Lead-Lag Live

The Myth of Market Efficiency with Cullen Roche

• Michael A. Gayed, CFA

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Ever wonder why markets seem to overreact to news we all saw coming? Cullen Roche challenges conventional wisdom about market efficiency with a refreshing perspective: "The price is always wrong." This fundamental insight transforms how we should approach investing during uncertain times.

When tariffs send markets plunging, investors face the classic struggle between what they intellectually know they should do versus what feels right in the moment. Roche expertly dissects why traditional risk profiling fails most investors—everyone knows the "correct" answers on questionnaires, but real-world market volatility triggers emotional responses that make seemingly irrational decisions feel completely logical. As uncertainty surges during market corrections, even legendary investors can get caught in this psychological trap.

The conversation introduces a powerful framework called "defined duration investing," which quantifies investment time horizons to match appropriate assets with specific financial needs. The stock market, fundamentally a 17-year instrument, cannot be forced to behave like a money market fund without consequences. This misalignment explains why many investors struggle behaviorally with market volatility—they're trying to "turn water into wine" by expecting short-term stability from inherently long-term assets.

Particularly enlightening is Roche's analysis of treasuries as "deflation insurance" and his critique of popular income strategies. The discussion on dividend stocks versus total return challenges mental accounting habits that separate yield from capital appreciation, while his examination of monetary policy reveals how interventionist approaches can create unintended consequences.

Whether you're navigating current market turbulence or building a portfolio for the long term, this conversation provides critical insights into aligning your investment approach with both market realities and your own psychology. Check out Roche's work at disciplinefunds.com or explore his ETF (DSCF) designed to weather behavioral challenges in volatile markets.

The content in this program is for informational purposes only. You should not construe any information or other material as investment, financial, tax, or other advice. The views expressed by the participants are solely their own. A participant may have taken or recommended any investment position discussed, but may close such position or alter its recommendation at any time without notice. Nothing contained in this program constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments in any jurisdiction. Please consult your own

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Speaker 1:

Is there something to the argument that maybe the stock market is less efficient, more behavioral, more emotional than ever before? And just if anything, because of the way Al goes, are also just sloshing money around? Yeah, I mean.

Speaker 2:

I've never, I've never loved the idea of market efficiency. I mean, I think that the the way that pricing works in the market is it's sort of it's a discovery process all the time. I mean, I actually prefer to say that the price is always wrong. The price of the stock market, literally every single minute of the day, is always wrong. There's always two competing sides in any trade and you know, you look at any basic instrument I mean every instrument in the world has a bid, ask, spread, and so you've got two, a buyer and a seller, that basically fundamentally disagree about a price, and one has to settle with the other eventually.

Speaker 1:

Quite the day to be doing two podcasts live streaming. Just did one with the always great Meb Faber, and now I've got and also always a great Mr Colin Orochu, who I've been a fan of for many, many years with his content, one of the guys that I have a lot of respect for in terms of his views on markets, his take on behavioral analysis when it comes to markets, all this stuff. So this will, of course, be an edited podcast under Lead Lag, live on all of your favorite platforms Apple, youtube, spotify, top 5% most downloaded podcasts out there, which I don't know is not that impressive, I guess, given how many podcasts there are, but hopefully Colin can help me get more attention there. So, with all that said, my name is Michael Guy, a publisher of the Lead Lag Report. Joining me here is Mr Colin Roche. Colin, a lot of people have seen your work over the years with your content and interviews, but for those who don't know your background, introduce yourself. Who are you? What have you done throughout your career? What are you doing currently?

Speaker 2:

Yeah gosh.

Speaker 2:

I started my career at Merrill Lynch decades ago and spun off on my own.

Speaker 2:

I run an independent advisory firm called Discipline Funds and we do have a publicly available ETF the ticker is DSCF and we focus a lot on a financial planning based and sort of behavioral approach to building portfolios where, like the methodology I use, where the ETF is built into, this is I call it, defined duration investing, and so we take what's similar to sort of the way that banks and big pensions manage their portfolios from an asset liability matching perspective. We start with a financial plan and we quantify someone's liabilities and expenses over certain time horizons and then we're matching the appropriate assets and we've actually quantified the duration of all these different assets and strategies. For instance, the stock market is a 17-year instrument. Inside of this methodology, something like a T-bill is essentially a zero-duration instrument. So I do a lot of planning, a lot of personal advisory work, but my bread and butter really is doing where the rubber meets the road and building the portfolios for people that are not only behaviorally consistent but helping them understand how their portfolio matches their financial lives and their financial plans.

Speaker 1:

Behavior has a funny way of becoming a bigger, bigger thing when there's volatility, so let's get right into it, since obviously everyone's focused on that in the near term. How does behavior change when prices gyrate like this?

