Posted On: 2006-09-20
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Alright, today's guest we have is Doug Wakefield. Doug is the president of Best Minds and he's been in the financial planning industry for about 20 years, he received a CFP in 1988, his Masters in Estate Planning in 97, and is currently an investment advisor. His industry research paper Riders on the Storm is one of only a few documents written on the topic of short selling, it's excellent I encourage you to track it down if you can find it. He also writes the monthly research newsletter, The Investor's Mind which is available on his web site www.bestmindsinc.com. And, Doug is married, he has three sons and Doug you're down in the Texas area is that right?
Doug: I'm in the Dallas area
Doug and I have had the opportunity to exchange e-mails over the past 18 months and get a little bit familiar with each other's philosophy behind some of the things going on and it's one of the reasons I wanted to have a chance to interview Doug. And Doug, thanks a lot for coming on to the show today.
Doug: You're welcome Johannes
Doug, your situation seems very similar to mine, coming out of the late 1990's, we used to be a conventional asset allocation type of a firm, registered investment advisory type of a set up and we ran into a lot of those questions that seems like you ran into in 2003 and really had to recalibrate our outlook on things. But, one of the things that I ran into over the years prior to that, and I've been in the business since 1990. You know, boy, I have a stack of books on my office windowsill that I could read off to you that, you know these things were written in the late 70's, the early 80's, mid 80's and they all talk about various sorts of economic problems that were looming, that were going to bring substantial problems for the stock market or the economy as a whole. Of course coming out of the 70's where you had the hyperinflation [...] seemed a lot more logical and argument. But, progressively, you know sort of falling a little more on deaf ears, And even up until, you know with the exception of maybe the 87 crash, where we had a sudden downturn but then of course a quick recovery to kind of wash that away. Other that Greenspan's irrational exuberance comments in 96 that brought some new people on board it seems like every time contrarians or anybody coming from the alternative side of the fence that maybe we should be a little more skeptical of the bull market pretty much was, they were flat out wrong until 2000. But what's different this time that we should really be taking a different look at things, why should people be a lot more concerned today in 2006 verses 1996 when you would have been 4 years early to the crash if you would have sold out?
Doug: well, I would have to say that one of the things that really impacted me the most and which really is at the base of my whole outlook as I view economics, is that I never really understood how you create money. And it really wasn't until I read Dr. Murray Rothard's book, A Case Against the Feds, that I finally began to understand our long, and I mean, much longer than a few decades, our literally century long now, almost process of since the Federal Reserve came about in 1913. And so as I look at today, one of the things that I really try to get my readers to understand is this whole view of you buy, you hold for the long term is nothing more than a piece of marketing mantra that's great for the financial industry, but it is not the way that history unfolds. Because if you go back to 1971, we realize that when Nixon, basically, here he is, having DeGaulle coming to him and saying, "look, in 1931 we were holding all these sterling pound notes," and Britain under Montague Norman had come in and says "hey you can trust this guys, we are not moving our currency from a gold standard." And let me just stop for a second, I'm sure your readers are already familiar with gold standard but I think it is, you know, is something that sometimes is thrown out as oh, that's one of those gold bug things, it's not it is basic science. That if you are trusting someone and they say, "listen I can make this stuff called money out of thin air," and you ran up all of these debts and expenses prior in the 1800's especially, you knew that as a country you'd come in and say, "well listen I'm getting really nervous about holding all your paper, but I know that gold stuff is very real in your vault and you can't make any more of it. So, why don't you ship me that gold and I'll give you back your paper?" And there was a check and a balance on our world economy up until the 1930's, and it was part of the great depression. And in 1931, Britain who of course is the dominant world empire says, "hey King's X" to France and to other countries, "we're not going to keep our sterling notes on a gold standard, so if you own all of these notes in your bank, and France and Europe around the world, we will not, we're not obligated to give you back gold for those notes." So, France of course then overnight literally within a week after that occurred in September 1931, the British pound sterling loses 30 percent of its value. That's a huge, huge shift. Then, we noticed that of course the United States basically takes over that error and then with the dollar as the underpinning, now we move into the next double decades, of course Bretton Woods which I won't go into but of course this was the thing in 1945 where all the world comes together and says, okay we've got to have something we hold in our bank. And so in order to keep printing more money, and this paper stuff we have to have standard [...] gold, now I'll have the dollar. Which was in many ways the same game that was occurring prior to the great crash. So, as this unfolds you get into the late 60's, well now, as we are from here today, here are the things that are going on in the late 60's. You've got a war that shows no end, you have expenses that are growing rapidly, you have social programs that are going, you know, straight up, we