Benjamin Felix: Wow.

Cameron Passmore: Just good. I thought I'd also share a couple of Netflix recommendations. I don't think you watch a whole lot of this kind of, stuff with the kids, but, Ozark season three is phenomenal. Absolutely phenomenal. And, someone's looking for another short documentary, How to Fix a Drug Scandal is super interesting.

Benjamin Felix: I heard about that, yeah.

Cameron Passmore: In Massachusetts. Crazy. And, then the one we watched yesterday, you heard of this Rowdy Ronda Rousey?

Benjamin Felix: No, I remember when Ronda Rousey lost. I can't remember who she lost to. But, she was very cocky going into the fight, and she just got smoked by somebody. Does it talk about that, in the-

Cameron Passmore: Yeah, that's how the show ends. You don't know what happens to her after. But, man, she is an unbelievable athlete. So, that was a great documentary. And, a couple of books, I mentioned in the podcast, Dan Gardner, The Science of Fear, phenomenal book. I also just started on the book called Stumbling on Happiness by Daniel Gilbert. There's a couple really good books I'm reading right now.

Benjamin Felix: Awesome. I wish I read books. I know I've said this before, you always read so many cool books. I just read the papers that we talked about later in the video.

Cameron Passmore: You read the papers and I mean you're a little bit busier with your kids than I am with mine so I have a lot more free time. But, also started playing guitar again lately, so super happy about that.

Benjamin Felix: I made wooden swords for the kids yesterday, we had some sword battles.

Cameron Passmore: Hmm, that sounds safe.

Benjamin Felix: I sanded down the edges, it wasn't too bad.

Cameron Passmore: Have you heard of the cookbook, how not to die?

Benjamin Felix: No. Sounds like a good book though.

Cameron Passmore: So, it's a cookbook that one of our clients, who is quite thoughtful, recommended. So, I picked it up, and it's all about interesting vegetarian cooking and the recipes look phenomenal. So, I'm going to tackle that this week. I've picked out two recipes I'm going to make for the kids and I. Super interesting book. Interesting ingredients.

Benjamin Felix: Are you vegetarian?

Cameron Passmore: I'm not vegetarian, and they don't promote being vegetarians. They said, you just improve your diet by eating more whole foods and more vegetables, it's going to be better for you. But, it's not some sort of, new preachy type way of eating. And, the recipes look fabulous.

Benjamin Felix: Interesting. On a completely other dietary note, I made bone broth for Susan, using beef bones.

Cameron Passmore: Oh, Lisa loves bone broth.

Benjamin Felix: I usually toss the fat while in the compost like you're supposed to. But, this time I decided to keep it. So, all the fat that cooked off, I filled up a container and it's called tallow be fat, like rendered beef fat.

Cameron Passmore: Yep.

Benjamin Felix: And, I've been using that to cook.

Cameron Passmore: It's great.

Benjamin Felix: But, wouldn't fit with your vegetarian recipes, I don't think.

Cameron Passmore: No, but it tastes great. Okay, anything else?

Benjamin Felix: No. Let's go.

Cameron Passmore: Hope you enjoy Episode 94. All right, so off the top, you want to talk about a webinar that you and I both watched last week featuring Edward Lazear, who is the Davies Family Professor of Economics at Stanford, and is also a Senior Fellow of the Hoover Institution.

Benjamin Felix: Yeah, so it's a webinar that Dimentional released. I think they've made it sort of, available to the public now, like we could give people access, I think.

Cameron Passmore: But yeah, I think that expires pretty soon. So, that's why we thought we'd do this little talk about-

Benjamin Felix: Yeah, that was the key is, we figured we could tease out the main insights that he had, and talk about them on the podcast. But, it was overall fascinating to hear. I find, when you get outside of financial economics, and into... Well, he's a labor economist, this wasn't really all about labor economics. But, you start getting in other fields of economics outside of financial economics, there's so much other information and other theory that we never really think about, or talk about.

Cameron Passmore: And, also, it gives you an insight because he was an economic adviser to George Bush. And, it just shows you the level of thinking. He was one of a team of people advising the president. Incredible insights and education and brain power that goes into different policy decisions, just shows you how much is going on. A bit of a background too. He is also an independent director on the boards of a number of Dimensional's US mutual funds.

Benjamin Felix: Right. So, this is, I guess, why they had easy access to him to have him come and speak in the webinar. We're basically just going to talk about what he talked about. And, maybe we'll add some commentary of ours if we can, but like I was saying, this is so outside of what we usually think about and talk about that I don't know how much we're going to have to add.

Cameron Passmore: And, again, this isn't to predict anything, I just thought, and I think you agree, it was interesting information from someone who observes this kind of, stuff and advises governments on it.

Benjamin Felix: But, you know what, the prediction piece is fascinating, because a lot of it is predictive. But, one of the things that I picked up from him speaking is that, for the type of things that he's studying, prediction is what you're looking for. I guess, you could make the same argument where you're talking about stuff like small cap and value premiums. That's, to an extent, predictive.

Cameron Passmore: Yeah, I guess I should have been clear, we're not trying to predict what the market will necessarily do, coming out of this link, directly to the teconomic numbers.

Benjamin Felix: Right. But, the prediction that he was talking about, it's all prediction that would inform policy decisions.

Cameron Passmore: For sure.

Benjamin Felix: Which I thought was fascinating. So, anyway, there are quite a few predictive statements in there. So, he figures that the employment numbers predict a decline in economic output of around 25% for the quarter, just based on the numbers that are coming out now.

Cameron Passmore: And, that's when he talked about, how this doesn't affect the whole economy. I think he estimated that, basically, 20 to 25% of the economy is affected, and so many professions are not affected at all, like he gave himself as an example. He's a professor, he's not affected. School teachers and principals are not affected. So much the economy is not affected by this.

Benjamin Felix: He thinks that the decline will last one quarter.

Cameron Passmore: Yep.

Benjamin Felix: You can see all the prediction. Like I was saying before, it's just fascinating to hear him making predictive statements, but it's all based on, how can we make informed policy decisions using this information?

Cameron Passmore: Exactly.

Benjamin Felix: Like it's required prediction. So much different than trying to predict the stock market. Not different in the sense that you can do it any better. Just a motivation. So, different. Yeah, the disruption's not uniform, like you're just saying, Cameron. He said that transportation, leisure and hospitality have basically shut down completely. And, that's where he got that 20 to 25%.

Cameron Passmore: I was amazed yesterday, I was out for a walk, and I saw a plane fly overhead. I just realized, I have not seen a plane fly... Because, we live near the airport... I've not seen a plane fly in weeks. It's incredible how it stands out when you see one.

Benjamin Felix: Yeah, that's interesting. I have not noticed that. I don't see many planes where I live anyway. One point that he made. I didn't know this, but the National Bureau of Economic Research... I don't know if you knew this or not Cameron, they define a recession. You hear stuff like, two quarters of economic contraction or whatever, it's a committee. It's a committee that sits down and decides, yep, this is recession. And, there's no real quantitative definition of it.

Cameron Passmore: I did not know that. And, I went and did a little bit of homework on that this afternoon to learn more about that. But, amazing, there are people that do this.

Benjamin Felix: Yeah. So, he figures that this will be declared a recession. But, because there's no quantitative way to define it, that's not guaranteed. But, I mean, realistically, it would be tough to imagine them not calling this a recession. And, we'll talk about this, because we're going to talk about some of that research, too, but I just wrote a video on the differences between the stock market and the economy. And, in that research, I was reading also about the National Bureau of Economic Research. In a lot of cases, they won't define a recession until more than a year or a year after the recession has happened.

So, he talked about it being a backward looking metric. It's very backward looking. The person hosting the webinar asked, Ed Lazear, if this will be defined as a recession. Well, it's a good question, because we don't always know what's going to be recession and what's not. It's like, oh, wow, I actually didn't know that.

Cameron Passmore: And, it's only obvious in hindsight, of course, you don't really know when you're in it, necessarily.