Speaker 2:

What happens in environments like this. You know it's funny because I, as a financial advisor, I used to go through the sort of cookie cutter standard approach of risk profiling and for the most part that process, I've sort of come to the conclusion that a lot of this is just BS. The way that a lot of us go through this, and a lot of us are taught to do this is we try to think through scenarios where, for instance, let's say, you're walking this through with a new client or something and you're thinking of how to measure their risk profile. You might ask them a series of questions and the bogus part about all of this is that everybody knows how to answer these questions. So every time I would send out one of these risk profile questionnaires literally probably 90% of the time the responses are the same, because they're typically like how do you respond to a 30% downturn in stocks? Or do you buy more, do you hold, do you sell, do you overreact? And of course, everybody knows the right answer to this.

Speaker 2:

And the problem is that what happens in an environment like what we're going through today is that uncertainty surges. And uncertainty surges because what's going on and the causality for why stocks are typically going down. It seems perfectly rational in the moment. And so, for instance, during COVID was a great example of a time where even great investors like Warren Buffett and Bill Gates looked at the environment and they said this has never happened before. What is happening to the stock market fundamentally makes sense. The stock market being down you know what? Was it? Down in March of 2020, down like 30% or something. It seems so rational in the moment because the uncertainty of it all is rational Because, for instance, nobody had seen nobody living, had seen a global pandemic occurring. We'd never seen the government come in and start shutting everything down. And so, when you're in the moment, it all makes sense.

Speaker 2:

And what happens to you psychologically inside of that moment is you say it is different this time. And you look at the stock market being down 30 percent and you say, well, during the Spanish flu, the last time this happened, stocks went down, say 50 percent. So we have, we have only just begun this downturn. And that's the story that you always tell yourself. Because in the moment, it always seems to make sense because the uncertainty is there, the uncertainty, you know. Morgan Housel famously said that risk is what we don't know and we don't know what causes all of these things when we're in the moment.

Speaker 2:

And so it always seems rational and that's the thing that makes this profiling process sort of bogus is that when you're in that moment where the stock market is actually down, you know the right answer is I should be buying more, I should be indifferent to my instinctual urges. But in reality you look at it and you say no, this makes total fundamental sense, and I'm worried that this is only just begun. And so you know we're in a sort of similar environment here where we're potentially upending the entire post-war global trade system. So you could look at what the stock market is doing today and you can make up a perfectly rational argument for why this is occurring and how this could go on for a very long time and how, potentially stocks being down what are they down now?

Speaker 2:

15%, 16% from the highs. You could make really rational arguments that that is nowhere close to being done. And so that's the psychology of what happens in big market downturns, and it's what makes stock investing so difficult inside of these sorts of environments, because it's always different this time and it always seems rational the way the market is behaving. And so for me personally. I mean, I think that that sort of profiling process is sort of bogus and that you can't think of things in those sort of, I think, subjective terms and quantifiably react in a much more systematic way, where you're letting something, a methodology and a process drive the way you respond to price, rather than letting your emotions just respond to price.

Speaker 1:

Do you think we're in an era where recency bias is perhaps the most powerful bias of all, because everyone's got just an incredibly short attention span and the behavior of today is literally based off of the behavior of yesterday? You know, and that's it.

Speaker 2:

Yo for sure. I mean. I think that that's the other thing that makes the stock market really especially, I should say. You know, all financial markets are difficult to understand and digest across different time horizons, but the immediacy of the availability of news and everything that has sort of compounded the way that our attention spans have been reduced over time, it all exacerbates these emotional, these behavioral biases that we all have and I think we have an extraordinarily difficult time processing the appropriate time horizons over which to think about all of these things. So, for instance, I mentioned this methodology that I use, called the defined duration process, where I quantify the stock market.

Speaker 2:

The global stock market is a is a roughly a 17, 18 year instrument inside of this methodology right now, and the purpose of that, the purpose of quantifying that, is to communicate to people that the stock market is this inherently long term instrument. If you're taking the stock market and you're trying to turn it into a 17 hour or 17 day or 17 month instrument, you are fundamentally misunderstanding how this instrument works and you're misusing the way that it should be designed to be utilized inside of a portfolio, because stocks companies, by definition, are very long-term entities. It takes a long time to build a company that ever gets into the S&P 500. It takes decades to build a firm big enough to even qualify for something like that. And so you're talking about firms that, even though we talk about initial public offerings I mean even when firms go through their IPO process most of those firms have been around for years and decades, potentially, before they ever even get to the point where they can become a public entity. And then the average lifetime on a public stock exchange is decades and decades. And so the stock market and the entities that it's comprised of are these very inherently long-term instruments. And that's what makes investing in these entities also very difficult is that we've all got this recency bias, these very short perspectives, these very short time horizons. We want the stock market to just go up every day in a nice straight line, kind of like the way that a money market fund works.

