The transcript from this week’s, MiB: Kenneth Tropin, Graham Capital Management, is below.
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ANNOUNCER: This is Masters in Business with Barry Ritholtz on Bloomberg Radio.
RITHOLTZ: This week on the podcast, I have yet another extra special guest. And this is really a fascinating extra special guest who you probably never heard of, but you should. His name is Ken Tropin. Where do I even begin with him? He is a member of the Futures Hall of Fame. He is the chairman and founder of Graham Capital Management, which runs $18 billion and has amassed quite a track record. He used to work with John Henry, currently the owner of the Boston Red Sox, and another successful hedge fund manager. He worked with Paul Tudor Jones. The list of people he knows and has trained with and under is quite astonishing.
The firm that he’s built is one of those very quiet, very successful entities that without a whole lot of media coverage, without a whole lot of fanfare, just amassed an enormous amount of capital because they’ve done so well for their clients over time. I found the conversation with Ken to be absolutely fascinating, and I think you will also. If you’re all interested in macro investing, trend following, commodities, currencies, fixed income, various types of quantitative strategies, and most important of all, risk management, you’re going to find this conversation to be absolutely fascinating.
With no further ado, my interview of GCM’s Ken Tropin. I want to start with your background. You began at Shearson in the 1980s. Tell us a little bit about those days.
KENNETH TROPIN, CHAIRMAN AND FOUNDER, GRAHAM CAPITAL MANAGEMENT: Well, you know, here we are at a very different place and time, so it’s kind of cool to reflect back on what was happening in 1980.
RITHOLTZ: Like, very different universe, right?
TROPIN: Right. Well, for example, interest rates were 14% when I started at Shearson.
RITHOLTZ: And those were Treasuries. We’re not talking junk bonds here.
TROPIN: Yeah. No, no, no. And in fact, I think we got as high as 20 early in my career. And so, you know, it was a very interesting time to begin, which I did as an account executive at Shearson. And then in 1982, Dean Witter recruited me to join them and to really start managing what was their fledgling hedge fund practice, which was really with CTAs back in that era, and then evolved into, you know, more macro style funds.
RITHOLTZ: So you eventually become director of Managed Futures at Dean Witter Reynolds.
TROPIN: Yup.
RITHOLTZ: That’s pretty early in the managed futures history. Tell us a little bit about that era.
TROPIN: Sure. It was an era where, you know, first of all, the markets were really inefficient, right?
RITHOLTZ: Right.
TROPIN: So it was very fertile to do what we do because markets moved a lot. There was a lot of volatility. And I think it’s almost the polar opposite of where the world has been the last few years, where volatility has been so much subdued, and you know, equities have been such a strong performer. But back in 1982, you know, stocks were very quiet. They were in a trading range. Interest rates were super high. Commodity markets were moving a lot. And there wasn’t a lot of competition, if you’re a trader in that early part of the industry’s history.
RITHOLTZ: So let’s talk about that inefficiency for a moment. Today, you want to hang a shingle or you want to open your own proprietary trading, it’s very difficult to find an edge and consistently make money. Back in the 1980s, that wasn’t necessarily the case.
TROPIN: Yeah. I mean, relatively simple trading systems made money. And you know, they had volatility, and people were okay with volatility because everything was volatile back then. And so, you know, it was relatively, I wouldn’t say straightforward because I don’t think generating consistent profits has ever been something that’s so straightforward or so easy. But on a relative basis, it was easier. And of course, when you have a young industry, that’s a great time to get involved.
RITHOLTZ: Yeah, to say the very least. So after Dean Witter Reynolds, you end up as CEO of John Henry and Company. Tell us a little bit about that experience.
TROPIN: Yeah. John was one of our managers that we had, you know, our clients invest in. And in 1989, he and I explored, me leaving Dean Witter to join his firm as CEO. His company was in California at that time. I wanted to be on the East Coast. We moved the firm to Connecticut, and I was there for about four and a half years. And then he and I saw things differently in 1993. And I parted company, and you know, had a lot of time to think about what I wanted to do, and ultimately decided I wanted to start up my own fund. And that’s how Graham got, you know, underway in the spring of 1994.
RITHOLTZ: So we’re going to talk a lot more about Graham, but John Henry seem to have done pretty okay for himself.
TROPIN: Sure. I mean, he now owns the Red Sox, among things.
RITHOLTZ: Yeah, relocated to Boston, right?
TROPIN: And you know, he’s done very, very, very well. He’s left the finance world, but he’s certainly not left the business world.
RITHOLTZ: And he seemed to have brought the same set of analytical chops to owning the Red Sox as he did in his own hedge fund.
TROPIN: Yeah, I think that’s kind of who he is.
RITHOLTZ: Quantitative database and logical decisions, which, you know, seemed to have broken the Curse of the Babe.
TROPIN: Well, yeah, you know, let’s face it, right? I mean, it was a year that they were down 3 and 0 to the Yankees or something, and then ended up prevailing in that World Series. I’m a Yankee fan so I can’t say I was rooting for that, but that’s what happened.
RITHOLTZ: A hundred years was all it took to overcome that one mistake. All right. So let’s talk a little bit about founding Graham Capital in 1994. You leave John Henry. You have a little time to think about what you want to do. What was the process like launching a new hedge fund in the early to mid ‘90s?
