Interview with the leading Czech economist Pavel Kohout, who worked as an investment analyst and who founded several investment funds during his career. His latest work is a unique stock trading algorithm called QUANT. In addition to his macroeconomic outlooks, he shared with us his views on cryptocurrencies.
Pavel Kohout has been working in finance for over 25 years, he is one of the greatest experts in investment and economics in the Czech Republic. Besides his investment career, he served as an advisor to several finance ministers in the government and wrote several books on investment and economics.
In 2016, Pavel Kohout founded the Robot Asset Management SICAV company and launched the first investment fund called QUANT, which manages clients' money worth more than 20 million EUR. QUANT's investment strategy is based on an algorithm that compares the amount of money in the US economy with stock prices in the US, so it is not governed by an investment committee whose members could be subject to emotions and moods that impair trading judgment. From the given data, the algorithm then calculates the rate of overvaluation or undervaluation of shares and then decides on the distribution of investments between shares and bonds.
Hello, Mr. Kohout. How is the QUANT investment fund doing today? You mentioned in your blog that the rules of the QUANT fund algorithm were set once and do not change, and if they are ever modified, then after many years of operation. Does this mean that you are not working on improving the algorithm, but only observing and evaluating it?
Our algorithm works on the basis of "low frequency" trading. This means that it uses rules that have long-term validity. There is no need for the frequent changes that are necessary for high-frequency trading, where rules quickly become obsolete because market participants are constantly responding to the changing microstructure of the market. I cannot absolutely rule out future changes, but for now, it is neither necessary nor desirable.
In addition, I am working on other algorithms that are somewhat similar, but I do not intend to make major changes in a short time.
During 2020, QUANT (and Algorithmic Investment Management) prospered as we significantly reduced our equity positions. Not that our algorithms predicted a pandemic, but the market was significantly overvalued in January and February. During March, they managed to buy shares cheaply. The algorithm worked exactly as it should - if it weren't for the pandemic, something else would have triggered the fall.
On the QUANT fund's website, you state that the most important factor for the share price is the inflation caused by pumping new money into the system. So, if the FED and the ECB cut interest rates and eventually further waves of quantitative easing come, should we look forward to rising stock indexes again and again?
My algorithms track the growth (very rarely the decline) of liquid money, which is exactly what counts. Central bank balance sheets do not enter the model directly. The point is that stocks are sometimes above the level that would correspond to the balance, sometimes below it. In principle, this is an approach that is methodologically similar to the CAPE indicator (or Shiller's P/E), but unlike it, it is more robust and does not have a built-in methodological error. By this error I mean the discounting of past profits by the consumer price index, as this inflation rate has nothing to do with valuation models. So, my indicator indicates a better overvalued or undervalued market than any P/E variant. As I like to emphasize, P/E fails the most whenever you need it the most. This cannot happen to my indicator.
But even overvalued stocks may continue to rise and undervalued stocks may fall deeper. Therefore, the model also takes into account other auxiliary indicators, especially the state of banking and credit markets. These are much more useful as an indicator than cumbersome statistics such as GDP, which is published with a delay and then often subject to back-revisions.
What do you think about the quantitative easing by the FED in the last few years and all those stimulus packages as help in the COVID-19 pandemic, can the forthcoming US presidential election play a role in these incentives? Stock indices at new highs sound like a good reason to re-elect current President Trump, don't you think?
Maybe. The FED seems to be quite accommodating to President Trump. But I'm not doing a politics analysis. It would be a frustrating and unproductive activity. Numbers are important to me. Politicians' discussions may move the market in the short term, but the real trend is determined by the numbers. For example, when the market reached a slight overestimation during the second half of 2017, it was clear that the robust growth trend had ended or at least weakened significantly - and that market corrections would be more significant than before.
How do you view the shares buybacks and the purchase of shares by banking institutions thanks to the "printed" money they receive from central banks? Ad absurdum is the situation where the Bank of Japan currently owns an incredible 75% of all Japanese ETFs! Is it a healthy development of the economy at all and is this situation sustainable in the long run?
Shares buybacks are not bad. It's just a more tax-efficient way to pay dividends: fewer shares have more profits. Their value is growing, who can complain?
There is nothing extraordinarily bad about monetary inflation either, this phenomenon has manifested itself since the time when there have been reliable time series of the money supply - that is, since 1959. The purchases of shares by central banks are to be considered. This is a really unhealthy phenomenon. By the way, in this way, the Swedish radical left wanted to carry out the overall nationalization of large corporations in the 1970s. It even started then, but then the plans changed. Swedish state funds are now one of the pillars of the local pension system. But 75 percent of ETFs held by the central bank is already a pathological finding!