Speaker 2:

You look at a money market fund. It just goes like this and it generates a low but stable return. But the reason it generates that low and stable return is because it's an inherently less risky instrument. It's an inherently short duration instrument. It's an inherently short duration instrument is really what it is. That's what gives it its predictability.

Speaker 2:

And the stock market is sort of the opposite.

Speaker 2:

The stock market is this very long duration instrument that it has a higher return, in large part because there's a risk premium embedded in the temporal nature of the way that it accrues its returns over these very long time horizons.

Speaker 2:

And so when people think of the stock market as this very short-term instrument, they're, in a way, they're trying to turn water into wine. They're trying to take this long-term instrument and they're trying to think of it and turn it into a very short-term instrument. And that's why things like day trading and very short-term trading are oftentimes detrimental, because you fundamentally cannot turn the water into wine, you cannot make this long-term instrument operate like a money market fund. And so you know, and the tricky part is for all of us how do you blend all of these things in a way where you can optimize your portfolio for the highest amount of risk, the highest amount of returns, but optimizing it over time horizons where you're generating a stable enough return that behaviorally, you can stick with it. And that's the process that makes all of this interesting. It's the thing that makes investing fun and challenging and an ever-changing sort of environment.

Speaker 1:

To begin with, I think a cynical person would say okay, all that's fine and valid, but markets are a discounting mechanism and yet they react off of tariff news, like we're seeing, which should already have been discounted because we all knew it was coming. Maybe not to the extent and magnitude that has been announced here, but is there something to the argument that maybe the stock market is less efficient, more behavioral, more emotional than ever before and, just if anything, because of the way Al goes, are also just sloshing money around?

Speaker 2:

Yeah, I mean I've never loved the idea of market efficiency. I mean I think that the way that pricing works in the market is it's a discovery process all the time. I mean, I actually prefer to say that the price is always wrong. The price of the stock market, literally every single minute of the day, is always wrong. There's always two competing sides in any trade and you know, you look at any basic instrument I mean every instrument in the world has a bid, ask, spread, and so you've got to a buyer and a seller that basically fundamentally disagree about a price, and one has to settle with the other eventually, and so, but what? What's happening there is that somebody is committing to saying this price is a little bit wrong, but I'm comfortable with, you know, extinguishing this asset or buying this asset at this price, and so I think it's totally rational to say that the price is always wrong in the market and there's this weird sort of discovery process.

Speaker 2:

I think that you think that what's going on right now is really interesting, because the stock market, when it goes through, for instance, we talk about corrections versus bear markets, and I think that what happens in a correction so a correction is typically thought of as like a 10% decline, whereas a bear market is a 20% decline and typically correlates to something much more fundamental a recession or some real fundamental market event that has discounted prices lower, basically. The difference between these two environments, though, is that the correction environment is the stock market feeling out what's going on, so you might get some worrisome news and something happens that kind of starts to make the stock market look like maybe it should be discounted lower, and what typically happens in an environment like this is that, oftentimes, the stock market will fall 10%. It's kind of feeling out the right price level, and then it realizes over time, investors realize that eight times out of 10, this is an overreaction. We actually got it wrong. We were discounting this thing that never actually materialized.

Speaker 2:

So you know, for instance, today I mean, if, right now, I would say the stock market is discounting this sort of perpetual and upending environment of the global trade system, and that's what the market is now feeling out it's trying to decide okay, are we really going to go through with this sort of a process, because that has the potential to be a very long drawn out process, or you could wake up on Monday and Donald Trump could say it was all a joke, I take it all back, and stocks would rally 10% on Monday and the market would slowly start to reprice in the reality that now, okay, global trade war is not on the table, and so that's the process that we're going through right now.

Speaker 2:

So you can very much argue that, yeah, the future forecasts that are contingent on the pricing mechanism that's going on today, they're all going to end up being wrong to some degree and at some point the market finds its sort of equilibrium and things adjust and we'll start rising in price for whatever fundamental reason there is. But I think in the moment, especially in moments like this, where you get extreme volatility, the market is always sort of wrong because we don't know what the future holds.

Speaker 1:

Yeah and I made this point on the Meb Faber show I hosted that the anxiety comes not necessarily, I think, from stocks going down. It's from the whipsaw risk of exactly your point. Trump could come out on Monday and say, yeah, we're fine, it's a joke. I don't think that's the case, because it seems like he has to kind of dig in even further, if anything, before he loses credibility. But that's the issue, right. It's more than just the anxiety around the losses.