TROPIN: I mean, this is not an easy thing to do ever. I would say would probably somewhat, you know, easier to do in ‘94 than it would be today, where the world has become so institutional. And you know, I’ve been longtime close friends with Paul Jones and Mark Dalton, the President, and you know, when Paul, the founder and CEO of Tudor. And when I left Henry, we talked about a couple of ideas I had about starting my own fund, and they were kind enough and eager to invest and help me seed Graham, which made it a lot easier to get the fund off the ground.
RITHOLTZ: Sure.
TROPIN: And I invested my prop capital alongside of their prop capital, and we began trading in I guess it was July or something like that of 1994.
RITHOLTZ: What sort of strategies were you using when you first launched the firm?
TROPIN: Yeah. So it was trend following systems that I designed. And they had some features to them that were intended to take advantage of what’s very good about trend following, which is sort of capturing these big right tail moves. But we’re also intended to not have some of the givebacks that people associate with trend following when trends reverse. And those were techniques that I came up with, that I thought would work. They ended up being pretty successful. And that’s, you know, in the early days of Graham, like any new hedge fund, I did everything from designing trading systems to executing those systems.
RITHOLTZ: So let’s talk a little bit about trend following because people who are professional traders, or especially futures and commodities traders, are fairly familiar with that strategy. I don’t know if all our listeners are. The basic concept is when one of these asset classes starts a long move, they tend to go much further and much longer than people typically expect, and you want to capture as much of that move as possible. Is that too much of an oversimplification?
TROPIN: Yeah. That’s a pretty good description.
RITHOLTZ: Yeah.
TROPIN: And think of it this way, that a good trend following system will identify based on momentum signals, that a trend is underway. Let’s take a recent example, energy prices. Everybody knows energy prices have gone up in the last six months quite a bit. And you know, a simple trend following system is going to identify that this is a strong trend, and it’s going to get you on the right side of that trend.
Now, at some point, that trend is going to end. And that same trend following system is never going to predict the exact top, but it’s going to get you out of that trend after it’s made some amount of profit on the way up. And it’s always going to expect to lose some of those profits when the trend reverses, but still end up capturing the meat of the trend. So if you could say that the maximum size of a trend was, say, 100, maybe you might capture 60% or 70% of that trend.
And if you’re able to do that in a diverse number of markets and asset classes, while managing risk in the markets that aren’t trending, you know, that’s in general how trend following works. It’s much better to be involved in trend following when markets are moving. And when markets are quiet and sideways, not as easy to make money in turn.
RITHOLTZ: Right. Right. I’m thinking about how you catch the reversal at the end. Obviously, you have to be willing to give back some of the profits before it’s clear that the trend was broken. How do you avoid the false positives, the whipsaws? I can count how many times when I was a young Turk on a trading desk, you would get shaken out of a move, and then it would, as soon as you’re gone, immediately go back to the prior trend.
TROPIN: Yeah. It’s a great question. There are a lot of technologies that people use that we use. You know, some of those technologies can include having multiple signals and multiple time horizons. So maybe your quick systems get shaken out on sort of a minor or medium reversal. But your longer term systems, for example, take longer to get knocked out. And so most people I know who do this do not have one-time horizon.
RITHOLTZ: Right.
TROPIN: They use multiple time horizons. That’s just an example of a technique that’s easy to understand.
RITHOLTZ: You guys do everything from quantitative analysis to macro. Tell us a little bit about your approach to trading the markets.
TROPIN: Sure. Well, as you sort of referenced, we do a lot of different trading styles at Graham. We do discretionary macro trading, which is typically a portfolio manager — and we have some number of portfolio managers, 15 or 18 different portfolio managers that independently manage a book of, you know, risk assets. And they will decide what they’re going to buy and sell. And they’re going to live with certain risk policies, and they’re going to, hopefully, not be all doing the same thing at the same time.
And then we also run a large quantitative business, which is a model-driven, you know, computer trading system business that is also really diversified in the types of models it uses. Some are pure momentum-based models which people identify with trend following. But then there are some models that are value-based, that are fundamentally based. Some, you know, are smart systems that are learning systems. So there are a lot of different ways to hopefully make money in the macro markets that we are involved in.
RITHOLTZ: So let’s talk a little bit about that diversification. If you have 18 different portfolio managers, and I know you’re only half joking when you say “we hope they’re not all doing the same things,” by design, the assumption is each of them are bringing a different approach to the assets they’re covering, or is it possible that some of them are overlapping with others?
TROPIN: Yeah. Well, the answer is yes to both. So we currently have 15 different teams, not 18, although there are a couple of teams that are pretty close to joining us. And many of them are going to be trading the most important macro market. So you know, that’s fixed income markets. That’s the equity markets. That’s the foreign exchange markets, and to some extent, commodities. And some of them are going to have similar views when really interesting big moves are happening. An example of that is there was a big move up and rates that sort of peaked in May, and a lot of our traders got involved in that and benefited from rates going up in Germany and rates going up in the United States.
There are other times where they have very different time horizons. And so one trader might, you know, be long U.S. fixed income, and a trader right next to him is short. And they could both actually be right, depending on the time horizon. So somebody who has a very short term trading style could be short for a week and get out and make a profit doing that. While the other trader who’s long is waiting, you know, for 6 to 8 or 12 weeks for his position to accomplish what he thinks he should accomplish.
So different time horizons, different assets. We have traders that are involved in, you know, a lot of interest rate derivatives, swaps, the yield curve, things that our trading systems don’t always get involved in, but our traders will. So for example, as you know, there’s been this giant flattening of the yield curve. That’s been something that a number of our traders have been involved in, something that typically the, you know, technical systems wouldn’t be so involved in.
