Jesse Felder  4:13  

I think that’s another example of people freaked out after the Brexit vote. And that’s another really slow moving dynamic where, I believe the European Union is on borrowed time. And it’s an experiment that’ll eventually unravel. But it’s going to take a lot of time. There’s some referendums, and most notably in Italy coming up. That’ll be interesting to see how that happens, but they’re not going to let the thing kind of unravel without a fight.

Stig Brodersen  4:39  

So do you see Brexit as the catalyst that the market might have been waiting for to find this intrinsic value? Or as you also suggest, since it’s so slow paced, that might not influence the markets at all?

Jesse Felder  4:53  

That’s a really good question. I’ve been expecting a bear market for two years, I think. I don’t know if I told your audience of a story about growing my beard last time I was on the podcast. That was mid-September of 2014. And I said, forget it, I’m not shaving again until we get a 10% correction in the market occcver the next two weeks, went down 9.8%, and didn’t quite hit my hurdle. So then it took me 11 months to grow my beard out before it finally got the 10% correction. But really what I’m looking for is a reset of overvalued asset prices. And the catalyst for that really is totally unpredictable. It could be the Italian referendum and problems in Italy. It could be Deutsche Bank issue. It could be any variety of things.

Preston Pysh  5:38  

Now, Jesse, I’ve read some of your articles since the last time we’ve chatted. You’re one of these guys that really doesn’t buy in to the gap between what the fixed income market’s offering and what the equity market’s offering. So the argument goes like this for people that aren’t familiar with what I’m referencing here. So on the fixed income side with the 10 year Treasury, where is it at right now, 2%? I haven’t looked at it for a little bit. 

Jesse Felder  6:01  

Just under.

Preston Pysh  6:02  

Just around 2%. If the 10-year Treasury’s at 2%, and the S&P 500 is offering you, let’s call it 3.7% to 4%. That 2% gap is the reason why you have stock market bull saying that it has more to run because the higher it goes, it’s going to bring those two yields to parody. 

Jesse, you’ve been arguing the opposite of that. And I’m kind of on the same fence as you. But I’m gonna try to take the other side of this just to play devil’s advocate. And I want to hear your logic behind why you don’t think that that argument stands up.

Jesse Felder  6:35  

There’s actually been some interesting discussion about this. The mistake that people make when they argue that low interest rates should justify higher equity valuations, essentially comes back to a discounted cash flow model. And they say, okay, we’re going to lower the discount rate, lower the risk free rate of return, and so that means these asset valuation should be higher. The problem is a discounted cash flow model also assumes a growth rate for earnings. And when you lower the risk free rate, your discount rate, but don’t lower the growth rate, that’s either disingenuous or it’s totally naive. Because when you look at the history of earnings, they’re right in line with interest rates and inflation. Basically, earnings grow at the same rate of inflation. So, if you don’t want to lower your discount rate to 2%, and then keep an earnings growth rate of 3%, 4% or 5%, you’re going to have a discounted cash flow model that’s justifying asset valuations that are insane.

Preston Pysh  7:38  

I totally agree with you. Now, I should know this figure and i don’t. I’m hoping one of you two know this. But if you were going to say the average between that spread, between the fixed income yield and the yield that you would expect getting in the equity market and as far as like the S&P 500 as a whole, what’s the gap usually at? What percent? 4%?

Jesse Felder  8:00  

I think what you’re trying to get at is, okay, we have the risk free rate at 2%. Obviously, a dividend yield is not risk free. So we need to demand a greater rate of return from stocks. Dividend yield is not the best predictor of total return from stocks going forward. Best predictor that I’ve found for long term returns from stocks is the Warren Buffett yardstick – the total value of the stock market to the total value of the economy. And when you look at that, it tells you stocks are expensive or cheap. And the reason that’s valuable is when you actually flip that upside down, it basically shows you, it correlates 90% with forward 10-year returns on the stock market. So when that measure has been really low, you get 10%, 12% to 15% forward 10-year returns and stocks awesome. When that measure is really high, like how it was in late ’90s to 2000, you get close to 0% or even less negative rate of return over 10 years. Right now that measure shows 0% to one 1% over the next 10 years. That’s what you should compare to 2% risk free, or 0% from stocks.

Preston Pysh  9:08  

I think that’s a fantastic point. So Doug Short, who I’m sure you probably know who that is, Jesse, you’ve seen some of Doug’s charts out there. 

Jesse Felder  9:16  

Great website. 

Preston Pysh  9:17  

Oh, fantastic website. So we’ll have a link in our show notes. Because the chart that you’re talking about. Doug updates about once a month, they’ll update that Warren Buffett valuation metric. And we’ll have a link to that chart. So people can pull it up if they’re listening to this. And they’re curious to learn more about that. But I want to say that it’s like at a standard deviation of 2 right now, based off of that Warren Buffett metric somewhere around that ballpark, which is pretty interesting.

Jesse Felder  9:44  

I mean, it essentially re-aligns up with where we were in November 1999. So there are four more months of the .com bubble, that we saw higher valuations in the history of our stock market. The rest of the time, valuations have been lower than they are today.

Stig Brodersen  10:00  

Yeah, and one of the things, and I would really encourage people to go to Doug Short’s site, because one of the things that he does really well is that he’s not only including the one factor that Jesse is talking about here, or Warren Buffett’s metric here. He’s including a ton of different factors. And you can actually look at all the metrics and they all show the same picture. Now, some might be one standard deviation above or two standard deviation above, but it’s really across the board. You see a huge overvaluation. And just a quick note in terms of what Jesse also said about dividends. Because it is true that it’s really difficult to rely on that because that’s how the future might look like. Right now that you’ll get just short of 2% yield in dividend. But also just remember, the whole nature about dividends compared to the fixed income bonds from the government is just less safe. And we can only just go back to the last financial crisis and see what happened to dividends whenever we saw the problems in financial markets. So, I would definitely not have people align those 2% from the Treasury yield and then approximate it at 2% from dividend yield and say, and then we have an upside. I think that’s a very dangerous approach.