Speaker 2:

It's the anxiety around the losses taking the loss loss and then we've seen the comeback. Yeah, I mean, it's God speaking of Trump, I mean it's. I was going to ask, you know, my Twitter followers this morning, what are the chances he walks this back? And you know, I don't, I don't think he can at this point, I don't know. And this is all the thing that makes it so sort of worrisome is that you've got this system that was built for, you know, basically the entire post-war era, and in a lot of ways, we're sort of upending that, incinerating a lot of agreements and incinerating a lot of relationships that we've had in the international community. And what is? How does that play out going forward? I mean, nobody knows. So this is one of the bigger behavioral cluster Fs that we've seen in a long time.

Speaker 1:

You, can curse man. Come on, that curse is not soft. The algo loves it. So look, okay, I named this kind of myth busting around tariffs because I know you wanted to kind of touch on this. For the longest time people have been saying tariffs are inflationary. Now people are starting to say, well, maybe it's actually deflationary because of the reverse wealth effect on equities, and look at what's happened to oil and slow down concerns and all this stuff. How should one think about tariffs? I mean, is the classic economic view the right one, or something odd about this cycle? The inflation.

Speaker 2:

One's great because I mean I wrote about this back in December that the, the potential for this to be more deflationary than anything else, was the, the stronger probable outcome. And I think that the cause here's the thing, the, and I think from a. So, looking at the macro landscape of the last, say, 18 months, the economy was already softening. We already had softening labor reports, at least a slowdown in the labor market. We had, you know, everything was kind of mean reverting back to where it was sort of pre-COVID, and so this period of really unusually high growth and you know, huge job market numbers that we had for a few years there. This was all going to mean revert and so and the other big kicker here was that the Fed was already tight. The Fed is still tight, and so there's a. There's a lot of pieces in place where you already had a macroeconomic landscape for softening and I think that you know going forward, then the, the rationale for everything sort of being more sort of disinflationary, meaning a declining rate of inflation, made a lot of sense. The tariffs just were sort of the icing on the cake that created so much uncertainty that now you're getting this deflation. The potential for deflation is higher today is because the assumption of the inflation being passed on from tariffs is that consumers are going to just take all the price increases, and I just never thought this was going to happen.

Speaker 2:

And I think the stock market is behaving in such a way because what the stock market is basically saying I mean when you have a going back to sort of a fundamental economic principle, when you have a tax hike, for instance, corporate taxes I hate corporate taxes because corporations don't pay corporate taxes. The corporation passes those taxes on to somebody. They either pass them on to consumers, they pass the price increase on to shareholders, or they pass it on to labor in some way. Those are the three ways that corporate taxes really get paid for Tariff is essentially the same thing. It's a corporate tax hike that gets passed on. And what's happening with the stock market right now is that the stock market is telling us hey, if these huge tariffs go into place, the stock market is going to eat this. Shareholders are going to eat the price increases, in large part because their margins are going to fall. Corporate profits are going to fall, so share prices have to fall in response to that, which basically means that the corporate shareholders are the ones that end up eating a lot of this. Consumers are also going to end up eating a piece of this.

Speaker 2:

But I think what we're seeing now, especially today, I mean God you have a sort of waterfall decline in the price of oil which is indicative of that's, that's, demand falling. That's indicative of a deflationary sort of environment where you are now getting a pricing mechanism that is sending a signal that says OK, this is not just an orderly decline in prices based on supply and demand. This is now an imbalance of. We suddenly had this shock to the system where demand is actually getting shocked now because of what's going to go on with the tariffs, and so you've got oil prices down, you know 12, 13 percent in just the last couple of days, and that's indicative of. You know this is the sort of stuff that you know not to necessarily compare this to like 2008, but that's the sort of stuff that happens in a 2008. Imbalance on one side. That is indicative of something worse going on than just a garden variety market correction or even potentially just a recession.

Speaker 1:

It's interesting that seemingly everyone thought that treasuries were no longer going to be a safe haven until suddenly they became a safe haven again Last several years. As you know, the correlation has been upended largely because current spreads kept on getting tighter and tighter, despite the fastest rate hike cycle in history, and the message of oil is consistent with the message of treasury strength, although you know, obviously I haven't seen the real yield collapse just yet. I personally think that's coming. But I want to get your take on treasuries. How should one think about treasuries? Because I know that's a big part of your own etf. Should one think about treasuries Because I know that's a big part of your own ETF? Should one think about treasuries from the standpoint of a tactical position, a strategic position, something that you just don't worry about? What are your thoughts there?

