Jesse Felder  2:55  

Oh, really, I was reading Howard Marks, his latest memo and he talked about in every bull market, you get a group of stocks that become priced for perfection. So I started looking at the stocks since obviously it’s the FANG stocks in this bull market. 

When you look at them individually, so the way I look at valuations of stocks is not necessarily the company relative to the broader market, but I like to look at that stock valuation relative to its own history. I include Apple and some people might say, “Well, Apple is not expensive relative to the broader market.” However, Apple is actually very expensive relative to its own history. That’s kind of what I’m talking about in terms of valuation. 

So I look at these stocks, and I see they’re almost across the board trading at their highest valuation, relative to their own history in the last five or 10 years, if not more. Nvidia is a great example of this because it trades 15 times revenues, which is just absolutely insane. At the peak of dot-com mania, Nvidia, traded out about seven eight times revenues. At that time revenues were growing 100% year over year. 

Today, it trades at 15 times revenues, and revenue growth is 30%. I think 28% of the last quarter and projected to grow 12% or maybe even flat in subsequent quarters. So revenue growth is much, much slower today than it was at the peak of dot-com mania. The valuation was twice what it was back then. 

So that’s kind of what I’m talking about with these stocks just trading at really high valuations despite the fact that their growth is slowing. Apple’s gross margins are falling. In almost every case, I could go stock by stock. Netflix is another great example. Free cash flow has plunged from $300 million positive to $2 billion negative. Even still, the stock trades at its highest valuation in its history. So these stocks are absolutely priced as if things could not get any better.

Stig Brodersen  4:55  

Jesse, let’s specifically talk about the valuation of Netflix. I just looked up the stock here and it looks like the price to sell is 7.6, price to earnings almost 200. The reason why I asked this is because Netflix has gradually changed strategy. 

Now, they’re looking to go into content creation. I guess to me, that doesn’t sound like higher margins, if anything that sounds rather expensive. Though I guess my question also comes from an appreciation of knowing that you could be wrong, and the mind could be right.

Jesse Felder  5:29  

You’re absolutely right, Stig. When you look at Netflix 10 years ago, when they were putting Blockbuster out of business, you can make the case that they’re gonna own the DVD business. So yeah, I’m willing to pay a high multiple because they’re going to take all of that business to Blockbuster. 

Then, they went to video on demand, you go, “Wow, this is a new market. They’re doing something brand new.”So maybe that does earn it a higher valuation and growth premium today. They’re getting into content creation, and when you look at every single one of the company’s competitors and content creation, they trade one to two times sales. 

Then you have Netflix free cash flow is plummeting and the reason is because this content creation is very expensive, and the return is very minimal and very hit or miss, right? You have some hits, you have some misses. So cash flow goes up and down, deeply negative for them right now. I don’t know how you justify 7.5 time sales when you have Disney in 2.5 or 3 times sales, which is best in the business.

Disney is an interesting example too, because they’ve decided to take all of their video product away from Netflix and create a competing platform. So it’s a very interesting situation. That’s why it’s so awesome right now.

Preston Pysh  6:46  

The thing that I can’t understand about Netflix doing their own content is back in the day, you turn on your TV and you’d flip through the channels and try to see what was on and you’d give things kind of a try because you just had to. There wasn’t like you could do on demand TV, but now with on demand, like when you go into Netflix, you’re looking for something specifically. 

You’re not just perusing and seeing what pops onto the screen anymore. There was a lot of discovery that happened with these original shows that were maybe coming across the network. So I think that’s a major problem for them as they’re trying to…

I mean, we all know why they’re trying to do it. They’re trying to get people to stay hooked on some type of program that’s decent, that keeps them subscribed to the service. But I think that it’s a harder sell than it used to be back in the day when you’re just channel surfing than it is now because of the way on demand TV works. Would you guys agree with that? Or do you see it a little differently?

I absolutely agree. I think Netflix also when they had the first mover advantage for a long period of time in the video on demand. There was a great case everybody had to get Netflix, but now you have Disney creating their own platform. You have Amazon Prime, who you know has its own platform, HBO Go, Hulu. 

You have a lot of different platforms, a lot of different choices for people. A lot of people were well-placed in the media industry, you’re talking about a price war on the horizon. So I think that’s another risk to Netflix.

Something that I think a lot of people that just invest based off of the brand are they’re not a numbers person. This is how I would like to describe this for people as they’re thinking about Netflix specifically. 

So if you bought one share of stock for $183 right now, you could expect the profit after an entire year of buying that $183 business to be 43 cents. That’s what it was at the end of 2016. It looks like the past year, it’s about $1. Let’s just say best case scenario, it’s $1. You’re paying $183 to own a business that’s going to give you $1 after a year.

I wrote a blog post recently about this and this goes to the broader market too, but this was specifically in regards to Nvidia, Facebook. Stocks trading 10 times revenues or more. Back in 2001, kind of late 2001, Scott McNealy gave an interview to Bloomberg and this was after his stock had just gotten crushed, and he was talking about the valuation of some micro at the peak of dot-com mania. I got to read this quote, because it’s perfect for what we’re seeing today.

Jesse Felder  9:15  

He says, “10 times revenue is to give you a 10 year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that past my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. But as soon as I have zero expenses, which is really hard for 39,000 employees. 

That assumes I pay no taxes, which is very hard, and that assumes that you pay no taxes on your dividends, which is kind of illegal. That also assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. 

