Summary
In this episode of The Acquirer’s Podcast Tobias chats with Jesse Felder, who is the Founder of the popular U.S newsletter – The Felder Report, and is the co-founder of a multi-billion dollar hedge fund. During the interview Jesse provides some great insights into:
– The Current Market Environment
– There’s A 97% Correlation Between Today And 1937
– The Most Important Thing For Investors To Focus On Right Now Is Not Earnings – It’s Margins
– Investors Can Combine ‘Good’ Buy-Backs and Insider Activity To Find Great Buying Opportunities
– The Perverse Incentive Of Passive Investing
– Why I Love The Acquirer’s Multiple
– Semiconductors Are The Canary In The Economic Coal Mine
– If You Don’t Own Gold You Don’t Know History
– Breadth And Risk Appetites Provide Investors With Great Timing Tools
The Acquirers Podcast
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Full Transcript
Tobias Carlisle: You ready?
Jesse Felder: Yeah, let’s do it.
Tobias Carlisle: Let’s do it.
Tobias Carlisle: Hi, I’m Tobias Carlisle! This is the Acquirers podcast. My special guest today is Jesse Felder. He runs the Felder Report, which is a U.S. stock market-centric but macro newsletter. He’s co-founder of a multi-billion dollar hedge fund, and he’s got some very interesting thoughts about market. So we’re going to explore those right after this.
Speaker 3: Tobias Carlisle is the founder and principal of Acquirers Funds. For regulatory reasons, he will not discuss any of the Acquirers Funds on this podcast. All opinions expressed by podcast participants are solely their own and do not reflect the opinion of Acquirers Funds or affiliates. For more information, visit acquirersfunds.com.
Tobias Carlisle: Hi Jesse, how you doing?
Jesse Felder: Good Toby, thanks for having me on.
Tobias Carlisle: My pleasure. Let’s get right into it. What do you think about the U.S. stock market?
The U.S. stock market
Jesse Felder: Well, I think we’re in the midst of a topping process, and I think we have been since the last ’17 run up, strong run up late ’17, early ’18. It was probably pretty clearly a blow-off top. I think, valuations that are most valuable in a long-term time-frame all suggest that we’re near the highest valuations in history, if not at all-time high valuations. But you combine that with, over the past six or 12 months we’ve seen changing risk appetites. Investors shifting away from risk and to me, the combination of those two things suggests that we probably entered a new bear market late last year, and this rally we’ve seen so far this year is a … I mean, I can’t call it a typical bear market rally, but it does what bear market rallies are supposed to do, which make you believe that there is no bear market.
Jesse Felder: So I think that’s where we’re at today.
Tobias Carlisle: Why do you think it’s atypical?
Jesse Felder: I think it’s just because it’s in such a strong v-bottom. I was looking at rallies in past bear markets, especially early on in bear markets and I was using kind of an early 2001 analog for a while. And also kind of in early 2008. For a while we looked really similar to that, the early 2001 period. But this rally’s been stronger than your typical bear market rally. Not in terms of the percentage gained, but in terms of how much of the losses have been recouped.
Tobias Carlisle: So the market sort of topped out about September last year, and so now we’re six or seven months into it, which is pretty typical behavior that there’s often that little initial selloff, there’s a rally, and then it sort of seems to drift sideways for up to a year or more before you really start seeing the carnage. Is that what your expecting to see? And what would cause you to think that it was back on?
Price analogs
Jesse Felder: Well, the analog that I’m using right now, price analogs are one thing that I like to use. And actually this is one that Ray Dalio brought up three years ago. It was the 1937 analog, and the historical parallels are just fascinating. But the price analog is actually very close, too. You look at the past one year and three year price patterns, and there’s like a 97% correlation between today and 1937.
Jesse Felder: That would suggest if that price analog is valid, that prices should return to the lows pretty quickly here. So that’s one thing that I’m looking at. But I really do think what the market’s trying to price in right now, or what investors are counting on, is the second half rebound in earnings. I think as we start seeing this first quarter numbers come out and start hearing more guidance from companies, if that second quarter, or the second half rally in earnings or rebound in earnings doesn’t materialize, it looks like it’s not going to materialize, that’s probably what the market’s going to have to start pricing in again if it looks like that.
Jesse Felder: And the companies that have come out recently, especially on the semiconductor side, it doesn’t look like there’s any second half rebound on the horizon. So I think once the market starts beginning to price that in, that’s the catalyst for a return to the lows, and kind of see how the market behaves there.
Tobias Carlisle: What was the final result in ’37? How far was it down from the peak?
Jesse Felder: You know, it was … gosh. It was another 50, 60% decline back then. The price analog that I’m looking, when you line them up it doesn’t suggest that much of a decline. It suggests we take out the lows from last year. But it goes more back to the ’15-’16 highs would be the extent of that if the price analog is valid.
Tobias Carlisle: That’s an interesting time period and I’m glad you brought that one up, because that was … I think I had been following you for a little while, but that was when in 2014, you started your 10% draw down beard.
Jesse Felder: That’s right.
Tobias Carlisle: And that was reaching sort of ZZ Top proportions before we finally got that draw down. Take us through that. That was a fun period.
ZZ Top
Jesse Felder: Well yeah. So that was, it was actually August or September of ’14. We hadn’t had a 10% correction, right? Since what was, 2011 or something like that. It had been a … Typically the market has one every year, and it hadn’t had one for a number of years. So I thought, “We’re getting close. We have to.” For a number of reasons, I was expecting the breadth warnings in the market.
Jesse Felder: So I said, “Hey, I’m not shaving until we get a 10% correction.” And then in September of ’14, the market went down 9.8%. Literally right after, and people were telling me, “Jesse, okay. Go ahead and round up, shave it off.”
Tobias Carlisle: You can take it.
Jesse Felder: I said, “No, no. That’s not it. That’s not it.” So it wasn’t until August of ’15 when the market actually had it’s … That was a steep sell off. So it was 11 months of beard growth, and it was, yeah. It was definitely ZZ Top at that point. My wife was very happy.
Tobias Carlisle: To the great relief of your wife.
Jesse Felder: Right.