Speaker 2:

Yeah, well, I created this approach the defined duration methodology in part because I manage a lot of bonds for people. I manage a lot of bond ladders for clients. The vast majority of people I work with are retirees. They're people who are living off of their portfolios and so they need very specifically temporally structured portfolios where we're building, say, t-bill ladders and then bond ladders out, say, to zero to 10 years, for instance, and what you're doing there is you're trying to create a lot of temporal certainty around the way that an investor is going to generate a specific return across very specific time horizons, and that's really hard to do with the stock market, because the stock market doesn't generate these stable sorts of income streams over very specific time horizons. And so to me, when you look at the bond market, you know I'm using bonds in a sort of all encompassing term, meaning the entire fixed income market. Basically, I think that it really depends on your time horizon. And so you know T-bills, for instance, are something that anybody who has a money market fund the Vanguard money market fund is filled with just T-bills for the most part, or something similar to T-bills, and so T-bills are just a very short-term instrument. There's something that you can clip a coupon from, you're earning 4% or so these days, you have absolute certainty of the time horizon, the stability, the credibility of the instrument and the income you're going to generate, most importantly, over that time horizon. So you have absolute certainty of your cash flows and your risk relative to your expenses over time. And the thing that makes fixed income investing and all investing difficult is that, by definition, we all end up having to take some level of higher risk because typically T-bills I mean T-bills for the last 10 years paid virtually zero, so you couldn't even rely on an instrument like that over any time horizon almost to generate reliable income.

Speaker 2:

And so, in terms of I think, the way that I think about bonds and more longer duration instruments, I mean I calculate something called the escape velocity of bonds inside of my bond portfolios, where I look at what is sort of the break-even point between the yield curve and the current interest rates relative to a bond's interest rate risk. And so, for instance, right now, if you look at this, the escape velocity of a T-bill is actually really high because it's earning 4% or so and its duration is zero. So you're earning, in essence, a very reliable return relative to its duration risk, whereas the longer out you go, when you look at a 30-year treasury, you're getting what 3.5% or so, but the duration of that instrument, its interest rate risk, is like 17 or so, meaning that if interest rates were to fall 1%, the price of that instrument would rise by 17% and vice versa. That's the thing we've seen in the last few years that you're basically owning an instrument that for the last few years has been paying you 3.5% or so, but it's been falling 17% for consecutive years. So it has this huge amount of duration risk, meaning that its escape velocity is I mean, it's negative, like 12% inside of that calculation, 12 to 13%. So when you look at this across the entire yield curve right now, the sort of sweet spot here is like the five, six, seven year treasury note where you're earning a relative to your interest rate risk. You are offsetting it almost entirely by the amount of interest that you're earning on an annual basis. So if interest rates were to rise or fall by one percent, especially if they were to fall by 1%, you're basically offsetting that. So you've reached what I'm calling escape velocity inside of that instrument, and so that's sort of what I would say is the perfect sort of point on the yield curve today where you're getting a nearly perfect risk reward relative to the amount of temporal duration risk you're taking inside of the instrument.

Speaker 2:

But the way I think of, for instance, like a 30-year treasury bond is, I basically think of instruments like that as they're almost like a form of insurance. Their deflation insurance really is the way to think of it. If you were to think of this in terms of like the sort of the traditional Harry Brown permanent portfolio, for instance, if people are familiar with that, you buy sort of four quadrants to match different environments and the deflation component quadrant is you buy treasury bonds and knowing that in the long run deflation is unusual and not a very probable outcome. But when you get these very unusual environments, environments potentially like today, treasury bonds perform very well because they're this super long duration instrument that it literally operates like deflation insurance, and so that's what all insurance is in essence.

Speaker 2:

Insurance is always something that it typically has a long duration, something that it typically has a long duration but it has a very acute asymmetric return inside of a very specific type of environment.

Speaker 2:

So, for instance, if you buy life insurance, you buy 20-year term life insurance.

Speaker 2:

Obviously you don't expect to die and that thing has a negative real return on average. But if you do die, that thing has a huge asymmetric positive real return. And treasury bonds operate the same exact way inside of a deflationary environment. And you can, you can apply this to really lots of different instruments. I mean a long duration, you know, put on a stock is essentially insurance that is very unlikely to actually come to fruition, essentially insurance that is very unlikely to actually come to fruition, but in an anomalous sort of event, if it does come to fruition it pays you this huge upside asymmetric return that has a very insurance-like payment to you. And so for me, the longer out you go on the treasury curve, the more sort of insurance like and the more specifically deflationary type insurance you're getting. So in an environment like this, you know, are we going to get real a true deflationary outcome? I don't know if the, if these tariffs stay in place, the probability of that is certainly on the rise and we're seeing that getting priced into long duration treasury bonds right now.

Speaker 1:

Yeah, I think people forget there are. The pendulum always swings from inflation to disinflation to deflation, deflation to disinflation, to reflation to inflation. So it's certainly could be the case. You mentioned you've got a lot of income investors and you do a lot of bond letters. I'm curious your thoughts on this proliferation of covered call strategies to generate income. I mean, it seems like everywhere I look there's an ETF that does some kind of covered call to generate some insanely high yield. Any take on that? Uh yeah, I hate them let's go?