Benjamin Felix: And, you don't know when it's going to end. That's the crazy thing about it. Because, the economic data, well, we're getting ahead of ourselves, because I have a bunch of research on this for another section of the podcast. But, by the time the economic data come out, it's like you're already, in real life, way ahead of that data. Anyway, we'll get back to that in a second. Ed Lazear said that we need to know the death rate relative to the number who have the disease in order to establish economic policy.

Cameron Passmore: And, that was fascinating. Give me a greater appreciation for one of the reasons why we have to do a lot more measurement of people to see who has been infected. And, that's when he gave the example of Iceland that is, I guess, by far, done a much better survey of the population. And, it's found that four and a half times more people were infected versus with the number that were identified as having it. So, with more people having had COVID-19, the same number of deaths, it means, effectively, the death rate is lower than we might think.

Benjamin Felix: Right. And, he also talked about how, as more people get the virus and recover, I guess, they become immune. Even if we don't have a vaccine or anything, we might be more willing to open the economy back up. Because-

Cameron Passmore: So fascinating.

Benjamin Felix: Right, that risk of overwhelming-

Cameron Passmore: You need to know where is that point, and how many tests have to be done to determine when that point will be?

Benjamin Felix: Yip.

Cameron Passmore: And, currently doing 100,000 tests per day in the US, which he said is good, it's just not enough to get to that decision point.

Benjamin Felix: This is a week ago that this was recorded or two weeks ago? So, it could be more than 100,000 now. This is a little out of date, by the time our podcast comes out. Yeah, 100,000 per day, but he said that's not where we need to be. I don't know. I didn't check where they're at now. The webinar host asked, where are we at in terms of their recovery, which is interesting to think about, especially when you look at what the financial markets have been doing? They're down a bit today when we're recording this, but for the last week, they were, well, ridiculously good, which a lot of people wouldn't expect.

So, Lazear said that he likes to feature... The way he described it, he likes to feature changes in the S&P 500 as the best predictor of future economic growth rates. He said, he's not as comfortable using that in this period, specifically, because the models that feature the S&P 500 are based on normal times. And, obviously, these are not normal times. But, he didn't specifically refer to which models he was talking about, but based on these models, the changes in the S&P 500 so far, say that we would have a negative 0.5% growth over the next four quarters. And, he thinks that's optimistic. He said, he doesn't think that we'll do as well as that and, we, being the US, he doesn't think the US will do as well as that, but it might be close.

Cameron Passmore: Hmm. He mentioned coming up flat, basically flat, for the next four quarters.

Benjamin Felix: Right. And, they talked about how this is a supply-based recession, because we've shut off a supply business activity and labor.

Cameron Passmore: It has been incredible. You look at how little... I know, our household is spending, for example, because we just been shut off basically from the marketplace, from travel, from eating out, from so many things. Even simple things like flipping our snow tires off the cars. It's incredible.

Benjamin Felix: You didn't flip them?

Cameron Passmore: Not yet. I'm going to.

Benjamin Felix: I've got an appointment next week. Should I go?

Cameron Passmore: Sure, you should go. You got to get them flipped. But, we have record... Not record, but we have very low gas prices here in Ottawa. For the past month since we've been working out of our house, I've filled up the other day for $12. I just topped it up at Costco.

Benjamin Felix: Crazy.

Cameron Passmore: Whereas normally, that's a couple a few days of gas in our world.

Benjamin Felix: Well, talking about that demand piece, Lazear said, imagine, what would happen if tomorrow, we did have 100% effective vaccine, and could inoculate the entire population, because obviously, you couldn't do that quickly. But, he said, imagine if that happened. He expects, there's going to be a ton of demand. So, whenever this thing turns around, when we decide people can go back to work and go back to normal, he figures there's going to be a ton of pent up demand.

Cameron Passmore: Yeah. And, you read lots of comments on Twitter saying, the world has changed forever, and we're all going to be different people going forward. And, that may be the case, I'm not so sure. I'm curious to look 2, 3, 4 years in the future to see how our lives have permanently changed because of this.

Benjamin Felix: It would be fascinating to see what the world looks like.

Cameron Passmore: Certainly a whole lot more respect for the risk of a pandemic.

Benjamin Felix: That is for sure. So, this part, I thought was really interesting, and it speaks to what the government's have been doing. And, he was very careful. He doesn't like to call what the government's have been doing in terms of fiscal policy. He doesn't like to call them stimulus packages, because they're not stimulating anything. He called them liquidity packages.

Cameron Passmore: Absolutely.

Benjamin Felix: So, his comments on, if we get the disease under control, the economy is going to go back to work quickly, because there's going to be a ton of pent up demand. He says, but there's a caveat. That's only true if we can avoid major economic disruption in the interim. And, it's basically like, if businesses shut down, if there's a ton of bankruptcy, then things are not going to go back to normal quickly. But, if the government's able to use the programs that they've been putting out to keep businesses afloat, so that as soon as things go back to normal, businesses can fire up again, very quickly. Then, he thinks it's going to be a fast recovery. But, it's getting from here now to things going back to normal without having all those businesses go out, go bankrupt.

Cameron Passmore: Right, things that went bankrupt ends up becoming much more expensive for the economy than trying to get through this with a stimulus package.

Benjamin Felix: Correct. And, he gave his experience when he was working in the White House for President Bush and Bush decided to bail out the auto industry. And, he talks about the logic behind that decision. Was it allowed for a Chapter 11 bankruptcy instead of a Chapter 7? So, explain what those mean, because we're not American. Chapter 11 is a negotiation between the business and its creditors. So, that's what they ended up being able to do. Whereas, the Chapter 7 is a sale of the assets, right, to pay the creditors.

So, he said, from an economic theory perspective, getting that... Well, just logically, too, it makes sense. Getting the assets from the auto industry back up and running in a Chapter 7 would have been very hard. If they sold the factories, sold the inventory or whatever, it would take a much longer time to get those assets to be productive again.

Cameron Passmore: You can't even imagine how long that would take.

Benjamin Felix: Right. So, the government looked at this and probably did a bunch of modeling, and decided it would cost the government less to do this massive bailout, than it would for them to lose all the associated revenue with the productivity. I've heard that thinking before, but it was fascinating to hear somebody that was directly involved and responsible for thinking about it, is fascinating to hear him explain it. He's a big fan of what Powell's been doing with the Fed. I think it's been well-designed, and the actions been very quick. And, I've heard that from a few other sources, too.

In general, supply-based recessions, which he says this is, tend to be more V-shaped. This was interesting to me, because I would not have drawn this comparison, but it does make sense, he said, "The best example to compare this situation to is World War 2."

Cameron Passmore: Exactly. Because, back then, so much of the labor force was taken out of work when they went to war.

Benjamin Felix: Exactly.

Cameron Passmore: And, when they came back, everything ramped up so quickly. So, I thought that was a great comparison.

Benjamin Felix: Yeah. And, at the time, people thought that it was going to be damaging to the economy to have such a supply of labor. But, it ended up well, not being, and there was a massive bull run and economic boom, afterwards. And, then this is another fascinating example. You try to think of an example and you think about 1918. And, 1918 is a good example in terms of the narrative. But, in terms of the actual economic outcome, it's very different. At that time, everybody's in the middle of World War 1, while you have the influenza pandemic. But, I mean, you have a recession, you have a stock market crash, so it seems like it's very comparable. But, when you hear an actual economist talking about what this should be compared to, that was not one of the examples that he gave.

So, anyway, the other example that he said was is worth looking at, is reorganizations of economies. I would not have thought of that. But, he talked about a command economy, which is like a communist type situation. An economy that's organized by a centralized government that owns most, if not all of the business assets. And, those officials direct all the factors of production. So, North Korea, former Soviet Union, versus a market economy, which is like a free market type situation, which is not organized by a central authority determined by supply and demand of goods and services. So, that's like the US and Canada, obviously.

So, he said that when a command economy changes to a market economy, which we have historical examples of, there is a period of disruption where the whole economy changes. And, then once things get reorganized, there tends to be massive growth. So, he talked about Chile, and the former Soviet Union as examples of this.

