Stig Brodersen  06:29

Yes, not too long ago.

Preston Pysh  06:31

Yeah. So, about two weeks ago, the IMF finally decided that they were going to allow the RMB, the Chinese RMB, into their basket of currencies. I don’t remember the composition. I want to say it was like 15%. Is that right?

Stig Brodersen  06:45

I’m looking at some numbers here. It just showed up 11%. And just for comparison, the dollar is 42% and the Euro is 31%.

Preston Pysh  06:53

So, the idea here is like right now, we got the strong dollar. So, that’s adding value to the SDR because it’s a sub-component of it. Now, if let’s say the dollar starts to weaken, and then maybe the Euro gets stronger. Say, that starts to reverse itself, which I don’t see happening here in the short term, but let’s just say that that starts reversing itself. That would basically offset and the value of that SDR would remain to be unchanged, which is the higher-level currency that oversees all these baskets underneath of it. So, you would see that offset, basically, the SDR wouldn’t change value.

So, the idea is if all these central banks around the world are printing through the nose, and they’re devaluing altogether, the SDR is not going to change in value at all if that SDR is tracking all the main currencies in the world. So, that’s a discussion that’s what’s interesting about this is So, you’re probably saying So, what?

China’s currency is now in the SDR. So, what that means is that China’s emerging as a global power here. The IMF would not be including their currency in this basket if it didn’t have some buying power and some staying power. So, what you’re seeing is that this RMB is now emerging as a global currency, which we haven’t seen in the past. And I think that that says a lot about the direction that maybe the Chinese economy is going.

So, Stig any thoughts on this: RMB, IMF. SDR? We got any other acronyms we can throw out there for people?

Stig Brodersen  08:26

Yeah Preston, in a way I wouldn’t surprise at all because, like China with the size of the economy, they should be a part of that basket. But it’s hard to find a currency that is as manipulated as the Chinese currency. So, I was also thinking they probably weren’t included because it would simply not be stable enough. Also, it’s tied So, much to the dollar and what they’re doing in America. So, I was thinking, they’re probably not going to do that. This is the IMF.

The whole thing about the IMF is to bring stability to the financial system of the world. So, inherently that should not look at China, but still, they are. I think this is just a new world order that we’re seeing and in currencies right now and perhaps this transition. I don’t know. Preston, would you be surprised to see the dollar be a less significant currency in years to come? That’s a hard one, I think

Preston Pysh  09:16

That’s a hard one. I think in the immediate term, in the next year, definitely not. I think the dollar is going to continue to do extremely well over the next coming… Let’s call it the next four months, I think the dollar is going to do well. But after that, that’s hard to say.

I think that it is going to definitely have a turn here in the future, within about a year from now. I think the dollar is going to eventually have a turn. But for the time being, I think that it’s definitely the place to be these days.

Over the next 10-20 years, it’s hard to see what happens out of China. I think that like we had previously discussed the big concern is government intervention. At what level is that occurring, if you pull back the blinds and take a look at their books? Because they don’t have like their SEC, that’s regulating them at the level that you see in the US or anywhere else in the world for that matter. So, that’s where I’m concerned, as an American, it’s just a lack of knowledge. I don’t think that it’s anything more than my lack of understanding of how they operate over there.

Stig Brodersen  10:17

One thing I want to talk about is what’s happening in Europe right now what the world has probably been talking about, like whenever you hear this, is that what *inaudible will do the with the Fed and the interest rates. And So, what I want to talk about is what we’re doing here in Europe, what ECB, the European Central Bank is doing. And just to give you some context, in terms of what the deposit rate here is. And the way to think about that is what type of returns can banks achieve whenever they’re depositing with the ECB? And So, if that rate would be high, the ECB would not provide banks with that incentive to lend that money out to customers because they will get a high return having an ECB.

But right now, we see a negative interest rate and it’s even more negative now than it was a week ago. So, what that means is that they want to give banks an incentive to lend out money to spark growth. So, basically, banks are paying money to have a *store in ECB right now. This is not unprecedented, but you rarely see such negative interest rates that we see here in Europe.

And what is even more interesting is that Draghi, who is the chairman of ECB, has also extended the quantitative easing. It should be stopped here in September 2016. But he has extended that with six months. So, we have right now here in Europe, we are running the program to March 2017. And that is 60 billion euros bought back from banks every month right now. So, that’s significant.

