On this week's Stansberry Investor Hour, Dan and Corey are joined by Hari Krishnan. Hari is a hedge-fund manager with a quant background. He has worked in many different areas, including foreign exchanges, commodities, and hedging mandates. His core business has been providing hedging strategies for institutional and high-net-worth clients. Now, he's joining the show to share some strategies from his newest book, Market Tremors, for handling market volatility and risk.
Dan and Corey kick off the podcast by discussing 2023 as a whole. They talk about the Dow Jones Industrial Average hitting a new all-time high recently and investors looking forward to the Federal Reserve cutting rates. Plus, they go over what they're bullish on for 2024 – including homebuilders, bitcoin, and energy, among others. Overall, Dan sums the year up simply...
What I'm sort of leaving 2023 with is this feeling of "something doesn't add up at all here."
Next, Hari joins the podcast to discuss his toolbox of strategies for profiting after a market sell-off. He notes that there are times that are great for buying credit, while other times aren't so good. And the same principle applies to other areas of the market as well...
There are times when volatility is very cheap. It's cheap precisely because nobody wants to buy it. Nobody wants to buy protection.
The conversation then shifts to how the average investor could utilize Hari's strategies. He gives a few examples of what to do in different scenarios. And he especially emphasizes the importance of having a plan...
There's some level at which you can only take so much pain, and you have to get out so that you can at least focus on other things... Having a plan, for the average investor, is very important... It allows for good decisions in the long term because you can work on your research instead of being fixated on watching the [trading] screen, and losing your mind in the process.
Further, Hari details how he assesses and categorizes risk. He describes why he looks at consistency across different asset classes and how this helps him find winning investments. Plus, Hari talks about the cycles of volatility, using equities as an example. He explains that risk taking drives the market upward, which leads to even more risk taking. It then becomes a vicious cycle that feeds on itself...
The cycle continues until it just breaks. It snaps. At some point, there's a shock that's large enough that it forces the latecomers out of the market, and the snowball starts rolling down the hill...
Finally, Dan asks Hari for his opinions on the S&P 500 Index's recent rally. Hari brings up the fact that there are currently high levels of complacency in the markets, and he argues that now is a great time for investors to think about hedges for their portfolios. He finishes by urging investors to look beyond the U.S. stock market and to broaden their opportunities with other asset classes.
Head of volatility strategies at SCT Capital Management
Hari Krishnan is a hedge-fund manager with a quant background. He has worked in many different areas, including foreign exchanges, commodities, and hedging mandates. His core business has been providing hedging strategies for institutional and high-net-worth clients.
Dan Ferris: Hello, and welcome to the Stansberry Investor Hour. I'm Dan Ferris. I'm the editor of Extreme Value and The Ferris Report, both published by Stansberry Research.
Corey McLaughlin: And I'm Corey McLaughlin, editor of the Stansberry Digest. Today, we interview Hari Krishnan, money manager and author of The Second Leg Down.
Dan Ferris: And today, Corey and I will talk about 2023 and 2024, things we learned this year, things we're bullish on and bearish on for next year.
Corey McLaughlin: And remember if you want to ask us a question or tell us what's on your mind, e-mail us at [email protected].
Dan Ferris: That and more right now on the Stansberry Investor Hour.
Well, here it is, friend, our last sort of freestyle rant of 2023, and what a year it's been. I think we learned – I feel like we learned a lot this year, but I'm not sure exactly what it is. I feel like I learned a lot, but I'm not sure what it is. A lot happened. I mean, I started out the year thinking, well, this is going to be the second year of a bear market, and that kind of didn't happen at all, really. I mean, we had some bearish action here and there, but it was really nothing.
Corey McLaughlin: Right. I mean, it is and it isn't only just recently that the Dow Jones Industrial Average is making new all-time high. The rest of them still, as we're speaking right now, haven't. They're pretty close now all of a sudden. And then you would say, hey, that bear market is kaput for good, but yeah, this is – or a lot of other people would say this bear market is done for good, but I guess what I learned this year, that the most heavily forecast recession of all time could – that all those people would be wrong and the market will still go up despite all these obvious kind of concerns that are still now heading int 2024, the same concerns I think and a little bit more when you look at the consumer debt levels and corporate debt and those sort of things heading into next year with a Fed that appears to be saying rate cuts are coming before anything else. So it's usually when the bad news starts to turn into bad news, I think.
Dan Ferris: Yeah, that's what I'm sort of leaving 2023 with is this feeling of something doesn't add up at all here, and I know I've been accused of being kind of too bearish, perma-bearish, whatever, even though that's – I can demonstrate that that is absolutely false and have many times, but it's weird to me that the markets are kind of on fire and 100 basis points have been lopped off the 30-year mortgage and other interest rates have fallen quite a bit, and the stock market is on fire all of a sudden, new highs in the Dow, new highs in actually S&P 500 total return. But in the same way, interest-rate cuts against low unemployment and bullish stock market action and optimism stuff, interest-rate cuts would not be good. That would be something that you would do if you were afraid of interest rate – you know, the cost of money hurting the economy if you were a central banker. You take interest rates down when you think things are slowing up and the economy needs a boost and you don't – you do it when you want to stimulate, in a word. And why would you want to stimulate with stocks making new all-time highs and everything else looking pretty decent? I don't get it. There's a disconnect between expectations of rate cuts on the one hand and everything on fire on the other.
Corey McLaughlin: Yeah. To that point too, I don't know if you saw this, but we're talking a couple days after the latest Fed meeting with Jerome Powell where the markets shot up as that announcement came out of a pause and projections for three rate cuts next year. And now we have the Fed underlings, the other people on the Fed coming out in the media this week and saying, "Pump the brakes on that." They're trying to do a little – you want to call it "damage control" or "message clarification." You had Aaron [inaudible] today saying he's confused by the market reaction and it doesn't make sense to him. OK, but that's what the market was thinking, so I don't know. But it's – John Williams, the New York Fed president, who's probably the No. 2 guy there saying we aren't really talking about rate cuts right now. That's what he said on Friday on CNBC. So I don't know. Either they're trying to dampen the mood or just really aren't talking about rate cuts, which I don't believe since they literally wrote down in their projections that they are talking about rate cuts.
