Jason Hartman: Welcome to the Creating Wealth show. This is episode number 272 and this is your host Jason Hartman, thanks so much for joining me today. Well thank you so much for all of you who have registered to join us for our Creating Wealth boot camp in Atlanta along with our Atlanta distressed property tool. We are getting lots and lots of registrations for that and we usually get one or two every day, so it is just plugging along nicely and I’m glad to see a lot of you taking advantage of the early bird discount. So that’s fantastic, so on this show today we are going to have a caller from Australia and we are also going to talk about the counts and dark pools and what that is all about is that is about high-frequency trading and all of the stuff that goes on Wall Street that continues to amaze me. And I hope it continues to amaze you as well because it really is incredible. And I think you’ll find this guest today to be very, very insightful, so we will have that in just a moment. But on the last episode, on episode number 271, you know I talked to you a little bit about organizing your income property portfolio and I promised after talking about the acquisition file that legal sized files and we are talking about good old paper files here, but we also of course use software in our real estate investing business. But we are just talk about good old-fashioned paper files here and today I’d like to just talk to you for a moment about the operations file.
Now the operations file is the file you will use often, so you want to keep this and a physical drawer somewhat near you. Of course you can scan it and you can use it within the property tracker software which I highly recommend or you know some people just like a good old physical file and I got to say I consider myself to be fairly techy. But for some things I just like old-fashioned paper that tends to work well that way. So with this physical file and this is your operations folder, this is the one that is letter-size, so 8.5/11 and it is a classification folder. So it’s got six tabs to it and the way you organize those tabs very simple and this is a continuation again of last episode where I talked about the other file that goes with it and that is the acquisitions file. So in this one, tab one you will have your HUD one closing statement, a description of the property and many photos of the property, copies of maybe a plot plan of the property and a change of address receipt from the U.S. Postal Service.
Now I always recommend that you do those change of addresses for your properties because if statements get sent to the properties and of course you don’t occupy the properties right. You live somewhere else because you’re following my advice to invest in properties that make sense. So you can afford to live in a property that doesn’t make any sense. In other words a nice high-end property for yourself, but lots of bread-and-butter properties that you rent to other people whether they be single-family homes or apartment buildings or fourplexes or whatever. So you do that change of address so that mail is forwarded to your either PO Box or the place where you live so you get the mail for that property. Tab number two, mortgage statements on the first loan on the property. Tab number three is your warranty on the property and any property tax information. Tab number four, mortgage statements for the second loan on the property or and/or your insurance information, Homeowners Association statements if you have a Homeowners Association and utility bills and then tab number five is your monthly property manager statements that you get from your property manager or if you are self managing your property, any records you use to keep track of that. And tab number six are your contracts with your property manager if you have one and your tenant leases and maybe the tenant application as well. So there you go, there you have it your operations folder, the one you will reference probably at least once a month and that acquisitions folder is sitting in a bottom drawer. You know those gold bugs, they are always bugging me, those gold bugs and I don’t know why I just have a thing for them. I guess they just bug me because they are so illogical and the lack of logic in the gold bug world never ever ceases to amaze me and I want to remind you that Peter Schiff I am a fan of Peter Schiff, but I also want to hold him accountable to something. Peter Schiff said by the end of Obama’s first term gold would be $5000 an ounce and better hurry up Peter because we’re not even close to $5000. Gold has got to triple or kind of more than triple to be at $5000 an ounce every gold bug you talk to if you ask the question is the price of gold going up or the value of the currency in this case the dollar, is it going down they will unanimously say and then this is a trick question by the way on my part, they will unanimously say that it’s the dollar that’s going down. In other words the metal this silver, the gold whatever the commodity is for that matter but usually silver and gold we are talking about that is simply keeping pace with inflation. They will say that to you every single time. So I ask you this. Now I don’t think Peter Schiff is going to be right. But even if he is, if gold goes up to $5000 by November, the end of Obama’s first term and I hope the end of Obama’s presidency in general, but if it goes to $5000 what will happen to the value of your debt on your income properties.
Let’s see gold, let’s just say gold triples in price. That means the destruction of your debt if the gold bug argument is correct and I actually believe it is, it’s not gold that’s going up. It’s the dollar that’s going down. That means your debt will be decimated by two-thirds. That means you’ll have a huge 66% reduction in your debt. Wow amazing. If you will a $1 million against your income property, you will after gold triples in price, not in value just in price in nominal dollars, not real dollars because there hasn’t been any real gain. That’s what gold bugs will tell you, right. After it triples your debt will decline massively. Okay, so you will owe far less than what it says you owe in real dollars. In nominal dollars, of course it will still say the same thing and I just got to point that out. I want to remind you let’s see if Peter Schiff is right, see if by November gold is $5000 an ounce. I don’t think it’s going to happen but if it does, our debt is going to be dramatically reduced against our income properties and the value of the commodities attached to that debt will have kept pace just like the gold with inflation, with the devaluation of the dollar. So that’s that. Okay hey let’s take a caller from Australia and thank you so much for calling into the show. By the way be sure to do this and I want to just tell you I know some of you are kind of shy out there and you may not want to call into the show but remember it’s edited in post production. So if you say anything silly or you know you got too many uhms and aahs in there, out editor will fix that up for you. Okay, so it’s not like calling into a live radio show. That’s one of the other beauties of it. I hope that takes away a little bit of your reluctance to call into the show. It’s easy do it, call into the show. We want to have you calling in and asking questions and participating and contributing to the show. So please be sure to do that. Anyway let’s take a caller here and I’ll be back with you for just a moment before our guest. Hey it’s my pleasure to welcome Stephen to the show, he’s calling from Australia. How are you, Stephen.
