Introduction:

Tom Essaye is the Editor of The Sevens Report. He joins the show to discuss macroeconomic topics including China, Russia, and junk bonds.

Key Takeaways:

(1:30) Jason brings his mother back to the show
(6:38) A discussion about technology
(20:26) Jason asks his mom: why did you become interested in real estate?
(23:30) Introducing Tom Essaye
(24:22) Some thoughts on the junk bond market
(37:15) Outlook on inflation
(38:05) China & Russia
(40:37) Closing comments

Links:

Visit the Sevens Report at www.SevensReport.com.

Bio:

Essaye is a professional trader with more than 10 years experience trading foreign and domestic equities, commodities, currencies and bonds.

He began his career as a trader on the floor of the New York Stock Exchange for Merrill Lynch’s Institutional Equity Trading division, where he regularly traded multi-million dollar orders from clients that were some of the largest mutual and hedge funds in the world.

In early 2005, Tom Essaye recognized, through his own fundamental analysis and research, a unique investment opportunity developing in the natural resource sector and commodities markets. He left the floor of the NYSE to join an associate starting a fledgling global macro hedge fund focused on investing in commodities and natural resource equities. Mr. Essaye was responsible for all trading in the fund and for conducting fundamental research in the commodities and natural resource markets.

The fund made investments in precious metals, agricultural commodities, energy, and natural resource related equities – placing initial long positions in gold below $500/oz, silver below $7.00/oz, corn below $2.00/bushel and buying shares in then little followed equities such as Silver Wheaton, Newmont Mining, Cameco and EOG Resources. The fund also invested in Canadian and Australian mining and energy companies, and at one point foreign equities comprised nearly half of the fund’s portfolio.

In mid-2007, while managing the energy sector portion of the fund, Mr. Essaye was one of the first analysts to realize the potential of shale natural gas, and invested heavily in shale gas producers and energy service companies that specialized in shale drilling.

While interacting with both institutional and retail investors during his time at the fund, Mr. Essaye first began to recognize the large discrepancy between the quality of information available to professional traders versus the that available to non-professional traders. The 7:00’s Report is the result of his desire to show the investing public how professional traders analyze and interpret the markets each day, and to demonstrate how, by trading a real money portfolio, that analysis translates to trade ideas and, ultimately, profitable investments.

Audio Transcription:

ANNOUNCER: Welcome to Creating Wealth with Jason Hartman! During this program Jason is going to tell you some really exciting things that you probably haven’t thought of before, and a new slant on investing: fresh new approaches to America’s best investment that will enable you to create more wealth and happiness than you ever thought possible. Jason is a genuine, self-made multi-millionaire who not only talks the talk, but walks the walk. He’s been a successful investor for 20 years and currently owns properties in 11 states and 17 cities. This program will help you follow in Jason’s footsteps on the road to financial freedom. You really can do it! And now, here’s your host, Jason Hartman, with the complete solution for real estate investors.

JASON HARTMAN: Welcome to the Creating Wealth Show. This is your host, Jason Hartman, this is episode #406, 406, and our guest today will be Tom Essaye. He’s editor of the Sevens Report, and he’s got some very interesting thoughts on the market, the economy, junk bonds, and a warning of the US direction, Russia being an opportunity or a falling knife—some interesting stuff. So I think you’ll like that. But before we get to our guest, I have back on the show here, my mother, who happened to stop by on her way back from the Socialist Republic of California. As you know, from prior episodes, my mother is an extreme do-it-yourselfer. Of course you’ve heard of extreme sports. People surfing 100-foot waves, and doing crazy stuff. You know, jumping out of spacecraft, basically, or weather balloons, I should say, from the stratosphere…well, my mom’s an extreme do-it-yourselfer. And she’s really excited today. And I’m going to bum her out. So, mom, why don’t you tell everybody what you’re excited about?

JASON’S MOM: Well, I just got back from Los Angeles, after having rented my first little house there for $4000. Which was $700 more than what I was getting the previous year. And I rented it in absolutely one day.

JASON HARTMAN: In one day. Okay, fantastic. That’s an amazing story. Now. I would propose that the reason you rented it in just a day, is because you got taken advantage of [LAUGHTER]. And here’s why. That house, in West Los Angeles, that we actually used to live in—now, you did tear it down and rebuild it a few years back. But that house is worth about $850,000. And you’re excited because you rented it for $4000, right?

JASON’S MOM: Right.

JASON HARTMAN: Because you had it rented for what before, $3300?

JASON’S MOM: $3300.

JASON HARTMAN: You think you’re up $700, and I think you’re down $4000 a month.

JASON’S MOM: Do tell.

JASON HARTMAN: Yeah, right. Exactly. Well, you’ve heard me lecture you on this repeatedly, and that is the concept of the rent to value ratio. If you invested $800,000, or in that case $850,000, the value of that house, with my company, and you have invested with my company, now you’re kind of slow to learn, you know. I don’t know. You just don’t want to take advice from your kid, do you? Is that it?

JASON’S MOM: It’s always risky to do that.

JASON HARTMAN: What, to take advice from family members?

JASON’S MOM: Yeah.