Tobias Carlisle: So you proposed to her the 10% draw down beard and she said, “No chance.”
Jesse Felder: That’s right, exactly right. I did that what, last year or something. She goes, “Nope. That’s not happening.”
Tobias Carlisle: I know this … She knows the market too well.
Jesse Felder: Yeah, yep.
Tobias Carlisle: So the thing that has been most amazing about this market, would you have thought at that time that we’d be this far into it without really seeing that deck clearing crash or decline? Would you have thought that would have taken this much longer or we still wouldn’t have seen it?
The market and politics
Jesse Felder: No, and I thought that ’15-’16, the late ’15, early ’16 correction was probably the beginning of a new bear market. There’s been a lot of speculation of what prevented a bear market at that time. Clearly, it wasn’t. We did have an earnings recession, and some people even believe we probably had a mild economic recession. It was mainly an oil-focused thing at the time.
Jesse Felder: But yeah, I was surprised. But then when you look at Trump getting elected and the deregulation and tax cuts that went along with that, that essentially extended the cycle. That’s the thing with the famous thing everybody says about markets is they go a lot longer, bull markets. Trends, in both directions, go longer than you would ever imagine they could. So, yeah.
Tobias Carlisle: This market seems to be, it’s supported on … The multiple is very high, but earnings have also been very high for the S&P 500. Margins have been very high. It’s sort of at every part of it that you might want to look at, it all seems fairly extended. If any of that came back a little bit, you see some pretty substantial draw down in the market at least.
Jesse Felder: Well, I think you hit on it, that the number one thing that I’m paying most attention to right now is margins, because by earnings-based measures, stocks don’t look extremely overvalued. But on sales-based measures they do, and the difference is profit margins. So I think a lot of people who are using earnings-based measures don’t really understand this that well, that if you’re using an earnings-based PE to ratio, what have you, you have the embedded assumption that profit margins are going to remain at record highs indefinitely, that there will not be any reversion in those.
Jesse Felder: Historically, Jeremy Grantham has said that’s the most mean averting series in finance. Warren Buffet wrote about it in ’99, in one of his articles for Fortune where he talked about, he said something along the lines of, “You have to be crazy to think that corporate profits can remain over six percentage ADP for any extended period of time.” And he goes, “If …” And so he was wrong about that, because profits have remained higher than that. But he was right in the fact that he said, “If you were to see a situation like that, it would create all kinds of political problems.”
Jesse Felder: I think that’s exactly what we’re seeing right now. With global populism on the rise, this is the labor share of corporate profits is at record lows. That’s the inverse of corporate profit margins. So corporate profits margins are only so high because labor has been getting a much smaller share than they ever have historically. So now labor is essentially revolting, through politics.
Jesse Felder: So you have Ray Dalio’s partner at Bridgewater, I’m spacing on his name right now, said that there’s all these forces right now that are working against corporate profits. I think if you look at what’s going on politically in that light, then you start to see the risk to profit margins and the risk to evaluations over the next several years. People don’t understand the risk. If profit margins revert to historical norms, then you’re looking at an S&P 500 today that’s at a 40 PE, higher than the dot-com mania.
Adjusting for profit margins
Jesse Felder: So that’s why my friend John Huspin has come up with one of my favorite valuation measures, is a margin-adjusted cape ratio, essentially. When you adjust for profit margins, stocks today are higher than they were in 2000, higher than they were at the peak in 1929. So I think investors who are using earnings-based measures need to be really really careful about profit margins. What is the embedded assumption that I’m making in profit margins today, and is that a safe assumption to make?
Tobias Carlisle: The bulls would say to that, there are two arguments for the higher than usual profit margins and sustainably higher than usual profit margins. One is that we’re transitioning to a more asset-light economy and that might warrant higher margins, so they’re able to generate higher margins. And the other one is that it’s a global world and the profits that U.S. companies are earning are typically foreign. There’s a lot of foreign profits in that mix, and so there’s no reason why it should be constrained by those old labor profit margin ratios.
The change in the anti-trust framework
Jesse Felder: I think the real way to explain it is the change in the anti-trust framework over the last 25-30 years. We’ve had this rise of oligopolies that have essentially colluded to set pricing whether it’s in airline industry or what have you. I had Jonathon Tepper on my podcast, his book The Myth of Capitalism is fantastic on this topic. I really think that is probably the main driving force that has led to these winner-take-all type of profit margins. But that’s exactly what we’re seeing in this political backlash right now, is a direct attack on that framework.
Jesse Felder: So we’re seeing a total rethinking of the anti-trust framework. You have Elizabeth Warren talking about breaking up big tech, and that becoming the foundation for a political platform. It’s not just her. In fact, there’s a .. To me, it’s fascinating to watch the bipartisan support for this anti-tech movement, because those are really the companies that have the biggest profit margins and cash piles and those kinds of things.
Jesse Felder: So to me, I think this is what Bridgewater’s talking about when they say, “All of the forces that are working against corporate profits.” It’s really a groundswell of political movement that’s moving to take back on behalf of labor what they’ve lost over the last 20 years.
Social media
Tobias Carlisle: Your Twitter account, you do have a theme of some distrust of some of the social networks. Facebook and Google and so on. What’s the impetus for that, and what’s the solution? Is it breaking them up?
Jesse Felder: You know, for me it was … I got off Facebook years ago when I just started realizing it didn’t make me feel good to be on there. And Twitter, you can get the same feeling being on Twitter too. But I find Twitter immensely valuable from the standpoint of being able to follow people like you, Toby, and I follow about 100 accounts. To me, the information that those accounts provide me with is invaluable.
Jesse Felder: But I do think the problem with social media is that it’s become far, far too powerful. I think we underestimate social media’s ability to get our attention whenever they want, and then manipulate our attention in ways that … Everybody says no, this is not happening to me, right? I’m invulnerable to this kind of stuff.
Jesse Felder: But all the studies show that whether it’s manipulating people to vote a certain way or to buy a certain product or what have you, the data collection and then the use of it to manipulate peoples essentially free will is gone way too far. That needs to be reined in, and so I think … I don’t know if it’s breaking up these companies, but I had Roger Macnamy on my podcast a couple years ago, and we talked about this when this was first breaking with Facebook.
