In This Episode
As markets gain back some lost ground from trade war rumblings, Dan is turning to some different kinds of land mines for investors – Elon Musk, Beyond Meat’s latest bounce, and a looming reckoning in the bond market.
Dan breaks down an article from Bethany McLean, warning of how Elon Musk is “full of shit” and playing both credulous investors and unwilling taxpayers, before turning to the warning signs he sees in today’s bond markets, which he anticipates some listeners will find “excessively bearish.”
Dan then gets to this week’s guest, Marty Fridson.
Marty is the chief investment officer at Lehmann, Livian, Fridson Advisors (a SEC registered investment adviser) and a widely respected fixed-income analyst. He is one of Wall Street’s most thoughtful and perceptive analysts. In 2000, he became the youngest person ever inducted into the Fixed Income Analysts Society Hall of Fame.
With the bond market now commanding huge attention as signs of a looming recession stack up, you won’t want to miss Marty’s warning of the next shoe to drop.
NOTES & LINKS
- To follow Dan’s most recent work at Extreme Value, click here.
- To check out Marty’s book on high yield debt, click here.
1:54: Last week, Dan exposed three once-conservative investing vehicles Wall Street corrupted. Now he reveals a third to go alongside the fallen investment trusts of the 1920s, mortgage-backed securities, and mutual funds of the 1960s.
4:24: Dan warns of the unprecedented control that a new kind of fund has over the equities market, which could result in a mass selloff based on just a few simple triggers.
11:42: Call Dan overly bearish if you must, but here’s why he can’t envision Wall Street’s newest entanglement “works itself out in a wonderful way without hurting a lot of people.”
17:54: Dan goes over the recent Vanity Fair article exposing Elon Musk, “He’s Full of Shit: How Elon Musk Fooled Investors, bilked Taxpayers and Gambled Tesla to Save Solar City.”
23:24: Beyond Meat is jumping again after KFC agreed to test Beyond Meat “chicken.” But if it’s a hit, there’s a major dark lining for Beyond Meat as competitors with much deeper pockets pile into the arena.
27:24: Dan introduces this week’s guest, Marty Fridson. Marty is the chief investment officer at Lehmann, Livian, Fridson Advisors (a SEC registered investment adviser) and a widely respected fixed-income analyst. He is one of Wall Street’s most thoughtful and perceptive analysts. In 2000, he became the youngest person ever inducted into the Fixed Income Analysts Society Hall of Fame.
31:04: Dan asks Marty about a quote from his book, “The purpose of financial reporting is to obtain cheap capital” and Marty explains his warning to readers.
38:17: Is GE the last straw to tip over a house of cards of Triple B debt? Marty gives his take on the debt so many people are calling to be labeled “junk debt.”
46:21: Marty is no Pollyanna, but in the case of Triple b downgrades, the threat is vastly overstated. “If you have a substantial downgrading of Triple B paper, you could have a negative performance impact of 60 basis points.”
47:33: Dan asks Marty about ETFs with heavy bond holdings, and Marty talks about the mechanisms these funds have for dealing with selloffs when they’re far more liquid than some of their holdings themselves.
58:48: Marty gives his opinion on the credit ratings agencies, and why he’s putting a spotlight on their accuracy against market ratings in a coming article.
1:15:40 Dan answers a mailbag question from Todd L., who subscribes to Extreme Value and asks about negative interest rates and a paper by the IMF centered on enabling interest rates – could 0% really be a boundary at all?
Voiceover: Broadcasting from Baltimore, Maryland and all around the world, you’re listening to the Stansberry Investor Hour. Tune in each Thursday on iTunes for the latest episodes of the Stansberry Investor Hour.
Sign up for the free show archive at InvestorHour.com. Here is your host, Dan Ferris.
Dan Ferris: Hello, and welcome to another episode of the Stansberry Investor Hour. I’m your host, Dan Ferris. I’m also the editor of Extreme Value, a value investing service published by Stansberry Research.
All right. Let’s get to it. OK, the last two rants, last week and the week before, they were on the same topic, and I’m going to stick with that one more time.
I got one more thing to add, and what I did was I showed you a few historical examples of how Wall Street turns conservative investment vehicles into dangerous toxic waste, and we talked about you recall the investment trust of the 1920’s, mortgage-backed securities of the housing bubble, and then last week we added the mutual funds of the 1960’s era.
OK, all three of those things came out of conservative traditions of investment and they were transformed in a big boom period into dangerous, leveraged, risky instruments that led many, many investors to big losses.
In both of the last two rants, I offered the negative-yielding sovereign debt phenomenon of the current age as the best current example. Right, there’s – at this point, I think it’s like 16.5 trillion of negative-yielding debt.
Almost all of it is sovereign debt, although now there’s a trillion of corporate debt in the world that’s negative-yielding, as well, but most of it is sovereign debt, right.
So sovereign debt is supposed to be this really safe stuff, right. Government bonds from big developed Western countries, and yet now it’s been turned into toxic waste.
OK, but that’s not the only example. OK, that’s my message this week. That’s not the only example of the current age, may not even be the very best.
I mean all the examples are pretty good, so picking a best one is tough. OK, another example, I mean essentially sound, you know, relatively safe proposition that is now bordering on toxic waste is the overwhelming move over the last decade or two towards so-called passive investing.
Now recently, Kirill Sokolov and the folks at his firm, 13D Research reported that passive investment strategies now control 60% of U.S. equity assets, and quantitative funds control 20% of U.S. equity assets.
This is according to a J.P. Morgan report that they were reporting about, and it’s 80% total combined control of the stock market by passive funds and quant funds.
So Black Rock and Vanguard are the big you know, ETF and index fund sellers, and they have more than 12 trillion, with a T, trillion of combined assets under management.
So because of this, 13D says quote, “The U.S. equity market has proven more susceptible to herd behavior. It has grown more at risk of falling into liquidity traps, and it has seen safe havens quickly turn into danger zones,” end quote.
That’s what I’ve been telling you, man, safe havens are turning into danger zones. It’s perverse. So the question is so what happens when all these passive and quant funds want to sell, all at once?
Right, 13D points out that you know, we’ve never had this situation before, and this has never – we’ve never gone through a recession with this in place, with the equity market controlled by these funds that kind of sell, based on some mostly pretty simple rules in the case of the passive funds, right.
The rules of the passive funds are we get a dollar of assets in and we buy a dollar of equities. You want to take a dollar of assets out, we sell a dollar of equities, right, and you know, however fast you need that to happen, then we’ll try to do it.
The question here is like what happens when they sell? Yeah, well you know, maybe we get a moment like 1987 when the Dow Jones Industrial’s average fell 22% in one day.
It can happen. Those things can happen. I pointed out plenty of examples of that. Facebook and a couple of other things just lost huge market cap [snapping fingers] just like that, drop of a hat.
Another example of a relatively safer kind of thing that’s been turned into what I would call toxic waste, or at least it’s a lot more risky than it used to be.
Right, that’s what I’m really saying here. Bonds are supposed to be safer than stocks, but what happens when you put them into an ETF, right? I mean it’s supposed to be safer.
Debt is higher in the equity. It’s higher than equity in the capital structure of a business. OK, that means that you know if the company is in bankruptcy or needs to be liquidated or something, the bond investors get paid first, and a lot of the bond investors are made whole.
They get 100% of what they put in where – you know and pretty much all the bond investors get paid something, but the equity investors get wiped out, zero, nothing. Right, so that’s why equity is generally speaking riskier than bonds.
So bonds are supposed to be boring and safe, right. Bonds are boring. You know, at least that’s how I’m certain many, many investors think of them, you know, for pretty decent reasons, but I think it changes when you put the bonds into an ETF.
Bond ETF’s are potentially dangerous, simply because bonds are not as liquid as stocks. Right, liquidity, what’s liquidity? It’s the ease of buying and selling without affecting the price too much. That’s it. That’s liquidity.
Right, how quick can you sell the thing without making the price move, and if you can sell it instantly and the price doesn’t move at all, that’s highly-liquid, right. That’s cash.
Right, you know, bonds should be in – generally in the same category. Most bonds today are actually not in that category but they need to be in that category if you’re going to sell them out of an ETF, right.
If somebody says – and we had a past guest, Adam Schwartz of the Black Bear value fund. He talked about this in Episode 81. What happens if the – you know bond ETF’s are sold off in a big hurry.