Now, having done that, would any of you like to buy my stock at $6  a share? You realize how ridiculous those basic assumptions are. You don’t need any transparency. You don’t need any footnotes, what were you thinking?”

So that’s the Nvidia today. That’s Netflix today, it’s Facebook today. All these companies that trade at very high price to sales ratios. Interestingly, at the peak of the dot-com mania, we had 29 of the S&P 500 components traded at 10 times revenues or greater. Today we have 28. So it’s very, very similar situation, actually.

Preston Pysh  10:21  

We had a comment from an individual on Twitter who said, “Hey, are some of these prices justified because interest rates are a whole lot lower than they were back in 2000?” What do you say to something like that? 

Jesse Felder  10:29  

I think the best quote that I’ve heard about the best way to think about this is there’s an incredible dichotomy. What do low interest rates imply? Low interest rates imply very low growth. What justifies a high multiple of earnings? High growth.

So Jim Grant said we have boom time equity valuations and depression era interest rates, right? So you have the bond market saying there is no growth. Then you have the stock Market saying growth is off the charts. 

We could get into the math of it but when you use a discounted cash flow model, if you discount the discount rate, you lower the discount rate to 1% or 2% or whatever you want to lower it to. But you don’t lower the growth rate in the discount cash flow model, you’re making a massive mistake. 

In fact, the Federal Reserve has written a paper on this, how every single cycle, investors make this mistake. You cannot lower the discount rate without lowering the growth rat. When you lower both at the same time, it doesn’t matter if you grow at 5% and discount of 5%, or grow at 10 and discounted 10. The valuation stays the same. 

I mean, it doesn’t justify high equity valuations. Although it does help explain it investors are desperate for returns. So they’ve piled out on the risk curve to push junk bond prices way too high, equity prices way too high. It’s just a sign of desperation on the part of investors. But it doesn’t mean they’re not making a grave mistake in doing that.

Stig Brodersen  11:59  

So let’s talk more about valuations, Jesse. Here with the FANG stocks, I’ve heard a lot of different arguments in terms of how to assess valuations because typically we’d be talking about this discounted cash flows as you talk about, like how much money is flowing back to the owners. 

Now, you hear other valuation metrics, like the networking effect for something like Facebook or the top line growth for something like Amazon. How much should we pay attention to these new valuation metrics? Also giving that these FANG stocks are impacting our lives in a way that perhaps you can argue we haven’t seen before?

Preston Pysh  12:41  

I mean, in every cycle, it is different in some respect. However, the iron law valuation is never different. My friend John Huston likes to say, “Any security, essentially, today’s price is discounted future cash flows.” 

So for a company like Amazon, to justify today’s valuation, they have to be able to turn on the profits eventually. When I look at the valuation of Amazon specifically, it is trading at its highest valuation in 10 years, and I just look at price to sales, again that there really is no income. So you can’t look at a price earnings ratio. 

Jesse Felder  13:21  

You look at the price to sales ratio, and at the same time growth has been cut in half or by two thirds over the last 10 years. So growth rates are falling dramatically. You can see this and Amazon trying to get into other industries. The risk there is that Amazon now is drawing the interest of regulators in terms of antitrust. 

I talked to my friend Peter Atwater about this and he says, “Welcome to the backlash era.” We’re now seeing people around the world, this populist move that people are tired of being taken advantage of, tired of being bullied. There’s been a backlash towards politicians. There’s been a very, very justified backlash towards sexual harassers. That’s not just a trendy thing. That’s very, very justified. 

However, I think we’re also going to start seeing a backlash towards these companies that are taking advantage of… Facebook and Google, especially, but Amazon destroying the retail sector and destroying its competition has so much power, so much monopoly power, that it’s drawing a lot of antitrust interest. If they were to start saying, “I’m sorry, you cannot get into pharmacy benefit management, we will not let you into these industries, because you already have too much monopoly power,” then growth declines not… and then how do you justify sky-high valuation?

Stig Brodersen  14:43  

Yes, very interesting point to bring up about regulators because it seems at least so far, not to be something that investors are to worry about. But obviously, if it will happen, if they will start to get regulated, this is something that we all need to consider, in terms of our valuations. where do you see this going in the future?

Preston Pysh  15:04  

Well, I think there’s a very big difference to be made between the way investors feel about these companies and the way the general population feels about these companies. When you look at the way that politicians and the general population feels about these companies, USA Today did a poll, and more than half of respondents said these companies have too much power. More than half of those people that were afraid of how they potentially use that power. 

Jesse Felder  15:33  

Then, now you have in Congress, there’s a bipartisan effort. I think this is one of the things that could pass Congress very easily, is new legislation to rein in the power companies because it’s not just liberals talking about this. Steve Bannon came out and said that the Republican Party, at least kind of the Tea Party side of it is going to make it their top priority to rein in these companies next year. 

So you have both sides of the aisle saying… It was really the Russian influence in the elections that helps people to wake up to these risks and to the unchecked power that these companies have. I think that was just a catalyst to understanding the power that they have.  

I haven’t published this yet, but I recently had a conversation with Roger McNamee, who was one of the first investors in Facebook. He convinced Mark Zuckerberg not to sell Facebook to Yahoo for a billion dollars. He also introduced Sheryl Sandberg to Mark Zuckerberg. This guy has been instrumental in Facebook’s evolution as a company. 

Then, 18 months ago, he went to them and said to Sheryl and to Mark, “This platform has become extremely dangerous and it’s because there is no oversight. You guys will allow anybody to come in and pay any amount of money to use brain hacking platform, hacking people’s brains to get them to consume what you want them to buy, vote for who you want them to vote for.”