had Medicare that just came along in 1965, and so DeGaulle comes to Nixon and says, "hey, listen, you know this is chapter two, we've been there before and we want to take our dollars and give them back to you and you give us gold. And Britain, having done that before actually beat France to the punch and within a week before Nixon closed the [...] I believe it's 3 billion, but anyway came and said, "hey, here's some of your dollars, give us the gold." And Nixon thing, where this is all headed is "whoops King's X again, we're not going to do that." So, now in 1971 to the day we have a venture of the world, basically saying we trust each other. I'll hold your currency, you hold my currency, we'll buy your debt, you'll make debt, we'll create this scheme going forward. But that being the case we all of us around the world can print currency. And by creating more debt upon debt upon debt you have a system that's since 1971 nobody has eve seen, this has never happened in history. So right off the bat, the thing to see is not so much 87 or 2000, but clearly since 1971 we're on a path that there's no economists there's no historian, there's no money manager, nobody has ever been on this exact path before. So, I think that's the most crucial thing to notice. The second then of course that makes it so compelling is that eventually, that's an unstable path. And you're going to start to see tremors or in science you'd say just like in an earthquake, you'd start to have cluster patterns. So you would look for events that started hitting together to tell you, I can't tell you the exact day or the hour, but I can tell you the severity of an earthquake is growing more intense. Because those tremors are getting sharper and there's more evidence of it. And so the first round of evidence was the, or not first round of evidence but the first major cluster pattern of events was those that acuminated there with the 99, you know, rolling into 2000, the bust that took the S&P down 50 percent from 2000, 2002. Massive change 7.5 trillion dollars worth of capital. So as we're now going back to, well what have we learned as basically bureaucrats, central bankers to solve the problem, easy, debt. We'll just borrow more money, print more money and that goes into circulation now we can kick start and get this economy off the ground again. So, we do, only now as people have quote, more money, really not more value, but just more money because of all the debt, now you lift off your markets. But now you're going to see more in derivatives in housing, so it's not just the stock, you're seeing all across many, many different areas and literally world wide. So as that lifts, now you have to ask the question, is it sustainable that you can come out of an economic slump by borrowing your way out? And I don't think you'd have anybody that would say, "of course, that's sustainable" - that's not sustainable. So the real concern I have right now as people look is to realize the path anyone, and I don't care who it is, giving you rhetoric that this is a strong economy has to be completely unfounded in history or science There is just no way that you can argue that this is a strong economy based on the historical record or a look at science and nature.
What surprises me [in Blair's] dilemma in some respects where more people get by, by you know they're gambling, they're putting a little on the table but the more they win with it, even though they know that there's that risk out there they begin to suspend reality a little bit with situations and so forth. And that, I think that when people size up some of the economic problems today, and you're starting to read more analysts looking at it through this lens, they're surprised just by the amount of complacency with the set of variables we have today verses how people might have looked at this 15 years ago, the amount of debt and so forth.
Doug: well I think that the complacency, at least from different readings, probably, you know especially the newsletter we did back in, oh come on let me think, back in July where we talked a lot about social angles; and in here one of the things that is just so prevalent, and it really is not just financial, it is the way that we as human beings think in crowds. So many times we've heard these analogies, hey if we had, you know, 50 people in a room and somebody holds up a card that's red and 49 are preprogrammed to say, raise their hand that it's blue, and the one person even seeing it's red just feels timid, I can't raise my hand I must be wrong, maybe something is screwing with my eyes. And so they doubt themselves, they will not fight the herd. And the greatest symbol of social behavior has got to be the Dow Jones Industrial. It is, I mean you can ask somebody what happened in the market and you could have various sectors of the market, other markets, other world markets that are hit, and as long as the Dow is up well things are good. If the Dow is down, maybe things aren't that good. And so it is an enormous social barometer. So I think from that standpoint that there's comet of dissonance. I could pick up the paper, I could see how many are laid off in the auto industry. I could pick up the paper and see that foreclosure is on the rise. That concerns me, but I can turn on the television and I say, oh well so far the stock market is still up there at 11,500, 11,600, I guess things are doing okay. And so I turn it off because the other part of it is, I really, really don't want to go into, well what if the market has come down? I don't want to go there, I don't want to discuss it socially, I don't want to discuss it individually, I just don't want to believe that that can happen. Because if it does, history has shown us time and time again, there's a whole lot more issues than just a price of my stock going down. There's a lot of other issues that I'm going to have to deal with. And I just don't want to deal with it, as long as I can see it green or going up that emotionally says I just will not need to investigate any of these other areas.