This is an interesting concept. We talked about quantitative easing before and just to give you a quick reminder, basically, that is ECB rearranging the balance sheet for European banks. So, basically, they’re providing reserves instead of the bonds that banks are holding right now. And that is all in the hope that banks will start lending out and generating more credit and spark growth. But So, far, it hasn’t happened.

Preston, I see you have definitely interesting comments on that.

Preston Pysh  12:18

No. I just want to talk about quantitative easing real fast, and how much I think that it’s just maybe not the best mechanism to induce spending. And I mean, that’s what they’re trying to do. They’re trying to add liquidity to the system. I mean, it’s absolutely having an impact. It’s just not flowing through all the channels. I think that’s my issue. So, if you’re Joe Schmo in XYZ in the US, you’re not seeing that money flow through your pocket.

I guess my concern with quantitative easing is it’s the wrong filtering mechanism. You need something that basically goes through all the people within whatever region it is. That’s their country that’s executing this quantitative easing, instead of just interacting with some major bank and buying back all the bonds on their balance sheet and providing liquidity that way it’s basically just coming into the system at the very top level of whoever owns that company. That’s my concern.

So, like, why don’t we take this approach where everyone files their taxes at the end of the year? Why don’t you do this approach where you’re providing liquidity through all these people that are filing their taxes by providing refunds of some sort, and flowing the money that way So, that it flows through the entire breadth of the population of that country. That’s where I think they’re making the big mistake here. If they need to provide liquidity, which is the issue here, I think they need to go about it in multiple directions. And I think they need to focus more in the direction of getting it through all the population. And I just don’t know enough about it. I haven’t done enough research to speak more intelligently on it, but I think that that’s where they’re making the mistake.

Stig Brodersen  13:52

Yeah. And the weird thing about quantitative easing is also that the liquidity that is provided banks have more liquidity is not the same as a society will benefit from that if there are not any credit-worthy customers, they’re willing to borrow money, it doesn’t matter. Like banks can be flooded with cash but if you don’t want to lend it out, and they don’t want to lend it out to anyone who just says, “Hey, I need a loan.” It has to be creditworthy, then nothing is happening.

Preston Pysh  14:18

So, real fast on Japan since you mentioned that. So, back in August, the Japanese market and this is I think, when we first started talking about this, the Japanese market was with a 20.5K on their index. Now they’re at 19.6 So, it’s had a little bit of a pullback, not much about a 5% pullback. But I do want to say that on the 16th of November, Japan has officially slipped back into a recession. That’s the fourth time they’ve been in a recession in the last five years. So, we’ve said it before, we think you should stay away. The PE ratios over there in Japan are very appetizing. Let me tell you, they’re like at a 10, which means you might be able to get a 10% return. My concern is with the currency, I think they’ve got major, major concerns with that currency over there. And I think that that might be why you’re seeing such a low PE in Japan that I’m staying away. I am not getting lured in over there. Let me tell you, I’m staying away from that market and Stig’s nodding his head that he’s doing the exact same.

Stig Brodersen  14:18

That is what you have seen in Japan for So, long now. It’s not enough that you put out cash in the society if no one’s going to spend it if no one is going to borrow it and start investing. And you can’t just force that. I think you just see the same pattern in Europe as in the US, is that you might see a soaring stock market, but you don’t see the real growth in society from these initiatives. And I think that’s concerning because that’s what leads to bubbles.

Yeah, I’m definitely not looking at Japan. If you look at the Pareto’s principle, this was also a concept that we touched upon a few times, it might look like the Yen is undervalued. So, that would say that you should start investing in the Nikkei Index, but still, that’s not a game that I play. I usually don’t play on currencies. But that was just an interesting observation I had with a colleague the other day that was doing some model forecasting on currencies. So, I don’t know. I definitely don’t want to say that you should start investing in Yen, but the Pareto’s principle might suggest that over the long term, but that’s a long time when you talk about currencies.

Preston Pysh  16:17

The last thing that we want to talk about on the current events, I’m curious to hear Stig’s thoughts on what the Feds are going to do on the 15th. Now, here’s the thing, as I said, people are going to be listening to this after we already know what happened. So, let’s just see how wrong we can be. We have no idea what’s going to happen, but we’re going to make some guesses here So, everyone can laugh at our expense for right or wrong. So, my opinion is that they are going to raise rates. I think they’re going to change the federal funds rate by 25 basis points. And that’s it. I’m not going to say anything else. Now, I want to hear Stig’s prediction.

