TDI Podcast: Risk Happens Fast (#976)

0:01The Disciplined Investor is all about you, your money, and the markets. Sit back and get ready for this edition of The Disciplined Investor Podcast.

0:11Steve Sosnick:This episode of The Disciplined Investor is sponsored by Horowitz & Company. If you're looking for a portfolio manager, look no further. Horowitz & Company, from seed through harvest, cultivating financial success.

0:30Hey, buy in May and, well, let's stay. Market concentration, getting more concentrated. Eco reports, well, they're looking kind of fresh. Good stuff out there. And we're looking into the ratchet trade with our guest today, IBKR's chief market strategist, Steve Sosnick. All this and much more on episode number 976 of the Disciplined Investor Podcast.

1:12And hello and welcome to this edition of the Disciplined Investor Podcast. We're here in the middle of, well, the start of April. Let's start again. We're in the start of June. I don't know where I was thinking, but we are in June now, almost halfway through the year, which is pretty amazing considering all the things that have gone on. Markets are up and doing really well against the odds. The fact of the matter is that we look at what's happened this year. You got to wonder, how is that possible? Well, we'll get to the bottom of some of that with our great guest today. Looking forward to speaking with him.

1:42In the meantime, I'm Andrew Horowitz, and I am the host of this show. We know as the Disciplined Investor, where we spend our time each and every week trying to figure out how best we can get towards that area of, well, nirvana financially. financial security, financial independence, and making sure that we get there in a steady way and a way that makes sense to all of us. So hopefully you're learning, you're knowing more about what happens in the market each and every day that you are looking at things and you're doing the right things by making the decisions that the future you will look back on the current you and say, you know what, that was a smart person right there doing what needs to be done to make sure that me and my family are taken care of.

2:29Now, I hope that you're doing things that are smart. I hope you're doing things that are wise tax-wise, investing in your 401ks, making sure that you're not in a target allocation fund necessarily, that you're spending your time diversifying, as we talk about quite often, in areas of the markets that make the most sense. And that's an important thing. It's not always easy, but it's important. Spending a little bit a time, whether it's maybe even once a month, looking at what it is that you have in your portfolio and if, in fact, it's the right thing that fits not only for the current times from an investment standpoint, but also and more importantly for you, for your risk tolerance and your time horizon.

3:09Those are the key elements of what it takes to put together a proper financial plan. And we talked about that before. We talked about our flower garden, our one foot in, one foot out. We talked about the lobster trap mentality. We have talked about so many different ways for you to orient yourself and understand better to kind of take all the jargon out of what you hear on other shows and really try to put it in a way that's understandable and gives you confidence that what you are doing is right for you. So that's kind of a backdrop of what we do here on the show. And when we talk about things that are going on in the markets today, it's not necessarily to get anybody to make instantaneous moves or changes in what they're doing.

3:57But what it's all about is making sure that you are educated. When we talk about the economics, we talk about the earnings. We talk about things like how the impact of the war, the oil prices, what's happened there is going to affect various things. We talk about consumer sentiment. All those things are put into a giant pile. Well, the riddle that is formed and then the answer that comes out of it is all about making sure that you're educated and can make proper decisions for the long haul, not for the short haul. Not for tomorrow, not for the next day, but for many years to come. What I want to do today is I want to spend a lot more time with our guest Because he is a key individual when it comes to understanding what's going on with markets Investments, behavior, and all areas and aspects of what's happening But more importantly, he's someone who is actually day-to-day doing it He's on it He's writing, he's researching His name is Steve Sosnick.

5:01He's the chief strategist at Interactive Brokers. He also serves as head trader at IBKR Security Services, which is the firm's trading division, which was formerly known as Timber Hill, by the way. He's a member of Interactive Brokers Group, and he's part of the firm's holding company. Now, he's served numerous roles in the organizations since joining Timber Hill in 1995 as the equity risk manager and as an options market maker. He led the team firm in Canada in 1998, managed Timber Hill Canada throughout his existence. And much of Steve's career was spent quietly developing and implementing algorithmic and electronic trading strategies for stocks and options before moving into a more visible role as chief option strategist and later now chief strategist.