RITHOLTZ: And you sit on the risk management committee, when you have all these teams with a lot of authority and a lot of independence, trading their own models, how do you manage that? That sounds like that’s a lot of balls in the air at once.
TROPIN: It is. But you know, we have a lot of technology to support all of that. We have risk systems that are live P&L reporting models that tell us what every trader’s performance is every minute of the day that the markets are open.
RITHOLTZ: Wow.
TROPIN: And then we meet every day at 9:30 and have since 2008, to look at every trader’s portfolio, how has it changed since the previous day? Who’s added to risk? Who’s got risk? What assets are they in? We run stress tests on all of their positions. We see who’s performing well, who might be struggling. And you know, if we have to encourage a trader to reduce risk or do nothing, we, as the senior management team of the firm, are acutely aware of exactly what the firm’s risk is at any minute of the day. And I think it’s that discipline to meet and have, you know, total transparency into risk taking helps manage, you know, the outcome quite a bit.
RITHOLTZ: And you guys have been doing this for almost 30 years, so you obviously know a thing or two about risk management. I look around this year, I see some quant-focused hedge funds blowing up to say nothing of all the venture investments into crypto. And some of the crypto funds really just losing 90%, 95%, in some cases, a 100% of their assets. As someone who is a professional risk manager, when you look out, what do you see when the world around you has these frequent flare-ups?
TROPIN: Well, you know, it always gives you religion about managing risk, right?
RITHOLTZ: Yeah.
TROPIN: I mean, at the end of the day, it’s awfully important to make money for our clients and on our proprietary capital for ourselves. But the only way you’re going to do that is by managing the downside. And so we’re just really conservative in our risk policies. We’re not so conservative that there’s no breathing room to make money because if you’re not willing to lose some money, you can’t make any money. I mean, it’s an age old thing in investing and trading. But the question is how much.
And we’re just very process-driven in how we look at risk, how we analyze it. You know, we’ve learned that we just have to make some hard decisions fairly quickly at certain moments. And we’ve had moments where we’ve had traders lose more than we would have liked them to have lost. We’ve got trading systems that have had bad cycles. But we have prevailed over 29 years because, in general, we avoid, you know, some really bad experiences that sort of, as you alluded to, we try not to let that happen to us or to our clients.
RITHOLTZ: It’s pretty clear that a number of the funds that have blown up didn’t seem to have a whole lot of risk controls in place. It’s one thing to take a loss, it’s another thing to let a bad situation become a fatal one.
TROPIN: Yeah. Well, I think that, you know, it kind of speaks to who is Graham. We’re a conservative firm. We’ve been doing this for 29 years. I’ve been involved in the markets for over 40. You’ll learn a lot over that amount of time that, you know, you can’t be in a hurry to try and make a profit.
RITHOLTZ: Right.
TROPIN: You’ve got to just, you know, be a patient investor. You got to be an opportunistic investor. And if you manage conservatively your business, I like the odds of you finding the moments when it’s good for what you do and capitalizing on it.
RITHOLTZ: You know, I’m going to editorialize briefly, but I’ve had this conversation —
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RITHOLTZ: — countless times about just be long term greedy, just be patient, it will come to you and everybody that seems to get into trouble, whether it’s a trader or a fund, or whatever, it’s always that hurry that seems to cause their disasters.
TROPIN: Yeah, that’s a factor for sure. It’s not the only one, right? Like liquidity can change.
RITHOLTZ: Sure.
TROPIN: And that is something that can bite you when something that was relatively liquid and easy to get in and out of becomes eloquent.
RITHOLTZ: Right.
TROPIN: And you know, we’ve seen that in some of the situations you described earlier of funds having problems. And so one of the things we really scrutinize as risk managers is what’s happening with liquidity? How is it changing? And is there any adverse behavior as it relates to liquidity that we should be very careful and thoughtful about?
RITHOLTZ: And last question about the various teams, does everybody have a different benchmark? How do you track performance? Is it strictly absolute returns, or are people working towards a specific bogey that they’re comparing themselves with?
TROPIN: Yeah. It’s really an absolute return business. And you know, we are trying to have our traders generate, you know, call it high single digits, low double digit returns, with relatively moderate volatility. So annual volatility of 4%, or something like that. And that’s a pretty good ballpark idea of the parameters that we ask traders to live within. And that’s a pretty comfortable place for our clients. You know, our —
RITHOLTZ: Meaning the amount of risk they’re willing to assume relative to potential reward?
TROPIN: Correct.
RITHOLTZ: Really, really interesting. I want to start talking about the current environment with a quote of yours that I really like. You said, “I can’t recall a more interesting time to be a macro investor since the financial crisis.” Tell us a little bit about that. I haven’t heard a lot of people describe this year 2022 that way.
TROPIN: Yeah. Well, you know, because we’re a macro-oriented fund, what we’re really concerned with is what’s happening with interest rates, what’s happening with foreign exchange, what’s happening with commodity prices, and what’s happening with equity prices. And all of those four sectors have been moving a lot. And so that’s a really fertile, constructive environment for us to try and generate returns.
RITHOLTZ: Meaning if they’re moving, you’re finding opportunities?
TROPIN: Exactly. You know, for us, it’s nowhere near as productive environment if asset classes are really quiet. If you think about interest rates as an example, you know, today is a Fed meeting. But, you know, think about that Germany didn’t raise rates for 10 years until recently, right? So just practically speaking, there’s going to be less to do if you’re trading German interest rates, and the central banks not moving them for 10 years. Now, rates are moving and they’re moving a lot.