Stig Brodersen  16:50

I think you might be right also with a new job report that just came out that was positive. So, yes, raising rates would probably be the right time. Now, they have been talking about it for So, long that the market almost expects that So, perhaps, it was like a strategy. It is a very cautious strategy that they’re applying for not to give any shocks in the financial markets. So, I think I’m with you on this one, Preston.

Preston Pysh  17:11

I can tell you one thing, if they don’t raise rates, I cannot wait to see what the reason is that, I mean, they’ve painted themselves in the corner. They said that they had to have international stability, all these other things. And I think that they’ve got that since that last report. So, we’ll see what happens.

Stig Brodersen  17:29

So, the last thing I want to talk about is an article by Hussmann. I saw this interesting article here the other day  Preston was sharing this article over LinkedIn. That’s sometimes how we communicate and exchange information.

Preston Pysh  17:43

How we usually communicate.

Stig Brodersen  17:45

Whenever I see Preston upload something or share something on LinkedIn… And it was interesting because he was saying that the market valuation today is So, high that he was expecting a 1% annual return over the next 12 years. And So, since that will also include dividends, if you just look at the index, you might see a declining index from where we are today and the next 12 years. And he might be saying, “Well, you might think that this is impossible that we haven’t seen this before. But look at 2000, it took 12 years in 2000 before the market rebounded.” I think that’s the best handoff to give to an “Irrational Exuberance,” which was originally written just before the burst of the dot-com bubble. I just think I want to leave you with that. I don’t know if he’s right or wrong, but that is how what he projects like, this is the new 2000.

Preston Pysh  18:35

Just my thoughts on Hussmann real fast. So, I love his writing. I enjoy reading everything that Dr. Hussmann writes, and we’ll have a link to this in our show notes in case you haven’t seen anything that he’s written before. He’s very analytical. He understands market valuations well. You can tell all that in his writing and his research and things like that.

Now, with all that said, his performance over the last like six or seven years in his fund has been very poor, relative to the market, he has done very badly. Now he hasn’t lost money, but he hasn’t gained money either. So, I think that that’s an important highlight for people to realize that when the government was doing all this quantitative easing, he was not buying it. He was basically sitting on the sidelines, just protecting his principal and missed this entire growth in the market over the last six years. That’s important to highlight. And I think people should know that.

But with all that said, I still thoroughly enjoy his writing. I think he definitely knows what he’s talking about. And he’s very good at laying out market valuations in a broader sense.

Real quick, I want to go back to this Fed decision and potentially the impact of what would happen. So, let’s just say that the Fed does raise rates, okay? If that does happen, which we don’t know, at this point, and you as the listener right now know what happened. But if the Fed raises rates, I think that the impact is the dollar is going to get stronger relative to all the other currencies. I think that that’s going to be for US businesses. It’s going to be much, much harder for them to compete in the global economy if the dollar gets stronger.

I think that that’s going to lead to earnings power and margins to decrease in the United States market. I also think that high yield bonds are going to start to go through the roof because I think that all these emerging markets that have a lot of dollar-denominated debt are going to have a harder time repaying their debt.

I think that the fact that the European market is easing in combination with the US market tightening is only going to make that strength of the dollar even more dramatic. I think that you have the potential to see oil prices potentially go down. I think that this is a hard one to forecast and I think this one’s going to be a hard one to call, but I think that you’re going to potentially see oil even go lower when the dollar could potentially strengthen if the central banks decide to tighten more.

 

I think you’re getting to a real close breaking point with all this oil stuff and these commodities. I’m watching this very closely. I am sitting on my hands when it comes to the oil market. I have a lot of people asking me what my opinion is. But as of the 7th of December, I still have not entered into the oil market yet. But I’m telling you, it’s getting very close and I’m watching this thing like a hawk. I’m getting very tempted to start diving in. So, with all that said, Stig just gave me the thumbs up like, “Hey, just let’s get going here, dude.”