Jesse Felder  11:04  

Absolutely. And I would recommend people just pull up a chart of what TLT (iShares 20+ Year Treasury Bond ETF) on bond ETFs did during the financial crisis. That’s how bonds typically perform during a risk off phase, and a lot of people instead of buying bonds or reaching for yield in real estate investment trusts. So just pull up something like VNQ, the Vanguard Real Estate Investment Trust ETF, and see what that did during the financial crisis.  You can see the difference between how bonds performed. Real estate investment trust went down from something like 70% in just a few months time. During the financial crisis, bonds went up 50%. So, for people who are looking for bond alternatives, these are not bonds.

Preston Pysh  11:47  

One final thing that I want to ask while we were talking about Doug Short. One of the charts that I find really interesting on his site is this New York Stock Exchange Leverage Chart that he throws up a lot of the time where he shows that leveraged contracting and how that’s totally correlated to the stock market performance. And recently, you’ve seen that New York Stock Exchange Leverage really start to contract in a major way. I want to say it was like a 30% or 40% pullback. And for anybody interested in seeing this chart, what’s kind of neat about the chart is it almost seems like it’s a leading indicator as to what might be happening in the near term future of the stock market.

Jesse Felder  12:26  

I think you’re referring to margin debt. 

Preston Pysh  12:28  

Yes. 

Jesse Felder  12:28  

And New York Stock Exchange Margin Debt, that’s a really interesting measure. I think it’s sort of hilarious to see people talking about this week or maybe the last couple of weeks, all the cash on the sidelines. Some investment managers are saying that they have higher cash levels, but actually when you look at the numbers, you look at individual investors. We can see through the Fed that they have no money in money market funds right now. They have no cash in sidelines. You look at the margin debt, and it’s huge debit balances. There are no credit balances, and it’s much, much bigger than it’s ever been. So one of the things I do with margin debt is I like to just like how Buffett does with stocks to the GDP. You can look at margin debt to GDP, and it’s interesting to see financial leverage. Leverage speculation as a percentage of the economy. That measure has a pretty high 30-month correlation to future stock market returns. And then, you know, so when margin debt’s really, really high, the next two and a half years and stocks has usually been pretty bad, when there’s been a lot of cash on the sidelines measured by this number, the next two and a half years and stocks have been really, really good. So there is some utility to that for sure.

Preston Pysh  13:44  

And I’ll tell you the number when you see this chart, which we’re going to put it up in our show notes for people. I’m telling you go to our show notes and check out this chart, this thing’s going to blow your mind when you see how large this margin debt had grown to. And it kind of peaked, I want to say maybe the beginning of the summer, you see a peak out at a very high number. And you’ve seen it pull back about 30%. When you’ve seen this in the past, you’ve seen some major corrections in the stock market. So we’re going to put that chart up for people to view and you can arrive at whatever conclusion you want of your own. But it’s a very interesting look.

Jesse Felder  14:18  

Yeah, and I just want to point it out, because a lot of people try and say margin debt is useless. And it’s correlated with Symar *inaudible*, but there’s no causation there. I think, to me, it shows potential supply and demand in the markets, right? When there’s a bunch of buying power on the sidelines, that’s a bunch of potential demand to come into the stocks and push prices higher. When people are fully leveraged, there’s very little potential demand to push prices higher, and a lot of potential supply that could come in if they’re forced to pay off those loans. So to me, it’s a clear measure of potential supply and demand in the stock market.

Stig Brodersen  14:53  

Jesse, I would like to touch on one of the things you talked about before in terms of cash. You talked about how some of the fund managers are saying that they actually have high cash balances, but it also seems like cash is a very unpopular asset class right now. Actually, there are some investors that seem to prefer negative yield bonds rather than owning cash, which might seem a bit odd. So, could you explain why you can also observe this, and in continuation explain why doing a Warren Buffett route looks at cash as an option of every asset class with no strike price.

Jesse Felder  15:27  

One of the questions I like to ask myself on a regular basis is what’s the most hated stock in the market? Because that’s where there’s going to be potential opportunity. What’s the most hated asset class on the planet? Because that’s where there’s great opportunity. This time last year was gold. It’s hard to imagine gold getting more hated than it was this time last year and I’m no gold bug. I’ve almost never owned gold stocks in my career until this time last year, and that was just because they’re so hated. 

I think cash, it’s interesting. Today, there was a good interview with Howard Marks on Bloomberg recently talking about this. And him saying, investors are talking like they’re concerned about the markets and things, but they’re all acting bullish. Nobody’s willing to raise cash and even the moderator asked them “well, are you raising cash?”. He said, “no, I can’t. People are paying me to manage their money. So even if I think we should raise cash, they’re paying me to invest it”. So, you know, I don’t think there’s ever been a time in my career, certainly, but even long before that, where cash has been more hated than it is today. People are willing to put their money into negative yielding bonds, rather than keep it in cash. And not just negative yielding bonds. Many, many asset classes, you put money into today, you’re locking in a negative return going forward, and people would rather do that than own cash. And today in terms of the optionality of cash, it’s never cost you less to keep your money in cash, because the alternatives are nothing. So, when Buffett talks about the optionality of cash, he’s talking about if I have cash that’s basically a call option on any asset class. So if bonds sell off and give me an opportunity to buy bonds at a better price, cash allows me to take advantage of that opportunity, or what real estate stocks, whatever it might be. Cash is giving me that free call option, and being able to take advantage of an opportunity that might arise for the next few months.

Preston Pysh  17:25  

Buffett’s literally putting his money where his mouth is, because last time I think I saw this last quarter he was sitting on $70 billion of cash. Is that the right number Stig? $70 billion? 

Stig Brodersen  17:35  

Yeah, just above.

Preston Pysh  17:36  

I mean, that’s insane.

Jesse Felder  17:38  

All these smart money guy, Mohamed El-Erian came out today, said I have the biggest cash, but in my personal money. Jeff Gundlach a couple months ago. In terms of their personal money, they have more of it in cash than they’ve ever had in their career.

Preston Pysh  17:52  

Yeah, and I saw an interesting thing on Jeff just the other day where I guess one of his major indicators was tripped for recessionary indicator with the unemployment rate. Basically bottoming out for a 12-month period of time, which I found very interesting. The one question I want to ask you, Jesse really had to do with gold. So my opinion on gold at this point is that once credit starts to contract and whenever that happens, we don’t know. But when that event starts to really take place, and it starts to unravel, and basically all these positions are getting called and people have to settle those positions and have to settle their debts, they have to do that in cash. They can’t do it in some other medium of exchange. And so my concern with owning gold at this point in time is that I think that the price is going to be penalised as for all these people that are holding that position as this contraction takes place. They’re going to have to sell out of that this can be for selling out of that position in order to come up with cash. In order to settle their obligations before you’re going to see the rebound. I think the gold’s going to just kill it. But I think it’s going to kill it after the contraction takes place, at least in terms of a comparison to the US dollar.