If you think about the U.S., you know, the central bank started giving us something they never used to do, which was forward guidance, saying, “Not only are we not changing rates today, but we’re telling you we’re not going to change rates for the foreseeable future.”
RITHOLTZ: I’m so glad you said that because I remember in the 1990s, CNBC used to have the Greenspan briefcase indicator, how thick or thin the briefcase he carried into the FOMC meeting was their hint as to what was going to go on with rates. That’s a different world. Now, they literally say, “This is what we’re doing.” Earlier this last week, or two weeks ago, somebody at the Fed said to Nick Timiraos at the Wall Street Journal, “Hey, we’re going 75 basis points.” There’s no misunderstanding. They are not just telegraphing, explicitly telling us what they’re going to do, how does that affect your ability to find opportunities?
TROPIN: Well, so here’s the thing, if they’re telling us they’re going to do nothing, that’s not so helpful.
RITHOLTZ: Right.
TROPIN: If they’re telling us that they’re going to be moving interest rates a lot, and they’re not just going to do this at one meeting, but over some series of meetings for the next year or something, then there’s a lot to work with in terms of the markets. They’re going to move a lot. They’re going to overreact. They’re going to give us, you know, trading opportunities, both on the long and short side.
And so when I say the markets are more interesting, they’ve been for a really long time, it’s for a variety of reasons. Markets are moving. We’ve got central banks all over the world starting to move. We’ve got equity prices moving a lot. You know, there’s a big realization of P/E to lower levels, right, as earnings start to decline and erode. You’ve got commodity prices that went through the roof in the first third of this year because of supply chain issues, the Ukraine war, and so on. And then you’ve got the dollar making one of the biggest moves that I’ve seen in a long time, like 20 years.
RITHOLTZ: Yeah.
TROPIN: I mean, we’ve had a move in dollar-yen. It was 25%. We haven’t seen that in a long time.
RITHOLTZ: Right.
TROPIN: So that makes —
RITHOLTZ: And euro parity is —
TROPIN: Exactly. So you’ve had great moves in a lot of markets. And what I’m excited about is I don’t see that changing into a quiet moment anytime soon.
RITHOLTZ: So let’s talk about next year. But before we get to that, I want to ask you about last year. So 2021, for equity investors, hey, plus 28% seemed like a great year. But if you’re a volatility trader, markets were never less than 5% from all-time highs. It was a shockingly quiescent year, straight up, and hardly any move. Was 2021 a less interesting year than 2022?
TROPIN: Yeah, for sure. Definitely. I mean, we’re able to generate on average returns last year, a positive year. But there’s way more to do this year. And you know, last year, if you’re going to have a good year, you had to be essentially long beta.
RITHOLTZ: Right.
TROPIN: And we like —
RITHOLTZ: From the beginning of the year and straight through.
TROPIN: Correct. And just be patient and stay with it.
RITHOLTZ: Right.
TROPIN: And you know, we certainly did that on a portion of what we look at as our risk budget. But we’re much happier. We’re going to be more profitable. There’s going to be more interesting environment when, you know, you’re not looking at one asset class and that’s the only game in town, but rather there’s something to do in foreign exchange, or something to do in rates, or something to do in commodity, something to do in credit. All of these asset classes now are moving and moving a lot.
RITHOLTZ: So 2021 not so interesting, 2022 very interesting. Why do you believe 2023, this high interest, high volatility environment is going to continue into next year?
TROPIN: Yeah. So the question, of course, is I expect there to be plenty of volatility next year, will it be as volatile as ‘22? Maybe not. But will it be volatile enough for it to be fertile for what we do and constructive for what we do? And I think the answer to that is yes. So I’m cautiously optimistic that will be the case. And I say that because I think of some of the problems that the Fed is trying to manage through and central banks in Europe are trying to manage through. These problems I don’t see ending when we flip the calendar on ’23.
RITHOLTZ: Right.
TROPIN: You know, the supply chain bottleneck is going to end that soon.
RITHOLTZ: No, no, it’d all be good January 1. It will go away.
TROPIN: Exactly my point. So there are secular issues that are causing inflation, that I believe the Fed really can’t do that much about. And I think the problem that inflation causes for central banks are not going away so quickly. So I think this year may be unusually good for macro, but I think the upcoming several years are going to be also pretty interesting for what we do.
RITHOLTZ: So the consensus of economists has the Fed raising 75 basis points today, July 27th, and then another 75 in September, and then —
TROPIN: I think 50 is the base.
RITHOLTZ: Is that where that’s now moving back towards?
TROPIN: Yeah, I think it’d be 50.
RITHOLTZ: Because the prior hint was 75.
TROPIN: Yeah, I think when we got that —
RITHOLTZ: But the economy really seems to be slowing.
TROPIN: Well, we got that really bad inflation print a few weeks ago.
RITHOLTZ: Right. For June.
TROPIN: And then, you know, we’ve gotten some weaker data since. And so I think people have priced in 50 basis points in the next hike, and then there’ll maybe one —
RITHOLTZ: And then cuts in 2023.
TROPIN: That’s the thing. They’re pricing and also cuts in ‘23. Maybe, maybe not. You know, I’m not so —
RITHOLTZ: You’re not in that camp?
TROPIN: I’ll wait and see. I mean, I think we need to see inflation get a lot closer to the Fed’s target. And you know, I don’t see inflation coming down as rapidly as the market is pricing in Fed cuts.
RITHOLTZ: Oh, really? That’s very interesting.
