Featured Guests

Micheal Covel
Micheal Covel
Characterized as essential and required reading, Covel teaches beginners to seasoned pros how to generate profits with straightforward repeatable rules and is best known for popularizing the controversial trading strategy TREND FOLLOWING.
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Transcript

Michael Covel, author of Trend Following: How to Make a Fortune in Bull, Bear, and Black Swan Markets, joins Porter and Buck to demystify trend investing and reveals why mastering this will change your entire concept of what bull and bear markets mean for you.

Buck and Porter talk risk management, the latest false starts with North Korea, and Porter reveals three "battleship businesses" that in his mind are so reliable, entrenched, and permanent, the typical rules of risk management just don't apply.

Brandon from Dallas asks Porter how to distinguish from "good debt" and "bad debt" when it comes to determining which companies will go under in the coming corporate debt meltdown.


Announcer: Broadcasting from Baltimore, Maryland and New York City, you're listening to the Stansberry Investor Hour.

[Music plays]

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: Hey, everybody. Welcome back to another episode of the Stansberry Investor Hour. I am nationally syndicated radio host, and gluten-free advocate, Buck Sexton. With me here today, the founder of Stansberry Research, Mr. Porter Stansberry. We need a cooler additional title for this week, Porter. What else you been up to?

Porter Stansberry: Let's see. "Coyote Hunter."

Buck Sexton: There we go.

Porter Stansberry: "Blue Marlin Slayer." "Failed Country Club Athlete."

Country Club Guy: Repeatedly.

Porter Stansberry: [Laughs]. Hey, listen, Buck, why don't we get into a couple of important topics and then we've got a great guest today. Michael Covel is a global expert at trend investing. And I know a lot of our listeners love the idea of trend following because it's all upside. You get out when there's downside, and that's pretty cool.

Buck Sexton: I was going to say: we got our guest this week. I wanted to tell everybody about him just so they make sure that they stick around. We got Michael Covel, host of the popular Trend Following Radio podcast, which has released 600-plus episodes, and racked up 7 million listens. Michael is the bestselling author of The Complete TurtleTrader, Trend Commandments, and Trend Following: How to Make a Fortune in Bull, Bear, and Black Swan Markets. Michael's always been fascinated by reclusive traders who have quietly generated spectacular returns for decades by going against the investment orthodoxy of efficient markets.

Throughout his career, Covel has uncovered astonishing insights about human behavior, decision-making, and trading systems. Covel's also director of the 2009 documentary film, Broke: The New American Dream, where he interviews top traders like Larry Hite, Jim Rogers, Bill Miller, and David Harding. Michael's joining us today all the way from Vietnam to give you an introduction to his work, how you can use it, and to talk about the latest in the sometimes-controversial world of trend following.

Remember, folks, you can get transcripts from the Stansberry Investor Hour, additional information about guests, and be notified each Thursday when we publish a new episode by just going to InvestorHour.com, and just give us your e-mail. InvestorHour.com. All right.

Porter Stansberry: Are we at war with North Korea yet? Or are they now best friends? Because it seems like this is kind of like an elementary school spat where the two guys are like, "I know you are but what am I?" And then all of a sudden they're best friends. Where are we now with North Korea?

Buck Sexton: We're nowhere particularly significant because we don't know where we are. And I know that that's convoluted but it's supposed to be. If it goes well, the nuclear negotiations with North Korea are going to span at least months, more likely years, and there'll be stops and starts; there'll be ups and downs. And that's if we actually can get to first base, which we don't know if we will yet because who knows if this June 12 summit is on or off? It was off last week. Then it was a maybe. Now there's more indications it may be on. So we simply don't know, Porter. But even beyond that, even when we know, we won't know what we know because it's going to go on ad infinitum.

Porter Stansberry: This sounds like General Motors trying to do their earnings press release [laughs]. All right. Well, listen, we will count on you to let us know when nuclear war is immanent. Otherwise going to go on with our business.

Buck Sexton: I got you. That's why I hang out with all you guys: because I need to have friends with firearms, hunting skills, residences that're kind of off the grid –

[Crosstalk]

Buck Sexton: – and gold.

Porter Stansberry: We've got gold. We've got fresh water. We've got crops. I've got a farm. And I've got a mountain aerie. So I think we're all set. And you're certainly welcome. But I do want you to work on your pheasant-hunting skills.

Buck Sexton: [Laughs]. That's a totally fair point. I would just say that you guys – for dudes who work in finance, the whole Stansberry squad, you're all the people that you want to be friends with when the zombie apocalypse comes, which is important.

Porter Stansberry: I have a gigantic affinity for rednecks. I love rednecks. And I'm not being facetious. I'm not talking down to them. I love them. I love them so much, Buck. I don't know if you saw on Facebook or anything yet some stuff I posted over the long weekend. But I took my family and we went with my wife's sister – so their family. So it was four kids and four adults. And we went to Altoona, Pennsylvania. You guys get your Google out. This is flyover country, ladies and gentlemen. I mean, this is the real rough area. Really nice people. Not rough at all. Not dangerous. But this is the sticks. These people are – it's not Halloween. That's how they really dress [laughs].

Anyways we went to this thing called DelGrosso's, which is this fantastic small-town theme park. One side of the road is a water park; one side of the highway is the carnival rides and stuff. And I've got two things to share with you about this fantastic adventure we had. I had a ball. Two things. First of all, fat-shaming has clearly not yet reached Altoona [laughs]. I saw some of the most obese human beings I've ever seen in my life and they were wearing bikinis and proud. Okay? The second thing I realized is that there are no good tattoo artists in Altoona [laughs].

That brings me to this point. I went to a similar – this was a while back. I went to a similar fair and I told my buddy I was going. He's like, "Oh, fats and tats." I didn't know what he was talking about. I showed up. Everybody was fat and everybody had a tattoo.

It was really very impressive. So, Buck, I think we're friends on Facebook. Look for some interesting pictures.

Buck Sexton: Oh yeah. I'll look for the photos.

Porter Stansberry: And God bless DelGrosso's. I really did have a great time. If you're ever in Central Pennsylvania and you want to have a lot of fun, it's great. Truly. Very well-done theme park. Lots of interesting people. But the park was great; the food was great; the rides were great. We had a ball.