Jesse Felder  19:13  

That’s really what we’re talking about. Golden dollar terms is what matters to us. I think that the idea of a massive dollar short out there is a very interesting idea that there’s some smart people talking about that. There have been a lot of Chinese companies that have borrowed in dollar terms. Banks, Japanese banks and etc, that have lent a lot of money in dollar terms. So there’s this whole kind of shadow currency and lending market. That’s not stuff that the Fed really has control over, but it’s really kind of part of the eurodollar banking system. I think that’s some fascinating stuff to think about. I do think there is a massive dollar short out there, people who’ve borrowed a lot of money in dollars and may be forced to pay it back in certain circumstances. I think the gold thesis is valid regardless of what the dollar does. I think gold and the dollar can both go up at the same time. I think real assets are a very interesting idea in an era when we’ve seen money printing like we’ve never seen before in world history. So, when countries are trying to devalue their currencies, and inflate their way out of these massive debt creations that have happened, where do you put your money? 

Ray Dalio says if you don’t own gold, you don’t understand history, you don’t understand economics. And there’s been times in history where gold is the only thing that can save a diversified portfolio of different asset classes. So, I think there’s there’s a place for it all the time, but it’s especially compelling today.

Stig Brodersen  20:47  

Yeah, and let’s dwell on that for a minute because that was actually one of the things that we’re also going to discuss in this episode. I know that you have been talking about real assets and you talked about gold. One might also think of something like oil or timber for that matter. So often we have done this as investors to diversify sales away from typical stocks and bonds. And with the yields that we’re seeing right now, it might make a lot of sense. But why do you think, especially today that real assets might be a good idea for the private investors portfolios as well?

Jesse Felder  21:21  

That’s a great, great question. I think Meb Faber has done some interesting work on this. Just generally, when you add real assets to, I mean I’m talking about studying billionaires, he’s done some great work studying some of the best asset allocators on the planet. And that’s the one thing they all have in common is they don’t just run a 60/40 portfolio or anything close to that. They own stocks, they own bonds, and they own big chunk of real assets. And so when we talk about real assets, what are you talking about? We’re talking about real estate, we’re talking about commodities, sometimes you can separate gold out of commodities, and then things like Treasury inflation, protected securities, so things that do well in inflationary environment. 

So I think there’s a place for real assets in every diversified portfolio just to begin with. But especially today, when you look at real assets, the valuation of real assets compared to financial assets, real assets are cheaper than they have ever been in history compared to financial assets. Now, part of that is because financial assets are very highly priced. Part of that is because commodities have just gotten crushed in recent years. And I think, the most compelling case within real assets is gold because when I look around the world and go in terms of currencies, do I want to own yuan? Do I want to own yen? And do I want to own euros? Do I want to own dollars? Do I want to own gold? Which currency? I think of gold as a currency. I would rather own gold than any of those currencies that are potentially being manipulated and consciously devalued.

Preston Pysh  22:56  

Yeah. And I totally agree with you. My only hesitation with going to gold right now is just the concern of the credit contraction. When you have this credit contracting, there’s a run two fiat currencies. Once that run, which historically only lasted a month or a couple of months, once that run finishes, and you kind of start to see some bottoming, in my personal opinion, that’s when you see the whole commodities gold hard assets take off because this is where the central banks have to print and basically create the whole cycle over again. That’s when you see the big change and the big tide change currencies.

Jesse Felder  23:39  

I agree with you. I think what’s really interesting to me about this discussion is that a lot of people think that if we have a deleveraging, that’s deflationary. And typically, it almost always has been deflationary. And that’s bad for gold and those types of assets. There have been times in the past though, where you have a deleveraging, and interest rates are going up, and inflation is going up. And that’s very, very bullish for gold. And so I don’t know where inflation is going. I have said that in the last six months. I think interest rates are in a bottom in process. And we’re seeing signs of inflation starting to pick up. So if you get an inflationary rise in interest rates, that creates a credit crunch, but inflation is taking off at the same time, that’s the one instance where it maybe is not a deflationary credit contraction. There’s something else going on. So I don’t know how that’s all gonna play out. I just know that there are a variety of reasons to be bullish on gold, and also expect a credit contraction.

Preston Pysh  24:40  

Yeah, trust me, I’m a bull on gold if you’re talking long term. If you’re talking the next 5 to 10 years, absolutely. I mean, it’s like a no brainer, as far as I’m concerned. 

Okay, so Jesse in September, you wrote an article on junk bonds, titled, “Junk Bonds Officially Enter Bubble Territory”. This was based on the Standard and Poor’s chart that followed the valuation with respect to yield, which was at a two standard deviation away from the average. I’m curious if you can talk to us about this a little bit. And I also want to highlight to you, you might not know this, but back in December of this past year, I talked openly with the people on our show about how I was putting on a short for high yield bonds. I mean, it wasn’t a big position, but I wanted to talk about it on the show to see how it developed and just kind of talk about the trials and tribulations of putting that short on. And it hasn’t really done so great. Initially it did. But ever since probably the first two or three months, I had it on, it started to pull back. I still have the position on I’m still continuing to short, high yield bonds. I’m curious what you have to say about this and your opinions moving forward.

Jesse Felder  25:49  

I have to say that my blog post was based on the work of Martin Fridson, who really is the man when it comes to corporate bonds and junk bonds in particular. The only time in the history of his record keeping, which is 20 plus years when junk bonds have ever been as highly valued as they are today is literally just prior to the financial crisis. I just think that junk bonds are fascinating because you buy a junk ETF, and it has what like a 5% yield right now on ETF. We’re already passing or we will very soon 5% default rate in junk bonds. And the recovery on the bonds is the worst we’ve ever seen in history. We’re not even seeing the down part of the credit cycle yet. But recoveries on junk bonds are like 20%. And so the recoveries are horrendous, and defaults are rising. 

