Peter and Jonathan discuss Reddit traders, hedge funds, skyhigh valuations, miserably low bond yields and the outlook for 2021.
Hosted by Creative Planning Director of Financial Education, Jonathan Clements and President, Peter Mallouk this podcast takes a closer look into topics that affect investors. Included are in-depth discussions on financial planning issues, the economy and the markets. Plus, you won’t want to miss each of their monthly tips!
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Transcript:
Jonathan Clements: Hi, this is Jonathan Clements, Director of Financial Education for Creative Planning in Overland Park, Kansas. With me is Peter Mallouk, president of the firm, and we are Down the Middle. Peter, it was a pretty wild January. You look at the broad market averages, you think not very much happened and yet there are all kinds of craziness going on. Let’s start with GameStop, AMC, Blackberry and the whole battle between what seemed to be everyday investors on Reddit and hedge funds that had sold these stocks. What do you make of all that, Peter?
Peter Mallouk: It’s interesting, I was interviewed a couple times about reporters asking, “Were our clients asking to buy these stocks?” I said I hadn’t had heard from a single advisor or any of my clients that anyone asked about buying one of these stocks, but I’d get a ton of questions about what the hell was happening. People don’t understand what’s happening. I might just start by laying that groundwork.
I mean, basically hedge funds don’t just buy stocks, some of them short stocks, and it’s basically just the reverse of buying a stock. It’s, you make money when the stock goes down. Most of us are long stocks. We buy McDonald’s or we buy the S&P 500 and we make money when it goes up. If you’re short, McDonald’s or the S&P 500 or anything else like GameStop, you make money when it goes down.
Hedge funds regularly pick stocks that they think are going to go down and they short them and hedge funds love to short GameStop, because they view it like Blockbuster Video. Everyone used to go there and then Netflix took it out. Games are going online, why would anyone go to a game store? This company’s going to go under let’s short this stock. Then you have these guys online led by one millennial who was really mad about how his parents got screwed over in the tech bubble and he wound up having to eat tomato soup made out of ketchup packets if you want to believe the whole story. But it sounds great. A bunch of people followed and he said, We’re going to take down this hedge fund and let’s buy GameStop, because they’re shorting GameStop. If we buy it and push the price up, they’ll lose a lot of money.
A lot of people joined on that bandwagon and the stock took off. You have some people in there sending a message, you have some people in there just having fun. You have some people in there who think they’re going to make a lot of money on this and maybe a few will. In the meantime, the hedge fund did almost blow up. I mean, the price of GameStop went way up. They had to cover their position, I mean, they had to buy shares to cover their short and they lost huge, huge amount of money. Now some of the training platforms like Interactive Brokers and Robinhood took trading down, which I think is disgraceful.
Now what’s interesting about this is are these people, are these kids or whoever, millennials, we don’t know who really who they are, are they really manipulating the market? I don’t really think they are, but they’re very, very transparent. They’re going online, they’re saying exactly what they’re going to do and then they do it. Hedge fund managers manipulate the market. Hedge fund managers say, “Hey, I’m going to short. Here’s a stock I want to short.” Then they short it, then they go to an event, it’s usually a charity event, and they announce they’ve shorted this stock. Other managers in the room start to short it and then they go on CNBC and tell everybody why they shorted the stock and then the stock goes down and then because the stock is down, the company’s cost of borrowing goes up and sometimes the company goes under and that fund manager makes a ton of money.
I don’t have any sympathy for the hedge funds. I think a lot of the people that are trading the stock that think they’re going to get make money are going to lose a huge amount of money as these stocks plummet. But really the real, I think, interesting part of all this was watching platforms shut down trading, which I think was just terrible.
Jonathan: This is a little bit about digression, but one of the comments I’ve seen online is that you need to think about diversifying not just across different investments, but across different platforms in case you get locked out like this. I guess maybe if you’re that active in a trader, maybe that does make sense. I mean it wouldn’t make sense for me, I just buy and hold. But if you’re an active trader, maybe you do need to be on multiple brokerage platforms.
Peter: Yeah, I mean it doesn’t make sense for me either. It doesn’t make sense for a creative planning client. Most high net worth people, that’s not how they invest. But if you’re a day trader, this is a big warning sign to you. If you’re just somebody who likes to hop in and out of things based on buzz or you’re feelings or things like that, big tech is going to decide when you can trade or not trade.