Stephen: Yeah. Hi Jason good. I thought I will just take you up on your opportunity to call in on Scott and I have a question for you.
Jason Hartman: And thank you so much for calling. We love to get a lot more calls I haven’t really pushed that yet but you’re one of early few callers, so how are you doing?
Stephen: Yeah I am good, I’m calling you from the Sunshine Coast [PH] in Australia and I listen to your podcast and find them very helpful. I had a question, you had a guest on a little while ago and he was talking I think he is one of your investor clients who was talking about being in an advantageous position if the banks too go into a hyperinflation by earning multiple rental income earning properties and not being too financially intelligent, I wasn’t really clear as to why it is advantageous to own multiple rental income properties if we go into a state of hyper inflation, and was seeking some clarification on that.
Jason Hartman: Yeah actually a great question, well there are two main reasons and really there are three. So the first thing I would say is what are the options out there. Most people would say in an inflationary environment you know you want to own gold or precious metals and I think then and you like you’ve heard me say on many episodes, I think those are okay. I think are just okay, they are better than dollars or any currency out there but they’re not better than income property and the reason for income property that it performs so well in an inflationary environment is really twofold. One is of course just like gold and silver any commodity generally does very well as a hedge against inflation. So whether it be soybeans, coffee beans, lumber, petroleum products, gold, silver, any form of commodity item does pretty well. It usually keeps pace and hedges inflation pretty well. Okay, so that’s the first part. So of course when you own these income properties, you own a lot of commodities. I always talk about packaged commodities investing, or assembled commodities investing, you’ve got concrete lumber, labor, petroleum products glass, steel, all the ingredients for a house. So you know we all would agree on that. The commodities, that’s the first part, but the part that really, really, really makes it special is what I call inflation induced at destruction where when you have inflation, inflation basically pays your debts for you. So for example, if you borrow $1 million and you buy real estate with it and let’s assume it doesn’t produce any income. It’s not even as good as income property, it’s just a property. Say for example you live in it or it’s a property just keep vacant and if you got a $1 million interest-only loan on these properties, then in one year if there’s just 10% inflation, the value of that dollar of that money you owe declines just like the value of the money you have declines. So the money in your savings account would go down by 10% if there’s 10% inflation because it would be — it would have 10% less purchasing power, but also the value of the debt you owe against the properties would decline as well because that is — that is also being destroyed by inflation just like our savings our stocks our bonds, equity and real estate, that’s inflation induced debt destruction. So we like it when our debt gets destroyed.
Stephen: But doesn’t that mean like you’ve got tenants that are paying rent on your property and they are in effect paying the devalued mortgage, but the amount that the tenants can afford and what they’re actually paying is also devalued as well.
Jason Hartman: Well, the amount of their rent, if you — say for example you have a one-year lease on the property. Now you know if we had hyperinflation within that year that would that would hurt you because you could probably charge more if you were to kick that tenant out or they were to move anywhere to lease to a new tenant because rents are indexed to inflation very well. In fact, historically speaking at least in the States, rents typically outperform inflation, but remember here’s the thing. Okay, the mortgage payment doesn’t go up and the cost of running the property really don’t go up except maybe very nominally, but the mortgage certainly won’t because it’s a 30-year fixed loan. Even if you could get a higher rent from somebody else, in relation to the property if you can’t raise the rent for — you have to wait a whole year to raise the rent for example. So what, that’s not really going to hurt you that much because it’s tied to the property’s functioning and so that’s not going to hurt you too bad. Now here’s another question that you may be thinking of because you almost alluded to it in the last question. When you talk about how, we’ve always got to I think about our tenants, and how inflation affects them, not just how it affects us because we’re not investing in a vacuum, right. We are subject to market forces too, if our tenants have problems, we have problems, potentially right.
Stephen: Exactly yeah.
Jason Hartman: Yeah, well okay. So let’s look at how inflation will affect them. They may get a raise that is tied to say the cost of living, but that always understates inflation. So what you’ll see there is the tenant will suffer, okay and say for example that one-year lease comes up and you raise the rent and you raise it a lot because there’s been a lot of inflation in that year. So rents are skyrocketing with everything else, with the cost of gas and coffee and food at the supermarket and everything is going up right.
But the question is because that’s a pretty — a pretty grim scenario, it is a pretty gloomy scenario if everybody’s hurt by inflation. Well so what I say will happen is the standard of living will just decline, that’s where the pain will be felt. So maybe now that tenant rents a nice four-bedroom 2. 5 or 3 bathhouse from you and say that house is 2000 ft. Well if inflation comes long, they might have to move out of that house and move into an 1100 ft. ² home with – you know with three little tiny bedrooms and just 1. 5 baths, so their standard of living will decline, but there will still be a renter, that’s the person that moved down from the 3000 ft.² house, that moved into your 2000 ft. ² house. So you know, it is just a ladder, you are always moving up and down the ladder. And I think it is a good gloomy scenario for most people except us because we know how to — how to beat the inflation.