5:53He's been all over. You've seen him on Bloomberg and Redmond Barron's. He's been on CNBC. He's been everywhere. So I thought this was going to be a great opportunity for all of us to find the wisdom and understand and have the wisdom imported to us from someone who lives it, breathes it, and does it on a daily basis. Let's get right into it. So Steve Sosnack, it's wonderful to have you on, Chief Strategist for Interactive Brokers. I really appreciate you spending some time with us today. My pleasure, Andrew. It's great to be here. So I have a lot of questions. I have a long laundry list of things I want to talk about.

6:29So I thought we would warm it up and warm the discussion up with a kind of a discussion of your background, how you got here, why you do what you do, and how you deal with the markets on a daily basis. So you've lived through some wild markets, right? You've been doing this for a while. This isn't something you just started last year. I wanted to kind of go back and maybe ask you, what are some of the things and times maybe over your career that really stood out to you? And in terms of markets or times? Well, it depends how far back you want to go. In August of 1982, I was a summer intern at a firm called LF Rothschild Unterberg Tobin, which no longer exists.

7:16Because the name was well too long. Yeah, partly. But what was fascinating then was I happened to be there when Volcker basically said, we're no longer restricting monetary policy. And I just remember the place exploding. And that was one of the most explosive moves higher that anyone's ever witnessed. between finishing school and graduate school and some other stuff. I, you know, one of my first professional experiences once I'd finally, you know, I realized I liked the trading floors and was working at Solomon Brothers at the time. So shortly after I'd gotten my own book, I was greeted with the crash of 87.

8:01So then I saw five years later, pretty much, the end of that euphoria in a very nasty way. Obviously, since then, there have been a lot of other ups down sideways. I joined Interactive Brokers a little over 30 years ago, the predecessor firm, Timber Hill, which was an options market-making firm, not all that big at the time. Within a few years, we became the largest options market-making firm, and I had a role in managing the risk and managing the positions on those books. But as we became more customer focused, started to branch out, realized I liked writing about markets, talking about markets, being interviewed about markets.

8:42And so here I sit more as a talking head, but with a long background in proprietary and customer-based trading. So that was a great time. So 82. So So I think it's fascinating that we pay such attention to the Fed. Why? And it took me a long time to really get this into this thick skull of mine, is that they have all the money. I mean, that's basically it, right? Even though they may not be right, even though they may not do what they say they're doing necessarily, just the notion of it is that they have all the money. Well, I mean, I just gave you two examples of the Fed completely influencing the market.

9:27Number one was Volcker had been running a regime of higher interest rates to knock out the 70s inflation, which is quite understandable why he did that. And it was quite also understandable why the market reacted so violently to the upside after essentially four to five years of extreme monetary repression, which the Fed could could do. Also, 1987, that was the birth of the Fed put. People don't realize that. But it was born during the crash of 87. And it's not born, it was not, neither of these measures, by the way, was done to help the stock market. Although certainly the Fed put was born out of the stock market crash.

10:12It wasn't because stocks were going down. It's because the banking system was having trouble as the result of stocks going down because you had various trading firms that were probably unable to meet obligations. And in a five-day settlement window that you had at that time, it was going to take a long time for the dust to settle. And the Fed basically said, we will provide whatever liquidity we need. And I happened to be on the trading floor when they stepped in and basically backstopped major firms such as definitely Solomon. I'm pretty sure it was Goldman and Morgan Stanley at the time as well.

10:51Backstopped them to basically put a tourniquet on the market that was crashing, not on Black Monday, but on the next day, which was actually worse than the crash. but because again, the panic was ending, market turned around and came off its lows. So it's not remembered as being as bad of a day, but that's when the Fed intervened. But again, they intervened in the stock market, but it was not to protect the stock market. It was to protect the clearing system that was being threatened by the stock market crash. Yes, they're the big dogs and they are. Do you remember where you were for these different events?