Dan Ferris: I was just going to say that. Doesn't it say something like penciling in – sort of penciling in in the summer of economic projections, like I think three cuts in 2024. So those zany Fed guys, you never know what they really mean when they're talking.
Corey McLaughlin: Right. and at the same time, you've got oil prices down 20% from their last highs like our guest will talk about a little bit, which is confusing, which would indicate some expectation for a slowdown, so yeah, it is a –
Dan Ferris: However, I'm glad you mentioned that because our friend, Jason Goepfert, over at SentimenTrader put out a piece recently, the gist of which was a 25% drawdown in oil prices is not necessarily a reason to sell, or hasn't been one historically. That's their thing, they crunch historical data like nobody else, and historically speaking, they said a 25% drawdown, I mean, it's a volatile commodity, right? Commodities are volatile, so a 25% drawdown in oil doesn't necessarily mean that the oil price is going to continue falling or stay low or whatever. And I don't know, in general right now, like $70-plus a barrel, the big guys are minting money at $70-plus a barrel. They're minting cash, and they still are up against this green political thing that discourages the long-term investments they need to make in order to generate new supply, so they're going to be paying dividends and buying back stock, as they have been amidst falling capital expenditures, so I continue to believe they're actually a pretty good bet even though they have, to some extent, followed the price of oil around.
Corey McLaughlin: Yeah, you've got the U.S. government too buying at these prices too to fill back up the oil reserves, so got that going for them too.
Dan Ferris: All right, so I wonder if we could – I don't know, if I could sum up what I learned in 2023, it would probably – the learnings in the market tend to be just an affirmation of timeless wisdom. Nobody knows if there's going to be a recession, don't even bother trying to predict it, don't predict short-term market direction. You don't know where it's going in the coming year, even if you're Dan Ferris and you think you know it's going to be the second year of a bear market, etc., etc. You don't know. So it's just the usual stuff that one year usually teaches you that one year doesn't mean sh-t.
Corey McLaughlin: Yes. Correct. Because I will say one other thing as you're – that I maybe am reminded of is stocks that go down 20%, 30% in a given period, 40%, 50% like these tech stocks did in 2022. Typically if you have a longer time horizon than that, that is the time when you should be – if you're interested, should be thinking about buying shares, not unloading them at that point. If we've seen the returns from these tech stocks, you can say what you want about the valuations now. But last year when Netflix and Meta were down 40%, 50%, nobody wanted to touch them, and that would have been the time to do it. So that's always a reminder too, and I'm reminded of that now with a stock like I keep looking at Hershey is still down 30% and now trading sideways. That's not going to – right now is the time to kind of think about those things. Whenever you see a company that you like has a massive drawdown like that, it's time to put the cash to work then, more than any other time.
Dan Ferris: Yeah. Right. If you still like the business, why aren't you buying, period? We've talked about Disney in this respect too. So yeah, let's – maybe we'll look ahead to 2024 a little bit. Is there anything like – and we got a nice piece of feedback from a listener that says stop talking about the Fed so much, so maybe we'll stop – I don't know if we'll stop 100%, but we'll try to keep it to a minimum. And is there anything that you're really bullish on for 2024? Maybe what we're really bullish, really bearish. Let's do the bullish first. I have a couple of them right off the top of my head. Is there anything that you, like looking ahead, you think, wow, this is a really good buy right now?
Corey McLaughlin: Bullish right now, because I am concerned about recession/slowdown sometime in early 2024. I really am. So if anything, I would be bullish on kind of a conservative approach to things at this point, and T-bills are just – if you're waiting to pounce on stuff, T-bills – the shortest of short term, the one-month ones, are still paying 5.5%. So if you're concerned about something in the next month, two, three, four months, just – I'm bullish on that and rolling those over until proven otherwise. And exactly what I just said, looking for things that are down 20%, 30% and knowing that in the longer run those prices will be higher. And if we're going to see something like – even like if we end up seeing some sort of deflation that surprises the heck out of everybody, you're going to be happy to have cash because that by definition should be more valuable. So I am bullish on T-bills, which is probably the least sexy thing I could say right now, but that is the truth.
Dan Ferris: You know, T-bills like – I agree with you about T-bills. You're not going to get any movement on your principal there. It's just going to stay steady, and your yield might even fall, but I agree, at 5.5%, I'm gobbling it up, man. I love it. I would say housing is one thing because if we do – rates are down a little, you know, somewhat. Actually, it's a lot. If you look at the bank rate, sort of national 30-year mortgage rate, it was 8% and now it's 7%. that's – 1% over the life of the loan is substantial. So that's really good. Plus, on top of that, the big homebuilders are buying them down to 4% and 5%, definitely the 5%-ish neighborhood. So I have to continue to be bullish on housing.
If we really do get a rate cut, that first one, your housing stocks are going to pop 5% because it's like, wow, yeah, this is great, and then the spreads are going to close up even more. So that's one thing I'm definitely – I continue, like we got a bit of a head fake, like a bearish head fake in housing this year, but the stocks all came roaring back, and now rates are down so – and those buydowns are coming through there. It's not like the oil companies we just mentioned because these guys can put the money to work. People aren't selling their existing homes because they've got 3% mortgages, and so homebuilders are filling in the demand by building. So they can build, they can put the money to work, and they can make plenty of money doing what they're doing, so maybe their margins will suffer from the mortgage buydowns, but they'll keep making money, and I think that trade is going to continue to do well into next year.
Corey McLaughlin: Cool. Very good. One other thing I'll say I'm bullish on since T-bills might not scratch the itch for too many people: bitcoin. I am bullish on bitcoin because we're approaching one of these bitcoin halvings next year, which traditionally throughout the brief short history of bitcoin has been a catalyst for much higher prices, new highs eventually. It might not be in 2024, but it may be in early 2025 based on history and timing these things out. You're already seeing – I mean, we've seen a 150% gain in bitcoin in the past year. You may think, all right, it's not – that's overbought, but it's not. If you look at this – I'll get a little in the weeks of the stock-to-flow model, which I'm sure you've seen, which if you believe that bitcoin is a hard currency, this model has been dead on on the path of the price since the beginning really. And the limited supply, and then when these halvings happen, the increase in demand, that's the whole balance and there are different charts you can find out about it.
