Episode #65: “The Days of $80 Oil – That’s a Long Way Away”
Guest: Emil van Essen. Emil is the CEO and CIO of Emil van Essen Managed Futures. He’s a commodity trading advisor with more than 25 years of investment experience. He has also won awards for achievement in mathematics, and has written two books on systematic futures trading.
Date Recorded: 8/2/17
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Summary: In Episode 65, we welcome CTA and commodities expert, Emil van Essen.
Meb starts with a fun bit of trivia – if you mesh his and Emil’s name, coming up with “Emil Faber,” can you guess in which movie that name appears?
It turns out it’s from the classic comedy, Animal House. “Emil Faber” was the founder of the movie’s “Faber College” and under his statue was his quote, “Knowledge is good.”
After Emil gives us a bit about his background, the guys jump into the deep end. Emil trades managed futures, and while most people think “trend following” when they hear “managed futures,” there are other styles. Emil tells us about a style he uses often, spread trading.
Emil looks at the term structure in commodities futures contracts. There’s a price for every month going out in time. You can trade the differences between those months (calendar spreads). He also trades relative value and roll arb. Emil likes these strategies because there’s tons of alpha available.
Meb pauses to explain a bit for any listeners who are less familiar with all this. He explains exposure to the futures markets, using oil as an example. This leads into a discussion about the growth of commodities markets. Back in the 2000s, commodities went from being just a product to an investment vehicle. So the powers that be created indices and various commodities products to meet this demand. Investments in commodities exploded, driving up prices.
This dovetails into what Meb calls “one of the dirty secrets of indexing,” which is how many indices can be front-run. Meb tells us how, for some 1.0 commodities indices, the slippage was in the order of 3-4% per year.
Meb then asks Emil to describe what he looks at when establishing a position. Is it fundamental? Technical? Emil tell us it’s very important that you use both, because “you have to understand the fundamentals because things change.”
Next is a great conversation about front-running trend followers. This is something that Emil does. He knows that if there’s a big move, the trend followers are likely all on the same side of the position, so when it comes time to roll the front month, and Emil generally knows when that will happen, Emil takes advantage of the price movement. Meb and Emil then discuss the easiest way to implement this strategy.
A bit later, the guys discuss what themes/positions Emil is interested in right now. He tells us how there has recently been a shortage in gasoline, so gas has been running up against crude oil. It’s at high levels now, and Emil thinks it’ll come down. Emil also tells us that he’s looking at grains, the energy markets, and certain metals including platinum and palladium.
This leads into a discussion on oil. Meb asks Emil’s take on the industry.
Emil gives us some great background on what drove oil up so high, and why it crashed. Then he discusses the technological revolution in oil drilling, the result of which is that the cost of finding and developing oil has collapsed. There are some great details in here which oil investors won’t want to miss, but Emil wraps up this part of the conversation by saying “the days of $80 oil – that’s a long way away.”
Meb then asks what areas of commodities Emil likes right now. Emil tells us his thoughts on at what level crude is buy. And he mentions a certain metal which he considers a “no brainer.” You’ll have to listen for the details.
There’s way more in this episode: how Emil views gold in light of new cryptocurrencies… A Twitter poll Meb conducted that reveals just how stubborn some investors can be when it comes to selling out of overvalued equities… Where Emil has seen the most investors make the biggest mistakes over his 25+ year career… The dangerous false belief that “we’ve seen this before” in the markets, and how computerized investing is taking us into uncharted waters… And finally, Emil’s most memorable trade (which was a loser that will get your blood racing).
What are the details? Find out in Episode 65.
Links from the Episode:
- Emil’s website
- 46:10 – When Genius Failed – Lowenstein
- 49:47 – Ugly Americans – Mezrich
- 54:10 – What Works on Wall Street – O’Shaughnessy
Transcript of Episode 65:
Welcome Message: Welcome to The Meb Faber Show where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the Co-founder and Chief Investment Officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information visit cambriainvestments.com
Meb: Welcome podcast listeners. I hope you’re enjoying the full on summertime. It’s hot here in LA, and hopefully you picked up our new book, “The Best Investment Writing” on Amazon, and took advantage of all the free books available for download last week. If you didn’t don’t complain to me. They were available for five days.
But today we have a super-special guest. He’s a commodity trading advisor with more than two decades of investment experience. He’s also won awards for achievement in math, has written two books, and is now the CEO, CIO of Emil van Essen Managed Futures. Welcome to the show, Emil.
Emil: Well, thank you for having me.
Meb: You know, I have to say that the first thing that I thought of, when we were having you on the podcast is, if you were to mash together our two names so, Emil Faber there is… And I polled people the other day in the office. I said, “Does anyone know who Emil Faber is? Does that name ring a bell to you at all?”
Emil: There is an Emil Faber?
Meb: He’s fictitious. He’s a fictional character. But podcast listeners, super gold star if you know who this is. He was the founder of Faber College in the movie “Animal House.” So if you look at the first scene, there’s the statue of Emil Faber and the best part is his quote on the statue is, “Knowledge is good.” I thought it would be just a funny story, anyway. But maybe that will be the title of this podcast when Jeff puts it up. “Knowledge is Good.”
All right. So, our podcast listeners may not be familiar with you. They might be, but we usually start by asking our guest to give us a little background info. So how about taking a minute or two and just tell us where you started? How you got to what you’re doing today.
