In This Episode
As the dust from one of America’s uglier midterm battles settles, Buck makes sense of the new political order.
On the one hand – Democrats won the House, and with it the ability to kill all legislation, investigate the President and subpoena his aides and – most explosively – demand his tax returns.
On the other side, Republicans expanded their majority in the U.S. Senate, giving President Trump the ability to nominate scores of lifetime conservative judges – meaning his vision for America could prevail for decades after he leaves office.
Who got the better end of the deal? After speaking with campaign strategists, politicos and journalists, Buck has a verdict.
“We are in for a two-year battle royale.”
Meanwhile, with markets reacting to a split decision that invites a new era of gridlock, Dan Ferris gives the lay of the value investing land, starting with the moves of the greatest value investor of all time. “You can’t be a value investor and not talk about what Warren Buffett is doing.”
Dan’s got a theory of why Warren Buffett has held on to a cash hoard of over $100 billion for five quarters now, and what his relatively meager $1 billion buyback of Berkshire stock really signals.
They’re joined by this week’s special guest, Chris Cole. The founder and portfolio manager of the Artemis Vega Fund, Chris built a track record of profiting from volatility that drew the attention of publications like The Financial Times, International Financing Review, CFA Magazine, and Forbes.
With markets continuing their whipsaw activity this week, we think you’ll find his insights particularly relevant – especially as he outlines what history spells for an emerging age of value investing.
NOTES AND LINKS
For more information on Christopher Cole’s work – Artemis Capital Management
For more information on Dan’s latest work – Extreme Value
02:46: As liberal Justice and left-wing linchpin of the Supreme Court Ruth Bader Ginsburg heads to the hospital following a rib fracture, Buck breaks down the Senate GOP’s new ability to confirm a stampede of conservative judges.
4:04: With markets reacting to a split decision that invites a new era of gridlock, Dan Ferris gives the lay of the value investing land, starting with the moves of the greatest value investor of all time. “You can’t be a value guy and not talk about what Warren Buffett is doing.”
8:18: What’s behind Spotify’s just-announced $1 billion stock buyback program? Dan makes sense of why an unprofitable company that’s been publicly traded all of six months would aggressively buy back its shares instead of investing in growth.
10:31: Now that Apple’s been downgraded for the second time on Wall Street, investors have a choice to make about the stock reminiscent of where they were in 2013, when Dan recommended it to readers. “I don’t care about the downgrade, and I don’t care about people being disappointed. This has happened many, many times with Apple.”
14:45: With stock prices roaring higher until very recently, the investing landscape has been almost a famine for value investors. But Dan’s found a few exceptions. “We’ve found cash-gushing companies with really great competitive advantages.”
18:30: Dan teases a dividend juggernaut on his value investing radar that’s raised its payouts for more than 85 years, including dividend hikes for each of the last forty. It’s a world class dividend grower, and you just don’t normally find this stuff.”
21:28: Buck introduces Chris Cole, founder and portfolio manager of the Artemis Vega Fund, a specialist in the emerging asset class of volatility. Cole began his career in markets at Merrill Lynch, structuring billions of dollars in derivative transactions for high profile issuers. After big returns in 2008, he decided to trade even more heavily in volatility, while building a track record that caught the attention of The Financial Times, International Financing Review, CFA Magazine, and Forbes.
28:42: Chris points out that we’re just coming out of the longest period of value underperformance relative to momentum stocks in history – and there’s a scary lesson written in history. “The other periods of time include right before gigantic crashes. The other major underperformance period was prior to the 2007 crash.”
32:00: Chris explains why Warren Buffett, so widely considered a preternaturally patient buy and hold investor, is actually the greatest short volatility trader to ever live.
38:04: Volatility is commonly associated with risk – but Chris points out it can actually be used as a form of insurance for investors. “Let’s imagine you’re going to a foreign country and want to rent a car. You ask about insurance, and the rental desk says they’ll pay you to own insurance at a specific time.” Who wouldn’t take it?
44:13: In extreme heat, a snake can’t regulate its body temperature, and hallucinates to think its tail is prey. Chris says that’s similar to the unsustainable mania in chaotic financial markets today. “This image of a snake eating its own tail is the perfect image, for me at least, of modern financial markets.”
Broadcasting from Baltimore, Maryland and New York City, you’re listening to the Stansberry Investor Hour.
Tune in each Thursday on iTunes for the latest episode of the Stansberry Investor Hour. Sign up for the free show archive at Investorhour.com. Here are the hosts of your show, Buck Sexton and Porter Stansberry.
Buck Sexton: Hello, everybody. Welcome to another episode of the Stansberry Investor Hour. I am nationally syndicated radio host Buck Sexton. I am going to be joined this week by long time Stansberry member and editor of Extreme Value, Dan Ferris. Just a quick note. Want to let you know that our fearless leader, Mr. Porter Stansberry, is busy with some end of year projects. So he’s gonna be taking a little bit of a sabbatical from the podcast for a few weeks. But we are talking to him about all kinds of exciting stuff behind the scenes for 2019. And we’re excited when Mr. Porter is back in action here on air. We just want to let you know he’s gonna be about for a few weeks. But we’ll have some wonderful and insightful Stansberry folks joining to make sure you get the financial info, expertise and knowhow that you come to us for.
I just want to give you some quick midterm thoughts. Because as we know now, the Democrats took control of the House of Representatives and the Republicans gained a few seats in the Senate. This is effectively a split decision if this were a boxing match. It went both ways. The Senate is obviously very important for judges. The House of Representatives in a split Congress will be very important for investigations and of course, as you know, impeachment. Which is certainly looming somewhere in the background here. It’s going to get a lot more attention in the months ahead I can assure you of that.