Buck Sexton: Let's get to Mr. Covel, shall we?

Porter Stansberry: Bring him on.

[Music plays]

Buck Sexton: All right, everybody. Our guest on the podcast this week is Michael Covel. He is an avowed entrepreneur and the author five books including the international-bestsellerTrend Following, his investigate narrative TurtleTrader, and the 2011 title Trend Commandments. His perspectives have garnered international acclaim and have earned him speaking invitations from organizations such as China Asset Management, Managed Fund Association, Market Technicians Association, and multiple hedge funds and mutual funds. Michael also has the distinction of interviewing five Nobel Prize winners in economics and has been featured in the Wall Street Journal, Bloomberg, CCTV, and Fox Business.

Covel shares his writing on trend following at TrendFollowing.com and can be heard each week on his podcast, Trend Following Radio, which has racked up over 600 episodes and been downloaded 7 million times. Michael's clients are in 70-plus countries and he splits his time between the U.S. and Asia. He'll be speaking, along with our own Steve Sjuggerud, at the Stansberry-Research-produced Asia Investment Opportunities Conference in Hong Kong next week.

Please welcome to the Stansberry Investor Hour: Mr. Michael Covel. Hello, sir.

Michael Covel: How you doing, guys? Thanks for having me.

Porter Stansberry: Michael, Porter here. Glad to have you back on. Where are you joining us from today? You're one of these folks who seems to always be somewhere new in the world every time we speak.

Michael Covel: I'm in Saigon today.

Porter Stansberry: You're in Saigon in Vietnam. Holy Moses. You sound crystal clear. You must have some kind of wicked-expensive Internet connection.

Michael Covel: [Laughs]. I don't think so. I stay at a pretty cool place and it's just whatever standard they've got here. Sometimes the connection will get a little whacked out, but it works pretty good.

Buck Sexton: I just want to say: I love Saigon. I actually think it has some of the best food in the world. I'm a huge fan.

Michael Covel: Absolutely. You can get just about anything here. You can go Vietnamese all day long. You can go Italian all day long. You can go Japanese all day long. Doesn't make a difference. Great hamburgers.

Porter Stansberry: Well, I have to ask before we get into the finance stuff: what led you to Vietnam in the first place? And how much time do you spend there?

Michael Covel: About 80%-plus of the year for the last five years. I was living in San Diego and I got hired by a Hong Kong bank to give a little speaking tour five, six years ago. I was in 10-plus countries, 25-plus cities, giving presentations all over. And at the end, I was like, "Heck, I'm not going back to the States." And I said, "Where did I have the most fun in that four-month stretch?" And it wasn't a choice. It was Saigon.

Porter Stansberry: That's great [laughs]. I'm amazed by how many people I know that've gone to Asia and never come back once they discover the quality of life and the freedom that you can have there, particularly as an expat.

So, let's get into the finance. There's something about trend following that I've just never been able to wrap my brain around. And you'll have to forgive me, Michael, because I'm probably a bit of a dinosaur. You know, I see shares and stocks – and I know you trade lots of things besides equities and commodities, currencies. But I see stocks as being a part of a business. And as such, I see the value that is built over time by adding new customers, building new profits, reinvesting dividends, and repeat. And particularly as a small business person, I know that's how it works. And I know the valuation of the company is a reflection of that.

Obviously my businesses don't trade on the public markets. But even if they did, I wouldn't really care very much about the share price. I'd focus as an entrepreneur on the underlying intrinsic value: getting more customers, earning more profits, and reinvesting in the same. You, as a trader, you have a whole different view. What you care about is the price. You care about the price on the screen, not really the underlying value. And what I want to ask you is: is there any way to connect those two concepts? Is there anything about trend following that you think is caused by the underlying business or impacts the underlying business?

Michael Covel: That's a great question. As you were laying that out, I was thinking: they're not mutually exclusive. They're not designed to – it doesn't have to be all one way. Because what's so great about a trend-following strategy combined with what you just described, a value strategy – if you combine the two, you get more return and less risk. Because a typical trend-following stream of return is correlated with the value stream that you just described, generally at zero for the last three, four, five decades. So that's the real value there. It's an entirely different way of looking at the markets, as you describe. But the benefit is: it just makes its money at different times compared to the value strategy that you outlined.

Porter Stansberry: Let me see if I understand you correctly. What you're saying is that the trend following is a reflection of the value that's being created but it's either racing ahead of it or it's trailing behind it, one or the other.

Michael Covel: No. As a trend-following trader, I don't think about value at all. I mean, I'm having that conversation with you because we're kind of trying to flesh this out for people. But trend-following trader says, "I don't have to know anything about the business that you're giving an example about. I don't care. I just want to know: what's the price and has it moved?" And I'm going to apply this across a portfolio.

I'm not just going to – you're almost like a venture capitalist for trading the markets. So you're going to say, "You know what? I'm going to place 20 bets here," and somebody out there on Sand Hill Road in Silicon Valley is doing the same thing with their angel investments. We're going to place 20 bets. And maybe 18 or 19 of them are going to bomb out because we just don't know what's going to happen. And one or two of them are going to become Google or the next Uber already, which will pay for all the companies that didn't work out, and then you'll end up with your home run. So it's very much a venture capital mindset – is a great way for your audience to think about it.

Porter Stansberry: Okay. So you're saying clearly there is no relationship between the way that I would look at the market and the way that a trader like you looks at the market. And, by the way, I'm not saying that there has to be. I just wondered if there was any in your mind. And I'm glad to know that there's not. That kind of makes it easier for me because I've always been trying to figure that out [laughs], and I'm looking for a relationship that you don't think exists. So that's helpful.

So if what you do, therefore, is primarily in the market, not outside the market – in other words – just stop talking about my companies because they're not publicly traded. Let's talk about a big company that everyone's familiar with. Let's just say Microsoft. If you were going to do a trend-trading strategy on Microsoft, for example, you wouldn't be looking at all for what the earnings are forecast to be or what the new product developments were or whether or not there's going to be a new deal with Uber or something like that. You would solely be focused on what is happening in the price and in the volume action of that stock. Is that correct?