You know, if money needs to flow out of them in a big hurry. Well, that means you know that they’re going to have to sell bonds to give investors cash.
Now mostly, these things just trade back and forth, right. So it would take like an institutional investor, you know, somebody coming in and saying you know, get us out of – your boss comes in and says, "Get us out of this junk bond ETF" or whatever it is, and then you say, "Yes, sir," and then you wind up having to – you’ve got so much of it, you’d crash the market. So you go to the authorized participants, they call them, and you try to redeem your ETF shares.
Right, so they sell bonds, give you cash, basically. There’s a couple more steps to it than that, but that’s it. So you know if big insurance companies and pension funds, you know if they all decide they need to get out of high-yield bonds right away, and they do these things as a herd anyway, right?
They all get in and get out at the same time. Pension funds are notorious for that. They wait until – you know they’re the fools who get in at the end, right.
The wise man – what the wise man does in the beginning, the fool does in the end, Warren Buffet likes to say, and pension funds are always the fool. They’re always getting in last and then trying to get out.
And so if they sell these bond ETF’s, man, it could get really, really ugly, and like I said, episode 81, we talked with Adam Schwartz and he told us all about that.
And this reminds me kind of when the auction rate securities market blew up during the financial crisis, auction rate securities, those were like corporate and municipal debt instruments, and the interest rates on them were set at these auctions every – it was like every seven, 14, 28, 35 days, like that, and they were marketed as suitable alternatives to cash-like instruments.
Like you know it was like they were saying, "Hey, this is just like a money market fund but you can get a higher yield on it." Right, typical, yield-chasing behavior at the end of the cycle got people in trouble, and Wall Street, you know, Goldman Sachs basically invented these things in the 1980’s.
Of course, Goldman Sachs, one of the all-time great purveyors of toxic waste played a role in all the major toxic waste meltdowns. Right, investment trusts, mutual funds, all the things that we’ve talked about, mortgage-backed securities and you know, the folks who sold these securities were supposed to act as bidders of last resort, right, that they were running the auctions, you know, people like Citigroup, UBS, Morgan Stanley, Merrill Lynch, you know, they sold you securities and then they said, "Well, we’ll act as the bidders of last resort."
You know, we’ll bid on them at these auctions but they didn’t guarantee. That was part of the problem. They didn’t really disclose to investors exactly how dangerous this garbage was.
They didn’t say, "Hey, by the way, if there’s a crisis, we’re going to stop bidding on this stuff," and God only knows what the interest rate really will be.
You know, and some municipalities wound up paying like 20%. You imagine, being you know like a city or a state or something, and having to pay 20% on your bonds because Morgan Stanley said, "No, we’re not bidding on this stuff this week, because you know, the world is falling apart."
So you know, various occasions starting February 2008, the auctions failed. It was a total disaster and I think the bond ETF’s might represent a similar thing where you know, you got this big pile of bonds that you need to get rid of, and nobody wants them, and you know, the way this works is like there’s five or six dealers for these things.
You call the first one and he says, "Well I don’t know what the price should be," and then the first one calls the second one, and the second one says, "Hold on, let me call the third one."
The third one calls the fourth one, and then they’re back around to the first one. You know, so there could be – this could be also a liquidity trap like the 13D folks were talking about with passive investment vehicles and quant funds.
So Wall Street has done it again with index funds and ETF’s and things, and they’ve also got central banks, you know, we’ve got them playing an even bigger game, debasing currencies and turning safe sovereign bonds into toxic waste through negative interest rates.
So call me overly-bearish if you must but I can’t imagine this stuff all works itself out in a wonderful way without hurting a lot of people. So you know, what should I do?
Worry about being too early with my warnings? I don’t think so. I don’t think that’s the right thing for me, and I found this wonderful quote in a book called A Demon of Our Own Design by a guy named Richard Bookstaber, who I really would love to have on the program, Richard, if you’re out there.
And in A Demon of Our Own Design he says, “In most fields, the evolution of engineering reduces risk. We learn from our successes and failures, and year by year end up with safer bridges and buildings, and cars and airplanes.”
“This does not seem to be the case for engineering in the financial markets. The results of financial engineering, the increasing sophistication of markets, the complexity and the speed with which markets unfold and propagate seem to be taking us in the wrong direction,” end quote.
Wall Street and central banks are taking you and me, and everyone else involved in stock and bond markets, and anything related to them in the wrong direction.
It’s arguments like these that can cause people to make drastic, drastic mistakes. You know, these – the idea that this is all OK can cause us all to make a horrible mistake.
The idea that these are still safe instruments will cause you to make horrible, horrible mistakes.
Now another mistake you can make from listening to an argument like this is you know, you sell everything and head for the hills but I’ve never said to do that, have I? I don’t say to do that.
As long as you stay calm and you don’t do anything crazy, you ought to be fine over the long term, and I’ve said many times you should hold plenty of cash, buy gold and silver, and you know if you want to own stocks, own good businesses, bought at reasonable prices, and that should work out well over the long term, and know yourself as an investor, right.
That’s the point of all this is pointing to risks, and then you’ve gotta look back at yourself and realistically project forward, and say, "How would I behave if the doo-doo really hits the fan," and you have to recognize that human beings are really bad at making that assessment.
They say, "I’ll be fine" and they won’t be, because we all have uncle points, a point at which the pain is so bad you cry uncle, uncle, I can’t take it anymore and you have to sell, and you know then you lose a lot of money and you lock in your losses, which is why at Stansberry we always recommend, everybody recommends using trailing stops.
Basically what that does is it takes you out long before you get to that horrible uncle point. So instead of being down, you know, 80%, you’re only down 20 or 25%, or something.
You know, but overall, what I’m trying to do with many of these rants like this one and the previous two, I just think that it’s time. It’s time to talk about the history of bubbles, and panics and crashes, and take from it what we can, and compare it, compare the past to the present.
You know, find out how similar things worked out in the past. That’s why I’m talking about all these things where Wall Street turned it to toxic waste, because nobody thought it was toxic waste while everybody was buying it hand over fist.
It was only later on, after everybody got wiped out that aw geez, that was a really bad idea, wasn’t it.
So I’m going to keep – this is the time to look at history and do this exercise and I’m going to – you know I’m going to do this until things change. Hopefully, one day, not too many years from now, I will switch gears.
The market will be down, you know, 40, 50, 60%, whatever it is, and I’ll mostly be talking about the benefits of buying equities on the cheap.
Right, the time for talk of bubbles and panics will be over, and it’ll be over right when absolutely everyone on Earth has trouble talking about anything else [laughter.]
Right, that’s when Dan is going to start talking about buying stocks, when nobody on Earth thinks it’s a good idea to own them, and then you know, then we’ll have all our value investor guests back on, you know.
Maybe we’ll have one giant program with everybody on, and we’ll give all our best ideas when the market’s down 50, 60%. So until then, you know what to expect from me.
There’s a lot of risk out there. There’s all this stuff that’s been turned into toxic waste. None of this has ever happened before. We’ve never had 80% of the market controlled by passive and quant funds.
We’ve never had negative-yielding – you know, 16 trillion of negative-yielding bonds, a trillion of negative-yielding corporate debt. These conditions have never existed. We don’t know how it turns out.
Just from a common sense viewpoint of being a securities analyst who doesn’t want to overpay, negative-yielding debt means everybody’s overpaying for it, and we’ll talk more about negative-yielding debt in the mailbag today.
I got a lot of e-mails about that, so we’re not done with that topic for today, but that’s the rant. Write in to [email protected] if you have any comments or questions about it and we’ll be talking more about this, but that’s really – I think that’s my three-parter on the history of toxic waste and the situation today.
So next week, I’ll turn in another direction and we’ll talk about something else. For now, let’s find out what in the world is new.
OK, it’s time to find out what’s new in the world this week, and of course, what else would be new? What’s new almost every other week is you know, Elon Musk.
There’s actually an article about Elon Musk in Vanity Fair, and the title of this is – I mean they’re probably going to bleep out the title but I have to read the title to you of this article in Vanity Fair.
It’s called "'He’s Full of Shit'": How Elon Musk Fooled Investors, Bilked Taxpayers, and Gambled Tesla to Save SolarCity", and it’s written by Bethany McLean. I don’t know if you remember who she is.