TROPIN: Right. So in order for the Fed to want to cut, they’re going to need to see inflation contract quite a bit. And it will contract from the very high levels it’s at now. But will it go down to their target? I’m not sure.
RITHOLTZ: So let’s talk about commodities. Lumber cut in half. Copper down 30%.
TROPIN: Yeah.
RITHOLTZ: Oil under a 100. What are we like? 32 days in a row of gasoline prices falling.
TROPIN: Yeah.
RITHOLTZ: Industrial metals also down 25%, 30%. Most of the commodity complex that really ran amok seems to be starting to roll over and soften. How do you view that? Is that just —
TROPIN: I view that as helpful, for sure. But, you know, have rents collapsed? No.
RITHOLTZ: No. And they’re sticky too.
TROPIN: Housing is really tight. Labor still really, really tight. The employee still has the upper hand, you know, as it relates to —
RITHOLTZ: Is that still true? Because the sense seems to be you have layoffs at the tech firms. They were in a mad dash to hire. They overhired. And now, some of the retailers are talking about easing Amazon and Walmart. It feels like the great resignation is over. And whatever upper hand employees had, they seem to have lost a little hand over the past few weeks.
TROPIN: I think that’s a perception, not necessarily the reality. I think that will become reality. I don’t think we’re there. I don’t think psychology changes so fast. So I think, you know, employees here at Bloomberg do have remote work policy.
RITHOLTZ: Right. And free lunch. So in perspective view is skewed.
TROPIN: And most firms, you know, have similar policies. And I think that’s reflective of employee having a lot of leverage over employers. And these policies will probably evolve, you know, because they all got birthed out of COVID, and so on, an incredibly hot labor market. But I don’t see drastic changes yet in how employees are thinking and what their work expectations are. I think that we’ll get to there, but we’re not there.
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RITHOLTZ: You know, it used to be “How do you keep them down on the farm once they’ve seen Gay Perry?” And now it’s “Hey, how the hell do you get them back into the city?” They want to work from the farm. The world has changed. Personally, I can’t help but notice how much more productive and efficient I am up into a point where, “All right, I got to get the hell out of the same four walls.” I’m wondering how that extrapolates out to the entire labor market.
TROPIN: Yeah. I think it really depends on what people do, right? I mean, I think, you know, some people can be very effective working remotely. And I think others are more effective when they collaborate.
RITHOLTZ: Sure.
TROPIN: And I think it’s easier to learn, right, when you’re around people who are very bright and very innovative. And you know, you can hopefully piggyback some of that knowledge and experience, and have it improve your knowledge base and your skill set. And so I’m a big fan of, you know, people working in offices to a significant degree. But I also understand that a lot of people really enjoy working remotely, and I understand that. I mean, it’s very efficient, right?
RITHOLTZ: Right. But it’s pretty clear that there’s going to be some form of hybrid at most major employers going forward.
TROPIN: Right. Right.
RITHOLTZ: The question is, is it 4 and 1? Is it 3 and 2? It’s not going to be 0 and 5 like it was for two years. That’s pretty much done.
TROPIN: I have to agree with that.
RITHOLTZ: Yeah. Let’s talk a little bit about some interesting trends that we’ve seen play out in 2022 and whether or not they’ll continue for the rest of the year. We haven’t talked a lot about equities. But if I think of anything in 2022, finally. value has started to show its advantage after lagging growth for practically a decade. Do you guys look at these sorts of factors? Is that one thing to consider?
TROPIN: We do. I mean, a lot of our training systems are sort of momentum-based systems. But then we also have value based quantitative models, and our traders are definitely looking at value. And you know, look, equities have come down a lot. But I think the question is what’s next? And you know, to me, do we test the lows? You know, we’ve bounced about 7% off the lows in the last few weeks.
You know, it would not surprise me as earnings slow down and the economy slows down. And the fact that these rate hikes begins to kick in, you know, earnings should deteriorate. And the question is how much and how much we’ll spend in contract and things like that? And what kind of demand destruction are we going to see? So I think equities probably have some downside on them. On the other hand, the bull cases, there’s not a lot else to do with money. And so, you know, the sell-offs are pretty well bought by institutional investors.
RITHOLTZ: Said differently, what’s already in the price? So let me throw a couple of things at you. We talked earlier, down 20%, more or less price is in a recession, right, or at least a mild recession? Is that a fair assessment the way you would think about the macro environment of stocks as a leading indicator?
TROPIN: You know, I don’t know that’s all priced in there because think about it, we’re up 28% last year, right?
RITHOLTZ: Right.
TROPIN: So it’s a lot. And we were down 20% this year.
RITHOLTZ: And up 21% the year before.
TROPIN: Right.
RITHOLTZ: So this is just a little mean reversion.
TROPIN: You know, I think of this as sort of a very normal correction after the years and years and years of unusually good performance for equities. And I’m not sure that a recession is completely priced in.
RITHOLTZ: Interesting.
TROPIN: I think the slowdown in the economy is somewhat priced in, but I think we could see lower prices from here.
RITHOLTZ: So let’s talk about earnings both second quarter and third quarter. Second quarter earnings have started to trickle out, a few disappointments, but stocks really haven’t been punished. The way when we saw a first quarter 2022 earnings come out in April, if you missed, you got (Gillette) down 20%, 30%. Walmart, really, I can’t say on radio what they did, but terrible. The stock was off 8% or 9%. It’s really relative to how badly they missed. I was surprised that that’s all they were down. So the question is, what does it mean when stocks aren’t punished when bad news comes out?