I think this is a really, really scary time if you’re a retail investor. I mean, watching interact, what Interactive Brokers and what Robinhood did, it’s jaw dropping stunning. There are people that bought this yesterday and the stock’s going to plummet and they can’t trade the stock. You’re right, if that’s in that business, you really can’t be out enough platforms having watched two shut down, two of the most actively traded stocks overnight without warning. They just shut it down. They didn’t even say when they were going to shut it down, which really left people trapped in their positions.
Jonathan: Before we move on to other stuff, I think a transfer, an educational movement about short selling here. I mean, most of us are along the market. We don’t sell stocks short, but one of the things people should realize and learn from this incident, is how dangerous short selling is. If you go longer stock, the most you could lose is what you paid for the stock if it goes to zero. But if you short a stock, your potential losses are infinite. That’s nothing’s ever got there yet.
Peter: It’s what GameStop and AMC are trying. Yeah, I think this is a concept that a lot of people don’t understand, so I’m glad you brought it up. If a stock can only go down a hundred percent, right, Lehman Brothers, WorldCom, Enron, they can only go down a hundred percent. But a stock can go up 10,000%, right? If you’re short a stock, you can lose many, many, many times more. That’s what happened to the hedge funds that were shorting in GameStop and AMC and so on.
Also, with short selling, you’re fighting a major trend. You can be longest stock and there’s a lot of things in your favor. Inflation is in your favor. The management of that company every day is going to work, trying to make the company better. This army of people that know more about the company than you trying to make the company survive. The people at GameStop are trying to figure out how to survive in an online world. There is nobody working at the company trying to make the stock go under.
When you’re long, you’ve got management on your side, you’ve got inflation on your side, you’ve got the markets upward bias on your side. To be short, you have to be right on so many levels, just so very hard to find long short hedge funds or short hedge funds that do well. That’s the reason.
Jonathan: Emotionally, emotionally being short is a killer. Which brings me for a quick story from early in my career. Not long after I joined the Wall Street Journal, there was enormous hoopla over a single country closed end funds, and particularly over the Germany fund. I don’t know if you remember this, Peter, the Berlin Wall had come down, they thought Germany was going to be this economic powerhouse and it was, but they also thought that stocks were going to reflect that.
People piled into the Germany fund, this closed end fund. One of the things about closed end funds is exactly what they’re worth, because every closed end fund report what the value of its so-called net assets and it’s the value of the stocks held within the fund. Despite that, people bid up the price of the Germany fund, so that at one point it was almost a hundred percent above the net asset value. To anybody who knows anything about closed end funds, it was an obvious short.
I knew a guy who was short the Germany fund, and I talked to him a number of times as the price just rose and rose and rose and eventually he threw in the towel, he was getting margin calls. It was not just a financial crisis, it was an emotional crisis. He had analyzed the situation, he knew it was massively overvalued and yet one, he was getting the margin call, but two, he just emotionally couldn’t take it any longer and he bailed out, locked in his losses and he pretty much had to start getting from scratch after that in terms of building his net worth.
Peter: It’s just like whether you’re shorting a stock or longer stock, the fundamentals eventually catch up with the, the price eventually catches up with the fundamentals. The market is always right in the very long run, but in the short run it does a lot of irrational things. Which brings us back to that saying that, “The market can stay irrational longer than you can stay solvent,” right? Just because you’re right doesn’t mean the market’s going to make prove you right away. You might be broke by the time the market gets there.
Jonathan: Talking of irrational, there’s been a lot of talk, that the market is frothy, people have been declaring that things are going to come crashing down and they start pointing to different pieces of anecdotal evidence, what’s happened with Tesla, what’s been going on with the SPA, special purpose acquisition companies, they’ve talked about leveraged exchange traded funds, what’s going on with Robinhood traders and so on. Of course what’s been going on with crypto currencies and the way those suddenly sawed. When you look at the market, Peter, I mean do you sense that it’s frothy? Do you sense the people should be nervous because of these different pieces of anecdotal evidence?
Peter: I would divide with the market, let’s say market action into two parts. The first part would be the rising tide lifts all boats part. When interest rates are low, it inflates real assets. All real estate benefits from low interest rates, all stocks to some degree benefit from low interest rates. I think it’s an easier concept for people to understand with real estate.
Whether you own a house or a rental duplex or town home or a storage building, if you’ve borrowed money to buy that property at 4%, it’s not worth as much as if interest rates are at 2%, someone can pay you more for that property if their interest rate payments are only going to be at 2%. It inflates all real estate to varying degrees. But in certain parts of the real estate market, you might have a frenzy, in certain parts might be weak, like cell towers is a bit of a frenzy. Office buildings and retail are pretty weak.