Stephen: So is there any, any implication of the hyperinflation of the banks then adjusting sort of what the value of currency becomes because. Let’s say you have a 30 year mortgage on a property and let’s say you owe the bank $200,000 and then the value of the currency increases or sorry decreases, but the amount that you owe the bank is still $200,000, isn’t it. The bank can’t say, well now $200,000 is not worth 200,000, you actually owes us $800,000.
Jason Hartman: Right, well you know I suppose they could pass some kind of law, and basically revalue all the money out there, but that would be extremely difficult to do. The fact is no, under current law they can’t do that. I mean the bank cannot rewrite your loan and think about it. The inflation game is only benefits the government and the central banks like the Federal Reserve and other central banks around the world.
They actually benefit from it because all of the — all of the money they owe, see the government is quite familiar with inflation induced debt destruction. Okay, even though they don’t use that term, but you know if we owe China a $1 trillion worth of our bonds and treasury bills and we have 10% inflation. Well then we owe them 10% less and the bank is still, right. So it’s a great deal for the government. So the government wouldn’t want to re-value. They wouldn’t want every bank to revalue their loan because that would dramatically hurt the economy. They would rather let the banks suffer and let the government benefit. That’s extremely unlikely, but hey, when you control the laws and the military, you can do anything you want you know. So I can never say never, but I can’t imagine it happening I will put it that way.
Stephen: So your strategy is to get into as much debt as you possibly can and have the more and have the rental income cover the mortgages and then wait for the hyperinflation to pay the loans off in affect.
Jason Hartman: Yeah, you know that’s not the only strategy, but it’s definitely a major part of that. I mean I don’t want to say debt in general, of course I want to say only long-term, fixed-rate debt tied to income properties that produce income, that pay for themselves. And you have the opportunity to outsource the debt to a tenant where the tenant becomes responsible for the debt and that’s not consumer debt, it’s good debt, it’s not bad debt.
Stephen: Right, okay. Yeah I understand, that’s helpful.
Jason Hartman: No a good question to ask Stephen is say it doesn’t happen, say that the hyperinflation never comes, say somehow we defy the laws of gravity and physics through this whole explosion of money printing you know just under Obama we’ve had another $5 trillion of money created out of thin air that didn’t exist three a half years ago. I mean that’s an incredible thought, $5 trillion dollars, right. And so if that doesn’t happen and if we just sort of plod along, the way we did you know in the 80s and the 90s and the first decade of the 2000s.
I mean heck, it’s still going to be great. It’s going to be as great as it was for all of the millions of people who owned property through the last three decades, but if we get that –
Stephen: And provided, we can have the tenants cover the mortgage on that?
Jason Hartman: Oh absolutely and every property we have nowadays is positive cash flow from day one, okay.
Stephen: So we don’t really having those sort of properties in Australia at the moment because we haven’t really sort of bottomed out, most of the properties are still a fair way off from being positively geared at the outset. We are still paying sort of 6 and 7% interest right on the mortgages and the tenants rental return, the rental income from the tenants is probably only about half of what the mortgage repayments are and that’s negotiated, might be a 10% reduction on the process because the market is slow, but it hasn’t. You know there is a lot of optimism and a lot of hope with the mining industries and resources thing in Australia that we are going through and so people are sort of thinking we are not going to see you know Detroit or like Miami’s sort of properties over there. Are you there?
Jason Hartman: Yeah I am here, can you hear me. Okay the connection got bad there for a moment. So yeah I think that, that is definitely not going to work because whenever you have a situation where your mortgage cannot be covered by the rent and your other expenses can’t be covered by the rent you know that’s a great sign that you are in a bubble, that things have to adjust and there’s only two ways they can adjust. Either the rents have to go up radically or the prices have to go down radically or the interest rates have to go down radically.
In other words, the cost of owning that property has to go to down. Probably it’s not going to be a matter of interest rates. What are your mortgages like there nowadays?
Stephen: Yeah they are about 25 to 30 years at about 7%. So it’s very high you know very high.
Jason Hartman: Well historically it’s not that high, but it’s high compared to the US. See the US is justifying gravity with the way its Federal Reserve system works, it’s a scam. So it’s a sort of a Ponzi scheme. It’s not exactly a Ponzi scheme the way that’s played out, but the point is that benefit from them I mean use that to your advantage.
Stephen: Now that’s very helpful. Thanks. I was wondering that because I was listening to you talking to one of your clients and they were sort of going on about how they want to get locked in as many lines as possible with tenants paying the mortgage and I thought if we go into hyperinflation isn’t that bad. So but you have explained that, so it’s helpful. Thanks.
Jason Hartman: Good, good. Well hey, just before you go, do you mind sharing your investing experience with listeners. Are you new to investing or experienced?
Stephen: Yeah, I’m fairly new. I’m 40 years old and I have done a couple of little places, one in Sydney a little subdivision and on in Sunshine Coast, two actually on the Sunshine Coast in my own place and the most sort of effective one that I found is a place that I renovated the downtown area to add four bedrooms. So this is a house sort of in the middle of a town area where it’s great walking distance to the beaches and the shops and everything. And I bought a two-story brick place that was old and rundown, renovated upstairs, added four bedrooms downstairs.