So from the perspective of what will actually happen in government, that maybe all of you care about that could affect markets or just affects the way the country’s going, we are in for a two year long battle royale between left and right, between Democrats and Republicans. It will play out through the remainder of the special counsel. The Muller probe. It will play out through congressional investigations. The use of subpoenas for often politicized or oversight purposes, depending on who you ask. And a Senate that is going to be invigorated with its new mandate of picking up a few more Republican seats. And they’re going to push through judge after judge. And very possibly another Supreme Court vacancy will be filled in the next two years. Will need to be filled. So that’s where this is going. There will not be most likely any major legislation. I would not expect there to be a massive healthcare fix. I would certainly not expect there to be any bipartisan cooperation on immigration. People will talk about an infrastructure package. I think that’s unlikely to work. I think that this is just going to be the Trump movement against the hashtag resistance. And this is going to drag out for the next two years.
All the political arguments that you hear at the national level from now until Election Day 2020 will be about who is in power in 2020. That’s my prediction. That’s where I think all of this is going. And with that, let’s get to Mr. Dan Ferris.
Dan Ferris: Well, thank you, Buck. It is good to be here once again. I really enjoy doing these podcasts. And there’s kind of a lot happening in the world. At least for a value investor like myself. I am the editor of Stansberry’s Extreme Value, Value Investing newsletter. So the first thing I’ve got to talk about, that I can’t not talk about, you can’t be the value guy and not talk about what Warren Buffett is doing lately and why he’s in the news. And it’s a little strange and I’ll tell ya. He announced that he bought back almost not quite a billion dollars’ worth of Berkshire Hathaway shares in the month of August. And so you know this is like a big topic for discussion. It was like trending on Twitter and other things yesterday. And the stock was up like 5 percent. Twenty-six billion more of market cap yesterday.
But when I look at it I say, okay, well, just under a billion. So his cash word has been over 100 billion for I think five quarters, maybe six. So it’s less than one one-hundredth of his cash. And Berkshire Hathaway’s market cap’s around 500 billion. So less than one five hundredths of the market cap. So he’s spent less than one one-hundredth of his cash to buy back less than one five hundredths of the stock. And I don’t know why this is a big deal, but the stock went up 5 percent yesterday and added 26 billion of market cap.
Now as a – if I were really cynical about Buffett I’d say he was spending a little bit of money cause he thought he’d get the big reaction that he got. But, you know assuming that he hasn’t changed, I know the big sort of consideration for him is – you know it’s not the effect on earnings per share necessarily or anything else. Or signaling or any of that. It’s just returns on incrementally invested capital. He has trouble finding things to do. He thinks the stock is undervalued. Or reasonably undervalued, right. Not deeply. Just reasonably cheap. And so he buys a little bit of it back.
Now this is not a big deal, you know. One one-hundredth of cash. One five-hundredth of the company. But what would be a big deal, what is worth possibly speculating a bit about, is if Buffett lets loose and spends like, you know 15 or 20 percent of that cash. You know 15 or 20 billion let’s just say. Or 25 billion or more. That would be an elephant, right. He hunts elephants when he makes acquisitions. Meaning he’s got to buy something big enough, he’s got to put enough capital to work to move the needle on what is now an enterprise worth 500 billion dollars.
So this was not an elephant shot. But if it were, that would really get my attention. And that would be a frank admission that Warren Buffett is having trouble finding things to do. And we know why he’s having trouble finding things to do. He can’t buy publically traded stocks because they’re all overvalued. He can’t buy bonds because interest rates are still scraping multi decade lows. And he can’t find private businesses to buy because merger and acquisitions activity is at all-time highs. And private equity has cashed up to all-time highs. So everybody wants to buy something nowadays. And it's hard to find somebody with the sense of discipline to not blow a big chunk of money on an acquisition deep into the longest bear market in history, most overvalued – I’m sorry, bull market in history. Most overvalued bull market in history. So this move doesn’t mean a whole lot to me. But it sure would if he spent a big slug of cash.
Now elsewhere in buyback news, while we’re on the topic, the music streaming company Spotify has announced a 1 billion dollar stock buyback program. This thing went public six months ago. It still makes losses. It does negative EBITA. Negative earnings before interest, taxes, depreciation, amortization. Kind of a common cash flow metric.
It’s weird. It’s just weird. Again though maybe, this could possibly be a bigger deal. They have about a billion six in cash. So spending a billion when you have a billion six and you’re losing money, that really sounds kind of crazy. I mean the stock is down 30 percent. Because it’s a brand new company. We just had a big correction. We understand the basic logic. That they’re trying to buy their own stock cheap. But I think this might be more in the category of we’re trying to support the stock and signal and trying to get people interested in it than anything else.
If they generate a bunch of cash – now the program, the buyback program is a billion dollars and it expires in April 2021. So more than two years. Just call it two and a half years out, maybe the company’s a lot bigger. Maybe they become profitable. Maybe they generate a whole lot more cash. By that time. And during that two and a half years. So maybe this starts to make a lot more sense. But for now going public and buying back your stock six months later, announcing a buyback six months later – I will say this, management is really confident. Let’s just leave it at that. And I'm really curious to see, you know I mean Spotify’s a great product. Everybody I know who uses it loves it. And they don’t use anything else. So who knows, maybe this will be really successful. It’s an interesting company. Great product. We’ll see.
Then there’s this other news. Which is more concerning to me as the editor of Extreme Value because we recommended Apple in 2013 and we’re off about 240 or 250 percent or something. And Apple was downgraded for the second time on Wall Street. And in the wake of the reported earnings _____ on Thursday. And people, you know people are always disappointed. I don’t care about the downgrade and I don’t care about people disappointing and the stock selling off. This has happened many, many times with Apple. This is like standard operating procedure with Apple. They come out with an earnings report. Everybody says, oh – either an earnings report or a new product, you know. Everybody said, aw, they’re not gonna sell any more of these things. And the stock sells off and then, oh, well, you know we’re kinda surprised a little bit and we start selling these things. We start selling phones. Or iPads or whatever the product is that they announce. And the initial disappointment is kind of turned around.