Cameron Passmore: Mm-hmm (affirmative)-

Benjamin Felix: And, then in terms of monetary policy, and this was interesting, too... and, this came up in that we talked about all the historical bear markets in a previous podcast episode, this came up in that research, he does not think that monetary policies will tighten up after this quickly. And, he said central banks are terrified of repeating the 1930s recession. So, that's where they had the '29 crash, terrible recession. Then, when things started to get better in 1937, there was a major tightening of monetary policy. And, that arguably caused the big recession that they had in 1937.

So, he figures the fed's going to be very cautious. And, he thinks this is why Yellen was very cautious in raising rates after '07. Central banks, he said, they're nervous of repeating that example. So, Gerard O'Reilly, he was the host of the webinar, that's Dimensional's, co-CEO, who's scary smart. But, he chimed in at one point in this webinar, and talked about financial markets and recessions. And, he had some pretty interesting data points. He said, "Stock returns tend to predict future economic growth. But, those predictions are a lot noisier in times like this." I guess, volatile times. And, he looks-

Cameron Passmore: …the pricing and all the information that's being fed to the market.

Benjamin Felix: Right. So, he gave some data points, starting in World War 2. So, from 1945, to now. And, he used the end bare definitions of economic peaks. So, it starts a recession. So, there's been 12 economic peaks from 1945 until now. The average recession is 11 months over that time period. The average excess return of stocks over the full period, stocks over bills, has been 65 basis points monthly. So, for that full period. Then, he said, "During a recession versus an expansion, the three months around the peak"... So, that's the three months before the start of a recession, or at the start of the recession, excess returns tend to be negative. And, then around the trough, they tend to be positive.

So, he said, "For the peak in the following two months"... So, the peak, this is when the recession starts, the economic peak, "the average equity premium tends to be negative, or on average is negative 2.2%." So, full period, average excess returns, 65 basis points, positive for stocks. And, then for the peak and the two months following the peak, the average equity premium is negative 2.2%. And, then for the-

Cameron Passmore: If you know when the peak is, of course.

Benjamin Felix: Which you don't. And, [inaudible] doesn't release it until after a year or more later. And, then in the trough, so this is the end of the recession, and the two months after, the average equity premium has been positive 3.2%. So, his commentary is that they're at the peak, around the peak, and around the trough. There are these big premiums, negative and positive. So, then the remaining months, and this is in the recession and the expansion, the remaining months, except for those months and two months following the peak in the trough, the average equity premium was about 70 basis points. So, recession expansion, whatever you want.

So, it's really just those key peak and the two months after the peak, you have a negative average equity premium. But then, at the trough, at the end of the recession, which, in both cases, we don't know when that's going to happen. And, the economic data won't tell us until way afterwards. But, you got these big positive premiums around the peak, around the trough. And, then all other months, 70 basis points on average, including during the recession.

Cameron Passmore: It's interesting how all this data is around data points that are only identified long after the fact by NBR.

Benjamin Felix: Right.

Cameron Passmore: So, it's not like you can pivot your portfolio around these as it happens. These are all backward-looking data points, obviously.

Benjamin Felix: Yeah. And, now that I'm rereading my notes here, this may have been what inspired the video and one of the topics we're going to talk about later. But, he looked at the GDP growth of countries and compared stock returns of high versus low GDP growth countries. And, this is actually different from the paper that I refer to later, so I don't know what time period he was talking about. But, he said that the return differences of those two groups have not been reliably different from zero. So, GDP growth, not a good predictor of future stock returns. Although, as we'll talk about later, other research has shown there is a negative correlation.

Cameron Passmore: I think that statement will shock a lot of listeners.

Benjamin Felix: Yeah, I would agree. This is still Gerard, we're not at Lazear talks again. But, there's one more comment from Gerard. He said that, based on those equity premiums, around the peak and the trough and all other months, he said, it does not make sense to change your asset allocation, because you think you'd have new information, but expected returns. You don't. Unless you can predict where the peak and the trough are, expected returns are basically the same in every other month.

So, there's those few months where equity premiums are a bit different. Other than that, they're pretty much the same, on average. So, back to Ed Lazear talking, he said that in an optimistic scenario, we make progress in treatment vaccine and/or disease identification, we would see a major contraction this quarter, and then hopefully, within six quarters, we'll be back to normal. So, that's his optimistic prediction. But, and this comes back to his comment about the fiscal policy piece, this assumes no major business failures. And, he thinks the government is doing what they need to be doing to avoid that from happening. And, globally, governments are doing similar stuff. He said, the fiscal policy packages, liquidity packages around the world, have been similar to what the US is doing.

Inflation, I thought this was fascinating, because I've heard a lot of people questioning this, with all these governments raising all this money, or printing all this money, however you want to describe it, people are worried about inflation. He said he's not worried about inflation, because there tends to be inflation when everything in the economy is tight, in terms of, I guess, labor supply and demand. He said, right now, there's a ton of slack in the economy. So, there's going to be no need to raise prices.

Cameron Passmore: That's interesting, right, because so many people are worried about so much stimulus causing inflation.

Benjamin Felix: Right. So, he said, in the early stage of the recovery, jobs start to come back, unemployment falls, and it's at the peak capacity of the economy, when we might start to worry about inflation. But, at this point, he said, that's not even a little bit of a concern.

Cameron Passmore: Well, it's going to be fascinating to see how this all plays out, no doubt.

Benjamin Felix: Oh, of course.

Cameron Passmore: The human side is obviously way more important, but you combine the human side with... It's like this grand experiment, right, to shut down the entire economy and see how it does restart again. And, hopefully restarts and everyone remains healthy, so we don't have to shut it down again. It's going to be an incredible thing to witness.

Benjamin Felix: It's historic, for sure. It'll be studied for many years to come. No doubt.

Cameron Passmore: Anything else you want to add to that?

Benjamin Felix: No, I just thought it was a different perspective. You had Gerard's points in there, which is the kind of stuff we usually talk about, the empirical data around stock returns and the economy. But, to hear an economist talk about... It's actually interesting, just to point out, that Gerard is not an economist, he is a rocket scientist. Anyway.

Cameron Passmore: Literally.

Benjamin Felix: Yeah, literally, I know. But, to hear an economist talking about how he's thinking about this, and what he's seen in the past, and how it relates to past events, I thought was, just, a really unique perspective.

Cameron Passmore: So, on to a news item this week that I came across. And, this one came from a Bloomberg article, and I've heard it mentioned a lot since I saw the article, about how State Street, which is a massive ETF provider, is delaying rebalancing, some of its biggest ETFs since the Index Provider Standard and Poor's announced that it will be postponing, yes, postponing its quarterly rebalancing from this March. So, this past March. They deferred it to June 19. And, this is a big deal.

So, there's a bunch of indices that had their rebalancing delayed in March by a week or two, but this one affects, I believe, over 60 of State Street's ETFs including the massive $250 billion-dollar SPDR SPY, which is the S&P 500 ETF. The reason given was, they have concern about the volatility surrounding the markets during the pandemic, which can lead to increased costs of trading, and they also traded to the uncertainty of global market closures.

So, I came across an article just doing some more research into this from Vanguard on their site. And, they were actually asked for input into this decision to delay the rebalancing. And, from their website, what Vanguard said was that, they believe that it is presently in the best interest of our investors to delay index changes until conditions normalize. So, the CRSP March rebalance was also deferred to June. Russell and other index providers said it's business as usual. The FTSE appears to be normal this quarter, and the MSCI, the next scheduled date is May 29. So, as business as usual for them.

Benjamin Felix: You'd love to see how much this is affecting the characteristics of the funds tracking these indexes. Like, relative to what they would look like if they were rebalanced to their ideal characteristics for the index, what do the funds actually look like?

Cameron Passmore: Absolutely. The example that Dimentional always uses is a haircut example. So, if you get your haircut once a year, for the last few months, getting pretty long and shaggy, so you only brought back to the way you want to look once a year. Whereas, if you're cutting your hair every single day, your hair always looks perfect, right? Well, the same goes for, especially, you say, a small cap or value index, where those can change dramatically, the makeup. So, you can even make the argument that even do it quarterly is not necessarily optimal, because only at the beginning of the quarter, are you properly in line with the kind of haircut you want.