I am more bullish than ever on bitcoin because I think at this point we've seen – you've seen – we've seen these crises. We saw SBF, FTX, you've got the SEC going after cryptos. This is all in the past year, and yet it's still there. It has not gone to zero. And so all those things behind, if you're going to get a new wave of people interested in bitcoin, which you might in an economic downturn or a recession from a new generation of people, I think that whole story can start over – the bitcoin story can start all over again, especially if you're seeing prices go – if you see something over 100,000 or something, that's going to get a lot of people's attention, which may create more FOMO and push it all higher and on and on. So I'm not saying put your whole net worth in there, but I am bullish on bitcoin the next year or two.
Dan Ferris: Yeah, I'm not sure how I feel about bitcoin anymore, honestly. I started out I was really skeptical. I was like this can't – I saw the price action and I was like this thing's going to fall 90%. And actually, after I said that, it fell 80%, so I was close. But then I recommended the thing in the Extreme Value newsletter because I thought it was real. I thought, "This is actually going to work. This is reasonably well designed, and I think people will use it." I thought people would actually use it. But the more time goes on, it just – it trades like such a volatile, crazy, tech-long type of a thing. But by the time a guy like me says, "Oh OK, this can function in the way it was originally intended, it'll be $1 million. It'll be $1 million and then it'll just go sideways at $1 million for a decade or something," and then I'll be like, "Oh OK, it works, it's good, and everybody who started getting bullish when you're getting bullish would have said Corey's a genius, Dan's an idiot." And that's the way it is on bitcoin.
Corey McLaughlin: Yeah, no, I see that. I still think it's speculation, like you said, the way it trades. I would not be surprised at all if it goes down 40%, 50% soon either. But I think longer term, I think it's clearly established itself as, if nothing else, a speculative asset class that is there. You might have the first ETF coming on soon, bitcoin ETF. There's other ways to get exposure to it in public markets, but not a spot ETF, so that may be a catalyst that a lot of people have been talking about that. I'm not sure it's an inflation hedge like gold is. It hasn't behaved like that yet. And you're right, how many people are exchanging bitcoin for things? I don't know, not – you're not buying McDonald's cheeseburgers with bitcoin at this point. You're still using cash and credit cards.
Dan Ferris: And even when you buy something, you're going from cash to bitcoin probably back to cash, right?
Corey McLaughlin: Yeah, and the banking system still is increasingly getting control over the on-ramps and the off-ramps to crypto, and to me, I'm looking at it more as a speculative asset than any real sort of – more so than the real use case for it. And that's been the story with bitcoin too since the beginning, and it still hasn't changed.
Dan Ferris: Makes sense. OK, so we've got housing and bitcoin.
Corey McLaughlin: Yeah, right. I've got bitcoin and T-bills, so I'm playing both ends of the –
Dan Ferris: Yeah, you're running a barbell strategy. So I think in addition to housing, I just continue to be a long-term energy bull, so uranium and oil and gas. I mean, the world runs on this stuff, and I think uranium will be – people will talk about uranium more and more and more, they'll talk about small modular reactors more and more, and they'll build more and more of them all over the world. And I think the incentivization price is probably around $60, so when uranium's at $60, though, that doesn't mean that investment comes screaming out of the woodwork into uranium. I think – I've spoken about copper in this way. I think it probably takes 50% or 100% higher than the incentivization price than the price at which people start making money. It won't take $60... it'll take $100 uranium or $120 uranium to really get money to start moving, lots of capital to start moving in and beefing up the supply. So I think it's got lots of legs under it, and I think it'll continue to do well for the next few years, however long it takes for the uranium price to get up there in triple-digit land, which I think it probably will go at some point. And as far as oil and gas, I talked about it earlier, and that's it. As long as oil and gas companies are disincentivized to make the long-term investments they need to generate more supply, they're going to keep minting money here at $70 or $73 a barrel as we speak, and they're going to buy back shares and pay dividends, and that's it.
Corey McLaughlin: Yeah, and I'm bullish on companies that are buying back and paying dividends too, throughout all these downturns that we've seen and fake outs and bear market rallies. I mean, if you just held on through those times and got rewarded along the way, you're probably pretty happy when you get a 15% spike in the S&P 500 the last couple two months. Prices are higher generally. You're like, oh all right, I'm glad I got more shares and dividends while I was just sitting there.
Dan Ferris: Yeah, I agree. I got one more for you. Mortgage-backed securities. They've already done well. They've moved along with the whole bond market here, but I think it'll be – it'll continue to perform as long as we're – interest rates are higher, so you want to own them more, and if we really do see lower rates, if the Fed starts cutting rates, guess what, these things are guaranteed, they've got really great assets behind them, etc., they're great securities, so they'll perform really well. I think they've got plenty of convexity built into them, which means a little move over here means a big move in mortgage-backed securities, a bigger move in mortgage-backed securities.
So I think MBS will do well. I'm personally holding them, I think they're great, and so that's another one. And it's part of the whole housing idea, and just the simple – and it actually relates to your T-bill idea too because we're talking about a safer bond that is generating a decent yield now and will continue doing that as long as you hold it, but with more convexity in it, with more kind of upside potential than that T-bill that you have. So that is really, really kind of attractive to me.
Corey McLaughlin: Yeah, yeah, I can see that. Yeah, T-bills you're not going to get any capital appreciation or anything like that.
Dan Ferris: Which is good. That's the way it's designed. Exactly. That's right. OK, so bearish for 2024. I've got one, but I'll let you go first because I think we might have the same one.
Corey McLaughlin: All right, bearish. What am I bearish on? I'm not necessarily bearish on stocks still, given all this given the concerns. You know, if we get a recession, yes, there will be – there should be a cut for stocks, but like I was just saying, if you're holding the right ones that are going to reward you along the way and you have a longer horizon, not necessarily a problem I don't think. I mean, if you're one or two years and don't want to lose anything, can't stand to lose anything, that's a different story. And I'm on the longer end. I'm not on the one- or two-year end personally.