JASON HARTMAN: Okay. Don’t loan money to a friend or a family member, because then you will be the person who’s not in control of that transaction. But, anyway, okay. Let’s talk about this house for a second. So, $850,000 worth of real estate should generate about $8500 per month in income, okay? About 1% of the value overall. And I don’t know why it is, but you’re just so maniacally focused on things. You always say to me, well, until I get my house finished, my big mansion in Gulf Shores finished, I can’t—I don’t want to think about selling properties or buying properties or anything, right? You know, you have a real one track singular focus.

JASON’S MOM: Yes, I do have that.

JASON HARTMAN: That’s good, in a lot of ways, right?

JASON’S MOM: Yeah. It’s excellent.

JASON HARTMAN: Your tenant, renting it for $4000 a month—I mean, those are extremely high numbers, and I don’t like those high end rental properties like that. But you got an $850,000 house there. I want you to get $8500 a month for that. You gonna come around eventually and listen to me here?

JASON’S MOM: Probably, but you know, it was the first house I ever bought.

JASON HARTMAN: Yeah. Oh, so yeah, that’s true. That house—you bought that in 1976. You have an emotional attachment.

JASON’S MOM: No, not really. But you know, it—

JASON HARTMAN: Well, you rebuilt it yourself—

JASON’S MOM: I’ve been able to refinance it, and do other things. It’s kind of a little security blanket.

JASON HARTMAN: Yeah, right, right. You rebuilt that house, and you moved back into it. And the reason you moved back into it—so, we lived in it when I was a kid.

JASON’S MOM: Right.

JASON HARTMAN: And then you moved back into it to qualify, to make it an investment property, so that you would have had the opportunity to 1031 exchange—or, not to 1031 exchange it, but to sell it, and take the homeowner’s exemption of the one time $250,000. Or, at that time it might have just been the rollover. The law changed. The tax law changed there, so I don’t know what it was.

JASON’S MOM: No, what happened is that the property had gained too much in value. If I had sold it, I would have had to pay way too much in taxes as an owner occupant.

JASON HARTMAN: But you didn’t sell it.

JASON’S MOM: I didn’t sell it; I turned it into a rental.

JASON HARTMAN: Again.

JASON’S MOM: So, now I could do 1031 exchanges on it.

JASON HARTMAN: Right, right. So, you could 1031 exchange into several properties, or an apartment building, or something like that, and get more than double your money per month. Like, even if it didn’t do that well—even if you had terrible problems on all the properties you exchanged that for, you’d still, I’m sure, get at least $6000 a month for $850,000 invested. You know, in like the worst case scenario. If you had vacancies, evictions, lower than expected rents, all of that stuff, you know, you’d still be a lot better off.

JASON’S MOM: Except I’ll be dealing with a lot more tenants.

JASON HARTMAN: Well, you would deal with more tenants, but if you had that in apartment buildings, then you still have kind of a centralized situation, even though it’s more people spreading it around. You don’t even have to go to that extreme. And investors, listeners, this is something for you to think about. High end properties never work well as rental properties. An $850,000 house makes an awful rental property investment. If you don’t want to buy 8 properties, or 8.5 properties if they’re $100,000 each, you could buy 4 $200,000 properties. And you could diversify, and have those in different markets. Not have to come across the country as the extreme do-it-yourselfer to rent your house. I mean, that just cracks me up. I don’t know anybody like you.

JASON’S MOM: But I do like to visit Los Angeles for shopping stuff.

JASON HARTMAN: Well, okay. You could do shopping in Phoenix, where you are now with me.

JASON’S MOM: Definitely.

A discussion about technology

JASON HARTMAN: Great shopping here, of course. Right? So, that’s one thing we wanted to talk about. the other thing we wanted to talk about a little bit is technology. I remember years ago, six years ago, in fact it was, I bought you an iPhone. And you never used it. And then I bought you a Kindle, and you never used that. I decided, you’re the most anti-technology person ever, and I’m not buying you any more tech items.

JASON’S MOM: I prefer perfume and jewelry.

JASON HARTMAN: Oh, okay. Yes. So, perfume and jewelry is better than technical items. But, you were really pleased at the technology on your little iPhone! Tell the listeners about that. You know, as the extreme do-it-yourselfer. Now, most of our clients, they’ve got property managers. They don’t manage their properties themselves. They never even talk to their tenants. But as the extreme do-it-yourselfer, you found it easier to run the credit report, right?

JASON’S MOM: Yes. I had three tenants that all wanted that house.

JASON HARTMAN: Well, of course they did. It was only $4000. It was a steal.

JASON’S MOM: Well, actually I was only charging $3850 for it.

JASON HARTMAN: Yeah. Oh, so you had a bidding war, even?

JASON’S MOM: No, I just decided that it should go for $4000.

JASON HARTMAN: Oh, alright.

JASON’S MOM: So I told this one person I would rent it to them for $4000.

JASON HARTMAN: Okay. And one thing I want to say though. So note, listeners, that that’s less than a 0.5% RV ratio. I want you to get 1%. I didn’t say that before, so I wanted to throw that in. Okay, go ahead.

JASON’S MOM: I didn’t have time to go and fax my applications for credit reports. So, I took out my iPhone, I took a picture of each application, and just emailed it the credit reporting company! I was flabbergasted at how beautifully technology works!