Let's stay with Japan for a while. Isn't the world economy in danger of a deflationary spiral like Japan? Is there now a trend of lowering interest rates, even to the point of losing it, just to kick-start the economy or prevent a possible crisis?
The deflationary spiral in Japan arose as a result of a fatal banking crisis, from which Japan has never fully recovered since the 1990s. In this context, I am worried about Europe (where I prefer not to invest). American banking, on the other hand, is generally sound. Loan volumes are not oversized and their quality is exceptionally good in historical comparison. America has also managed its financial crisis exceptionally well, despite numerous criticisms.
Today, with the benefit of hindsight, we can say that Ben Bernanke was a great economist and a determined man in his place. He saved the American financial system at a time when the worst was at stake, and his decisions were not entirely obvious. Fortunately, he was a first-class expert on the history of the period 1929-1939 and was able to prevent this unfortunate history from happening again. Even the often-criticized government of President G. W. Bush did quite well as best she could. Barack Obama inherited an economy that was already on the road to recovery after the crisis. He was lucky, thanks to which he was elected for the second time.
In contrast, the EU has long pretended that nothing was happening. "Overcoming" the financial crisis is as much nonsense as treating cancer in the same way. In these cases, it is necessary to act quickly, aggressively, and, above all, professionally.
I am in favor of a minimal state and limited interventions in the economy. In cases of crisis, however, this is not the case. However, the EU, including the ECB, acted late and incompetently.
The result is a situation where the ECB tries to treat the economy with negative rates, which is basically a subsidy to borrowers and a fine for creditors. However, these creditors are mainly savers and investors, including insurance companies and pension funds. That is the public. Attempting to revive the economy with financial penalties for the public is, of course, absurd.
However, the ECB (and some other central banks) have "brilliant" models on which to base negative rates. All initiates know that these models are not good. They have not proved successful in modeling the real economy, they have proved even less effective in forecasting, their only "usefulness" is in the academic sphere because their dissertations write well. Nevertheless, central bankers cling to them irrationally.
But back to the deflationary spiral. The idea that the deflationary spiral is based on consumer expectations is ingrained among academics and central bankers. Households expect prices to fall, so they will reduce consumption so that they can buy cheaper in the future. The reduction in consumption results in a fall in sales, followed by redundancies, rising unemployment, falling GDP, and falling prices. And so on. Deflationary spiral!
But this model is completely meaningless. First, anyone who has ever dealt with consumer credit knows that households never postpone consumption due to the illusory vision of prices falling by a few percent during the year. Households, on the other hand, are willing to pay a double-digit interest rate just to have a washing machine, refrigerator, or TV at home as soon as possible.
Second, the deflationary spiral in the form described above was nowhere and never observed. The deflationary spiral in Japan was caused by a chain failure of banks. The same is true for the 1930s in the United States and Europe. The cause of the deflationary spiral was banks, not consumer expectations. The fall in prices was the result of the crisis, not the cause. Ben Bernanke knew this and the "geniuses" at the ECB do not know it.
In the QUANT investment fund, you also have bonds as a more conservative instrument that serves as a store of finances in times when stock markets are in bubbles and stocks are expensive. However, does your algorithm take into account a situation where negative interest rates are appearing on the bond markets more and more often? It is a positive return for your fund that counts, but how will your algorithm deal with it if the bonds have a negative interest rate and the shares are overpriced?
In our specific case, we use only short-term time deposit instruments to bridge the overvalued market. There we are still able to achieve reasonably positive returns.
The algorithm on which QUANT trading is based could in some way be applied to cryptocurrencies? Have you ever consider setting up a fund to trade them or include some cryptocurrencies in QUANT? Do you think that even cryptocurrency trades could be timed, for example, according to four-year cycles due to the halving of Bitcoin, or is the crypto market too immature and young for such operations? In addition, Bitcoin is known in advance that there will never be more than 21 million. Therefore, if the volume of money in the world continues to grow, logically some parts should also fall into the crypto market, which, due to their limited amount, can act as a scarce asset.
I must admit that I still feel short of cryptocurrencies - I can't "grasp" them appropriately analytically. Their history is short and tumultuous, the models do not provide results that can be used at a reasonable level of probability, there is no equivalent of P/E, dividend yield, or a similar gross valuation indicator. Even the ratio of price to the amount of money, my favorite stock indicator, is not good enough, because the cryptocurrency market is still young and shallow, so very volatile.