Dan Ferris: OK, so my bearish call is actually Magnificent Seven. I think if we really do get – if this market action right now follows through into 2024 and we get another maybe even like a melt-up or whatever, and people respond to – and the Fed cuts and people respond to the lower rates the way everyone is – the way the market is discounting right now, I think money flies out of those Magnificent Seven and into probably garbage or small caps and stuff because the small caps really ripped better and bigger than anything in the wake of this Fed news. So I think that – and I think the Magnificent Seven was a good trade for late 2022 into 2023, but I think it's long in the tooth. I think they're expensive. They're great businesses, they'll gush cash, they'll pay dividends or whatever they do, buy back stock, but I think the move is big and they're kind of expensive now.
Corey McLaughlin: Agreed. Yeah, I would agree with you about that one, so you're right about that. Yeah, I'm not running out trying to buy Tesla right now. So it's – there's other things to do. And yeah, you're right, on the small caps have been ripping higher off this Fed news, which reminds me, OK, if it's really the end of the bear market, small caps usually lead the way out and up, and so maybe that's what we're starting to see. And it may not happen still for months or however long, but I think that you definitely saw small caps leading the way off this idea of Fed rate cuts.
Dan Ferris: Small caps went from – like the – if we're calling the Russell 2000 small caps, small caps went from 52-week low to 52-week high in a couple of weeks. It was like October 20-something, 23rd, I think, to just a few days ago, just like wham. I mean, that's a breathtaking move. And again, I mentioned our friends at SentimenTrader, they pointed out this doesn't happen that often, but it has happened before, and it's a bullish thing. It's been bullish. So if that signal, if you guys are right, and you just mentioned it and they mentioned it, that could be the one that's telling you, yep, this thing's for real, there's been a change, 2024's going to be a ripper, get long and strong, and away we go.
Corey McLaughlin: Would be nice. Get past 2023. 2023 was a confusing, puzzling year in some ways in the markets, I would say, as I guess maybe all of them are, but this one definitely qualifies.
Dan Ferris: Yeah, they're all puzzling years. Yeah, one-year timeframes are puzzlers because they're unpredictable. All right, well OK, let's turn to our guest today. We talked with him recently, and I'm thrilled to have him on the show. I'm thrilled to have Hari Krishnan on the show because he just has a different way of looking at things, and he's had an interesting career. I follow him on Twitter, I always want to know what he has to say, and we're going to talk about his book, The Second Leg Down, which is an interesting title, isn't it? And I really want you to take notes on this one. He's a sophisticated guy but he tends to be able to explain things pretty well, and I'm thrilled for you to have the opportunity if – you've probably never heard of him before, but you're about to learn a lot, I think, and I will too. So let's do it. Let's talk with Hari Krishnan. Let's do it right now.
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Dan Ferris: Hari, welcome to the show. Thanks for joining us.
Hari Krishnan: It's a pleasure. Thank you, Dan.
Dan Ferris: So I have my trusty compatriot, Corey McLaughlin, with me today, and we will be hitting you with lots of good questions. Hopefully they'll be good. And I'm sure you'll have some good answers.
Hari Krishnan: That's the question. We'll see.
Dan Ferris: So you're new to our audience, and I'd like our listeners to sort of be a little familiar with you, what you've done and what you're doing now, and who is this guy? Who is this Hari Krishnan?
Hari Krishnan: Well, I should shave my head. I've told this joke before. Moved to Denmark and become a faith healer or a _____ or at least a commercial guy in that vein, but no, I've been a hedge fund manager for many years covering a lot of different areas. I was an FX manager for many years in the UK. I've run numerous long volatility/hedging mandates over the years. I'm even in the commodities space at this time in a fairly big way, but my core business for the past five or six years has typically been providing hedging strategies for various clients, institutional and high net worth. So I've been around the block, and I do have a quant background, but I'll try not to go too far in that direction because I may never return. So that's pretty much my background.
Dan Ferris: All right, sounds good. So, Hari, the one idea that I want to start with is something that I found very interesting because it just speaks straight to the way people really most want to behave. They're short volatility. They're long. Most of the time they've got their stocks and bonds and their 401(k)s, and then when do they think about hedging or worrying about downturns? Is it before the downturn? No, it's after it. It's after that first leg down, and I found – I was so intrigued when I found your book, which is titled The Second Leg Down: Strategies for Profiting After a Market Sell-off just for that reason alone because I thought isn't this exactly what people want to hear and yet I would have thought it's too late. But according to you, after that first leg down, not necessarily too late. Even in terms of pricing for some strategies, I was impressed by what I found in the book.
Hari Krishnan: Well, let me give you a little story there. A lot of what I do, even though I do go into the weeds quite a bit, everything I do, I try to base on what I see from clients. So I'm trying to address what clients, real clients are worried about. And it's only natural that if you sit back and look at valuations or you look at the credit markets, there are times that are great for buying credit, and there are times that aren't so good. And the best times are after a bit of a sell-off when spreads widen and you get more return per unit of risk taken, assuming that the bottom doesn't fall out in the world. Volatility should be the same thing. it does have a fairly discernable cycle. It's not precise but fairly discernable, and there are times when volatility's very cheap, but it's cheap precisely because nobody wants to buy it. Nobody wants to buy protection.
And I could go out, and I used to go out and say, look, I can go out and buy a two-year to maturity put that protects you against a move greater than 10% down in the S&P, and you'll only pay 15% vol for that, which is pretty low. And nobody cares because they said, well, there are a bunch of good reasons why stocks will continue to go up. And I never really got that many mandates except from fairly forward-looking people during bull markets. But then as soon as things went bad, take something very severe like March 2020 or 2008, early- to mid-2008 and so on, everyone wants to hedge. And it's precisely because everyone wants to hedge that the cost of hedging becomes expensive.