So to me, I look at that and I go, when you buy junk bonds today you’re locking in a negative rate of return for any time period you’re looking at, and it’s fascinating. It’s just the sign of the incredible, I can’t remember who coined this phrase, but the “zeal for yield” right now. People are so desperate for any yield, they’ll buy junk bonds at a 5% yield when they don’t realize that you need a little bit more than a 3% spread over treasuries to make money in junk bonds.

Stig Brodersen  27:15  

And Jesse, I’m really interested in why this is happening. I mean, I don’t want to blame you for the price of the junk bonds. That’s not what I’m saying. But also to talk about the difference between being an asset allocator having your own opinion, but might need to work on something else because you are obliged to do that. For instance, if you’re Warren Buffett, and you think that cash is a good investment, or at least it’s not a good investment, but it’s the best opportunity right now. You can basically just pile up all the cash you want because you have autonomy to do that. But as an asset allocator for other people’s money, you might feel that you’re pressured to take on because you’re so hungry for yield, for instance, or whatever it might be. So, Jesse also with your background, could you tell us about the mindset of a fund manager and as a management, and how they might have one opinion about junk bonds but still buy into the asset?

Jesse Felder  28:10  

There’s a variety of different things going on. One of the main themes that I’ve been looking at is price insensitive buyers. There are people that have decided. This is part of the whole indexing movement that I’m going to buy this asset class, regardless of the price, right? I’m not even going to look at what my potential return is. I don’t even look at the yield. I’m going to buy stocks no matter what the price is. I’m going to buy bonds no matter what the price is. I’m going to buy junk bonds no matter what the price is.

Preston Pysh  28:39  

You’re sounding like a central banker right now

Jesse Felder  28:42  

They’re one of the price insensitive buyers. You have a number of these buyers. You wonder who’s buying these negative yielding bonds. Well, they’re insurance companies and pension funds that have to hold a certain amount of their money in this asset class regardless of the price. You have central banks, you have index passive investors, then you have insurance companies that are buying, literally have made the decision we buy regardless of price. And I think we’ve probably never seen that before in the history of finance where we have a huge segment of the market of people that have just decided to buy it no matter what, even if they’re locking in negative returns. 

And so I think that’s a lot of what’s driving these prices in some things to astronomical levels. And the crazy thing is, people think about the financial markets so different than anything else in their life. If you actually thought, there’s a big boom in cars, everybody’s buying cars today, and I’m gonna pay $50,000 over MSRP (Manufacturer’s Suggested Retail Price), you’d go that’s insane. I’m never gonna pay that much for a car. But that’s what people are doing in financial markets. I’ll buy it regardless of the price and it’s interesting to watch.

Preston Pysh  29:50  

I totally agree with you. My concern is this. I think central bankers around the world know that their back is in the corner of the wall at this point. I think that they know that they really don’t have any wiggle room left as far as being able to impact the markets. And so can the government do things to basically spark the economy? I’m of the opinion which the answer is “yes, they’ve got to use fiscal policy”. Because the monetary policy of at least here in the US because it doesn’t have the ability to do some of the stuff that Japan’s doing with buying ETFs and stuff. Here in the US, their back is up against the wall because now it’s reliant on fiscal in order to solve the problem. Monetary can’t do it. 

So, my personal opinion is that they are at a point that they are going to fight this until something breaks through. They’re not going to just allow the cycle to basically take its turn and run its course like they have in the past where they’ve allowed it to start to contract because they had tons of interest rate left to play around with the basically sparked the cycle back into existence again. So that’s why I see it maybe them really fighting this thing, and it might play out a little longer than some of us had suspected. I know for a fact that this has played out a whole lot longer than I ever expected it to.

Jesse Felder  31:10  

Absolutely right. I mean, look at any novice trader. What’s the most common mistake they make is not cutting their losses. It’s putting a trade on because they have an idea or an investment or whatever it is a novice investor, and the markets telling them wrong, wrong wrong.  They sell their winners to keep their losers. That’s like the basic, first most common mistake. And I think of these central bankers who are all academics and don’t have any real world experience in running businesses or in the financial markets as like a novice trader. The markets are telling them, this isn’t working anymore. This is not stimulating the economy. Jason Cummins showed a great chart recently. His former Fed economists speaking to Fed heads at this recent conference and saying, “look in the past when asked, as the prices went up, it increase spending”. This cycle, it’s not happening. So you create this wealth effect. And it’s not inspiring people to spend anymore. Markets are telling you, it’s not working anymore. But they’re like a novice trader, where they have this position that’s going against them, but they’re not going to take it off. They’re going to ride it into the ground. And I wish I could have more hope than that. But that’s really what I think they’re kind of doing right now.

Stig Brodersen  32:24  

So Jesse, I’ve really been looking forward to asking you this question, because it’s titled, “Janet Yellen for a Day”. It’s a question that you knew beforehand. So I just want to put it out there because it’s a really horrible question to ask because it’s definitely not an easy job to be Chair of the Board of Governors of the Federal Reserve System. And I think that Mrs. Yellen will probably agree with me, because no matter if she’s easening or tightening the monetary policy, someone will be unhappy with that and we’ll blame her for that decision. So, Jesse, if I can put you in her shoes, could you outline the implication of both an easening and tightening of the policies, and what you would do if you had the power that she has right now?

Jesse Felder  33:08  

That is a great question. And that is the question that should be put to every critic of the Fed or any central bank, “what would you do differently?”. And I have a lot of empathy for them right now because they’re not in a very good position, right? You raise interest rates, and we have the most over leveraged corporate sector in our country’s history. You’re going to start a default cycle, and potentially a very painful one if you raise interest rates. Now, if you don’t raise interest rates, then the pension crisis is going to just get worse and worse. But I think if I were Fed chairman for a day, I would immediately go to Congress and say, the dual mandate is impossible. I cannot possibly control inflation, unemployment. I don’t have the tools. I mean, I do have the tools to try and keep inflation in check. I don’t have the tools to increase employment. That’s kind of silly. All I do is exacerbate the credit cycle when I move interest rates up and down. So I don’t have the tools to do that. 