Seems also that, you know, and you were mentioning this before with the buy and holders out there, one of our ongoing themes within our Vigilant Investor site is that, that all was very much positively reinforced from 82 to 2000. But if you look at different time periods as well from say 65 to 82 what was going on in the equity and bond markets? And good heavens if you don't run into a hundred of these, the average person is getting an asset allocation, a pie chart and you know, oversimplifying it but you get 60 percent equities, 40 percent bonds and roll with it. Without any real concern about the shorter time periods of 20, 25 years as opposed to looking at the 65 to 100 year history of the S&P 500 or the bond indexes and so forth. But, do you see any similarities from you know, today's situation 2006 to maybe what was transpiring in the 60's leading up to Nixon dropping the gold standard and so forth and then the hyper-inflation we ended up with later on and the problems we had in the 70's?
Doug: I do see some similarities and I see some differences. The similarities as I was referring to earlier, of course we both know that in the 60's you had massive expansion of government programs, I mean the sizes, Social Security benefits, what they provide for even in the 1950's increased over seven fold. So, when you added on Medicare and Medicaid in 1965, I mean it was just like you've blown the doors off what you can actually provide to the public. Sounded great, and it's still with us today but why is it still with us today? Because we basically have said, "we'll inflate our way out of this, we'll print more money, create more debt to pay for the things that we can't pay for today." And so the burden is always been really for the last three decades, we'll just add more debt to the equation. And we can add it a whole lot faster today than we did in the 60's. And I think that's the thing that most people are not cognizant of is as they watched the stock market there's this thing called the derivative market, which is leverage money. And it is substantially larger. Literally, I was looking at the numbers today, the worldwide stock market at the end of 2005 was around 37 trillion dollars according to the IMF. At the end of 2005, the derivatives market was around 284 trillion dollars. So, you know, having the fact that prior to, if I was an investor in the 1960's, I didn't have financial options. Now there were an options market commodities, but there was not financial derivatives, there were no credit default swaps. A lot of the instruments that existed today into the tens of trillions of dollars weren't even around in 1960. Though, if you just went back to your science again, you'd say well then, what is the likelihood of something you know, exasperating and causing a problem today, verses the 1960's. It is higher than it was then. So there's similarities, but it is a riskier market than it was then.
It also strikes me that you have to look at the balance sheet of the U.S. as a whole compared to then. And I think that we have a lot of the similarities, you know a lot of people say will it play out similarly to what you had in the 1970's. And I think the response is, well it could, but you also have to look at the difference in the U.S. consumer, look at the Federal Government, how much more debt is out there, the deficits today, I'm sure you're familiar with the Fed study that was published under the title of something along the lines of, Is the United States Going Bankrupt, where the author concluded that there is an 80 trillion dollar short fall in future obligations. You're facing that kind of thing and you're also looking at the U.S. consumer and negative savings territory. You know what blows me away a lot is how we manage to redefine what is normal today. Today we can live with all this debt, the consumer doesn't have to save and it's no worries. And that, in my mind leads to a tremendous amount of uncertainty out there and yet you still have this inherent bullishness coming out of Wall Street day in and day out. Now, that's a subject you often talk about, the bullish bias.
Doug: Well, one of the things that I think was such a clear comment just on what Wall Street is societely. It was when we interviewed you know, in our research paper, Different Short Sellers, and I was fortunate enough to be able to interview Jim Chanos. And Chanos' remark in our paper was that Wall Street represents the great, is basically a great selling machine. And that being the case if you looked at, I know even in Barton Biggs book, and Biggs retired from I believe it was Goldman Sachs. But you know here's a man who is, Morgan Stanley, been with you know in the industry since gosh, going back into the 60's. And literally being a partner there at the Wall Street lever, this major brokerage firm, says, after he retired, not retired but left there, now running a hedge fund, you know one of the things that we did [...] going in to 2000 is that Morgan Stanley came out and said, "here are all these products that you need to invest in." Of course people wanted to buy technology, I mean I was even buying into that mindset, hey this is going to be, yeah it'll be a rough ride but it's in here for the long term. It was no long term. And as we painfully learned, but he said, "in looking at Morgan Stanley we produce the product that the consumer wants to buy." And so in 2002 they are looking and said you know at that time he said he was in a meeting and they had basically seen a dwindling of their merging markets fund, and asset size. And so, and of course I'm sure part of that was just the performance as well. But the public, or not the public, Morgan Stanley says, "you know I don't think that we should even offer this fund, so let's shut the thing down." And he being then looking at it from a contrarian standpoint says, "but it's oversold, now is when we should be marketing it!"
I think that's the same logic that Jim Rogers used for deciding of the commodities were an opportunity to get in, but at the same time I think Merrill closed its commodity on [...] something of that nature.