So what I wanted to do is to come up with a suite of strategies, a range, a toolbox of strategies as it were that would allow clients to have hedges on no matter how bad the situation got, but where the nature of the hedging would change over time. So the whole book is really – The Second Leg Down is really about regime-based hedging. And the theory that I had was – and it's borne out in a lot of analysis – is that there's no option strategy that is universally bad and there's no option strategy that's universally good. Each strategy is – sort of fits into the "every dog has its day" category where there are hedges that are efficient that you can put on no matter how bad market conditions get. They might not protect you all the way down and you may have to be more dynamic, but the beauty of that approach is that if you have different hedges that you can put on as conditions get worse, as there's a second leg down as fear increases, you automatically have profit taking built in because you're rotating from one type of hedge into another. And I know I'm sort of rushing through this a little bit, but my basic point is that for a lot of hedgers in quiet markets, they can hedge, and timing doesn't matter too much because the cost of insurance is low, but they don't know how to take the hedge off. And having a strategy where you have different types of hedges that you put on as market fear levels go up can be very effective not only in terms of efficiency but also in terms of profiting.
Dan Ferris: OK, so this all – already this sounds like very sophisticated, swapping in and out of options strategies depending on where you are in a market decline. What I wonder is – and I wondered this – like I didn't read every word of your book because, frankly, I look at some of it and I go too many equations in that sentence there or whatever.
Hari Krishnan: Yeah, I was told that my sales would go down by 50% for every equation I put in. Couldn't help myself, but there you go.
Dan Ferris: Well, I bought it and I still don't know the equations, so I mean, maybe that's not 100% true. At any rate, what I wonder is let's say the average guy who might have a – what would to him be a substantial six-figure sum, usually in stocks and bonds, is that without having to get a PhD in math, I wonder if there's any simpler way to do what you're suggesting. In other words, when they're down that first leg, is it a simple matter of – actually I'll leave it there. When the average investor is sort of down that first leg, they don't have your knowledge and experience, short of having you manage their money, is there anything they could do, or do they simply have to suffer through the drawdowns?
Hari Krishnan: Yeah, that's a great question, and I'll try and break it down a little bit, which is that you never want to have too large a position on than you feel comfortable having. So there are various ways to play it. If you were very long stocks, let's say tech, and tech goes into a 10% drawdown, you have a few choices. One is to sell your position down a bit, but then try and re-own it by buying coal options. If I own the Nasdaq in size, the Nasdaq is down 10%, 20%, I might feel like it could go down 50%. My perception of risk will have changed. But if I go and I sell some of the position and rebuy the position with bounded risk using call options, that's one way to play it.
Another way to play it is to have solid risk management, have some rules for increasing and taking down positions as conditions change. I know that in the equity world life is a bit different from other asset classes in the sense that when an index gets cheaper, it's usually considered to offer better value, which kind of flies in the face of a lot of the strategies that I apply in markets outside of equities, but there's some level at which you can only take so much pain, and you have to get out so that you can at least focus on other things. I mean, one of the big topics in the book is what sort of strategies can you apply that allow you to take a look around the block, maybe with your dog, I don't know, but where you don't have to be glued to the screen watching every tick, not knowing what you're going to do with the next tick. In other words, let's say you're long in size the big seven in the Nasdaq, and you've lost 10%, 15%, you have a sizeable portfolio, and market trades up a little bit. What do you do? Do you just breathe a sigh of relief and continue staring at the screen? Or do you do something about it? And what if the market ticks down a little bit? Do you panic and sell the position, or do you just watch the ticks again hoping it will go back up?
Having a plan for the average investor is very important. Even if it doesn't maximize alpha in the short term, it allows for good decisions in the long term because you can work on your research instead of being fixated on watching the screen and losing your mind in the process. So I think having a plan is very, very important.
Dan Ferris: You actually are reminding me of another guest that we had on the show, Annie Duke, and she talked about making decisions and the mistake of resulting, meaning that you could think you've done something awful because your portfolio is down however much percent, but maybe you haven't done anything awful at all and the right thing to do is nothing because you've actually made a very good long-term decision. And of course, it works the other way as well. You haven't necessarily made a great decision just because your portfolio is up over a given time. It's hard to know all that, though, isn't it? It's hard – actually, I'm reminded of – you know what else I'm reminded of. There's a quote from Cliff Asness in the book, and he's talking about I can't tell you how impossibly difficult it is. I forget the exact words, but the gist of it was I don't have the words to tell you how difficult it is to ride through a drawdown, basically, even though you know that this drawdown is normal, you're on strategy, everything's working out as it ought to according to history and what you expected the strategy to do. It still doesn't matter. And so that's multiplied by folks in your business because you have clients beating on you every day, but it's no less difficult. In fact, it may even be more difficult for just the average individual investor who is our listener and our reader to stick to their strategy without a Cliff Asness calling them up and saying it's going to be OK, or a Hari Krishnan calling them up.
Hari Krishnan: Well, a couple of things on that point. The first thing is that I once heard a musician say that – jazz musician say that I'm practicing today for things that will naturally or spontaneously appear in my playing in six months. And that's what you're doing research for, and you need the time to do research so that your learning does evolve over time. So I don't want to give clients or listeners the view that your strategy, once you decide it, is etched in stone and it will never change. You do need to be dynamic, but I think you need to be dynamic over longer time scales than just trying to come up with a moment of brilliance in the middle of a volatile market. That's where I say you need to stick to your strategy. That's point No. 1.
Point No. 2 is – Jerome Abernathy told me this, well-known managed futures guy, and I put it in the book. I should have given him more credit, but he said something like it looks good at 60, it looks great at 50, it looks absolutely fantastic at 40, and you're out of business at 30. So that kind of mindset is very important to have because you will have opportunities in other markets. I mean, I used to know an investment club, my wife was in it, and they basically had the view – and they were old retail – they had the view that, well, if we have a winning stock, we'll sell it because we can monetize that, but if we have a stock that's really dropped, we won't sell it because it's going to come back. It's eventually going to come back. And there are two problems with that.
One is that you've just thrown risk management out the window, but perhaps another problem is that even if you lose money on that one trade, if you find a better opportunity to redeploy the capital, I would argue that, ignoring tax consequences and so on, that that's the right way to think about investing. You don't think about tabulating every individual trade and saying that was a winner or a loser, but you search for opportunities at scale and see if you can find them and take the cash that you have available and deploy it... rather than saying, "I've got this position on and it's eating me up inside, I'm losing money every day, and what am I supposed to do about it?" Think about what else you could do. Think about whether you can diversify to something else that may have some convexity, some upside potential that your current position doesn't have instead of thinking of, oh, this is like my family, I cannot sell this position. It's very different. You've got positions on, and you need to be willing to look for new opportunities every time. And that's something I would recommend to clients as well, don't get stuck in one paradigm. Manage your risk as though you have a system, use a system, but also look out for opportunities where you can build upside into your portfolio.