And the third mandate, which nobody ever talks about. Financial stability, that’s the one that gets forgotten. And all of these policies that we’ve seen over the last 20 years, especially lately, to create a wealth effect, go entirely against the Fed’s mandate to pursue financial stability. This is why Alan Greenspan gave his irrational exuberance speech 20 years ago. I wrote about this today. He was worried that if we don’t reign in an asset bubble, it’s going to have major painful economic consequences going forward. And he was worried about that in December of 1996. 20 years later, the Fed has not incorporated any of that thinking into policy. And so financial stability needs to come back as the number one mandate. That’s why the Fed was created in the first place, to maintain financial stability. Not to try and boost employment, not to try and reign in inflation. It was to prevent bank runs, and assist in the event of a bank run. And ironically, they were created to help support financial stability. And all they’ve done over the last 20 years is make the markets and the economy more instable. And so yeah, if I were Fed chairman for a day, that would be my thing. I would say, forget the dual mandate. Financial stability is of paramount importance, and that’s what we’re going to pursue.

Stig Brodersen  35:37  

It’s not just about what Janet Yellen is doing. Clearly, the US is the biggest economy and it’s very important what she’s doing. But she also needs to think about what will other central bankers do if she does X,Y, and Z. So Jesse, what do you think the European Central Bank would do, the Chinese, the Japanese, what would they do if she would say hike rates?

Jesse Felder  35:59  

That’s a good question. If she hikes rates, that sends the dollar higher. I think that’s what they want. They want the yen and the euro to drop in value. So, it would be good for them. The problem is China’s still trying to peg their currency to the dollar to some extent. And with all of the dollar debts in the corporate sector in China could cause major problems there. So, yes, you’re absolutely right. We are a global economy now more than ever. And so, what central bank does. This all ties in together. The Japanese Central Bank taking rates negative. I think a lot of the buying we’re seeing in junk bonds and stuff here is from Japanese investors. So wait a second, I can get a negative yield here, I can get 5% in American junk bonds, and hedge my currency risk. So I think a lot of money, especially this year has come over from Japan. And so, absolutely, and that’s one thing I don’t think that central bankers think about enough. There’s a book called, “Economics in One Lesson”. And it’s essentially one lesson over and over in every chapter. Since every time economists try and come up with one policy to fix a short term problem, they overlook or don’t think about all of the consequences, the longer term consequences of that one policy that they’re pursuing. And I think that current central bankers are guilty of that as anybody. We’re going to pursue this one policy, and we’re going to try and create this one effect. But what are all the other effects that are happening longer term, not just right now? And how are other people affected? You know, probably the most obvious example of this is let’s lower interest rates to 0%. It makes it cheaper to borrow. But what about all the people who are trying to save for their retirement and are getting 0% on their savings? The Fed doesn’t consider the fact that that forces them to save even more money. So this is why the wealth effect is not working in getting people to spend. Lower interest rates to 0%, people are forced to save more, not spend more. That’s kind of backfiring.

Preston Pysh  38:00  

And I think even going beyond what you’re saying there, and we brought this up in our last Mastermind discussion was when you have interest rates at 0%, and you start talking about the insurance industry, and how they make profits by just investing their float, because it’s such a competitive marketplace on the underwriting portion of it where they’re underwriting at a loss a lot of the time, and they’re left with trying to make the profit on the float. When you have 0% interest rates, now you’re putting all these large, enormous insurance companies in a position where there’s no money to be made at this point.

Jesse Felder  38:36  

Not to mention, German and Japanese banks, pension funds. I mean, absolutely. There’s so many corollary effects that it’s hard to argue that the ends justify the means at this point. I really do think they understand that they have encouraged a massive amount of debt creation during this cycle. It’s been all spent on buybacks, and mergers and stuff. If they do raise interest rates, that credit cycle is going to unwind. It’s going to be painful.

Preston Pysh  39:08  

So Jesse, changing gears just a little bit here. I want you to talk to us about the Minsky Theory, and how it applies to volatility trading.

Jesse Felder  39:19  

He really created this theory in terms of the debt cycle. It fits right in with what we’re talking about now. So Hyman Minsky, nobody knew his name until the financial crisis because he wrote this theory. Everybody thought he was crazy, and nobody paid any attention to it. But his theory is basically there’s three stages of the credit cycle. There’s the initial stage where companies borrow an amount of money that they can easily pay the interest and the principal back during the course of the loan. The next stage of the credit cycle is they borrow an amount of money that they can pay the interest on, but they can’t pay principal back. They’re going to have to basically refinance that debt when it matures. The last stage of the credit cycle is when companies borrow an amount of money that they can’t even pay the interest on that they have to borrow more money to pay the interest, and Minsky called that Ponzi finance. 

And when credit for some reason, tightens for those guys, and they can’t borrow money to even pay interest on their debt, they’re forced to sell assets. And so you get a piling on of selling assets and this ties into margin debt. And basically Minsky’s point was that over the course of an expansion, and the longer an expansion goes, the more this is true, people take on greater and greater risks. Such that, basically the bubble or the expansion, sows the seeds of its own bust. And so, during the financial crisis, we saw that where the banks took on amazing risks in the mortgage market. And when they started to have to unwind those risks, everybody was selling at the same time, and everybody essentially became insolvent at the same time. The firm I worked for, Bear Stearns was one of those that became a casualty of the financial crisis. 

One of the things that’s going on in terms of risk taking, we’re seeing that in junk bonds, right? So people have gotten to the point that this expansion is so long, that’s never going to raise rates. I can go buy junk bonds because we’re never going to see another down cycle and credit again. So I can buy junk bonds for 5%. What’s going on in the volatility markets is investment managers are not just reaching for yield and junk and real estate, these things. They’re selling volatility futures to try and generate premium income. And, in the past, these volatility products are really only about 10 years old. We’ve never really seen them go through a market cycle. And shorting volatility is a very frightening trade for me, I think. 

First, I should probably explain what happens when you short sell volatility. I short volatility, that means, I’m betting on the the market. Basically going higher. Market needs to go higher for volatility to stay low. So somebody on the other side of that trade has to buy volatility. In order to buy volatility, the market maker then offsets his risk by buying stocks. Since February, right? We see this pretty steady uptrend in the stock market. And I think a lot of that is due to this volatility selling, forcing market makers to go out and buy stocks. What happens when volatility goes up, and this massive notes futures market and volatility ETFs? These guys have to cover some of this volatility short. They have to go buy volatility from the market maker who has to short volatility and he has to sell stocks in order to put on that trade. 