Michael Covel: The price actually. The volume would really not be an issue. But here's the tricky part about what you just outlined. You really can't be a trend-following trader on one market alone, right? Now, you'll see people come on TV and they'll talk about technical analysis and they'll say, "Hey, I can look at this cross, this death cross, and this means such and such will happen," and they apply that thinking to one market. Well, I would just implore people to say that's not trend following. I don't know what that is exactly.

But trend following is more: "Hey, we've haveto have a basket of things we're following, a basket of different markets, hopefully a basket that's not really correlated amongst each other. And then we're going to take simple signals, like breakouts, moving averages, to get in, and we're always going to have a tight stop because we don't know what's going to happen. We're going to take a position. Hopefully the market's going to go our way, but we know we're going to have 60%, 70% losers. And we're going to come in with the big hit." So it's a very different way of thinking. But it works well. And it's worked for a long, long time.

Porter Stansberry: So let me ask you a question about that. Would you say most of your profits accrue because you found the right trend and it was very powerful? I'm just making up an example. But I know that, for example, commodities in particular can have huge moves following breakouts. So you follow the price of corn and it doesn't go anywhere for seven years and all of a sudden it's up, up three days in a row, and you happen to be in that after the first or second day or something and it goes on and makes a huge return. Is that where your returns come from, by finding the thing that's trending really strongly early? Or do most of your profits actually accrue from just your trading techniques? In other words, the fact that you cut your losses quickly, the fact that you let your winners run? Or is there a mix?

Michael Covel: It's really the cutting the losses and letting your trades run, your winners run. Because you really can't predict a trend or you really don't know a trend has happened until it's over and you could look back and measure it. So if you start the hypothetical year one as flat, you have no positions, and you say, "Okay, I don't know where my profits are going to come from this year. It could be crude oil. It could be corn. It could be Tesla. Who knows?" And you don't know until frankly the end of the year is over and you can look back and say, "Oh my gosh. That trend in crude oil – that paid for everything. We made a bloody fortune that year. It woulda been nice if all those other markets didn't crap out and didn't all become small losses. But, hey, that's the name of the game."

Once again, it really helps to kind of keep that venture capital mindset, that kind of card-counting MIT mindset. It's all about finding your edge. What's the edge that you can bet on?

Porter Stansberry: This is where, again, my brain just comes unraveled about this. And I had an idea what your answers would be obviously. We've spoken many times before. And I know the basic tenets of trend following. But here's my dilemma. You know, I'm a free-market capitalist and I believe that the markets serve a purpose. I'm not saying that they're efficient. But I believe that they have value in and of themselves and that they help direct capital. So for something that requires capital where the prices are still high and profit margins are still very good potential, that's going to attract capital even if it doesn't have earnings yet.

And that's why the stock market is so important: it allows people with a good idea to raise capital even if they don't have earnings or profits yet. And that is important to the economy. It helps the American economy get ahead of other economies because we can raise capital for innovation and other folks can't. That's one example. There's lots of examples about the way that markets function to allocate capital. I'm not going to go into all of them.

But the thing that really I can't get my head around with trend following is: it seems like it doesn't participate in any way in that function. In fact, it seems like trend following takes advantage of where markets are wrong more so than taking advantage of how markets function. Do you have any comment about that? Has that occurred to you? That the big profits in trend following almost seem to be like mistakes that markets are making.

Michael Covel: I must say that my alma mater, George Mason University, has become the hotbed of libertarian free-market capitalism these days. I think I've had six of their economists on my show. So we share that foundation. I think one of the things to think about though too is: if you go to Chicago and you look at the futures markets – and the futures markets are a zero-sum game, right? And so speculators coming into that market – they serve a purpose. Because not every person that's using, for example, a futures market is in there as a speculator. There's hedgers. There's people that're in there hedging.

And so trend following – and I've had a guy who's appeared in one of my books who laid this scenario out to me. This is how he viewed it. He actually came at the idea of like: "Hey, hold on. All these hedgers are coming to the Chicago futures markets." The big companies that you're talking about, the big-value companies you're talking about – they're coming to the Chicago futures markets to hedge their positions. And this guy didn't know anything about trend following, but he figured out: "How can I trade in such a way that when these hedgers are giving this money, essentially buying insurance – how can I collect their insurance?" And in many ways it's not too dissimilar to how Mr. Buffett's made his fortune. At least in the insurance-type thinking.

Porter Stansberry: Yeah. We do a lot of the same thing. I do think that selling puts, if you can understand that and master that, is by far the best way to be an equity investor. So I get the idea of capturing the insurance premium that's in the market and that's maybe one interesting way of understanding trend following that I hadn't thought about.

But we went off on a pretty philosophical track early into the questioning because those are the questions that I've always had. But let me ask something on behalf of my readers. And I know this is a question you get everywhere you speak. But let's say you're talking with a guy who's got $100,000 saved and he wants to see if trend following will work for him. What's your most basic introductory strategy for a new trader?

Michael Covel: So that answer's changed in the last five to 10 years because so many of the trend-following traders that I've kind of uncovered and written about have developed fund structures that're no longer the exclusive QEP stuff. It's like regular people can participate in ETFs, mutual funds, etcetera. So your listeners can definitely go out and look at one of my books, look at some of the names, and instead of trading themselves, they can go participate in a fund as easy as they can buy a share, and that's a great option for a lot of people.

On the flip side, for the do-it-yourself-ers – which there's many people that say, "You know, I don't want to pay fees. I want to do this myself." The simple way to really think about it is: let's get a tracking portfolio of 20-plus markets. This could be some currencies, and you could be trading ETFs, futures, LEAPS. I don't care. You'll be tracking some currency ETFs. You're going to be tracking some various equities. You're going to have this kind of tracking portfolio. And a simple way to think about it: has the market made its highest high in 100 trading days? What's the entry, you know? If it goes against you – let's just hypothetically throw a number out. If it goes against you and you lose 2%, 5%, you exit. I mean, you want to make that a concrete number, but you exit. You get out.

And you kind of have to really play this in your mind over time. And you just can't jump in and jump out. You have to have a strategy where you're going to be consistent about it. And you have to look for that edge over time.