They both kind of have been rebuffing his efforts to get them to fix this. Now Congress is realizing the dangers involved. It was actually the chief Google ethicist who’s now coming out and saying that this is legitimate brain hacking. We have used the psychological principles of gambling and persuasion in order to create a platform that manipulates human brains more effectively than anything in history. So I think that as people wake up to this, these companies, they’re going to be more highly regulated, or they’re going to have to find a way to take greater control of their platforms.

Preston Pysh  17:42  

One of the things I think about whenever you’re using social media is confirmation bias and how powerful and how reinforcing it’s like an echo chamber for people. Let’s say you’re a liberal or you’re conservative, pick whichever one you want, and you start liking things that are specific to that one thing. Well, next thing you know, the only thing you’re receiving in your newsfeed are those things. So it has this positive, maybe negative reinforcement to that’s the only thing you’re seeing. 

Now, that people are getting so much of their news through this stuff, it’s just the ultimate confirmation bias mechanism. So you call it brain hacking. I completely agree with you and I think that most people aren’t even aware of confirmation bias. So how can you set up your feed so that you’re not being susceptible to something like this? I mean, it is a major concern. I think it’s something that I think a lot of people need to think about.

Yeah, that’s a great question. I think that social media, these companies and I’m as guilty as anyone on Twitter, I love Twitter. I’m an addict, I confess that. But I think social media is just not the ideal platform to get most of your news from. I use it as my go to source but I also read a bunch of the major media outlets which double check their sources. They have all those types of things.

So, every The Financial Times, Wall Street Journal, New York Times. I mean, I think you have to broaden, you just can’t get all of your news from social media because it is so unreliable at times.

When you have one little preconceived notion and you start liking a few things and now it’s just it goes off on like a total tangent. That’s all you’re thinking about.

Yeah, absolutely, and they’re not all legitimate sources, either. I mean, there’s a lot of different people with a lot of different interests out there trying to shape public opinion.

So when we think about all this, this is from an investing standpoint, positive, negative, continues to exist for more years, because it’s not at a breaking point. One of the things that I was looking at was when you look at each one of these companies’ top line, the top line still growing.

 

I mean, it’s definitely not growing like it used to, like you’d pointed out, but it’s still growing and these things are definitely being traded off the top line and not the bottom line. So if we expect the top line to continue to grow and to continue to expand, should we expect the price to kind of go with it until that breaks?

That’s possible but we might not know about the rest of the top line until well after the fact. 

Jesse Felder  20:10  

It was interesting for me to talk to Roger because one of the biggest risks to this company was investors in Facebook and Google shouldn’t be praying for much tighter regulation right now, because if Washington doesn’t regulate, because they’re not going to regulate themselves, because it hurts the top line too much. 

If they don’t get regulated, then people are going to start revolting from these platforms. So they’re going to start realizing, “I’m being manipulated, and I don’t like being manipulated. I don’t like my data being sold to the highest bidder, regardless of who that is.”

As investors, we should hope that they’re going to get regulated because that’s going to make them better corporate citizens. 

Scott Galloway also makes a great point in Business School. One of the case studies they use is Johnson and Johnson and the Tylenol scare. When Tylenol pills had killed a few people, there was a huge scare about Tylenol. What did Johnson and Johnson do? They pulled every bottle off of every shelf on the planet. We’re going to protect our customers at all costs, right? 

That is Business School 101. When you have a crisis, you literally just shut it down. You do everything it takes to make it right. What’s scary, I think for investors of these companies is Facebook’s not doing that. Facebook is still allowing “we’re going to auction off brain hacking to the highest bidder, we’re not going to change our business practices and nothing’s changing.”

They’re not taking that lesson to heart. I think as an investor, that’s a huge risk. People would have so much more faith in the platform with turning over their data and turning over their lives to Facebook, and Google, if they started showing those types of behaviors like, “Look, we put your interests first. We’re going to make sure you are not manipulated.” 

That would be a hit go a long, long way to giving people confidence in still using the platforms. I look at all those things as rapidly growing risks to their underlying business models, really.

Stig Brodersen  22:12  

Okay, Jesse, so this is the last question I have about the FANG stocks. This is also the question I’ve been looking most forward to asking because I kind of knew that there would be some kind of bashing. So let me ask this counter question. If you had to hold one of the FANG stocks for at least a decade, you couldn’t sell it. You have to hold it for a decade. Which stock would it be and why?

Preston Pysh  22:37  

Yeah, that’s tough. For me, I want to own stocks that I think are very cheap out of favor. Classic value. My favorite way to think of it is the way Jim Rogers put it, which is, “I want to wait until I see $5 laying on the ground and I’ll have to just pick it up.” Like it’s that obvious. I don’t really see any of these stocks as being that $5 on the ground right now. 

Jesse Felder  22:58  

However, I think for me, it will probably be between Apple and Alphabet. I think those two have legitimate moats to their business that are probably more proven than any of the others. The valuation of Apple is obviously more reasonable than the others. 

Stig Brodersen  23:17  

Interesting that you should mention Apple and reading through their financial statements, it seems to me that they are perhaps too reliant on the iPhone. I can’t remember the exact number, but it’s something like 70-80% of the revenue that comes from the iPhone. 

As an investor, even though this is the biggest market cap in the world, quickly approaching a trillion dollars, should we be concerned that consumer preferences might simply change?