Emil: Well, I started a lot like Warren Buffett, delivering papers when I was a kid. And I used to invest my money in rare coins when I was like, 13. And the guy who was the owner of the rare coin shop was a commodity trader. So he started teaching me how to trade commodities. By the time I was 14 I was trading on his account and by the time I went to high school, I was reading all the papers on commodities and everything, and that’s kinda how I got started.
Then I knew what I wanted to do and, you know, years later I studied math and all that kinda stuff, and when I was 21 years old I started working for Prudential Bache Commodities. And, you know, went from there. Eventually started my own shop and developed some interesting programs for commodity spread trading and things like that. Here I am now.
Meb: You know it just reminded me, Jeff, we did an episode with a great numismatist, Van Simmons, and we’ve still got to go down to Long Beach and I’m gonna to make my first investment in rare coins. So that’s another episode and another conversation.
Okay, so we’ve done about 50 podcast episodes, and we’ve had a lot of chats with some trend followers in managed futures, and most people, when they think of the word, CTA, which is commodity trading advisor, they think of trend following. For our listeners just to get on the same page, why don’t we talk a little bit about your trading style? You know because a lot people may just associate managed futures with one investment style, but that’s not really the case.
So why don’t we get into just starting to talk a little bit about your framework for investing, how you think about markets and what your particular investment style is?
Emil: Sure. So, you know, people got into trend following, mostly because you know, when things blow up, when things go crazy, trend followers make money, and it’s sort of like the opposite of stock investors.
Stock investors lose money when things go crazy and blow up and you know, CTAs, trend followers, they make money. But there’s not a lot of alpha generation in this. It’s basically, you know, the assumption that things are gonna trend and that’s how they make money, but there’s not that much alpha in that strategy. There’s some, but not a lot.
So we looked at the term structure of commodities and the term structure is like, well you know what the first futures contract is. It has a price, let’s say, crude oil and oil might be $48, but there’s a price for every month, going out in time, and that’s the term structure. And you can trade the term structure. Trade the differences between those months. So that’s calendar spreads. So we trade the calendar spreads.
Then the other thing is like relative value. So there’s Brent crude oil and there’s WTI. WTI being the U.S. one, Brent being the water-borne one, the rest of the world. You can trade, like, relative value, trade those things against each other. Buy one, sell the other because you think one’s a little over and under priced. And that’s what we do. And what I like about it is, that the term structure is pushed around by different forces.
Like, in crude oil for example, if the price of crude oil goes up, the hedgers come in and they sell the term structure a year out. But the trend followers will be buying it. So all of a sudden there’s a big shift in the term structure, just because these different participants, these big players, need to do their own business. Like, hedgers need to lock in the price or trend followers are trying to get on the upward movement. It causes a lot of distortions in the term structure, and we can take advantage of that.
What I like is there’s tons of alpha available. So when you get all of these players moving the market around in the zones that they participate in, it creates some dislocations in the market. And all these create alpha-generating opportunities because we know that certain effects aren’t likely to last.
Another big one that we do is what we call roll arb. So big players, when they roll their positions, they roll out of the front contract and they go into the next contract, so they gotta one and buy another, and they push the market. And we know when that’s gonna happen and we take advantage of it.
So if we know that they’re gonna be selling the front month and buying the next one, then we know, you know, we can take advantage of that by doing it ahead of them. And then, when they move the prices, we can profit from it. So there’s a lot of alpha there, to take advantage of.
Meb: There’s a lot in here we can drill down into and let’s just take a step back because some of the listeners may or may not be familiar, that familiar with Futures. But for example, you know, if you were just to go out and try to buy oil. You know, a lot of investors say, “I want some exposure to oil.” Well there’s no such thing really. You could go buy the spot but there are these future’s markets where, you know, whether it’s every month or every quarter, all the way out, for a number of months and years is that you can buy these contracts to give you exposure.
And so some of the discussions we’re having is, is how these contracts relate to each other at different times. And there’s also a lot of players, participants, in the futures markets that aren’t necessarily price sensitive. So we talk about, people that have to hedge. Where you think of an airline that needs to hedge its fuel costs, or a cereal company that needs to hedge its wheat, or vice versa, etc.
A couple of things, so one you started to talk a little bit about roll arb and in a way to kinda give some insight into podcast listeners to make this a very, kinda, real discussion. A lot of people that say they want to invest in commodities, and if you remember back to the early mid-2000s, investors, everyone was super excited about commodities. One of the reasons, because oil was going straight up and lot of commodities, oil was up above a hundred bucks. Everyone wanted expose to commodities and portfolio, but because you can’t just go buy a bunch of commodities, spot. You have to do it through futures, a little more nuanced.
Why don’t you talk a little bit about the kinda intricacies of an investment, in just a broad-based commodities, as kind of an instructive platform, and we can get a little deeper from there. And talk about how, kind of like, a lot of this 1.0 commodity indices were very poorly designed, and actually really benefited people like you guys.
Emil: So, yeah, I mean, one of the reasons why, you know, commodities went up so much in the 2000s is everybody decided that they wanted to have an investment in commodities. So commodities went from a product that people used, like oil, to an investment vehicle and it really was never meant to be like that.
So they came up with all these commodity indices like Goldman Sachs Commodity Index and then all these funds around that. And all of a sudden everybody was investing in commodities through these indices that you could buy an ETF or what have you. And the amount of investment in that went from 10 billion in 2000 to hundreds of billions by 2008. And that drove up the price up of commodities, because you have all these massive buyers pushing up the price of commodities.
In this world, everybody, you know, the primary investments are stocks and bonds and the problem is, around the world these things are getting more and more correlated. And everybody needs some other investment and that’s why they got into commodities and that was the whole build up of the commodity machine. The long-only commodity funds.