Tobias Carlisle: It’s a great podcast.
Jesse Felder: Yeah. He’s an amazing guy, and it was really, really fun to do that. But he was … eh thinks the business model just needs to be changed. I do agree. I think when you have such powerful platforms as YouTube and Google Search and Facebook, Instagram, and their ability to manipulate people, and there’s a profit motive behind it, the problems that can arise are unimaginable and very very serious.
U.S equities
Tobias Carlisle: Just returning to U.S. equities. Are there any industries or sectors in U.S. equities that you like? I know I saw you Tweet out that bank stocks are at relative, the PEs of bank stocks relative to the market are as low as they’ve ever been.
Jesse Felder: Yeah, I think it was Dry House Chart that they shared, and I thought that was interesting. In some ways, I feel like this current situation we’re in in terms of valuation is very similar to the dot-com mania. Back then, there were a handful of stocks that I was finding … I mean, value, I think the similarities, growth was so popular, value was left for dead. I think we’re seeing something very similar right now where there is some true value out there, and it’s just being left for dead.
Jesse Felder: For me, financials … A stock that I bought in late ’90s, 2000, was Washington Mutual when it was just a simple thrift and the stock was trading five times earnings. Financials have been crushed them because of the same situation that’s going now, which is that the flattening yield curve, net interest margins are squeezed. So that hurts earnings, and financials get hurt, stock prices.
Jesse Felder: To me, that was a very easy investment to make because Washington Mutual was literally just taking in deposits and lending it on home loans. They hadn’t gotten into any of the other types of interest rate hedging or things that they got into later on when they hired one of the top guys from GE. That’s when I sold the stock.
Bank stocks
Jesse Felder: When they created this derivatives portfolio and it grew into tens of billions of dollars, I said, “I don’t understand this, I have to sell this stock.” But it was a good investment for a period of years. Today, to me one of the lessons I learned in the financial crisis was a lot of these banks are black boxes that not even the top executives at those companies really understand the risks their taking and that sort of thing.
Jesse Felder: So it’s really hard for me to invest in bank stocks today, when the business is so complex that not even they understand what’s going on. I mean, even for years after the crisis, I remember these companies would announce earnings and then have to restate them a month or two later because, “Whoops, we miscalculated this and we didn’t understand that.” If you guys don’t even know what’s going on with your books, how can I have any confidence?
Jesse Felder: It’s interesting, financials might be cheap right now in the banks. I think if you have a well-run bank that’s cheap, it’s probably a good opportunity today, especially … Usually in this situation, my experience when the yield curve flattens to the extent that these companies get hammered, it’s usually an opportunity. But I have a hard time with those companies for those reasons.
Tobias Carlisle: I’ve noticed that there are a number of commercial banks that have come into my screens recently, they’re sort of taking up 15-20% of the slots in the screen. So that leads me to think that they might be something investigating, but I haven’t look at them in any great detail. So I tend to agree with you.
Insider activity
Jesse Felder: One other point I’d make is one of the things that I follow, since the start of my career, is insider activity. I haven’t seen any significant insider buying at any of these things yet. One of my favorite books is Reminiscence of A Stock Operator, and in that Jesse Livermore says, “When a stock gets cheap, the top management will never fail to buy because they know that it’s a great opportunity. They know they’re going to make a ton of money.”
Jesse Felder: So when I find a value opportunity and there isn’t insider buying, to me that’s kind of a red flag. Why are these guys not putting their mouths where … their money where their mouths are?
Tobias Carlisle: Or buy-backs, which is another favorite topic of yours. So let’s talk about good buy-backs and bad buy-backs.
Good and bad buy-backs
Jesse Felder: Right, yeah. There’s good buy-backs. For me that was something that I followed for a long time through my career, because I remember Devon Energy during 2001, 2002, natural gas prices were super cheap. The top execs started buying stock themselves, and announced they’re going to buy back 20% of the outstanding shares.
Jesse Felder: To me that was a great confirmation of this stock is cheap, and they’re bullish on natural gas prices and all that. But today what you see a lot more often is buy-backs announced, and then as soon as the company starts buying back, top execs just start dumping stock right at the same time. And so to me, that’s not so much of a bullish signal as it is, we need a buyer so we can sell.
Jesse Felder: It’s interesting to me too, that’s another one that congress is looking into, because studies show statistically, insider selling goes up five-fold during buy-back periods. To me, that’s just a clear sign that these companies are, the executives are using the buy-backs to help prop up stock prices so that they can cash out. Which is, to me, if that’s a company I’m invested in, I would not be too happy about that.
Tobias Carlisle: They have some restrictions and some limited windows where they’re able to trade. So you would hope that when the company’s doing the buy-back that any market moving information has been properly disclosed. So that might describe the reason for it. I think buy-backs in aggregate, tend to be value-destroying because the bulk of the buy-backs happen when stocks are expensive, and then they disappear when stocks are cheap. When ideally you want it around the other way.
Tobias Carlisle: So if you can find that rare management that buys stock back when it’s cheap, and issues it or doesn’t buy it back when it’s expensive, that’s a good opportunity and that’s a management worth following. But in the aggregate, I think they’re probably not good for investors.
Jesse Felder: You want your management to be good capital allocators. You don’t want them to be burning cash by buying back stock at top valuations. Which is, that’s one of the things that we’re seeing with companies today. I look at some of these stocks and the DOW. I wrote about the McBam stocks that McDonald’s, Caterpillar, Boeing, and 3M, and this was a year ago. Back then, each one of these stocks on a price to sales basis or enterprise value to revenues, was trading at the highest valuation in the company’s history. Some of them, twice as high as they’d ever traded in their history.
Jesse Felder: You look at the buy-back activity and you go, “How did they get that expensive?” Well, they’re buying back more stock than they’ve ever bought back in their history, too. So it’s, to me that’s representative of what’s going on across corporate America in many ways. So yeah, it’s rare to find those companies that do the right thing at the right time, on behalf of shareholders.