Benjamin Felix: And, you can see that a bit when you look at the rolling regression data. I did a blog post a while ago comparing building a tilted portfolio, small cap and value-tilted portfolio, using Vanguard versus using Dimensional. And, in terms of factor exposure, you can get pretty close. But, when you look at a monthly rolling regression, what is the factor exposure each month? It's not bad, Vanguard still looks okay. But, the standard deviation of the regression coefficients is higher in the Vanguard portfolio because of the less frequent rebalancing, whereas Dimensional's obviously implementing every single day. So, that effect will be more extreme in this case.

Cameron Passmore: One of things I was wondering because we know that a lot of hedge funds trade around these reconstitution dates or rebalancing dates. So, I found an article in Forbes titled, Hedge funds suffered losses as index rebalancing trades went awry. So, quoting the article said, "The postponement of the rebalancing of hundreds of equity indexes, set off a stampede among computer-driven hedge fund operations that had been preparing for the event." So, for years, hedge funds were making profits off the anticipated changes in the index reconstitution? Probably, the most obvious one would be the Russell series, the Russell 1000, 2000, 3000, because they're strictly rules-based.

Benjamin Felix: CRSP is pretty similar, I think.

Cameron Passmore: Absolutely. Yeah. Good point. Another comment in the article talked about, how do you figure out what sectors might be added to an index? Because, the S&P index, the 500 index, is much more subjective. And, the example they gave with it, since IT has done so well, maybe the index would need more IT exposures. The hedge funds may try to predict who will be in, who will be out. So, the quote here in the article says, "A lot of people lost a fair bit of money trying to position for that stuff," said a hedge fund employee that was hit with losses. It was such a tail event and not in anyone's consideration that it could be postponed. Nobody remotely considered this, whatever happened.

Benjamin Felix: Just another reason it's hard to predict stuff.

Cameron Passmore: Yeah, exactly. Okay. So, on to our feature topic, one of the featured topics that you want to talk about, the portfolio topic, which you wanted to compare and contrast the stock market with the economy.

Benjamin Felix: Yeah, I just see so many people pulling their hair out, saying, oh, this terrible economic data we released, but the stock market went up, how does this make sense? And, people are saying that's a reason to say that the market is not efficient, and it's completely irrational and it's rigged. I'm going to do a video on that, too, is the market rigged? It's not.

Cameron Passmore: Well, it's the screenshot I shared with you. On March 30, I think it was, that had the great big title, Coronavirus, job losses could total 47 million people. This is in the US. Unemployment rate may hit 32% Fed estimates. And, then on the top of the screen, the Dow was up almost 700 points on the day.

Benjamin Felix: Right. So, that's one of the first points for this topic is that, Canada lost 1 million jobs. A record at just over a million jobs in March 2020. And, this was released on Thursday, last week. And, what did the S&P TSX do when that data was released? They closed up, 1.75% or something. And, so that's the kind of data point where people look at that and say, oh, the markets completely irrational.

But, the thing that I don't know if everyone's properly thought through, if you're pulling your hair out wondering how could they be so disjointed, the explanation is fairly simple, it's that, the stock market is a forward-looking pricing machine. The stock market's, pricing and future expectations about cash flows and risk.

Cameron Passmore: Exactly.

Benjamin Felix: Economic news, like we just talked about for the Lazear webcast, economic news is backwards looking. And, sometimes, far backwards looking. By the time we have the data, it could be, in the case of the recession definitions, more than a year old. So, when stock investors are investing in stocks, what are you getting? You're getting the rights to participate in a company's future profits. And, in an efficient market, like I just mentioned, stock prices contain information about future profits and risk, forward-looking, expectations.

And, so when you think about economic news, it's already in the price. The expectations of economic news are already in the price. So, if we use the example of the employment numbers, that really bad expectation for huge job losses, was in the price. And, those numbers come out. The thing that we don't know, and can't know, is how the data that are released are going to compare to what the market expected. That's unknowable. But, if the data come out, and even if they're worse than what an analyst had predicted, that does not mean that they're worse than what the market expected. So, in this example, you could make the argument that even though the job losses were record high, they weren't higher than what the market was anticipating.

Now, that's just that in isolation, there could have been other factors like the US stimulus or liquidity packages that could have affected the stock market that they do. But, in isolation, that would be one of the ways to explain that.

Cameron Passmore: And, the handful of clients that I've spoken to that chose to go to cash recently, and it's very few. The reasons are always similar. And, even when I look back, past crises where people made that decision, whether it's '08, or '01, or the late 90s, the reason is always the same. It's bad out there, it's going to get worse, I've been watching the news. My question back is always the same, well, what have you said that others don't know? No one has any original new information.

Benjamin Felix: Yeah.

Cameron Passmore: And, just because it looks bad doesn't mean that it's going to stay bad. That doesn't mean that, that terrible news hasn't been present in the market already. But, so many people aren't able to make that leap somehow, in the logic.

Benjamin Felix: You'd expect big further declines if there were major unexpected economic events. I don't know what an example would be, a natural disaster, like an earthquake or something. Maybe, that would be...

Cameron Passmore: Well, that was one of the examples you gave a couple of weeks ago.

Benjamin Felix: Right.

Cameron Passmore: Right.

Benjamin Felix: Sure, if we want to think about how much further down could the market go? Now, the current pandemic situation could still get worse?

Cameron Passmore: Absolutely. We're not saying prices are right.

Benjamin Felix: Right.

Cameron Passmore: Absolutely.

Benjamin Felix: But, it would have to be some major unexpected thing, like the mortality rate ends up being way higher than anybody ever anticipated, and that data starts to come up. That can have a big negative impact.

Cameron Passmore: Yep.

Benjamin Felix: Or, natural disaster, like I said, like a massive earthquake destroys half of North America. That would probably have a big impact on stock prices, not to mention the human impact. So, I think the main point to drive home there is that whether economic news, like jobs numbers, or GDP numbers, or whatever, whether that information is good or bad, in absolute terms, a million job losses is bad. But, in terms of how that would be expected to affect financial market prices, or stock prices, it only matters how good or bad that news relative to what the market expected, which is unknowable ahead of time.

So, I thought there were two good case studies that we could talk about, not including the current one, because we don't know how it ends. So, the US to the global financial crisis, is an interesting one. Can you hear my kids in the background?

Cameron Passmore: Yes, we can. It's awesome.

Benjamin Felix: We'll leave that in the audio. So, the US markets started to decline in October 2007, which is two months before. You just think about that leading versus lagging idea. So, two months before, the stock market started to decline two months before the National Bureau of Economic Research defined the economic recession as having started. So, the '07 recession, NBER defines it as, starting in December 2007 and ending in June 2009. Now, like I mentioned earlier, those days were not announced, and I find this so interesting. They were not announced until December 2008 for the start of the recession. So, a year after it was determined to have started, and September 2010, for the end of the recession, which is more than a year.

Cameron Passmore: Incredible.

Benjamin Felix: Yeah. It is. Then, like we mentioned earlier, I know I'm repeating myself, but it is interesting, those dates are not quantitative determined. It's a committee that has, probably, a Zoom call and talks about, I don't know, the kind of stuff that Ed Lazear was talking about, and decides what date the economic peak happened.

Cameron Passmore: Yeah, the business cycle dating committee.

Benjamin Felix: Yeah, it's just fascinating. We think about, so we're in this recession that was declared the year after it started, so May 2009... Or, since May 2009, US unemployment had been above 9%, and reached a peak of 10% in October 2009. And, real GDP, in the US, reached its low point for this recessionary period in the second quarter of 2009.

Cameron Passmore: Right, so that's when the market is starting to pick up.

Benjamin Felix: That was the bottom.

Cameron Passmore: Bottomed out in March of '09.

Benjamin Felix: But, this is a crazy thing to think about. It bottomed out then, but the committee decision declaring the end of the recession didn't come out until September 2010. So, you're seeing unemployment as is getting worse, GDP has continued to fall. And, it reached a low point, but we didn't know it was a low point at the time. And, nobody has come out yet and said the recession is over, because they didn't know. And, it wasn't until more than a year later that they actually had the numbers to say, this is when it ended. So, you imagine being an investor at that time, economic data is continuing to get worse. Why would you think that things were going to get better, that they were getting better.