21:27

So, with that said, let’s talk about the book that we read, “Irrational Exuberance. “This was a very good book, but I guess I didn’t like the writing style. I’ll be honest with you. The content was very good, like what he’s talking about. This guy’s brilliant, don’t get me wrong, but I was not a big fan of the writing style. It was a little dry. Very good points were made in the book. I guess just the way that they were presented was where I struggled with it. And it didn’t help that we were reading “Liar’s Poker” at the same time, and that book is highly entertaining.

So, I was reading this one and “Liar’s Poker” simultaneously. I was basically swapping back and forth between books and I think it made this one a little bit more boring as I was reading it because “Liar’s Poker,” which we’re going to talk about… not the next episode, maybe the episode after that was very entertaining. That’s going to be a fun conversation.

Preston Pysh  22:20

But anyway, So, let’s jump into some of the key points that we pulled out of this book really fast before we start doing this. This is where the name of this book came from. So, back in 1996, I believe it was, Alan Greenspan, the chairman of the Federal Reserve made a speech titled “The Challenge of Central Banking in a Democratic Society.” And this was the quote from his speech back in 1996. He said, “Clearly, sustained low inflation implies less uncertainty about the future. The lower risk premiums imply higher prices of stocks and other earning assets. We can see that the inverse relationship exhibited by price to earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then becomes subject to unexpected and prolonged contractions as they have in Japan over the past decade?”

So, basically, what he’s talking about here in 1996, he’s saying inflation keeps going down. And it has since the early 1980s when Volcker basically put an end to the insane inflation rate. And as that’s coming down, he’s basically seeing a very similar thing playing out to what was happening in Japan. And if you know your history for Japan back in the 1990s, when the market in Japan basically exploded, and it’s had trouble ever since.

So, Alan Greenspan is saying, “We’re seeing the same thing happen here as interest rates go down, that’s going to push asset prices up. And how do we know where the top of this irrational exuberance is, as those interest rates continue to push lower?” That’s what he’s saying in that very fetish speaking paragraph that I just read, which makes people’s eyes glaze over. That was pretty much the premise of the book.

That’s where Robert Shiller wanted to open up this “Irrational Exuberance,” this discussion of growth basically continuing to go down, inflation decreasing, which then pushes up interest rates. So, whenever you go to our intrinsic value calculator on the Buffett’s Books website, and you play around with that a little bit and you adjust the interest rate, which is how you’re comparing the value of the business to, and you push that interest rate lower and lower and lower, what happens to the market price of your asset?

24:39

So, if you don’t know the answer, I’d highly recommend that you go to our website and you play around with this thing and see what happens. But what happens when you lower that interest rate that you’re comparing it to, the market price and the intrinsic value goes up. It goes higher. So, when we think about this in a broader context, and you’re talking about the market in general and interest rates are continuing to go down and down. And like Japan, they’re at zero percent there. They’ve been there for like five to 10 years, they haven’t moved.

When they bought them out at zero percent, everything’s getting polarized to zero percent. It pushes asset prices through the roof because it’s basically saying, “I will buy this asset at a 1% return,” when you do that you push the price super high. Now let’s say that we were using 20% or better example probably be 16% back in the 1980s, the price that you would pay for that is much lower because the price in the yield is completely inversely proportional, just like a bond. So, that’s an important concept for people to understand before we go much further that’s the premise of the book.

And that’s what Shiller’s getting at is, what is causing this? What is causing this churn and what’s going to be the impact in the future? So, as we go through the book… I’m going to just highlight the first thing that Shiller talks about. The first thing that he talks about is his Shiller PE ratio in the first chapter here, where he’s talking about the stock market level performance from a historical perspective. And So, what he says when, this was written back in the early 2000s, 1990 range… He was saying that “Hey, at this current market valuation, you’re going to pretty much not get any return over the next 10 years.”

Stig Brodersen  26:04

He was right.

Preston Pysh  26:12

And he was exactly right. Yeah. So, if we go to 2010, and we look at where the market moved over 10 years, it didn’t move at all. And he was exactly right when he wrote this book, and So, that’s what he’s getting at. And that’s what Stig was talking about with this Hussmann article. Hussmann was looking currently at the market prices and saying, “Hey, at the current market level, and 10 years from now, you’re going to get a 1% return. If you’d buy the market, say you’d buy the S&P 500 and you just sit on your hands for 10 years, you’re going to get a 1% return in 10 years from now.” That’s what Hussmann is saying.