And we took advantage of this long-only commodity funds. But as an investment there’s not a lot… Like, when you buy commodities yeah, it’s not correlated to stocks and bonds, but there’s also not that much-, it’s just a lot of volatility with not a lot of gain to it. And that’s where CTAs come in because, you know, we’re better at playing the commodities not being correlated to stocks and bonds, and being able to take advantage and generate alpha and better returns.
Meb: Listeners, we often talk about this because we manage both, obviously passive and active funds. And we’ve talked about this a lot on the podcast, but one of the dirty secrets of indexing is almost all of the indexes get front run. And there’s academic papers on this, so if you go to the S&P 500, it’s a massive, massive index, but there’s not, it’s very liquid so there’s not as much, kinda, slippage. It maybe 20 or 40 basis points.
But some indices, the Russell 2000 is a super-famous one, where people would simply screen through the stocks that are likely to go in, because you know the rules. Buy them a month ahead of time, and then of course short the stuff that’s probably coming out. And that has been a very profitable center for traders for many, many decades.
But particularly the commodity indices, I’ve seen a reports on this kind of 1.0 indices where the slippage on some of these indexes from these just, very naïve roll systems was in the order of 3% to 4% per year.
And so, as you mentioned, now the good news is a lot of the providers are starting to develop a lot more dynamic, or 2.0 versions, of kinda the commodity indices that make a lot more sense than the first ones. But again, a great source for people like Emil to take advantage of.
So you know, so you put together a number of this sort of spread ideas. And so for investors, you know, a lot of it sounds a little bit like arbitrage, you know? Like a relative value sort of play. Why don’t you talk about how you, kind of, is this a sort of fundamental inputs where you’re looking at your beliefs about certain markets and the fact that they may get too stretched or not. Is it purely technical inputs based on price? How’s the machine work?
Emil: Well, I think it’s very important in commodities that you have both, but most people don’t use both. I think we’re kinda unique in that way. But you have to understand the fundamentals because things change. I mean, look at the shale revolution in oil. It change the whole dynamic and if you look at things like it was 10 years ago, you’re gonna get run out of town. You’re gonna lose a lot of money.
Look at natural gas, I mean they can produce it for half the price than they did years ago. So if you built the model on that, you would lose money. So we do built our models which tell us how things, the relative value, moves around. How we can make money taking advantage of it. But we also look at the fundamentals and study it and make sure we understand how the big pieces are moving around, so we don’t get caught.
Like you said, for example, in roll arb the big players who are rolling or getting a little savvy now and they’re changing the way they’re doing things and it’s not as easy to take advantage of them. So you have to know that they’re changing things, otherwise when the opportunity’s gone, you don’t wanna keep trying to play the game and lose all your money, after these guys have gotten savvy.
Meb: You know, it’s interesting talking about front running as well. I heard you on somewhere, talk a little bit about, I’ve long thought about this idea and always wanted to kinda test it or put it in a practice, but the concept of you have a big pot of money that’s also in trend following. And the ability were most of the trend followers do the same thing, you know, in general. Like, it’s not that complicated, you’re buying what’s going up and selling what’s going down. They may have different systems and different timing, but in general it’s a pretty darn similar sort of system.
You and I could probably write down some rules in 10 minutes on a napkin and get the majority of what most these guys are doing. No offense to my trend-following listeners, but that’s, kinda, the beauty of the strategy too. But one of the things is, I heard you mention that a possible trading strategy as well on, kinda, the spread trading and thinking about, is also thinking about when trend followers are all gonna be entering a market. Maybe you could talk a little bit about that, and is that something you still implement or no longer trade as well.
Emil: Yes so we definitely take advantage of the trend followers. So the long-term trend followers, like, from a roll stand point they all get, if there’s a big move, they all end up getting on the same side of the position. They’re all long crude or they’re short gold or whatever they are. They’re in their position and then it comes time for the front month to expire and they have to roll. We kinda know when they gonna do that. So they tend to be very methodical and mechanical in how they roll. And they rolling as a group, like, you know maybe tens of thousands or hundreds of thousands of positions. And they’re what I would call price taker were they go on the market and execute the trade. They’re not really trying finesse it that much. And that creates a wide price movement. And we know exactly, you know, when somebody’s doing big trades and you know ahead of time what they’re gonna do, you can take advantage of it.
Now, something that’s a little trickier but also possible, is if you know that, let’s say you can build a model that essentially is, sorta, the middle ground of all the big trend followers and you can say, “Okay my model is getting close to triggering the buy,” let’s say. So let’s say gold is going from a sell to a buy.
And you know, pretty soon all the trend followers, if it keeps moving up, are just gonna jump on that band wagon. You can get ahead of them, essentially front-run their move into the market because, you know if it moves up it’s gonna start domino-ing all their triggers to get in the market, and you can make money off of that.
Meb: What’s the way that kinda, is the easiest implementation because I’ve long thought about this topic. Is it, do you express it through straight-up futures or through options? Are there, kinda, spread trades on that? Like, what’s the best way in general to, kinda, put that into practice?
Emil: I would say futures. I mean you could simply say, when it gets close to the point at which I think that trend followers’ gonna get in, you have to assume, let’s say, assuming they’re all short and it’s getting just to the edge of where you think it’s gonna start triggering all their signals, just buy it. And then you know, if the market moves back down then it’s too far away you get out. Essentially you’re paying [SP] a trend following yourself, but you’ve got added bonus that you’re gonna really make money off of their orders.