Preston Pysh  23:48  

I really do think that’s a legitimate risk capital. I mean, the thing about all these companies is people don’t remember a time before the iPhone. They don’t remember a time before Facebook, but the history of technology. Somebody had a great tweet recently. It was the cover of Forbes 10 years ago. 

“Will anybody ever be able to chip away at Nokia’s ownership of the cell phone market?” This was 10 years ago and so, there’s always the king of technology, but it changes. It doesn’t seem like it changes very rapidly, but it does every 10 years, there’s seems like there’s a new king. 

Jesse Felder  24:24  

For me, I am an Apple fan. Totally sucked into the ecosystem. I was just looking at Google Trends. You look for searches for feature phone and what’s a feature phone. It does talk text and music. That’s it. Feature phones, I think could be the next big thing in mobile devices because people need to be able to get away from social media. Get away from notifications. 

There’s so many more studies coming out that these things make us depressed. The more notifications pop up on your cell phone, the more frustrated and angst is built up inside of you. Social media does the same thing.

People want breaks from these things. I think that is maybe a risk to Apple. I don’t know. I mean, they have such a wonderful ecosystem, and they do have a strong mode that will protect their business. So we’ll always be fans of the iPhone. But for me, I think there are risks.

Preston Pysh  25:18  

Well, that’s a great story. I’m glad you shared that. 

All right. So Jesse, let’s transition into talking a little bit about something you’re hitting on earlier, which was inflation and growth and intrinsic values when you’re doing discount models, because I think that this is something that a lot of people are wanting to hear more from you on. So what would you say is you’re looking at this moving forward into the next 10 years? What are you looking at for a growth rate? Like what do you think is reasonable?

Gosh,  again, my friend John *Hustman has done some really interesting work here. It really depends on where you are in the cycle. When you have 4% unemployment, there’s just not a lot of potential left in the economy to create a ton of new jobs. That’s a lot of the times where growth comes from…. You look at periods of really good growth, and you start with a high unemployment rate. Then the jobs take care of the rest. 

Jesse Felder  26:12  

You guys had Eric Cinnamond on the podcast recently. Eric has been writing about inflationary pressures building here in the United States. At least, for me, it’s more interesting from his bottom up perspective, he’s tracking, and listen, I don’t know how he does it– all 300 conference calls a quarter. 

When he does all that, he’s hearing wage inflation becoming a big problem for these companies. 4% unemployment, it makes a lot of sense. The only time you know real interest rates were held this low for this long was during the mid to late 60s. What was the experience after that? Did inflation just take off? 

I think there’s a lot of pent up inflation, wage pressures building and things. We still have a Fed funds rate at 1% change. I think it’s very possible the Fed is far behind the curve. Wage inflation is going to take off. 

There was a great stat today that I tweeted. Japanese beer brewers just raised prices for the first time in 10 years. We’re starting to see wage pressures in Japan, the epicenter of deflation. So if deflation is potentially ending in Japan, we’re starting to see wage inflation there. This is a global phenomenon. 

If we start to see inflation around the world, all of these central banks are going to find themselves so far behind the curve, and you have to raise interest rates rapidly to try and play catch up. So it’s a very interesting time.

Preston Pysh  27:45  

When we talk about what does that mean, for people that are listening to this and they hear… Let’s say that that is a true statement, and that happens, what happens if they have to start raising interest rates quickly like that?

Well, the first thing I think about is if you justify high valuations with low interest rates, your premise is immediately evaporated. I don’t think that means much in the minds of a lot of bulls today. However, when you look at junk bond yields in Europe, at less than 3%, no company has been able to borrow at incredibly low interest rates. You junk bond yields here in the United States at 5%. 

Jesse Felder  28:25  

These low interest rates have enabled a whole army of zombie companies to stay alive. That has kind of prolonged the cycle and prevented a real washout of businesses. If you have been financing your business at 3-5% for the last 10 years, then all of a sudden, you have to refinance at 6-8%. 

Those zombie companies are toast and you’re going to have a new credit cycle, where defaults start rising at a corporate level. Then spreads start widening and that’s not good for risk assets of any sort, including equities.

Preston Pysh  29:04  

These have been the stories for so long that we’ve been talking about– how much longer can the Fed do this? Now, something that I find really quite interesting is when you go back and you look at the balance sheet of the Bank of England, the ECB, the US and Japan. 

When you look at the balance sheet, and you look at the QE that’s been conducted, and you look at the time whenever the US stopped doing its QE, and then the ECB picked up, and you look at that transition point, we had a big correction in the markets here in the us back in 2015. You go back, I think it was in 2013 or was it 2012? I can’t remember. 

You saw another similar event where basically the quantitative easing was swapped, and you saw a big correction in the market. This is when the ECB just started doing some QE. Right now, you turn on the news and you see guys like Ray Dalio that are saying, “Hey, the central bankers are done. 

They’re going to start pulling this back in 2018. They’re not going to be doing the QE like they’ve been doing in the past.”I’m really curious to see how that plays out and whether that’s even a true statement. That’s what Ray’s saying. 

The Fed has obviously stopped, but the ECB still hasn’t turned on full throttle. So are you hearing anything different? Are you seeing that the ECB is going to start pulling back on some of their quantitative easing efforts? Is that going to be something that we see a major transition in 2018?

Jesse Felder  30:24  

I think they’re going to have to. They’re running out of bonds to buy. They’re starting to Japanese own a ton of huge percentages, more than 50% of their own bond market. ECB is running up against their constraints of the bonds that they’re allowed to buy. So they’re gonna have to start tapering. 