So I would say really for the listeners: look at one of these pros do it for you. Or if you want to take the deeper dive – and this is not necessarily a pitch for one of my books, but there's many books that will give you a foundation to where you can really have a good basic trend-following strategy. But, look, there's no secrets here. I mean, it's something simple for getting you in: a moving-advisor crossover, a breakout. That's not the key. The key is consistency.

You mentioned the efficient market. And I know you don't believe markets are entirely efficient. Nor do I. And that gets into the behavioral realm of things. I mean, that's why, ultimately – the behavioral realm – that's why these profits exist in different strategies exist in trend following: because people do do crazy stuff.

Porter Stansberry: [Laughs]. That's the only thing that's certain in life. The idea that markets could be efficient is as true as the fact that people are rational. My experience is: people are only rational by mistake [laughs]. They're never rational intentionally.

Let me ask you one more question, Michael. It's a pretty simple one, and you may want to punt on it. But what is the best market that you personally trade? In other words, if you look back at your 20 or 30 years as an investor using trend-following strategies, what market do you seem to have an affinity for catching correctly?

Michael Covel: That's a good question. I'm thinking about the way you phrased it. The answer that I would give though: currencies. Currencies have provided really so much of trend-following foundational profits over the years. If currency markets did not exist in the last five decades – which exceeds my lifespan [laughs] – if currency markets did not exist, I really don't see how trend following as a strategy would've existed.

Porter Stansberry: Why is that? That to me is the most interesting thing that we've uncovered so far in this interview. What is it about currency markets that makes them trend so strongly and for such long periods?

Michael Covel: Well, that probably gets into some of the fundamental perspectives that you might have. When the proverbial you-know-what hits the fan, people kind of run for cover. It's one of the reasons, for example, that if you look at a trend-following strategy, you can typically see: they do really really well during black swan time periods. Like October of 2008. You know, Ben Stein famously said, "If you made money in October of 2008, you were doing something wrong." Every trend-following trader made money in October of 2008. And so that's a really – it's a complicated question, but I think when things go bad, the currencies are the foundational instrument, right? So whatever we're trading, currencies are involved. And you really get some of those big moves.

Porter Stansberry: Yeah. That was a really unusual time. I don't remember the details now. Looking back, though, I can remember writing essay after essay about how ridiculously correlated all of the world's markets had become. They were all going down. So that was a period of unbelievably strong trends. And if you were a trend-following guy, that's manna from heaven. For everybody else, it was kind of terrifying.

Michael Covel: But I think you make a good point there in the sense that, ultimately, as we said at the top of this call, it's not an either/or thing. I would implore people to say: okay, if you've got your core value strategy and it's worked well for you and you have a market hero like Warren Buffett who's done exceptionally well, don't break from that. But does it make sense to have this kind of insurance policy that protects you when the next you-know-what swims in and bites? And that's where trend following can help people.

Porter Stansberry: Yeah. And there's certainly plenty of evidence that that actually does work as part of your allocation mix, that adding in the CTA or the commodity trading advisor component to your portfolio is non-correlated. It'll have an impressive dampening of volatility and increasing of returns over time.

So, Michael, listen, I want to make sure people understand how they can get more from you. You have two books out. Is that correct? The Complete TurtleTrader, Trend Commandments, and then your second book, Trend Following: How to Make a Fortune in Bull, Bear, and Black Swan Markets.

Michael Covel: Yeah. I'd stick with Trend Following as your first stab if you're new to my world. That's my fifth edition. It's a massive book. Even if you don't read it all, it's heavy enough to literally swing and hit somebody with and it'll probably kill them.

Porter Stansberry: And it'll look very impressive on your bookshelf at least.

Michael Covel: Absolutely. It's one of those ones you don't throw away because it looks so impressive.

Porter Stansberry: Trend Following: How to Make a Fortune in Bull, Bear, and Black Swan Markets. Now, the thing I haven't ever discussed with you – and I admit I've never seen it – you did a documentary, Broke: The New American Dream, where you interviewed Larry Hite, Jim Rogers, Bill Miller, David Harding, and I'm sure a couple of other impressive investors and traders too. What's that about? What's "broke" mean? And what is the "new American dream"?

Michael Covel: Well, see, that was right around the time period we were talking about, during the chaos of the crisis. Gosh, it's a decade now. But I had this thought. At the end we were having a hard time with the naming and I thought, "Well, you know, by the actions that everyone is taking right now, literally they want to be broke." And so I thought to myself, "'broke' is the new American dream." It's like we're taking these terrible actions that're kind of giving us what you would expect if you take these actions." Anyways, it was three-year journey on my part traveling the world, talking with everybody under the sun during that time period. And it was really that kind of free-market capitalist foundation. And I just ripped the hell outta the media, and that kind of fun stuff.

Porter Stansberry: Great. I have to look for it. Any idea where I can find that? Is it on YouTube, Netflix, anything like that?

Michael Covel: Easy to find. Off my website, TrendFollowing.com, you'll see the link.

Porter Stansberry: Perfect.

Michael Covel: Or you could type in my name on Vimeo. It's easy to find, easy to buy.

Porter Stansberry: TrendFollowing.com is your website. You've written two great books. We've had an interesting discussion today. I wish you well on your trading. And I frankly with I could understand it better. I'd be more open to it [laughing].

Michael Covel: Hey, I always enjoy our sparring. We've been doing it for a long time. Since Jungle Island I believe. So I always enjoy it.

Porter Stansberry: Yeah. Great to have you on. Look forward to seeing you this fall in Las Vegas. And best wishes.

Michael Covel: Thanks, sir.

Buck Sexton: Hey, Porter, can I do a follow-up to the question you asked him? For you, by the way. You asked about somebody who has $100,000 and how they could apply what this guy is talking about, his philosophy and what he does. Can you just recap what his answer was to that?

Porter Stansberry: Yeah. He said that there are a number of ETFs and funds that you can get involved with for people who have that level of money today, and that's unusual. Because ten years ago those things didn't exist. So I'd look for specialty ETFs that follow trend-following strategies. One simple one is – I think it's – what is the symbol for – Jammer, help me out – for Meb's – Meb has a basic trend-following fund.

Country Club Guy: Cambria.