TROPIN: So I think perhaps part of the explanation is that there was a deleveraging that occurred in the first quarter. And I think that is somewhat behind us. So —
RITHOLTZ: Meaning that very richly valued stocks —
TROPIN: Yeah. I mean —
RITHOLTZ: So this is more multiple contraction than being punished for missing earnings?
TROPIN: I mean, you know, there were equity hedge funds that were pretty levered, that had pretty highly concentrated, you know, growth bets, and a lot of technology companies and so on. And a lot of those equities went down a lot. And a lot of those funds had to exit and a lot of investors, you know, exited some of those positions, and then come back to Earth. And so I think some of the deleveraging has already occurred, and that’s why the reaction function is not as severe as you see new earnings hit the tape.
RITHOLTZ: Really intriguing. So let’s talk a little bit about third quarter earnings. If the Fed goes 50 or 75 in September, is the market pricing in a potential decrease from record highs for S&P 500 earnings?
TROPIN: I don’t think we’re pricing that yet. And I’d be a bit surprised if we don’t — if we have continuing, you know, erosion of earnings, I think equity prices will follow that. Well, I’m not forecasting another 20% down, but I do think we could go down 5% or 10%.
RITHOLTZ: Easily, right?
TROPIN: Yeah.
RITHOLTZ: I mean, that’s a bad Tuesday down 10%. People forget what a very bad Tuesday —
TROPIN: It’s a very bad Tuesday, black Tuesday.
RITHOLTZ: That’s right. Or it’s really just a fraction of that. So we talked about if this is pricing in a recession, does it matter if we’re in recession or not now, or will be next year? How do you contextualize the economic data and the broad stamp recession when you’re thinking about managing risk?
TROPIN: You know, we obviously have to be concerned with it. And you know, we would not be at all surprised to see the economy contract. The Feds rate hikes take effect, beta slips, prices go down somewhat, if you’re talking about equities. And then at some point, buyers come back and invest because there’s a perception. And if you think about, you know, the last decade or more, if you didn’t buy the dips in equity prices, you are sort of punished by the market.
And so there is a psychology that’s been well trained into all investors, institutional and otherwise, that when equities go down, you need to shut your eyes and buy. And so I think we’re going to continue to have that behavior occurring. And you know, we’ll just have to see how it plays out in terms of what does the market do, not just over the next quarter, but over the next several.
RITHOLTZ: You were awarded for buying the dip in 2010 when we had the flash crash. You were rewarded for buying the dip in fourth quarter of 2018 when we were down almost 20%. If you bought into the end of the quarter of the pandemic, March Q1, you were awarded. This seems to be the first year where the dip buyers really got their hand smacked by the market. How long does it take? You’ve been doing this for 40 years. How long does it take for that psychology of buy the dip, buy the dip, buy the dip, for that muscle memory to get broken?
TROPIN: I think it takes a couple years.
RITHOLTZ: Really?
TROPIN: Yeah. I don’t know it will happen — I don’t think —
RITHOLTZ: Like ’08, ’09 definitely had a big impact on people.
TROPIN: Yeah. I think it takes a couple years. I don’t really think it happens in — let’s face it, we’re five, six months into the year, six or seven months in the year now. I mean, I don’t think we’re there. I think, you know, if we were to see two years of poor performance in equities, the buy the dip psychology would really erode a lot. But if you see seven months of poor equity performance, I’m not sure we’re there.
RITHOLTZ: So we’re halfway through 2022. We’re looking at the rest of the year and into 2023. Any particular asset class or sector that strikes you as intriguing? Energy, you mentioned earlier, had a great year, the past 12 months. The banking sector really seems to have missed earnings. What looks interesting?
TROPIN: Well, the dollar is really interesting. I mean, the dollar is making a big move, and it continues to be a currency, right, that has positive carry versus its counterparts. So you know, rates in the United States are still considerably higher than the rest of the world.
RITHOLTZ: And that attracts capital?
TROPIN: That’s going to attract capital, you know, until proven otherwise. I mean, Japan has committed to a maximum rate of 25 basis points, while the U.S. is marching on up 75 basis points today. So you know, I think the dollar continues to intrigue me. You know, it’s moved a lot. You have to be cognizant of that. We’ve seen, you know, the dollar moved 25% against the yen.
RITHOLTZ: Huge.
TROPIN: Well, could it go more? I think so. And could it go more against the euro? I think so.
RITHOLTZ: So here’s the pushback from my Gold Bug friends who I have been tormenting for the past decade. Yeah, the dollar is up, but it’s the only clean shirt in a dirty hamper. We’re going to go, the won, the yen the euro, everything else is junk. The dollar is just half decent. How do you respond to that sort of criticism to dollar strength?
TROPIN: You know, I guess my question is, does it matter? I mean, if the dollar is going up because —
RITHOLTZ: Who cares?
TROPIN: Well, because it’s got a much higher interest rate than other currencies, I don’t know if I’d call out that it has a clean shirt. I think it has favorable fundamentals. And people should buy things that have favorable fundamentals and not buy things that have lousy fundamentals.
RITHOLTZ: So if the dollar is strong, what does that say about our ability to export? What does that say about global macro travel? I had a buddy who in the late ‘90s, in early 2000s, the last time the dollar was as strong, was flying to Europe, buying 911s and Z8s, and other European sheet metal Ferraris, bringing them back to the U.S., converting them and still selling them at a healthy profit versus what the dealers were asking for, because of the strength of the dollar. How does this impact global trade and other economic factors?
