E428: Michael Green on Peter Thiel, SpaceX, and Inefficient Markets

0:00So Michael, you're a portfolio manager at Thiel Macro, which is Peter Thiel's hedge fund. What did you learn working with Peter Thiel? What I would define as Peter's core characteristic is the willing to challenge conventional thinking, right? When you interview with Peter, the question he is famous for asking is, what is the one thing you believe to be true that nobody else believes or the vast majority of other people believe to be false? Or the reverse, what is the one thing you believe to be false that everybody else believes to be true? And that's really meant to effectively stimulate and isolate a deviation from the crowd, which is necessary for extraordinary or breakout performance.

0:39That thought process, combined with a second Peter Thiel insight, which is you should never strawman your opponent's arguments. You should steelman them. You should prepare yourself against the best argument that they can make, even if they can't make it themselves. That approach is very rigorous, and I think Peter has exploited that to an extraordinary extent within his portfolios and his investments. It's very much aligned with the way I approach the world from the standpoint of you should always use the scientific method. Adopt the null hypothesis. Try to disprove your conjecture as compared to try to prove your conjecture.

1:14What do you believe that most smart people in the industry do know? This was actually the topic of the discussion that I had with Peter. And my argument at the time was that passive investing was not passive in any incarnation, that it was creating distortions by virtue of the fact that they transact. And so the definition of passive investing in the academic literature is an entity or an individual who always holds every security in proportion to the market capitalization or its exposure within the market. Perversely, that means that there's no mechanism for them to get into that position or to get out of that position.

1:48And since we know that can't exist, it would require magic. And literally in Bill Sharpe's 1991 paper, he describes it as they are able to trade in the liminal hours in which the markets are not open. Obviously, that's absurd, but as a thought exercise, it was useful for his purposes, which was basically demonstrating why index investing was better. He was an index consultant. He was pitching his own book. 2016, Lasse Peterson and AQR successfully challenged that with another paper called Sharpening the Arithmetic of Active Management, in which he looked at the behavior of passive managers. And he said, well, what about index-free constitution?

2:22That's a change in the portfolio that requires them to transact. Therefore, they become active managers during that time period. And the thought experiment of Sharps, where they own the same aggregate securities, and therefore passive and active are identical, except for the fees associated with the product, was untrue. And that actually has grown into the single largest hedge fund strategy in equity space by allocation. It sits at the core of most multi-manager platforms or pod shop type books. Which is betting against the passive investor. Actually, what you're doing in that strategy is you're betting with the passive investor.

3:02So you are trying to anticipate, you're front running them. You're trying to anticipate the trades that they will have to make when a new stock is included in the index by buying those, or when a stock is ejected from the index and selling those. And so that long, short portfolio is trying to capture the impact of the eventual passive trade into the individual securities themselves. Where it becomes a facilitation exercise as compared to betting against them is perversely the rules of passive. You are raising the probability of entering an index if you drive the price higher. Are you raising the probability of it exiting the index if you drive the price lower.

3:40And so it's actually a self-reinforcing trade. It's a characteristic I refer to as investment judo, using the heft of the passive investing complex against itself in large flow characteristics where a new stock enters the index or one exits that creates a large rebalancing flow that most of your listeners will be aware of. That's what index arbitrage is doing. And this is why you think many stocks are driven not by business fundamentals, but by net inflows? They're always driven by net inflows. Fundamentals themselves are simply a signal of information that causes somebody to transact. An active discretionary manager seeing a favorable earnings report from a company says, gosh, the prospects are better than I thought.

4:25I should probably buy this stock that I was evaluating. Or if the earnings report is poor and they have an existing position, it failed to confirm my hypothesis around the fundamental behaviors, therefore I should sell. It's the actual act of transacting that causes prices to change. Markets are not truly weighing mechanisms in the sense that you put them on a scale and you compare it against a DCF. They require discrepancies from your estimate of fair value that allows you to say, I think the expected return for this will outperform the market or underperform the market. It's the transaction that drives the prices.

5:00So it's always been flows. And this is why certain companies will, for years and sometimes decades, trade at different multiples than other companies because of the demand for that company. A good example of that would be SIN stocks like a Philip Morris or Altria today. Some people have investment mandates that prohibit them from owning tobacco stocks. all else equal that should lower the price of Altria relative to its competitors, reduce the speculative aspect associated with it, and create conditions under which higher outperformance can be achieved for each unit of fundamental performance.

5:36That's why people were attracted to that. That's why the ESG framework emerged. People speculated that the idea that companies behaved in an environmentally social and governance manner that was favorable to investors and the broader population would ultimately lead to better fundamental results. A lot of those theories are ultimately nonsense. You're basically trying to play a variant of the Keynesian beauty contest and figure out what other people are going to want in the future. ESG was a giant bet that woke investing was going to spread wildly and suddenly people would become far less capitalist and aggressive in their prosecution of profit.