Porter Stansberry: Cambria. It's a fund where you're in the S&P 500 if it's going up, and if it goes down, you're out. And it's a very simple, basic trend-following strategy for stocks. And you're not going to beat the S&P in a bull market, but you'll certainly not suffer losses if you're in that kind of a fund. So it's an interesting way of hedging some of your money.

But there's other things out there I'm sure. I haven't done the research myself so I can't give you any other specific answer. That's just the one that comes to me off the top of my head.

Buck Sexton: And do we have a specific guess or somebody who could speak to things to look for before it's obvious that the 20% or 30% market correction that people have been talking about for the last year or so – some a lot longer – that's coming – sort of what the markers are before it's obvious?

Porter Stansberry: Yeah. So that's a great question, Buck. And I would love it if we could, on our website or with the e-mail that we put out to listeners, put up an essay that I wrote last August I believe – Jammer, I'm sure we can find it – where I wrote, "Hey, a correction is now guaranteed. It's going to happen. Because we've got this signal, that signal, and this signal." And I wrote that last August. And of course we did have a market correction. The stocks did fall by more than 10%. And my indicator tells you that a correction will occur within the next 12 months.

Now, you think, "Well, that's not – that could just be lucky." Well, it could just be lucky. But if you look back in time, the fact that this indicator has triggered every single time there has been 10% correction is very interesting. And within 12 months – that's as small as you can narrow down the window without ending up with missed corrections. So if you try to get tighter than that, you're going to miss some. And the point of this indicator is to give you a warning when it's absolutely positively going to happen. And that warning is based, ironically enough, around complacency. In other words, it doesn't signal because things start looking scary. It signals because things cannot get any better for equity valuation.

So there's a couple different measures, but they all revolve around measures of risk that're market-based. So a market-based measure of risk, for example, is the VIX index, the volatility index, which measures the prices of put options. When put options are very expensive, that means there's demand for them and that means people are very afraid that stock prices are going to fall. What we're looking for is the opposite: when people become so complacent that no one wants to buy a put because everyone believes the market's going to continue to go higher and higher and higher.

So that's one indicator that's part of our mix. The other one is an indicator of liquidity and what's called the "eurodollar market." Now, I'm not going to get into what that is. You don't need to know the details. But it just means that there's a lot of intrabank liquidity, that banks are not worried about each other at all, that there's massive amounts of lending going on between banks. That's a very good sign for equity valuation.

So those things, and then there's another indicator we also include, which is an indicator of credit market liquidity. So it's something called the risk spread between junk bonds and Treasurys. We study that. You put all those things together and you end up with a scenario that when people are just too optimistic that nothing is going to go wrong, well, that's ironically when you know that, within 12 months, something will go wrong. So that's my best warning sign.

And how would I use that? well, pretty simple. When that thing flashes, what I start to do is just – I don't want to go make any large acquisitions. I don't want to go buy a whole bunch of stocks. Instead what I want to do is just let my trailing stops hit. And when they hit, instead of buying something else, I just go to cash. So that each month, my cash is going to add up a little bit more, a little bit more, a little bit more.

Also when I see that thing flashing, I would start to lean into shorts more. Meaning: if I have a short book in my portfolio – and I think everyone should. Even the guy with only $100,000 – he should still be short two or three stocks. Just little amounts, $1,000, $2,000 is plenty. What I would do then is just: as I became more interested in a short, I would be more willing to put that on as opposed to, during a bull market, I'm very selective in the amount of money I've allocated to shorting. So when I see that signal, I want to build cash and I want to build my short book.

But, Buck, I want you to understand: I know that it's a 12-month signal, which means it could happen next month or it could happen 11 months from now. So I don't want to do anything radical in my portfolio. I'm not going to go halfway to cash. I'm not going to go 90% short. I'm just making small incremental changes month after month after month because I know that a correction is coming. And then as soon as stocks have fallen by more than 10%, I want to invert. I want to start closing my short positions. I want to start putting my cash to work.

These people who think they're going to get the very top or the very bottom of any market – it's impossible. It can't be done. All you can do is lean into things. So after a market's fallen by 10%, that's when I want to start looking for stuff to buy. And before that, I'm going to be building cash. Does that make sense, Buck?

Buck Sexton: That makes perfect sense. That was a great answer actually, if I may say so. Because I understood everything you said. So I like it. Thank you.

Porter Stansberry: No problem. And, you know, the most important thing though, Buck, is just to get started. I don't even really care about you becoming a great investor or anything like that. Not yet. The bigger lesson that you can learn from us by listening to this podcast is that you have to first learn how to save. So you have to learn to always live beneath your means. And that discipline has to come first.

The second thing that you have to learn is how to value a security. Now, Michael Covel will tell you the exact opposite, that what you need to learn is study price waves and things like that. I can't get my head around that stuff. So that may be true, but it's not been true for me. What I want to know is I'm buying a really good business that I'm very confident three years from now, five years from now, 10 years from now is going to have a much higher intrinsic value. And it gets that way by growing revenues, by growing earnings, and reinvesting into that business. That's how business works and that's what I understand as an investor.

So I want to teach you how to value a security so that you can understand what you're paying to become an owner of that company. And if you don't understand that, I don't know how you're going to be very successful investing. So I want you to learn how to save and then I want you to learn how to value a business. And by valuing a business, you're going to learn what makes for a good business. And of course the things that I think are important about that are good operating margins and good capital efficiency, stuff we've talked about many many times.

So then it just becomes a question of time. How much time do you have? How much money can you earn during your life and how much can you save? And that's really all it is. It doesn't have to be any more complicated than that. And you don't really need to know anything about trend following or about how to predict corrections. All those things are add-ons to the cake. They're the icing. They're the things that're going to get your returns from 8% or 9% to maybe 11% or 12%. But they're not the important things. The important thing is learning how to save and learning how to value a business.

Buck Sexton: Can I ask you also a philosophical question about a particular – without naming the equity, but just from the philosophy of: what's the difference between – I think Jammer once said, "Buy and hold versus buy and fold." Let's say you buy into something and you expect – it's a biotech and you expect that within 12 to 18 months, the Phase II clinicals will come out and you buy the stock and then it just gets hammered. But you know that in 12 months, there'll be a big day of reckoning for whether or not you've been right. Can you override your stop loss, in a sense?