As for the limit on the total volume of Bitcoin, it is a double-edged sword. The argument that the relative rarity of Bitcoin compared to conventional currencies such as the US dollar will increase is understandable. On the other hand, many Bitcoin devotees and investors just "HODL" and not let go of their crypto in all circumstances. This can result in limited liquidity, which is reflected in large price fluctuations. Every investment asset needs a sufficiently large speculative market so that it does not suffer from high volatility. Another limitation is a long time for the settlement of transactions resulting from the technical design of Bitcoin.
In one of your recent interviews, you stated that "cryptocurrencies are a means of a silent struggle against a rogue state that manipulates currencies and dilutes their value with inflation." Do you actually see any limits in creating new money? Or can the economy be stimulated and previous debts paid indefinitely? In fact, the state has been devaluing citizens' resources for a long time, and in fact, it is still going through it. Can this ever change, for example, due to the greater adoption of cryptocurrencies?
There is no theoretical or, in fact, practical limit to the issue of traditional currencies. We have seen a number of examples of hyperinflation, where the money supply has increased by many decimal orders and the price level has risen adequately. There is no upper limit, fortunately, or unfortunately.
Central banks can do a lot with currencies, after all, we have seen enough in practice. Including paying old debts with new money. During the spring of 2020, the volume of dollars in the US economy increased by 30 percent year on year - this was due to measures against COVID-19. This is the highest monetary inflation since 1983!
Cryptocurrencies, if they function flawlessly, quickly, and safely, have some chance of at least violating the monopoly of state money. However, this would primarily require the system to ensure a sufficient rate of transactions compared to the speed of payment card transactions. That is a big problem so far.
In addition, many potential users are discouraged by high price volatility, which makes cryptocurrencies a more speculative tool than a store of value. Hard-core fans don't mind, but they make up a tiny fraction of the percentage of users that would need cryptocurrencies to actually compete with traditional currencies.
In total, it would be necessary either to create a fast clearing system for Bitcoin (which is being worked on, but the result has not been very successful in practice, as far as I know) or some new cryptocurrency, which would either completely bypass the "proof of work" mechanism or accelerated very significantly.
In 1992, you developed a computer game called "Stock exchange 92", which was about trading. So I take you as a person who could easily have been on the team of the founder of Bitcoin, which is hidden under the pseudonym, Satoshi Nakamoto. Do you understand cryptocurrencies as a lifetime opportunity for this generation? Like could the shares of IBM, Apple, or Amazon be the previous one? After all, the king of the cryptocurrencies Bitcoin has only been here for 10 years and, for example, the infrastructure is still in its infancy and has a lot of room for improvement and growth.
Cryptocurrencies can be a lifetime opportunity. But it doesn't have to. During my practice, I have seen a number of "life opportunities" since 1992 that have failed monumentally. What's more, we don't know if the future belongs to Bitcoin or something yet to come. Example. Xerox was the first to come up with a graphical operating system, but no one today uses a Xerox computer. Even IBM no longer plays a major role in sales, profits, and market share today. For the next ten or twenty years, today's most fashionable stocks can only be a shadow of their current size. Even Bitcoin can be replaced by something more technically advanced.
The advantage of Bitcoin is its openness to all people without borders, as well as the absence of a higher authority that could censor transactions or determine who can use the network and to whom you can send Bitcoins. This is his highest quality, transferring value without an intermediary. At the same time, if you own private keys, you have absolute control over your Bitcoins. This cannot be said entirely about money in bank accounts, so cryptocurrencies return financial power back into the hands of citizens. Each of its owners can now have their own "Swiss bank account," as once stated a cryptocurrency expert Andreas M. Antonopoulos. Isn't that a reason, why it is so valued among its users? What do you see as the greatest benefit of Bitcoin?
The biggest benefit is the chance to create a parallel, state-independent financial system. But there is still a long way to go.
Can Bitcoin be perceived by investors as a hedge against traditional markets? By following the four-year cycles given by halving, it does not correlate with any traditional asset. Moreover, it cannot be devalued by inflation, as Bitcoin will have a predetermined limited number of 21 million and others cannot be printed, such as US dollars. When people realize this quality of Bitcoin in the future, unless trust in it falls to zero due to some unprecedented event, it should just be appreciated, don't you think so?
Yes, in theory, it is true. However, in practice, it doesn’t seem so clear with the "non-correlation". In addition, I still think that a major breakthrough in cryptocurrency will only come in the form of a new cryptocurrency that will not suffer from Bitcoin's biggest ailment, which is the incredible slowness of transactions.
Thank you for the interview and I wish you much success with your QUANT investment fund and also with the latest published book INVESTMENT: A NEW STRATEGY.