JASON HARTMAN: Yeah, right. It’s pretty cool, isn’t it? You took a screen shot and just emailed it, and it was done. It’s an amazing time to be alive. And the tools we have as real estate investors are awesome. All of the stuff that is going to shape our economy forever, technologically, is just mind-boggling. Let me share with you something that is amazing. I read this article yesterday on Newser. It said, you could someday get from China to San Francisco in 100 minutes. That’s just over an hour and a half, right?

JASON’S MOM: Amazing.

JASON HARTMAN: Amazing, right?

JASON’S MOM: How?

JASON HARTMAN: And I couldn’t believe this. Because what struck me about it, was in the article was a picture of none other than a submarine. And I’m thinking, submarines don’t go very fast. But there is a technology called supercavitation. And listen to this, folks. This is amazing. What they basically do, is, they have a submarine, and they intentionally form an air bubble around the submarine. And they say, this submarine would have a top speed, and they say that the Chinese government has perfected this technology. It’s already used in torpedoes, by the way. Okay? This is already used, this air bubble technology. And this submarine could potentially reach a top speed of—get this—3600 miles per hour. Now, I thought the fastest way to get anywhere was to go through the air, right, not the water. The fastest submarines on earth now only go 46 miles per hour. So—that’s what our fastest nuclear submarines do. Torpedoes using this technology have hit 230 miles per hour. But they say they can get this thing up to 3600 miles per hour. Now, on prior episodes you’ve heard me talk a lot about the self-driving car, and the impact of the self-driving car on real estate. And this submarine, Elon Musk, what does he call that, the hypertube, or the hyperloop? Hyperloop technology? If that every happens—of course, in the Socialist Republic of California you’ve got this totally stupid LA to San Francisco train that’ll probably actually never get built.

JASON’S MOM: The train to nowhere.

JASON HARTMAN: The train to nowhere, yeah, you know, Jerry Brown—

JASON’S MOM: Which takes longer than going on a regular train.

JASON HARTMAN: Only the government could be this good at anything, right? And I’m being sarcastic of course. The government is terrible at most everything. The amazing thing here is, think of the impact on real estate prices! If you want to visit San Francisco, and you can do that from Shanghai, China, in an hour and a half, what does that mean? Real estate has always been based on three things: location, location, location, right? I say the thing here with self-driving cars, and with high speed transportation technologies of whatever type, or unmanned technologies, okay, because either unmanned or high speed, it doesn’t have to be fast, it can just be self-driving. If you had a self-driving motor home, you could just jump in your motor home and sleep, and wake up and be in your destination. So that means that the value of very expensive real estate, I say, will be diminished in years to come. Because people don’t need to live in location, location, location.

Now, of course, when it comes to walking your specific neighborhood, that matters. Because, you know, people will still walk, and want to be in a good neighborhood. But does it mean that you can be in a nice neighborhood of Phoenix? Like I am? Or do you have to be in a nice neighborhood in Manhattan, New York? Vastly different prices. Or Los Angeles. Versus Phoenix. Or Dallas, versus Los Angeles or San Francisco. Much cheaper to live in those places. And these are the kind of markets we recommend. The markets that are the lower priced markets, where properties make sense the day you buy them, they get 1%, or even sometimes greater, RV or rent to value ratios, and my mom’s house example that we’ve been sort of joking and bickering about today, that would be $8500 per month in income versus $4000. Like if you look at Southern California, where I grew up, okay, where we both lived for many, many years, the thing was, you’d always rather live in Orange County, or Los Angeles, than Riverside or San Bernardino. The Inland Empire, as it’s called. That was always like, the cheap seats at the concert.

JASON’S MOM: Right, exactly.

JASON HARTMAN: And people would commute, because there’s this old thing in real estate that people drive until they can qualify. That’s sort of a funny saying; drive until you can qualify. And so, people will make that long commute in order to be able to afford a home. With this new technology that we’re on the verge of, we’re probably going to see, realistically, flying cars. Those aren’t too far away. People have been dreaming about that ever since the Jetsons. When I was a little kid, we used to watch that cartoon. Amazing stuff. There’s a company called, I think it’s Samson Motors, and I’m on their email list, and they have convertible light sport aircraft. It’s very easy to get a license to fly this plane, and you land on the runway, and the wings fold in, and you drive right off. So, it’s a car and a plane all in one. Price right now, I think stands at around $150, $170,000. But you know, that’ll come down. The light sport license for flying a plane—you can’t fly at night, and you can’t fly in bad weather, but that’s fine. You can just land and drive. If nightfall comes upon you.

There’s really some amazing stuff. The most realistic though, of all these things, and the most amazing thing, and the most impactful thing, I think, will just generally be the self-driving car. That might go as fast as 80, 90 miles an hour. It’ll take you from one place to the other even at current speeds without you driving it. If you go online, and you look for the Hyundai Genesis, the 2015 model, there is an amazing video where they demonstrate this car’s self-driving capabilities, and here’s what they do. This video will blow your mind. It shows you that a $50,000 car—nothing experimental, nothing at Google’s labs, nothing that costs $200,000—a $50,000 car today almost drives itself. Here’s how it works. Basically what they do in this video, is they all start driving, maybe six cars in a convoy, and they’re just right behind each other on the road. And a truck comes along, and all of the drivers jump out of the car. They jump out of the car, they jump out of the sunroof, into the truck that’s near them, and they jump over at 60 miles an hour. They jump onto this truck. You know, you’ve seen this stuff in the movies, folks. It can be done. And they leave the car on cruise control. And then there’s a truck in the very front of all the cars in this convoy. And the truck—now the cars have no drivers. Okay? The truck makes a sudden stop. Oh, and by the way, before the sudden stop, there’s turns in the road, and the cars all perfectly stay in their lane. I mean mom, this would be good for you, because you know many times I’ve called you like the world’s worst driver, right?