Cameron Passmore: Right? That's what we often hear, too, I'll buy back in when things look better.

Benjamin Felix: Right. Then, you look at the stock market, February 2009 was the bottom. So, unemployment reached a peak in October 2009. So, it was just getting worse and worse and worse, unemployment's getting higher, until October. And, GDP is continuing to drop. Second quarter 2009 drops again. But, in February 2009, that was the bottom of the stock market. And, then we know the story after that where there's a major rebound. So, it's like you said, Cameron, yes, things could get worse from an economic perspective. And, they often do. And, in this one example, they continue to get much worse. Meanwhile, the stock market's rebounding. But, you can just hear the people saying, the markets are rational, this doesn't make any sense. But, the markets forward-looking.

So, in this example, from that bottom, February 2009, to the end of that year, the stock market was up 56%. And, again, we know what happened after that, it kept mostly going up until 2018. But, really until recently, for a proper drop. Yeah, so the theoretical explanation would be that, well, I guess the market was expecting them to be worse. And, when they came out as not as bad as expected, the rebound started to happen. And, by the time things were getting better, the market was already well into its rebound.

Cameron Passmore: You wonder how much of that is just pure bandwagon, people jumping on the bandwagon as it starts to come back.

Benjamin Felix: Who knows? To me, it's just crazy to think about, imagining being an investor seeing, in October, that the GDPs dropped again, and thinking, geez, it's just getting worse. But, by October, you've missed a good portion of the recovery.

Cameron Passmore: A huge amount of the recovery.

Benjamin Felix: Yeah.

Cameron Passmore: It's also a testament to the ability and the devotion to rebalancing through that, right, because I remember, in early 2009, like January, February, it was ugly, right. And, I know we've talked about this in the past, but to stick to the discipline of continually rebalancing. So, you're buying more equities as things are looking ugly. And, I can tell you, it was not obvious in March of '09, that things are going to turn around then, at all.

Benjamin Felix: Having a sample of both, in this downturn, having a sample of portfolios that we manage that are still made into components, and ones that are automatically rebalancing, the automatic rebalancing experience is, in my opinion, from the client's perspective, phenomenally better than having to think about, should we rebalance? When do we rebalance? How much do we rebalance? What's the trigger?

Cameron Passmore: Yep. And, you get big swing days, like 3, 5, 8 percent swings in a day or in a week. Your portfolio could be off its target mix in no time.

Benjamin Felix: Yep. And, then you rebalance, and it's off target in the other direction.

Cameron Passmore: Yip.

Benjamin Felix: It's not easy. So, then the other example I thought would be worth walking through... and, this is a paper we've talked about before, so I hope people aren't bored of hearing about it, but it is a great paper. It's the 2018 paper from Fama and French, Inverted Yield Curves and Expected Stock Returns. And, it's just again, that relationship between economic data and financial market performance, stock market performance. So, they, in their paper, fully acknowledge, and a lot of that acknowledgement comes from Fama's past empirical research, that the yield curve tends to forecast economic activity.

So, looking at the yield curve inversions does tend to forecast economic activity. This one, it happened this time, but, yes, the yield curve inverted and yes, there is a recession afterwards, but nobody was expecting the Coronavirus. When the yield curve inverted last year, it didn't invert because if the Coronavirus, I don't think. Maybe, the yield curve knew more than everybody else, I don't know. Anyway, that's just an interesting sidebar. So, yield curve inversions do tend to forecast economic activity, and they built a market telling model to see if shifting out of equities and into treasuries when the yield curve inverts, adds value to portfolio returns.

So, can you generate an active premium by using the yield curve to predict future stock returns, basically? And, their conclusion is, we find no evidence that yield curve inversions can help investors avoid poor stock returns. And, then they explained that the simplest interpretation of the negative active premiums we observed, is that yield curves do not forecast the equity premium. And, that's an interesting point. Because, they do forecast economic activity, empirically know that. But, they do not forecast the equity premium.

Cameron Passmore: Wow.

Benjamin Felix: Yeah. And, you just think about how that relates to what we're just talking about, without that anecdote about the US market. And, that their example is, I think they built three different portfolios. I'll botch it if I try and say it. No, I got it, US World and World ex-US. They used local yield curve inversions. So, not just US, they used the yield curve in each local market to shift in and out of equities. So, we gave the anecdotal example of the US which I thought was interesting, but Fama and French looked at all over the world, using a whack of data and found the same thing. I thought that was pretty interesting.

I think, in the short term, it should not be a surprise when economic data and stock market returns seems disjointed. And, it can go both ways. I think we're kind of focusing on the example of bad economic data and good stock returns. But, you could also have good economic data and bad stock returns. It's kind of, like company earnings releases, you can have really good earnings release and bad returns.

Cameron Passmore: Absolutely.

Benjamin Felix: It's kind of similar in a way. You can't think about what's the relationship between the stock market and the economy. It's not about what's happening in the economy now, or what data we're getting now, it's about what's happening relative to what the market expected to be happening.

Cameron Passmore: :It's all about expectations.

Benjamin Felix: But, bad economic news paired with good stock market returns, does not mean the markets irrational. Someone actually tweeted at me today showing an image kind of, like the one you were talking about, Cameron, with massive job loss numbers, but best one week market return since 1930, or something like that. And, they said, I think we need to talk about the efficient market hypothesis. That was the tweet. It's like, no, I don't think we do.

Cameron Passmore: I don't know. I'm not sure you'll engage on that.

Benjamin Felix: No, I didn't, I might. So, that was in the short-term, that we just talked about. Short-term economic data. Over the long-term, I found a bunch of interesting research, also. So, if you think about GDP, which is a pretty good way to describe a country's economic output, and you think about what's going on now, what if we do have a slow economic recovery? What if GDP does decline and take a long time to ramp back up? Then, you think about, okay, what is the relationship between GDP and stock market returns?

This is maybe obvious to everyone, but in normal times, you'd expect an economy like China to have a faster growth rate than an economy like Canada or the US, more developed markets. And, maybe China's not even that good of an example anymore, because they've gone through a pretty rapid expansion there. They're probably, I don't know, Eritrea. Just throw that one out there. They probably have a really high growth rate. And, then obviously, a big economic event like a country shutting down everything, well, not everything, but a lot of things would, would be expected to have a big negative impact on GDP.

You'd mentioned earlier, Cameron, this is something that a lot of people wouldn't expect. You'd expect a rapidly growing economy in terms of their GDP growth rate, to have higher stock market returns.

Cameron Passmore: Absolutely, you would expect that.

Benjamin Felix: And, lower GDP growth, you'd expect to have lower stock market returns.

Cameron Passmore: People can't hear this, but I'm nodding like crazy because this comes up all the time.

Benjamin Felix: Well, if we release the video, we're recording on Zoom, so maybe people get to see you nodding.

Cameron Passmore: We'll see if the video turns out. Between your kids and my dog, we don't know if this is going to work or not.

Benjamin Felix: Well, that's the audio. If we're not keeping that then no one's going to hear this episode at all. Okay, so I found two papers, and I messaged on Microsoft Teams like our Slack thing that we're using... I messaged our Director of Research saying I was researching this topic, does he have any papers? And, he pointed me to the two papers that I was already reading. So, my conclusion from that, me finding these as the leading papers and our Director of Research saying these are the leading papers, seems to me like these are probably the leading papers on this topic.

So, one's a 2012 paper by a guy named Jay Ritter. He's done a bunch of research on IPOs, too. I've referenced his stuff in a video in the past. And, we talked about that in the podcast, too. So, his 2012 paper titled, Is Economic Growth Good for Investors? You can tell from the title, it might answer our question. So, he looked at the relationship between GDP growth and stock returns, and he showed for 19 mostly developed market countries from 1900 to 2011, that the cross-sectional correlation between the compounded real return on stocks and the compounded real growth rate per capita GDP was negative 0.39.