So I have now got 8 unrelated people renting individual rooms from me and I cover the utilities and I provide a wireless internet facility through the house and that’s seem to work very well. That property is actually positively geared, but that was an interesting lesson because when I bought it what I could’ve rented it out for would’ve been substantially negatively geared, but by spending another hundred thousand dollars on the renovation and adding the extra rooms and then getting the four additional rental incomes in, it bumped it up. So I spend a little bit more, but the returns were a lot more and that makes sense. So that that property is sitting there and it’s in a fantastic location and it’ll all – I am sure it will get some capital growth center and light but, like a lot of people I am not sure what’s happening with the economy and whether things are actually going to go up or just plateau out for 10 years or so, but in either case it’s just ticking along paying for itself. It’s not going ahead, but it’s not going backwards.
Jason Hartman: What got you interested in US investing and how long have you been listening to my podcast.
Stephen: I have only been listening for about 3 months and I did live in the States for while about, probably ten years ago. I won a green card in the visa lottery pop-up internet adds. They just when you are online, these ads pop-up and they say you know the American government is giving away certain amount of green card, so I applied for that years ago and I actually won a green card, so went over to the sates and enjoyed it and I particularly liked Miami and sort of being interested in the property and reading some forums on Miami investing and in time to come I think I’ll probably look at buying a property over in Miami somewhere.
Jason Hartman: Let me just tell you, it’s too early for Miami. I just think it’s too early. Still, we have people asking us about Miami many times a week and the other one they always seem to ask about is Las Vegas, those too. And it’s just too early, just wait. Miami is one of those high flyer tiny market.
Stephen: All Latin Americans. Yeah it seems as all the Latin Americans have just moved into Miami and they are spending all their equity, the Venezuelans and Brazilians and stuff. But once they have, once they hit problems then I think it will really slump. So I am sort of holding out a little bit.
Jason Hartman: Yeah I would be very careful of areas like Miami and if you’re in them, don’t do condos, just do good old-fashioned single-family homes because once you add that condo complex and the homeowners association to the mix, it just has so many new problems that are created, they won’t there before.
Stephen: Even in university districts because I hear that you can get a condo apartment for $40,000 or $30,000 and it’ll you got good rental income from university students and low homeowners fees.
Jason Hartman: Right, right well we are generally against condos, a few times we will make an exception. We did make an exception in Dallas where we have got these really inexpensive condos that you can almost treat like apartment buildings where you can buy several of them right next each other and you know those are kind of interesting. They are especially interesting by the way for foreign nationals because they’re very inexpensive and they have really good cash flow, but a lot of the — a lot of the Miami condos I see investors buying them all the time and I just think gosh what are they doing, I wish I could stop them and get some — knock some sense into them.
You know they are expensive really nice condos and they just it just doesn’t work. It’s just too risky I mean thousands of people have been burned from things like that so I would really, really be careful here.
Jason Hartman: And what are your thoughts on the single-family homes sort of on Miami beach up in the North [Unintelligible 0:27:02] in surf side you can pick them up for sort of low 200s.
Jason Hartman: I think they are too expensive. Look, my general philosophy is it’s the opposite of everything I like. Okay I like sexy and swanky and cool. I live in a gorgeous penthouse myself, but to invest in, I like milk and cookies, meat and potatoes, whatever you want to call them.
Stephen: The middle of the Bell Curve.
Jason Hartman: Yeah, yeah just really simple suburban single-family homes that has always just been a really nice stable type of deal.
Stephen: Yeah I agree, when you are tagging bell curve of the population and you are more likely to hit the nail on the head than if you go for the extremes either too high or too low.
Jason Hartman: No question. So today now this is you know this is a moving target, but today that number means a property that say $130,000, somewhere around there not above. It might be 90 to a $130,000 and of course that price is going up a bit. So you know you talked to me in six months it might 110 to 150,000, but the nice thing about that section on the bell curve is that you can catch the people moving up and you can catch the people moving down and I say if we have this hyperinflation, there is going to be a lot of people moving down.
And those are still respectable enough houses that people can live a happy life in them and also batten down the hatches during an inflationary environment or bad economy of any kind. There are other types of bad economies that aren’t inflationary, you can just be a depression in general or deflationary depression or recession, but I just think that’s a really good stable bet.
Stephen: Yeah me too.
Jason Hartman: And the other thing I would say is spread them around geographically, have a couple in this city, a couple in that city, a couple in another city you know just in case hedge your bets that way as well.
Stephen: Yeah I like city investing because you got the and you always will have the concentration of the population in the large areas and if you need to turn it over or if you need to get more tenants you want to be in a area where you have got a lot of employment for people and that sort of thing, I am a regional area, but it’s some thing with 320,000 people here on the coast, but it’s a high tourist area probably sort of similar to the [Unintelligible 0:29:27] or somewhere like that.
Jason Hartman: Well I like I mentioned I’ve been to Noosa and Surfers Paradise in Australia in Sydney as well and I love Noosa. I thought that was a great, great little town. And you are right near there, you are about a half-hour away from Noosa, right.
Stephen: Yeah, well look probably 45 minutes. If you’re down here again, yeah let me know I would love to catch up.