She wrote a really good book about Enron called The Smartest Guys in The Room, which later got made into a movie, and you know, it’s kind of like the book about the Enron crisis. She did a great job of covering it, and now she’s like kind of after Elon Musk and Tesla.
And the title refers to – part of the article involves a former Tesla solar plant employee at the Tesla solar plant in Buffalo, New York, and this fellow’s name is Dennis Scott, and he tweeted. He went on Twitter and he showed – he posted a picture of Elon Musk holding something that looked sort of like a machine gun, OK, on Twitter and he tweeted. He said if I were CEO and someone told me my company wasn’t working right, I wouldn’t be clowning around. I’ve got people counting on me for their livelihood.
And you know, that was the comment that he made on Twitter. So a couple hours later, this guy is at home and his phone rings, and the voice on the other end of the line says it’s the clown.
Elon Musk called him up and they – you know they had a conversation, and this guy has a lot of concerns that are – some of which are dealt with in the article, like for example I didn’t know that SolarCity took $750 million, like the lion’s share of a billion dollar program that the State of New York was offering.
They took this money from the State of New York and you know, part of their promise was well, we’re going to employ 1,460 people at the plant here in Buffalo, and Buffalo you know, McLean does a pretty good job of showing that Buffalo is you know, not what it used to be.
Right, it’s sort of a – she represents it as a – you know, kind of a hollowed-out hulk of an older time when there were steel plants and other things that are no longer in operation.
But – so you know, Buffalo needs it, right, and they thought they were going to get some stimulus from Elon Musk but there are like 329 people working in this plant today, maybe 328 because Dennis Scott was fired.
I don’t know when he was fired but so there aren’t – you know they haven’t really kept their promise, and Dennis Scott along with Bethany McLean and other folks want to know what happened to the money, and Elon Musk is – he’s a strange guy and he’s obviously engaged in a lot of goofy behavior.
The article goes into some substantial detail about you know what of course is basically the bail-out of SolarCity at the hands of Tesla shareholders. I mean it’s the most self-serving ego-gratifying sort of a deal.
Obviously, you know if you have this company, SolarCity, that’s going bad, and then you’ve got another company where things were going somewhat better and you use that company to buy out the one where things aren’t going well, it just looks really bad and you have to wonder like where was the – where was the Tesla Board while this was happening? I mean just – it just doesn’t look right and you know, now the article deals with SolarCity sort of needing a bail-out because it’s not doing so well.
And even before the acquisition, like Goldman Sachs said it was like the worst play in the growth of the solar market. It does – you know, none of this stuff surprises me, and I think one day, like we’re going to look back at all of this and we’re going to feel so fooled by Elon Musk.
You know one of his – they quoted one of his board members in the article saying that you know he’s just – he’s a master of the universe. You know, they’re just fawning over this guy and I just don’t think that’s the right way to behave towards anyone.
You know, you should never – you should never be – you should never fall in love. You should never fall in love with an Elon Musk or you know, a hero. You shouldn’t engage in hero worship as an investor, and that’s what’s happened with Elon Musk.
He’s just got all these big projects going, and everybody thinks he’s a genius and he’s changing the world and doing great things, and the simple fact is he’s lighting money on fire, and people are going to lose a lot of money.
Ugh, Elon Musk, I mean it’s like for somebody like me it’s the gift that keeps on giving. I could just call it the Elon Musk news every week, you know [laughter] and the Tesla news or the SolarCity news or the – you know who knows what’s going to happen with Space-X.
I mean cross your fingers that nobody gets killed by one of these rockets, and apparently from what I hear, people who know a lot more than I do about rockets say that he’s done some pretty cool – Space-X has done some pretty cool things with rockets that NASA never did.
So you know, I wish this guy no ill. I don’t wish him harm but his behavior I think is bad for investors. I think the outcome is going to be bad.
Another outcome that I’ve said – expected to be bad, despite the fact that the stock is up 500% or thereabouts is a company called Beyond Meat. They make these products that are made out of pea protein, right, peas, like peas in a pod, pea protein and they use it to make things that allegedly look and taste like beef, and chicken, and sausage and stuff, and various companies have come out and said they’re going to use these products. The latest one is KFC. They’re planning a test of the Beyond Chicken product, and the parent company is Yum! Brands.
They own KFC and Yum! Brands says they’ll test the plant-based chicken item made by Beyond Meat in Atlanta. They’ll test it in Atlanta, look at customer feedback, and then they’ll use that feedback to determine whether or not they want to go ahead, and you know, roll the product out all over the country, all over the world, wherever, and you’ll be able to get it as a – it’ll be like a chicken nugget, a Beyond chicken nugget, or a Beyond chicken boneless wing.
Now the word "wing" has no meaning to me because there ain’t no wings on a pea plant, right [laughter.] So it’s a – I assume the preparation will be similar to you know like a Buffalo wing, or just a fried chicken wing, or however you prepare wings. That’s what I’m taking from that.
I mean, again, I wish this company no ill will but it just sounds a little crazy, and there’s really no reason to suspect that – the dynamics are similar to Tesla, right.
There’s no reason to suspect that dozens and dozens of other, larger, much more established and profitable food companies won’t be all over this and make their own version of it, right.
So there should be a lot of competition coming out of the woodwork any minute, if this stuff really takes off with customers, and the good thing is those profitable companies can wait.
Right, this is the old innovator’s dilemma: they come out in the market with a new product, maybe they don’t make any money with it, but it turns out to be not a bad idea, and then you know, a bunch of other people pick it up and run with it, and make a lot of money off of it.
Once again, you know, you can afford – there is this idea like people feel – always feel like they need to get in. They need to hurry into the market, and you just about never, ever do.
You can always wait. Sure, Beyond Meat is up 500% but if they don’t stop lighting money on fire, if they don’t start actually making money, which they’re not doing yet, you know, that 500% gain is going to turn into a 50, or 60, or more percent loss, and maybe there won’t even be a Beyond Meat company eventually, or maybe somebody will buy them when they’re – you know, 90% cheaper than here. That would be really typical. So you just have to be careful.
Now that really is it for the news this week. There’s a bunch of other stuff I could talk about. Big surprise. Argentina’s facing billons in losses in another default of their debt, and you know they’ve had bail-outs, like tens of billions of dollars in bail-outs less than a year ago, and they have like a 5 billion dollar payment due next month, which you know, who knows if they’ll actually be able to pay it.
None of that is a big surprise to me. I think – you know maybe I’m looking at the stereotype instead of really doing the work of an analyst, but you know when you mention a country like Argentina and you tell me that they’re facing the default, it’s like I don’t even bat an eye.
So I don’t even know if that qualifies as news, right, but that’s the news for this week. Let’s get on with our interview.
OK, it’s time for our interview this week. This week’s guest is Marty Fridson. Marty Fridson is the Chief Investment Officer at Lehmann, Livian and Fridson Advisors, an SEC registered investment advisor, and a widely-respected fixed income analyst.
He is one of Wall Street’s most thoughtful and perceptive analysts. In 2000, Marty became the youngest person ever inducted into the Fixed Income Analyst Society Hall of Fame.
The Financial Management Association named him its Financial Executive of the Year in 2002. He’s been dubbed the Dean of the high-yield bond market, in conjunction with being voted to the Institutional Investors All-America Research Team.
In 2013, he served as Special Assistant to the Director for Deferred Compensation in the Office of Management and Budget in New York City; a respected author, Marty has been ranked in the top 10 most widely-published authors in finance from 1990 to 2001.
In 2000, the Green Magazine called Fridson’s Financial Statement Analysis, a Practitioner’s Guide, quote, “One of the most useful investment books ever,” end quote. I totally agree. It’s a great book.
The Boston Globe said his 2006 book, Unwarranted Intrusions: The Case Against Government Intervention in the Marketplace should be short-listed for best business book of the decade. Welcome, Marty Fridson, thank you for being here, sir.
Marty Fridson: It’s terrific to be back.
Dan Ferris: So Marty, I would like to start by asking when in your life you were bit by the finance bug. Did it happen like before college, or after, or when you were a child, or later on?
Marty Fridson: Yeah, I did get some exposure as a child at – was something my dad gave to me. I remember getting a share of Lear Siegler common stock as a birthday present, one year.
Yeah, my father was very interested in the financial markets and taught me some of the basics of it. I really though, I have to say that I wasn’t expecting to go into this field right up until I did an MBA, but had an invitation to interview with one of the – what they used to call boutique research firms back in those days, and I really got turned on by that meeting and got very interested in getting into this field.