You know, I look at it this way, if you can ever get in a situation where you know that somebody’s gotta move a large amount of money, and you can get it front of that movement of money, that’s a good way to make money yourself. By getting in front of large amounts of money moving through the market.
Meb: Talked about a few different things here, but in general you’re kinda bread and butter spread trading. Where does that fit into a portfolio? You know, I mean it falls under this sort of active management. The thing that I imagine most, or I put myself in an allocator’s shoes, the big, sorta, take away for an allocator that-, and I imagine you get this on a daily basis from some very uninformed big investors. I imagined they say, “What is your risk management?”
Because, thinking in terms of a lot of these positions, really everything comes down to how you build these trades and, sort of, on an arbitrage level, you know, what is the maximum pain you can endure? Is there any, sort of kinda rules of thumb, that you guys implement, on how you structure the portfolio that says, “Hey look we’re gonna build this spread trade but if it blows out to XYZ, we’re just out.”? Or is there some, sort of like, dynamic position sizing that it’s so small, that you’re actually pyramiding into that. What’s kinda, how do you think about the money management side? Because in many ways that’s more important for a lot of systems than just straight-up buy and sell rules.
Emil: Well certainly the stuff we do is something you don’t wanna try at home. Spread commodities, spreads are very risky instruments and they are very volatile. Like, they can go from, you know, sort of, you know, very little volatility to being super-high volatile in a day or two. So it’s dangerous.
The way we mitigate risk is we diverse supply. So we try to keep our money in, sorta, very across the commodity sectors, and keep it spread around. So that no one product, if it did something radical against us, can really hurt us.
Now from the allocator’s stand point, the thing we add for them is we generate a lot of alpha that’s not correlated to what they do. So we actually tend to be negatively correlated to the trend followers. So, you know, when the trade followers get beaten up in a choppy market, that’s actually when we do our best.
And anybody, sort of, investing 101 if you add something to your portfolio that’s just, like, if you add a stock to a stock portfolio and it’s correlated, you gain very, very little. But if you can add something that has zero or negative correlation, you know, your portfolio goes way up and sort of risk-adjusted returns. So they gain a lot by investing with us because we have no correlation to any of the other investments.
Meb: And I imagine part of the not doing it at home, is not necessarily just the challenge of putting on the spread trades, but the challenge of you have to trade enough of these, so that each one only has a small percent of overall exposure to the book. Right?
So, for the challenge for the small at-home investor, is probably just because of the futures and options, they can’t put on that enough trades. Because I imagine you guys gotta have, at any one point, you know, probably dozens of different trades on. Is that right? Or do you guys concentrate on just a few, or it spread across a hundred markets? Like, how do…?
Emil: We trade a bunch of different sectors. We probably have three to five themes at any one time. And each theme might have many different positions within it. So it’s kinda complicated. The sizing [SP] of the position is complicated, to understand the risk. You also have to understand the potential risk. You know, if you’re getting to an area where, you know, there could be an explosion in volatility, like grains in the summer, or like natural gas in the winter. You kinda have to understand all these effects. So it can get complicated.
Meb: You know, it’s interesting. Because, you know, as you look through Emil’s performance, it’s one of the rare strategies that would have had an up year, in both 2008 and 2009. You can look across almost any market and, you know, almost all of them it was either one or the other, it just got decimated. But then again, there’s a couple of random years after where it had negative performance. So it’s kind of a interesting allocation that doesn’t really, like you mentioned, correlate to anything else.
You mentioned a couple of different themes just now. Are there any you can talk about or we kinda already touched on’em? Or is there anything that’s kinda currently and I don’t know the extent you can talk about the current positions, or themes, but is there anything that you could talk about?
Emil: Yes sure, I mean there’s always a little things that are going on. Like, for example there’s been some bit of a shortage recently in gasoline. And so gasoline’s been running up against some, you know, against the price of crude. So we call that a crack spread when you trade gasoline against crude oil.
And they’ve gotten to really high levels and we think they’re gonna come down so we’ve sold some of those. There’s also, there was some talk about the grains. You know, it’s the summer growing season. There was some worry that the heat was gonna, you know, cause a problem but it hasn’t. So, you know, we’re always playing the weather from that stand point.
In the energy markets it’s a very interesting dynamic right now because for example, in nat gas there this massive increase in production, but there’s also a massive increase in demand from different sources. So we’re playing a lot of these different themes.
We also look at the metals and the relative value of, like, things like platinum and palladium versus gold and silver. We look at the things like the value between Brent and WTI now that, in the U.S., U.S. you know, producers are exporting their crude, that becomes relevant. So there’s a few different themes that were working on right now.
Meb: And one of the cool parts of having talked with you a little bit, but also doing the research on y’alls [SP] firm is that, it seems like you’re continually doing research. You know, and I think the challenge, for a lot of quantitative managers is they say, “Look this is my system, and I’m done.”
But we talk a lot where markets can often structurally change over the years. You know, an example in the equity space is the huge influx of companies using their cash flows for buy backs instead of dividends, which really goes back to a structural break in the 1980s. And now there’s this hundreds of billions of dollars of funds that focus only dividends and it’s a huge mistake in our opinion.
So what do you, kinda, guys thinking about now? I mean like, if you look around the universe and think of the new ideas, and systems, and things you’re working on. Is there anything that gets you excited? Or are you guys starting to trade Bitcoin and anything else weird? Is there any sort of research that you guys are thinking on, these slow summer days?