So that basic reaction that we’ve had here in the market with the stock right around, I don’t know, 200, 201, something like that these days, I’m not worried about that. But I will tell you what I don’t like as a guy who recommended this thing to people on Extreme Value. And we’re not recommending selling it. I just don’t like this. And you can not like something about a company whose business you like. And what I don’t like is they have made the decision to no longer report iPhone and I think it was also Mac unit sales. Right. So the number of units. The number of iPhones and the number of Macs and things that they’re selling. I think this is insane. It’s crazy. And it’s the kind of thing that a company does – I mean in Extreme Value we’ve shorted companies that were making these kind of announcements. Now they didn’t have the phenomenal business Apple does. With over a billion units of phones and other hardware worldwide and this wonderful ecosystem where they just embrace you to do everything within their ecosystem. But still, it’s not good news and it’s not good corporates practice. It's bad. We have come to count on these unit sales figures. And it means something to us as investors. And I immediately, as soon as they did this, I tweeted right at Tim Cook and said, you know no matter what you intend, no one is going to think, that you’re doing this just because of some innocuous reason. We’re all gonna think the exact same thing. We’re all gonna think that you’re doing this because the unit sales aren’t looking so good now in your opinion or won’t look so good the next time you report them.
So it’s a big mistake. I don’t like it. It’s irritating. It’s more irritating when you like the business as much as we like this one. Frankly, great businesses have been hard to come by. They’re hard to find. And – I mean I won’t name any names. I guess we’ve named Starbucks in public. As a recent find. But we found a couple other things, including for the new issue of Extreme Value that’s coming out this Friday, you know by some miracle we’re finding like these world dominator businesses that are trading at multiyear valuation loads. I’m just like knocking wood, I’m knocking everything around me, wood, linoleum, glass, whatever, for luck because longest bull market, most overvalued bull market in history, a value investor is like, you’re running out of oxygen. You’re running out of things to do. Perhaps oxygen is not the right analogy. But you’re running out of things to do. And yet somehow miraculously we’ve found cash gushing kind of companies with really great competitive advantages that cannot easily be disintermediated by competition, trading at really excellent valuation. Surprisingly good valuations.
And, of course, this happens when, you know there’s a problem or two with a company or something goes wrong and maybe, you know people don’t quite follow the story closely enough. Certainly with Apple, you know the stock tanked back in 2013 and people figured, well, this is the end. They can’t sell any more stuff. And of course they were wrong. And we took advantage of that. And we’re up 250 percent.
That’s like one of the basic things that we do, right? We’re doing – how does one say, time arbitrage. Right. You’re saying, well, the average investor’s time horizon is five minutes. Or less than one year anyway, right. And if we can hold XYZ security, whether it’s Apple or Starbucks or something, for two or three years, maybe we get a good double or triple out of it. And while taking less risk than buying, you know mining stocks or some other kind of risky technology play let’s just say.
So it’s just kind of a minor miracle that we found Apple when we did. It’s kind of a minor miracle that we found Starbucks. It’s kind of a minor miracle that we found this new company that we found. For this Friday’s edition of Extreme Value. And last month, you know we found another good one. And I would say this year, just taking a look at our portfolio, like since January we’ve found, what? Let’s see, one, two, three, four, five, six, seven and then eight this month. Eight stocks. And I would say two of them are kind of riskier than our normal fare, but they were so unbelievable dirt cheap that we had to recommend them. And then another one is also kind of in the material space where you get a little bit more risk.
I would say four and now five of them are like really great businesses at really great valuations with very good management teams. Management teams that own ten, 15 percent of the stock. And just have everything on the line. And we’ve got another one of those this week. The CEO owns 15 percent of the thing. And he’s been in the business like a long, long time. And his whole net worth is on the line. So you want somebody like that running the thing who’s really committed and on your side. Truly on your side. If somebody’s papered up with stock options, you gotta wonder if they can really be said to have the same incentive as a shareholder who put his own capital at risk, right? And we don’t often find all these ingredients all in one place. Great business. Gushing free cash. You know good or sometimes excellent balance sheet, you know consistent profit margins and shareholder rewards. Lots of buybacks and growing dividends.
I mean the company that we’re recommending this Friday has paid a dividend every year for like – I think it’s like 88 or 89 years or something crazy like that. And it’s raised the dividend every year for more than four decades. I mean it’s a world class dividend payer. And you just you don’t normally find this stuff.
So I feel really lucky actually to be the Extreme Value guy after several years of value underperforming the growth of your technology stuff. That’s been going on for a long time. And we’re gonna actually talk about this just – we’ll touch on this again with today’s guest that we’ll get to shortly. It’s turning into a really good time to be a value investor. And it's my thesis, which I’ve shared with readers of Extreme Value, it's my thesis that it’s gonna turn into a fantastic time over the next five to ten years. And that that transition has already begun and that’s why we’re finding this stuff. That’s why, you know at this time when you don’t expect to be finding it, you know you find it in one area and then maybe there’s a dislocation in another industry and you find a few deals there. And then it kind of builds up steam and gets rolling. And pretty soon being a value investor in almost industry is a big advantage over other people.
So that’s my pitch for value investing. And believe me, value investing need pitchmen these days. Because nobody wants to do it. And I think that’s – I think I should leave it there.
There was one little thing I wanted to touch on. Goldman Sachs put out this thing where they said the economy needs to slow down because it’s dangerously overheating and there was – there’s this labor market tightening and these things. And I don’t really care what Goldman says because people like me and Stansberry’s Doc Ifrig and others have been talking about this recently and for some time that you know labor market tightness and rising interest rates could be signaling – and of course then you see the signal also may be a signal. I don’t know. In the gold market with gold kinda punching up through 1,200 and staying there finally. You know there could be inflation in the air is all I really take that announcement from Goldman to mean. I don’t think Goldman’s special. Although I do think they mysteriously wind up on the right side of the trade like every time. They might start out wrong, but then they din up right. That’s really all that means to me.
I think we should probably get to our special guest today who I am super-duper excited to have on the program.