However, it’s also the inflationary phenomenon. This is very, very interesting to me, because I talked to Carol Sokoloff about this recently and William White, who was chief economist at BIS. We talked about the same topic that it turns out quantitative easing was actually deflationary because it allows for a massive amount of debt creation. 

When you pile up all this debt, it reduces the amount companies can spend or consumers can spend. So it actually slows things down and it’s a deflationary impact. I think that’s what we’ve learned during the cycle, so that when you reverse QE, that’s potentially an inflationary impact. 

I think that’s something that a lot of people aren’t thinking about that if QE was deflationary, undoing QE or tapering QE by all these central banks could potentially be inflationary. Then what do they do? Then they have to obviously raise interest rates, [which] rapidly did catch up.

Stig Brodersen  31:39  

Alright, so say that we don’t want to be invested in stocks or bonds, whether or not we believe it’s because interest rates are going up. We just don’t see any kind of yield. So basically, we just want to hold cash. 

Now, how do we hold cash? Should that just be in US dollars or should we divide that up into, call it USD, yen, euro? Perhaps pounds as well, even though some of these currencies start to look more vulnerable than they have in the past. What are your thoughts on that? 

Preston Pysh  32:08  

That is a great question. I bearish on the dollar. I think we started a new bear market for the dollar. To me, it’s a very simple look at the way the federal deficit is going. This is potentially the first time in modern history where the federal deficit is widening, during an economic expansion. That’s potentially a big problem. 

I’m not saying this entitlement spending and stuff… Every economic expansion we’ve had, tax revenues grow, and things are great for the federal government. That’s not happening right now. So that’s actually really worrisome. 

Jesse Felder  32:49  

The federal deficit is only going to widen and if you look at a chart of the dollar deficit, it’s very highly correlated. The better the US Federal Government’s finances are, the better the dollar does. The worse the deficit widens, the worse the dollar does.

You also look at the Japanese yen. [It] is very, very cheap relative to the dollar. You look at things like purchasing power parity, the Big Mac index, and the yen is very cheap. If Japan is going to see an end to their deflationary scenario and the central bank is going to have to start to tighten, the yen is going to do very, very well against the dollar.

 

I think the Euro probably will do well, instead. Just look at relative central bank policy. The Fed has been tightening for years now, really. The ECB has been loosening for the last few years. When that changes, the ECB has to start tightening, and the Fed goes, “Oh, no! We’ve maybe started a new recession.” The Fed has to start easing again, the dollar is just going to tank against the euro, the yen.

But honestly, I think you mentioned Ray Dalio earlier Ray said everybody should have at least 5% of their portfolio in gold. When the dollar does poorly, gold does well. So if you’re bearish on the dollar, per se, you have to be bullish on gold. So financial assets are extremely expensive. We have bonds and stocks. 

I can’t remember which brokerage firm came out. Recently, a research house came out and showed that since 1900, the combination of stocks and bonds has never been highly valued in history. So they’re both extremely expensive. 

So financial assets are something that… there’s a lot of risk there. I think real assets are something you’re going to want to own the next 10 years. That to me is real estate commodities, gold potentially tips, treasury inflation, protected securities… My favorites are real estate and gold. I think those two probably in an inflationary environment do the best. 

So I mean, a lot of these things tie in together. If the dollar goes down, that creates inflation. And so it’s really kind of a holistic view over the next 10 years that I think real assets will do better and gold will probably do well because the dollar is down the next few years.

Preston Pysh  35:03  

If interest rates are going up, wouldn’t that be a concern for real estate though, because the prices are going to go down?

It could when you think of residential real estate, but when you look at investable real estate, it’s mostly commercial. The nice thing about commercial [real estate] is when there’s inflation, they can raise rents. And so yes, real estate prices are very, very high. I agree with you. So maybe that’s not the best area, but they do have pricing power in an inflationary environment. 

Gotcha. The next question obviously becomes because this is the hottest thing that everyone’s talking about, and you’re smiling because you know where this is going. What are your thoughts on that thing?

Yeah, Bitcoin is a classic mania. It’s a classic mania. I think it’s just so fascinating to watch it play out in real time. I’ve done a lot of research on it, and I understand that every time I say… you don’t understand what Bitcoin is, I understand what Bitcoin is. I was talking with a friend of mine today who is a reporter for Quartz, because he was asking me about this.  I think Bitcoin is a technology. Blockchain is a new technology and blockchain possibly has a lot of potential value. 

Jesse Felder  36:17  

However, if there’s any lesson from technology, it’s whatever is great today, there’s somebody who is going to come up with a better version of it tomorrow. That’s the simplest thing I think about in terms of when somebody creates a better Bitcoin tomorrow.

Central banks are talking about creating their own Fed coin, and these types of things. However, fundamentally, the argument for only Bitcoin is there can only be 21 million coins created, and this was a limited quantity. 

But there is no limit to the number of digital currencies or cryptocurrencies that can be created. So don’t understand at all why Bitcoin should have any value over something very, very minimal because the higher the value, the harder it is to become a medium of exchange. 

The Wall Street Journal wrote about this last week that a lot of companies are trying to use it and accept Bitcoin. But people don’t want to spend it so long as they think the price is going up. So it actually works against itself, the volatility. 

There’s another point to be made to that. My friend, Fred Hickey, made in this latest newsletter, which is now the IRS considers every purchase to be made with Bitcoin, a sale that has to be… you have to pay capital gains tax. You don’t have to do that on your dollar. 

Preston Pysh  37:30  

Yeah, I think that’s a concern.