So I kind of – I guess I was a late bloomer compared to a lot of people from the field but I really became very, very focused on it after that.
Dan Ferris: That’s cool. Marty, I have to tell you, I really like your book, Financial Statement Analysis. It’s one of the books that, especially just reading like the whole first portion of it.
It’s one of the books that kind of helped me see things in a more realistic light, and especially there’s this one quote that I have to read.
I never heard anybody say anything like this before I read it in your book. It said the purpose of financial reporting is to obtain cheap capital.
And you know all the other authors say very high-minded-sounding things like you know, the purpose of financial reporting is to elucidate the condition of the business and all this stuff.
But you spent actually a fair amount of ink in the book saying the opposite, that the purpose, that most of them use financial statements to conceal it. Do you still feel that way?
Marty Fridson: Oh yeah, that’s absolutely right, and we’ll see what happens with this current development at General Electric. Harry Markopolos who was credited with exposing the fraud at the Madoff operation has clearly devoted a lot of time.
I would say about General Electric that it remains to be seen whether his claims of really fraudulent reporting will ultimately be vindicated, but General Electric, I have to say is – it’s not a surprise, if you ask me of all the companies out there, which one might become subject to these kind of accusations.
Not a total surprise because they have clearly been for a long time involved in aggressive financial tactics, and that’s a big part of what the book talks about.
It’s not all fraudulent but you know, as people said that the real scandal is often what turns out to have been legal, and there’s a lot of deceptive financial reporting that is legal but misleading, and you have to be wary of as an investor, and the big part of that is discretionary financial choices, having to do with accruals.
And I don’t want to get overly technical about this, but there is a lot of discretion, more so than I think many people realize and the result at – you know General Electric, executives there were quite open about the fact that if they were not making their numbers into the quarter, they would make an acquisition which would enable them under certain rules to count the revenues of the acquired operation for the full quarter, which was certainly not an accurate representation of what went on.
So if that was allowed, and you know is not breaking any laws, you have to wonder what else might have been going on as well. So it really is a very rich field.
The good news is that for all the criticism of the Sarbanes-Oxley Act which came in, in 2002, it has clamped down very dramatically on outright financial fraud in the United States, because now the Chief Investment – the Chief Executive Officer has to sign off on the financial statements, and if there turns out to be fraud, that CEO will go to prison, and that’s a big change from the past.
In the past, the CEO was able to blame some lower-level person and kind of get away with it, and since that change went in, we’ve had very few egregious cases of financial reporting fraud in the U.S.
There’s still plenty of opportunity outside the U.S. for people looking to short-sell on that basis.
Dan Ferris: It’s interesting to me that you mentioned that a lot of this stuff is legal and they’re just kind of pushing it to the limit. Of course, that reminds me of Enron, you know or Andrew Faust later on. Of course he came out and said that’s what we were trying to do.
We were trying to push the law and the rules right to the limit, and of course they went beyond in some cases, but do you think that – you know Markopolos says GE is bigger than Enron. Do – are you willing to weigh in on that, at all?
Marty Fridson: Well I think if what he – if what he says is correct and if it’s born out, then yeah, you’ve got a very huge enterprise there, and yeah, I mean the repercussions potentially would be greater.
I mean I can remember very distinctly seeing – it come across the tape, there was a $60 billion fraud in Madoff, and we all did a double-take.
You know, we had no idea that there was anything of that scale going on. I mean I was generally familiar with Madoff but he was certainly not known to the extent that General Electric is, you know, as a real cornerstone of American industry.
So yeah, we could be talking about something very big here, and Markopolos talks specifically about reserves in the insurance business, where again there is a lot of discretion, a lot of judgment involved.
And you know, often you can get the auditors to sign off on things that are certainly pushing the limits, and you know, so it is kind of choppy when you delve into it and discover what is permissible, and which you know, subsequently gets reversed in restatements, and you know it really is staggering.
And you know, what the companies were trying to present is that their earnings go up on a nice, steady basis, quarter by quarter. If you run a business, you know that’s not the way it is.
So it’s really financial reporting tricks in many of that, most cases that maintain that illusion of very steady growth, as opposed to what might be very fine and you know, legitimate growth in earnings, over time.
But the demands of investors to see a very steady progression, quarter to quarter, year to year, are unrealistic but companies are willing to take those steps, make those aggressive accounting assumptions in order to satisfy that unrealistic demand.
Dan Ferris: Yeah, I think it’s perverse that in the attempt to make things seem safe and steady, they turn them into toxic waste.
Marty Fridson: Yeah, yeah.
Dan Ferris: It’s perverse, but I’m glad you brought up GE though, because GE is a big topic. It can go in a lot of directions, and you and I e-mailed a little bit about one topic that I think you can shed a lot of light on, and I’ve heard investors ask, you know, maybe GE is the kind of last straw that will tip over some of the debt that’s rated Triple B, and there’s a lot of Triple B rated debt.
It’s the lowest investment grade rating, and the belief among some people today is that a lot of it should really be rated, you know as non-investment grade, essentially as junk debt, and that that re – you know re-assessment in the marketplace of that will cause a big dislocation.
You have some thoughts about this, do you not, that are different from what I’m hearing from other folks. I’d really like to hear you about this.
Marty Fridson: Yeah, I don’t want to come across as a Pollyanna. There is a lot of Triple-B debt. It currently accounts for almost exactly 50%of the investment grade corporate market.
Prior to the great recession that was running about 38%, some of the comparisons that are made are between the low point, and during the Great Recession where that percentage dropped to 33%.
So I was going to say when – in just a few years, from one-third to one-half of the corporate market, that sounds a little bit more extreme than the change that has gone on.
But their – you know the story, I could elaborate a little bit on what you said that kind of sets the ground for what I want to say about it is that two problems: one is that if you’re an investor in the investment grade, you know, Triple-B paper and it gets down-graded to below investment grade, there is – it’ll fall like a rock because institutions in many cases are forbidden from holding paper that’s rated less than investment grade, and in fact, they’ll engage in a fire sale, and that paper will – those bonds will drop very drastically, rather than smoothly into the next category of Double-B, you know, which there is an active market, and under ordinary course, those will trade cheaper at a higher yield that is than the Triple-B issues, but it’s not completely falling off a cliff.
And you know, as it goes from – as the paper goes from Double-A to Single-A, or from Single-A to Triple-B, again, you tend to see a reasonably smooth transition to the lower price levels.
Now the other problem that’s talked about is for the investors in the high-yield, unfortunately often referred to as junk bonds rated Double-B or below.
And they say well, here is this gigantic supply because of course the investment grade market is much bigger, and if 50% of it is Triple-B, and a substantial part of that gets downgraded to Double-B, how will the high-yield or speculative grade market possibly be able to absorb all that new supply.
So the high-yield market will sink drastically under those certain chances. So let me just point out a couple of things about this. Contrary to popular belief, the – it’s not the case that all regulated institutions are not able to own paper rated less than Triple-B.
The really huge part of the institutional investment universe is pension funds, which are ruled by the prudent man rule, essentially saying they have to use good judgment in selecting the securities.
There’s no Federal legislation in the Arista law saying there’s a minimum of Triple-B. I once called up the five largest pension plan sponsors in the United States and asked them what do you do if a bond gets downgraded from Triple-B to Double-B, and they universally, unanimously said, "Well, the worst thing we could do would be to sell that fist day when it’s been down-graded, because that really will be a fire sale. That’s going to be shooting ourselves in the foot."
Now if we have a manager with a mandate to manage investment grade bonds, we do say to that manager over a reasonable period of time, move out of that because your portfolio should consist of investment grade bonds, but certainly don’t sell it at a time when everybody else is selling, and we’re going to get hurt very badly.
And you mentioned my experience in 2013 with the City of New York’s defined contribution plan, and they at that time, decided to put a portion of their investment into speculative grade bonds, and I raised this very issue to say that – or I’m sorry, this was dealing with their investment grade corporate bonds, and that they were looking at the rules on, and I raised this point about you don’t want to hurt yourself by putting in a very rigid rule about selling if a bond gets down-graded.
And they agreed and put in a sort of a timeframe which – of several months within which the downgraded bond, the so-called fallen angel is another term for these bonds that drop from Triple-B to Double-B, and so they put in a time frame but it was not sell instantly and hurt ourselves in the process.