Doug: And you know from looking at things like that if you understand that Wall Street really especially like this last one we did proceed to the exit, when people can understand, hey you know there are literally historical events that have changed the way that we handle money. They've changed the way that our markets work, they've changed the way that our lives are unfolding. Then we get to understand, okay, I understand the game. It is not that life goes on the same forever. And you know even just going back to the comment about the bond hold, when you look and think, you have an industry where the BIS, the IMF are putting out these 150, 200 page reports on a quarterly or annual basis of all of these different markets and all these various risks, the FDSC puts out a quarterly thirty page report on all the variances inside the banking industry that could create good or bad scenarios. And yet, we're supposed to believe that no [...] before in the market, things just kind of plug along, if they go bad, they go bad for a while, if they go good, they go good for a while. But over the long term you always make money. Well then why would there be tens of thousands of people writing about something that everybody should know can't be beaten? That is ludicrous.
But also I think it is a big money machine, I mean that's a huge asset gathering apparatus out there that I think is very systematized and yeah, you know as well as I do that these products can literally just be pulled off the shelf; you run someone through a quick investment questionnaire and they're on their way. And, you know when you're seeing Sam, is it Sam Waterson who does, the guy from Law and Order would have you offering one of the discount brokerages saying, "about the time it takes you to brew a pot of coffee, we can get you rolling with a professional portfolio allocation." And you know, things are very systematized now. Which, you know I think an efficient business model can do that on one hand but you know, we comment off an on how the managers kind of get more or less blocked into the mentality of just being above mediocrity. They don't get a lot by trying to perform their peer group ending up wrong, which can really cost them. But more than that, the biases within the industry were, if you're specifically a manager, you're in that institutional methodology that everybody uses, your focus is, you know, hey, I'm a large cap growth manager, that is what I do, I'm going to be measured against other large cap growth managers and God forbid, even if I think large cap growth happens to be the worst place to put my own money right now, dang if I'm going to do anything but, you know, as that money is flowing through the doors is keep, you know, doubling down on large cap growth. Even if the PE ratios are through the roof, and you saw a lot of that in the late 1990's you know, with the tech side of things where you were fired by every 401K or every institutional consultant out there that was doing fiduciary consulting. If you defied what the convention was, and you know that's where we get in that relative return fiasco where, you know I don't think I've ever met anybody who felt all that great to know that the average dropped by 25 percent, but they only dropped by 22 and they beat that by 3 percent, we should all clap.
Doug: I think, you know, the whole premise of what you just said is, that in our industry, our industry is reflective also of our culture but it's fascinating because, and I've thought about this quite often, I've thought, you know, and looking back on my early days, and I basically started out this, I left the teaching profession, I said I'm going to get into financial planning, I was working on my CFP in 1985 and if you ask somebody well what did he really do? I really wasn't a financial planner, I was a salesman of insurance and mutual funds. And the financial planning tool was just an instrument in order to be able to sell a financial product. And that is still the industry predominately today. But that being the case, you couldn't train legions of people to bring in and gather tremendous amounts of assets if you said, we'll look this thing is complicated, it requires ongoing monitoring, there's many variables, there are no clear absolute this is the perfect way to make money. There's many different things we have to think about. And emotionally it's as very tough game. Oh, that's not going to sell at all. That's not easy to package, that's not easy to train legions of people to do. So I've now got to come up with a system. And to me, that's why efficient markets were such a perfect thing. To think that Fama basically just looked at bachelors work and said I'm going to write about this, writing a doctoral dissertation, suddenly boom, you've changed the way that everybody is looking at investments. And I think that Wall Street looks and says hey back in the 60's especially says, "you know this thing would sell like hotcakes, this is easy. Just tell them, don't think, be dumb, listen to us and we will give you everything you want in the future."
In their defense to some degree you did see a lot of people in the late 1990's especially, my God the average 401K investor who had a mid cap growth fund in their alternatives was you know, looking at, you know, hey where am I going to invest my money, and they'd go down the list of last year's performance and then they'd, hey this looks like a good fund here, I'll take the four best performers which happen to be primarily growth oriented and you know, and each year the positive reinforcement of those doing well, you know, they'd scraped even basic asset allocations. So, to some degree I think, you know, what I, you know, always tell people is that you don't want to throw the baby out with the bath water on that front, and that clearly you have to be doing things astutely and you know market timing in that sense is wrong. But on the flip side when you have, you know Peter Bernstein basically being chastised by the entire investment community like he was in 2003 when he did a speech in front of a, I think it was a group of institutional investors and large funds and so forth, where he basically said, "look, I think the environment has changed where we just can't be continuing on auto pilot, and while what I said way back when made a lot of sense, I think that we need to consider the variables and that times are different and therefore I am actually talking about the four letter word of market timing." And, of course he was brow beaten from everybody from Vanguard's guy, there was John Bogle over there, all the way on down for, you know, suggesting that we begin engaging brain rather than just continuing on auto pilot. It's pretty amazing. Now, your piece Riders on the Storm, Doug, tell us a little bit about the importance of short sellers and what's happened with the industry bias, even the legislative bias against that. What kind of problems do you think that's caused in the markets out there?