Jesse Felder  37:33  

Yeah, a lot of these companies are saying, “Okay, we can’t accept Bitcoin anymore, because we don’t want to be responsible for reporting to the IRS.” And so there’s so many issues with it. So many problems. It’s modern day tulip mania in my mind. 

Preston Pysh  37:47  

I’m a fan of it. I really am. But I think that there’s…I have some concerns, obviously. I think that there [are] concerns of it going into the mainstream adoption. I think that’s a lot of risk, a whole lot of risks, if you’re if you’re going down this path. 

I think the point that you just made, I think is a huge point without being treated as if it’s a security, because companies are not going to want to accept this if it’s being treated as a security for all those reasons. 

I think the other concern is really from the government side of it: how is the government going to play with this as it continues to mature? The part that you had mentioned there, Jesse, about people not wanting to spend it because the value is going up, I think that that has a potential to even compound the interest into it even more. I think that it has a potential to drive a network effect, maybe even a bull case for it based on that. 

But man, there’s a lot of smart people in this space. There’s a lot of coins trying to beat Bitcoin. So like even though you own Bitcoin today, there’s a lot of ones that are very high in market cap that are trying to rise up in there and I think if you’re in this space, it has a huge potential upside if it actually does become some type of world currency.

Jesse Felder  38:57  

I think it’s an interesting [thing]…My friend, Steve Bregman, Horizon Kinetics, I mean, brilliant, brilliant thinkers. They’re some of my favorite guys to talk to and read their thoughts. They’ve been in Bitcoin for a long time, they’re very early in it. The way they look at it, I think makes most sense that if you look at it as a lottery ticket, as it does take over a portion of the global transaction market, then it’s worth a ton of money. But for people to put any more than 1-2% of the portfolio in it is taking on way too much risk. 

What you’re seeing today are the classic mania signs of people selling their homes and putting all of the money into bitcoin? Neel Kashkari, the president of the Reserve Bank of Minnesota, said somebody stopped him. 

He tweeted this. Somebody stopped him in a line at LAX when he’s trying to get on a plane and said, “What do you do for a living? Oh, I’m president of the Federal Reserve Bank. Well, I just pulled out $35,000 my home equity to put it in Bitcoin. What do you think?” It’s those types of decisions [that] are classic signs of a mania. Most people are not looking at it like Steve Bregman and Horizon Kinetics are looking at it.

Preston Pysh  40:14  

That’s exactly what Stig and I have been saying on the show is it’s almost like a venture capital play. If you’re in this you’re kind of looking at it is like the odds of this turn up or probably 20% or 10%, but the upside is absolutely astronomical. It’s huge. 

So if you’re throwing more than 5, we were saying, 5% if you’re taking more than 5% of your net income, and it really depends on the person, like, 5% for Jesse might be different than 5% for Preston, which is different than 5% for Stig, because it’s really about if you lose all that, is that going to impact your life?

That is actually a great point and that’s what I tell people about trading about anything. Create yourself a nice diversified portfolio of stocks, bonds and real assets, which I think most people overlook. It can be a third-third-third, be very, very simple. Then if you want to speculate in the stock market, you want to learn how to trade, you want to speculate in Bitcoin, take as much money as you’re willing to lose. I’m talking about trading stocks. Don’t put more money into that than you’re willing to lose because even just in learning how to trade stocks, if you read Market Wizards, one of my favorite books, these are the most brilliant minds in the business and almost every single one of these guys has gone completely wiped out their trading account, as they’re learning how to be good traders. 

They’re learning how to be good investors. A lot of times more than once, two three times to wipe out their trading accounts. But they look at it like and I love this term, “tuition at the school of trading.” It’s okay to lose money as long as you learn something from it. 

Jesse Felder  41:52  

I think most people put the money in Bitcoin but don’t put more than you’re willing to lose. Look at it that way. I think that’s something that also Paul Tudor Jones preaches is think about your risk first. Don’t think about how much money I could make. Think about the risk first. 

Preston Pysh  42:08  

Absolutely. That’s some sound advice right there.

I don’t know how environmentalists are not already completely up in arms about the whole Bitcoin thing. Bitcoin just by itself, excluding the other cryptocurrencies blockchain behind is already using more energy than Nigeria. 

If it does get bigger than…the estimates are it could use more energy than Japan. For me, the energy usage is also just massive and costly. I don’t understand how you could be an environmentalist and a bit one investor at the same time because they are mutually exclusive at this point.

Stig Brodersen  42:48  

Great point, Jesse.  I would like to bring up the concept of trust here because whenever we talk about money in the conventional sense, it doesn’t really have any type of utility. The only reason why it’s worth something is because we agree is worth something. You trust the system that you can actually get milk or whatever you’re trying to buy for your dollars. So how does trust play into this discussion about the validity of Bitcoin, in your opinion?

Preston Pysh  43:20  

That is a really good question also. I think Bitcoin has yet to be really tested in terms of trust. I worry about the platforms we saw the other day when there’s some higher volatility, that Coinbase went down. So you couldn’t be traded as the biggest trading platform for it. 

Jesse Felder  43:38  

There was an accident where a bunch of bitcoins were wiped out, because somebody hacked a platform by accident. For me, I just come back to gold. It has been money for 5000 years and no matter what, you can take a gold coin and somebody will trade you something for it, because it’s been accepted in society for a very, very long period of time.

Every time, every single time throughout history, when money has been debased, to a great extent, people have fled to gold. That’s just a historical fact. I think if you’re looking for something that has a historical know basis in protecting you against money creation, protecting you against those types of things, gold is really the answer. 