The – and by the way life insurance companies similarly, perfectly fine for them to own debt rated less than investment grade. They are reserving issues.
They – it affects the reserves they have to hold, but believe a very large portion of the invest – subinvestment grades of high-yield debt outstanding is owned by life insurance companies that need the yield in order to make a profit over their cost of funds.
So first of all, that fire sale story is somewhat overstated. On the high-yield side the – you know there is sort of a natural, built-in market in the – through the closet indexes.
These are managers who unfortunately are telling you that they’re actively managing your portfolio and charging you a fee that represents that, but in reality, are plugging the index very closely, so is – in order to avoid possibly under-performing the index by a substantial amount.
It’s not feasible to buy the entire high-yield universe. Many of those issues are highly illiquid but they will create a portfolio, maybe even a couple of hundred issues but -- that will closely reflect what’s in the index.
They’re not going to out-perform the index substantially with that kind of portfolio but they will avoid losing clients by substantially underperforming.
Marty Fridson (cont): They really should be, if they’re doing that, they should be charging you something closer to a pass advantagement fee. But of course, they’re not publicizing the fact that in fact, they’re staying very close to the index. Well, those investors, if you were to get an issue like General Electric, or one of the other very large triple B issuers downgraded, that would represent a substantial portion of the high-yield outstandings.
And for them to have a zero weighting in one of those names would be a significant risk of underperforming if, in a particular period, one of those fallen angels happened to do extremely well. So you do have some built in demand, kind of unofficially but in reality there are some buyers.
So the bottom line is, I don’t dismiss this issue. I have done some research, some analysis and concluded that over, when you get into a recession, if you have a substantial downgrading of triple B paper, you could have a negative performance impact of about I estimate it at 60 basis points or six tenths of 1%, whatever else is going on.
Because if you’re in a recession or going into a recession, you're probably going to have some negative performance even aside from this the triple B downgradings. So it’s not a, you know, completely nonexistent effect or necessarily even completely negligible effect. But I think some of the stories that are getting written are a little bit loose.
The media tends to love the world coming to an end kinds of stories, and unfortunately some of the market pundits like that as well. Because it’s their chance to be able to come back after the disaster and say see, I told you so. This burnishes my reputation.
Of course, if it doesn’t happen they’re going to not mention that again. But, you know, it’s a story that’s great for the permabears if it works out as badly as they expect. But I don’t expect that it will work out in the kind of worst-case scenarios being presented.
Dan Ferris: OK, so there’s another source of hand-wringing in the bond market, and I wonder if you could sort of school us on that one. And that is, basically the simple fact that bond ETFs hold a bunch of bonds in them and the ETF itself tends to be more liquid than the bonds within them.
And you know, the argument goes that if lots of money goes out, you know, tries to run out of these ETFs, selling those bonds to give investors cash would be, you know, would cause a lot of people to lose money in bonds. What do you think of that situation? Is that a real problem?
Marty Fridson: Well, there’s a lot of debate about that. The managers of the ETFs have presented data, done studies, argued against that scenario. You know, it hasn’t completely been tested yet in the sense of prior to the Great Recession, the amount of bond ETFs outstanding was fairly small. There’s been tremendous growth since then.
So really it’s the next recession, whenever that occurs, that will have the real test of that. You know, we’ll have sell-offs from time to time. They’re selling, as a combination of selling and the ETFs, you know, exchanging shares. They have mechanisms to deal with that with large institutional investors that they believe will curb some of the impact of that.
The real test is when we get into a full blown recession, you know, bear market, which may, if somewhat, anticipate the official start of the recession. How much selling will occur and how difficult that will be to absorb. But the difficulty there is that it’s always a very harsh set of conditions when you get into that you know, situation where credit quality is falling, where the speculative of grade default rate is likely to escalate sharply.
The rate of downgrading of the investment grade, corporate bonds, is likely to accelerate. And you see selling in response or in anticipation of those effects. So it’s going to be difficult even after the fact to separate the effects of the you know, these liquidations in ETFs from just the normal bear market effects. And unfortunately, I think there will be people saying see, we told you so. Prices are going down just like we said it would as a result of the ETFs.
Well, they would have gone down anyway when you get into a situation where people can clearly see that the GDP is declining or going to decline a short period. They fly to safety in every cycle, and they did that long before ETFs were even on the horizon. So you know, I think it’s one of those things that may wind up aggravating, making the situation somewhat worse than it would have been otherwise.
Again, I don’t, I don’t tend to believe that we’re looking at a you know, totally catastrophic scenario where you see bond price declines far worse than we’ve seen in previous cycles. And particularly since the most recent recession was by many measures the worst economic downturn in the U.S. since the Great Depression of the 1930’s, I don’t think we’re likely to see even with the ETF in fact a replication of the 2008 to the first half of 2009 experience, because I don’t expect this downturn to be associated with a global banking crisis as we saw the last time.
And that makes a huge difference. You can have a recession without having the prospects of major banks in large numbers failing and getting to the point where they’re afraid even to lend overnight to other banks because they could suddenly fail. I don’t think we’re looking at that scenario again in this next recession, whenever it may begin.
Dan Ferris: OK, one thing I know you pay a lot of attention to, Marty, and I’ve seen you in presentations discuss this in detail, is default rates. Where are we, historically speaking, where are we right now and what’s the outlook from here?
Marty Fridson: Yeah, right now would be expected an expansion. We are at a below average rate. Trailing 12 months, basis Moody’s for U.S. speculative grade debt on a percentage of issuers basis. And I specify all that because you see various kinds of numbers thrown about.
But this is specifically the percentage of issuers rated double B or below and not already in default that were in the universe 12 months ago. You know, what percentage of those have failed on an interest or principal payment or engaged in a distressed exchange offer where in effect they avoid it. Those two things have failure of payments.
But they did that by getting investors to accept a substantial reduction in their terms. Either the interest rate or the principal amount that they’ll eventually get at you know, at maturity. So on a trailing 12 months basis that’s at 3%, Moody’s projects 3.2% under their base case scenario.
To their credit, they publish an optimistic and a pessimistic scenario as well in case the more or less consensus economic forecast that’s built into their base case turns out to be wrong. And if the economy turns out to be worse then the default rate will be higher. But I think that that 3.2%, now, and that compares with an average of about 4.5%.
The average has been hit in almost no years. It’s really the midpoint between the level that you see during expansion such as we’re in currently and the much higher rates, typically getting into the low double digits that you see in a recession. So it averages out.
Of course there are more expansion years and recession years. But when you average out all those years, it comes to about 4.5%. But you very rarely see a year where it’s 4.5%. And you know, I think the, so the projections for the next 12 months are realistic. As far as the other question to ask is, where will we be in the peak of the next cycle, of the current cycle when we get into recession and default rates do go up to typically around a low double digit kind of a number.
The good news there is that the, again I don’t think we’ll see the kind of peaks that we saw on a trailing 12 months basis. You got up actually into the mid-teens as a peak in the Great Recession. I don’t think we’ll see a peak as high as that, because that is affected by the severity of the recession, and we’re more likely to see a recession on the order of the 1990-91 or the 2001 recession, where the default rates were not as high at the peak as in the 2008-2009 recession.
And the positive news there is that on the brink of that Great Recession, December 31 2007, the percent, the portion of the index, this is measured on percentage of bond issues rather than issuers. But, that, 24% of those issues on December 31, 2007, were rated in the triple C category or lower. And we can get into if you want a discussion about the rating of these.
But one thing you can say is that you do not see bonds rated triple A going into default in the corporate sector. They almost invariably have bonds rated down into triple C and possibly even the double C category by the time they finally default. So, you had 24% in the category that essentially accounts for you know, the defaults that occur. And currently, that is only 14% in that category.
So we’ve actually seen improvement and we’ve seen improvement year by year for the last few years, although not going all the way back to 2007. But just the last few years, in that ratings mix within the universe. So, that’s a positive sign. It would be much more worrisome if we were seeing, as a result of the ongoing expansion, a tendency for investors to get more and more confident, have less and less of a sort of institutional memory of how bad it got during even previous recessions, not to mention the very severe recession of 07-08.
And in those circumstances, you could see the ratings mix getting worse. You know, more and more risk being taken. And that would lead to a higher expected peak default rate. But in fact we’ve seen the opposite happening over the last few years.