Buck Sexton: I want to introduce Chris Cole this week. Christopher Cole is the founder and portfolio manager of the Artemis Vega Fund LP, a specialist in the emerging asset class of volatility. Cole began his career in capital markets and investment banking Merrill Lynch, structuring 10 billion dollars in derivatives and debt transactions for high profile issuers. He has since focused on systematic and quantitative trading of volatility. And his decision to form a fund came after achieving significant proprietary returns during the 2008 financial crash trading volatility futures.
Cole’s research letters and volatility commentaries are widely read in the derivatives community and have been referenced by publications such as the Financial Times, International Financing Review, CFA Magazine and Forbes. He has been a key speaker at several industry events, including the Global Derivatives and Risk Management Conference. Please welcome to the Stansberry Investor Hour, Christopher Cole.
Dan Ferris: All right. Chris Cole. Welcome to the program, sir.
Christopher Cole: It’s a pleasure to be here.
Dan Ferris: I have to tell the listeners, I am super excited to have this guy on the program. I’ve been – Chris, you may know I’ve been quoting your work for like over a year and telling everybody you’re the smartest guy who’s talking about volatility. At least before the public certainly. I don’t think that’s a stretch at all. And I’m really excited that you could come on the program.
So let’s jump in here. Right. The first thing when somebody goes to your website, Artemis CM.com, Artemis, A R T E M I S C M dot com. And I encourage them to go there. There’s lots of great stuff to read. The first thing you see is a definition of volatility that is different, I mean it says explicitly volatility is not the VIX. It’s not what you think. So maybe you could tell us what is volatility?
Christopher Cole: Absolutely. Yeah. I think I have a little bit more of a philosophical view on what volatility really is. Because I think volatility as a concept is just widely misunderstood. It’s not fear. It’s not the VIX index. It’s not some sort of a statistic. Volatility is really in markets is no different in markets than what it is in life. Volatility is an instrument of truth. It reflects the difference between the world that we imagine and the world that actually exists. And if we deny truth, if we try to ignore truth, we try to pave over truth, then the more we kind of deny the reality, the more the truth will find us through volatility.
Dan Ferris: Wow. I love this. I love this philosophical view on volatility I have to say. It’s poetic. Let me ask you this though. So as a value investor, and even just an equity investor in general, some people say, well, you know volatility – some people think volatility is risk. Some people like me think, well, risk is really the risk of permanent loss of capital. Where do you stand on all of that. Is volatility risk?
Christopher Cole: I think volatility is a very poor proxy of risk. You know the Markowitz portfolio theory they looked at this idea of you want to optimize your return per unit of risk. Which is not a bad idea. But they measured risk using the statistic of volatility. So specifically if you go to an MBA program or a financial engineering program, you know every one in these programs are taught that you measure risk by looking at historical volatility. And this is assumption is actually I think not only wrong but actually quite dangerous. Because in many instances truth can be denied and volatility can be artificially suppressed. And as a result of that if you’re using volatility as a metric to measure risk, you are in essence levering up right at the point in time where risk is most great.
If you look at some of the lowest volatility years they occur before a three year period of financial crisis. So this gets back to this Minski concept that – and if we relate this back and we move it outside of markets and we just relate this back to life, if you talk to marriage counselors, they say that the couples that are not fighting, the ones that are silent, are the ones that are most likely to break up. Because they’re not working through their problems.
If you suppress forest fire, forest fire suppression actually leads to greater forest fires. If you – the forest service for avalanches will actually try to induce controlled avalanches in order to release some of the tension. The more you don’t have an avalanche the build up to a potential great avalanche is much greater.
So the problem is if you’re looking historically to measure volatility in any of these life proxies, you’re getting a very inaccurate measurement of risk right when risk is actually greatest. So I think this fallacy that the volatility equals risk, which actually drives the majority of the trillions of dollars of financial engineering strategies out there is an inherently dangerous idea. In life and in markets.
Dan Ferris: Right. And I love that. The moment at which that system tells you that everything is all clear it’s really not. And you refer to the Minski idea. And that’s basically it, right? Something that appears highly stable, you know probably isn’t.
Christopher Cole: Probably isn’t. And there’s this view that risk, and I think this view has permeated through financial engineering strategies. It’s embodied by the policies of Greenspan, Yellen and Bernanke. There’s this idea that risk cannot be destroyed. Or excuse me, there’s this idea that you can somehow mitigate tail risk or control tail risk. But risk can’t be destroyed. It can only be shifted through time and redistributed in form.
So if you seek total control over risk, you will ironically become its servant. Because there’s no such thing as control. There’s only probabilities. This actual process of trying to destroy tail risk, you can’t do it. You can only redistribute it in form and time. So in this dynamic today, we have had the longest under performance of value investing.
Dan Ferris: Don’t I know it.
Christopher Cole: Yeah. It’s been one of the longest underperforming periods of value investing _____ _____ history. And the other periods of time include right before gigantic crashes. The last major underperformance period was prior to the ’07 crash. Before that was the period of ’97 to ’99 during the dot com bubble leading up to that crash. So it’s very interesting that you can deny truth and the policies of central banks, people think they’re destroying risk. They’re not destroying risk. They’re just bringing returns from the future to the present. And they’re taking tail risk – they’re taking risk from the middle and pushing it out to the tails.
I think this concept that you can mitigate risk in this way or somehow control risk is quite problematic.
Dan Ferris: Okay, Chris. I believe that this is a perfect moment to kind of make this a little bit – we’re gonna get a little bit more concrete here. Now you contend that there is essentially a roughly 2 trillion dollar short volatility position kind of out there in the market. And just for the listener’s sake, if you’re long stocks and long bonds, you’re short volatility. If you’re long, you’re short volatility. So now what are the components of this? What are all the strategies and the assets involved in this 2 trillion short volatility position that you write about?