Bitcoin is very interesting to me. I really do sympathize with the underlying story of it. The lack of faith in central banks have created these bubbles and printed a ton of money. I mean, something that I’ve written about for a long, long period of time, so I do sympathize with it. 

Though I just think there are too many problems in the fundamental case for owning it. Too many inconsistencies, that it’s hard to really put much more faith in it than looking at it as an option or as a lottery ticket. 

Preston Pysh  45:02  

I would have to agree with you on the fact that there’s no incentive, if anything, they’re incentivized to manipulate their monetary baseline to manufacture growth. So for me, it’s really exciting to know that there’s technology that’s out there that could potentially fix that, or to peg that on a global level. That’s where I know Stig is also very excited about the technology, that it could potentially do that.

However, it’s just a matter of, what is this going to actually look like as it shakes out, because there’s so many unknowns, there’s so much risk. You don’t even have to start going into all the risks to know that there’s a lot of risk in this. I think that anybody that’s going into this space has to come into with their eyes wide open to know and not just to buy into the narrative like this is going to replace everything and they have to really do the due diligence and a lot of hard work to try to understand all those different variables if they’re in the space.

Absolutely. I think when you think about how you rein in central banks, there’s a reason why there was a gold standard to begin with, so that central bankers couldn’t print money because it had to be backed by gold. When central banks after World War Two, one by one went off the gold standard. That was the beginning of all these problems. 

Jesse Felder  46:18  

Now, I’m not an expert on this, but Neil *inaudible* and his thesis, *inaudible* brings up some very, very interesting points about where we are in this cycle.  I really do think at some point, if the monetary policy gets so out of control, and we do start seeing hyperinflation, potentially in some governments, that these central banks will be reined in, and they will have to be forced to… just like Germany did go back to a currency that’s backed by something. 

It’s a lot of speculation, but when you look at the trajectory of the US Federal spends $100 trillion of unfunded liabilities. Is there a congress to reduce Medicare, to reduce social security? You vote for that. You’re going to get voted right out of office. 

So there’s a lot of people who have hypothesized that those things will never be reformed. The only way they’re going to get paid for is by printing a ton of money. So yes, I do understand and it makes a lot of sense when I own something like Bitcon or gold that protects them against that scenario. 

Hopefully, someday we’re going to hit some type of a crisis that forces people to rethink the central bank policies and to rein them in and take away these powers that they have abused.

Preston Pysh  47:42  

Very interesting discussion. All right, Jesse, such an honor to have you back on the show. We always have so much fun when you come on. If people want to learn more about your work where can they look you up? 

I try and write on a regular basis at *Felder Report, I put blog posts there. I’m really active on Twitter. I do a ton of reading and research and I tweet most of the stuff. Just @JesseFelder, and follow me on Twitter. I put up most of the stuff that I read and that I find interesting, I’ll tweet it out. Awesome.

Stig Brodersen  48:12  

Thank you so much, Jesse, for coming on the podcast.

Preston Pysh  48:15  

All right, so this is the point in the show where we play a question from the audience. This question comes from Amit.

Amit  48:22  

Hi, Preston and Stig. My name is Amit. I’m from New Zealand. Thanks so much for putting together a great show. My wife and I are really big fans. My question is what do you think will happen with the Bitcoin price, if the CME offers Bitcoin futures? Thanks and keep up the great work.

Preston Pysh  48:38  

All right. So Amit, I’m kind of cheating here by answering this one because the futures started this past Monday, actually Sunday night. So it’s been active for a couple days now. We’re recording this on a Wednesday, so it’s been about three days since the futures went active. 

What we actually saw was the price spiked up and it’s plateaued and now it’s coming off a little bit. But I think it’s still really early to have kind of any idea what kind of impact this is going to have into the long term. 

Before the futures opened up, I was talking with Pierre Rashard about this. And I told him that for me it was a 50-50 split as to whether this was going to make the price pop or make the price go down. I think a lot of people on Wall Street, in my personal opinion, having friends on Wall Street, are very skeptical with crypto and Bitcoin in general. So I think a lot of them are anxious to short Bitcoin and to sell it short. 

However, I think that a lot of them aren’t stupid either and they’ve seen the price go wild for the last year and I think a lot of people are hesitant to step in front of that freight train. So I think what you might see with this is if you do see the price start to pull back, which I think is a very real possibility at this point, because the price movement has been just going wild. I mean, on a tear. 

So I think if Wall Street does see this start to pull back and start getting a little bit momentum and a pullback, I think you could see the futures market really heavily compound on that and really cause a pretty abrupt pullback. Maybe even down to like 5000 bucks or something like that. But there’s no way of really knowing. I mean, that’s the thing with futures. I’m curious to hear what Stig thinks.

Stig Brodersen  50:18  

For some of the listeners that might be, “We heard futures but what is it really?” So I think before we talk about Bitcoin, perhaps the easiest way to think about a future is to think about a typical commodity. It could be something like oil. So if I’m an oil producer, and I plan to produce 10 barrels of oil in six months time, I can log in that price already. 

So it’s actually a very convenient mechanism for a lot of producers in terms of purchasing and scheduling, knowing that you have that price. Obviously the price goes up and obviously you’d be paying an opportunity cost for the price going up. However, you can also make the counter argument. So it’s basically a question about certainty. 