JASON’S MOM: I do need one of those cars.

JASON HARTMAN: Yeah. Oh, so you admit it!

JASON’S MOM: Of course!

JASON HARTMAN: You—oh, you admit that you’re a bad driver.

JASON’S MOM: I wouldn’t have any more bumps in my car. Backing up.

JASON HARTMAN: Okay. Anyway, they jump out of the car, and the car stays in its lane, and the truck in front slams on its brakes, and all the cars stop beautifully, with no drivers. There’s nobody in the cars. It’s amazing. This is here, now. This is not some pipe dream. And Elon Musk, the founder of Tesla Motors, he said, by next year, one year away, and he said this a few months ago, we will have—and I tell you, when Elon Musk says something, it happens in reality. I mean, the guy is an amazing CEO. Although I do think his Tesla car is pretty overpriced. But, he says, within one year, we will have a self-driving car, affordable, for the highway. For highway driving. If you’re driving from Phoenix to Orange County, that’s highway driving. And the vast majority—

JASON’S MOM: I could be reading! I could be doing all sorts of things!

JASON HARTMAN: You could be reading, you could be taking a nap. I’m sure they’re gonna make laws against that, of course. But ultimately, once the technology’s proven—and it’s pretty proven already—but once it’s proven widely—

JASON’S MOM: I can’t wait for something like that.

JASON HARTMAN: It’s phenomenal. Folks, it is an incredible time to be alive. That’s the bottom line. And this technology’s gonna shape the way we invest, the way we think about investing. It’s gonna shape the economy dramatically. It is largely a deflationary force, and that’s what also makes me think, the government is doing everything they can to screw everything up. That’s what I generally think. However, maybe they’re right. Maybe Keynesian economics, maybe Obamunism, as I call it, and many people do, maybe it’ll actually be okay. Because maybe what will happen is technology will literally rescue us all. And this massive government spending, and these deficits, and these entitlements that are coming due, and all of these obligations that would in the past have caused massive inflation. I mean, right now we should be experiencing massive inflation.

Maybe all these things really will be muted dramatically by technology. Check this out. I recorded an interview today for another show of mine. The guy was talking about these things, they’re called bioblocks. And there’s a Kickstarter project now—Kickstarter, the crowdfunding website—where you can donate 40 bucks to back these people’s campaign on Kickstarter, and they will send you a new life form that they created in their garage. A new life form. And new life forms are being created all the time now. It’s kind of scary. It’s like, maybe Frankenstein, right? And the guest said he talked with a major authority figure at the FBI, and they said, what are you doing to regulate this stuff? And he said, nothing. There’s nothing to regulate it. So, someone could invent Frankenstein. What’s happening here is what—they call it the democratization of science. We’ve already seen the democratization of publishing. I’m doing it right now. No one had to tell me I could make a show. No one had to hire me at a radio station. I just created a show, and by the way, I go off on tangents, you know I tend to do this. And by the way, I want to thank all of you listeners very very much, because just yesterday I found out that my show, the Creating Wealth Show, is now the #2 real estate show in the entire world, according to iTunes rankings. Now—

JASON’S MOM: Jason, that’s terrific!

JASON HARTMAN: Yeah, isn’t that great news? Now, iTunes isn’t the whole world, of course. You know, people can listen to podcasts without iTunes.

JASON’S MOM: Right.

JASON HARTMAN: It’s about 70%. It’s probably a pretty good bet; as the iTunes ranking goes, so goes everything else. And my show’s now #2. There’s only one other that beats me, and I’m not gonna tell you who it is, and that show sucks, so don’t listen to it.

JASON’S MOM: Tell me off the air.

JASON HARTMAN: Okay, I’ll tell you off the air. You know, all my listeners will be curious, and they’ll go figure it out. So, bioblocks. And Kickstarter. For $40, they will send you a life form they created. And check out what it is. It’s weeds. It’s a weed that glows in the dark.

JASON’S MOM: Really.

JASON HARTMAN: It’s a plant. And they created this in their garage. And they’re looking for funding for more research on Kickstarter. So, we have the democratization of raising capital, we have the democratization of publishing, we have the democratization of science, okay, which means—

JASON’S MOM: And food, maybe. From the plant.

JASON HARTMAN: Maybe, yeah. Maybe something great will come out of this. You can buy these bioblocks. And bioblocks are like Legos that basically put life forms together, and so, people are experimenting, and creating all these different life forms all the time. It is an amazing time to be alive. There are gamification websites that have gamified the concept of gene sequencing, for the human genome. All kinds of science and discoveries will come out of this. And you know, these are deflationary forces. They make life better, and they ultimately end up being fairly inexpensive. And so, it is an amazing time to be alive. If technology doesn’t rescue us before the chickens come home to roost on the terrible math and the budget deficits and the spending and the bad economic and monetary policy—well, then we’ll have inflation. And your income properties will hit a home run for you, inflation-wise.

JASON’S MOM: They’re the best hedge against inflation.