Stig Brodersen  26:43

He’s even using Shiller’s PE in his argumentation. Apparently, there’s like a 95% correlation or something. So, it does explain a not that the Shiller PE that Preston I’ve been talking about. I was interested in this chapter and also because he kept talking about 1929 and what we can learn from that time, just as we’re talking here in 2015, about what we can learn from 2000. And what he’s saying is that the *mark was So, high in 1929, that it took 29 years for the stock market to recover.

Preston Pysh  27:16

So, after this chapter, he gets into this discussion of So, why is the market push multiples So, high? And So, the next chapter he gets into, it’s called the “Internet, the baby boom and other events.” And what he does is he goes through and he’s talking about all these external events that he thinks has potentially manipulated the mind of the market, to drive these multiples, these valuations So, high.

He goes through each one of those. He talks about each one of them in-depth and talks about why something may or may have not led to the market valuations we saw. I think that the internet was such a game-changer back in the 90s. And looking back at that from where we’re at right now, there was So, much excitement and So, much expectation built into the fact that you could start your online business and reach a market of the world. And something that we hadn’t seen from, you know previously, where you basically had to have a brick and mortar store where your only market size was the number of cars that drove past the store. This was a game-changer. And this is something that was definitely adding to the multiples that were being paid on companies.

Now one quick highlight before I throw it over to Stig is Greenspan didn’t help things at all. If you go back and you look at bond yield curves from 1996, I want to say or 1995 to the peak of the bubble in 2000. That yield curve was completely flat at I want to say like 6%. I mean, this is off the top my head, So, I might be wrong, but it was around that number. And he let it flat. He just let those interest rates stay right there. He didn’t even raise them for like four or five years. He just let it sit. So, what do you think’s going to happen if you got all this excitement, you’re not raising rates or tightening? It’s going to continue to go wild and that’s exactly what happened. So, I think Greenspan was very guilty in the fact that he was not tightening anything. He was allowing it to occur for a very long extended time. Go ahead, Stig.

Stig Brodersen  29:09

Yeah, before I transition to my point. I just have a quick note on Greenspan. I know it’s easy to be a *inaudible, but I think his main mistake was that he wanted the stock market to be a driver. And that’s definitely not how I see it. I don’t see the stock market as being a driver for the economy. I see the stock market as being the result of a bull run economy, not the other way around. And if you rely on the stock market to drive the economy, you’re simply just creating bubbles, which will help no one in the long run.

But my main point was that what Shiller does, and he doesn’t do that in chapter two, but in chapter five, but that doesn’t matter. He’s comparing what happening in 2000. Again, he’s comparing that to what happened in 1928-1929, where he’s saying this is a new economy because the arguments back then… And he coached Moody, the founder of Moody’s from 1929, who was saying, “Yeah, I know that the stock market is high right now. But we’re transitioning into a new era, a new economy. So, that’s why we can justify having these high valuations that they had back then.”

So, he was saying that, well, we have new techniques for production. So, he was referring to force production lines. We are starting to advertise differently. This will create demand. And he will also say that we have tax cuts, all of these changes justify that we have the high multiples that we have right now.

Now, if you rewind to 1999, like people didn’t say, “Ford’s production lines,” but they were saying something different, right? They were saying the internet, banners, and clicks, and everyone thought that “Hey, this is a new economy. That’s why we can justify having 100 PEs multiples.”

And what she was basically saying is that no we cannot. If we had a single company that had access to the new technology and other companies haven’t, he might want to invest in that company. But it’s not like you can say if everyone starts to use new technology, then the world will just you know, from one day to *inaudible justify a more than a doubling in stock prices from an average level. That’s just not going to happen.

Preston Pysh  31:24

Stig brings up a great point. And this idea of multiples is such an important discussion for people to have if they want to understand any type of expectation that they have of getting a return. So, let’s look at today’s market. Let’s talk about Amazon, which is usually a topic that we enjoy going over. What’s the multiple on Amazon right now? So, if you Amazon and you can’t answer the question, that’s not a good thing. You need to know this. So, Amazon, the multiples are close to 1000. I would say a normal multiple on a stock is a 15.