Speaker 2:

um, yeah, I, I should. I should be more more, a little more balanced about. I mean, look, I don't. Um, I've got nothing against insurance. I mean I it's funny because my first job out of college was selling whole life insurance and and I I fucking hated that it was. I thought it was awful.

Speaker 2:

I you know I actually sat down with my boss at one day and I was like you know cause I went through being sort of analytical thinking. I actually went through the product and I was like I was comparing it to our sales pitch and I was like I would go through the quantification and I was like this thing doesn't do what we claim it actually does, like we're, we're selling what is really like a. It's based on a lie, almost. And I went into my boss's office one day and I told him this and he was like you're not a whole life insurance analyst, you are a whole life insurance salesperson. You sell the narrative that we tell you to do. So go, you know, continue dialing your phone for the next 10 hours and sell some whole life insurance. And so I didn't last very long at that job. But I think that the so there's nothing wrong with insurance fundamentally, and I think that when you look at something like these covered call strategies, I think you have to assess is this really a smart form of insurance on a portfolio, or are we just incurring something that is just sort of an unnecessarily high fee product that is capturing more of our returns than we should be to the essentially the insurance salesman? And so you know, the basic example is like I have a 20 year life term life insurance policy for myself. I think it's perfectly rational, I pay a low premium for it. I think it's perfectly rational, I pay a low premium for it.

Speaker 2:

I would never buy whole life insurance because I would say that the whole life insurance is sort of the it's the covered call equivalent of this, where I'm giving away a lot of the premium, a lot of the potential return that I could be generating elsewhere, in return for a level of certainty that I probably don't even need to begin with to cover my whole life. Like I don't need insurance for my whole life because I know that my dependents, my daughters and my wife they really only care about the, probably the 20 years over which I'll be working in the future, those are the. That's the period over which there's the most amount of financial uncertainty, so it makes a lot of sense to cover that period, whereas when you look at something like these covered call strategies, they oftentimes end up being very expensive or they throttle the potential returns. You know, where they're protecting the downside so much that the underlying contracts end up costing the investor in a lot of ways, where they're giving up so much of the potential upside in these things because they're getting a very, very high degree of certainty, a degree of certainty that the investor potentially doesn't need. And so, like me, personally, I would say that an investor can embed a lot of insurance into a portfolio without necessarily creating these thresholds where we're paying an excessive amount for it. So I mean, for instance, I would argue today, what's probably the best form of insurance today? It's probably treasury bills. I mean treasury bills today, paying a real return. You're getting four and a quarter or so still on a one-year treasury bill. You're getting a real return. You're getting the optimal amount of certainty inside of a portfolio. Why do you need something that is, a contract that costs you 2% per year, that gives you a greater degree of certainty potentially, but ends up throttling your returns in a lot of different ways. I think that when you start assessing this on a more quantifiable level, I think that people overpay for certainty and what they really end up paying is they end up paying a huge amount in fees and tax inefficiencies and potential returns because of this. So I get it.

Speaker 2:

I think there are use cases where these things make sense and everyone's different, so everyone's got different behavioral needs and if you're someone that you really like owning these things because, let's just say, you understand them and they give you comfort, they're keeping you calm in an environment like today, there's nothing wrong with that.

Speaker 2:

Me personally, I mean, I don't like these things because I think they just end up costing too much in the long run relative to other insurance options. So you know, I don't love. I think a lot of it is the narrative, especially when you take the sort of high yield narrative of it all. You can't take stocks and call options and things like that and call it yield in a way that is comparative to traditional plain vanilla bonds, for instance. It's just they're not the same things. They don't generate their income the same way, they don't generate it in the same safe sort of way, and so I think there's a little bit of trickery going on in the narrative behind these that you're trying to again sort of turn water into wine, where you're taking a stock instrument and you're trying to turn it into a high yield income generating instrument, which it fundamentally is. Not that thing mental accounting right.

Speaker 1:

It's like people tend to separate yield from capital appreciation, when you should be thinking about total return, and the role of financial advisor has always been to try to get people away from that to think about total return. Now it's like to your point about the narrative. It's marketing leans into the idea that yield is different from capital appreciation and that total return isn't really a thing that anybody should think about.

Speaker 2:

Well, you mentioned that you interviewed Meb earlier. I mean, meb is brilliant on this stuff because Meb has spent a lot of the last decade trying to differentiate the yield on stocks from the shareholder yield and the real way that these total returns are generated. And people you know I get this question all the time with my clients that people love dividends, they love seeing the income come in, and I think there's a certain degree of sort of behavioral comfort. But really, at a more fundamental level, I mean using, for instance, a really simple when you run an ETF, for instance, you see the way this really works at a more fundamental level and you see that when something pays a dividend, when we pay a dividend out of our ETF, well, that's just a hit to NAV, to the NAV, to the net asset value of the fund. So if the fund is worth $50 today and we pay a $5 dividend tomorrow, well, the NAV just falls to $45. You get your five bucks, but the fund falls $5. And so the alternative scenario is that you don't pay a dividend. Let's just say that we capture the total return inside of the instrument and you just maintain that $50 NAV. Well, is the investor any different? Well, you know, meb, and I think every smart investor would argue that the difference that's crucial here is that oftentimes the dividend recipient has received an unfair tax treatment relative to alternatives. So, you know, maybe they're getting an unqualified dividend where they end up paying, you know, a higher tax rate than they should.