Doug: First of all, to really understand short selling, I'm going to jump back to last year. I had met with John Malden and [...] and John had invited me to come to an Altegris out in California. And Altegris as far as I know is probably the largest hedge fund consulting group in the country. Very, very sharp group of people. And I went out there for two days, and I'll say, you know that's not been my background. And hedge funds are typically 5 million plus, my client base was not, I want to undulate that. But I realized that I could learn something from just listening, so as I went out there, there was a presentation one day on how to choose an excellent hedge fund manager. And listening to this, you just thing about we are today with risk in the markets. And it's part of what led me then to come back and say, you know, if there's one topic that is gravely misunderstood throughout our industry, there is absolutely no teaching at all through the college of financial planning on it, I'm not a CFA, but I don't know how much is taught there, I imagine very little, but is on the area of short selling. So let me go back to Altegris. Jon Sundt who was the president made this presentation and he says, 'you know, when we look for an excellent hedge fund manager, we look for these three things: first of all we do a diligent, extremely intense on their background, we want to look ethically at who they are, we want to look systems wise what they have in place and we want to look very, very stringently at their background of experience." He said, "I'm not talking about background of last year's performance, and a lot of people confuse that, because you have to understand, in order to get ahead of a trend, you're going to have to build something before the trend arrives. That way when the trend sets in your platform of business will be elevated because the trend has turned in its favor. So the second thing is you need to look for someone who is small in size. And that being that being the case, you know, 15-50 million under management is something that would be right in line with our radar screen. We're not looking for something with multi-billions, because chances are, this is a strategy that everybody has already heard about, they've seen track records for years, and it may even be a system that's coming to its closure. And that's of course the greatest time and the easiest to sell, is years of experience and when something is coming to and end." And so as I look at that and [...] the third thing was the trend itself. You know, look for someone who really understands what the next trend is and you understand. Well as I looked at it and I kept thinking, you know, look at all these issues out there in the markets. I mean my lord you have something like 600 billion dollars taken out in home equity loans last year, it's just mind boggling. And as we look societely along these lines you realize something massive is out there to change. You can't have Forbes give 75 thousand buy outs and say well this is just a temporary slow down for a quarter or two. I mean something massive is going on. So, as a defensive posture, trying to say, I want to seek out ways that if I had a client come to me and say, you know I'm still concerned with some of the same goals I was 10 years ago, and that is that I want to provide a future for my children, I want to be able to have a retirement at some point in my life, basically I need to grow my assets. If I need to grow my assets and it's very, very risky, what would you suggest. And I would have to say, well then I've got to find someone who you know, depending on the strategy we use short only managers, but we also use long short managers who trade both sides of the market. And, but somehow, I've got to be able to not look and say I can just sit and trust that everything is going to work out. And in addition to that, part of the riding then is we got into the short sellers was realizing, you know, going back to the market timing comment; why is it that you would have massive, massive amounts of money this spring and insiders filling happening, where your CEO's, your CFO's, your major [...] corporations are selling in legions their stock, and they did the same thing in the spring of 2000. Well, that's telling you that the people who you're putting your money with are getting out and handing you their stock. Why in the world I want to believe that I knew more about what was going on in these major corporations than the people who are supposed to be running them? So, to me market, one of the greatest market timing signals is, well what are the people who, they have to put their own money there? I mean on thing the client can look at and I'm sure you're in the same boat, when I recommend something to a client and they look at me and say, "okay so what do you do with your own money?" I can easily say, "I am doing the same strategies as you are." And that is not the case with a lot of people playing in the world of money.
You see the way legislation is structured and now, a lot of people are not aware that of course anybody can buy a stock long and that's basically Wall Street's job out there. But, what about this institutional, the legislating, literally it is legislated against people who are actually out there trying to short. Can you tell us a little bit about the benefits of the shorters to a healthy economy and a healthy market?