Dan Ferris: So, Marty, you mentioned the ratings agencies. I know this is an enormous topic. You know, I always, I wonder about these businesses. Obviously somebody needs to do that job. Investors need to know, you know, in general what’s, you know, what’s a safer bond. What’s a more risky bond. What are the prospects of getting paid back, et cetera.
But when I looked at the ratings agencies, it seems like they, it’s almost like they’re an amplifier of the cycle, you know? They’re never acting to counteract the cycle. They’re always pushing it in whatever direction it’s going. That’s what it looks like to me. What do they look like to you, since you're actually in the business and know them a lot better than I ever will. What do you think of the ratings agencies?
Marty Fridson: Well, again, it is a huge topic. As far as accelerating it, you know, hard to avoid the effect you’re describing in that you know, credit quality is declining. Prices are falling. And the credits are genuinely getting riskier and more prone to the fall. They really don’t have much choice but to lower the ratings. You know, they try to be anticipatory in the ratings.
But you know, companies are at greater risk of default when we’re in the middle of a recession than they are in an expansion. So, and the investors by the way have expressed a preference for not having ratings move more you know, as a function of the business cycle. So their, at least I think it’s hard for the rating agencies to avoid the effect you’re describing.
It’s sort of an unfortunate fact that yeah, you’re getting a signal when things are already pretty bad that they’re getting worse, because default risk is rising. But I think that’s a reflection of the reality. So there are many other criticisms of rating agencies. Some you know well founded, some less so.
But you know, there’s not, it’s not much of a defense but you know also not much of an alternative to that amplification of fact. The, you know, I don’t have any horse in the race or any dog in the fight so to speak about the validity of ratings or not. I actually have an article that will be published soon in the Journal of Investment Management, looking at the question of you know, are the ratings of the agencies better or worse than the so-called market ratings.
Because you could, instead of looking at whether the bond is rated triple B, double B or what have you, instead look at how the market is evaluating it. Because the higher yield on a bond, the greater its risk of default. Which is also what the ratings are measuring. And you have overlap in yields among the rating categories.
So you have some triple B’s and kind of alluding to something you were saying earlier, people saying that a lot of those triple B’s in their view should be rated double B and part of the so-called junk universe. Well, the market is saying that in some cases. There are double B’s that yield less than some triple B’s. So you could argue that well, the rating agencies have it wrong. The market is right.
And what’s interesting to me, I think I’m the only one who’s pointed out the contradiction of a lot of the people who say that in the market. Saying well, who knows. The rating agencies are backward looking. They’re slow. They’ve only been doing this since 1909, so they don’t understand the credit quality very well. And the market is always right.
So if the market says it’s a triple D, and but it’s rated double B, I should be able to buy it for a portfolio that’s managed, that’s restricted to owning triple B or higher. You know, they should ignore the ratings and allow me to get this higher yielding issue that the market already views as a triple B.
Those same people will turn around after saying that the market is always right and you know, more right than the rating agencies. They will turn around and say we add value to you as an investor by buying bonds that the market has misvalued. Well, which is it? You know, is the market always right or is the market sometimes wrong.
And again, I’ve been saying this for years. I’ve never seen anyone else comment on this, but it just seems like an incredible contradiction for people to say it. So the article that I have coming up for the Journal of Investment Management addresses that question of the relative accuracy of the ratings versus the spreads.
And this is not, the ratings versus the yields assigned by the markets. This is an old topic. It’s been looked at in a couple of ways. Are the ratings or the market better at predicting defaults and estimating the probability of default for issues. And they also have looked at the issue of what I was referring to a moment ago.
Do the yields as shown in the market inevitably in effect upgrade a bond sooner than the rating agencies do. And the flaw in a lot of that research is they point to a lot of cases where a bond, still rated double B by the agency had a yield more in line with the triple B’s. What they don’t include in their analysis in many cases is the cases where a bond rated double B temporarily traded at a yield commensurate with a triple B rating and then sell back and sort of suggested that it should have been rated and viewed by the market as double B all along.
So it’s sort of a type two error to use a technical term. And unless you look at both cases, it’s really not a fair evaluation of the ratings versus the market yields. But the study that I’ve done with some colleagues, collaborators, shows that what is really most, more important than any of those, those other two issues, I believe to most investors is, you know, if I have a portfolio of corporate bonds, how much downside do I have in the event of a general decrease in credit quality.
Not just the particular issue that may fall out of bed for reasons having nothing to do with the overall economy but just loss of market share, product liability, so a variety of things that can affect that individual company. So if there’s a general decline, how much downside in price do I have in this portfolio? And it’s fair to ask, should I use bond ratings to assess that downside risk, or should I look at the spread of the bonds, or the yield. And I talk about spread, that’s the yield differential between a corporate bond and a treasury bond of the same maturity.
It’s another way of looking at the risk being associated with the bond or the risk assessment that’s made by the market of the bond. Well, I looked at this problem and I found that in fact, the yield on the bonds are a better way of a risk manager at an institutional investor making a judgment about the price downside in a bear market. And I think that’s taking nothing away.
It’s not a criticism of the rating agency. It’s because they say explicitly that their ratings are not meant to be market opinions. Or they’re not trying to say how much will the bonds go down before they recover, you know, when the bull market comes. They’re just saying, this is the rating that reflects our assessment of the issuer’s probability of default, and this particular issue’s expected recovery in the event of default. And that’s largely related to the standing in the capital structure.
Because if you’re a secured senior issuer, you generally recover more in the event of a bankruptcy than an unsecured holder and that unsecured holder will generally recover more than a subordinated bondholder. So, the ratings reflect both the probability of default and the loss given default. They do not attempt to say this bond is cheap or expensive based on the price that is being offered either at underwriting a new issue or in the secondary market.
Dan Ferris: OK, well then, Marty, let’s talk about that. Let’s talk about right now and we’re getting to the end of our time, so maybe this is what we can leave our listeners with. Is the high-yield market overall cheap or expensive or somewhere in between, and are there you know specific areas within it that are more attractive, from a valuation standpoint?
Marty Fridson: Yeah, great questions. First on the high-yield market as a whole, again, we look at that spread or the yield difference between the ice vis a vis Merrill Lynch U.S. high-yield index and treasury bonds. Of course that’s a lot of issues and a lot of different maturities involved. But I’ll translate into a figure known as option adjusted spread.
So that’s the difference between the yield on high-yield bonds and on treasuries. That was currently at 341 basis points, one basis point is one hundredth of a percent. So it’s 3.41 percentage points. The spread on the high-yield index as a whole is 425 basis points. Our, we do a fair value analysis based on the factors that historically drive that spread to cause it to be as low as 250 basis points and one point in history as over 2,000 basis points during the Great Recession.
We look at the factors that have influenced where that spread has been. By that analysis the spread should be much wider. Rather than 425 it should be 683 basis points currently. Which suggests that the market is very expensive relative to fair value. Now, the catch in that is that one of the factors that is affecting the spread over time has been quantitative easing.
Now that’s officially ended, but the Fed’s policy during the Great Recession of buying corporate bonds rather than operating just in the Treasury bill operation, they bought mortgage backed bonds and not corporates but mortgage backed bonds and Treasury longer dated bonds. And it could be argued that the effect of that is still being felt, because they still own a lot of the bonds they acquired in that effect.
It looked like toward the end of the year that they were getting away from that policy, but then they sort of reversed tracks and have now begun lowering interest rates again. If you take out the effect of quantitative easing, that apparent overvaluation is substantially reduced. By that measure, the fair value spread would be 534 basis points. And of course compared to 425, still an overvaluation.
So it says that the high-yield market is expensive at this point. Within that, so kind of very mixed message. Unusual in that the double B and single B or sort of medium to high quality paper within speculative grades is that a spread of 341 basis points versus a historical median of 412.
So that’s saying you know that the high end of the speculative grade market is saying the economy is going to hold up for a while, because the risk of default is less than it has been on average historically. Whereas the triple C and lower portion of the market has a spread of 1,068 basis points. The median historically before that is almost 100 basis points lower at 971.
So the low end of the speculative grade market is uh-oh, we ought to be worried about a recession because credit risk is likely to be rising. So you’re getting a very mixed message. It says that the better value is in the lower rated paper, but I can tell you that the comparative performance of the two sectors is not a function of the relative value at the beginning of the period. It’s whether the market goes up or down.