What’s going on with Bitcoin futures? Well, one thing I would like to add here is that a Bitcoin future is settling cash. It’s not like you actually see when you buy a future with physical delivery for someone like oil, you actually own that oil. That’s not the case. It’s all settled in cash. 

Basically, what that means just to give you an example, is that if you buy one Bitcoin contract and a contract is composed of five Bitcoins. Right now here’s the middle of December, the price is around 16,000. So it will be around $80,000 for one contract. You will have what’s called a tick. 

It’s basically just a fancy way of talking about the minimum fluctuation, that will be $5 per Bitcoin. So if you have a tick up, there’ll be $25. So that means that if you are having the long position, that contract you will be gaining to $25 and then your counterpart will be losing $25.

It probably doesn’t come as a surprise that most people [are] bullish. If I look at the future with the expiration date, in March, middle of March 18, it’s trading up 17,280 right now. It’s very interesting to see what happens when the money is in the hands of the bull, if you see a transfer of wealth. If that actually materializes, or as Preston talked about, if you see the opposite, perhaps.

I do want to point out again that this is not like an ETF. It’s not like an ETF, where you will buy that ETF and the S&P 500 and then they will actually go into the market and then buy those 500 securities in the S&P 500. That’s not how it works. This is all cash based and this is kind of like a separate market. You can now pour a lot more money into the market, but it’s not like you will necessarily hold Bitcoin, which would clearly move the market a lot more for the new futures that you see. I expect almost all of them, if not all of them to be cash based, but I would definitely pay a lot of attention if it’s not.

Preston Pysh  53:12  

The thing that I guess that I find interesting with the future side is if the derivatives are now stood up. That now opens the door to ETFs, which then adds more and more credibility to all of this. I think that for the US to step in, and the government to step in and shut down exchanges, I think that that becomes so much harder, the more reinforced all of this becomes with derivatives and ETF type products later on. I’m kind of curious to hear what you think about that, Stig.

Stig Brodersen  53:44  

I thought a lot about that because you’re starting to see a lot of regulation. Regulation is something that we will look at as that is that, at least for the price of whatever *inaudible* is a stock and there’s a lot of red tape. It might limit the growth company or whatnot. 

Whenever it comes to something like Bitcoin, I actually see it primarily as a good thing. If you look at the first regulation that you had about Bitcoin, that was in Japan in 2014, after the exchange *inaudible* was hacked. The most welcoming country in the world for Bitcoin that’s Japan is probably because they’re in the *inaudible* getting used to it. Also if you’re regulated, you legalize it. You accept it in one shape or form and I think that’s very important.

So if you set up futures and perhaps even linked directly to an exchange, you will need to have to build a system around that you need to have something that’s public that’s going in and handling it. That just provides a lot of legitimacy to a lot of investors, not just private investors but also institutional investors. 

What will happen if we see an entire ban? That’s definitely a different concern. It’s actually very interesting currently being in Korea. One of the reasons why Korea is one of the biggest markets in the world. And we’ve seen all this volatility lately in this market specifically because China regulated and said, “You close down exchanges a few months ago.” 

That doesn’t mean that people stopped buying bitcoins. [It] just means that they’re going to Korea or Japan. I’m not trying to sell the story that you can’t just ban it. It’s just with something like Bitcoin, it’s just a lot more difficult than for so many other things.

Preston Pysh  55:37  

That’s impossible. It’s impossible to ban it globally. Even if you get the biggest countries in the world and they all banded together, kind of like the sequencing that you’ve been seeing with the ECB, the Fed and the Bank of Japan recently, with the way they’ve been doing monetary policy. I mean, it’s totally sequenced. 

They could maybe come together and say, “Hey, we got to shut this down because this is getting crazy.” But at the end of the day, you still have small countries all around the world that would not ban it and it would be allowed. 

Now, I think that the price would get punished in the short term. But Bitcoin continues to march along, the protocol continues to operate. I guess for me, I’m looking at it more from like, what happens when this thing hits a market cap of $5 trillion? 

Does the Fed start interjecting with elected officials to start saying, “Hey, this thing’s evil.” And they start spinning it from a political and media standpoint to try to really manipulate the markets and then try to shut down the exchanges. I think all of that is a real possibility. 

However, I think that it’s a much harder possibility, the longer they wait, and the more that the finance industry wraps itself around all of this, which is what we’re seeing right now. I mean, that’s my opinion. I’d love to hear somebody say a good strong counter argument to that because for me it’s a huge risk, and it’s something that I really want to fully understand. I just haven’t really met anyone that I think can really make a strong argument around why that’s going to happen. 

I hear a lot of people say that that’s going to happen, but then they have no substance behind the opinion. There’s no substance on why or how they’re going to do that, after so much is kind of, I don’t know, shoot us some good articles. If people are listening to this, and you’ve got good articles, please send them our way because we’re really curious about that risk.  I think it’s a big risk and it’s a concern, but I just don’t have any substance behind it. So we’d like to hear that. 

So Amit, we love these kinds of questions. This is really fun for us. It’s very speculative. I think it’s an interesting topic for everyone to be aware of.

For submitting your question, going to asktheinvestors.com and recording your question there, we’re going to give you a free course on our TIP Academy website. Some of the courses there are paid. We’re going to give you our intrinsic value course that Stig and I had prepared. It’s 18 lessons long and we’re really excited to be able to give this to you and thank you so much for being a part of our community and asking such an awesome question there, Amit. 

Stig Brodersen  58:00  

That was all Preston and I had for this week’s episode of The Investor’s Podcast . We will see each other again next week.

Outro  58:06  

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