6:13that if anything, I think the current environment says that that is absolutely not the case. The woke trade is an interesting one in that it would have worked if institutions had codified specific rules to such an extent that there were more inflows than outflows. So it could have worked even if the fundamental businesses were weaker pre this mandate. It could have. It would have required a sustained inflow. And in fact, during the period in which ESG investing received significant inflows as people embraced this style of investing, it actually contributed to the outperformance. Again, the flows were suddenly directed into those stocks that caused those stocks to outperform on a relative basis, and it became a self-validating component.

6:55The minute that bloom was off the rose and the allocations had already been made and very little additional capital was making its way in, and in fact, as people became aware that it wasn't meaningfully outperforming in part because funds were able to charge higher fees on this differentiated process, And that is a real challenge. Firms like BlackRock, for example, are constantly forced to balance very low income ETFs or index funds against higher fee alternatives, which is really where they're making their money. If you charge 90 basis points for enhanced indexing and three basis points for indexing, you can see that there's not much profit margin in the index itself.

7:34It's really about the access that portfolio and that offering gives you to sell the higher value products. We're seeing that across the industry as every entity is now exploiting their access to customers because of their presence in other products by delivering higher fee products. Maybe the most famous example of the effect of inflows is SpaceX. We just passed a big unlock on the company. And full disclosure, I remain an investor in the company. I've been a private investor for a while. Double click on how inflows may have affected the SpaceX price. So there's a couple of things that are really critical in understanding SpaceX.

8:15It's just the evolution of a process that has been playing out for an extended period of time. There's a lot of people out there that will cite Medigliani-Miller and say, dividends and buybacks are the same. And so people complaining about buybacks are just wrong in their analysis. They haven't studied the formative literature and they're functional idiots. This falls into the internet meme of midwit basically shouting at everyone, the simplistic view and the sophisticated view are ultimately the same. That Medigliani-Miller expression is just wrong in an index world. Imagine a scenario in which a company pays a dividend.

8:52That dividend is received by an index fund, and that index fund then reinvests the proceeds. It's going to take that dividend from Apple, and it will only send 6 % of it back into buying Apple stock. It'll send 94 % of it to buying all the other stocks. In a market that we have discovered is far less elastic than the original theories presented, and this was the key findings of Xavier Gabay and Ralph Koagian in 2021, with their paper, The Inelastic Market Hypothesis, that tested the idea of elasticity, meaning the response of price to changes in supply and demand in the market. The efficient market hypothesis presumes that markets are highly elastic.

9:32They can accommodate almost anything that is thrown at them in terms of activity. And the actual specification is that a dollar into the market, because every buyer has a seller, which is a mathematical truth, creates about one penny of additional market capitalization, basically the crossing of the bid-ask spread. Gabay and Koijin's findings was that the average impact of a dollar into the market from 1992 to 2019 was$5, so 500 times more inelastic than was speculated in the theory on which we have based all the passive investing. That number itself is an average from 1992 to 2019. Valentin Haddad at UCLA with his paper, how competitive is the stock market, identifies that is actually a trend that is a function of passive share relative to active share.

10:22And if you update those numbers for the current levels of active versus passive share, my estimate is somewhere around$22 is created for every dollar in. For some of the largest stocks, the most inelastic stocks, those multipliers are now approaching$100. And so$1 into an NVIDIA is raising NVIDIA's market cap by$100. That's causing the market to become more concentrated. It's causing all sorts of perverse effects. When you think about the market in that framework, and you think about something like SpaceX, what they're really trying to do is make investors aware that bid will be there to provide liquidity for them to exit if they participate early.

11:04And so it's similar to a Greenspan put, right? We can call it the Vanguard put. Vanguard will show up to buy those shares, or investors who have referenced the NASDAQ 100 will show up to buy those shares regardless of valuation. Ultimately, that creates a time race that basically says, are we expanding index participation fast enough to offset the insider selling? And the mechanics of how they worked with NASDAQ to magnify the float so that there's actually roughly a three to one increase relative to the float dynamics, facilitates that exit. Anyone looking at this comes to the conclusion that this is going much higher.

11:43You as a private investor in SpaceX experienced this in the run-up to the announcement of the inclusion in the NASDAQ. As that became rumored, SpaceX roughly quintupled in price, very similar to the dynamics of when Tesla was included in the S &P in 2020. So you saw the same underlying phenomenon. The real key with SpaceX was twofold. One, it was heavily marketed to retail investors under a buy and hold approach. You want to be part of Elon Musk's vision of men on Mars. That drew in retail who didn't know that they were the patsy at the poker table. And they have actually proved remarkably resilient, locked up under exclusion components and platforms where they are limited from selling for an extended period of time, where they will be barred from future IPOs.