Porter Stansberry: Absolutely. I think there's two cases where, in my career, I can see very clearly that stop losses simply aren't effective. There's just two cases in my opinion. And the one case is the scenario you just asked about, which is these stocks that are binary. They're either going to work great or they're going basically to zero. So if you have a binary investment opportunity – it's either all or nothing – a stop loss is just not going to be effective. Because if you don't hang on, you're never going to get the payoff. And a biotech stock – it's normal for a biotech stock to have 50% annual volatility [laughs]. That's normal. In other words, if the stock falls in half, it doesn't mean anything. Just noise. So a stock like that – it just doesn't do you any good to use a stop. In fact, using a stop almost guarantees you'll have a loss, not a profit.

So in those situations, you have to measure and balance and deal with your risk in a different way. And the way that you should do it is very simple. You should have a very small position size. So if you lose 1% of your portfolio, are you hurt? Not really. You can survive easily. In fact, if you're using a trailing stop loss and you have a 4% position size and you're using a 25% stop, then when you get stopped out, you're going to lose 1% every time. And that's okay. That's a completely manageable level of risk. Where people go wrong of course is they put 25% into that biotech stock and they get wiped out. And that's what you simply cannot ever afford as an investor. You can't afford to lose money.

So I would tell you: when you have those kind of opportunities, great. Just put in a 1% position. Or if you're going to go really aggressive, maybe a percent and a half. And you can do that. And those are fine.

And, by the way, those things are biotech stocks, and they're also – you find a lot of things – brand-new product innovation companies. So there's a new widget; there's a Roku or there's, heaven forbid, a Tesla. Something like this where you just have no way of knowing whether there will be product acceptance, whether it'll be the best new thing ever or whether it will be a dud. Is it the next Tesla or is it the next pet rock? Well, it's very hard for you to know beforehand. And you know there's going to be tons of volatility along the way. So the thing that you have to do is limit your position size. So that's the one category where stops don't work.

The other category where stops really don't work, ironically enough, is the opposite. So there are certain companies whose earnings and revenue growth are so consistent and so assured that using a stop is just foolish. I'll give you a great example. Hershey is one of these companies. McDonald's is one of these companies. These are just battleship businesses. And over any five-year period, they're going to grow their sales; they're going to grow their earnings. It's going to work. There is never going to come a time –

Buck Sexton: McCormick must be in that as well, right?

Porter Stansberry: What's that?

Buck Sexton: McCormick must be in that battleship category as well.

Porter Stansberry: McCormick, yeah. People are not going to stop using salt. People are not going to stop buying McDonald's hamburgers. People are not going to stop buying Hershey's chocolate bars. But somewhere along the way, if you happen to buy at the wrong time, if you pay a little bit too much for the stock than you should've – there'll be the documentary that came out about McDonald's 10 years ago that said that McDonald's was responsible for America's obesity problem. Super Size Me I think was what it was called. And the stock might fall 30% because of the change in the public sentiment. Now, it's possible you'd get stopped out. And if you look at the 10-year history of McDonald's stock, you'll realize what a disaster that would've been.

So the way that you protect yourself with these companies is the exact opposite, and that is: you hold onto them no matter what because you know that the dividend and the growing dividend will eventually lead you to have no risk. And so if you can make a pretty good case that over a 10-year period you're going to get all your money back from dividends, then you just hold onto the stock. Now, does it exactly equal what you paid over 10 years? Maybe, maybe not. Maybe it's 90%, maybe it's 110%. But if you can figure out, "Hey, I can get all my money back from buying this stock just by dividends over a 10-year period," then you don't worry about a stop.

The key there is: you don't want to overestimate the security of a business model. So you have to be looking at companies that have 20-, 30-, 40-, 50-year periods of consistently-growing revenues and earnings before you can be confident enough to buy those without a stop.

Buck Sexton: All right. You want to get into the mailbag?

Porter Stansberry: Let's have some baggery. Let's do it.

[Music plays]

Buck Sexton: First up here – oh, wait. Before I get to that, let me say thanks to everybody. We appreciate when you fill the inbox with useful feedback. We've gotten a whole bunch of e-mails this past week with very insightful notes. And we like seeing all that. People like Phyllis H., Vic B., Geann B., also known as Gene B. – I'm not sure how to pronounce that – Brian O., Matt R., and Larry S. Your comments and questions make us better at this. So please let us know. And Porter wants you to tell him things, not even necessarily things that he's going to love to hear. He'll tell you this. He likes to just hear – me too, by the way. So just tell us the things you want to tell us. Write to us at [email protected].

First up, Brandon R. in Dallas. "Hey, Porter and Buck, I'm a long-time listener who loves to follow your work and can't wait to listen to your podcast every week. Porter's thesis about debt crushing many companies in the near future is fascinating. I've come across many companies that appear cheap like Kraft Heinz, General Mills, AT&T, and Walgreens, but I'm concerned about debt levels. Is there a metric or ratio that an everyday investor can use to make intelligent decisions about whether a company has a safe amount of debt? Thanks for your time. Love what you do. Brandon R."

Porter Stansberry: You know, that is a fantastic question. And I really hesitate to give an answer. Because as soon as I give an answer, there will be 17 snotty listeners who write back and say, "But what about X?" or "What about Y?" or "What about Z?" So let me at least preface this by saying that every situation is different. And it's impossible to give a sensible one-case-fits-all example.

So let me give you the principle first. So the principle is: the more secure the business, the higher the operating margins, the more entrenched the business, the bigger the moat, then the larger amount of debt it can safely employ. Think about a company like Coca-Cola, for example. Coca-Cola typically has negative net equity. They're typically employing more debt than they're using in equity capital. Why? Well, because they have one of the world's greatest brands and they sell syrup. They don't have to do most of the bottling or that kind of stuff that takes a lot of capital. So they have a very high return on net capital, which is a great thing to be as a business. I mean, that's the highest-level quality business you can have. So it wouldn't make sense, in my mind, to run a business like Coke with no debt. This wouldn't make any sense at all.