Volatility goes up higher because you have selling in the stock market, which creates more volatility and these guys have to buy in their volatility to cover their short. It’s a vicious cycle. To me, it’s very, very similar to portfolio insurance that we saw in 1987. Where selling begets selling begets selling. So you have this volatility short, but then you also have $3 trillion in volatility targeting funds. Now, and this is a lot of insurance companies. We’re talking about the insurance companies. If you want a variable annuity, the way they protect your downside and the annuity is they sell stocks when volatility rises. If you have this volatility short, which could be exacerbated, sell off, and then you have $3 trillion in volatility targeting funds. So volatility starts rising. Now these guys start selling, in addition to the volatility market makers, you could have a situation very similar to like data, I’m not calling for a crash. Let me clarify that. Very, very low probability event. I’m just saying that the structure of the markets right now is very similar to portfolio insurance in 1987. Where selling begets selling begets selling.

Preston Pysh  43:52  

So I read something from Carl Icahn that he had posted talking about this exact same subject, but it was probably a while ago. I wouldn’t say It was probably 10 months ago. It was back in the end of 2015 that I saw this. And he was saying that this is something that is a huge issue moving forward. And he thinks that’s going to potentially be something disastrous whenever this all starts to unfold.

Jesse Felder  44:18  

Absolutely. I should clarify that to all these volatility target strategies. I’m lumping them all together. They all have different strategies. They don’t necessarily sell when volatility comes up. Maybe they give it a week to see what happens and then they start selling. But essentially, you have this huge short position against volatility, which is essentially a massive, massive levered long position. It’s like you talked about the margin debt is a huge levered long position in the stock market. Well, that wasn’t enough. That levered long position isn’t enough. We’re going to short volatility which is leverage upon leverage. This is why Warren Buffett calls, derivatives “weapons of mass financial destruction”. And I think these volatility ETFs are going to be outlawed at some point because they allow these market practitioners to create a structure within the market that’s very dangerous to the whole financial stability. So when I talk about the Minsky moment, these investors are at the point where they’ve gone so highly levered because they’ve been encouraged by a rising market for seven years now. That’s just gone. We’ve had 110% correction in however long, and they feel like the Fed has my back, market’s never going down. I can take incredible risks that I would never dream of taking in another environment. And when those risks unwind, it creates a very difficult situation. I just think risk is extremely high.

Preston Pysh  45:47  

Very, very interesting discussion. And I know that there are some people out there because we get emails from time to time from people talking about VIX (Volatility Index) and volatility and I’m sure that that’s going to be some very useful and valuable information for them.

Jesse Felder  46:01  

Yeah. And I blogged something about it a few months ago. If you go to thefelderreport.com, you’ll see it. I referenced a piece written by a guy who’s a volatility specialist. It’s like a 70 to 80-page piece. So if people are interested in this, they can really delve into it.

Preston Pysh  46:16  

Oh, I’d love to have a link. So we’ll get a link to that in our show notes. So if you’re wanting to read more about that, we’ll have it up. 

Alright, so at this point in the show, we’re going to take a question from the audience. And this is going to be fun because Jesse is going to stick around with us, and he’s also going to join in on our comments back to the question. So this question comes from Subraden. And here’s his question.

Audience 1  46:36  

Hi, Preston, and Stig. My name is Subraden. I’m from Houston area. I really enjoy your show and your show has been a companion for me while driving to work. I have a small request if you can explain how we value. In the balance sheet, I find sometimes goodwill as an asset. So is there a guideline for that? Because when we pick our assets, select in few stocks, and then try to use the tools to have an intrinsic value calculation. But this particular aspect, I’m not sure how to account for. Because sometimes I see these numbers are really, really big. So is there a way to kind of evaluate this aspect of the asset? So I really appreciate your answer on this. Thank you so much.

Preston Pysh  47:28  

So I love this question because I know whenever I was first starting to try to learn how to do stock investing, I was reading income statements and balance sheets and everything. I saw this figure goodwill on the balance sheet, and I had no idea what that stood for. So, Jesse is going to take the first stab at the question and then we’ll just kind of go around the horn and get some different responses. So go ahead, Jesse.

Jesse Felder  47:50  

This is a great question. And you know, goodwill on the balance sheet is what I believe you’re referring to. It mainly comes from when a company makes an acquisition, and they buy a company and they pay a price above the net asset value of that company’s net assets. So, they pay with $100 million of assets, they pay $200 million. That $100 million of assets will go on the acquirer’s balance sheet and then $100 million will go into goodwill on their balance sheet. To me, I don’t use those goodwill numbers for anything when I’m looking at an individual company. It’s interesting to look at those from the standpoint of, are the managers of this company good capital allocators if they made good acquisitions in the past or not? If they’re regularly having to write down that goodwill, then maybe they’ve made some bad acquisitions in the past, and that’s something to pay attention to, that they’re not doing a great job of allocating the shareholders capital. Now, there are companies like Berkshire Hathaway who paid nothing for See’s Candies and they still have a little bit of goodwill probably on the balance sheet for See’s. But See’s is worth incredibly so much more money than they paid for. Obviously, Buffett is maybe the best capital allocator on the planet. But that’s what I would look at goodwill for us to evaluate. Is this management team good at allocating capital in terms of acquisitions? Are they doing a bad job in overpaying more companies? When you see companies that have a long term streak of making acquisitions and then writing down goodwill, that’s a real big opportunity for some financial shenanigans in the statements and for them to hide some things and whatnot. Valiant pharmaceuticals might be a good example of that. So, that’s my take on goodwill.

Preston Pysh  49:34  

So I read a shareholders letter from Buffett. He had a really fun discussion about goodwill. He talks about economic goodwill, and he talks about accounting goodwill. And so what you’re referencing in your question, you’re talking about accounting goodwill, and what that number represents. And so the way that Buffett framed the argument, or the point that he was trying to make is he said if you went on to the stock market, and let’s say you picked out one share of let’s just call it General Electric. And let’s say that the book value for General Electric was, I don’t know what it is, but let’s just say it was $20 a share. And let’s say that the market price and you bought one share of General Electric. And let’s say that the share was trading for, and excuse me because I don’t know what the market price of General Electric, but I would guess it’s $30. If you bought that one share that was $10 higher than the book value. Supposedly, you have now been able to add $10 of goodwill to your acquisition of that one share. So what’s really fun about the conversation that Buffett has is you obviously don’t do that as an individual investor that you’re now able to take that extra premium that you paid over the book value of the company, and carry that now as an asset on to your personal balance sheet. That’s the way that he described it. 