11:30I was 87. I was just starting my career, by the way. And I remember being there and I'm like, I don't get it. Like, you know, it was like it was just happening so fast. And I was just beginning to get involved in the financial services industry. And it was like everybody's freaking out. I didn't have a lot of money to talk about being invested inappropriately or appropriately at the time. So I didn't either make money or lose money on it. So it didn't matter to me. Right. That was the glorious part of that. But the lesson was very clear and ingrained in my head. And we had other things. Right.

11:59You know, you fast forward to the 2008 financial crisis, which again was a backstop by the government on all this. And then the COVID crash of 2020 was a little bit different, but similar feeling. And then we had the Volmageddon. We had the flash crashes. We had, what, taper tantrums, right? We had all these different things. So I guess I'll ask you this. How much then in your career are you influenced by the idea that the government is, in fact, extraordinarily, you know, very much involved in what goes on? I mean, how much of a on a daily basis is the government overlay part and parcel of the markets?

12:48Well, you know, bearing in mind that the Fed is an independent institution, but if we want to think of them as governmental, Fed and global central banks are critical because what is the main ingredient to financial markets? Money. Who controls the price of that key ingredient? The central banks, right, by their interest rate policy. So, you know, if you think of the financial industry having a raw, you know, there's basically two raw materials, money and people. They don't control the people, but they do control the money and they control the cost of how much. And so they control the cost of the main raw ingredient for the financial system.

13:28So, yeah, of course, you know, if you think, you know, right now we're all up in arms about, you know, the price of the price of oil because of the situation in the Gulf. Right. Right. But if you think, you know, so the main ingredient to the energy industry is under some price pressure. If if you think about if you think about the financial industry in those terms, if you know, if the Fed lowers the price and I'm just speaking, I'm just going to use the Fed. But it applies to ECB, it applies to Bank of Japan, it applies to global central banks. If the price of that input gets cheaper, meaning that it's more plentiful and has lower cost associated with it, meaning interest rates, then that's generally good for that industry.

14:13If the price goes up or the quantity is constrained, that's generally not good for this industry. What we're seeing now is a little bit different because we're basically seeing the market telling us that they don't care that the Fed might have moved toward a regime of tightening rather than a regime of easing. And for the first time in quite some time, markets are telling you, we don't care.

14:41But markets don't seem to care about anything right now, do they? Oh, no, there's a ton of nihilism. To be fair, they do care. They do care about earnings and guidance. And I will say that we have seen a huge string of earnings and guidance come through since April. April earnings season was phenomenally well received. And it should have been. I mean, it was pretty amazing. Yes. Now, to be fair, markets were already pricing in about 10 % or 11 % earnings growth. They got, call it 14%, 15%, which is good. I'm not sure that it's slingshot rocket ship good. And I do get concerned that some of the guidance that we hear about is being extrapolated.

15:29They're telling us to expect good guidance for the next quarter or two, which is wonderful. We stipulate that's what we want to hear. But I do get the sense that markets are a little too willing to extrapolate one or two quarters worth of good guidance into three to five years worth of good guidance. And I think that's why you're seeing stocks, you'd get good guidance from some of these companies in the past, and they would go up 5%, 10 % after earnings. Now you're seeing 20%, 25%, 30 % routinely, which is telling me that it's not just a cold calculation at the back of the envelope spreadsheet type of calculation.

16:14There's an emotional component or there's just sort of an over extrapolation of good news component or just, you know, people willing to see, OK, this stock's up X. We're going to just chase it up X plus whatever. So all that is going on, I think, around the same time. But I don't know if it, you know, we'd usually try to explain it from a short squeeze. Right. But there's not a huge amount like Dell doesn't Dell doesn't have a huge short position on it. It's You know, it had some, of course, but maybe that was going into the earnings. They could have flipped it overnight. People would have probably protected it with some options.