Emil: Well, I mean, we’ve been doing a lot of work on like different things and fundamental commodities but also in the equity sector. Actually, I kind of like some of these [inaudible 00:25:19] the stocks but for a different reason I think, you mentioned. I kind of think that the shale plays are gonna keep growing for the next several years, and I think it creates a lot of opportunity. And I think some of these, like, MLPs are paying out huge dividends but I think they’re also gonna grow and I think provide a tremendous opportunities for people. Now, I just do that for myself because that’s not what we do in our firm. But I really like that.
Meb: Why don’t we expand on that? You know, talk about oil a little bit. Because a lot of investors when they think commodities, it’s oil. And if you look at a lot of the gen. 1 commodity indices, it’s like 70% energy is the index. So you’re basically trading oil. What’s your perspective?
I mean there’s been a pretty crazy last ten years in the energy space with, you know, oil well over a hundred bucks and then crashing back down because of this revolution. Give us just a couple of comments from somebody who’s kind of in that world. What’s your thoughts on oil in general and this, kinda, shale revolution.
Emil: I think the original drive to $140-something was really a case of long-only commodity funds investing tens of billions of dollars as an investment in crude oil, and other commodities. So we drove the price too high. And as the price was way too high, way up above the cost production, more money got spent on developing oil and things like that.
And as soon as that happens and it takes years for these projects to take hold, but once they do, we had way too much oil. So the price comes crashing back down, and so where we stand right now is we’re, there is overproduction still. I mean OPEC had their agreement and demand is good for oil. So oil demand is going up like a million and half barrels a day every year, but the shale guys are essentially growing by the same amount. The reason, the big thing that’s happening now is there’s a technology revolution going on in all oil drilling and the cost of finding and developing oil has just collapsed in price.
So there’s a lot of projects now, that are profitable at $40 a barrel. So that’s why the price is here and this is why a lot of stuff’s getting developed. Now, they say, I mean, it seems like in a couple of years, prices may need to go up. Because the big projects, the deep sea, the stuff that’s deep-water drilling, some of these multi-year projects, when the prices collapsed in ’15, ’16, you know, none of that stuff got approved, no new projects.
So the long-term projects, the long-cycle projects, the ones that they were starting in ’14 are getting going now and so that’s keeping us in the oil. But nothing got approved in ’16 and ’17, or not much anyway, and that means probably in a couple of years there’s not gonna be any big projects coming on stream, or very few, less than normal. And there might be another shortage of oil and push the price up. But I think the days of $80 oil, that’s a long way away because,m just technologically, the oil they are developing is all has like $40 or less break-evens.
Meb: Interesting. We have a little wheat farm in western Kansas and there’s been a bunch of people that have found oil in the region, and I’ve long wondered out of just curiosity, I don’t even really care, but to see if there’s anything underneath. So we may be exploring if the oil ever ticks up a little bit. More for fun than anything else although my brother just bought a tractor, he texted me this weekend, which is gonna be fun to go drive around on.
So you know, you gotta have more in touch with this than I do. What’s the perspective now, from professional investors you talk to on a consistent basis? Because, I used to go to a lot of the professional conferences, institutional conferences and it’s kind of humorous, in many ways, to watch the themes come in and out of favor. You know, like you mentioned, commodities were super popular in the mid 2000s and then it was the bricks, and then after 2008 it was tactical strategies and tail risk, and now it seems like it’s simply just a massive, massive shift to purely passive investing, and paying as little as possible.
What’s kinda your perspective on conversations in the institutional community particularly with a focus on commodities in general? Are all of the managers just puking out of their commodities exposure, and saying that was a dumb move? Are they, kind of, shifting their thinking? What’s, kind of, the general perspective there?
Emil: Well that’s what’s happened. So generally if I look over the last 20 years when stocks start going up and up, over a period of years, like they have. Then there’s a certain point at which sort of most people gravitate towards more and more stock investing, more and more equities in their portfolio. So they forget that stocks have their down periods.
And so, hedge funds get more inequities. And then, all of a sudden, stocks blow up, have a big down correction or a bear market and then everybody goes, “Oh, geez, we need some alternatives here. We need something that’s not correlated to our stock portfolio.” And they they get into CPAs and hedge funds and other things. So we’re in that sort of that tail end of the equity move, and everybody feels like they’re resting well with their equity portfolio and then I think there’s gonna be a down move.
And then, you know, with correlations, to me in the world, correlations are getting higher and higher on the equity side. You can’t get any diversification. And I think commodities are the one area where there is diversification, where commodities just don’t act, at all, like stocks. So I think when you get that bear market, then you’ll see the big shift back into commodities like we did 10 years ago.
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Meb: There’s a lot of things at a coincident sentiment indicators you see at various turning points in markets where you look around and kinda notice things. Like you know this Harvard has been shifting huge, major shift. One of the most impressive active managers of the past century, largely due to a number of factors, but shifting their portfolio to a much more passive investment.
We saw the other day that they are selling their, I don’t know if it’s a goat farm or a cattle farm in New Zealand. But like all these other sort of commodity and real asset investments. And, well you see that. You see after a number of down years for commodities in general. Long only [SP] You know, and a lot of these institutions throwing up their hands and saying, “Well, that was stupid. I can’t believe we got sucked into that. We’ll never invest in that again.” And that sets the stage, of course, for the next, kinda, big run. Are there any other, sort of like, if you look around at markets, you know, commodities or anything else, any other big, kinda, long-term opportunities that you think are particularly interesting in general?