Doug: Well, you know when we did the Riders of the Storm, the one thing that I wanted to bring out, and we did extensive reading and talking with people on the issue of naked short selling; because I believe it exists, I believe that the SCC has a very good case for proving that it exists, and there's too much evidence that is occurring. But that's not a problem with you can legislate your way out of this thing. That's the ethical problem that quite frankly I think, the purging of bear markets brings about. And so I think hopefully that will change, but that's something you can't really legislate. And I think that's once again another problem from our societal level is, hey if people are not acting responsibly or ethically in the market place by golly we better go have the government act as though they are our ethical controllers. They can fix things, they can make things ethical. The SCC can only do as much as the ethics in those markets now, granted, you know anybody can make arguments that they can do more, and they certainly could, but they can't make people act ethically. And that as we brought in our paper is probably the most important thing that people need to look for in a manager. Now why would we focus on the short selling side is people like Jim Chanos and [...] who really have played by the rules of the market place. This is a legitimate thing and so, and in fact it goes back into the 1600's, so this is no new technique. And, by having, in fact Doug Gillespie made this point to me before he passed away in June, this was back in the spring. He says, "you know," or actually last year, it's part of our paper, he said, " you know, if you looked at 2002," he said, " I have no data that could really define this for sure, but just the people I know and looking at the information it seems to make sense this is what would happen, is that the market's were so oversold, that you had your short sellers who had taken very large positions and having the market had increased so much, well they had to go out then and buy the stock back at those lower prices in order to close out that short position and have again. And as they did, they created a base of liquidity. And -
It provides more or less a floor when these shorts start coming back into the market -
Doug: Correct, correct. And even what we have out there today, you know as long as there's a market it could act very violently to the downside. But, you know if a client is sitting there in 90 days, no matter whose money they are and saying, "well how much did you make?" Well if it's a whiplash and it's bouncing back up and you're short, you're losing money so, at some point you're going to close out that position and try to take gains. It's the same way as somebody trading for the long side. So, anyway that being the case, you know, if you have, and just for the listener who is not familiar with short selling, short selling, of course you're going out, you're borrowing the shares from another player in the market, they're then charging you interest, you then believe that as of course technically as you take those shares in and I'm talking about an individual stock, not a ATF or derivatives, but as I take an individual stock in I short it, I have to sell it and I have to give it cash back to that brokerage house. And they're holding it, and then at some point I'm selling, or, buying the stock at a future date believing that the price will go lower, if the price goes lower I buy back the stock, I can pay off my stock loan, and as soon as I do, the next result if I've made a gain is still in my account.
Do you see any problems, now you were talking earlier about the derivatives and one of the thing that, and I think you even mentioned this in Riders of the Storm, again not to keep going back to that piece, it's a great one though, with a lot of the shorting now being done it seems as if people are hedging a lot, or using derivatives of just using indexes and so forth as opposed to actual positions in the equities themselves. You're getting these derivatives, and you know, here we are in today's news, I don't know if you've had a chance to go around but it's definitely hitting the wires pretty hard. You have a 12 billion dollar hedge fund, it's Amaranth or something like that name and lost about 5 billion in energy trades gone [...] and is causing a bit of a stir out there. Who is going to mop up that mess? I'm sure that's you know your leveraged up derivatives and that kind of an approach as well. Not that that's necessarily tied to the short side of things, but what do you see with you know, derivatives coming in there and being shorted, and the difference between that and the actual stock itself.
Doug: Well, there again, that's part of the thing that I think investors have to understand is that, in fact I remember this in oh, Michael Covel's book, Trend Following where he spent, I think it was like 8 or 9 years following, he's one of the great hedge fund managers of the world. And he says you know, one of the things I understand, is that somebody is always winning, somebody is always losing. There was a 7 trillion dollars loss from 2000-2002, there was also a lot of money made on the short side. And whether it is a short seller, or whether it is a hedge fund manager, a long short manager, whether it's hedging techniques that are used in an institution, I mean there is a variety of short selling going on. Far more than just the short seller themselves. But, in the shorting process, when you add into that equation for instance that there was no such thing as a credit default swap prior to I believe is 1994-5, and today it's a market at least estimated over 5 trillion dollars and that's 11 years into its development. I mean it's just, we can't even once again understand what is the implication of this instrument should there be a contraction of credit? I can't, you know, nobody can fathom that other than they know it's not good. The same thing happens with like the exchange traded funds. It appears to me from reading stuff in the industry, talking with people in the industry that a lot of buyers after 2000 said, "the thing I did wrong, is that I tried to hire active money managers and buy and hold still work, but you just can't beat the markets, so lets hire all passive money managers. And instead of doing that, I'll just go by ETF's. Well an ETF, and exchange traded fund as we both know is a basket of securities representing a particular index, and it can be shorted or I can go long on that any hour of the day. So, suddenly you watch and see as Alan Newman has so eloquently shown, here is an industry that has just gone wild. I believe it's a 35 percent growth now for almost 6 years running, that's unsustainable. You can keep producing legions of these things out there and everybody buying them knowing that you can go long or short, that much paper and especially those, our program traded hedge funds or program trading without there being some serious problems at some point out there.