Jesse Felder: To me, where you find that usually is where you have owner-operated companies. You have guys that have a large equity stake in the company, and their interests are truly aligned with shareholders, not just through option compensation, which they want to offload at some point. It’s the owner operators that seem to make the right choice, and it’s interesting to me that these indexes now, that they’re float adjusted, systematically underweight owner-operated companies and systematically overweight companies that are not owner-operated.
Passive investing
Jesse Felder: To me, that’s a potential problem with passive investing today. Also, people don’t necessarily appreciate.
Tobias Carlisle: That’s a very interesting point, I hadn’t thought about that before. But that’s a fascinating point.
Jesse Felder: Something that Steve Bregman, I had on my podcast a couple years ago, and he was … I don’t think people appreciate the fact that it was 2004 or five when they actually changed the index methodology from just cap-weighted to float-adjusted cap-weighting. Still they use the track record of the S&P 500, as if it was just cap-weighted prior. But today it’s not cap-weighted. It’s float-adjusted cap, and so … To me, philosophically too, that goes exactly opposite of what I’m trying to do. So you have companies where there’s massive insider buying and they’re reducing the float, so the index has to underweight those companies to some degree.
Jesse Felder: And companies with massive insider selling, they’re expanding the float and so the index is now saying, “We’re going to buy more of these where there’s insider selling, and we’re going to buy less of these where there’s insider buying.” The greatest example of this is probably Intel.
Jesse Felder: Go look at Intel, a stock chart of Intel. You look at the chart from when it went public, when Andy Grove was running it and had a third of the shares personally, to 2000. The stock went up 30% a year for that period. Andy Grove retires as chairman and CEO, sells all of his stock, and Intel today is still down 30% from its 2000 high.
Jesse Felder: So you look at that period of the mid-80s or whatever it is to 2000, and you go, “Okay, this is what an owner-operated company does.” Right? This is going to make me 30% a year, and I’ve lost money in the 20 years since it’s been a non owner-operated company. The way the passive methodology now works is that entire time Andy Grove owned a 30% of the shares, we’re going to underweight Intel, because of the float.
Jesse Felder: Soon as Andy Grove goes and sells all of his stock, boom. Now we’re going to overweight Intel, because the float just went up a ton. So to me, it’s a philosophical problem with passive that a lot of people don’t appreciate.
Tobias Carlisle: It’s a perverse incentive. You’re incentivized to issue more stock that’s not held by the owner.
Jesse Felder: Right.
Tobias Carlisle: Held by the main shareholder. You and I were both tagged in a question about Boeing, where Boeing’s off a little bit because it had the two plan crashes. Both of us sort of agree that it was extremely overvalued. I was looking at my favorite metric which is the Acquirers Multiple. And then you said you agreed on the basis of revenues to enterprise value.
Tobias Carlisle: So I looked at that chart and that was a striking chart that a few years ago, Boeing sort of took off in terms of that enterprise value to revenue metric. I’ve looked at several other companies and that’s common to a lot of companies that they’ve all got extremely expensive on an enterprise value to revenue basis. How do you account for that? Is it just the margins or what’s going on there?
Normalizing profit margins
Jesse Felder: I think in some cases it’s the margins, but the reason I like to look at that metric is because I’ve talked with Eric Synamont a ton about this and he’s another fantastic investor, very successful guy who normalizes profit margins in his valuation process. Because if you look at a company that’s … maybe looks cheap but profit margins are at all-time highs for whatever reason, you have to make a decision on are those profit margins going to normalize or have they literally entered a new era?
Jesse Felder: Nine times out of ten, profit margins will normalize over time. It’s just the nature of competition. And so I see that with a lot of companies, and that’s why I’m using enterprise value to revenues a lot more these days, is because I want to see … that’s basically just the easiest way for me to normalize for profit margins.
Jesse Felder: I think in a lot of cases, it’s growing profit margins, but in a lot more cases, this is another thing I think equity investors don’t appreciate. There’s been this huge debt-for-equity swap where companies have been issuing tons of debt to buy back stock. It makes the stock potentially look cheaper, but when you look at something like enterprise value, you go, “Okay wow, but the debt has gone through the roof.”
Jesse Felder: That’s why I love the Acquirers Multiple. If you think of a company as an Acquirer does, and I think you have to to be successful over a longer period of time, you have to take the debt into the equation. So when you’re not doing that, by just looking at just the simple price to earnings ratio or that sort of thing, you’re completely missing this dynamic that’s happened which tons of companies, especially small cap companies, this has really been more of an important dynamic where companies have just issued tons of stock, or tons of debt, I’m sorry, to buy back stock. It makes the stock look cheap, but in terms of the holistic valuation, the debt has gone through the roof.
Jesse Felder: So the valuation of the whole enterprise has gone very very high. But the simple fact that I think equity investors aren’t paying attention to the debt side of the equation.
Overvalued companies
Tobias Carlisle: That was another Tweet of yours that I remember looking at, was looking at the Russell 2000 in terms of enterprise value to eBit. I think that was the metric, or it could have been eBitter. And that’s been … I think it’s traded around sort of maybe a dozen … a multiple of 12-15, something like that. Over the last few years, it looks like it’s at 35 times now, which looks like it was unprecedented in the data or in that chart, which I don’t recall how far back it went but it was 20 or so years.
Jesse Felder: Right. And I think that was the chart from Eric Synamont. It’s fascinating, when you look at … That’s similar to looking at the median price to sales ratio, and these types of things. They all show smaller companies especially, are extremely overvalued and perhaps more overvalued than they’ve ever been in history.
Jesse Felder: This has got to be the passive dynamic. So you have big big companies that can absorb flows, passive flows. Then when you have passive flows going into a small-cap index, those companies can’t absorb the flows without pushing prices higher. So this dynamic of so much money flowing into passive I think is directly responsible for the valuations we’ve never seen before in these smaller companies.
Tobias Carlisle: It’s one of the things that I certainly didn’t realize until I saw the statistic, but of the top three thousand companies, the Russell three thousand, so the Russell two thousand is the smallest two thousand of that top three thousand. The total market capitalization of those two thousand companies is 6% of the three thousand. So the Russell one thousand is 94% of the capitalization. The two thousand is 6%, which is why if they get a little bit of flow it makes them go haywire.