16:46But the fact is they went up 30-something percent, which, by the way, they were great earnings, right? But I agree with you, this whole extrapolation, and we're going to use Dell as another example, and I want your opinion on this. So back in the day, way back in the other day, there was another Dell phenomena. The phenomena was Dell, before it was taken private, if you remember, it was the, you know, for years, it was uh you know the poster child for success for computers for computing for personal computers and what happened back then if you recall there was uh analysis done an extrapolation done just like you said that's going to go on forever in fact if you took it and you went to the extreme everybody would have to have about three or four pcs on each of their desks to extrapolate out what they were predicting they would sell which we realized was kind of like that's stupid right Right.

17:37Is that kind of what you're talking about? That whole idea that this continuation of what's going to happen is is probably not possible? Well, I mean, you know, here's the thing. This this whole market right now is being driven by the amount of the billions of dollars being spent on AI and that build up. You know, to me, the biggest fragility is if Sundar Pichai or Sachin Adela or someone in that situation says, you know what, maybe we're going to slow down this spending a little bit. I don't want to see what happens as a result of that. But that, to me, is the single biggest point of fragility.

18:18But just thinking more broadly, you know, we've always had big market moves around the periods when new technologies were being adopted. And this is, you know, yes, we could think about the internet. Yeah, we could think about the 80s, the mid-80s PC enthusiasm, which actually in some ways led to the, you know, led to the conditions. That was one of the things that led to the enthusiasm that eventually ended in a crash. But before that, right, there was the nifty 50 phenomenon of the 70s where you had all these great new technology companies like Polaroid and Kodak and Xerox, a little theme here, that were going to just dominate the world forever.

19:04You go back to radios, RCA being the NVIDIA of its day. Radio Shack. And railroads, I mean, this happened, this is human nature. And we see this every few decades or so when there's this big technological achievement that I will stipulate is incredibly transformative and ultimately good for the economy and society. but we extrapolate too much good news into it. At the risk of overdoing, let's say, the internet example, I'm going to rattle a few names at you here, because one of the things that we needed for the internet was a lot of bandwidth. And I will stipulate that that bandwidth was necessary, that we're still using a lot of that bandwidth, and that the build-out had to occur in a very rapid manner.

20:00So you had market leaders like Global Crossing, Northern Telecom, Lucent. I got all the symbols coming up my head as you're saying this, by the way. World Cup. I mean, they're all gone. Yep. I mean, I'm not saying that a lot of these internet companies will be gone. You know, I'm sorry that the AI companies will be gone. But we get these massive, you know, we misallocate capital sometimes at the peaks of these frenzies. And the question now is, are we closer to the, you know, from internet bubble terms, are we in 1995 or 1999? And I will say, having been in a bull market for three and a half years, that literally coincides with the introduction of ChatGPT.

20:51it's hard to say that we're in the early inning of this. And that's what makes, that's what makes some of these comparisons a little bit nerve wracking, shall we say. And the question is that there was also a stream of other companies that during that period, we didn't know who the winners and losers were right. You know, and everybody was a winner until proven otherwise, you know, I will mention a couple of names just to throw in your basket of non-existence like a web van and a peapod, right. That's the same thing. And we have difficult to really figure out who that's going to be. Is chat GPT going to be the number one?

21:27Is perplexity clawed? Or who knows what is going to be the number one? Or is any of these going to be just taken over, taken out, and by the wayside? Excellent, excellent points. But I think everybody's betting that everything stays. And everybody is profitable. And that the existence of these are morphing into something, whether it's going to be put into robots or utilized to create unmatched wealth for all of us by just sitting around. And I don't know what we're going to do. Our agents that we program will just watch them stream money to us, I guess, or something. I don't know what's going to happen.

22:06Well, there's a few elements in there. Rather than picking on, let's say, Webvan or, you know, or Pets.com or something like that that didn't make any money. Right. Let me stipulate that these companies are making money. And let me stipulate that I'm going to, you know, the ones I focused on, you know, Nortel and Global Crossing and things that were phenomenally profitable at the time. They were. Yeah. They just, and so, you know, not to this degree, but again, these were profitable companies. But just to show you the example of how technology changes, at 1998, 1999, I think the basic model was that we were going to connect via the newfound bandwidth, which we did.