If you believe we’re in a good, good shape, the market will continue to perform well. A recession is well off, beyond a year from now. Then you should own the lower, overemphasize the lower rated paper within speculative grade. If you think we are facing substantial risk of recession within the next year, you should stick to that medium to higher quality double D to single D paper.
The other main way to look at segments within the market is the industries and you have one industry that stands out right now as being cheap relative to its ratings. If you compare the yields on the bonds in the homebuilders sector to other bonds of similarly rated, you’ll find that homebuilders are cheap to its ratings despite the fact that the rating agencies say that it’s improving industry.
The ratings are likely to go higher on this industry. It’s the only one right at the moment that currently has that characteristic. So there’s some good value to be seen there. The energy industry and the metals and mining are right at neutral. The ratings neither likely to go higher or lower on balance.
Individual issues may have a positive or a negative prospect. But the industry as a whole is neither going higher nor lower. But those industries also, particularly energy, trading much cheaper to its ratings than its peer group of other industries. There’s a lot of volatility. Energy prices could go lower and bring that industry down a lot.
But again, if you're a true value investor, you’re not too worried. You tend to be a Warren Buffett type of investor, take a very long view of the market. So in terms of where to put your money for good value over the longer term, it does happen to be in the lower rating end of the high-yield market, and in homebuilders or metals and mining and energy currently.
Dan Ferris: Wow, Marty, thank you. That is awesome. I feel like we just got a 30-minute master’s degree in high-yield bonds. You are definitely invited back, sir.
Marty Fridson: I know, it’s always a pleasure to be with you. I really enjoy all the interaction I have with the Stansberry people and I look forward to speaking with you again in the not too distant future one way or the other.
Dan Ferris: Excellent. Thank you. All right, have a great day and we’ll talk to you soon, Marty. Bye-bye.
Marty Fridson: Bye-bye.
Dan Ferris: OK. It’s time for the mailbag. And remember now, your feedback is really important to me personally, and to the success of this show. It’s important to me personally because I want to interact with you. I want to have a discussion here about investing. And this is your chance to send me your comments and questions and then I can respond to them in the mailbag segment.
So you write in to [email protected] with comments, questions and politely worded criticisms please. And I will read, I guarantee you I will read every single one. I hope I can get, I hope we can be so successful one day that I can’t read every single one. But for now, it’s easy, I absolutely promise you I read every single one every week. Even the Russian spam.
And this week, we got a bunch of good stuff. And it was really hard to choose which ones to read but it was made a little bit easier because a lot of you had questions about negative-yielding debt. So let me just, I picked one of those and I believe that this question and my answer to it will handle all the others, you know, must have been, I don’t know, five or 10 others which is a lot on a single topic. We usually never get that on negative-yielding debt.
So this is from Todd L. And Todd L. says, "Hi, Dan. Wonderful job with the Investor Hour since taking the helm from Porter. I look forward to the podcast every week and subscribe to a number of Stansberry’s products including yours and greatly appreciate the excellent advice. I sent you a note a couple of weeks ago. Didn’t hear a response. It continues to gnaw at me.
Would appreciate your thoughts. The idea of negative interest rates or extremely negative interest rates seems baffling. Wondering if you’ve read this paper published by the IMF in April of this year." And then he gives a link to the paper. "It’s called “Enabling Deep Negative Rates: A Guide”. By the IMF. And it’s available at IMF.org."
And then he continues. "Their thesis is that the idea of zero being the boundary for interest rates really isn’t a boundary at all. The last ten years have proven that the central banks can easily take rates slightly negative and potentially far below zero with no risk to monetary or political stability. Really? A quote from the paper."
Quote: “In summary, ten years after the crisis, it is clear that the zero lower bound on interest rates has proved to be a serious obstacle for monetary policy. However, the zero lower bound is not a law of nature. It is a policy choice. We show that with readily available tools, a central bank can enable deep negative rates whenever needed, thus maintaining the power of monetary policy in the future.” Endquote.
"My questions, one. Why is there such demand for sovereign bonds that have explicit nominal negative return, not including inflation? I know central banks are buyers, but beyond that, who buys them and why? Seems to me the market should not exist for these products, yet it does. Since the central banks may see no boundary on negative interest rates, does that mean the party in the stock markets can go on much longer than thought?"
That’s his second question. Then the third question is, "one of the ideas in this paper is to penalize those who hold cash or money in the bank by depreciating the currency. What effect might these policies have on gold and precious metals? Thank you again for your excellent financial insight and wisdom. Regards, Todd L."
Wow, Todd. You covered the waterfront here. And I think you really successfully summed up all the reader concerns about this and questions. So first, and the biggest question by far was your first one. Who buys this stuff? Who the heck buys negative-yielding bonds? There was actually, I could point you to a decent little article in Financial Times not too long ago. Or, well, actually I guess it is from 2016.
But the basic idea is still quite valid. And as you said, central banks are buyers. That’s a, you know, like they say in that paper, it’s a feature, not a bug, of central bank policy, right? They buy negative-yielding bonds. And then there are investors and institutions like if you're buying a global portfolio of bonds and you're trying to represent the global economy, well, you know, you’ve got to have, your bond portfolio has to be 20 or 25% negative-yielding bonds.
And that’s your, these things in large institutions, they tend to be ruled by mandates and rules and things. And you know, on what they can own. So, you know, we heard our interview guest say you know, there are rules, but there’s a little bit of leeway. When a bond gets downgraded they have months to get rid of it or something. But the rules are pretty clear about what they’re, you know, what they’re allowed to own and what they’re not allowed to own. And banks and pension funds and insurance companies are similar.
For example, imagine you have you know, just say like a money market fund. They typically, you know, they’ll invest in what they would consider really safe cash-like instruments that are of near-term maturities. You know maybe, I don’t know, even up to a year, let’s say. And those are, a lot of those are negative-yielding in the world today. It’s only in the United States where they’re not.
And a few other places. Not every country. But most of the developed countries. Like a lot of European countries and Japan, all that short-term stuff is negative-yielding. So, you know, they kind of have to own it. And that’s the only way that this could work.
There’s also, you know some people are looking for capital gains in this stuff. As long as it keeps going, you know the yields keep going lower and lower and lower, that means the price is going higher and higher and higher. So if you’re looking for capital gains in the bond market, you know, the move from zero to negative one is just as good as the move from you know one to zero. Not quite, but almost as good. So, yeah. People buy this stuff. Big institutions mostly.
Your second question. Since the central banks may see no boundary on negative interest rates, does that mean the party in the stock market goes on much longer than thought? I don’t think it’s wise to believe that central bank activity can hold the market up. I really don’t. That’s the great conceit of all this.
There’s a guy who I’d like to get on the program. His name is David Levine. He calls himself Paranoid Bull on Twitter. And he has this thing about the myth really of the infallibility of central banks. And he’s right. They’re not infallible. And the belief that they control markets and hold markets up with interest rate policy I think is really dangerous. I think all they can do, they can push interest rates down and they can encourage speculation and misallocation of capital. But they can’t tell, they can’t tell you not to sell, I’ll put it that way.
If you say, can the party go on much longer than thought? Well, of course. It can always go on much longer. But my question to you is, can the central bank tell any investor not to sell? I don’t think so.
Third and final question. One of the ideas of this IMF paper that we quoted here from your e-mail, Todd, one of the ideas in this paper is to penalize those who hold cash or money in the bank by depreciating the currency. What effect might these policies have on gold and precious metals? They’ll make them go up. Period.
Depreciating currencies means, and you know, penalties on holding cash mean, OK, let’s hold something else. And that’s part of the dynamic in the negative-yielding bonds, too. If there’s a penalty for holding cash, well, you know, why not hold a slightly negative-yielding bond and pay a penalty on your cash. It just feels a little better.
Lot of great questions, Todd. Appreciate it very much. I hope that answered all the other folks. OK. Another big question here. I have to tell you. This is from Andrew B. I love getting this kind of stuff. We talked about Smile Direct. The Smile Direct IPO, the company that does teeth straightening through the mail.
And this guy, Andrew B., has done it. And he’s writing in. He says "Dan, I’ve been listening to you religiously since you took over the podcast and appreciate your insights and all the education I’ve been receiving from your weekly rants and interviews. This past week you were skeptical of the company Smile Direct and their upcoming IPO."