TROPIN: It’s a big factor. I think, you know, keep in mind, your supply chain bottleneck problems are as persistent as ever. So you know, our ability to do what you just said, right, to go and start buying Porsches or something, it’s not happening because you can’t get them.
RITHOLTZ: Right.
TROPIN: So some of that stuff has to work itself out independent of the currency. But, you know, one of the things that’s causing inflation is secular trends, such as supply chain problems and what have you. And that’s one of the reasons I think inflation is going to be around for a while because those secular trends are slow moving.
RITHOLTZ: So when you say inflation, we’re obviously or maybe not so obviously, we’re not talking 8%, 9%, but we’re talking elevated above Fed target of 2%?
TROPIN: Correct.
RITHOLTZ: So 4% or 5% inflation?
TROPIN: Correct. Yeah. Maybe we’ll get down to 4% or 5%, but that’s the number the Fed doesn’t like.
RITHOLTZ: I like 4% better than 9%.
TROPIN: Yeah.
RITHOLTZ: But that still means that that’s pressure.
TROPIN: But we’re going to move to the right direction. But are we going to move as fast as the Fed would like? I don’t think so. And that’s why I think people who have this expectation that the Fed is going to be cutting rates sometime in the first or second quarter of next year, I’m not sure that’s realistic.
RITHOLTZ: So let’s assume you’re right. We’ve seen peak inflation. But transitory takes much longer than expected.
TROPIN: Right.
RITHOLTZ: And we slowly work our way down to maybe there’s 6 handle by the end of the year, 5 handle.
TROPIN: Right.
RITHOLTZ: And then sometime next year 4%. What does that mean in terms of wages and people demanding higher salaries? What does that mean in terms of consumer spending? That has to mean mortgage rates are going to be much higher. What does that mean for housing? And lastly, what does that mean for politics? I can’t imagine the present occupant of the White House is happy with that sort of inflation forecast.
TROPIN: Yeah. I’m sure he’s not. And I’m sure, you know, the Democratic Party is not very happy going into a midterm election with really high inflation.
RITHOLTZ: Right.
TROPIN: And you know, I’m not sure, for good or for bad, politicians are really bad involved in managing inflation, right?
RITHOLTZ: Right.
TROPIN: It’s not what they do. The central banks really had that mandate.
RITHOLTZ: They like to pass through around it, but —
TROPIN: But they’ll take credit or blame accordingly, you know, depending on what side of the policy you’re on. But I think, you know, we’re going to have a pretty thorny issue, which is that inflation and the things that need to happen for it to go down, just are going to move slowly. And that’s my base case. I could be wrong. We could really contract quicker.
I mean, you mentioned that energy prices would come down some. You know, other commodity prices have come down a lot. But let’s also not forget, you know, crude oil is still about $1 right now. And could it come down? Sure. But it hasn’t come down that much. Are we going to get down to 80 cents or something like that? Maybe. But we’re not there.
RITHOLTZ: Really intriguing. And last market question, so we’ve seen equity valuations come down. I get the sense you’re expecting cheaper valuations, if not much cheaper valuations.
TROPIN: Well, I wouldn’t go so far as to say much cheaper valuation. But I would say I think the risk is to the downside more than the upside.
RITHOLTZ: How do we get there? Do we get there through multiple contraction, or do we get there through price?
TROPIN: I think it’s really choppy price behavior. I mean, we’re seeing —
RITHOLTZ: Stair step down?
TROPIN: Yeah, a little bit. I mean, you look at some of these rallies, they’ve had vicious bear market rallies this year, right, where the market was up, you know, 3% one day and 2% or 3% the next day, and so on and so forth. And then the next week is the exact opposite.
RITHOLTZ: Right.
TROPIN: So I think that kind of erratic behavior, maybe not quite as volatile as that is what I would expect. And I think, you know, there’s a lot of money that needs to get deployed. And if I’m an investor, I’m an institution, I’m going to have so much in hedge funds. I’m going to have so much in private investing. But I need to be in liquid markets. And I’m not going to just exclusively invest in, you know, alternative assets, if you will. So there’s going to be a continuing bet for beta because institutions need to invest a lot of capital. But will the economy continue to support ever higher valuations like the last 10 years? I don’t think we’re there.
RITHOLTZ: So one last thing I have to ask, you mentioned institution sitting with capital. Did you imagine, didn’t want to go back to the ‘80s, but even 2000, that there would ever be these many trillions and trillions and trillions of dollars looking for a home? I never, in my wildest dreams, imagined that so much capital would be amassed. How do you contextualize all this money looking for a place to be well treated?
TROPIN: Yeah. I mean, it’s almost hard to fathom.
RITHOLTZ: Right.
TROPIN: I mean, when you think about all of, you know, the quantitative easing that’s gone on, and all of the stimulus, and all of the capital that there is, all the cash in the world, it’s really huge. And I think that is something that is a positive fundamental for equity prices. That cash has to get invested somewhere, sometime, somehow. So even if earnings aren’t great, even if the economy continues to look slow, even if inflation is too high, I think there is an argument to be made that there’s a lot of cash out there looking for a home, and that cash is going to periodically be deployed into equities.
RITHOLTZ: Yeah. No, that makes a lot of sense. All right. Before I get to my favorite questions, let me just throw a curveball at you. Graham Capital Management’s headquarters is at a site named Rock Ledge. This used to be the Office of General Douglas MacArthur?
TROPIN: Correct. Yeah.
RITHOLTZ: Tell us first how did you find Rock Ledge and make it the home of GCM, and tell us a little bit about the place.