Stock market is the same way, corporations borrow money, whether it’s AMC theaters which is struggling, or a really big corporation like McDonald’s or Microsoft, they’re borrowing money. When interest rates are lower, they all are borrowing at lower rates. They’re more profitable. If they’ve got a higher interest rate payment, they’re spending more money on interest so they’re less profitable.
Low rates inflate all stocks to varying degrees. That’s rational. It makes sense that if rates are low, I don’t want to own as much in bonds because I’m not getting as much lending money to these companies. I’d rather put my money in stocks, because they’re more profitable, because they’re not paying as much in loans. Separate from that, you get these frenzies and little pockets of the market and they always exist all the time. Right now you can argue whether there’s a frenzy or not in Bitcoin. There’s definitely a frenzy in some of these stocks that Reddit message boards are promoting like AMC and Reddit and penny stocks like Blockbuster and so on.
There’s a lot of intense interest in these specs that are coming out that are just a Shell company that you put another company in and go public. There’s nothing wrong with that, but we have a frenzy of them now. This is because a lot of people have a lot of money to spend, partially because of low rates and partially because of fed spending. These little frothy things are not a big deal. It’s when the whole market becomes frothy that’s a big deal, like back with dot-com bubble, we don’t have that here. We have pretty normal valuations in international stocks, pretty normal valuations of the emerging market stocks and US stocks are at the higher end of the range, but of normal. Market wide, no, it makes sense. Are there pockets? Yes, there are always are.
Jonathan: Actually, just a quick data points here, and this was something that I wrote in my latest piece for Creative’s clients, if you take the market and look at what’s happened over the past 30 years, the average price earnings ratio of the market is around 25 times trailing 12-month earnings. Right now, we’re pretty close to 40 times earnings. But the reason is that earnings got hammered last year with the coronavirus shut down.
If you look at expected earnings for 2021, what you discover is the market is at 25 times expected earnings. It’s right at the historical average. While the market may seem super expensive, it really isn’t by historical standards and people shouldn’t get unnerved by that sky high price earnings ratio that’s getting reported right now, because it’s not really indicative of the state of the market.
Peter: Yeah, I’m glad you said that, because every time I read a reporter write that the market’s at 40 times earnings, I want to pick up my computer and throw it out the window, because no one, no investor looks at current. Every investor looks at future earnings. Every investment decision is based on future earnings. Nothing should be reported looking at what the actual PE ratio is now, it scares people necessarily.
Everything is always about, if I buy this, what am I getting near the future? Just like if you’re buying a duplex and it wasn’t rented for the last year because you were remodeling it, we wouldn’t say the earnings are zero, we’re going, “Oh, it’s remodeled now. Somebody’s moving in tomorrow. What are my expected earnings going forward?” That’s how every investment decision is made, should be made. That’s how it should be reported. It’s a really critical distinction.
Jonathan: With January in the books, so one of the things that was interesting was not only to the broad market averages not do very much in January, despite all this craziness around AMC and GameStop and Bitcoin and so on. But there were a lot of people look at January and say, “As goes January, so goes the year.” I don’t know whether that’s really true, but it was sort of interesting to the degree that while the broad market averages didn’t do very much, small stocks had a pretty good month in emerging markets, had a pretty good month. That certainly seems to be a change from what we’ve seen in recent years.
I don’t know whether we can extrapolate that, but I think one of the things that investors should take away from that, is the importance of being broadly diversified. If you invest looking in the rear view mirror, which means you’re loaded to the gills with large cap growth stocks, you may discover that 2021 is not your year and that there is a reason to be globally diversified.
Peter: Yeah, I think if you look at 2000, 2010, large US stocks earned exactly zero. International emerging markets, bonds, real estate, they were all up a ton. 2010 to 2020, all these asset classes were up, but large US stocks did much better than everything else. Interestingly, in the fourth quarter of 2020, BlackRock, Vanguard, JP Morgan, these are the biggest managers in the world, all released reports that they believe that international stocks and emerging market stocks will outperform US stocks.
They all believe small stocks will outperform large stocks over the next decade. To your point, that’s what we saw in January of 2021. Is this the great rotation everybody has been waiting for? The answer is, who knows? Right? For the last few years there’s been more value overseas than in the United States. While we’ve seen little runs, the reality is for the last few years, large US has crushed everything else, which comes back to a point we were discussing earlier. Just because there’s value somewhere does not mean the market will realize it right away.
I think it’s going to realize it eventually and that BlackRock and Vanguard, and JP Morgan will be proven right. The question is when, right? When will that rotation? Has it begun or is it a year or two or three from now? That part nobody knows and the smart investors globally diversified for that very reason.