JASON HARTMAN: No question about it. Nothing else beats it. If that doesn’t happen—if we don’t have massive inflation, and things just kind of go the status quo stagnation example, you’re gonna do pretty well. And even if we have deflation, you’re going to outdo pretty much anything else you can do. And I’ve given that example on prior episodes; I don’t have time to go through it now. This little intro for Tom Essaye’s running kind of long. But mom, I had one more question for you. And I just want you to share for your listeners, why income property? Why did you become interested in buying real estate? You were a single mom, you didn’t have a lot of money, you were bumping your head up against the glass ceiling, which really, in those days, was there. I don’t think it’s there that much anymore. But, please, female listeners, don’t send me a bunch of hate mail. I think the world’s pretty open and equal nowadays. But back then, there really was a glass ceiling.

JASON’S MOM: Oh, yeah.

JASON HARTMAN: No question. So, just tell them quickly about that, and then we’ll get to our guest.

Jason asks his mom: why did you become interested in real estate?

JASON’S MOM: I was associating, because of the job I had with a charity, with people who had a lot more money than I had. And I was constantly thinking about, how could I make some money? And I knew I wouldn’t make it being an employee.

JASON HARTMAN: You worked for Muscular Dystrophy Association, and then you worked for the Leukemia Society, and ultimately became the executive director of the Leukemia Society LA chapter. That’s kind of a big deal. And, well, you’re smirking at me. That’s not a big deal, you’re saying. You were meeting wealthy donors, and board members, and they were investing in real estate, right?

JASON’S MOM: A lot of them had made their wealth by investing in real estate. I was always reading in the newspaper for lectures and seminars about how to do things, how to learn things, and one of the seminars I went to was entitled, do you really want to be rich? And it was a two series seminar. The object was to turn $1 into $2, literally, and but the person who gave the seminar became rich by investing in real estate. And the simplest way that I could think about investing in real estate was to buy a house as the first step, and then to just keep buying little houses. Because I knew I could manage those.

JASON HARTMAN: It’s easy to do.

JASON’S MOM: So, anyone can really do it. The thing is, just get started.

JASON HARTMAN: Just do it. As the Nike saying goes. It’s amazing, like all these people that invest in stocks, and you know, Wall Street type traded assets and so forth—like, I never hear the story of the person who started with $10,000 and created a whole bunch of wealth from the stock market. Or from mutual funds. Or from bonds. Or anything else. I’ve heard that story a zillion time with real estate, with income property. Isn’t it amazing to you?

JASON’S MOM: Real estate is a lot of common sense. To be very good in the stock market—

JASON HARTMAN: You gotta be an insider.

JASON’S MOM: You have to be kind of an insider; you have to take a lot of specialized classes to be a trader. No matter how good you are, you still could lose it all in a great big crash. But in real estate, that little house will still be standing there.

JASON HARTMAN: That’s the great thing about it.

JASON’S MOM: It might be worth a little less, but it is still there, and it is still a real asset.

JASON HARTMAN: The investment we recommend starts with the word “real.”

JASON’S MOM: Exactly.

JASON HARTMAN: Need I say more? Okay? Mom, thanks for joining me today. And letting me tease you about the fact that you’re getting cheated out of $4000 a month by that tenant—

JASON’S MOM: Well, you should just congratulate me, because I’m making $700 more this year than I did last.

JASON HARTMAN: See, always looking at the bright side, that’s awesome. Let’s get to our guest, Tom Essaye; we’ll be back with him in just a second.

[MUSIC]

Introducing Tom Essaye

JASON HARTMAN: It’s my pleasure to welcome Tom Essaye to the show! He is editor of the Seven’s Report, and has some interesting ideas, and thoughts on the stock markets, and the junk bond market, and interest rates, and Fed policy. We will talk about that. Tom, welcome. How are you?

TOM ESSAYE: I’m doing well. Thank you very much for having me on.

JASON HARTMAN: Pleasure is all mine. You’re coming to us from New York City, I believe?

TOM ESSAYE: Coming to you from sunny Florida.

JASON HARTMAN: Oh, sunny Florida! You said you were on east coast time, and I just assumed you were a Wall Street guy.

TOM ESSAYE: I used to be, in a former life, yeah. But I’ve come south now for about ten years.

JASON HARTMAN: Are you a recovering Wall Street guy then? Is that a fair way to put it?

TOM ESSAYE: I am. Yep, I used to work on the floor of the New York Stock Exchange, right there in the heart of it.

Some thoughts on the junk bond market

JASON HARTMAN: Good stuff. In the belly of the beast. You know, you were talking to me before we started about what’s going on with the market in general. And I don’t want to make this too timely, because the show’s kind of evergreen. But in terms of right now, you’re saying people should watch the junk bond market, because that is a good indicator, right?

TOM ESSAYE: It’s interesting. With the proliferation of ETF, now individual investors can pay attention to a lot of things that previously they would have needed a Bloomburg Terminal to use. And there’s an ETF JNK, and basically that’s an ETF that monitors an index of junk bonds. And junk bonds basically predicted the current correction that we’re seeing in markets, and it predicted it by about a month. JNK topped out about a month before the S&P 500 did. That by itself is not particularly exciting, but if you consider the fact that the market is now concerned, that the Fed may be starting to switch policy. That it’s gonna go from what we’ve all become very used to, which is 0% interest rates, and round after round of QE, it’s finally going to end that. And that decision, or the anticipation of that decision, is gonna cause reverberations in parts of the bond market. Junk bonds first. And that’s why it’s very important to watch them as a leading indicator for stocks going forward.