Speaker 2:

Or let's say that you know the argument for buybacks, for instance. A lot of people hate buybacks, but buybacks make sense because, in large part because they give shareholders optionality. I don't want the income, say I don't need it. If the company is paying a dividend, they're imposing a taxable event on me, whereas the alternative is what if you held on to the cash? The firm maintain the cash, or the fund maintains the cash, doesn't pay out this distribution and you use it in a more, you know, optionality based way, where you say you know what, I'll take my cash when I need it, but you know how I'm going to do. That is, I'll reduce the NAV at a personal level when I want to by selling some of this, and that gives you optionality to, say, manage your tax rate, and that's the. That's sort of the genius in the. You know, the simple reason that buybacks are a thing is because you're giving the shareholder more optionality over whether or not they're going to be forced into paying taxes. And so you know someone that Meb works with who's a genius on all this stuff is Wes Gray. Wes Gray is firm Alpha Architect.

Speaker 2:

They built the box ETF B-O-X-X specifically to structure this, because things like T-bills T-bills when they pay out, when they ultimately mature, they impose a taxable event on their investors. And so what this ETF does is it allows the investor to basically decide for themselves when am I going to? They're using a box spread, basically not to get overly complex with this, but in doing so they're avoiding this taxable event. They're allowing the shareholder to create a more tax efficient vehicle where it's still a T-bill. In essence, it's a synthetic T-bill, but it gives the investor the optionality to be able to decide okay, I'm gonna sell some of this, I'm gonna sell it at a long-term capital gain rate, and that gives me the optionality to be able to decide whether or not I'm going to incur income and a taxable event ultimately. And so that's.

Speaker 2:

The other big kicker inside of all of this is that when we talk about yield, especially from a dividend perspective, especially from a dividend perspective, yield is different for different instruments and I would say that the biggest, I think, behavioral trap with especially dividend paying stocks is that dividend paying stocks are still stocks. They're oftentimes less risky than, say, a tech stock or a high beta stock or something that is a momentum fund or something like that, but they are still stocks at the end of the day, they're still corporations with the long duration uncertainty that I mentioned before, and that means that these instruments are fundamentally more risky than things like, say, the five-year treasury note that I mentioned before. Over a five-year period, that treasury note has a hell of a lot more certainty of the style of return it's going to generate versus something like a long-duration dividend-paying stock. And I think a lot of people get caught up in this sort of trap of thinking that a dividend or a dividend-paying stock gives you income-like certainty. That is very similar to a bond and I try to communicate to people that you know, don't get it twisted, don't mix these two things.

Speaker 2:

These are not the same things. You cannot rely on dividend paying stocks over the same time horizons as, say, a T-bill or a five year treasury note. So they're very, they're very fundamentally different things and they shouldn't be treated the same way, even if I get again that people love seeing the dividends come in and I get it. There's a certain sort of behavioral comfort to seeing you know the cash flow from that and I can appreciate that and I'll you know, if somebody loves dividends, I'll build a dividend paying portfolio for them If that'll help them stay the course. You've got to navigate all of this to your behavioral and your preferences to some degree. But I think you do have to be clear that high yield dividend paying stocks are not the same thing as bond yields and the certainty that those type of instruments create across different time horizons.

Speaker 1:

Well, and certainly they're not consumer stable stocks, healthcare stocks, utility stocks, which are lower beta, less economically sensitive, which is when you'd want dividend payers anyway. It's a totally different dynamic. Over a decade ago, you published a book Pragmatic Capitalism Whatever Investor Needs to Know About Money and Finance. And I mentioned that over a decade because a lot's happened over the last decade when it comes to money and finance. Has the monetary system changed, in your view at all? I mean, it seems to me that COVID really created a very ugly precedent, more along the lines of what the BOJ does in terms of intervention. The fact that Powell basically said we'll buy junk debt ETFs in the midst of the COVID crash to me was actually a very dangerous type of dynamic, but I'm curious your thoughts on that.