Emil: Yeah, so, well I do think crude in next couple of years can’t sustain prices much less than $50, so I think anything in the mid to low $40’s a good buy. But like I look at something platinum. I mean Platinum has ran a deficit in the last four years, a production deficit. The price is, you know, in the 900s but it’s dipped down into the 800s. And, essentially, it’s below the cost of production.
So gold costs less to produce but gold is over $300 more than platinum. So you get platinum that these guys are breaking even or losing money on all their mines. And they’re not spending any CAPEX to develop anything new, and the mines are getting older. And yet, demand is probably steady or going up. So how long can that sustain itself? A year, two years? But eventually it has to go up. It’s, kind of like, a no-brainer. People are worried maybe that the main use of platinum is in catalytic converters for diesel engines and people are a little worried that maybe with all this problem with, you know, diesel engines that maybe they might get hurt. But other than that, at this price they just can’t sustain the mining of platinum. So it’s got to go up. So there’s things like that are, I think, it’s a waiting game, but it’s also kind of a no-brainer. Where, you know, just supply-demand is just not gonna work at these prices.
Meb: So you mentioned gold, is that an area that on a fundamental or sort of even on the spread-trading world, like, do you think about gold? In particular does it look interesting right now? Is it something that you don’t really have a strong opinion on? Any general thoughts there now?
I mean it’s funny because you talk about sentiment and what comes in and out of favor and almost every social-media story these days is about cryptocurrencies and is there a shift in sort of sentiment from the older to a younger generation. How do you think about gold in general? Any main thoughts?
Emil: Well gold and cryptocurrencies are in the same realm, let’s say. Maybe gold is the older generation, and cryptocurrencies is the new one. But essentially there’s some people who want to take their money out of traditional investments and want it portable or what have you. And the world’s investment pool is so large right now, you know, 100 trillion-plus, that it only takes a very small amount of that total pool to go into these, to make them skyrocket.
I mean if 1% of the global investment pool went into gold right, you know, now, it could cause, you know, a massive increase in price. And so you could easily have squeeze plays in both crude… Or, sorry gold and the cryptocurrencies. And, I’m also a little suspect of, you know, all the technological changes, especially in equities trading and everything that’s gone on in terms of QG [SP] and, you know, this big global experiment by central banks.
And knowing that everything is now controlled by computers, I think, you know, the flash crash in 2010 we could have something way bigger than that, in the future. And if that’s the case, what happens to gold? Gold could, you know, now that you can get gold through GLD in this ETFs. What if, like, a million people click on that because something catastrophic is happening? I mean you could see gold go up $1,000 in one day, conceivably because, you could put a squeeze on in the market.
Meb: You know, so that kind of goes back to the talking about front running the trend followers. I mean, another concept here is trying to identify somewhat liquid markets, that have the potential for big money to get interested and come in and, kinda, distort the demand, to where the price moves can be really strong. It’s an interesting way to think about, not just investing, but potential trends in the future where we’re saying, “Look, trying to identify markets that you know, have the potential to have these really, really big moves and positioning ahead of that.” That’s interesting.
Totally unrelated and I just want to bring this up because I asked yesterday, I did a Twitter poll and under this theme of passive investing because, it’s curiosity to me, where in some way a lot of investing comes back to common sense. So I asked people three questions. I said, “What percentage of you… Do you own U.S. stocks currently?” And it was like, 90% of people did. Then I said, “Would you own-” And the long-term PE ratio and we’re not even going to get into that, the pros and cons to that, but we use it with listeners.
We’ve long talked about the shiller [SP] CAPE ratio. It’s around 30 right now, which is expensive but not terrible, not bubble. But I said, “Would you continue to own US stocks if they hit a valuation of 50, which is the highest we’ve ever seen in the US. I think it hit 48 in the .com bubble.” I think it was two-thirds said they would still continue to own stocks where there is no probable future return on that investment. In a historical speaking, that future return is probably negative.
And then I said, “Would you continue to own stocks if they had a long-term P ratio of a 100?” We’re talking the SMP, not just Amazon. But 100 and this is what Japan hit in the largest equity bubble we’ve ever seen back to the 1980s. And it was like 30% or 40% said they’d still continue to own stocks even, if they traded at a P-ratio of a 1 or 2 [SP]. You got a lot of players in this world that are like, kind of, we were talking about commodity markets earlier that are not necessarily price sensitive, and that creates a lot of opportunities.
Emil: Oh, but they are.
Meb: [inaudible 00:40:34] I think in your world.
Emil: They just say they’re not. They’ll pay a 50 PE, and they’ll pay a 100 PE and look at Amazon and Netflix and all this. But if you get to those ridiculous valuations and then margin [SP] usage gets to more and more record highs, and things like that. And then when things turn, you see everybody go, “Oh no, now what?” and there’s the race for the exits and then everybody who convinced themselves it would never go down, starts getting scared. And you know, that’s the whole market cycle. I mean look what happened in real estate. Everybody thought real estate could never go down and then 2008 happened. So I think you’re gonna see some ugliness in the cycle. Not sure when it’s gonna happen, but for sure we’re in the later innings of this bull market.
Meb: You know, it’s interesting. Everything is kind of old and new again as you watch these cycles and it appears in different places of course. We talk a lot about investment bubbles. I’ve written some papers on it and you see some kinda coincident indicators like the Canadian real estate has just been bananas. But of course you see Tony Robbins and Pitbull doing real estate, the seminars in Toronto. Things like that you only see when people start to behave crazy.