12:32Something like a 15 days hold period. It's actually 30 days at most and longer at some. And so that actually created conditions under which the index demand, which showed up the next couple of days and continues to expand as shares become available, facilitated that exit for the insiders that want to sell into it. Everyone I talked to on the show is chasing the same thing, an edge. And more and more, the edge comes down to your information, not just having it, but being able to trust it when the stakes are highest. AI is doing more of the information gathering for you every day, and most tools are very good at sounding right.

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13:59That's alpha dash cents.com how I invest. And what was the mechanism that drove the price to over 3 trillion? Was it hedge funds front running the passive traders? Same phenomenon we were describing in index inclusion, except now they're trading in an illiquid secondary market, right? So these are private share markets, far less liquid than the overall market itself, which is why it had such an incredible response. Did that also explain why it then went down from$3 trillion to, I believe,$1.25 trillion? People started to sell. And so there was more net selling. Those people being whoever held the shares, right?

14:37Shorts began to emerge, et cetera. There was an extraordinary bid for SpaceX on its initial launch because levered ETF variants had to buy twice as much exposure as they actually had access to. but that also unfortunately creates a self-fulfilling prophecy levered ETFs that have to rebalance on a daily basis create an endogenous form of flow if prices are going higher they're forced to buy more to maintain their leverage ratios if prices are falling they have to sell more into that activity to maintain their leverage ratios we can walk through the mechanics of that if you want it's like double risk not only are you levered 2x 3x where a 10 % stock movement might really to a 20 % gain or 20 % loss if you're short.

15:21But also, all these levers together are creating this buying pressure that's creating these kind of very parabolic outcomes. That's what I refer to as endogenous leverage, right? Self-created flows. So let's just use the SOXL as an example. Imagine that there's only$100 invested in a triple levered semiconductor ETF. That means it has$300 worth of exposure because it has taken a three to one leverage ratio. If the underlying index rises by 10%, an unlevered position would appreciate to 110, the levered position appreciates to 330. That means that the equity in the levered position is now 130. In order to maintain a three to one ratio, you have to buy an additional 60, which is the endogenous flow that is created.

16:08And the reverse plays out on the other side. Levered ETFs have been around for a long time, and they actually provide a stabilizing impact on the market in a weird way. Most professionals who will trade these recognize that high degree of leverage associated with volatility creates a harvestable component called the volatility drag. Volatility drag is a simple recognition that we live in a geometrically compounding world as compared to an arithmetically compounding world. Simple answer is 10 % today up, 10 % down today. The next day in arithmetic terms, it's zero, right? But if I do that in a geometric series in which it's a sequential event in either direction.

16:48Today I'm up 10%, so now I have 1.1. Tomorrow I lose 10%. 10 % off of 1.1 takes me down to 0.99. That zero has transformed into a 1 % loss. If I add leverage to that, it becomes a volatility drag to the power of my leverage. And so if you go to 3x levered on that same scenario, you actually end up losing 8 % on that event, those losses are large enough that the dominant strategy in levered ETFs has historically been to take short positions on both sides. That allows you to harvest that volatility and it functions as a volatility suppression engine for the industry overall because anybody who is trading implied volatility in one form or another has to recognize there's somebody else on the other side that benefits from that increase and realized volatility that you yourself are betting on.

17:44When narratives take control, when we see something like memory stocks or AI become kind of a no-brainer, there's an interesting phenomenon that you can track in the behavior of the holders of those types of products. Starting in February, we began to see the holder base changed, and retail investors began using that 3x leverage, like a Leo Aschenbrunner, for example, to exploit their certainty that this was the trade. Now, it's a terrible strategy because if you're running 3x levered on something exhibiting the type of volatility that semiconductors do, our rough math is that the break-even on that trade, if your dollar cost averaging in, is about 150 % annualized depreciation.

18:28It's an extraordinary hurdle to have to cross over any extended holding period, which is why all of these products carry SEC disclaimers saying these are not meant to be buy and hold products. nobody pays attention to that when they get excited about stuff so it's not just that if you have 2x leverage and it goes down 50 you're completely wiped out it's also that on a daily basis the volatility is hurting your returns maybe you could bring it down to a lay person like my mom who's a big fan of the podcast or me who's a private investor relatively uninformed public investor what should i do with information about how much of the public markets is passive how should I act on that?

19:05The quick answer is there's not much you can do, right? So this is what's referred to as a systemic risk. It's largely non-diversifiable. So it doesn't matter what you do is kind of the easy answer to it. You are going to be exposed to the ramifications of this regardless. And under that framework, unfortunately, like lemmings, the right answer is you run off the cliff. That's been part of the challenge for me in explaining and articulating this for roughly a decade. I'm simultaneously saying these things will be the end of the market as we know it. And also they're the best investments that you can make on a short-term basis.