But let's think about a business that's not Coke. Let's think about a business that's say Nvidia, the chip business. Nvidia's booming. People are using its chips to make bitcoin miners and they're using its chips to make videogame players. And they're going to be using these chips to make cars that drive themselves. I mean, this is a very high-tech, complicated business. But there's no moat. The guy who makes the better chip is the guy who's going to win tomorrow. And so they have to reinvest lots of capital into R&D. They have to keep on that treadmill of technology. That's a business that, even if it has big cash flows today, you wouldn't want to put a whole lot of debt on because you're very uncertain about what those earnings are going to be in 10 years.

So, again, I want to just emphasize that there is no one-size-fits-all ratio. But I do of course start with a screen like that, and what I'm looking for are companies that have more debt than equity. So a greater than 100% ratio between debt to equity seems very foolish and dangerous to me in most cases. So that's one example. The other example I like to use is: judging by say three-year average cash flows, can a company pay off all of its debts in less than 10 years? So looking at cash flows to debt levels. And thinking about your own balance sheet, right? If you wanted to, could you pay off all your debts in less than 10 years? I think that's a position that every individual should be in as well. If you're not in that position, you're probably taking too much personal risk.

So those are kind of the two things I look at: I look at what's the overall debt-to-equity ratio, and I look at this particular business' cash flows – how long would it take them to pay off all their debts?

Buck Sexton: Al right. Let's get into more of the mailbag here. We have Craig, who writes, "Hey Porter and Buck, thanks for the great podcast. Always informative and always thoughtful." Well, Craig, same to you. "Is there a straightforward way to check our mutual funds for exposure to the coming corporate debt meltdown or should mutual funds be avoided in general?" I am really curious about this, too. Porter, what say you?

Porter Stansberry: Well, most mutual funds do not have corporate bonds in them. So let's start with the fact that most mutual funds are not going to be near the epicenter of the corporate bond crisis. However – and this is a big "however" – there are lots of very large corporate bond ETFs. So HYG is I think the iShares junk bond ETF. There's another one – the symbol is JNK. I can't remember who administers that one, but it's another junk bond ETF.

Buck Sexton: Doesn't Vanguard have a really big one too?

Porter Stansberry: I don't know off the top of my head, Buck, but I'm sure they do. But what you want to be careful of is the mutual funds and the ETFs that advertise and that are dedicated to owning corporate debt. And I want to be really clear about something: I'm not being critical of the managers of these products. These products have an important function in the marketplace. They allow small investors to get exposure to the corporate bond market, which I'm a big fan of in general.

The problem is that these things are very poorly designed because of boneheaded regulation. So these things are required to have daily liquidity. And what that means is they're required to allow you to sell them with no notice. You just log in and sell. And I'm not exactly sure of the timing of the closing of the trades, but it's three to seven days I'm sure. I mean, you get your money back right away or almost right away. And the problem is that the underlying asset class doesn't function that way. It's not like a stock where you're just trading shares: boom, boom, boom. So there oftentimes isn't a functioning market for an individual bond.

So how does a mutual fund or a ETF that's – let's say a billion dollars' worth of capital wants to exit. That fund can't necessarily go into the market and raise a billion dollars at sensible prices. To get that cash, they're going to have to sell those bonds at extremely stupid prices, which is going to lead to big, unexpected, and in my opinion, totally unnecessary losses. And, Buck, hear me... This is going to happen. It is 100% certain that when you have this big of a disconnect between the daily liquidity of the entity and the underlying illiquidity of the asset, it's only a matter of time till there's a terrible accident. And I'm surprised and disappointed that regulators aren't doing more to correct that woeful misallocation of expectations.

Buck Sexton: So in the most basic terms, Porter, I can go on any number of different apps where I can hold these ETFs, I could sell them and instantaneously it's supposed to be able to sell it, but in reality, there are bonds that have to be sold in order to tie into the ETF that I've sold, right?

Porter Stansberry: That's right. And there may be no bid on those bonds; I mean, no one in the market who's willing to buy them. So, you know, I'll tell you a funny story. This is something that happens to traders all the time, but this was a friend of mine who was trading Russian securities during the August 1998 meltdown. So these were Russian sovereign bonds. And a month earlier, these bonds had been trading for – I forget what the prices were. Let's say it was 75 or 78 cents on the dollar. So the asking price is $0.78 and the bid is $0.75. So if you want to sell, you're going to take a 3% loss. Or you can try to cut the price in the middle and maybe you can get them at $0.65 or something like that. Okay?

So the guy calls up a week later and he's like, "Hey, I need to reduce some exposure here. Things aren't looking too good in Russia." And he says, "What's the market look like right now?" And the market maker for a major bank says, "Well, for you – you're a good customer. I can probably take those bonds off your hands for 55." And the guy said, "What? They were $0.75 last week." And he's like, "Yeah, well, that was last week. Now they're $0.55." And the guy goes, "Okay. Hang on. I have to run a model. I'll call back to you."

So he calls back and he says, "Hey, man, my model says that there's less than one chance in 20 million that those bonds aren't worth at least $0.75. Can't you take them off my hands at $0.70?" And the market maker of the major bank goes, "Yeah, no way, man. They're now $0.45." The guy's like, "What are you talking about? $0.45?" And he's panicking and he starts clicking away and he's picking up another phone, talking to his hedge fund manager and screaming at him. They're like, "You're going to take those bonds and we're getting at least $0.70 for them." And the guy's like, "Actually, latest bid is $0.38. You want to talk some more, you're going to lose some more money."

And that's the reality of what happens in the bond market when there's a crisis. And unfortunately, people think of these things as being like your faucet: you pull up on the handle, the water always comes out. Well, it's not. It's way more like a well. And sometimes you put the bucket in the well and there's no water in it. It doesn't matter what your expectations were. It doesn't matter what the prospectus says. You can't get a blood from stone. You can't make someone buy your bonds. And therefore you can't guarantee liquidity in a bond mutual fund or a bond ETF.

Buck Sexton: All right. Last one in the mailbag for this week, everybody. Ray L.: "This question is for Porter. Earlier this year you predicted that natural gas prices would rise significantly this year. Currently they're at about the same level as the beginning of 2018. Do you still hold this prediction or have you changed your mind? I don't see a large rise in natural gas prices, due to the continued growth of production in the Appalachian Basin. Your thoughts? From Ray."