So, what do you get when you have a multiple of 1000? Okay, that’s a .1% return, .1%. That’s like nothing. Now, the reason people are paying So, much for Amazon is that they have this expectation that the revenues are going to continue to go wild. And that’s going to continue to get bigger. So, it’s not in a steady-state condition. But with Amazon, you would have to have some just insane amount of growth to be able to justify a multiple of 1000.

Stig Brodersen  32:25

I think you bring up a good point here, Preston, when you’re talking about Amazon, and how it might be valued based on revenue instead of how much money they’re making. And I just can’t help think of about Pay Pal, which is another one of these companies that emerged back then when they were making no money at all. Actually, back then, PayPal paid $10 for every new customer. You’re getting paid to become a new customer of PayPal. And that customer-generated, I don’t know how much revenue, and then PayPal was sold based on that multiple. I’m not saying PayPal is a bad company or anything. It’s just a problem if you start evaluating a company based on the revenue and not on the bottom line, in the end, it is the profit that the company is generating that flows back to you as an owner. Revenue is great but if you have a high cost, what does it help?

Preston Pysh  33:10

At the end of the day, it all comes back to you can hold on to a company for five, or 10 but eventually it will always come to what’s the net income profit of this company. And that’s what’s going to be traded on. So, real fast with PE ratios. I want to give people a little tip. So, if the E ratio is a 15, what does that mean? What in the world does that mean? So, it’s 15 over one. So, that means that you’re paying $15 to $1 of earnings in one year. That’s what that means. So, if the PE is a 25, that means you are paying $25 to earn $1 of earnings one year later.

So, Amazon, a PE of 1000, you’re paying $1,000 to earn $1 of profit one year later. That’s what that means, folks. So, when we’re saying these multiples a lot of the times, we just throw these things around, and we don’t break it out for you. But for the beginner who’s out there listening to us, that’s what that stuff means. That’s why it’s So, important for you to know your terminology before you get involved in any type of financial market because it’ll eat your lunch if you don’t know what you’re talking about. So, that’s important stuff for people to understand.

Moving on,  we talked about that one probably way too long. But let’s go to the next chapter. And we’re just picking through the high points that we saw really fast. In chapter three, he talks about the amplification mechanisms, naturally occurring and Ponzi schemes. I felt like this chapter resembled a lot of the “Alchemy of Finance” by George Soros, who’s also one of the billionaires that we talk about from time to time.

34:44

George Soros wrote this book, it’s called the “Alchemy of Finance.” And the whole theme of the book is that success breeds more success and the psychological piece of that fallbacks or shortfalls breed more shortfalls, and that’s what he’s getting into in this chapter is, if a company is doing well, or the perception that the company is doing well, that means that they can now go out and get additional funding even though they might not be doing all that well. If the perception is that they’re doing well, they can now procure more funds.

The fact that they got more funds means that they now might have the opportunity to perform better, which then would allow them to even grow more. That’s the whole theme and the whole thesis of the “Alchemy of Finance” by George Soros, and that’s what he’s talking about in chapter three in this Robert Shiller book.

The next chapter he talks about is the news media. I love this discussion  I totally agree with him, where news media has this ability to basically amplify things as well. It’s funny to me when I’ll pull up call it Fox Business or The Wall Street Journal or whatever. And in the morning, they’ll have this theme that’s tied to how the markets performing let’s say the market is way up. They’ll say, “Oh, this news event or whatever was what caused the market to go screaming higher.” Later in the day, the market will just out of nowhere start moving lower. Maybe let’s just say goes in into the negative territory, no news story whatsoever. And you’ll see these journalists go start tying all the negative performance of the market was due to event, whatever. And that event might have happened before the other event, which brought it up. And So, you can see that the media is literally looking at what’s the performance, and now let me backfill that performance with whatever story has happened in the last 24 hours.

Stig Brodersen  36:29

It’s a cheap way of producing journalism. He compares this to the sport. He says you can always come up with some star as you’re saying it’s because we have a great linebacker or a great quarterback, whatever. That’s the reason why you see these swings ups and downs. And it’s just liked a game where you consistently have a new score. And it’s very easy just to spin a new story on that and put it as something new and something important. And he’s basically just blaming the media for all the hysteria that we experience in the financial markets.