Stephen: I will definitely look you up and thanks so much for calling into the show, it is like 10 minutes after 11 PM here, but I just happened to catch your call and I will always want to talk to investors especially from down under. What time is it there?
Stephen: It’s quarter past our in the afternoon.
Jason Hartman: All right well you get back to work and we will talk to you soon. Thanks for calling in.
Stephen: Okay. Thanks Jason.
Jason Hartman: So another great call. Please be sure to call into the show. We would love to have you participate. Now let’s go to our guest in just a moment here but I just want to remind you if you haven’t registered already for our Atlanta Creating Wealth bootcamp and property tour be sure to do that as soon as possible at jasonhartman. com/events.
All right we will be back with our guest today in just a moment.
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Jason Hartman: My pleasure to welcome Scott Patterson to the show. He is a writer for the Wall Street Journal. He is the author of a very different books including the Quants and Dark Pools and we are going to talk about how this effects Wall Street and high speed trading and all of the stuff related to those things. Scott welcome how are you?
Scott: I am great. Thanks for every having me.
Jason Hartman: My pleasure, are you located in New York by the way today?
Scott: No I am actually in Washington DC. I used to work at New York for the journal but now I do financial regulation for the journal and this is where other regulators are, so.
Jason Hartman: Being close to the government is helpful, right.
Scott: Yeah, yeah just down the street here.
Jason Hartman: Well your latest book is Dark Pools, right. Start with one and tell us about it.
Scott: Right so you know this book about the shift to automated trading and computer driven trading on Wall Street. It’s really exploded on the scene in the past ten years or so. When I was in New York working at the Wall Street journal a couple of years ago after I had written the Quants we started hearing more and more about this trading style called high frequency trading and I wrote a piece that said that it was estimated to account for about 70% of all the volume on the markets and that was just sort of a jaw dropping number for all of us at the paper who cover the stuff. So I dive more and more into it and basically it was a whole about the industry.
Jason Hartman: In other words 70% of the trading on Wall Street, 70% of the market is controlled by computers then.
Scott: It’s probably more like 95% is controlled by computers.
Jason Hartman: Oh even worse, wow.
Scott: But 70% is specifically high frequency trading. So most of the trading that goes on today is driven by computers. You know if you are investing in a mutual fund your fund manager is using computers to implement those orders into the market often interacting with the high frequency trader.
Jason Hartman: And you know it just begs the question. Can the little guy the middle class investor just the regular everyday investor out there can they beat the system. I mean so many people are kind of sold on the idea that they can somehow can match the computers, the algorithms, the quants, it’s really part of the same equation because the quants make the algorithms that run the computers right.
Scott: Right definitely.
Jason Hartman: You know is it even possible for the little guy to compete with this?
Scott: In a word, no. You know after seeing how sophisticated these firms are, they hire PhD physicists and you know electrical engineers and you know people from the top universities in the country and MIT and University of Chicago to design these systems and you know so I mean just day trading is just a bad idea now.
It takes so much firepower, so much speed and I think that’s not really the problem that I’m concerned about though. I mean if people want to try their luck and play in the market, that’s their decision, but what I’m really worried about is that even the trade execution experts for the mutual funds are getting outgunned by these HFT firms which are you know there is really just a few of them that are very, very good and from what I can tell they are constantly winning the race on the exchanges and you know you could say in a way that attacks on the individual investor who is investing in 401(k)s and mutual funds.
Jason Hartman: You said HFT firms, what does that mean, HFT.
Scott: Right, yes. Sorry that’s short for high frequency trading.
Jason Hartman: High frequency trading, oh ok thank you, okay. So it’s not just that high-frequency trading is something that firms on Wall Street do. There are firms that call themselves HFT firms that’s an actual category of business. This is what do you do while I have a high-frequency trading business and that sort of.
Scott: Yeah these are private companies largely, the best ones. Kind of like a family office, they are run by just a few owners and a employee teams and teams of quants and computer programmers and they are just wildly successful. You know one of the biggest is called GetGo it is based out of Chicago that is short for Global Electronic Trading Company I believe and they are just wildly successful get-go accounts for something in the order of 20% of the volume of some of the biggest stocks in the United States and that’s just one firm.
Jason Hartman: Unbelievable so where they get their money to invest with, are these just wealthy families that set up an HFT firm or?
Scott: They started off you know this is one of the stories I tell in my book Dark Pools is you know how they rose in the late 90s and early 2000s, very small firms trading on these new electronic communication networks that were trying to compete with the big stock exchanges like the New York stock exchange, or NASDAQ. These are completely computer driven networks. The high frequently firms started using them because they could handle the automated trading that they were very good at, but they are very small. They didn’t have a lot of money, but over the decade they got bigger and bigger and bigger and as the market shifted towards automated trading and you know the New York stock exchange and NASDAQ incorporated those computer-driven trading networks, they came to dominate the market and explode in profitability. So it’s really only been you known the past five years or so they have gotten to be as big as they are and as dominant they are.
Jason Hartman: So, then high-frequency trading definitely works, right.
Scott: Oh yes it’s the very effective, its a brilliant strategy you know they basically flood the market with buy and sell orders and only trade when their systems predict it that they will be profitable or at least that’s what they try to do. So they cancel most of their orders so they will put in tons of buy and sell orders. But they will cancel something in the order of 99% of those orders and only trade when they, when they really want to.