JASON HARTMAN: So, basically here, the Fed must be really seeing an inflation threat then, finally, right?

TOM ESSAYE: I think that they’re starting to, yes. I’m of the opinion that inflation is a lot greater than what the Fed, or the economic data says it is—

JASON HARTMAN: Couldn’t agree more, by the way, I couldn’t agree more.

TOM ESSAYE: Yeah, you know, anybody who’s living in the real world, who has to go buy groceries, and go buy gas, and go buy healthcare, which are things that we all cannot do without, realizes that the inflation rate is a lot more than 2% year over year. But nonetheless, we have to deal with the statistics at hand. But I do think that the government—the Fed specifically, I believe is starting to address the fact that they have been too easy for too long, twice now in the last 15 years. And that has ended up causing significant problems in the economy and in the banking system, each one larger than the last. And even though they may not see significant uptick in inflation statistically yet, at this point, the marginal benefit of additional QE versus the marginal damage you’re probably going to cause, is switched, and it’s time for them to start dialing back. The Fed is always slow to do that, but I think they’re starting to realize that they have to.

JASON HARTMAN: Explain the mechanism on the junk bonds though for a moment. I don’t want to just gloss over that. You talked about how the junk bond market started experiencing trouble, or sensitivity to the Fed’s tightening threat early. Now, why? Why did the junk bonds feel that first?

TOM ESSAYE: That’s an excellent question. And the reason is because an offshoot of that policy, okay, the 0 interest rates for 5+ years and round after round after round of QE, has been that investors have reached for yield. Because normal debt instruments now pay nothing, courtesy of the Fed, investor measures still have to enact—still have to get a return, right? So, basically what it’s forced them to do, is to pile into higher yield the assets, somewhat ignoring the inherent risk in those higher yielding assets, just because they need to get that yield. I’m not making a direct analogy here. But to liken the piling into the junk bond market to what we saw in the subprime market, is not completely off base. Now, I’m not saying it’s gonna be the same thing, and we’re gonna see a redo of the housing crisis. But the reason that the junk bond market is gonna be the first to feel the disruption from the Fed starting to potentially tighten policy, is because it’s become the most distorted.

So if you think about the subprime housing market, right, what did investors do? They piled into it, because A) subprime debt paid a higher interest rate than normal debt. And it did that, of course, because it was riskier. And B) it was most leveraged to a rising housing market. Similarly, junk bonds pay the highest yield of any major bonds, because they have more risk, and they are more leveraged to a rising bond market. So, to a point we’re seeing a repeat of the same effect we saw in subprime housing. Again, I don’t want to scare people; I don’t want to say hey, this is the same thing, because it’s not. The behavior, though, by investors, is similar. The first to feel the effects of the housing market starting to go down, junk bonds will be the first to feel the effect of the market going down. And that’s why we need to watch them; it’s because they’re like a warning light.

JASON HARTMAN: They’re the early indicator. They get hit first.

TOM ESSAYE: That’s right.

JASON HARTMAN: Okay. Very interesting. Very interesting point. You and I agree, thankfully, that inflation is a lot higher than they lead us to believe. But with that, what’s interesting is something you said to me before we started; we talked for just a couple of minutes. You thought that the recovery, the economic recovery, and I’m kind of putting that in quotes, that word “recovery.”

TOM ESSAYE: Which is fair enough.

JASON HARTMAN: Sarcastic quotes. You think it’s pretty real, it sounds like.

TOM ESSAYE: I do. The term that we’ve been working on for a while here at our firm is escape velocity. Does the economy finally have the momentum to break out of this 1-2% annual GDP growth malaise that we have been in since 2008? And I believe that finally, after 5+ years of low interest rates, after round after round after round of QE and a recovery, at least in nominal prices in the housing market, that finally, we are starting to see that recovery hit escape velocity. Now, does that mean that I think good times are here again and we’re back to the 90s where the economy was roaring? Certainly not. But I do think compared to the pace of growth over the last several years, we are seeing a definitive uptick. And I have both economic data and anecdotal evidence to tell me that. I live in South Florida, which as we all know, was one of the hardest hit areas economically out of the housing boom. I can tell you that for four years I didn’t see an earth mover working in the area I’m in. And now stuff is going up again like you would not believe. We’re trying to hire here at my research firm; when I was hiring three years ago, I had a mountain of qualified resumes for an entry level position. Now I’m having trouble filling that position. So, that anecdotally tells me that things have gotten better.

JASON HARTMAN: Well, that’s interesting, but that could be based on geography, or you know—

TOM ESSAYE: Certainly.

JASON HARTMAN: Maybe a lot of—you know, I don’t know. There’s a lot of factors there. But it’s anecdotal, you said that.

TOM ESSAYE: It’s anecdotal. And again, do I think the economy is roaring? No I don’t. But do I think the pace is a little better than what we’ve seen over the past couple of years? I think that’s probably fair. Now, is it sustainable? We don’t know.