Well, definitely the whole derivatives market when you realize how much it is you know, it's purely paper too. There's you know, when it's supposedly being written on, you know the assets themselves don't even exist in that volume, that really makes you scratch your head. I can think of, I think it was the GM bonds where they had so many more derivatives covering the bonds that were actually co-existing in bonds that were outstanding. And -
Doug: Yeah, well the derivatives are really an easy thing though. Going back to change this comment, Wall Street is the ultimate selling machine, if that's the case then, you know, one thing I saw from Jim Grant, I had a chance to meet him when I was in New York in the fall, he's a fascinating guy to listen to, I just love it...but anyway in Grant's interest [...] last issue, is he took out how you would take somebody buying a mortgage and showing you, okay, I bought a mortgage for, I went out and took out a mortgage for my house. And, what happened to it, well it was not shortly after that, that whoever I bought it though, you know, they sold it to another bank, and they sold it into a group of mortgages. And those mortgages were then bought by mutual funds or institutional houses and those were wrapped into a credit default obligation, a derivative product and is was wrapped into a fund of funds type of environment, a credit default on top of a credit default. And so he says, "you know, basically what we're seeing is that Wall Street has figured out, you know there's a way that we can make a buck all selling the same thing four or five layers deep." Repackage it and sell it again. So, I think that's probably the thing that is most disconcerting is people don't realize when one part of this starts to come unraveled, look for the seven or eight pieces that are connected to it. Because it is not a solo stock market. It is connected to multiple variance.
Well, we're definitely moved along here. We've gone a lot longer that I thought we would. Once last question for you Doug, you mentioned the program trading. What do you see as potential problems with that as opposed to where we used to be, you know, where human beings were actually making cognitive decisions as to what ought to be done. And a lot of people are relying on program trading to cover themselves in the event of downturns and so forth. What do you see with that?
Doug: Well, you know, and once again, this is one of the things that I think that if you ask, hey, should we lobby for legislation, should we look for ways to back change. No, because I'm not going to make the change in the market. And as I've seen in many things, especially a steady short selling, you know, we're just men creating other things that I've heard, in fact a friend of mine who had, someone from the ASD made this comment, said, "you know, what we've found is that people who are playing ethically by the rules are not the ones that are pushing the envelope, cutting corners or that we grew out our laws for. And the ones who we write the laws around, we give specific days, specific requirements, they're the ones who are sitting down, studying our laws going, humm, I wonder how I can cut the corner and get around this law. And so, when you come to program trading, I don't think there is anything that we can legislate to make a change. I think it will actually change. Now, going back to the scientific aspect of it, Doctor Jacobs of Jacobs and Levy, I don't know, I think it's 10, 12 billion dollar long short portfolios that they run someplace out of the East Coast but a brilliant, brilliant book he did on the [...] called Capital Ideas. As far as I know Levy is one of the most widely recognized authorities on the 1987 crash. And in our paper we talked about that as well, because your portfolio insurance products where out in the 80's, 82, 83 you're coming out of the 70's and you know, why in the world would you want to espouse a by and hold method. I mean my Lord by 1975-76 you've got about half of the industry that's already lost their jobs [...] So, you certainly didn't have the extreme optimism you do today, we're just at the other end of societal behavior. But, that being the case as the 80's roll around, you know and you're seeing this market start to turn and come back up, and now you're trying to get out there and convince them to put more money in the market. So you got to create a product though that's got to convince them if something goes wrong, we're going to protect you. So we come up with portfolio insurance. And by doing so as we go from 82 to 87, you know it's kind of just, the snowball just starts rolling and we're saying, "look tell you what, if you do this, this program and tell you..." and it was nothing, nothing sophisticated to the nature of what we have today. But it was still based on this computer model saying if you go by the certain level means the market's picking up pace and thus we will increase your long exposure to the market. If the markets start declining, then the computer will kick in and say we need to sell this amount of stock. Well that's all great on the upside. The problem is, and it gives you the illusion, hey there's plenty of people who will buy my trade if it starts going south. But as Jacob points out, well what's the fallacy of that? The fallacy of course is on the downside. If everybody starts programming and kicking out at pretty close intervals, then suddenly, as in October 1987 occurred, you got 25 billion dollars, which was four times your daily trading volume occurring on one day. My Lord, you don't have anybody standing on the other side going, we'll take your falling knife. And that to me is the biggest concern today with program trading, because you won't know it's there until gosh maybe even in a two week period you've lost substantial amounts of money.
Well, the interesting thing also, and I don't recall the exact figure, but I remember reading it a few months ago that the percentage of trades out there today, even in the midst of normal trading that are actually part of program trading is just, is astounding and to think how much higher that can get if you start ending up into a, let's say a 1987 situation.