Jesse Felder: Right. Yeah. The other thing about those companies too is they’re so highly indebted too. So the equity valuation has gone so high, and they’ve also piled on all this debt. That’s why when you look at things like enterprise value it’s like, “Oh my…” It’s off the chart.
Recessions
Tobias Carlisle: So that makes … the debt makes them susceptible to a recession. What sort of indicators do you look at to determine if we’re in a recession or whether one is approaching? And what do you think about our prospects?
Jesse Felder: It’s so tough to try and game whether recession is coming or not. To me, I think some of the work that Robert Schiller has done is really really interesting, and it kind of relates back to Soro’s reflexivity theory which is, all of these things are interrelated and recession is as much a psychological phenomenon as anything else. So following … I think a lot of people say, “Well, that’s fine. I’ll just be super long overweight equities until we get a recession.” Which they don’t necessarily appreciate that. Failing equity prices can actually precipitate a recession.
Jesse Felder: When you look at the correlation between equity prices and consumer confidence, it’s one for one. So I think that’s one of the things that Schiller’s been talking about recently which is, we can talk ourself into a recession pretty quickly. If people just start … We have an earnings recession, I believe. We’re already going to have negative earnings growth in the first quarter, probably carried through to the second quarter.
Jesse Felder: That sort of thing, if it really results in falling equity prices and falling consumer confidence, it kind of can snowball into a recession pretty quickly. Especially 10 years into an economic expansion. So yeah, it’s not something that I try and game necessarily, but I do very closely watch the semiconductors and I think they are, because semi’s going to everything now. They go into autos, they go into all kinds of things. And so semiconductor sales now are falling 20, 30% year over year.
Jesse Felder: To me, that hasn’t happened since the last recession. They’re kind of the canary in the economic coal mine, or at least the earnings growth coal mine for me. The last earnings recession was really just oil driven and relegated to that sector. This one, we’re now seeing technology stocks are leading the earnings recession. It’s much more broad-based and so I do think that creates it’s own risk of a self-fulfilling prophecy of recession.
Equity prices and recessions
Tobias Carlisle: Just to go back, there’s something that you said earlier. Just eyeballing it, I’ve never done the work to determine if this is the case or not, but just eyeballing it, it seems to me that equity prices seem to lead recessions. You get the fall off and the crash happens before we’re officially recognized as being in a recession. It happens the other way too, we seem to recover in the markets before the recession is officially ended.
Jesse Felder: Well yeah, and I think people wonder why the Fed is so focused on stock prices. It’s for that very reason. They know that falling stock prices can hurt consumer confidence and create a recession. So it’s kind of the tail wagging the dog. You think stock prices should, but this is Soro’s reflexivity theory that not only does what’s going on in the economy affect stock prices, what stock prices do can affect the economy.
Jesse Felder: So I think that it’s a very good point. People who say, “I’m waiting for a recession to back off my equity exposure,” are …
Tobias Carlisle: Too late.
Jesse Felder: Right. And evidence of that was the last two recessions, where stock prices were discounting it well in advance and even probably exacerbated the consumer confidence that really led to the recession. So yeah, it’s stuff to pay attention to, but it’s really kind of all you can do is really pay attention to how those things develop through time rather trying to forecast them.
Yield curve
Tobias Carlisle: What about something like the yield curve? That’s recently flipped and it flip-flopped a little bit. Is that a near-term indicator or is it something that’s worth paying attention to?
Jesse Felder: So many people talk about it as just an indicator. To me, I always want to find why should this make intuitive sense? Why should I use this as an indicator? I think I wrote about it maybe a year ago when we first started getting pretty flat on the yield curve. It makes sense. I mean, we talked about squeezing net interest margins. If you think about it in terms of that, a flat yield curve, it’s banks why should we lend long when we can just buy short-term debt and make just as much money with less risk?
Jesse Felder: I think it really … The yield curve probably is indicative of what’s going on in the credit cycle. A flat curve is going to lead to a lot less interest on behalf of lenders to lend. So that creates a tightening of credit on it’s own. So I think it’s probably valuable as an economic indicator for the fact that it is going to determine what’s going on in the credit cycle.
Jesse Felder: So to me, yes. I think that’s important but also these effects take a long time to work through. So if lenders now that the yield curve is inverted and some levels are saying, “Okay, it doesn’t make sense for us to really expand our loan book,” that’s going to have ripple effects over the next three to six months.
Jesse Felder: I do think it’s valuable, but for the standpoint of it kind of helping tell you where you are in the credit cycle.
Raising interest rates
Tobias Carlisle: The Fed seems to, last year it looked like it had this longer term plan to very modestly raise interest rates over an extended period of time, and then when the market sold off last year, I think we were only down something like 20% at the lowest point. It looked like the rhetoric changed and possibly the behaviors changed. Do you have any view on whether they’re … how they’re managing the economy and where the [inaudible 00:36:54] doing a good job?
Jesse Felder: Yeah, I think … What I come back to is right after the financial crisis, before Janet Yellen became FedShare, a few years before the became FedShare, she was interviewed for the … what was it? Money for Nothing was the documentary. Great documentary on the Fed and their role during the financial crisis. I think Michael Lewis’s book was fantastic in discussing the dynamics of what led to the housing bust.
The wealth effect
Jesse Felder: But he leaves out the role of the Fed. Money for Nothing is a very important film, I think, in detailing the role of the Fed in that. Janet Yellen right after said, “We need to find a way to get our economy growing naturally and not be so reliant on financial bubbles.” So I think she was right then, just honest, because she was in a position where she could be honest about it in saying that we had the dot-com mania, yes, and that was great for the economy until it bust. And then we had to engineer a housing bubble to try and rescue us from this dot-com mania bust. And then when she became FedShare, obviously she did her best to create a wealth effect and try to engineer higher asset price.
Jesse Felder: I think the Fed is very well aware of the fact that they … because they have talked so much about a wealth effect, they’re very well aware of the fact of asset prices on consumer sentiment. So I do think that it seemed like Jay Pal, when he first took over, was set on trying to normalize monetary policy from something that’s been abnormal for a decade and extremely abnormal for a decade.