Christopher Cole: I should elaborate on my general philosophy. For a long time there was a – there were questions about – I’m a volatility trader. I trade derivatives and I trade volatility for a living. For a long time there were people who questioned whether volatility was an asset class. And they’d be like, I don’t really know if vol is an asset class. And I would throw it back and them and I’d say, look, volatility is not only an asset class, it is the only asset class. Everyone is a form of a volatility trader but they just don’t realize it. And what I mean by that is that in life you can make or in markets you can make two types of bets. One bet is a bet on the expectation of stability and mean reversion. So in this type of debt you risk a little bit of money. You risk some money. And you are most likely to have a gain. You have a high probability of achieving a gain. But a very slim probability of achieving large losses. And you’re making a bet on the expectation of mean reversion and stability.
So for example, when someone buys on a dip, the stock market drops 10 or 20 percent and you buy on a dip, that is a form of a short volatility or a mean reversionary type of trade. There’s value investing, I would say Warren Buffett is the greatest short volatility trader to ever live. Because what Buffett looks to do is he looks to find, as you know, he looks to find companies that are at or below their intrinsic value. And then he places his money in them anticipating a reversion to the mean. Not anticipating they’d go out of business. There’s a continual bet on the growth the American economy, the growth on demographics and this idea that eventually we will revert to the mean. In exchange for that there is always a loss but there’s always a risk of catastrophic losses.
There’s another type of bet which is a I would call a long volatility trade. And this is where you’re actually placing an expectation on change and regime shift. And usually that costs some money. Some upfront money. And it’s very rare that these types of trades pay off. But when they do their returns are quite nonlinear.
So different asset classes, if you’re buying options, you’re a long volatility trader. But certain global macro investors, like George Soros, could be considered long volatility traders. Because they’re making bets on potential shifts in the way the world operates that would be a dramatic shift from the standard regime and mean reversion.
Dan Ferris: Right. So in just the crudest terms, they’re looking for huge opportunities to get shorts on major market, you know near the top or something. They’re looking to call tops basically in the crudest terms.
Christopher Cole: Or if you’re – if all we’ve experienced is a certain currency _____ and someone anticipates that a currency pick will be removed that’s a form of a long volatility bet. If there is an expectation that – other frameworks were someone sit back and said this, you know printing money is untenable. And eventually a government will face pressure in its currency or debt default as a result of that. That’s a form of a long volatility bet because what you’re actually betting on is regime change. You’re betting on something other than the expectation of reversion to the mean.
So these can take a myriad of different – the way that these types of trades, similar shortfall can be expressed in a myriad of different ways. But the thing they have in common is there’s an expectation of some significant deviation from the regime that most people have come to depend on and anticipate will prevail. There’s some kind of radical shift in the way the world operates.
Venture capitalists are always making long volatility bets. You know when someone put money in Facebook or when somebody put money in PayPal, they’re making a bet as a venture capitalist saying that they way that we interact with each other socially will shift from this tool called Facebook, or the way that we exchange money will shift through this tool called PayPal back in the 90s. Those venture capital bets are examples of positive but regime change long volatility trades.
So I think it's just a different way of looking at the world. So if you look at this world then most traditional asset classes, stocks, bonds, real estate, and traditional strategies really just come down to short and long volatility trades. Or investments that prosper from the status quo. And investments that prosper from some sort of shift in the status quo.
I think this is the central framework by which most investments make or lose money. I think what most people don’t realize is that they are dangerously exposed to the short volatilities rate. That almost 99 percent of their portfolio is driven by investments that assume the status quo. And in many cases are leveraged dangerously to the assumption that the status quo will remain the prevalent modality.
Dan Ferris: Right. So they’re that person who is the Minski moment when their stability is about to massively disrupted by volatility, and actually I want to talk then about – you know you mentioned the cost of certain long volatility bets. And if the listener could just think of like owning a put option. It’s like insurance. You buy the put option and if you don’t need it you lose all the money in it. And your portfolio does fine. And if you do need it, you know then our portfolio loses but you make money owning the put option.
Okay, but now I’m just sort of reading off your website here. Your funds seek to generate crisis alpha and profit from volatility without the negative losses experienced by more traditional hedging products like the put option I just mentioned. Chris Cold, how the hell do you do that?
Christopher Cole: IT’s very difficult. And that’s why we have numerous PhDs on staff and really focus on a myriad of different techniques. But I think there’s’ two broad ways of doing this. What we’re really looking to do is to own some sort of a nonlinear or powerful payout on change. We’re looking to use change and entropy to our advantage.
A lot of people look at volatility, long volatility traders and tail risk as analogous to insurance. So with that analogy I kind of will throw out this concept that let’s just imagine you were going to a foreign country and you were looking to rent a car. And you go down and you want to go rent a car. And you go to the car rental desk and you say, okay, I’m interested in insurance. And the person looks at you and they say, well, we’ll actually give you insurance. We’ll pay a dollar to own insurance. But only at these specific times and for this day and that day. And you’re like, well, wait a minute. You’re gonna pay me a dollar to own insurance? Yes, but only at these specific times. Or only covering these specific claims. And you sit back and say, well, of course, why would I not take that? That’s just a no-brainer. Why would you – you’re getting paid to own insurance.
Well, there are some times, some times in derivatives markets due to different liquidity dynamics, due to different behavioral biases, where you are actually paid sometimes positive carry, sometimes neutral carry, to own insurance on market crashes. We use computer algorithms to scan markets. And we’ll immediately buy those options with that insurance when we see those opportunities present themselves. So that’s a very exciting framework. So we’re using combinations of volatility arbitrage and valuation techniques and very tactical trading to get in and out of options when we see these opportunities present themselves. It’s just a no-brainer.
Dan Ferris: It sounds like. I wish my car insurance company would pay me.
Christopher Cole: Right. Exactly. Right. Why would you not take that? Well, there’s a second type of benefit. Let’s just say you go to the car rental desk and you’d say, I’d like to buy insurance. And they say it’s gonna cost $60.00 a day. And you say, well, that’s kinda pricy. I don’t know if I want to pay that much. And the guy leans over and he says look, I have some intelligence. My brother is a police officer. And they have been running data and gathering intelligence. And there is a bunch of thieves and organized crime that are gonna go around specifically this weekend to target the cars of tourists. So even though the insurance is expensive and it’s negative carry, based on this intelligence we think it's best that you buy the insurance.