And as somebody who looks at volatility a lot, that's what I think about. Can I come up with trades – you don't need to use options, but I do – that I can sort of put in my cupboard and not think about unless something really rips, and I'll look and see how it did, and then I can do something with it. So I almost have a different perception of these lottery-style trades that I sprinkle into my portfolios or into client portfolios than I do about the rest of the portfolio. And I think that's another thing that your investment crowd can think about. Are there ways to sprinkle in a few highly convex bets? Doesn't mean you need to use options, but you find stuff that's really depressed and they have big upside. Put that in, don't follow that to the same degree that you follow the core portfolio, and see what happens. I think that's another takeaway that clients can get without going into the technical issues too much.
Dan Ferris: Actually, in your book you did have one example that I found very simple, very easy to understand of something that is pretty complex where you talked about the return that you get from if you get plus 1%, plus 1%, plus 1%, plus 1%, plus 1%, plus 1, then minus 5%, and then reverse it and say minus 1%, minus 1%, minus 1%, minus 1%, minus1%, then minus 5%. And everybody wants the constant plus-1%s. Nobody wants the constant minus-1%s, and yet, as you pointed out, that's the one with the better return. I was fascinated by it. I've never heard anyone explain it that way. It was very simple.
Hari Krishnan: Well, Mark Spitznagel wrote a whole book about that, basically, about compounding risk, how – I've also Nassim Taleb said some stuff about this, how if you took out the worst 10 single days in the S&P, the annualized return would go up substantially. And this is all true, and it's all about compounding. If you lose 50%, it's going to be hard to get back in the game. So you need mechanisms in place, and this is why clients call me up. They don't want to lose more than a certain amount. They feel that if they lose more than 20% of the portfolio level, let's say, they're in a pickle because they're not going to make it back very easily. So they need something that's going to at least maybe not put a hard floor on their losses but cushion the blow substantially, and that's a big part of my job. I have seen and I know – I sympathize with many clients who look at volatility and look at ETFs and see all the ETFs decaying like crazy, whether it's the VXX or whatever. And they think, well, there's no way to hedge. But this is not true. There are ways to hedge effectively based on the state of the world at a given point in time, and we can go into that too if you're interested.
Corey McLaughlin: I am interested in that, Hari. That was one of the questions I had jotted down here to maybe ask you was how do you assess the risks – how do you personally assess the risks out there in the market within whatever you're allocating to – say somebody's allocating to a specific trade or idea or something. Do you assess geopolitical risks? Do you assess – I mean, assessing valuations?
Hari Krishnan: These are all great questions, and I try and divide my brain if I can into the guy in the engineering room and the macro guy. The guy in the engineering room writes a book like The Second Leg Down or Market Tremors. He's basically saying perhaps can I take a bunch of 50/50 bets and make money off them by structuring the trade? Or can I add convexity to a trade or reduce the bleed in a trade that has negative carry where I have to pay to keep the trade on? And do things like that where the engineering function is basically designed to take a view and turn it into something that can be held for a long period of time and provides plenty of upside capture should things go in the direction of the view. That's one side of my brain. I don't mean left or right but just some piece.
The other question is how do I formulate views. That's a more complex question because I do partner with people for that, but I'll give you some examples of things I look at. I tend to be very cross-asset-class focused. So right now I'm a bit puzzled because commodities – many commodities are depressed now – what, corn, copper's now very high, natural gas, you can go down the line. And they should be indicative of recession, and yet equity multiples are very high. And it's true that rates have come down. The 10-year has rallied hard in price terms, stuff that I do look at, but last year the move out was far wider and now we have kind of a symmetric 2022 and 2023, which surprises me. I would have thought we would be down in those two years given the change in the macro landscape what the commodity markets are signaling and so on.
So if you had to pin me down, even though I use a lot of external research for this, I would argue that the best way to look at macro if you don't have time to really dig into great detail is to look at consistency across different asset classes. So commodities, are they cheap relative to equities or rates? If you look at the change in rates, how would you explain the discount or the equity risk premium given the jump in rates, and so on and so forth? If you find inconsistencies, that's where the trades tend to evolve or tend to emerge from at the macro level. So I'm very macro focused. If you said to me what do I think of Nvidia or something, I wouldn't be able to tell you because that's not really what I do. I view everything from the top-down lens.
And I also look a lot at risk, what's the market pricing of risk. And a lot of people have done this work. I've also done some of it, and it basically shows the really weird stuff that happens in markets where – so take equities because I'm sure your audience is more familiar with that. So equity volatility is low, let's say. So what does that mean? It means that institutions have the freedom to allocate more to equities not only because their risk systems tell them that they can, but also because they've been making money in equities so they can add to their positions, especially if they use margin. So what happens then? The market rallies. Other people have FOMO, so they want to get in as well. Little dips are bought because people think that buying dips is always going to be good. Market continues to rally, volatility compresses, the VIX, not that it's the be-all and end-all goes down. That allows even more risk taking. It allows funds that allocate on a volatility-adjusted basis to stocks, bonds, commodities, and so on to increase their equity positions.
And so the cycle keeps feeding itself and the flows go into the indices, so the biggest names get the biggest pop based on the impact of all that buying, that sort of valuation and sensitive buying, and the cycle continues until it just breaks, snaps. At some point, there is a shock that is large enough that it forces the latecomers out of the market and the snowball starts rolling down the hill. So we're seeing very different dynamics from what we used to see in the sense that I think rallies are harder than they used to be because the leverage cycle winds pretty quickly nowadays on the upside, and sell-offs are also – can be very severe and come out of nowhere. And I think that's something that investors really should be thinking about, the fact that rallies are quicker and also sell-offs can be very rapid and unexpected simply because of the way the spring coils and then explodes to the other side, or pops out to the other side.