Jason Hartman: So they are just really clogging up the system too, right. I mean they’re keeping people from getting their orders executed. other people can’t get their orders executed because they are just flooding the system with noise it sounds like.
Scott: Well, that’s a big concern now is that the amount of data that the exchanges and other trading networks are forced to handle because of this is just clogging up the system and could be doing some outages and another problem is that they are able to jump in front of other firms, that’s part of the strategies. They can they – you know they have direct links to all these different venues across the markets and they can, they can see how the market is moving by you know detecting like you know when a stock moves on the New York Stock Exchange. When is that going to also move on a Dark Pool, say. So they are able to constantly jump in front of other firms in the order booking and be at the front and that’s really essential to their strategies being in the front and getting the order when it happens.
Jason Hartman: So explain to listeners what is a Dark Pool. I mean that’s the title of your book. What it is about?
Scott: Yeah, so the technical term for Dark Pools is sort of a private, secretive trading venue where stocks are bought and sold away from the public markets, the buy and sell orders are not made public. The order only is made public after there is an execution. So the supply demand that’s in a Dark Pools is invisible, but the larger argument I’m making this book is that the entire market is shifting toward darkness, the lack of transparency. Even the public markets like in New York stock exchange is becoming increasingly opaque and we just saw yesterday the SEC approved the New York Stock Exchange’s proposal to create their own sort of hybrid Dark Pool.
So that’s just a symbol of the shift or a symbol of the shift towards opacity in the stock market.
Jason Hartman: So even exchange is going to have or has Dark Pool in another its own. I mean the exchange is the clearinghouse and they have a Dark Pool too, it’s scary.
Scott: Yeah, yeah right it’s surprising, but it shows you know how the market is changing and one of the reasons why these Dark Pools have become so popular is because the big investment firms have been running away from the public markets because they’re worried that the high-frequency firms that can their buy and sell orders, they can see the supply and demand can use that information to front run them, so to escape from that they are going to the Dark Pool. So in a way the Dark Pools are a symptom of the disease that is infecting the exchanges right now.
Jason Hartman: And again there’s nothing illegal about this, is there?
Scott: No there is not anything illegal about it, although the suspicious activities that go on and the SEC is looking into some of these activities. The SEC, we’ve reported in the pages the Wall Street Journal is looking at whether the exchanges have provided benefits for these high-frequency trading firms that allow them to have an advantage over other regular investors, this is an ongoing probe we don’t know what’s going to find yet. So another problem is that the regulators can’t really survey the market at all because they don’t have the technology to track all of these trading. So you know if there was something going on we wouldn’t even know it unless they just got lucky or there’s a whistleblower or something.
Jason Hartman: Right, right, right. You got to wonder I mean, do you think there is any inkling of whether even the SEC, the regulatory body has been to some extent or any extent bought off by Wall Street itself by the people it is supposedly regulating because it’s seem so many things that are so unfair to the average investor and so favorable to institutional investors.
Scott: Yeah well you know bought off is the strong word.
Jason Hartman: Okay you may not be able to just totally answer that in your position.
Scott: Yeah you know I think that the regulators in terms of the stock market and a lot of the markets today have just been completely left behind by the technology that’s — that’s overtaken the market in the past 10 or 15 years, they haven’t kept up with the sophistication and that’s allowed these firms to do things that the regulator doesn’t understand. And I think we saw this with a lot of the derivatives that blew up in the financial crisis you know the credit default swaps and synthetic CDOs that just eviscerated the balance sheet of these banks around the world. The regulators just burn you know totally asleep at the switch, they couldn’t understand it and I think something very similar is going on in the stock market and other markets too like the futures markets or options markets where very sophisticated trading strategies are taking place, exchanges are helping those strategies succeed and the regulator is just completely in the dark about it.
Scott: You know what amazed me. I think it was the 60 minutes exposé on high-frequency traders that it amazed me is that literally these firms, these HFT firms, the speed is so important to them that at the speed of light 186,000 m/s it makes a difference whether you’re a few blocks away or you are right next-door the exchange in terms of how fast you can execute these trades and it blows my mind that people actually think they are void out with that system.
Jason Hartman: Yeah well you know that kind of tells you where we are at right now and that is the game being in front of another firm by micro seconds which is a million for the second. So these are firms are fighting to beat each other by microseconds and in my book, Dark Pools I tell the story of a company called Spread Networks that build a fiber-optic cable between Chicago and New York it cost them $300 million to build this cable, the cable allowed firms to gain a 3 m/s advantage over firms using the current system and that’s 3000th of a second.
Jason Hartman: And they spent $300 million to do that and it was probably a good investment, right.
Scott: And they believe that there was going to be demand for the cable. Unfortunately for this company innovation is moving so fast that other firms realized that they could use microwave signals to send orders between Chicago and New York faster than the cable, so the demand wasn’t as robust as they’d hoped because innovation is moving so quickly and everybody is trying to get in front of everybody else. So ardently that as soon as you build something it’s already out-of-date. So it’s just an endless cycle of innovation. The question is what advantage does that bring to regular investors and it’s really hard to argue that it’s bringing any advantage you know. You could see why, it used to it take an average of 20 or 30 seconds to get an order executed in the floor of the New York stock exchange. You know now it’s less than a second. You can see how that’s an advantage that helps the market become more efficient, but when you’re talking about an order being executed 10 µs faster, you really start to wonder whether the efficiency that we are gaining has any impact or improvement and if it actually could be detrimental to the market, if that’s what the race is now and it is where the race is know.