This would be analogous, if I were to make the analogy in markets, we use pattern recognition algorithms collecting data from like thousands of different market prices, data points ranging from international currencies, bond prices, different statistical combinations of data that are pattern matched over decades. To understand when probabilistically is it worth paying for that insurance.
And so very similarity this is predictive. You have some intelligence that even though the insurance cost is costly, you have some intelligence that allows you to buy that insurance based on the fact that it’s going to be timely and important. And I think that’s another technique that we use. So you’re not just buying insurance all the time. If you’re gonna buy car insurance, wouldn’t it be wonderful to understand when you’re most likely to be getting into an accident? Or if you’re gonna be buying forest fire protection, wouldn’t it be helpful to buy that protection at the points in time and ramp it up at the points in time when a forest fire is most likely to break out and threaten your home? And we use computer analytics on the different algorithms to do that in markets.
Dan Ferris: I see. So if I could just make this a little bit more concrete. I don’t want you to give away the secret sauce or anything. But your portfolio sounds like, I mean does it consist entirely of derivatives? I mean is there a regular stock or a bond or anything I’d recognize in there?
Christopher Cole: Yeah. I mean our portfolio consists entirely of derivatives. At any point in time. And most our clients will just layer that on top of their equity exposure. So that’s exactly what our portfolio looks like. It's very nontraditional in that sense.
Dan Ferris: Wow. So if you don’t mind, I do want to circle back to this idea of the 2 trillion dollar short volatility position because, Chris, people have – they just have these same old kind of ways of looking at markets in these top down ways. Is the market gonna go up? Is it gonna go down? Are interest rates gonna go up and down? And they ask the same questions and have these same thoughts. But this view of kind of really global financial markets of yours, it’s different. And I would like people to know a little bit about it. And it’s covered in your writings, but maybe you can kinda give us the shorter version of it here.
Christopher Cole: Yeah. Absolutely. I want you to imagine, and there’s a wonderful graphic that Brenda _____, who’s an artist friend of mine has done, for my paper Volatility and the Alchemy of Risk, which is available on our website. But I want you to imagine uroboros. And this is a Greek word meaning tail devourer. It’s an ancient symbol of a snake consuming its own body in perfect symmetry. And this actually happens in real life. In extreme heat a snake is not able to regulate its body temperature. And will look at its tail and think it’s a prey. And it will begin self-cannibalizing itself until it perishes. In this sense, you know self-organization in perfect symmetry becomes a source of chaos.
So this image of a snake eating its own tail is the perfect image for me at least of modern financial markets. There is a very dangerous feedback loop that now exists between the current, ultra-low interest rates, even though they’re rising they’re still historically extremely low. Massive debt expansion. And asset volatility in financial engineering that allocates risk based on volatility.
So when I talk about 2 trillion dollars, this 2 trillion dollar global short volatility trade, what I’m referring to is a variety of financial engineering strategies that leverage and rely on the assumption of stability whereby stock market volatility is a source of yield but also exerts influence over sizing. So earlier in the discussion, you know I defined short volatility as any financial strategy that relies on the assumption of market stability to generate returns. But the key factor is many of these strategies now rely on volatility as an input for taking risk.
So when volatility becomes a input for taking risk as well as a source of return, we end up with a dangerous self-reflexivity. Where the more volatility goes lower, the more these strategies are able to lever their portfolios. This reinforces lower and lower and lower volatility. If anything shocks the system with volatility going higher, this reinforcement loop goes in the other direction. Where vol increases as a result institutions have to deliver. And that deleveraging into a period of precarious liquidity causes volatility to go higher and markets to crash.
Dan Ferris: And we saw this in a small way in February didn’t we?
Christopher Cole: We saw this. We saw an appetizer of it in February. A teeny appetizer of it in February. So it’s interesting, you know we’ve seen this behavior before. It occurred in 1987. But the difference in 1987 where the market dropped 20 percent in one day, that was a self-reflexive liquidity volatility cycle driven by financial engineering strategies that had many of the same characteristics. The difference in ’87 is these financial engineering strategies portfolio insurance were really only about 2 percent of the market. Today these financial engineering strategies are comprising over 8, over 10 percent of the market.
Dan Ferris: Wow.
Christopher Cole: Yeah. It truly is scary. Most people think I’m talking about the VIX ETPS. You know there were these VIX products that blew up. And we had been talking about the potential of those blowing up for years. But the truth is these are the smallest component of these strategies. What I'm talking about generally about this 2 trillion dollars. This includes strategies like risk parity. This is a major institutional strategy employed by many, many pension funds. Where they lever bonds and they use volatility as an input to increase and decrease exposure. And they lever their bond portfolio on the assumption that stocks and bonds are anti-correlated. Risk parity works wonderfully in a stable environment where correlations are stable and volatilities are stable. It can potentially backfire tremendously if those assumptions are not stable.
Vol targeting funds are examples of short volatility trade. You have all of these institutional risk premia funds that are using volatility or using low volatility stocks and leveraging exposure. You have some CTAs that actually go long equity prices using momentum as a rebalancing tool. And then on top of that you have a trillion dollars of share buybacks this year alone. Which are propping up markets. Which in themselves are a form of a financially engineered short volatility trade. That rely on the assumption of low interest rates to lever up balance sheets to buy back shares. To generate –
Dan Ferris: So that’s uroboros trade, isn’t it? Consuming themselves.
Christopher Cole: I mean quite literally the stock market is consuming itself. You know this year alone 1 trillion dollars, 1 trillion dollars of in share buybacks. This is the only thing supporting the market. This is where companies issue debt. Buy back their shares. Reduce their share count. In order to artificially increase their earnings per share growth. It doesn’t flow through the PE ratio. It flows through things like the enterprise value EBITA ratio. But this is a phenomenon where companies are able to artificially self-cannibalize, they’re able to self-cannibalize their own share count in order to artificially create the illusion of earnings per share growth in a modulated way. And this is entirely driven by low interest rates – based on my analysis in this – and this is in a paper that was released last year, upwards of 40 percent of the EPS growth since the recovery has been driven by this compounded share buyback phenomena. It is staggering.