But when you’re doing that as an entire business, that’s actually how the accounting goodwill works. And so the thing that Buffett really wanted to get into with his discussion on this is that the accounting goodwill is pretty much worthless, exactly what Jesse just said, it’s not something that you can really place much value in when you’re looking at a company as a snapshot in time to determine what the value is. But what you can value is that there is real economic goodwill with a business. So let me give you an example of economic goodwill. Let’s say you go into a Walmart and you see a bin of DVDs there in the 50 DVDs sitting there. And let’s say you’re picking out a movie for one of your kids. And you’re flipping through the thing there and you see that there’s a movie from Disney. It has the Disney logo on it, and there’s some others that you don’t really necessarily recognize where they’re from. But a lot of the times people will go and buy the movie from Disney because there’s this goodwill that’s established with the customer with a brand loyalty that’s associated with economic goodwill. That has nothing to do with the accounting goodwill that you would mark up because you bought it at a premium to the book value of the individual share. So that’s the discussion. So you have to determine that as an investor. What is the real economic goodwill that I’m gaining by owning this company through brand loyalty or whatever? That’s my comments for it.

Jesse Felder  51:37  

And I would just also make one other point is that, you know, Buffett’s teacher, Ben Graham would say, I’m never willing to pay anything for goodwill. That I want to actually buy a company for half of the value of its tangible net assets. And so yeah, it’s a very interesting discussion.

Stig Brodersen  52:37  

Yeah. And I think the discussion of goodwill really underlines how important it is to read through the financial statements and understand them. If you’re looking at a company that might be reporting a loss, and you see all these write downs in the oil industry, and you’re saying this is a horrible sector. The sector might be punished for a lot of reasons, but there’s a huge difference between the individual stock picks. So for instance, if you look at a stock like national om avago *inaudible*, it looks like they’ve been punished. But the $1.6 billion ride off that was on goodwill. So actually the company is still having positive cash flows. And they don’t have a cash flow problem like other all companies are doing. Also I have a position myself, so that’s not why I’m saying it. I’m saying it really to understand the accounting and how that works, and how something might be a run off, but not like, it doesn’t influence your cash position on the cash flows for that company. 

And I think it’s important to understand that, Jesse, he also talked about See’s Candies, Warren Buffett’s famous acquisition and he bought that 50 years ago for I think was around $25 million. And it has a lot of goodwill now. So the way it works in terms of accounting is that if you have goodwill, that’s above the what’s called the carrying value, so that’s the value see in the balance sheet. You can’t ride it up, but you can actually ride it down. And that’s what’s called an impairment charts. So the management would every year go in and value the goodwill of that company and potentially ride it down, not up. So that’s why it’s really important that you actually go in and read the financial statements and see how you really calculate the earnings. Is it because of the operations? Or is it because of a lot of times of goodwill, for instance. It’s two very different things.

Preston Pysh  54:18  

And it’s important to note that the company gets a tax advantage whenever they would test it for impairment and write it down, which is a thing that you see a lot of companies do when they need to save some money on tax.

Stig Brodersen  54:30  

Subraden, thank you so much for a fantastic question. We’re just going to round this episode off with Jesse, and then we’re getting back to you with a brand new reward for asking the question in addition to a free signed copy of “The Warren Buffett Accounting Book” and the paid courses about “The Intelligent Investor”. 

Preston Pysh  54:45  

Alright, so Jesse. First, we want to thank you for coming on the show and answering the question with us, and just providing our audience so much valuable information. If anyone out there wants to learn more about you, where can they find you and any other information that you want to highlight.

Jesse Felder  55:01  

Yeah. At thefelderreport.com, I try and write one or two blog posts a week, and just read about stuff that I’m thinking about scratching my own itch in the markets. And so yeah, that’s that’s kind of where you can find my stuff.

Preston Pysh  55:14  

Awesome. Thank you so much, Jesse for coming on the show.

Jesse Felder  55:18  

Thanks for having me. I had a great time. You guys are awesome. And I really appreciate it.

Preston Pysh  55:21  

All right, fantastic question. And one of the things that we’re giving away in that three-part package that we just announced, is “How to Invest in ETFs”. And one of the things that we wanted to do is I wanted to talk with Stig and I wanted to talk with Dr. Chris Habib, who is also one of the developers on this, of this new course, and talk about what they had learned going through this process, what their intent was for doing this. And if you’re not interested in this discussion, feel free to hop off but I think that you guys are really going to enjoy this conversation as they talk about the course that they developed. 

So Chris, you and I started chatting a little bit back and you were a listener of the show, and you had reached out to me because you were interested in developing a course for the audience. He was just highly motivated. And so Chris and Stig decided that they were going to try to tackle this “How to Invest an ETF” course. And so Chris, I want you just to briefly introduce yourself to the audience, so they know a little bit about you. And then we’re gonna just talk about the development of this course that you guys made.

Chris Habib  56:24  

Sure, thanks. So I’m an evidence-based naturopathic doctor. I manage businesses and I’m also an investor, and the CFO of a herb company, and I’m the clinic director of two health clinics. I’m also involved in teaching, research and publishing. I am a clinic supervisor at a college. I teach board exam courses, and I’m the associate editor for two medical publications.

Preston Pysh  56:47  

So you just do a few things.

Chris Habib  56:50  

Yeah, just juggle a few things.

Preston Pysh  56:53  

So Chris has probably one of the sexiest sites you’ve ever seen on the internet. Right, Stig, you have to admit.

Stig Brodersen  57:02  

Yeah, I don’t know how he does it. It looks super slick.

Preston Pysh  57:04  

It’s probably the slickest site I’ve ever seen. Chris, I want you to tell people the name of your site. So that they can check out your sexy site, but if they are into this, if you’re studying for one of these exams because I’m sure some of the people in our audience might be in the scenario where they might be interested in some of that stuff. Give them a hand off to that site that you have that deals with day to day stuff. 