Cameron Passmore: Boom.

Benjamin Felix: So, negative correlation between GDP growth and stock returns.

Cameron Passmore: Wow.

Benjamin Felix: And, then he also looked at a sample of 15 emerging market countries for the 24-year period. So, that last period, 112 years, that's a big dataset. This one's less because there's less data. But, this time was a 24-year period from 1988 through 2011, for 15 emerging markets, including Brazil, Russia, India, China. And, he, again, found the negative correlation between economic growth and stock market returns of negative 0.41. So, actually, very similar negative correlation.

Cameron Passmore: Wow. So, the evidence clearly suggests countries with stronger economic growth, have had lower stock market returns. Let that sink in for a bit.

Benjamin Felix: Yeah.

Cameron Passmore: That is so counterintuitive. We've known this. I've known this for a long time. But, I'm sure a lot of listeners don't know that.

Benjamin Felix: I knew it to be true, empirically. I can't say that I had dug into the research on why it was true.

Cameron Passmore: Right.

Benjamin Felix: Because, why would you think about that? I accepted it as fact from empirical data and just figured, whatever, that's the truth. Why would you not invest in China? Well, because GDP and stock market returns aren't predictive? Or, GDP is not predictive of stock market returns? But, I never really thought that there was a robust body of research on this. Okay. So, the theoretical reasons for why this happens, one of the main ones is, it's like what we just talked about with economic data. Everyone's going to say, well, the markets not efficient, whatever, in an efficient market, investors build expectations in the prices.

So, if you invest in an expected high growth country, that growth should be priced in to, well, stock prices. And, if that country ends up realizing the expected economic growth, you're going to collect the equity risk premium. If the economic growth is less than expected, if it falls short, well, you're going to realize less than a normal equity risk premium, or a smaller premium, however you want to think about it. Now, if we take the empirical data showing that there's a negative correlation between economic growth and stock returns, you could think about that... And, I think Ritter mentions this in his paper, you could think about that, as people have historically overpaid for expected growth, which is what's resulted in that negative correlation.

Then, you look at China as an example, maybe people invested in China. I looked at the stock returns in China from '93 until now, I don't know if I have the data point, but they're terrible. Terrible. You're better off in T-Bills, I think. And, why would that happen when they've had such crazy economic growth?

Cameron Passmore: Expectations.

Benjamin Felix: Correct. One theory I can reason is, expectations were higher than what actually happened. Even though the economic growth has been fantastic, people expected it to be higher. So, then the other big theoretical reason that I took note of, there were a couple of others in Ritter's paper that I just wanted to keep it concise. And, this is one of those main papers on this topic that I found. So, Ritter mentions it, but the main paper is by Rob Arnott and William Bernstein, titled, Earnings Growth: The Two Percent Dilution. And, so they talked about this thing called slippage, which is the shortfall. This is their definition, "The shortfall between economic growth and growth in earnings per share."

Cameron Passmore: Okay, so let's go through this carefully. This is really important.

Benjamin Felix: Okay. So, as a stockholder, growth and earnings per share, or, I guess, growth in multiples of earnings, are what result in stock returns for an investor. Growth in earnings of the market as a whole don't necessarily benefit you, as the investor holding shares in a company. If the market-wide earnings are increasing, but the earnings per share of your company are not increasing, you don't necessarily benefit. And, that difference is-

Cameron Passmore: How can that happen? Because, there's more shares issued?

Benjamin Felix: There could be more shares issued from your company that you're already investing in, or there could be more shares issued from new companies that are selling their shares on a stock exchange, going through an IPO. So, you think about that as, from the economy perspective, that's economic growth, measurable economic growth. But then, you think about that as an individual shareholder perspective, the earnings per share of your company are not necessarily increasing, at least not at the same rate.

Cameron Passmore: Right.

Benjamin Felix: So, Arnott and Bernstein, in their paper, they showed in a chart, that corporate earnings and GDP have been directly related, going back to 1929 with aggregate corporate earnings making up a constant 8 to 10% of GDP. So, corporate earnings increasing at the same rate, or increasing with GDP, making up a constant percentage of GDP. But then, there's a slippage. So, the growth in aggregate earnings has not directly benefited investors because of the earnings per share issue that we just talked about. And, this is one of the main points that they make, per share earnings growth can only keep up with GDP, and this is what you just mentioned, Cameron, if no new shares are issued.

Cameron Passmore: Exactly.

Benjamin Felix: We went through this already, but it's worth maybe reiterating, if you own shares in a company, and a new company goes public, for you to participate in the earnings of that new company, you'd have to sell some shares in the company that you currently own and reallocate to this new company. So, for you, as owning a portfolio of assets, new listings, or new equity issues from existing companies, do not result in portfolio returns, automatically. But, they result in economic growth.

Cameron Passmore: Right. Bigger pie, but more slices of that same pie doesn't increase the value per slice.

Benjamin Felix: Correct. And, for this one, China could, again, be a good example because a lot of the growth in the market value of their equities... Like, their stock market capitalization has grown tremendously. But, a lot of it has come from new listings. I don't have the data, but I would even go out on a limb and say it's probably a substantial portion. Maybe even a majority of their growth and capitalization has come from listings as opposed to growth in existing listings. New listings, as opposed to growth in existing listings. So, if you're an equity investor in China, the market capitalizations increased, the economy is increased, your investment returns have not increased commensurate with that growth, because a lot of its come from new issues, which you would have had to reallocate capital to, to get access.

Cameron Passmore: Exactly.

Benjamin Felix: Yeah. And, then, Arnott and Bernstein give an interesting example, as opposed to looking at emerging markets or something like that, they looked at war torn, and the non-war torn countries from 1900 through 2000. And, 2000, this paper was written. I don't know, 2001 or something, it's an older paper. So, they showed that war torn countries had their economies devastated by war, but within a generation or less, or a generation or a little more, their GDP caught up and in some cases surpassed the GDP of non-war torn countries. But then, this is the fascinating part, is that the war torn countries stocks of GDP catches up, keeps up. But, the stock market growth trailed their economic growth by nearly twice as much as the non-war torn countries.

And, the explanation that they give, based on what they're talking about, theoretically in the paper, is that those war torn countries had this massive economic growth, but it was also a massive recapitalization. Those surviving companies had to raise a bunch of new capital, new companies obviously had to raise capital. So, if you're an investor, if you own the index, in Germany or something, you're not necessarily participating in their massive economic growth, because so much is coming from new equity issue. So, it's kind of, those two things working side by side. In a higher growth economy, you might have people more willing to overpay, leading to lower returns in the future if economic growth is only as good as expected or worse than expected. And, the other mechanism that you have working against you is that a higher growth economy will generally have more companies raising capital, whether that's existing companies raising new capital, or a new company's-

Cameron Passmore: That is it, right there. You're absolutely right.

Benjamin Felix: Yeah.

Cameron Passmore: Fascinating.

Benjamin Felix: And, there's a piece about buybacks in there, too, that you asked me about, Cameron, when we were talking about this offline, how to share buybacks fit into all this. Because, if a company's buying back shares, that should be increasing the earnings per share of that company, which is true. But, in aggregate, across the whole entire market, its net share issuance that matters.

Cameron Passmore: For sure.

Benjamin Felix: So, if companies are buying back their shares, that's increasing the earnings per share of that company. But, if other companies are issuing a ton of new equity, and it nets out to be positive net new equity issuance, you're still going to see that slippage. So, buybacks don't. And, that was actually the basis of their paper. They were talking a lot about what caused the tech bubble. They're saying that people were misunderstanding how buybacks would affect stock returns. They're thinking buybacks would make stock returns be able to go infinitely high, but, in reality, that's not true in aggregate, it's net issuance, not issuance for an individual company. That matters to the market as a whole.

So, to wrap that topic up, in the short-term, price changes are driven by expectations about the future. And, expectations change very quickly, especially in times like we're in now, based on new information. But, what we cannot know, is how that new information is going to line up with what the market expected. And, it's only that, how do those two things match up? That's what's going to drive big changes in stock returns. So, that idea of, I expect things to get worse. So, I don't want to invest or I want to take my money out. It's like, it doesn't matter if things are going to get worse. They might, they might not. What matters is-

Cameron Passmore: Do you think they're going to get worse than what the average investor thinks?