Dan Ferris: I’ve seen that published. Yeah.
Christopher Cole: It is absolutely staggering. And the numbers, you know we’ve published our numbers. And I think only recently, I think Artemis was one of the first firms to really bring this up and really highlight this. The media has now been jumping on this and people are taking note of it. And it is no coincidence. When has the last stock market crash has been? The crashes being were corrections I should say. We just had what was close to a 10 percent correction this last month. We had one in February. Right. If we look back in 2015 and 2016 we had close to 10 percent corrections in that kind of September time period in 2015. August and September. And that late January, February period in 2016.
The corrections are occurring during the five week moratorium on share buybacks. Companies are not able to buy back their shares the five weeks before they report earnings. So if you remove the snake eating its own tail, the market is unable to support itself. I don’t think that’s a coincidence. And we publish those numbers too. Then all the sudden when share buybacks become allowed, you see the market roar back. Because now companies are able to buy back their shares.
I have my CFA, but I don’t claim to be any value expert. But I would sit back and say that I don’t think that a stock market where companies are issuing debt and self-cannibalizing their own shares is something that – that is not fundamental growth that can be indefinitely supported. And if I remember correctly of Warren Buffett’s own writings on these topics, you want to be buying back your shares when they’re undervalued. So why were there barely any share buybacks in 2009 and now fast forward we have record amounts of share buybacks when price to sales ratios, enterprise value EBITA ratios, all these ratios are at historic highs? When was the last prior peak in share buybacks? Can you take a wild guess?
Dan Ferris: Two thousand seven I guess.
Christopher Cole: Exactly. Exactly.
Dan Ferris: This just proves that what we have been telling people for a long time. Most corporate capital allocators, they just – they behave like retail investors. They’re human beings and they behave the exact same way.
Christopher Cole: I’m gonna take it a step further and I’m _____ _____ just throw it on the table and say that it's – they’re following their incentive. They’re incentivized on earnings per share growth. That’s how you get your bonuses. If you are not able to grow your sales, invent new products or create value, then – but you want to get a bonus, the best thing for you to do is to issue debt – there’s the highest amount of the lowest _____ of corporate debt, investment grade debt in history. Best thing to do is to issue lots of debt and buy back your own shares. If you’re a CEO that wants to get your bonus. And you can’t actually innovate or grow your top of the line growth.
And then if you’re – you know I was around, you know if you look at the pension systems, they should be outraged at this because it’s not something that’s sustainable for 10 or 20 years. But if you’re the head of a major pension system and you’re only evaluated on your two or three year return, then you don’t have a reason to complain about this because you want to juice up your short term returns.
So this is all based on the incentives that are outlined on all ends of it. And it’s just the ultimate – it is the ultimate form of short volatility thinking.
Dan Ferris: So, Chris, actually we’re getting a little bit right on time.
Christopher Cole: Oh, sure.
Dan Ferris: I just want to know -
That’s okay. I wanted you to kinda go off. I love hearing you talk about this stuff. I promise you it’s like so different from most of the financial guests we have. And I love it. I hope the listener loves it as much as I do. But what I’m wondering now is are you – you know how bad does it get? I mean are we back at – do we wind up back at 2008 or worse?
Christopher Cole: SO the way that I kind of think about this, you know imagine you come over to my offices and I have a – and you’re like, hey, what’s that – and you’re sitting in my conference room and say, what’s that gigantic barrel over there? And I say, oh, hey, this is – it’s a barrel of highly explosive nitro glycerin. And you’re like, what? That’s incredibly dangerous. I’m like, well, you know the bank pays me an extra 1 to 2 percent yield to keep it over there. And you’re like, what? Are you crazy? Calm down. Calm down. It has not exploded. It’s been there for years. It's never exploded.
So the thing is is that it’s possible to carry these risks for a very, very long time. It doesn’t mean that those risks don’t exist. Once again it goes back to the very beginning that we talked about. The problem of looking at volatility as a proxy for risk because, you know my office could look very tranquil and peaceful. And there’s this barrel of nitro glycerin that’s highly dangerous there. But if a fire breaks out in the office, what that barrel of nitro – and actually, interestingly enough, the café underneath our building sadly had a fire two weeks ago. We actually had to evacuate our office because there’s a café downstairs that caught fire.
Dan Ferris: Did you evacuate the barrel too?
Christopher Cole: IT’s a perfect example. Like imagine if a routine fire breaks out. And that fire could just be a traditional business cycle recession. Or it could be a geopolitical event. Or something like that. And then a routine fire breaks out. And normally that fire would be containable. But by the time that fire reaches that barrel of nitro glycerin that becomes an explosion that takes out the entire neighborhood.
Risk does not necessitate outcomes. People can take really stupid risks and be perfectly fine. I can jump out of an airplane in a squirrel suit and survive. And the guy crossing the street can get hit by a car. But that doesn’t mean jumping out of a plane in a squirrel suit is safe.
So I think this is the key thing that a lot of people kind of fail to think about. These are massive risks that they have built into the system. That have been imbedded in the system. And I believe there is a, over the next ten years – I would say so far to say three years. There is a very high probability that we retest historic highs in the VIX index and have a substantial horrific crash. But it’s possible that there are ways and cards that central banks could extent that pain or different ways that they could mitigate that fire so it doesn’t touch the barrel of nitro glycerin. But anyone who is pretending that the barrel of nitro glycerin doesn’t exist is really – really has their head in the sand.
Dan Ferris: I think we should leave it there. That’s excellent, Chris. Thank you so much.
Christopher Cole: Thank you. It's been a lot of fun.