Jonathan: Talk about the stock market more broadly and going back to a point you were making earlier, “Yes, stocks may appear expensive, but the main alternative bonds is not especially appealing.” I mean, we still have interest rates at rock bottom levels. The rates picked up a little bit in January, but still, if you’re a long term investor looking for gains that are going to outpace inflation and taxes, bonds are not going to do it for you. You really need to be in stocks.
I don’t think you’re going to quibble with me, Peter on this one, that if you’re a long term investor, there is really no alternative to be in stocks if you’re looking for gains that outpace inflation and taxes over the long haul. What does that mean for your bond holding? I mean, should you change the way you think about bonds? Should you change the sort of bonds that you own, the way you think about those bonds? What would you tell people, Peter?
Peter: I was on a podcast with Jeremy Siegel, I think it was in March, and he’s one of my heroes. He’s the author of Stocks for the Long Run, and he was asking the same question about bonds and I said, 60/40 is dead. 70/30, 80/20 is the new 60/40. The 10 year treasury normally trades at around 6%. Meaning, if you loan money to the federal government, you get 6%. Today it’s less than 1% and all other bonds are kind of tethered to that rate. All other bonds to varying degrees usually pay a little bit more than that.
But rates are historically the lowest they’ve ever been. You simply cannot achieve your goals, most Americans anyway, by earning 2% in bonds. It’s forcing a rotation over to stocks, where the dividend alone is about 2%. If you get any return out of stocks over the next decade, you’re going to do better. We’ve reached a point, and we’ve always kind of had this bias at grade planning anyway, you should only have the bonds you need to meet your income needs over a very prolonged bear market.
Five years, seven years, have that money available, because we can’t be selling stocks if there’s a terrorist event or a war or a pandemic or a tech bubble or whatever, financial crisis, We don’t know when those are going to happen. They can happen any moment and we have to have money available. We can’t be selling stuff when it’s down 50%. But once you’ve met that need, the financial plan tells us what you need there, everything else should be out of bonds. It should be in US stocks, international stocks, small stocks, maybe alternative investments. But it needs to be going somewhere where we get, have some expectation of a return over the next decade.
Jonathan: What we’re saying here is you’re not buying those bonds for yields. I mean, there’s no reason to buy bonds for yield anymore. You’re buying them as a source of cash, when it’s unattractive to sell stocks. If you have money in bonds, they’re there to be sold so that you can pay for the grocery bill or you can rebalance back in into the stock market during the decline. You’re not buying them for yield and if their role is to be a source of cash when stocks are suffering, you really need to think carefully about the bonds that you own. Probably you really want to favor higher quality bonds, because those are the ones that are going to be maintaining their value when the stock market is going down.
Peter: That’s right. You should just have bonds, enough bonds to never be at the mercy of the market. That’s it.
Jonathan: Okay, Peter. Well, I think we should call it quits for the podcast for this month except for that one last thing, which is your tip of the month and my tip of the month. What have you got for me, Peter?
Peter: A lot of people hold a lot of cash at the bank, and they view it as their emergency reserve, and I think people think they need cash. You don’t really need cash, you need access to cash. Right now, if you’ve got cash in the bank, the bank’s lending it out to other people and making money off your cash, you’re earning nothing. There’s nothing to be earned sitting in the bank.
You should take that money, put it in your portfolio, and only leave what you need as operating income in the bank. You can always take money out of the quality bond side of your portfolio if you need it, and you can always borrow against your investment account if there were truly an emergency. Borrowing rates are extremely low in some cases, one 2%. You still have the access to cash that you need. That’s not for the everyday American. I think that’s for somebody who’s got a secure job and a taxable investment account they can easily access.
Jonathan: My tip of the month, Peter, is this don’t read market forecasts. Don’t listen to market forecasts. The reason I offer this is because I was reading some market strategist who was telling this wonderful, compelling story about the stock market and what could happen in the year ahead. Even though I know this guy hasn’t a clue what will happen, I found it subtly influencing my thinking.
Even though I know the guy is full of it still influences what I was going to do with my portfolio. I would say to people, don’t market strategists. Don’t listen to them when they come on CNBC or Fox Business, because you may discover that even if you don’t sell all your stocks or move everything into stocks, it may suddenly influence how you invest. You may be slower to rebalance or slower to invest a lump sum, because of what that strategist is saying. For goodness sake, just don’t listen to these people and you’ll probably be better off financially for it. That’s it for this month, Peter. This is Jonathan Clements, Director of Financial Education for Creative Planning. With me is Peter Mallouk, president of the firm, and we are Down the Middle.
Disclosure: This commentary is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.