22:53And our portal was probably going to be AOL, and our preferred search engine was going to be Yahoo. And we might still get our mail via CompuServe. These are technology moves. As we sit here now, ChatGPT got the whole theme of generative AI going, but it's not clear that they're even the leader now. It looks like they've probably been surpassed by Anthropic and Claude already. So these are very fast moving technologies. Let me also stipulate that, you know, Microsoft, I'm sorry, not Microsoft, that Google and Facebook did not exist during the Internet bubble. Yet they came essentially to dominate the Internet later on.

23:37Um, so, and, and I don't think most people had internet as advertising vehicle necessarily on their bingo cards for how this was going to be the profitable venture. Right. Uh, so, and also the key was it took a long time for the benefits of the internet to reach the bottom lines of end users. And right now we're still seeing that build out, but it's not, everybody's trying to put AI to use. Companies understand it. We understand it, certainly as a company. But you hear things like token maxing, where companies might give a perverse incentive to programmers to use as much AI capacity to show that they're using it, but not necessarily using it well.

24:29Or you take it down to its next extreme, which would be, okay, we can eliminate all these you know, maybe junior coders or junior spreadsheet filler-inners or legal brief writers, you know, because it's, you know, the AI can do a lot of that for us, which it probably can. And then we'll just have, you know, more experienced people, you know, checking the output for errors. The problem is, if you don't have people who've done that, who's going to know to check it for errors? So in the short term, yeah, that works. In the longer term, what do you do, right? I mean, you know, do you just, do you just have like, you know, uh, legal bots trading other legal, legal briefs with other bots and nobody really to check the mistakes because nobody, because you haven't, because, you know, as a junior lawyer, you haven't been working 75 hours and having your, your boss yell at you because you misplaced a semicolon.

25:23So these are things, you know, you learn from, from this scut work to some extent. And I think if we, you know, as a society, we're going to have to adapt to that. And this is part of the process. Any new technology brings change. That's okay. And we like that, right? I mean, you know, automobiles put a lot of, you know, buggy whip manufacturers out of business. Are we worse off as a society? No, we need to adapt. But the period of adaptation is not always necessarily smooth sailing. Sure. So I want to, I want to reel us back a little bit. I want to talk a little bit about your process. I want to talk about investing.

26:01I want to talk about something that you brought up and I read about and I thought fascinating, this ratchet process. And, you know, funny, the word ratchet has multiple meanings, right? For us more seasoned gents, ratchet means ratchet, right? The younger people, ratchet means disgusting, foul, and horrifying. And I think they actually, somebody along the way misspelled it and thought wretched was ratchet. And that's where I think the genesis of that particular word. I've tried to explain this to a lot of people and say, you're looking stupid when you say this, but nonetheless. Every day, I want to talk about market behavior.

26:41I want to talk about investing. I want to talk about what you do. You sit down each day and you think about what's going on out there. What's kind of the first thing that you will look at? I mean, the first thing I look at is basically, you know, turn on my trader workstation and some of the other apps that I use to check markets and see what just see what's going on. I've got a, you know, I've got a watch list. I'd look at overnight. Basically, I look at the base, look at the basics first overnight futures, you know, S &P and Q, you know, now that VIX trades to a certain extent overnight is their movement in the VIX, but more importantly, you know, two and 10 year yields to the extent they've changed overnight.

27:23Certainly I'm looking at oil a lot more than I used to. And so that gets me the general tenor of what's going on. And should I be concerned about too much based on some of these movements? Lately, we've been getting some conflicting symbols and that's where that ratchet effect comes into, but I'll get into that in a little bit. But to answer the question of what am I looking at, then I'll start to look at what's moving, what's making news, what stocks are making their moves, and then can I draw any patterns from that? And that's the part that's a little bit harder. So, for example, I recently wrote about patterns that last week, the prior week to taping this, the S &P had its ninth straight up week, which, you know, let's talk about a pattern.