Jesse Felder: And then when he saw what it was going to do to asset prices he said, “Wait a second, I can’t do this. I can’t do this.” Because … But I do think we’re moving towards a time, and Alan Greenspan has said this recently, that we are staring stagflation right now in the face. We’re headed to a time of higher inflation, of weaker growth. If that’s the case, and I do believe that’s the case, that we’re seeing a new inflation framework that’s very long-term in nature but it’s just kind of growing now, then the Fed is going to be forced to either start fighting inflation, or trying to prop up the market and they won’t be able to do both.
Fiscal authorities
Jesse Felder: So with this talk of modern monetary theory and these types of things, the Fed has come out and I think they’re deathly afraid of this, because it’s essentially fiscal dominance. It’s essentially, “You guys can’t pursue the policies you want anymore because the fiscal authorities are going to go nuts and force your hand. Your going to have to monetize this debt and fight inflation and do these things,” and they’re not going to be able to pursue their own agenda anymore.
Jesse Felder: I think if that’s the direction that we’re headed, then this idea the Fed put is going to go away. Right now, Jay Pal is trying to have his cake and eat it too, which is, “I’m trying to preserve the FedPut, and I’m also trying to let people think that I’m going to keep inflation in check.” Right now, with the oil price being down, that’s giving him some cover to allow inflation to try and pick up. But if inflation does start picking up, that could be what leads to the expiration of the FedPut.
Tobias Carlisle: If we go into that 70s-style stagflationary environment, it becomes extremely difficult to find good place to put your money. That period, I was going to say I remember. I don’t remember it. I was alive, but I wasn’t investing. Terrible for equities, equities got destroyed on some of the nastiest bear markets that we’ve ever seen. Terrible for bonds, too. Really the only place to hide was precious metals and commodities that did seem to perform fairly well through this.
Gold
Tobias Carlisle: And through that period, no lesser investor than Buffet could only just keep up with gold. So how do you feel about the prospects for gold and other precious metals and commodities in general?
Jesse Felder: I’m very bullish on gold. Not necessarily because of inflation, but because of the fiscal situation. We’re already running trillion-dollar deficits, and there’s talk about expanding those. I think we’re headed toward five to six percentage UDP on the annual budget deficit. The dollar is very highly correlated with the budget deficit, so the dollar was very very strong in the dot-com mania. We had actually a fiscal surplus.
Jesse Felder: And then during the recession we started getting deficits, the dollar turned down. Obviously we had massive deficits after the financial crisis. The dollar tanked and gold did really well until bout 2011, when the deficit started narrowing again. But right now, this is one of the first times, one of the rare times in history where we have a widening fiscal deficit during an economic expansion.
Jesse Felder: We’re already plus trillion dollars on this thing annually, and if we get another recession, we’re going to see $2 trillion deficit pretty quickly. That’s even without even more fiscal stimulus. We have talk about the Green New Deal and these kinds of things which are massive spending programs. If we get these, we’re going to just see this widening deficit, and it’s very bearish for the dollar longer term.
Jesse Felder: I think the only way, if you are a dollar-based investor, to protect yourself is to have some kind of allocation to gold. I think Ray Dalio has said, “If you don’t own gold, you don’t know history.” I think that’s really important that right now, a lot of the talk in Washington … I think for the first time maybe in my lifetime, you have bipartisan support for expanding the fiscal stimulus and not any worry about the debt. You don’t even have people talking about how worrisome the debt is.
Jesse Felder: And so, throughout my entire lifetime, people have been worrying about debt, worrying about debt, the debt’s too big. And now all of a sudden, that worry is gone. To me, that’s troubling.
Jesse Felder: So I think that you have to have some kind of a gold allocation to protect yourself in that environment.
Tobias Carlisle: Gold seems to have struggled through a period where there has been an enormous amount of money printing and not just from the U.S. From every other central bank around the world. The debt which, I think it should matter, but it doesn’t seem to have had … it doesn’t seem to have impacted the economy, it doesn’t seem to have … None of the risks that people said were out there seem to have manifest. And that might be why it’s gone away.
Tobias Carlisle: But is it just that it hasn’t happened yet and that it’s something that we’re still to see?
Jesse Felder: Yeah. I think it’s we’ve had this disinflationary environment for 30 years. And it’s a combination of things. I think it’s demographics. You have the Baby Boomers coming into the workforce which is an increase in the supply of labor. At the same time, we have globalization and offshoring of labor. So this is how companies have been able to take down labor share, is a combination of the demographics and then globalization and offshoring of labor.
Jesse Felder: Those have been two big forces in, I think, this disinflationary environment. But demographics are now shifting, Baby Boomers are retiring, and we’re seeing these political forces I talked about, nationalism and you’re even hearing talk about deglobalization. So to the extent that those trends continue to gain traction, with Baby Boomers retiring and these things, that brings back an inflationary impulse.
Jesse Felder: Right at the time when 30 years of disinflation or whatever has lulled people into thinking debt is not problematic, we’re potentially seeing those forces reverse into more of an inflationary dynamic and that’s the one thing that could make debt really problematic is that interest rates start rising and interest expense to the government goes through the roof.
Jesse Felder: So yeah, to me all those things together means you should definitely have some gold in the portfolio.
Investing in commodities
Tobias Carlisle: What do you see as the catalyst or tipping point for something like that? And how near-term is something like that?
Jesse Felder: To me, I have a longer-term time frame than most people. Most of my investments are equity investments that are one to three year type of things. But a lot of the stuff I’m looking at is more like three to five to 10 year type of trends. I think this is something to pay attention to. It’s a very long-term dynamic, right?
Jesse Felder: I’ve actually been short-term bullish on bonds just because of what’s going on in the economy and the oil prices come down. But longer-term I’m bearish on bonds. When I say longer-term, I’m saying over the next three to five years. So I think this is something that will take some time to play out, this inflationary dynamic. Its very, very long-term in nature. It might be a 20-year, 10 to 20-year type of dynamic.
Jesse Felder: But really I think it all depends too on how much debt we start to issue, how much fiscal stimulus we start to see, and what goes on in terms of risk appetites around the world, too. So all those things are unknowable until we see how they play out.