Chris Habib  57:26  

That’s just my name. It’s chrishabib.com.

Preston Pysh  57:29  

Okay. Very easy to find. And I promise you, you’ll be amazed at the aesthetic layout of his website. Let’s start talking about the ETF course. So my first question is, how much time did you guys put in because this was really Stig and Chris that did all this. I didn’t really put in anything other than really going through the outline and kind of making sure we hit all the different parts that we wanted to cover in this, but how much time did you guys end up putting into this?

Chris Habib  57:53  

A few months. And it’s one of those situations where you end up doing a large amount of editing. You might do like an hour or two of work, or two or three minutes of a clip. So it’s yeah, you make sure that the end product is really good.

Preston Pysh  58:09  

So let’s talk about a little bit more of the nuts and bolts of the ETF course. So you originally were wanting to do the ETF course just because of, why Chris, what really led you to have an interest in doing this from the beginning?

Chris Habib  58:21  

Yeah, I got interested in investing a few years ago, and eventually and gratefully I stumbled upon you guys. So that helped me learn and become a better investor. So I’m somewhere in my life now where I want to provide value for other people. And I recognize that I have a lot of different passions. Investing is one of those passions. So I think it’s another way that I have the ability to connect to people and to break down complex concepts and make them simple. 

Preston Pysh  58:50  

Awesome. And Stig, why did you do it? 

Stig Brodersen  58:53  

I think is weird that you’re basically coming from a background where you think individual stock picking is the best thing. So for me personally I’m impressed with you as well, Preston. You’re doing it because that was kind of what Warren Buffett was doing. But we kind of skipped a lot of steps here because he’s the best in the world. But that’s not necessarily the best approach for everyone. I think I should probably have started looking into ETFs first and then transition to individual stock picks because there are a lot of advantages in investing ETFs for new investors. 

So I think it was a way for me to relearn a lot of the basic principles about investing that applies to ETF investing, and also to become smarter about the terminology. Few other things so ETFs, stock investing, what’s the difference here? Isn’t ETF just like buying multiple stocks at the same time? And in many ways it does, but I think the hurdle for a lot of people, whenever they’re looking at ETF, it’s just the same thing as whenever they’re starting individual stocks. They need to learn an entirely new terminology. So they need to learn expressions like expense ratios, whereas for individual stock picks from I’d be looking more at moat or other terms that might be relevant to you. So I think that was a good way for me to relearn that because I think I needed that as well.

Preston Pysh  1:00:10  

Yeah, I think just one of my comments that I think I’ve learned just through doing the podcast is, I was obviously a hardcore individual stock investor before, deeply getting into the podcast and interviewing all these great minds. And you kind of realize that, hey, if I’m estimating the return on a single stock pick at 4%, and then I take what I think the S&P 500 is going to give me through an index and it’s given me the same yield. Why in the world, would I ever buy that individual stock pick? Why wouldn’t I go and buy the ETF? And I think these are some of the things that you and Chris have have obviously taught in this course, and how to think about that and how to go about making that assessment. Those kind of things are so needed in today’s market, in my opinion for people to understand that difference and to mitigate your risk by distributing and across an array of equities instead of just one that’s going to give you the same return.

Stig Brodersen  1:01:03  

Yeah. And also I think it’s is a different way of looking at investing because if you look into ETF investing, you’ll be talking about why does the strategy work? You talked a lot about strategies in general when you are investing in ETFs. Whereas if you are looking at individual stock, you might be talking about whether or not the business model is broken. So let me just give you an example here. If you’re looking at an ETF that’s a value ETF, you might have knowledge about that, and generically, you can say that it probably wouldn’t perform that well in the bull market. At least compared to another strategy like growth but it might perform really well if it’s a bear market. Now if you compare that to a stock pick, call it Bed Bath and Beyond. It’s another kind of decision because not we’re rather thinking, is the business model broken now because the competition from Amazon is too much? And it’s just a different way. I’m not saying it’s harder or easier. If anything, it might be slightly easier to think about that because it’s broader and specific. But it’s just another way. I think that’s my point of thinking about investing that we probably haven’t been *inaudible* as much as we should. And I think that’s the takeaway from this sort of investing.

Preston Pysh  1:02:13  

All right, Chris. So when you were doing this course, what was the biggest problem or issue that you saw with ETF investing?

Chris Habib  1:02:21  

Yeah, that’s a great question, Preston. I think the biggest problem that Stig and I identified is that generally, investors fail to stick to their strategy. There are really four keys to successful investing. Number one is maintaining a low cost which ETFs achieve. Number two is diversifying your portfolio which ETFs achieve. Number three is optimizing tax efficiency, which ETFs achieve. And then number four is keeping your emotions and temperament in check, essentially sticking to your strategy. And I think that’s the hard part.

Preston Pysh  1:02:52  

So Chris, if people are going to go to the ETF course, what’s one of the things that you think is going to be a large value add for them by going through this video tutorial?

Chris Habib  1:03:02  

So we talk about answering some of the most common questions like how do I find the best ETFs? Or how many ETFs should I own? What should I invest internationally? That type of thing. But I think one of the key points that the audience will really appreciate is that the course provides the step by step blueprint of Stig’s process for selecting ETFs. And I know for me, as I went through some of the editing and learning, I was just blown away by that information. 

Preston Pysh  1:03:28  

Awesome. So Chris, if people want to sign up for a subscription to the ETF video based course, where should they go? 

Chris Habib  1:03:34  

So I’m sure we’ll have a link for the course in the show notes. Otherwise, you can find it on the website at theinvestorspodcast.com/howtoinvestinETFs. Or you can find it on TIP Academy, which is at the top of the navigation bar on the website. And make sure that you act now because there’s a massive launch discount that’s only available for a limited time. 

Preston Pysh  1:03:56  

Awesome. Thank you so much, Chris. 

All right. We’ll wrap this this conversation up real fast. I just wanted to make sure that everyone in the audience knew about the new course. And for anybody that leaves us a question on the show by going to asktheinvestors.com. If you record a question there, you will get a free subscription to our ETF course. So make sure you guys leave us some questions to potentially be in the running for that.

Stig Brodersen  1:04:19  

Okay, guys, that was all we had for this week’s episode. We’ll see each other again next week.

Outro  1:04:23  

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 requests of guests. 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.