Dan Ferris: Okay. So thanks so much, Chris. That was excellent. And I’m really thrilled that we got to have you on the program. And you know I’m thrilled for you guys listening too. I’ve been following this guy’s stuff for a while and I just, you know I wanted you to hear what he had to say. And I encourage you to go to the website too. I promise you all the stuff at his website, ArtemisCM.com, it will go over your head. But you will learn something and you’ll be intellectually stimulated to think about risk, which I think is the most important topic that investors need to think about.
Buck Sexton: All right. It's time for the mailbag. Remember, your feedback is important to us and for the success of the show. We are here to serve you my friends. You can simply email us with a question or a comment to [email protected] We read them all and try to respond to every single one, even the hurtful ones that give us sadness on the inside. But don’t be mean. Try to be constructive. Ariana does not like it when you write in with all of the hate in the heart. Because if you do enough stretching and yoga, you will have a much better chi and your spirit will be full of positivity.
Very important for you to remember that. Let’s get to the mail bag. Email number one from Gary. Hi, gang. Thanks to Dan for bringing Vitali _____ Nelson. One of my favorite non Stansberry thinkers. I read Vitali regularly and always enjoy his perspective. He’s a very well rounded individual. Much in the mold of Guy Spears I think. Even better as he has interests outside of investing, art and music, for instance. Thank you, Dan. Buck, you’ve done admirable work filling in for the big man himself, so kudos to you for a swell job. You’re the best cohost in the business. But that haircut, shaking my head, love you guys. Keep up the good work. Gary.
Dan Ferris: That was a really nice note. Thank you so much. I really appreciate it. And thanks for listening. Tell all your friends. Tweet about it. Put it on Facebook. And I really appreciate the sentiments. I agree with you. I love – you know Vitali is definitely one of my favorite thinkers in the investment world.
Buck Sexton: Email number two. In the mailbag. Hey, guys. My question today is about two important themes that have been championed by the Stansberry firm over the years. Number one, the use of trialing stops to reduce the risk of catastrophic loss. And number two, investing in world dominating dividend growers. Bulletproof businesses that relentlessly increase dividends and let it compound over the years. I deeply appreciate both ideas when considering each on its own. But it seems very hard to not have any triggering or trailing stops if one tries to hold on to a WDDG over say a 30 year time span. It seems market volatility will always stop you out at some point, even though many of these stocks have relatively low VQ. How do you deal with this dilemma? Use some other kind of trade stops for a WDDG? Paid up subscriber.
Dan Ferris: This is a difficult question. And I’m afraid, there’s a couple questions here. I’m afraid there’s no easy answer. Certainly we have – you know we’ve reported on these fantastic businesses that they increase dividends, they compound over long periods of time. And at the same time, yes, you know everybody but me in Stansberry systematically uses trailing stops on just about every trade and recommendation in everything they make. We have taken to using stops here and there in Extreme Value because we know where we are in the cycle and we don’t want to let anything get out of hand.
So you know we are starting to use them. And if the market goes higher and higher we’ll probably use them more. Even on a world dominating kind of stock, like a Starbucks or an Amazon or something, you know just whatever you think is a world dominator that you can hold forever.
Now so you ask how do you deal with this dilemma of having these stocks that ideally you hold for a generation or more. And you know how do you square that with the use of trailing stops? You know and you asked is there a special other kind of trailing stop for world dominating dividend growers. To my knowledge there is not. You know using the VQ aspect of trade stops, you know can help you here. But this is a personal choice. It's a personal decision. And it’s a decision on the part of everyone in Stansberry, you know lately including me too, to just limit risk in this fashion.
So you have decisions to make. And we can do everything – we can lead you, you know right up to a certain point, but we provide research and we provide recommendations and we provide tools and we do everything but, you know reach into your account and pull the trigger and make the judgements for you. So I’m afraid it’s not much of an answer. But I think the answer is that you need to figure out how much you can tolerate those draw downs. They can be substantial. You know even – and you know I’ve made this point repeatedly that the – you know a big draw down, in a big bear market, you know owning the best businesses tends not to make a difference. Because everything falls and you can easily see, you know just pick your favorite world dominating dividend grower stock. You can easily see that thing fall 50 or possibly even 60 percent. You know it can fall a lot just because everybody’s selling. So you need to decide for yourself if you can really weather that storm and really hang on and not panic at the bottom.
See that’s why Porter has instituted this company wide use of trialing stops. That’s why he’s been so religious about it. And Steve _____ had started it many years ago and Porter adopted it. And I think it’s the right thing to do because they’re saving you from that catastrophic loss at the bottom. If you cut losses at 25 percent and the market goes down yet another 25 or 30 percent, and then you get scared there, that’s a catastrophe and you’ve just sold out with years of compounding destroyed. Right.
So that’s why I can’t answer the question. You see. It depends on you. It depends on your ability to assess your own – what your own psychology will be. And look, we humans are bad at that. We tend to be real bad at knowing how we’re gonna feel about something when it happens. We say, oh, yeah, I’ll be fine. I’ll hold on. And then you panic and you’re, you know you’re shopping for new underwear because you just can’t take it.
So that’s my answer. I hope that’s helpful. It’s a personal thing. And you have to decide how you’re going to behave and make your decision from there.
Buck Sexton: all right. That concludes another fabulous episode of the Stansberry Investor Hour. Be sure to check out our recently revamped website where you can listen to all of our episodes, see show transcripts, we’re got all the emails about that all the time. And where you can enter your email to make sure you get all the latest updates. Just go to the same address, www.investorhour.com. Investorhour.com folks. That’s it for this week. Love us or hate us, just don’t ignore us. Thanks for listening. And we’ll be back with you next week.
Male: Thank you for listening to the Stansberry Investor Hour. To access today’s notes and receive notice of upcoming episodes, go to investorhour.com and enter your email. Have a question for Porter and Buck? Send them an email at feed[email protected] If we use your question on air, we’ll send you one of our studio mugs. This broadcast is provided for entertainment purposes only and should not be considered personalized investment advice. Trading stocks and all other financial instruments involves risk. You should not make any investment decision based solely on what you hear. Stansberry Investor Hour is produced by Stansberry Research and is copyrighted by the Stansberry Radio Network.
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