Benjamin Felix: That's the key.

Cameron Passmore: Like, you have no way of knowing what the average investor is thinking.

Benjamin Felix: Yeah. And, then the long-term, I thought that data was fascinating, too. It's like, we start thinking about, okay, maybe, the developed countries are going to go through this big economic slowdown, because of what's happening right now. And, this is going to be this tipping point, and maybe emerging markets are the place to invest now, because they're going to have higher GDP growth after this. It doesn't matter. GDP growth, historically, it's been negatively correlated. Correlations are notoriously unreliable, but historically, you're better off investing in lower GDP growth countries.

Yeah. So, anyway, I think that paying attention economic data, like the Ed Lazear stuff we're talking about, fascinating. I love listening to that and hearing about it. Does it matter from an investing perspective? No, does not add value. It's not going to allow you to make better investment decisions.

Cameron Passmore: No, those data points don't, but understanding the interplay between those data points and what actually happens, is what's so fascinating.

Benjamin Felix: That's a good point.

Cameron Passmore: And, to realize that the markets a pretty smart place. There's a lot of smart people there. And, I think the fact that it is moving around so quickly lately, or as always, it does, just shows you how efficient it is at pricing in the information so quickly.

Benjamin Felix: And, not the other way around, which is the thing I keep hearing people say, that the markets rigged and broken and all this stuff.

Cameron Passmore: I think, for a typical portfolio to be down whatever 15, 20, 25% depending on your asset mix, considering what we've gone through, and to know you have a portfolio that is marked to market all the time, as you can get out, I think it's pretty remarkable.

Benjamin Felix: Yeah, what you just said makes me think about real estate. Like, as far as I know, I don't think real estate prices have changed too much, but the data are lagging. And, there's no transactions going on.

Cameron Passmore: Private equity-

Benjamin Felix: Like, go and try and sell your house right now. See how much you can sell it for.

Cameron Passmore: Yeah, I don't know.

Benjamin Felix: I don't know, either.

Cameron Passmore: Anything else to add to that topic?

Benjamin Felix: No, I think that's good.

Cameron Passmore: Okay, so let's go on to the planning topics. This is something I've been digging into a lot lately, which is determining your risk tolerance. And, this is certainly very topical of late. What really prompted me to think more about this, I've been reading Daniel Gardner's book called, The Science of Fear. So, he's a local writer, terrific writer, and professor at Ottawa U, and also worked at the Ottawa Citizen for years. So, this book is fabulous on how humans process risk, and how so many decisions are made irrationally, that can lead to a sequence of unintended consequences.

So, the example he gives, and I've seen it in a number of talks he's given online, is, after 9/11, in the horrible events there, many people took up driving instead of flying. Well, that led to an additional 1500 road deaths that were not expected. So, there's a horrible unintended consequence where people didn't judge the risk, based on data, it was more an emotional decision. And, as we've all heard, humans are hardwired to largely fight or flight when presented with what is perceived as danger, much like in the markets of lately. And, there's all kinds of dynamics going on in society today, such as, we're getting messages all the time, we're getting messages directed to us that feed into our own biases. That leads to things like tribalism.

I know we've talked about this in the past, with The Undoing Project, and Kahneman's work in Thinking, Fast and Slow. And, how so many people, I guess, all of us, make decisions, usually with our system one thinking, which is that quick, intuitive thinking, as opposed to system two, which is more the, sit back, analyze the information, make a logical, rational decision. It was interesting reading his book. I come away thinking that you are kind of the perfect example of someone who largely lives in a system two world because you're, I think, more than many people, not affected as much by system one thinking which is that emotional, perhaps irrational type, knee jerk type of thinking.

I know the point behind this podcast is to help people make better system two type thinking. So, it got me thinking, how do you measure risk properly when we know we're affected by system one thinking and what sort of system two type thinking is there around the risk questionnaire? I'm sure everyone who is listening has taken some sort of investment risk questionnaire in the past that helps you and your advisor decide how much risk should there be in your portfolio. And, there's different rules of thumb that I think people have used over the years, like keep your agent bonds. So, if you're 50 years old, you'd have half your portfolio in bonds.

We've talked about these rules of thumb in the past with Alexander McQueen, for example. Or, even think back to the discussion we had with Larry Swedroe, I remember his rules of thumb for taking on risk. It's based on your ability, your willingness, and your need to take on risk. He's always adamant, if you don't need the risk, why take it? So, we've had a risk questionnaire we've used for years in our practice, and these are straightforward questions, but we mesh those questions with the overall plans, we get to their clients need to take on risk and get to an asset allocation. But, it still begs a question like, what is truly the best way to get to your risk profile?

So, one of the companies in this industry, I believe, is the largest provider of risk analysis, is a company called Riskalyze. And, so we're looking at different providers now for risk profiling software in our company. And, what I thought was interesting with them is, they actually commissioned four academics, including three PhDs to look at their technology, and to get some academic feedback on how they were doing their questionnaire. And, it's super interesting to me because their questionnaire gets right to the point of where do plans typically come off the rails, in terms of people's risk level. And, that point is what we call the GMO point. The get me out point. So, most questionnaires and ours included, is usually softer questions like, how do you typically think about risk? Do you enjoy the thrill? Are you a risk type person? How much time do you have?

Benjamin Felix: What's the name for those type of questions?

Cameron Passmore: Those are psychometric questionnaires.

Benjamin Felix: Right. say

Cameron Passmore: Right, so they do a psychometric profiling of you to help get to some sort of asset allocation that makes sense for you.

Benjamin Felix: But, the Riskalyze research is saying that psychometric risk profiling is not ideal?

Cameron Passmore: Not ideal because it leads to much more subjective interpretation, is my interpretation. I'm not professing to be an expert in this. This field is huge, is my takeaway from this. That, there's so much study on this, my mind's been blown on this in the past week. But, their point is, what really matters is what causes you to decide, get me out, because that's where the plan gets derailed. And, you have to find out where that point is. And, that does not come out as clearly in a psychometric profile.

Benjamin Felix: Oh, the get me out point and how bad that is, I saw... Where did I see this? It was something with Larry Swedroe. I hope I don't misquote him here, but he referred to getting out of the market as portfolio suicide. Because, once you're out, now what? There's no way to know when you should get back in. And, by the time you decided it's bright to get back in, it probably means the markets recovered, which means you've eaten the loss and missed the game.

Cameron Passmore: The stress does not end when you get out.

Benjamin Felix: Right.

Cameron Passmore: You have to decide when to get back in. Will you sit in high interest savings or some sort of GIC portfolio or annuities? Is that enough?

Benjamin Felix: I don't know where this was, I got a lot of messages from people on Twitter and LinkedIn and email sometimes, although, less because I've tried to take my email down everywhere... But anyway, so I've had a few people messaged me saying, I got out in the bottom of '08 and I've never really gotten back in. Do you think now's a good time? Man.

Cameron Passmore: Wow.

Benjamin Felix: That's 12 years.

Cameron Passmore: That's a lot of pressure to.

Benjamin Felix: Yeah.

Cameron Passmore: Anyway, so I've been playing with this question from Riskalyze. And, it starts with a little slide, which you slide across how much risk you are willing to take on in your portfolio. And, what is interesting is that it shows in percentage terms, but also dollar terms. And, people's risk profile changes in dollar terms more than percentage terms. So, I read this in a couple places, because they base their profile on lottery gamble's, like would you prefer type questions. For example, at a very basic level, if I give you, Ben, a choice, a 50/50 chance of either getting zero or $10, how much would you be willing to pay for that bet?

Benjamin Felix: A 50/50 chance of getting zero or $10?

Cameron Passmore: Yep.

Benjamin Felix: $5, I guess.