Porter Stansberry: Yeah. That's a great point, Ray. I do understand how big these supply increases have been in Appalachia. And it's a real great asset for our country, and it's an amazing energy renaissance that very few people do understand, so it's a great question. But, yes, I do believe that natural gas prices are going to rise. Because I anticipate the creation of a global price for gas. And that would be very very bullish for America. A bullish price for gas is occurring because of major investments in LNG. And I'm sure Ray knows what that is, but for folks who don't know, that's how natural gas can be transported efficiently all around the world.

So, Buck, for the last 15 years or so, there have been hundreds of billions of dollars annually invested in LNG infrastructure. So these are plants that can convert a gas into a liquid, and then these are boats that carry that liquid to another port, and then those are port facilities that reconvert that liquid gas back into a gas-gas [laughs] – I don't know how to say that – and then distribute it around the countries. So these are major investments that've taken place over many years. And the result of all these investments is: by 2020 or so, we should be able to export something like 60% of our North American gas production, which is incredibly bullish for America because we have been drowning in gas. And I expect that the market will begin to rise in anticipation of that development. But we'll see, Ray. Of course I could be wrong. I've been wrong before.

Buck Sexton: You got a question for us, everybody, write to [email protected]. If we use your question, if it is so astute, so funny, or so worth everybody's time, we will send you Stansberry Research goodies. Love us or hate us, just don't ignore us.

Porter Stansberry: Hey, and speaking of Stansberry swag, Country Club Guy, what's the status? Shouldn't we have a swag store somewhere on our website at StansberryResearch.com?

Country Club Guy: We're going to do that – well, we have to get together to see what's going to be on the site. Because you personally have to pick out a lot of these things.

Porter Stansberry: I want some swag. I want to be walking around an airport one day – no I don't. I don't ever want to be in an airport again. But if I happen to be walking around in an airport one day because I have to be, I want to see someone wearing some Stansberry Research swag.

Country Club Guy: That's a better way to put it. Because we had our Spring Editors' Conference, Buck, down in Palm Beach, and I get on the plane, Southwest, which you don't do anymore, and –

Porter Stansberry: The cattle car.

Country Club Guy: – the woman next to me was reading American Jubilee.

Porter Stansberry: The book.

Country Club Guy: And I had the shirt on. And she looks at me, looks back. I'm like, "Don't do it. Don't do it." She goes, "You work at Stansberry." I'm like, "Oh, here we go." It was a good conversation, but the first thing she said was, "I bought the book. I didn't know I bought a subscription."

Porter Stansberry: Of course.

Country Club Guy: Yeah. So I had to go through a whole thing. But she was nice. It was a nice chat. And hopefully she will be a subscriber someday but just not yet.

Porter Stansberry: You should've been like, "I don't just work at Stansberry Research. I'm over at Porter's house every afternoon."

Country Club Guy: No, I didn't want to go that deep into what my relationship is with you. I don't want anybody to know. But anyways.

Porter Stansberry: Can we have a quick review of the Country Club Guy's lifestyle? There have been several major sporting events.

Country Club Guy: Where do I start?

Porter Stansberry: Well, I know you're in some kind of state squash championship. How's that going?

Country Club Guy: My uncle and I lost.

Porter Stansberry: You lost?

Country Club Guy: The team ended up winning the whole thing and they were very good. But my uncle's now 60. And I'm 46. So it's tough to play against youngsters. But we still have it. We took them to five games. I don't know – you guys probably don't know what that means. But we did our best. I played golf last week with our CEO, Mark Arnold.

Porter Stansberry: The member guest –

Country Club Guy: The member guest.

Porter Stansberry: – at Baltimore Country Club. How'd that go?

Country Club Guy: That was fun. We lost to a sandbagger who – I can't name his name, but a sandbagger's a guy who doesn't put in the good scores to bring his handicap down. So when he plays in a tournament, he gets a lot more strokes than he should. So this guy –

Porter Stansberry: The handicap cheater.

Country Club Guy: This guy had a net 60 score and this guy – the funny part of the story is I told Mark a week before – I said, "We're not going to win." He goes, "Well, that's a terrible attitude." Said, "This guy, Blank Blank, is going to win."

Porter Stansberry: Everybody knows he sandbags.

Country Club Guy: So after the 18th hole, we go up to the board, and Mark turned to me – you know how Mark hits people when he wants to talk to you, like a slap? He goes, "You called it." I said, "That's no big secret. This guy wins all the time."

Porter Stansberry: I have to figure out who that guy is.

Country Club Guy: I'll tell you off air. He's one of those dopey nice guys, but secretly he's just that guy. Like he would cheat somebody for a victory.

Buck Sexton: That's terrible.

Country Club Guy: It is terrible.

Porter Stansberry: Well, this is the risk that Country Club Guy takes.

Country Club Guy: Well, and in a couple of weeks I'm going on a boat trip.

Porter Stansberry: Well, I know, but that's not country club lifestyle.

Country Club Guy: Yes it is. On this boat it is.

[Crosstalk]

Porter Stansberry: Squash and then golf. And have you ever heard of – I heard of a new country club sport this weekend.

Country Club Guy: I know what it is.

Porter Stansberry: Pickleball.

Country Club Guy: Yeah.

Porter Stansberry: What's that?

Country Club Guy: Basically tennis with a wiffle ball.

Porter Stansberry: That sounds like fun.

Country Club Guy: Yeah. We should do that.

Porter Stansberry: You can curve it I bet.

Country Club Guy: Mm-hmm. There's a lot of good things you can do.

Buck Sexton: Do you play that sober or is it better with a bit of libation?

Country Club Guy: Well, that's kind of like paddle tennis, or they call platform tennis: you have a beer nearby. You're not playing it with your hand. But –

Porter Stansberry: It's nearby?

Country Club Guy: Yeah, it's nearby.

Porter Stansberry: It's like going hunting with us, Buck. We need some aiming juice.

[Laughter]

All right, Buck. This was a good podcast, a good week. I hope everything's well with you. I'm going to see you guys all back here next week for another edition.

Country Club Guy: That's right.

Buck Sexton: Stansberry Investor Hour everybody. Thank you so much. See you next week.

[Music plays]

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