"I have a little personal experience with Smile Direct. And while I can’t speak for their stock, I can speak for their product. I just completed a nine-month treatment plan, and I would rate Smile Direct a seven out of ten. The system worked for me and my teeth are significantly straighter, probably 95% straighter. I went into a local scan center, and they scanned my mouth with a 3-D camera. Then they sent it off to an orthodontist somewhere and created a computerized plan for my treatment."
"I was able to see this plan in 3-D on my computer, and within a month or two, all of my aligners showed up in a box. I knew going in that this was a disruptive technology. Orthodontists hate it because it costs 50 to 70% less than standard orthodontics. Best of all, I didn’t have to spend a minute in an orthodontist waiting room for the whole treatment."
"While my teeth didn’t completely straighten after the first six month treatment, probably 75%, they honored their guarantee and had me back in to the scan center and took updated pictures, produced a three month supplemental plan, all free of charge. I must honestly say I’m happy with the results and the deal I got."
"Now the bad news, and possibly a reason not to invest in Smile Direct. First of all, if you have issues, you end up in the typical foreign call center struggle, trying to communicate with someone with no dental training. Second and more disturbing, the order processing center can sometimes get things mixed up. Oh man, that’s bad."
"In both of my treatment plans, some of my aligners got mislabeled. This meant one or more of my aligners didn’t match the schedule for wearing them. Try putting month three aligners into your mouth during month two and you're in for a painful experience. And if you try too hard, you will probably break the plastic aligners. Fortunately I figured it out on my own by trying on several other aligners in my box. Otherwise, I’m sure that the call center would have had no clue how to help me."
"Finally, I ordered my retainer at the end of treatment and it looks like the material was misplaced on the mold. So one side of the retainer’s longer than the other. The retainer still worked fine, just shows a lack of quality control. I tried sharing my negative experiences with customer support, really never heard anything back from them."
"In the end, the inconvenience was worth it, especially compared to the alternative. My kids didn’t even know I was wearing aligners each day for at least three weeks. They were very discreet. And after nine months, my teeth are 95% straight, all for less than $2000. I’m a big fan of disruptive technologies. That’s why I hope companies like Smile Direct succeed."
"Hopefully they get a healthy dose of disruption to their quality control and customer service, so they can succeed. Otherwise a competitor will come along and own this market. All the best, Andrew B." I’m going to let that e-mail stand on its own. You know how I feel about the stock. That’s about the product and the experience, and that kind of stuff is kind of valuable, I think. I love hearing that.
OK, third and final e-mail this week. "Dear Mr. Ferris. I love your show." Sorry, this is from Jim M. "Dear Mr. Ferris. I love your show. You always have very interesting rants that are invariably very educational. I know that I will always learn something new in each episode. My daily goal is to learn something new. Keep my brain young. Keep an active open mind. Thank you. Your guest selection is fantastic. Not only do they provide many investing ideas, they candidly share many life hacks based on their experiences with us listeners."
"I have a question about Howard Marks’ second level thinking, your rent subject in episode 109. You encouraged listeners to ask what then? To achieve second level thinking. But when trying to find a stock to buy, at what point do you recommend the investor pulls the trigger and buys the stock? It appears to me that one could continue to ask what then in a to do loop and never buy. Can we students actually fall into the do something syndrome described by Shane Parrish in one of his blogs on Farnam Street?"
"To refresh our memory, the do something syndrome is when a person continues planning, fine tuning, gathering more information, editing, but never publishes the book, buys the stock, goes on vacation, et cetera. Thank you for introducing me to Mr. Parrish and Farnam Street in episode 84. What a wonderful resource. Keep up your excellent work. Cheers, Jim M."
Thank you, Jim. So you got two separate things here. Yes, at some point you do have to pull the trigger. And you're asking me at what point do you pull the trigger and stop asking what then, what then, what then.
The point is not to ask what then endlessly. The point is to get past the first level thinking, which is just a gut reaction to the headlines, and find out what’s really going on in the industry and the business and whether or not you think it’s priced right. So that’s, the goal is second level. It’s not like 112-infinity level. You know what I’m saying?
So, you want to just get past that first reactionary response and dig in and get up to your elbows in you know, analysis. And figure out what’s going on. And hopefully, you know, there’s no objective answer to this. Hopefully at some point you get to the point where you say yes or no, this is a good business. It’s priced right. I’m in. Or too hard, too low quality, too expensive, too whatever, no thank you. So, you know, don’t get suck in analysis paralysis. The point is to just get past the mistake of reacting and then get on and do the work you need to do to figure it out.
And your second thing was about you know, it’s a similar question, isn’t it? And I think the idea behind this question is as a student of investing, you’re just always learning and learning and learning, and when do you actually do something. I suspect that if you’re on a good learning path, the moment will present itself to you and you’ll know it.
And it’s up to you anyway. I can’t tell you anyway. But if you are in a mode where you're, you know, maybe you bought a stock but you’ve still got a lot of cash and you’re new to investing and you’re still wanting to learn more, just like I said, don’t be in a hurry. Be in a hurry to learn more. Don’t be in a hurry to commit capital to something that you don’t understand well enough.
And I hope that’s a decent answer. I’m afraid that’s, so that question, that’s all you're going to get. And actually there’s sort of a fourth question. But I’m not going to read a question. It’s just something that at least three or four people mentioned this week alone. And they said you know, keep recommending books.
Actually, you know something, I’m sorry. There was another question that I thought I had in here, and it was about short selling and I wanted to put it in here, but I don’t see it. So look. There’s a fellow who asked me what do you have against short selling? Why don’t you want to do short selling?
I don’t have anything against it. I just think it’s risky. You have to recognize the risk. If you buy a stock for $20, and it goes to $40, yay. You made 100. If it goes to zero, oh well, you lost $20, if you bought one share. If you short a stock at 20, what if it goes to 60? Well, then you’ve lost 40 on a $20 stock. You can lose more than the stock price, which is kind of crazy when you think about it.
But that’s just one of the risks to shorting. And shorting is just harder. It’s riskier because it’s harder. You know, there’s kind of an inherent long bias to the market, and you know, a lousy business that deserves to collapse will take forever.
We shorted, what was that called, Duluth Trading. You know, the funny commercials about underpants and t-shirts and stuff, and the no yank tank and all this stuff. I mean, basically we looked at it and we realized that the sales weren’t going so well, and they were trying to hide it.
And you know, the sales per square foot in the stores they were opening. They were opening a lot of stores so it looked like they had a lot of growth, and we thought otherwise. We knew otherwise, in fact. We were highly confident. But the stock kept going up, and we got stopped out. And the thing eventually crashed.
And there were folks who were telling me you know, you should be long. And I was like, you're insane. This is obviously a screw-up waiting to happen. And it did. You know, it finally fell apart. We weren’t in it, because we had to stop out. I have nothing against short selling, but I just acknowledge the fact that it’s very hard. There are risks to it that don’t exist when you’re on the long side.
And the other final thing that I wanted to say was books. We had a lot of people asking me about books this week. And they said wow, I love it when you recommend books. So what I’m reading right now is A Demon of our Own Design by Richard Bookstaber. It’s, the subtitle is Markets, Hedge Funds and the Perils of Financial Innovation. Which you know I’ve been talking a lot about how financial innovation is a perilous thing for investors.
So I couldn’t believe it. I had this book on my shelf for a while. For years now, I think. I don’t even remember when I bought it, but it’s been a while. And it was written during like right, I think right before the financial crisis. And in the introduction, he talks about it’s been a crazy year. It’s written right around that time. And I hear from, yeah, 2007. Right before. So I hear from folks that it’s one of the better assessments of the perils of financial innovation. So I’ve got to read it. I’ve got to know about it.
So that’s what I’m reading. That’s the mailbag. That’s another episode of the Stansberry Investor Hour Podcast. It’s my privilege to come to you once again. I hope you enjoyed it. I hope you enjoyed Marty Fridson. Great guy, I loved talking with him. He’s just a walking encyclopedia of bonds and especially high-yield bonds. So listen, I’ll talk to you next week. I can’t wait. We’re going to have another great interview. Man, can’t wait for that one. And look, have a good week. Take it easy and I’ll talk to you then. Bye-bye.
Announcer: 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 e-mail. Have a question for Dan? Send him an e-mail at [email protected] 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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