Preston Pysh  37:02

So, I’m going to jump to chapter six, “New eras and bubbles around the world.” And this is where Shiller’s talking about how the market basically values businesses and how these bubbles definitely exist. He gives some proof of why bubbles exist, why bubbles will continue to exist. I think, in my personal opinion, I think Ray Dalio has one of the best discussions on this, where he talks about how credit cycles are the reason that bubbles exist, but Shiller gets into it a little bit differently.

The thing I would like to discuss, though, as we look at the current market condition, and I want to throw up a chart on our show notes to show people one of these ideas is the idea of margins, and how when you look at a company’s margin, it’s a very good indicator of how the markets performed over the last 10 to 20 years, then an expectation moving forward.

So, let’s talk about this in a little bit more of depth So, that people understand where we’re going. So, let’s say that your top-line revenue is $100,000 on a business, and your bottom-line revenue is $10,000 on that hundred thousand dollars of sales. That means your profit margin is 10%. Okay, So, everything that you brought in from your sales, you’re able to pocket and profit 10% of that. Okay? So, across the board, when you look at this margin, if you go back to the 1980s, the margins were a lot thinner. Now the margins have been growing and expanding with each credit cycle and each boom-bust cycle. So, in this last one, margins got as high as 12%. And that’s looking at it from an entire index. If you go back to the 80s, I want to say that the margins were around at the high 6%-7%, around that level. And So, what you’ve seen is that these margins have through time.

Now, as we think about individuals buying businesses, why is somebody going to pay a bigger premium for a business? Well, they’re going to pay a bigger premium because that margin is growing and expanding. Now if that margin starts to contract on a macro level, what are people going to do? Are they going to continue to boost up the price and pay more and more and more of what the margin is dropping? No, and I would argue that that’s a very good indicator that you might be seeing the exact opposite, and you’re starting to see contraction occur.

So, the thing is, is with a 60-basis point movement with margins, it has always been a precursor in the last like 20 years to a recession that’s coming. And right now, we’re seeing that with margins on the income statement. And So, I’ve got a chart, we’re going to put that chart up in the show notes, So, people can see that, and this is usually been a pre-indicator by about 15 to 18 months before the recession occurs. And we’re about I want to say 10 to 15 months from where margins peak, they peaked at around 12%. Now, I think they’re below 10% at this point, but we’re going to throw that chart up there. So, you can graphically see this and see what we’re talking about. I think that that’s a good discussion to occur based on chapter six of the book where we’re talking about these boom-bust cycles and how margins play into it. And Shiller talks about it a little bit. We probably talked about a lot more here on the show than in the book. But I think it’s something very important to highlight for people.

Stig Brodersen  40:17

For the remaining of the chapter, I think I just have two points I want to highlight. The first one is that Shiller was saying, “Well, I don’t think I am wrong when I say that we’re in a bubble right now. But obviously, I could be wrong  as they say, it’s hard to read the label inside the box.” And he’s saying, “It’s So, easy looking back at past events to say, oh, he was So, very clear that you saw a bubble here or there was no bubble or whatever. But when you are in the middle of it, it’s really, hard.”

And then he’s saying that if you look at all the busts in the past, it’s not like it’s a linear progression. It’s not like, yes, the stock market went up for 30% like that year, and other months they were down. It wasn’t like that. The stock was going up and every day, for like long periods, even though you are building on the bubble. So, even though that you will experience a bubble right now as projected, and as what he was completely corrected, it is not So, easy to see when you’re in the middle of it. That was basically just what he’s saying. And that’s also what I think Preston and I are saying right now that we might be a bubble and we might see a crash.

But even so, it’s hard to see because then we have the strongest October but September was bad or whatnot. It’s just really, hard, depending on which type of timeframe that you have.

My last point and that’s the point he has in the chapter is that he is saying to the Fed back then, and this was like in the 1999-2000 timeframe, “I would suggest that you hike rates, and the address specifically that the reason why you should hike rates is that the stock market is overvalued  that might be the only thing that could prevent the bubble, but make the transition more smooth.” And if I could live like one piece of advice to *inaudible that would probably not listen to it at all, I would say the same thing: hike rates and say this is to avoid speculation.