JASON HARTMAN: I agree with you that it is better than it was. But in overall terms, I mean, if you believe inflation is understated, as do I, then if you look at GDP, which is probably overstated, I mean, we can—there’s lots of people that’ll pull that one apart too. If you look at GDP, if you look at stated inflation, and you look at population growth, the country is shrinking! The economy is shrinking! I mean, there’s no question about it, in my mind.

TOM ESSAYE: I agree. So, let’s differentiate for a second the economic data, and the general state of the economy on an absolute basis versus—and this is something that I try and talk to people a lot about. The economy is by itself just sort of this esoteric thing. You can make economic growth numbers go up or down relatively easy depending on what you’re doing with monetary policy. What we need to worry about is, is the economy starting to make people’s lives better? Are we making more money? Are the things we have to buy costing less? Are we getting a benefit from an economic increase? I believe the answer is no, over the last five years. Because what you’ve seen is way too stagnant. The job market mostly stagnant, although we’re seeing a little bit of an uptick recently, but it’s still not very good. And the cost of everything we have to buy, going up consistently. So, if you ask me, is the quality of life of the American person better now than it was five years ago, or better now than it was two years ago, my answer would be no. And whether or not the economy is accelerating or not, that by itself is only one piece of the puzzle, because you’re absolutely right. If the economy is accelerating, but inflation is accelerating with it at a faster pace, then it doesn’t really matter; you’re not getting the benefit to you as a person.

JASON HARTMAN: It just really worries me, because I sort of see it anecdotally in my own life, but then I kind of don’t see it. It seems like most of my friends are doing fairly well, but it feels like, or I just keep reading about this under class is just growing and growing, obviously we’ve got Obamunism in full swing, and you know, the Food Stamp president, and so on and so forth, all the things that the people on the right say, which are hard to argue with, you know…we don’t need to make it a political discussion necessarily, but feel free if you want to take my lead.

TOM ESSAYE: I agree with you. I will tell you though, listen, it’s my opinion, I believe that one of the main reasons the Fed has stayed as easy as they have been, and has done round after round after round of QE, is because of the government and the administration. Because we came out of a once in a century crisis, or twice in a century crisis, and the one thing that you—the cardinal rule of coming out of something like that is, you don’t make any major changes. Right? And you let the economy kind of get under its own two feet again. And then you can start making structural changes to things. And what did we do? We did the exact opposite through policy. Dodd Frank, the healthcare law, multiple other changes—it froze business. It froze business, and it froze decision makers, and I believe that history will look back and it will see the Fed’s reaction to that as basically saying—well, the fiscal side of Washington is now an anchor on the economy, because they’re injecting all this uncertainty. Fundamental uncertainty into the economy. We have to stay easy to counteract what they’re doing, and that’s going to have, unfortunately, some pretty significant consequences.

JASON HARTMAN: Companies, including my own companies, I just want to deal with freelancers. I don’t want to have employees, I don’t want to have fixed overheads, I don’t want to make long term commitments, but I used to think differently about that. Before Obama, it just seemed more certain, and I’m not saying anything was great under the Bush administration by any means. There seems to be just this huge level of uncertainty now. I just don’t want to make long term commitments. And I think a lot of companies feel the same way.

TOM ESSAYE: I think that’s absolutely right. I mean, the fundamentals of what you base your decision making on a business standpoint have been called into question. I mean, banks, to this day, are still living in fear of what the government is going to tell them they owe for sins of the subprime crisis! I mean, it seems like every time an attorney general from New York, or Mr. Holder, want to get on TV, they just announce that the banks are literally ATMs for them. Because they just walk over to them and say, here’s another fine for something you did six years ago.

JASON HARTMAN: And what they’re really doing when they do that, is they’re really punishing the shareholders. They’re not really punishing the executives who ran the companies in to the ground. And not one person has gone to jail, out of this whole—

TOM ESSAYE: Well, exactly.

JASON HARTMAN: Unbelievable global meltdown we had a few years ago. It is insane that the head of Country Wide got a slap on the wrist. What was it Mozilo got, a $70 million fine, or something? Which is like me giving you 20 bucks?

TOM ESSAYE: And I agree with you completely. I think that unfortunately, what they don’t get, and the administration has made a living politically demonizing big business, and they will continue to do it. I was on Fox Business the other day talking about how the president was saying corporate CEOs are whining, and they have to stop whining; things are pretty good for them. They’re whining because they’re sick and tired of swimming against the tide of the economy. Most CEOs have eked out profitability over the last several years by cutting costs, cutting benefits, streamlining their operations. But you can only do that so much.

JASON HARTMAN: Technology.

TOM ESSAYE: Absolutely. At some point you have to actually start selling more stuff. Whatever it is. Right? And you generally sell more stuff when the economy is better, a rising economic tide helps lift all boats. They’re sick and tired of having no rising tide. And that’s why they’re whining. And guess what? I don’t know why the administration seems to think that if a company makes more money, all that money just goes right into the CEO’s pocket. That doesn’t happen. It’s not like, they make more, they get 100% of it. The employees get more money. They can make pay raises.

JASON HARTMAN: Well, all the stakeholders. Listen, I don’t believe for a moment that it trickles down very equally. I do think at the top of these companies it’s become a monopolistic practice at the C level, in the board of directors. And I think a lot has to change in corporate governance. I am not happy with that at all. But I know I could sound like a bit of a socialist saying that. But I just don’t think it’s right. Some of it trickles down to the employees. Certainly a lot of it trickles down to vendors and contractors of the company. And the shareholders of the company. Who do you think owns these companies? Middle America, people that have the stock in their retirement plans.