Dan Ferris: Right, so let's maybe talk about that relative to this moment. Here we sit in call it mid-December of the year 2023, and I guess it was about October – I think it was 18th or 19th, since then we've had a pretty substantial move up. As we speak, we're a day after the Fed has done its thing, and markets were in love with it and rallied very hard.
Hari Krishnan: The victory lap. Yeah, the Fed victory lap.
Dan Ferris: The Fed victory lap, exactly. And after a year of really, really huge outperformance of the Magnificent Seven, if I had – I mean, are you looking at this and sort of anticipating, like you said, the rallies are hard. This has been a real screamer, especially the last few days, and especially in – you can point to certain pockets like small caps and things just really head full of steam. Are you anticipating – are you already anticipating the decline or how do you look at this moment?
Hari Krishnan: Yeah, there are lots of things to say. Well, the market was selling off – by market, I mean the S&P, so I'll just focus on the headline – until October 27, and it's rallied 15% since then up to the time of this call. Volatility has fallen off a cliff. It's gone down by 50% nearly. And we're in a situation where volatility in many, many asset classes is extremely low. I mentioned copper, natural gas, corn, wheat, all that stuff. So you have depressed commodities with low vol, you have equities with extremely low vol at the index level, and yet interest rates still have relatively high volatility. The 10-year note is trading at a reasonably high volatility, which should be suggestive of uncertainty in the system. Now, can I time when the market's going to sell off? Probably not. And the second book that I wrote which I should plug just for my own sake, Market Tremors, basically says that it's a bit like earthquake detection. You cannot really say when the earthquake will occur, but you can see that there are fault lines building up that are causes for instability.
I'm not a sell-side research guy who's going to say my price target for the S&P for 2024 is X. I won't even hazard a guess, but what I will say is that complacency levels are extremely high at this point, and if you have been in the market, I would think it's a great time to think about hedges. If you have participated this year, especially in tech, I think it's a great time to think about hedges. Now, if you view the hedges as a line item where they bleed a bit every month and you try and get rid of them because they're not doing as well as the other stuff, then hedging probably isn't for you. But if you think of it as one package where you can keep that sort of valuation in sensitive trade on and cover the downside, I think it's a great package, great combo. And now you don't need to be that sophisticated in my view to start hedging. If you didn't hedge this year, more power to you. Now is a great time to think about hedging even over longer horizons instead of selling your position. Why give up more upside? It's possible that things could continue rallying from here for a few months. So I think now you don't need to be super sophisticated to hedge your equity risk. Just go in and buy index protection and you can carry your positions for longer.
Dan Ferris: So we'll stick with the S&P 500 then. You mentioned earlier when you were talking about having at one point bought a two-year protection, two-year put for a 10% decline in the S&P 500. I don't remember if you were talking purely hypothetically or if you had done that, but –
Hari Krishnan: I've been doing that for years.
Dan Ferris: All right, there you go. So if you're not of a – if you're not Hari and you're not doing this for years and years and it's new to you, maybe this would be a time to learn about that.
Hari Krishnan: Well, I'll give a couple of little keys to hedging. One of them is where do people like to hedge? What do they like to hedge? What strikes and where? Think of it like this, and I think I talked about this in the first book, let's say the three of us worked for the same firm, we're long-only managers, but we have the freedom to hedge a bit. We sit around the table, maybe in London, maybe in New York, wherever, and we sort of say, well how much do you think the S&P could go down in the next six months? And you might say 15%, I might say 20%, and so on. And then what we do is maybe we average that and we say maybe the market could go down 15% in the next six months. That's the scenario we want to protect against. So we go out and we buy 5% to 10% out of the money in puts with three to four months maturity on the assumption that we don't just want to hit the strike... we need to go through the strike to start making money on the hedge.
So we sit and agree on that, and so that's where the liquidity is, and that typically is the area where protection is overpriced. So what I've found, and I've done a ton of analysis on this, is that three- to six-month puts on the S&P that are somewhat out of the money tend to be expensive. Now, some of the big institutions who will remain nameless trade spreads, big spreads through the market, and you can track what they do. I think the goal in tracking what they do isn't to do the same thing by any means. It's to avoid buying the strikes that they have bought or to anticipate what they will have to buy and buy it before them. I'm not suggesting this is a thing that you should do to try and honorably front-run these big institutions. I think a better strategy is just avoid hedging in the places where they're overhedging simply because they're price-insensitive rules-based hedgers.
And that brings me to the next question. Well, where else can you hedge? Well, shorter-dated stuff is attractive because even if markets are really selling off, there's this thing called Vega, which is the sensitivity of an option to fear or to volatility. The Vega's pretty low, so you can go in there, and even if the market's selling off and there's a panic, you can buy a one-week option pretty cheaply, in price terms at least. Also, the long-dated stuff tends to be laid off by many people because it's a little less liquid, but if you're not a huge investor, you can easily work limit orders in the market. But also because people don't 'really understand how these options will respond to sell-offs. They're more volatility sensitive and less price sensitive directly. But now is a great time to be buying some of that stuff because fear levels are extremely low. Now, to be fair, when there's no fear in the short term, there tends to be relatively more fear in the long term.
It's like any commodities market. If there is abundant supply for a commodity today, the futures curve will be in contango, which means that forward prices will be higher than prices today simply because there's some risk premium or there are carry costs, whatever. But still, the price levels out one year, two years are extremely attractive. So again, if you're someone who wants to hold onto your winners and ride them as far as you can, another quote from the book, it takes courage to be a pig, which is Stanley Druckenmiller's quote, be a pig but have some risk management down below. That's fine. And so those are some things you can do: buy long-dated protection and forget about it, keep your position on, maybe trim your position if you don't want to hedge, or look into the shorter-dated stuff. I would not look into the zero-day, one-day, two expiration, things that a lot of retail clients have been seduced into look at post-GameStop and so on simply because these are very hard things to trade. They take a ton of attention, and they're becoming increasingly rich.
So just giving you a couple of numbers, as of today at lunchtime, which was December 14, the December 15 straddle, which means kind of the implied volatility at the money options on the 15th was about 17, and it dropped all the way down to 9.9 going out two weeks. So there's almost twice as much risk baked into the one-day move as the two-week move. Now, to some degree, that's valid because one-day moves tend to have fatter tails, but this has become overdone in my view, and I don't find great value in trying to be a hero over one-day rises. Not unless you have a seat belt on your desk, on your chair that prevents you from leaving the desk so you can monetize profits as they come in. So I would discourage that in general.