So, you’ve had a couple of decade career, where have you seen most investors make, kind of, their biggest mistakes, particularly with the lens towards your world of managed futures, spread trading, commodities. What’s, kinda, the basic mistakes or biggest mistakes you’ve seen not just individuals, but also institutions, make over the last two decades?
Emil: Well, they jump on the bandwagon. So, you know, prices get high and they wanna be in on it. So stocks are high, they got to get more into stocks. If commodities are high, they want to get more into commodities. Then when things flush out and hit the lows then they’re like, they don’t wanna be long anymore. So they are sheep and, people always say, you know, “I wanna buy good value things.” But they don’t. And as a group you see this massive boom or bust thing and investors are really bad for that.
They wanted to get in on the thing that’s going up, and get out of the thing that’s going down and sometimes…now that’s fine if you’re a trend follower and you have a, sort of, a methodology that you follow mechanically and you know that that’s tended to work over decades, that’s fine. But other than that, I mean people get in on these bubbles and then they get flushed out. And I think that’s the biggest mistake people make.
I would say now, too, I mean there’s a real changing environment in terms of, like I said, electronic trading. You know, if you look at the flash crash in 2010 and you think how much more things are controlled by computers now than they were in 2010. And 2010 was based on nothing, like virtually nothing. What happens when there’s a real event that happens and what happens when the computers all pull their orders at the same time everybody’s trying to sell. I mean, things could happen that you’d never even envisioned. So people should be careful.
Meb: I was thinking about writing an article about that and, you know, the way that most money managers will talk about, particularly if they’re under performing or if an asset class is doing poorly is, they’ll write a paper and they’ll say, “We’ve seen this before. You know, stocks have underperformed, foreign stocks have underperformed, U.S. stocks or whatever, for X period and this has happened before,” and try to calm their investors.
But, one of the things we often think about is we say, “Well, look, at some point something is coming that we haven’t seen before. You know? Where the definition of draw out is the largest one will always be in your future.” And so, you know, as we talk about quantitative systems I think Cliff Azenath has a great quote where he says, you know, we take a look at a lot of the historical simulations and performance, but we say, well, take a good look at the draw-down number and double it because, at some point something will happen that is far worse than what we’ve seen before. And I think the importance of history, of course, is to have some expectations but also to realize, “Hey that’s just the base case, and things could certainly get worse.”
Emil: In commodity spreads this is a common occurrence and we’ve actually done testing on things that have exceeded the 30-year history. So something has gone beyond the 30-year history so outside of the realm of modern history.
We saw, like, 200 cases in commodity spreads like that and we would measure how far beyond history it went. And we saw things that would, let’s say you took the last 10-year range and you call that X. We seen things that exceeded the historical high by 10 times the 10-year range. Like, astronomical amounts. And it happens all the time and we try to build a model on how to profit from things when they just blow out, and blow everybody out and how can you make money off of that.
Meb: That’s interesting. So is the kind of solution that one, keep the bet small in the first place but windows, extreme events occur to come in as well? You know, I mean, though I think the classic example that we can all remember, and the younger podcast listeners may or may not be familiar with. But, long-term capital, you know, certainly in the late ’90s, putting on a lot of the relative value trades. But I think they were also leveraged like 70:1 or something, so there’s another lesson there.
What’s the famous book on that? Is it “When Genius Failed” I think?
Meb: But a great book. We’ll add it to the show notes, I can’t remember. But Emil, any comments or thoughts there? That seems like a ripe opportunity but also kind of hard to quantify, but I guess if you just simply say, lookit, if it ever hits the fan at 5 or 10 X we’ll put on this trades in the opposite direction.
Emil: Yeah, and the whole thing about long-term capital management is it’s based on assumption that everything happens in a normal orderly fashion. The fact is, if people think a price of 10 is too high and it goes to 11 and 12, and 13 so they sell more and more and more, like on a relative value. Then what happens when it goes to 20? Well, I’ll tell you, when it goes to 20, it goes to 30 because all the people got in between 10 and 20 get blown out and have to buy back and then it goes to 30. So these things are not normally distributed as people would say.
They have big tails and they do way more wild things than you would expect, especially when you’re talking about relative value plays. And, you should expect the unexpected. I mean, you should look for the fact that, what you see as the normal historical range. You know, things are gonna go way outside. And when they do, they tend to go way beyond it. And how you take advantage, is when everybody gets blown out, let’s say something’s going up and up, and people are selling it.
When everybody gets blown out, so the people who thought it was too high, when they get forced out of the market, then it’s time to sell. But only a little bit, you know? Don’t overdo it because you know, you never know, how many… like I said in most cases when we tested it they only went to 1 or 2 times the 10-year range. But we’ve seen situations where it went 10 times. Like, just absurd numbers, and so you, you know, you just got to be careful, I guess.
Meb: One curiosity for a lot of people, you know, you talked to the value guys and Buffett, he’s like, “I was born a value investor.” Some people self-harm [SP] and it’s like, it’s just innoculated. There are certain people that tend towards a certain style. Like, how did you eventually settle on developing this style? Was it something that you had a mentor that, in the early days of Prudential or whatever that, kind of, taught you this type of trading? Did you develop it, kind of gravitate totally on your own? Like how did you end up as a spread trader?
Emil: Well, it happened because of all this money moving into long only commodity funds and I realized this created an arbitrage opportunity with the roll. So I started out just doing roll arb, you know, over 10 years ago. You know, taking advantage of that. But then I started realizing that there’s tremendous opportunities in commodity spreads and we started looking at all different angles, and just developing them. But it all started with roll arb.