Speaker 2:

Yeah, you know, I wouldn't say that the monetary system at sort of a fundamental level has changed. I would say that certainly, as you alluded to, the policy response has changed a lot. I mean, I've been really critical of quantitative easing since it ever started. I mean in large part because you know, like a lot of people might probably know of my work, in the first place, because I predicted back in 2009 that QE would actually it would exacerbate the disinflationary or deflationary sort of environment we were in, and I just kind of had the good fortune of knowing a lot of people that worked in Japan and Japan had been going through this for, you know, 20 years before this, and so I was able to, you know, get the ear of a lot of accountants and financial analysts who had gone through this, and it was funny when they were we were first beginning to implement these sorts of things, the Japanese who I spoke to were always saying you Americans, you have it all wrong. You misunderstand what this is going to do. You're even your, your highest level economists and Fed bankers, have this all wrong. This isn't going to stimulate the economy. This is it's, if anything, it's just going to exacerbate the sort of disinflation, the low inflation, low demand sort of environment we're in. So that was my sort of basis for for that prediction back in 2009, in that period, and I agree, I think that I think that things like QE, I think that the Fed to a large degree has become too interventionist. I think I mean you could argue that a lot of the reason why Well, god, I don't even think a lot of the reason I think one of the main reasons why Trump is even president today is because people are tired of seeing how interventionist the government is with everything. You know, people saw COVID and they saw us. We we threw, you know, seven trillion dollars of money printing, of deficit spending from the fiscal side of everything at COVID. And people saw the high inflation and I think that people came out of that and said this is crazy, we're paying these insane prices for everything. And yeah, we saved the economy from COVID, but we did way too much. And I think those are totally rational, totally correct arguments to be making these days, and so we're kind of potentially going in the opposite sort of extreme here of upending the whole global trade system. But I think there's a lot of rationale for that basis.

Speaker 2:

I mean me personally. I would never do QE. If you put me in the Fed chair, I would never implement QE. I just don't think it's something that is necessary. I think that even the way interest rates are managed, I think that to me again, I like to do everything sort of systematically. I'm a big fan of just automating interest rates. If you hired me to be Fed chair tomorrow, I would fly back to DC, where I was born, and I would walk into the Federal Reserve building. I would give them an equation for how to manage interest rates and I would walk into the Federal Reserve Building. I would give them an equation for how to manage interest rates and I would say this is your Fed funds rate, updated every month.

Speaker 2:

I don't want 12 people sitting around a table talking about this. I want you to look at the quantified numbers and I want the number to be this number, and this is based on fundamental data. This isn't based on how I feel today or what Trump is doing, or any personal subjective assessment of the economy. Is a purely data based metric. That interest rates should be set by this sort of systematic methodology rather than a lot of this guesswork that we undergo with this process where, you know, we're sitting around watching somebody at a press conference decide the future of the most important price in the entire economy, and I think that's something that I think a lot of people fundamentally sort of understand and agree with.

Speaker 2:

They see 12 people in a room deciding the most important price in the world and there doesn't seem to be a lot of rationality behind it.

Speaker 2:

There doesn't even seem to be a lot of correct predictability behind what they're doing and why they're doing. They're more often than not reactive and you know some of that is by necessity. But at the same time, I think it's I think it's fair to look at a lot of this and say you know, the processes through which we implement a lot of this stuff are they're too subjective, they're too emotional and people would prefer something that you know. Gosh, gosh. I mean you've got people like the MMT people who, I think, make irrational arguments about a lot of stuff, but they would just say, you know, set interest rates at zero percent and leave it there forever, which you know. To me that's probably not a very smart way to do it, but it's at least. It's a, it's a methodology that, at least I think you know, takes away a lot of the you know the man in the tower sort of approach to this, you know, setting of interest rates in the way that the Fed is run.

Speaker 1:

You got some some fans saying God damn, this dude is on points. Thanks for that comment, colin. For those who want to track more of your thoughts, analysis and maybe learn more about your funds, where would you point them to?

Speaker 2:

Yeah, so I write a blog at disciplinefundscom. It's under the Discipline Alerts tab under News, and we operate the Discipline Fund. It's DSCF, the Discipline Fund ETF, etf, the Discipline Fund ETF. And yeah, that fund is, it's holding up well in an environment like this because it's designed with this sort of counter cyclical methodology that we built. It's designed to weather the behavioral challenges of this sort of an environment.

Speaker 1:

Everybody. I'm a big fan of Cullen's. I'm sincere when I say that I've tracked your writings for a number of years Cullen for over a decade. I think I may have reached out to you when I was still very early in my writing career, before I started publishing on MarkerWatch and for Ritholtz and all these other places. Congrats on all of your success. Thank you, buddy, for watching. Try not to lose your minds, folks. We don't have 24-7 trading yet, so enjoy at least the fact that the bleeding will stop at 4 Eastern. Thank you, I appreciate it. Enjoy the two day break before all hell breaks loose again next week. Amen, amen, thank you, buddy. Cheers All right. Thanks, michael. Have a good one.

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Michael A. Gayed, CFA

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