Jason Hartman: Just out of curiosity is there any access to either a high-frequency trading or Dark Pools because they both seem very beneficial to the people that run them and the investors in them, the middle class day to day investor can get involved. For example, can I buy a share of a mutual fund that runs a Dark Pool and a high-frequency trading firm and make some of their money. Now granted I know they are going to pay the management and the Board of Directors a lot more than me, but at least it could be part of the whole thing.
Scott: You know I mean one of these days we are going to see a mutual fund that’s you know a high-frequency trading firm. I think the closest that investors can get now is hedge funds, and there are plenty hedge funds that have high-frequency trading operations, you know one of the biggest is Citadel Investment Group. They have a very successful high-frequency trading firm that is called tactical trading and in 2008 it made a billion dollars. So you know the average investor though, not really, this is still something that’s there for the wealthy and the insiders in Wall Street.
Jason Hartman: Right, right. It’s way out of their league. Let’s just kind of backup. Maybe we should have started the interview with this, but let’s talk about quants for a minute. Your book is entitled the quants and you have probably seen I was fascinated by the movie margin call, right.
Scott: Yeah I had seen that, that was a good movie.
Jason Hartman: It was a great movie, and you know what totally impacted me about that movie is remember the scene where the Peter Sullivan character gets called in at three in the morning you know and then the head of the firm has flown in from Europe or something and wants to see him and he says, and you know with the Peter Sullivan characters like 26 years old and that head of quant.
Scott: He is a quant.
Jason Hartman: Yeah he is a quant and the head of the firm says, hey kid across the table, you know what’s your background, what’s your degree. And then he says something like, you know, I went to MIT and my thesis my PhD dissertation was on the way a rocket propulsion impacts resistance or some crazy something like that right? And the head of the firm says, so basically you’re rocket scientist and he says, yeah but there’s more money on Wall Street. So –
Scott: It says it all.
Jason Hartman: That’s really what these quants are, they are just mathematical geniuses and they would normally be. I think that’s kind of like you know not to go too far a field, but it’s kind of a sad statement in a way for you know American enterprise that these people aren’t in the sciences. They are just in the moving money game, your thoughts.
Scott: Yeah, well that’s the story I tell them and the quants as how Wall Street starting in I go all the way back to the early 60s became increasingly mathematical and these guys were able to figure out inefficiencies and prices between always different asset classes and design arbitrage strategies. They are also frequently good computer programmers, so that would help them crunch the numbers and it just got bigger and bigger and you know, basically was you know by the early 2000s running Wall Street you know. I think that there was, the machine behind everything and then it blew up. You know it’s kind of quant bubble and all sorts of different ways and I try to show that in the book is how they were stock trading strategies that blew up in 2007. These derivatives that were behind the big asset bubble and the mortgage industry blew up and all these things are designed by these mathematicians who have taken over Wall Street.
You know a lot of them are well intentioned, but yeah it was the money I mean you know see a old story of what drives Wall Street. It sure to end here.
Jason Hartman: Sure, sure there was that, what was the name of that firm forgive me I am not a Wall Street guy, so this is not top of mind to me, but there was that firm about 12 years ago that blew up that their whole thing was they said that –
Scott: That’s got be Long term capital management.
Jason Hartman: Yes, yeah Long term capital management thank you and their basic stance was we have figured out the markets, we know how to mathematically beat the market and were sure of it and then of course they lost a bunch of money and the whole thing blew up. Any background on Long term capital management.
Scott: Yeah well that definitely was a quant driven firm, their strategies were entirely based on these mathematical arbitrages that they had figured out. They had a couple Nobel prize-winning economist on their staff, so I think that you know like you say, they thought they’d figured it out and this is one of the big temptations of the Quants mentality is that you think you’ve managed risk so much that you can leverage up more. So Long term capital believes that it had hedged out all of the possibilities, all the negative events that could go on and that’s a big part of these quant strategies is to hedging out a negative event and if you have all the negatives under control, then you can take more leverage.
So they ended up becoming levered something like a hundred to one at point and even to rose to something infinity when they were losing all their money. So it’s hubris you know it is a classic tale of hubris and I think it just long-term it wasn’t a warning ironically to the Wall Street that there’s something dangerous in the strategy. I think Wall Street looked at it and said hey that was a big idea, we can just do it better.
Jason Hartman: What advice would you have for the average investor that’s the vast majority of the world out there in terms of numbers, they may not in terms of dollars, but or may still be actually in terms of dollars, just because there are so many of them, but you know what should they do, I mean should they just buy an index fund and follow the random walk advice or not be on Wall Street at all and buy some rental properties, what should they do.
Scott: Yeah it’s a tough question I mean everybody wants to know with interest rates so low, fixed income and seems like a terrible place to be, but the market seems really risky and I think it’s probably riskier than people realize given you know how everything running it now is and these computers that are susceptible to systemic events, but there have been so many studies showing that active investing is a huge waste of time. You pay more fees. These fund managers are often hugging the indexes much as they can because they are just trying to beat just a little bit, so why not just put your money in a low fee index fund and hope for the best.