TOM ESSAYE: Exactly. You hit the nail on the head. I mean, I don’t think that the administration realizes that the vast majority of the nation’s retirement is in 401(k)s and IRAs. And what do they own? Stocks. Yes, the CEO will make money, and he will get rich, and I agree with you 100%, that the plague of other people’s money in corporate America has gotten out of control. These executives feel that they can do whatever they want, because it’s not their money. Heads I win, tails you lose. But at the same time, you have to accept that the CEO is gonna make money if the company becomes overall profitable. It’s gonna do a lot of good too.

Outlook on inflation

JASON HARTMAN: I want to get two other topic areas in before you go, real quick. One is, just to stay on this topic for just a moment, not governance, but the general economy topic is, how bad do you think inflation is going to get? Or do you think the Fed can nip it in the bud, or do you think it can get out of control again?

TOM ESSAYE: I do not think the Fed can nip it in the bud. I am not a hyperinflationist, but I do think that we’ve got a pretty significant inflation problem.

JASON HARTMAN: Want to put a number on that? Just a range?

TOM ESSAYE: I’d say probably, based on their statistics? I think you can probably get, you know, between 4 and 7% annual inflation on the CPI.

JASON HARTMAN: Okay. And—

TOM ESSAYE: Which obviously will be significantly higher for real life.

JASON HARTMAN: Right. And so what that means, in real life, is that’s probably 8-12%, real inflation.

TOM ESSAYE: I’d agree with that. I think that’s something you can legitimately see. I think you can see interest rates have to go well into the teens to break it again.

China & Russia

JASON HARTMAN: The two other topics are, China, and Russia. We’ve gotta mention those. What do you think? Is China—I mean, China is such an enigma. I don’t know what to think about China. Overall, I don’t think their future is that rosy.

TOM ESSAYE: You know, I don’t think it is either, but I think that unfortunately, a lot of their issues—China arguments—I’m not in disagreement against. A lot of the bears, China’s arguments, are colored by people’s distaste for the way they do things, and the way they’ve set up their government, and the fact that they leave it one sort of big real estate bubble that has to go poof. And I’m not saying that’s incorrect. But I think that what is happening, is that China is going through an enormous transition as an economy. They’re making the same transition that the United Kingdom made in the 1800s, and that this country made in the 1900s. They grew into prosperity on the backs of workers, through manufacturing.

Now, they realize they must make the transition from a manufacturing based economy to a balance or service based economy, and that transition is bumpy. So I do not think that China is going to be the growth engine that we are used to. I don’t think it’s going to implode either. I think that they’re gonna slow down growth, and that they will over time make this transition to a more balanced economy. I’m not a big China bear. I don’t think that the economy’s gonna implode, because of a real estate bubble. Part of the reason I don’t believe that’s going to happen is because we have to remember that all the Chinese banks are state-owned at the end of the day. So all of the real estate property, and all the real estate loans that have been made, have been made by the government, in effect. So that changes how a real estate bubble pops. Because the government never actually has to sell any of the property if they don’t want to. Now they’ll take a hit on the balance sheet, and certainly there’ll be repercussions of that, but it doesn’t have the same sort of cataclysmic result that we saw here in the United States.

JASON HARTMAN: Good analysis. Russia?

TOM ESSAYE: Russia, Ukraine—and I don’t mean to in any way diminish the events—but from a market standpoint, it just simply isn’t that important at this point. I know it generates a lot of headlines, I know it’s generating a lot of angst. But here’s the deal. It’s the local event that’s the Europeans’ problem at this point. If Russia invades Ukraine, which is still a low probability event, then it becomes a bigger bigger problem, that I think is a reason to sell stocks in the short term. But short of that happening, I think it’s more a distraction for the markets than anything else. It is not what’s causing stocks to trade lower here.

JASON HARTMAN: I think from a geopolitical perspective though it just scares me. I mean, the aggression is—it’s like we used to see decades ago. Kind of don’t know what to make of it. It’s—

TOM ESSAYE: I agree, I agree. It is concerning from a geopolitical standpoint.

Closing comments

JASON HARTMAN: Well Tom, really good discussion with you; I know you’ve got an appointment, so we’ve gotta let you go, but give out your website, tell people where they can find out more about you, and just any closing thoughts you might have.

TOM ESSAYE: Thank you very much for having me on; I’ve enjoyed it, I would love to do it again, and for those people who are interested in our publications, the Seven’s Report, it’s a daily market research note, you can read it in seven minutes or less, it comes out by seven a.m. every morning, and you can go to sevensreport.com and just put in your name and email address and you’ll be signed up for a free two week trial. We don’t ask for your credit card, we don’t want your credit card. You simply get the report for two weeks, if at the end of that period you want to buy it, there’ll be a way you can do that. If you don’t, you just stop getting the report. It’s our way of providing a staple of Wall Street, which is the morning research note, to sophisticated self-directed investors, so that they can know what’s going on with the markets each and every day.

JASON HARTMAN: Well Tom Essaye, thank you so much for joining us.

TOM ESSAYE: Thank you, sir.

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Transcribed by David

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