Cameron Passmore: So, a risk neutral person would pay $5. If you're conservative, you'd pay less, you're risk-averse. If you're more aggressive, you'd pay more because you're risk-seeking. However, if you have a 50/50 gamble between $1,000 and a million dollars, or take $300,000, for sure, then what would you do? Because, now you're talking bigger numbers and real money. So, what Riskalyze does in those gamble's, they find out where that optimal utility function is for you. As they keep playing this gamble, to force you to decide with numbers that are similar to your own portfolio. So, that you can make real choices that affect you as opposed to some questionnaire, and ours does is, how much downside would you accept in your portfolio? If you don't link the real amount of money you're managing, it does not have the same amount of meaning.

Benjamin Felix: Okay. So, let me rephrase what they're doing, because I, unfortunately, have not read this paper because we had a baby a couple days ago. I was starting to read it, and we had to go to the hospital. I had no chance to read it. But, what it sounds to me like, they're using these lottery questions to build a utility function for each individual person. Is that right?

Cameron Passmore: Correct.

Benjamin Felix: Wow. That's cool. That's cool.

This is one of the models for assessing people's risk. And, it forces you to the point of where you actually bail on your plan. My takeaway is, having lived through this for a long time, that is all that really matters. Asking you if you enjoy the thrill of investing, who cares?

Benjamin Felix: Oh, man, okay.

Cameron Passmore: You enjoying the thrill of investing and me enjoying the thrill of investing, might be totally different, how we define thrill? Do you have a risky lifestyle? Do you enjoy hang gliding? Who cares?

Benjamin Felix: We might have different utility functions when it comes to our portfolios, which could depend on the size of our portfolios. It probably does. I don't have the research in front of me, but I've definitely seen research that risk aversion changes with wealth.

Cameron Passmore: So, they highlight, in this paper, the best ways to do a lottery choice. Number one, it must be consequential. For example, it must be real, in dollar terms, to your own situation. It must be simple. It must be specific, i.e. not an open ended question, such as, do you like to take on more risky options or do you prefer more certainty? It's not specific enough. And, it must be enough choices to narrow down your utility number. And, that's what this questionnaire does. We've not decided to work with Riskalyze. This is just me learning more about this tool to use the gambling proposition in making a decision about your own risk profile.

Believe it or not, they actually referenced a paper from Charness, Gneezy & Imas called, The Experimental Methods: Eliciting Risk Preferences. They highlight five different methods of appraising one's risk tolerance. They actually had this as an example, the balloon analogy, risk profile. Some of those examples, you hear them on the radio, for example, where, how long are you willing to let the song play before you take your money and bail? You've heard those things before. This one uses a balloon. So, you let the balloon inflate until a certain point that you get to your risk profile. It's, okay, I'll take my cash for the balloon blows up, and the balloon pops, you don't win. So, that's one example.

Another one is basic questionnaires like we've mentioned. There's one called the [Nizi 01:13:41] and Potters method, which is a simple question of how much of your portfolio would you be willing to put at risk? There's another one called, the Eckel and Grossman method, which uses the series of 50/50 type gambles. Another one is a risk tolerance quiz. I consider myself highly knowledgeable on a scale of one to five. But again, that's a perfect example of something that is virtually impossible. Like, are you a five, Ben, are you a four?

Benjamin Felix: Oh, that idea of developing utility function for each individual based on their preference for risk, based on their actual amount of assets, that's very appealing.

Cameron Passmore: Yep.

Benjamin Felix: I was just thinking about, as you're talking, it's easy to say the expected returns are higher at a 100% equity portfolio. But, if you end up bailing, which you don't know if you're going to do, if you end up bailing, you might have been better off 60/40 the whole time and never bailing.

Cameron Passmore: Absolutely.

Benjamin Felix: The same thing, 60/40. Maybe you're better off 40/60, if you're going to end up bailing.

Cameron Passmore: Anyways, was the punch line in that paper from Charness and Gneezy and Imas, at the end said, so what makes a good questionnaire? One that leads investors to stay invested. To your point.

Benjamin Felix: Yeah, it's interesting. That is fascinating. We have not been using this. Anyone who's being advised or not, it's highly likely that their risk profile has not been established based on an appropriate utility function, which is fascinating to think about. When you think about individual people who don't have access to advice, how do they establish risk preferences?

Cameron Passmore: Exactly.

Benjamin Felix: Fascinating.

Cameron Passmore: Anyways, I thought it was fascinating, more to follow on this, as I do more research, but I thought it was incredible. So, on to bad advice of the week.

Benjamin Felix: Yep.

Cameron Passmore: As you can hear my dog in the background wanting a snack.

Benjamin Felix: Yeah, my kids are screaming down there, too.

Cameron Passmore: So, we'll make this quick. Number one, I just thought I'd highlight some quotes I found on Twitter in the past couple of weeks, which I find incredible, just talking about rebalancing portfolios. Anyways, here's this quote, you'll enjoy this one. At this stage of the game, don't put all your money to work, it's time to start nibbling, but not gorging on values. Aren't you hired to manage portfolios of certain asset allocation? And, here's another one, don't be fooled by these rallies in the market, we're using them to trim the equity exposure in our portfolios.

Benjamin Felix: Maybe it ends up being true. Maybe things drop again, who knows?

Cameron Passmore: But, what decision point do you have that's better than... Anyways.

Benjamin Felix: I'm not saying it's good advice, it's bad advice. They just might end up-

Cameron Passmore: [crosstalk] get a kick out of, I bet you haven't even seen these notes, because I just added them, but Direxion ETFs, which is a big ETF firm in the US, they're launching a new ETF called Work From Home that's going to track companies that are specializing in remote working products since they, quote, as this Bloomberg article pointed out, these stocks are becoming hot. It's actually got the symbol, WFH.

Benjamin Felix: Oh, wow.

Cameron Passmore: Yeah. Anyways, Direxion is quote, expanding into buy and hold funds since they normally focus on leveraged ETFs. But-

Benjamin Felix: Oh, just sorry. Total digression.

Cameron Passmore: Morningstar's co-head of Passive Strategy Research said, "This too shall pass and investors have already bid up to shares, a lot of these stocks." So, I think that's a little bit more sensible, but makes me laugh how a company is so driven to product to take advantage of this, work from home era. Incredible to me.

Benjamin Felix: It'd be fascinating to look at... This is my digression... Direxion made me think about it. We talked about leveraged ETFs a while ago and the decay that you can get in times of high volatility. It'll be interesting, at the end of this period, to look at the returns of manually leveraged like borrow to invest portfolio versus the leveraged ETF portfolio, just because of that daily reconstitution to leverage ETFs. I bet there's been a lot of decay from the volatility anyway.

Cameron Passmore: Fascinating. Anyway, that's the bad advice of the week. Anything else?

Benjamin Felix: Nope.

Cameron Passmore: All right. Thanks for listening.

Books From Today’s Episode:

Science of Fear — https://amzn.to/2B1YWIw

Stumbling on Happiness — https://amzn.to/3fNkJ5x

How Not to Die — https://amzn.to/3dlrNok

Links From Today’s Episode:

Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.
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Benjamin on Twitter — https://twitter.com/benjaminwfelix

Cameron on Twitter — https://twitter.com/CameronPassmore

'Quarterly Shake-Up for World’s Biggest ETF Delayed Until June' — https://www.bloomberg.com/news/articles/2020-04-09/state-street-delays-shaking-up-world-s-biggest-etf-on-volatility

'Hedge Funds Suffered Losses as Index Rebalancing Trade Went Awry' — https://www.forbes.com/sites/nathanvardi/2020/03/27/hedge-funds-suffered-losses-as-index-rebalancing-trade-went-awry/#77c071c14218

'Inverted Yield Curves and Expected Stock Returns' — https://famafrench.dimensional.com/media/467645/inverted-yield-curves-and-expected-stock-returns-july-28-2019.pdf

'Is Economic Growth Good for Investors?' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2161183

'Earnings Growth: The Two Percent Dilution' — https://www.researchaffiliates.com/documents/FAJ-2003-Two-Percent-Dilution.pdf

'Experimental methods: Eliciting risk preferences' —  https://www.sciencedirect.com/science/article/abs/pii/S016726811200282X