Jason Hartman: Well and that was really the foundation of a huge company Vanguard you know. I mean their whole thing was just buy the index and call it a day and you know just wait.
Scott: Yeah that seems like a pretty smart strategy to me and especially the active managers tend to trade too much and given how you know what I had seen with these high frequency firms for a while yeah the market became more efficient and it became cheaper to trade but I think they are just getting their clocks cleaned these days. So the more you trade the more you are going to lose.
Jason Hartman: I love how in the Dark Pools book you talk about and you are probably kind of branded this term AI bandit, artificial intelligence bandits and the threat to the global financial system I mean we have talked today a bit about individual investors. But what is the threat to the overall system the systemic risk here and will they trade against each other and the software will become better, the algorithms will become better and the elites and the insiders will make all the money and basically the market will eventually go back to them. I mean really that’s the way stock market was in the old days, you know the little guy didn’t access the stock market very much and Merrill Lynch was really one of the big promoters that brought it into the more public sphere. And maybe it will just go back to the elites and they will just be trading against each other.
Scott: Yeah, I don’t think they would like that very much because they like to feed off the little guy.
Jason Hartman: I am glad that you admit that.
Scott: They are kind of like the fish food you feed to the sharks in the pool, but in terms of the systemic threat that I am talking about that partly comes from my experience covering the flash trash to the Wall Street Journal, I really got to see how the system is fragile. It’s highly complex and it’s very fragile, you know kind of like you know the space shuttle is an example. If tiny thing went wrong with the space shuttle Challenger in an ring and the whole thing blew up and there is theories that say that if, you know the more complex a system is, the more vulnerable it is just some kind of systemic even like that that can lead to a huge sort of Black Swan like event, the flash crash is like that, it was a 10% decline in the US stock market in a matter of minutes. It did bounce back, but you know we don’t know if it happens again, if it could be 20% if it will bounce back. There is also concerns that because these firms are trading many different asset classes at a single time like futures and options and currencies that if you get a big move in one it could spill over to another asset class and they call that the splash crash. Some people much smarter than me have come up with this they see experts in artificial intelligence and risk managements and these are concerns that people need to be aware of. It’s not just fear mongering, the people say that I’m trying to scare people and that is going to hurt them because they will afraid of the market. You know but I’m trying to draw attention to this problem that we have because the market has shifted to being very computer driven and these computers, they are trading so quickly that they can do things, they can do things so rapidly. They can pull out of the market in the blink of an eye and that’s what happens is these strategies, they don’t really like it when the market becomes too chaotic. They are risking too much money. So they just pull out and that’s what we saw on May 6, 2010, the flash crash.
Jason Hartman: You are right, they will just yank the money out and cause a sudden dive in prices yeah. It’s scary when you don’t — like a lot of people have talked about the psychology of markets and trying to predict how other investors will think and act and go counter to their trends and so forth. But it’s just very hard to do that if not completely impossible, when you’ve got all of these different motivations and big institutional players, it’s just a whole different world. It’s not very logical in a lot of ways is it?
Scott: Right. Yeah or maybe it’s becoming too logical.
Jason Hartman: One or the other. Yeah it’s kind of a conundrum.
Scott: I mean I didn’t, I think there’s going to always be room for the really smart investment manager who you know like Warren Buffett, I used to cover Berkshire Hathaway for the Journal and I got to know Buffett and became very impressed with his discipline and his ability to pick stocks, but there’s no question that more and more computer trading is going on and at the end of the my book Dark Pools in the final chapter I write about a small hedge fund in New York City called Rebellion Research [PH] and this is run by a group of really and young 20 something guys who have designed an artificial intelligence trading system that buys and sells stocks for the long term, kind of I call a digital Warren Buffett. So in a way I felt like this is we know that the computers are running the second by second microsecond by microsecond trading stocks. But there is always going to be a role for the fund manager who can really dig into the balance sheet and figure out the long-term investment, but these guys have created a computer that can do that and it’s been very successful actually over the past four or five years. So who knows in 10 years from now, is your fund manager going to be a computer and it’s possible.
Jason Hartman: Very interesting stuff. Well besides Dark Pools which just came out I guess last month, that dark pools high-speed traders AI bandits and the threat to the global financial system and your prior book, the year before, the quants, how a new breed of math wizards conquered Wall Street and nearly destroyed it. Great topics and your books have great reviews on Amazon by the way. Of course people can get them on Amazon, but you give out your website as well, Scott.
Scott: Yeah I have a website called scottpattersonreports.com, I occasionally put a little blog posts up on that.
Jason Hartman: Yeah some great blog posts actually. I like the one how you talk about this is your June 19, regulators are trying to define high-frequency trading. Good luck. Yeah right, good luck with that. Well good stuff, keep up the good work, what’s next for you.
Scott: Ah well you know I’m working hard in the Journal and we have got a lot of good stories in the Hopper [PH]. So I would say stay tuned and you know you will see some of those coming out pretty soon.
Jason Hartman: Fantastic. Scott Patterson, thanks much for joining us today.
Scott: Thank you.
(Top image: Flickr | pargon)
The Jason Hartman Team
Transcribed by: Renee’