TROPIN: Yeah. No. Back in, you know, 1994, when I started Graham, we moved into Stamford and we were in Stamford, Connecticut for some number of years. And that was a really good place for us to recruit and retain talent. And a lot of people, you know, enjoyed, as I did, the ability to have access to New York City, but you know, also have good school systems and what have you in the suburbs of New York and in Connecticut. And a lot of hedge funds were in Connecticut.
We outgrew the space in Stamford. And so somebody called me and said, you know, this building in Rowayton, Connecticut that’s available and it’s pretty amazing. And I went up and I saw it, and it has, you know, beautiful campus setting of about 100,000 square feet of office space. And you know, it needed a lot of work, but it was really pretty cool. And so I thought, “Gee, what a better place, what a great place to try and attract the best people you could find to work in your fund.”
And from a quality of work-life perspective, this was just an amazing place to run a hedge fund, to attract really talented people. You know, the success of a hedge fund is all about the people who work there, and having a great place to work is not unimportant.
RITHOLTZ: It looks like a college campus. It’s quite beautiful.
TROPIN: Yeah. It’s been fantastic. We’ve been there a long time now, and I’ve enjoyed every minute of it.
RITHOLTZ: We’re glad to hear it.
(COMMERCIAL BREAK)
RITHOLTZ: Let’s jump to Our favorite questions that I asked all of our guests, starting with tell us what kept you entertained during the pandemic. What were you watching or listening to?
TROPIN: Well, mostly the markets, you know. And so, obviously, being in a position of monitoring risk and performance, and position taken of all these traders and trading systems, you know, that’s always front and center in my conscious. But, you know, there have been some really good shows that have come out that I’ve enjoyed. You know, there’s recently something I’ve been watching that’s called Tehran. It’s on Apple Plus. It’s a pretty good show. Jeff Bridges is in a good show. I think it’s on FX or something like that called The Old Man. That’s a great show. So you know, everyone needs a break from the markets once in a while.
RITHOLTZ: For sure.
TROPIN: That’s a couple of things I’ve been watching.
RITHOLTZ: Tell us about your early mentors who helped shape your career.
TROPIN: Well, you know, I think about some of the people who really were just great mentors and great people to learn from. Paul Jones comes to my mind. I met Paul about 40 years ago. And you know, what an amazing person, philanthropist, great trader, visionary for the world of finance. And you know, I was very fortunate to have him help me get Graham going back in 1994. He’s been an insane role model, not just for me, but for a lot of people in finance.
When I was at Dean Witter, I had a really tough boss named Charlie Fiumefreddo that ran Asset Management. Charlie brook no nonsense. He had a Monday morning meeting at 8:00 a.m. every Monday. And you know, all of his division heads, I was one of them, had to be down there in the World Trade Center at 8 o’clock. And man, I left my house at 6:00 because if you got to that office at 8:02, you waited for an hour till the meeting was over outside his office, and then got to explain what you were doing, you know, one on one which wasn’t that much fun. So you know, he was a great boss because he was no nonsense and tough as nails.
RITHOLTZ: Tell us about some of your favorite books and what are you reading recently.
TROPIN: You know, I like spy novels. So the Portrait of an Unknown Woman, David Silva, just came out. That’s a great book. I’ve always, you know, loved The Trilogy by (inaudible), something I read when I’m totally stressed out, and I want to get into another world. It’s a great place to go. And then I’ve just devour all financial news and technology news, and things like that.
RITHOLTZ: Interesting. What sort of advice would you give to a recent college graduate who is interested in a career in macro investment or quantitative trading?
TROPIN: You know, the advice I would give is try and get a job at a really good macro fund that has some really bright people. And if you want to get ahead and you want to be successful, it’s really simple. You show up before anyone else. You leave after everyone else. You never are screwing around on the Internet. You’re paying attention to everything that’s happening. And trust me, if you have brains and creativity and innovation, there is no industry that rewards you better.
RITHOLTZ: Quite interesting. And our final question, what do you know about the world of investing today you wish you knew 40 years ago when you were first getting started?
TROPIN: You know, that’s a tough question. I mean, obviously, on one hand, our trading systems, our traders are so much more sophisticated and it’s more complicated. And you know, we’ve learned a lot of lessons about managing risk. We’ve learned a lot of lessons about being opportunist in certain market cycles, and really conservative in other market cycles.
And you know, the only way to learn those lessons is through experience and making some mistakes, and overcoming those mistakes and ultimately prevailing. So you know, it would have been great to never have to learn through, you know, making mistakes, but that’s the way the world works. And I think we’ve been successful because we’ve been intellectually honest with ourselves. When we make a mistake, we own it.
RITHOLTZ: Really, really intriguing. Thanks so much, Ken, for being so generous with your time. We have been speaking with Ken Tropin. He is the chairman and founder of Graham Capital Management. If you enjoy this conversation, well, check out any of the previous 400 we’ve done over the past eight years. You can find those at iTunes, Spotify, wherever you get your favorite podcasts.
We love your comments, feedback and suggestions. Write to us at mibpodcast@bloomberg.net. Sign up for my daily reading list at ritholtz.com. Follow me on Twitter @ritholtz. I would be remiss if I did not thank the crack team that helps these conversations come together so well each week. Sarah Livesley [ph] is my audio engineer. Atika Valbrun is my project manager. Paris Wald is my producer. Sean Russo is my head of Research.
I’m Barry Ritholtz. You’ve been listening to Masters in Business on Bloomberg Radio.
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