Preston Pysh  42:04

Okay, So, here’s the thing, guys, we went through the book quickly, there are 11 chapters in this book. We have an outline of all of our notes from each chapter. If you want to get the outline of our notes for this book, and for any other book that we read, go and sign up on our email list. We don’t send any marketing spam, any of that stuff. We basically send out our book summaries and that is it with our notes on the current market conditions. So, if you want to get on that list, go sign up on our website, theinvestorspodcast.com. You can see a link there right at the very top to get on our email list.

At this point, we’re going to quickly play a question from our audience. So, this week’s question comes from Yeeyee.

Yeeyee  43:21

Hi, Preston and Stig. My name is Yeeyee and I’m a big fan of your podcast and website. I learned through the lessons and having to learn a lot, but I’m still a very new investor. So, I’m wondering if you guys think using automated investing service like Betterment and Wealthfront is a good idea to start with. I know they mainly deal with ETFs and they manage $10,000 of your funds for free. My question is I don’t know if they can give you a good return. And also, I don’t know if there’s going to be actively managed and the choice of ETFs, they make for you, is that going to get the return I want. But I want to know what you guys think about this account and what suggestions you have for new investors like me. Thank you.

Preston Pysh  44:19

All right, fantastic question. And Stig’s going to take this one away.

Stig Brodersen  44:23

You know this is something that’s been on my radar for quite some time  I had quite a few emails from people saying, “What do you think about something like Betterment or Wealthfront?” So, I’m happy that we had a chance also to respond here on the podcast. I think that whenever I look at the website, something is just wrong. And I don’t want to like pick on a specific company, but I think something seems to be off whenever you start to what I would like to say manipulating with math.

So, on one of these sites, you could see that because the company is using a passive investing strategy, it beats the benchmark by 1.25%. Now, So, I looked into what the benchmark is, and that is actively managed mutual funds. And that just doesn’t make any sense to me that you can say, I have a service that will beat the market. But my benchmark is actively managed mutual funds. Like this just seems like such a random benchmark to choose and also is a benchmark that is not random actively managed mutual funds perform badly. Like I would never, ever start up a fund saying, “Okay, So, this is my performance compared to Japanese bonds.” If I knew that the yen was dropping and bonds were selling at a really, low-interest rate.

So, I think that might be misleading. So, that was like my first red flag. I also think that if you want to invest in ETFs, I’m not sure it makes any sense to have someone manage that for you. I think it’s somewhat easy to do that yourself. I just found another study and this was written by Cullen Roche that we had on the podcast a few episodes ago. He’s looking at, I think it was Betterment. He’s saying that the performance of the Betterment aggressive portfolio is 95% correlated to the Vanguard total world index. So, I’m just thinking, why would I pay anyone to manage a pool full of ETFs when I can just buy like a World Market Index?

I’m not sure I see the value-added. Like, I’m not saying that you shouldn’t use advisors. I’m not saying you shouldn’t be using actively managed funds or whatever that you’re doing. But if you buy into something you want to use ETFs, and you want to do it cheaply, why not just do it yourself? Because it’s So, easy to do. My advice would be if you want to buy the market, you can do that for seven basis points.

Preston Pysh  46:49

Yeah, I see it the exact same way, Stig. I do. So, you thank you for the question. That was a fantastic question. I know that there were people out in our audience that we’re asking a very similar question. So, we were happy to answer that for you. We’re going to send you a free signed copy of our book, the Warren Buffett Accounting Book. And for anybody else out there, if you want to get your question played on our show, go to asktheinvestors.com and you can record your question there. If you’ve got any questions about this episode on Twitter, or Facebook or whatever, be sure to use the #TIP65. And that’s where we’ll go ahead and answer your question there. We truly just love interacting with our audience on Twitter and Facebook and wherever else. So, great to see you guys out there.

That’s all we have for you guys this week. We enjoyed talking about this book, “Irrational Exuberance,” with you. And this was at the recommendation of billionaire Wilbur Ross. So, with that said, we’ll see you guys next week.

Outro  49:34

Thanks for listening to The Investor’s Podcast. To listen to more shows or access to the tools discussed on the show, be sure to visit www.theinvestorspodcast.com. Submit your questions or request a guest’s appearance to The Investor’s Podcast by going to www.asktheinvestors.com. If your question is answered during the show, you will receive a free autographed copy of The Warren Buffett Accounting Book. This podcast is for entertainment purposes only. This material is copyrighted by the TIP Network and must have written approval before commercial application.