I just knew, that everybody, all these guys were rolling their positions at the same time, and it was kinda, I don’t know about easy money, but it was very predictable what the markets were gonna do. We were sort of an early adopter, so we were able to make some decent money off of that.
Meb: I’m blanking on this. It’s early in the morning. We had our book happy hour last night so I’m a little cloudy. But there was a great fictional book about a rebalanced trade that was about, I think, Japanese equities. Maybe it was Ben Mezrich. Jeff, ring a bell? Emil? Does that ring a bell?
Meb: I’ll Google it and it to the show notes, but it’s a fun book. It’s fictional and it talks about, it kinda puts a, wraps a story around this topic that we’re kind of talking about.
One or two more questions because we’re gonna have to let you go. I’d love to keep you all day because this is a fascinating area, we haven’t really talked about that much, on the podcast. What’s been the most memorable trade for you over the past two decades? It can be good, it can be bad. It can be painful, whatever it maybe. We ask all of our guests this. Is there anything that comes to mind as the most memorable trade over your last two decades.
Emil: Okay, so I had a situation. This is bad trade, where I was short…
Meb: That’s the best type. Everyone loves talking about the best one it’s a little cathartic. Like, I feel like it’s like almost a little of a therapy session here.
Emil: Yeah, I was short a bunch of cattle options. A large number and on the last, now the way cattle works is the last day of the month was the expiry of the option, and then the next day is first notice day, and then position limits go down. And I had a big position like 2000 so on the last hour of the last day, when I thought the options were gonna expire worthless, they blast through my strike price and I gotta sign, I’m short these options and I gotta sign on 2000 of these, I’m short 2000 cattle contracts.
But first notice day is the next day and I can’t cover ’em because it just all happens in the last hour and so first notice day, position limits go down to 200 from 2000. So now I’m ten times the exchange position limits, and I have the, you know, the CFTC calling me. But I’m like, something happened in the cattle market at the exact same time as that happened and the market was limit up [SP] on the Monday. So it’s first notice day, I get exercised in the last hour of trading and now it’s lup [SP] limit and I’ve got ten times the position limit and I can’t get out. It then goes up, limit, the next day and the next day, and the next day.
Meb: My palms are sweating listening to this.
Emil: Seven days, it had never done that in history. Seven days it went up limit. Eventually it started trading again and we exited the position, and you know, I was doing this for a customer and we have made a lot of money for that customer, but we keep a lot back on that trade. It was just like a horrendous situation. But the funny thing is, I said to my partner at the time, I said, “This price of cattle’s ridiculous, let’s just sell some cattle before we go home for Christmas. Just, you know, just in our personal accounts. Now we’re out of this whole debacle, let’s just…” And mad cow hit, and the price of cattle collapsed and we made a fortune.
Meb: Well, at least there’s a happy ending. I love it. That is my co-host Jeff’s ears start perking up anytime anyone talks about options. He was getting excited listening to that story. All right, so this is a challenging, a lot of these strategies require, I think, a lot of deep knowledge of markets.
But let’s say there’s people that are listening and they want to start to learn more. Are there any resources? I mean, I remember in my younger days buying the yearly CRB commodity yearbook. I think it was probably because Jim Rogers was talking about it and used to buy those and pour through the CRB.
What are some resources for someone who in general just wants to become educated, learn a little bit more about your world? Are there websites, books, podcasts, anything you think might be of interest.
Emil: Yeah, I mean, there’s books but most of the ones I’ve read in commodities are not that good. So I’m trying to think now of books that I think are good. On the equities side, I like all the ones on factor-based investing. I think they’re excellent. I think you gotta, like, “What Works on Wall Street” by O’Shaughnessy. You know, this kind of thing.
Because I think an investor can do very well if he just uses the science of value investing, let’s say. You know, sort of like what Buffet does, but just play it by the numbers. I don’t think you need an index or anything like that and I think you can routinely outperform the market.
On the commodities side I think it’s a little bit tricky. Although I do think if you buy and hold and do your homework and don’t overplay it, like I said, in platinum, we did our homework, we know it’s underpriced. Whenever it gets like 850 or below we buy it, and that kind of thing. You know, any investor can do that. But you just got to do your homework on it.
And I don’t know too many good books in the area, I mean, I think I’ve gone through them all. You know, there’s all the classic trading books like “Reminiscences of a Stock Operator” and stuff like that. You know, and the books on top traders, “Jack Schwager wrote a couple of books. I love those, but a lot of the ones that teach you to trade commodity spreads, just kind of make me shake my head. So, not too happy.
Meb: No easy answer, certainly in markets, but we maybe getting a bunch of interns starting to email you and say, “We want to learn from you.” Emil, this was a lot of fun. I would love to keep you forever. If people wanna follow you, if they wanna learn more about you, what you’re up to, what are the best places to go? Where do they look?
Emil: Well I mean, we have a website but it doesn’t really allow you to sign up because we’re for credit investors. But if anybody wants to call me or email me we’ll be happy to sort of find a way, put you on our distribution list, that kind of thing, firstname.lastname@example.org is my email. and anybody can message me there.
Meb: You just asked for it. You better clean out your inbox. Emil, thank you so much for taking the time to chat today.
Emil: Okay, thank you. Appreciate it.
Meb: Listeners, it’s been a lot of fun. Thanks for taking the time to listen. We always welcome feedback. Questions in the mailbag at email@example.com.
As a reminder you can always find the show notes and other episodes at mebfaber.com/podcast. You can subscribe to the show on iTunes. If you’re enjoying it, please leave a review. Thanks for listening, friends and good investing.