Tobias Carlisle: One of the indicators that you watch, the M1, seems to be at the lowest level since the last great recession. What is the M1 and why do you pay attention to it?
Jesse Felder: Well, the money supply is something to pay attention to. It’s not something I pay super close attention to. The rate of change is important for various reasons. But yeah, it’s actually not something that I pay a ton of attention to, to be honest. I like indicators that are much more tactile, I guess, things that have a direct bearing on investments on a day-to-day basis. So a lot of the macro economic stuff to me is not as valuable as where’s the dollar going and that type of thing.
Preferred indicators
Tobias Carlisle: What are your preferred indicators? What are you looking at? We know the market’s expensive because we can look at, say, any … you can look at Cape which is just an inflation adjusted earnings to the price. So you can look at Toben’s Q, which is replacement value of assets against their market value. Or you can look at even Buffet’s favorite measure, which is just total market capitalization against gross national product, I think, which is just the size of the stock market relative to the size of the economy. All of those look at three different, very different aspects of the market and they basically all give you the same answer, that the market’s extremely overvalued.
Tobias Carlisle: But it’s been that way for an extended period of time. It’s been that way, maybe it’s sort of left the long-term averages in 1996 or the late 1990’s, and then at various points through there we might have touched long-term averages in 2009. I don’t know if we got that cheap in the 2002 recession, or the 2002 decline. It’s one of those things that I’m … I believe that the market is extremely expensive, but I’m also a value investor so I’m less interested in where the market is. I’m more interested in what the value stocks are doing.
Tobias Carlisle: You mentioned this a little bit earlier that it was an analog to 2000 where the market was expensive, value stocks were cheap. I think we’re in a situation now where the most expensive stocks are at extreme levels of … they’re as expensive as they’ve ever been. The median may be not as expensive as it was in 2000, but on some measures, using sales for example, it is extremely expensive. The value stocks aren’t that cheap on historical measures. They’re still at a premium to where the are on average, but they are cheap relative to expensive stocks.
Timing indicators
Tobias Carlisle: So I just … my question is what are the indicators that you like to look at for your own portfolio? And those are valuation indicators. And then what indicators are you looking at from a when or a momentum time? What’s your timing indicator?
Jesse Felder: You’re absolutely right. It’s become a mantra of the bulls, which is valuation is not a good timing tool. That’s absolutely true. I think what are good timing tools are breadth and risk appetites. So those are two things I watch very carefully. Late last year in September, I was writing about how many Hindenburg omens were being triggered on the NYSE and the NASDAQ. Absolutely astounding, more than we ever saw in history. And you see these bursts of Hindenburg.
Jesse Felder: A Hindenburg omen is essentially alerting you to great disparity in the market. So when the market is strong, it should be powered by most of the stocks in the market. You get a Hindenburg omen triggered when the market is rising, but fewer and fewer stocks are actually pushing it higher. So it’s essentially a breadth warning. I don’t use it as one Hindenburg omen is going to signal a crash like some people talk about. I want to see how man Hindenburg omens are triggered in a period of time and that tells me that breadth disparity’s widening.
Jesse Felder: In that fall of last year, we saw record numbers of Hindenburg omens triggered on the NYSE and the NASDAQ that told me there’s huge breadth disparity in the market right now. It might be powering higher to new highs, but the NYSE didn’t make new highs, even while the NASDAQ did, and the S&P did. That was kind of another sign.
Jesse Felder: Breadth can be an important warning, and then risk appetites also. So you want to see the right sectors powering the market higher. Today in this rally, we’re seeing the utility stocks do phenomenally well. That tells me that investors aren’t really keen on taking risk, they’re acting much more defensive.
Risk appetities
Jesse Felder: When you see staples and utilities and these things doing really well and you see consumer discretionary and technology and these things doing relatively poorly, that’s a clear sign that investor risk appetites are shifting. They’re not embracing risk like they should be at that point in the cycle. So to me, when you have the breadth and the risk appetites both pointing or kind of diverging from price, that’s a pretty good timing tool that the market is pretty close to reversal. You can use those on multiple time frames, too.
Jesse Felder: But that’s also one of the reasons why I’ve said the market is in a topping process, is because we’ve seen these massive number of breadth warnings over the past year. We have also seen risk appetites shifting pretty dramatically, like we’ve seen at past market peaks. Now for me in my own portfolio, things I look at for value and I think where the greatest value us to be found are in things that are outside. So these owner-operated companies that are systematically under weighted by the indexes. So much money is flown into passive and flown out of active that these stocks have been essentially enforced to be sold by active managers and they’re not being bought by passive because they’re low float.
Jesse Felder: So that’s, I think, kind of systematically one area where you can find value. But to me, there are pockets of companies too. I look for a situation where there is massive and predictive insider buying. So you see … have an executive who has a good track record of buying their own stock, and they’re buying a significant amount. That to me will hopefully confirm my idea that the stock is already cheap, and in terms of cheap I use a variety of different measures.
Jesse Felder: Basically a look at the valuation history of the company. I look at it’s valuation relative to its peers, and I’ll also do usually a discounted cash flow model, basically just to try and confirm my idea of what fair value is or even just to see what is the stock price discounting right now. So I don’t use the cash flow model as a primary valuation tool.
Jesse Felder: And then I’ll use technicals to see what is the trend, what is the strength, what is momentum. Usually I use technicals mainly for momentum. I don’t want to buy something that has strong downside momentum. I want, if it is still falling, I want to see waning momentum that shows me signs that sellers are running out of steam. So there are things, I think one of my favorite ideas that I’ve had over the past few months has been post. Bill Stearets is maybe the most successful insider I’ve ever seen in my career. The guy, when he took over Ball Corp in the late 90s and bought, 40, 50, $60 million worth of stock with his own money, brought in his own management team, they all bought as much stock as they could afford. Ball Corp’s up 40-fold in the last 20 years.
Jesse Felder: Bill Stearets also turned me onto Herbalife a couple years ago. I bought a big slug of Herbalife in early 2015 when he had nothing to do with the company. I really think that’s part of the thesis behind Post today is he saw a company like Herbalife. If you have 80% growth margins, you can’t go out of business, right? If I have 80% growth margins and I have no debt, I literally can’t go out of business. I can have idiots running the company like Buffet says, and it’s really hard to hurt the business.