Doug: Yeah, I know I believe it was last summer we had corresponded and I had been reading Alan Newman's publication Cross Current, and he's probably the person I've gotten the most out of program trading. But I know according to his charts [...] there was at one point, it was up as high as 70 percent of the trades that had occurred on a day were program tradings. There was no human thought process of this thing, the computer already had kicked in that this is the amount we'd buy. Also note, just as an aside, of you know, we get exposure to so many different people in the industry, and I of course of confidentiality sake could never say who it was, but there's a group up in New England, these guys have basically said, "okay, we're going to buy 10 stocks, and we will buy them based on a computer model." And it will show, it's basically a momentum based model, and yet it's extremely complicated and the computer though, makes all the decisions and their numbers have just been phenomenal. But there's no, this is a good company, I'll hold it for long term, or the economy has turned around. It's just this is the way she is, when you get those numbers kick about buy another stock. You know it's 10 o'clock in the morning, that one's done, let's go to the next one. And that's a world that none of us grew up with. We don't know how that world works, because it hasn't been with us. We can see it looks riskier, a whole lot riskier than going in and studying companies for days and buying it, holding it for years, but you know those are variables we have not experienced before.
Definitely not a Buffett or Graham type methodology.
Doug: No, it is not, it is certainly not.
It seems like the stage is set there for, you know you can get the grid lock and then when you start talking about the derivatives market cascading defaults and so forth. So, just one of those things when you look at the dominos, that if you even get tipped over the wrong way just for the wrong reason...
Doug: You know, one of the things, and I will say because, for any one listening at this point you can also, you have two thoughts, and I've seen, from what I've experienced, I was told this by some of the individuals in the industry I respected as, and you got to understand the more you talk about this, you're going to have people just close you off, and shut you down, and boy that has been the case. I either have people who either respect what we do or they don't want to listen to one word you got to say. And I think that part of this is not a disrespect, it is, you know, I can't change some of this, so I'm just going to ignore it. And my belief is, hey there's a ton of stuff I write about and read, I will not change at all. It is just going to happen. But by understanding it, I have a greater grasp of what kind of risk I am facing and how to practically try to reduce that risk level for those I'm serving. And I think the other aspect of it is, that you or I, neither one of us or anybody really knows all the variables when we're dealing with trillions of dollars, and domino effects and you know central bank roll out monetary policies, I mean these are extremely complex equations. But they certainly show that they are highly unstable because the more complex you build it, the more unstable it gets. However, coming back on it's day to day basis, I still have to say yes, but I have to live out my life as though I'm going to have these things in the future happen. I need to prepare, I need to plan wisely, I need to invest wisely, no matte what kind of markets I'm facing. And that's my responsibility as a fiduciary that's yours and it should be anybody in the industry. Not to say mediocrity will be fine for me and you, but I have a high moral obligation to try to protect you and believe that 5 or 10 years from now I'm still going to be trying to provide you the capital you need for your needs.
It amazes me how many people in the industry just don't even want to acknowledge, and if they even do acknowledge they're just indifferent, acknowledge the various things out there that are potentially teetering or could be a problem to at least build in contingencies, the what ifs, the what if it happens and then what? And there's not even that thought process going on because like you say, we're so far on the other end of the spectrum and so forth. Well, Doug, we've definitely gone on a long ways here and I'd love to, if you're ever open for it again to do another chat -
Doug: Thank you Johannes.
But, I do appreciate your time as a guest here on Vigilant Investor. Doug maybe you could tell the listeners a little bit about how they can get a hold of you and where they can get a hold of you and so forth.
Doug: Well, what I would leave it is with this, from an investor's standpoint, you know there are a variety of things that we offer to the public. I am very limited as far as any retail client, institutional consulting is kind of the same because we have to spend so many hours doing research and writing for he things that are far more available to the general public or our writings, The Investor's Mind is a paid publication, a person could subscribe to that. I know our format is not too repeat economic data or marketing data every month. We are not market technicians, we're not espousing ourselves to the economists, we are saying that we are nothing more than a human being with a high degree of curiosity, who looks at all these macro issues that hopefully at the end of 12 months a person reading those newsletters can go back and go I am smarter than I was 12 months ago. I understand more things, and because I understand more things, my fear level has been reduced, my confidence level has been increased. And I don't care whether you're managing a billion dollars, or if you're just getting started as an investor. You would value, you would find value in that learning process. The other of course is we do have a lot of stuff we put on our web site, and we have people who subscribe to a free e-mail service where we tell them once a month, here are 5 or 6 very important things that have happened and I think you ought to just take a look at these. And those are just educational services to the general public. Our web site again is www.bestmindsinc.com.
Alright, bestmindsinc.com. Thanks a lot Doug, that's Doug Wakefield and he is the president of Best Minds down in the Dallas area in Texas. Well, I certainly appreciate your time Doug, and I look forward to chatting with you again in the future. And great conversation, a lot of material there that I think is valuable and hopefully we can pick up on it again soon.
Doug: Very good, thank you for having me on.