I was known for this. I was apparent – some people sent me stuff on Twitter saying, "Oh, you're the guy who loves the zero-day-to-expiration option." Can we offer hourly options? And I thanked them for thinking of me, but I hadn't really proposed that. I just did – I basically took some analysis that others had done in an area called econophysics, which basically says how does the distribution change as the horizon increases. So are there more outsized moves relative to a normal move over one-hour horizons, one-day horizons, one-week, and so on. And I did find that short-term horizons had the fattest tails. But now the whole market knows that, or enough people in the market know that, so it's become very rich to trade that stuff. So I would do one week out perhaps or very longer-dated stuff, or at the very least avoid the whale or behemoth trades that you can see go through based on the largest ETFs.
Dan Ferris: Right, and you can probably see that – just a guy with a regular account could see that just by looking at the options pricing and seeing the incredible amounts of volume in those areas you're talking about, the three to six.
Hari Krishnan: Yeah, you'll see a lot of open interest, and then you have to guess which side the open interest is on, and this is a big project I've worked on for commodities. But for equities, it's pretty basic because everyone and their cousin is long the world equity markets. It's not like commodities where producers are trying to go short to lock in profits and there are other players, end users who are trying to go long to get some upside if the price runs against them to control their margins. In the equity markets, it's pretty clear. There's some buy rights. People do sell calls for income. There's a lot of put buying. There's some put spread buying that goes through the market. It's pretty clear what people do, so you don't need to engineer it too much. If you see a lot of open interest on the put side, it's either long a put or part of a spread generally. One could go into a lot more detail but I'm – there are others who could do it a lot better than I do, but that's the basic idea. And so even if you know where the open interest is, you can infer what the positioning might be. The high-tech way to do it is to say I'm going to look at every trade that goes through the market, look at the bid and the ask before the trade, and see if the trade price was above the mid or below the mid, and then back out whether it was a buy or a sell, but that's way beyond the scope of what those people will want to do.
Dan Ferris: Yeah, or have any ability or understanding to do. So we are at the point where it's time to ask my final question, which is the exact same question for every guest, no matter what the topic, even if it's a non-financial topic. Same question every guest, all right. And you not knowing what it is helps because I like to spring it on people. The question is simply if you could leave our listeners with a single thought today, what would it be? What would you like to leave them with?
Hari Krishnan: There's a lot more to think about than just the U.S. stock market, or even stock markets in general. There are a lot of good reasons to think about real assets, to think about bonds, especially now that yields have widened out, and other strategies as well. So broaden your palate, stick to your strategy, but build it out, broaden it over time, and I think you may be well positioned for what could happen in the next five or 10 years.
Dan Ferris: Excellent. That is perfect. I totally agree with you, and that has been a message of mine in The Ferris Report over the past year. I've been trying to get people to do other things, so thank you. I can only say hey, look, it's not just me... it's Hari.
Hari Krishnan: I noticed that a lot of people are worried about AI and what AI's going to do and this and that, but they're forgetting that people have to eat, they have to get places, they have to do stuff, right? And even whether you're agreeing or not, you need copper, you need infrastructure, you need to – there are all sorts of issues that will present themselves, food nationalism and so on in the commodity markets, and the ownership is so low. There's got to be stuff to do there, and that's a topic for another podcast, but yeah.
Dan Ferris: Yeah. Yeah, maybe we'll have you back, we can talk more about that. But listen, Hari, thanks so much for being here. I'm really glad that you came to talk. Thanks.
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So obviously a very sophisticated guy. People who deal in options like that, they know more math about investing than I will ever understand in my life. They've forgotten more math about investing than I'll ever know, but I was impressed in writing and in other podcasts that I've seen Hari in with his ability to sort of keep things simple and still offer some value, and I hope everyone agrees that he did that. How did you find that conversation?
Corey McLaughlin: Yeah, I mean, I feel like he said a lot but there's so much more beyond even what he was talking about, which was a lot, and so – but I think the value, the idea of – just of hedging in general, like he said at the end, we and a lot of people are focused, or me are focused mostly on U.S. stocks, and the idea that when – of the coiling of the markets and the rallies being so strong and the sell-offs also being so strong, just be ready for that stuff and not be caught off guard by it. Because I think he's totally right, like you brought up with we're coming off this Fed meeting and we're seeing it. Right away, all of a sudden it seems like the indexes are at new all-time highs or close. And just a couple months ago, people were bearish on the markets overall, so yeah. The point being that is when you want to be putting on hedges, not when the crisis happens, although there are things to do at that point too, which he wrote an entire book about.
Dan Ferris: I think the point too for the longer-dated puts a couple years out, maybe 5% and 10% out of the market because, like he said, if you get that 15% drawdown that you're hedging against, you want to be in the money. So just hearing him tell me about that, really valuable. Hearing him tell me that three to six months out the massive institutional whales of the world are jacking the pricing up, so be careful there. I thought that was really valuable. And just telling me that right now is kind of a neat time for people to think about hedging, and it's not that difficult to do. I thought that was all really valuable stuff. And you know, he's just a great guy and a fun guy to talk to overall, I think. Yeah, good stuff.
Well, that's another interview, and that's another episode of the Stansberry Investor Hour. I hope you enjoyed it as much as we did. We do provide a transcript for every episode. Just go to www.investorhour.com. Click on the episode you want, scroll all the way down, click on the word "transcript" and enjoy. If you liked this episode and know anybody else who might like it, tell them to check it out on their podcast app or at investorhour.com, please. And also do me a favor. Subscribe to the show on iTunes, Google Play, or wherever you listen to podcasts, and while you're there, help us grow with a rate and a review. Follow us on Facebook and Instagram. Our handle is @investorhour. On Twitter, our handle is @investor_hour. Have a guest you want us to interview? Drop us a note at [email protected] or call our listener feedback line, 800-381-2357. Tell us what's on your mind and hear your voice on the show. For my co-host, Corey McLaughlin, until next week I'm Dan Ferris. Thanks for listening.
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