Jesse Felder: So Post recently has started selling their own kind of a protein powder shake type of a thing, with their access to grocery store shelves and that type of thing. I think Stearets said, “Wait a second, 80% growth margin, that’s awesome. Why don’t we come up with something at Post?” It’s not Post branded, but I do think he owns a ton of stock and was buying more last year. The stock is still cheap relative to its own history, relative to its peers.
Jesse Felder: That’s the kind of thing that I look for. And then because of my concerns about the overall market, I’ll look to hedge that in some way against general market risk.
Hedging
Tobias Carlisle: How are you hedging? Just for the … How are you hedging?
Jesse Felder: Well, I’m short … I usually short individual stocks but in very very small size. I don’t like to short individual stocks. I’m not as aggressive as I am on the long side in that respect. I usually just kind of short the broad indexes and sometimes sectors. So I am short the semiconductors pretty heavily today right now, because talk about companies that are trading at the highest valuations in their history. A lot of these stocks are trading … Nvidia for example. I was short Nvidia last year. I’m still short it, with trading at twice it’s valuation from the peak of the dot-com mania, which is hard to believe. It’s trading 15 times sales when it only got up to seven, eight, nine times sales in the peak of the dot-com mania.
Jesse Felder: So what is that stock discounting? It’s discounting that that company’s going to take over every self-driving car, every AI application. I mean, they’re literally going to own it all and be able to keep incredible margins in the process. Really what was driving a lot of their sales, I think, over the past couple years is Bitcoin mining rigs. So when the Bitcoin price collapsed, a lot of that chip shortages turned into chip oversupply. So they weren’t talking about that very much in terms of their earnings calls. But that was the extra factor to demand factor that really pushed the results over the top.
Jesse Felder: Now we have this massive chip oversupply and sales are plummeting. So I want to be short. I’m short the semiconductor ETF against some of my long ideas. But I do think for the average investor, you and I have talked about this, there’s simple tail hedging methodologies that people can use. To me, when I suggest that and people say, “Oh god, that’s so bearish. Why don’t you just buy and hold for long periods of time?” I go, “Well, you buy auto insurance, right? You buy homeowners insurance. You protect yourselves in the case of an adverse event in those areas. With equities at the highest valuations in history, it makes sense to me to buy some insurance against my investment portfolio, just like I would with anything else.”
Jesse Felder: That’s how I look at tail hedging. I think it makes a ton of sense today. Maybe more sense than it’s ever made before. So yeah, there’s simple tail hedging strategies you can use. Buy deep out of money puts on a monthly basis, and it’s just look at it as an insurance policy.
Tobias Carlisle: One of the things I like about tail hedging is often it gets cheapest right at the moment that you really want it. So it’s often the best bang for the buck. I’ve done various things. I had HYG, which is the junk bond ETF. I had puts on that last year that were up a lot when the market was off but I wanted to hold them through to expiration in January 20, and of course they were 83. They were struck at 83, and I bought it at 85, something like that. And then by the time they expired Jan 20, they were out of the money even though they were up like 350% plus on December 24. That was a rapid rally. I was sad to see them go.
Jesse Felder: Right, yeah. I mean it’s funny, every time I’ve made a decision based on whatever tax thing, I don’t want to pay taxes with it, it’s been the wrong decision. You have to do it on the investment merits first. I’ve done that ton of times, and I’ve learned you know what? Take the gain, pay the taxes, or whatever. You’re better off in that respect. But yeah, it was interesting too, with that selloff and I think you and Chris Cole talked about this a little bit. I was surprised that volatility remained so subdued during that selloff last year.
Jesse Felder: For that reason, people who were tail hedging were probably disappointed a little bit to the extent of it didn’t really protect them as much as they would have liked. But that was very interesting to see volatility remain subdued even though it was a waterfall decline in December.
Tobias Carlisle: Chris … I was speaking to Chris as that was happening, and he was pretty … he didn’t seem to think that that was the real thing which I was surprised about, because I certainly thought it was the real thing. But he was pretty calm through the whole thing and he didn’t expect to see anything, and it was showing up in the volatility as well. It wasn’t taking off, and I don’t know why that was.
Jesse Felder: Yeah, it was the exact opposite of what we saw earlier in the year where you had the volatility implosion and there was just tons of short covering vol. Maybe it just was the fact that there wasn’t that much of a big short position vol. I am just amazed at how resilient a lot of these volatility short sellers are. They get crushed, and then they come right back in and start selling it at the lows. Maybe they were just comfortable in continuing to sell vol into that decline, which to me would be … I’m not willing to step in front of that steamroller.
Tobias Carlisle: But they’re right over and over again. But none of them have read Filled by Randomness evidently.
Jesse Felder: Right, right.
Closing
Tobias Carlisle: I think that that’s coming up on our time. It’s been a really fascinating discussion Jesse, I really do appreciate you giving me some of your time. If folks want to get in contact with you, what’s the best way of doing that?
Jesse Felder: At thefelderreport.com, I write a blog and there’s a little contact us there that I reply to personally. I’m pretty active on Twitter also. I don’t look at the ats, so don’t at me on Twitter because I literally just don’t look at them. But you can direct message me on Twitter if there’s things people want to discuss, too.
Tobias Carlisle: You just can’t be a bear on Twitter. Bears are excluded from the body somehow. They’re forced out. I’ve discovered that too. Anything that’s bearish gets a lot of hate.
Jesse Felder: Yeah, and so I think Twitter added a feature, maybe it was like a year ago or something, where you can literally just turn off your ats. I only see the ones from the people I follow, and I feel like that keeps me sane.
Tobias Carlisle: That’s smart. That’s a smart approach. Jesse Felder of The Felder Report, thank you very much.
Jesse Felder: It was my honor. Thanks Toby for having me on. I’m really excited to be on your new show and I’m a fan. I was really excited to hear that you were doing this, and so I’m eager to hear where you go with with and yeah. Best of luck with it.
Tobias Carlisle: Thank you.
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