19:39But I can't tell you that next year is going to be bad. In fact, my work around passive suggests that the rising aggregate return relative to valuations is a feature of this transition. And so people who listen to me closely have heard me say, for the average investor, you should continue to invest passively. Now, part of that was also a function of I had not yet cracked through the code of what exactly was happening in terms of how the indices were playing out and what were the parts that become predictive. It turns out that the success that I had around Volmageddon with Peter Thiel, where we had pre-positioned and pre-announced our expectation that the XIV ETF would collapse to zero in a single trend in a single day as it did on February 5th, 2018, was that index and ETF complex referenced a single security.

20:32So the product and the underlying were the exact same thing. When you think about something like the S &P 500, any product like SPY or VOO or IVV from BlackRock, what's actually happening is that's a liquidity collection mechanism, like a fire hose that is then directing liquidity at a crowd. And it's the behavior of the crowd that becomes interesting. The reason why you use fire hoses and crowd control is that they are non-lethal, right? They don't cause people to die for the most part, but they radically change the behavior of the crowd. And it turns out that all the interesting information is actually about focusing on the individuals within the crowd, the individual securities.

21:11And in Gambler's Fallacy, The success I had with the XIV trade somewhat blinded me to that insight until about nine months ago when I don't even remember exactly what the eureka moment was. But I suddenly recognized I was focusing on the wrong thing. And what did you start focusing on? We started focusing on understanding how the flows across many index products and many ETFs were affecting the individual securities. And to give you some idea of the complexity of the problem, when we first began doing our individual securities, we focused on the largest individual stocks because obviously that's where the most information and transaction activity is available.

21:50It took us about 45 minutes to analyze an individual stock. About two months ago, we got that down to about 45 seconds, and now we're about four and a half seconds, which radically increases the universe of securities that we're able to hold this information on, analyze it, and deploy it in a way that allows us to rebuild products that have similar exposures to large-cap U.S. equities, tracking error of roughly 1%, but deliver roughly 1 % outperformance while taking no known additional risk. It doesn't test positive for any of the other factors that we've traditionally thought about. In fact, I'm working on an academic paper called King of the Factor Zoo.

22:31It turns out that many of the factors like momentum are really just the shadow being cast on the wall of Plato's cave where the real information is actually in the flow characteristics. I was going to ask you about that trend following, is that there's more volatility in the market and the flows are creating these more parabolic outcomes. In many ways, that's the traditional momentum factor. So the momentum factor is presented by Cliff Asnes in his thesis paper was effectively an information diffusion mechanism. I see a stock behaving anomalously. That causes me to do research. That research in turn makes me comfortable with the price change.

23:07Therefore, I buy the stock at additional price impact. that causes other people to do the work, et cetera. And so momentum diffused as an information gathering process through the market that was manifested in excess price performance. It turns out that all of the information stuff is bunk, and really all that matters is the flows. And so as you move more and more to what the academic literature refers to as sunshine traders, who trade not in a random noise fashion, but under a predictable framework where the source of their transactions and the size of their transactions are somewhat known in advance, i.e.

23:44contributions to 401k plans, that creates a predictable trader that can be exploited in that manner. What we're really seeing in today's momentum is what's called auto-correlation. If the price of Apple rises today, it becomes a larger portion of the index, so the next dollar into the passive fund buys more Apple. If that was true, then we would see momentum become a better trade as there's more passive participation in the market. Is that proven to be the case? It's absolutely proven to be the case. So let's say you're not an institutional investor and you can't invest into inflow products or trend-following products.

24:27What do you do? Do you just sit around and be prepared for the next crash? Again, that's been the frustration, right? The answer is, perversely, the growth of passive has what is actually an exponential feature on the market. The larger passive gets, the less supply of shares that are actually available to meet that next dollar of inflow. There's no more informed traders left to say, this is a stupid price, I'll sell it to you here. They actually increasingly begin competing with themselves for liquidity, and that causes, as long as the flows remain positive, to get even more extreme in their components.

25:02Go back and look at the forecast from GMO of the expectations for a forward seven-year return period in 2019, and they would tell you that U.S. equities are supposed to massively underperform under a mean reversionary and valuation reversionary framework. Now, that type of positioning historically made sense because of the dominance of active discretionary managers who would see a surge in price relative to the underlying fundamentals and say, this is clearly an opportunity for me to take liquidity and find something more interesting to invest in. As passive becomes the dominant player in the market, and they currently represent more than 100 % of the net inflow, so passive vehicles despite the growth of active ETFs, etc.

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