The Compound and Friends - Yes it's a Bubble, DraftKings, Nikola, Bill Ackman, SPACs, Tesla's Index Run with Larry McDonald

Episode Date: July 24, 2020

On the newest episode of the Compound Show, join Downtown Josh Brown for a discussion about the bubble in belief. The rise of "Special Purpose Acquisition Corp 2.0" involves the backdoor IPOs of DraftKings, Nikola, Utz Potato Chips, the Golden Nugget Online, Virgin Galactic and many other well known companies. Pershing Square's Bill Ackman just launched the largest SPAC ever this week. What does it mean? What does it signify about the current market environment? Plus, a conversation with Larry McDonald (A Colossal Failure of Common Sense) about whether or not the S&P 500 index committee can keep ignoring Tesla, now that it's reported four straight quarters of GAAP profits and its market cap is larger than almost all the other holdings.  Leave us a rating and review and we'll love you forever! It helps a lot! Hosted on Acast. See acast.com/privacy for more information. Learn more about your ad choices. Visit megaphone.fm/adchoices

Yo, it's JB. We're back. We're talking IPOs, bubbles, Bill Ackman, Tesla, DraftKings, and a whole lot more today. Play the music. Let's go. Welcome to the Compound Show with downtown Josh Brown. Josh is the CEO of Ritholtz Wealth Management. All opinions expressed by Josh or any podcast guest are solely their own opinions and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast. Okay, welcome back to The Compound Show. You know me, I'm downtown Josh

Brown. Today we have Larry McDonald on the podcast. Larry was a bond trader at Lehman Brothers during the financial crash, and he wrote a best-selling book about it called A Colossal Failure of Common Sense. And if he didn't take that title already, it would have been great for my autobiography. Ask anyone. So that's a shame. Anyway, Larry's research firm, which is called Bear Traps Report, did some work on what the implications of including Tesla in the S&P 500 will be. And now we have Tesla's earnings, which came out later this week. We'll get into that whole mess in a moment. But first, I want to talk about where I think we are in terms of investor sentiment.

And I want to tell you what I think is the most apt descriptor. It's one word, the most apt way to describe the mindset in the markets at this moment. For the first time in history, we're experiencing an asset price bubble at the same time as we're experiencing an economic recession. It's never happened. In many ways, the stock market has never been as frothy and speculative as it is today. And this is occurring against the backdrop of levels of unemployment we haven't seen throughout the entirety of the post-World War II era. So it really is an amazing time to be around. There's that old expression, I think it's a Chinese proverb, but it's really meant to be more like a curse. It's one of like when the Southerners say,

bless your heart, you know what they really mean. They're really telling you, you know, GFY. your heart, you know what they really mean. They're really telling you, you know, GFY. So I think it's a Chinese proverb and they say, may you live in interesting times. And I don't think they mean you well when they use that. So we live in interesting times and it's both a blessing and a curse. Last week, we talked about the economy and the employment situation and what I think the federal government, the treasury, the Fed need to do in order to keep this whole thing from spiraling out of control. This week, I want to talk about the other side of the coin. We've got this speculative stock market bubble that has been developing on a parallel track concurrent with the pandemic

recession. And some would even go so far as to say because of it. Yesterday, Bill Ackman took a bag of cash public. He's launched what's known as a special purpose acquisition corporation or SPAC. I'm going to use the term SPAC a lot. That's what it means. Basically, a SPAC is a promise that if you give him money, he will put it to use within a specified period of time in order to buy an existing company and take it over. So in other words, it starts life as like, hey, just put some money in. And then it's like a board of directors and they usually get like all these famous people who used to work at Apple and Disney and Goldman. Like that's the conceit is like I put together this amazing board and I'm going to go find something to buy and then we'll change the name of the SPAC into the company that we're buying. Right?

So – and that structure has been around since the 80s in some way, shape or form. So SPACs aren't new. What's new is that investors love this idea so much that they handed Bill Ackman $4 billion, which will now sit in that special purpose acquisition corporation's bank account until Bill Ackman identifies the company that he wants to acquire with it. So $4 billion is massive. He did one of these a decade ago on a much smaller scale. He did one called Justice Holdings, which was on the London exchange. And that special purpose corporation ended up buying Burger King Worldwide, which at the time was owned by a private equity firm called 3G,

like a Brazilian private equity firm. So that's how Burger King became a publicly traded company for the second time. And the stock has worked out for investors. And we'll get into that in a second. So we'll see what Bill Ackman ends up acquiring with his new special purpose acquisition corp. And if he can't find a suitable target, the way it works is that the initial investors get their cash back, like minus some costs, but plus some interest. I don't know what kind of interest it's earning these days. So in other words, they spend 12 months to 18 months. They look for a target to acquire. If they can't find one, they say, okay, forget it.

Here's the money. If they can find one, they announce their intention. And then you, the shareholder can say, okay, I want to keep holding the stock because I believe in this. Or you could do what a lot of hedge funds have historically done. Whatever excitement there is about the announcement of the deal, you sell into it. So like a lot of retail people come along and say, oh, I've heard of that company before. I want to be in the SPAC. And then you'll frequently see institutional investors say, okay, thanks for the ride. Thanks for the free money. And they'll cash out. So I don't know what will be the case here, but that's how these things work. There have been 45 of these SPAC IPOs this year, and they've raised an average of 320 million. This is all record-breaking stuff. 59 of them

went public in all of 2019. So we're on pace to shatter that record from last year. And mind you, this isn't a recession. People are literally just saying, I have so much investment cash that here, put it in a SPAC. I don't even know what it's going to be invested in. We'll see what happens. Like this is an unprecedented situation. You usually only see a boom historically in SPACs, like a boom in the amount of them that come public.

You usually only see that either at a market top or like directly leading up to a market top. They are the ultimate sign of people having more money than they know what to do with. There's one guy who was a former Citigroup investment banker who's actually launched four of these in the last few years. DraftKings came public as a SPAC this year. So when the deal was announced, the precursor to DraftKings traded much higher because there was so much brand

recognition and everyone is pumped about the legalization and destigmatization around online gaming. In other words, you had the SPAC sitting there, its stock price probably right around where it originally came public when it was a pile of cash. And then they said, hey, good news, we made a deal. We're going to buy DraftKings. The stock went crazy. It's up 240% since January. And keep in mind, that's with almost nothing on TV to bet on. It's like zero bettable sports on TV, unless you know the names of the Korean baseball teams and you have a view on which one will beat the other one. So I think with DraftKings, there's a lot riding on the NFL season for that one. Like that's going to be make or break.

So fingers crossed. This year, two electric vehicle companies have come public via the SPAC structure. One is called Fisker, and it's years away from having a mainstream commercial product on the road. Investors don't seem to care. There's a lot of excitement about that. The other one is Nikola, NKLA, which they're not even trying to pretend that it's not a knockoff of Tesla. which they're not even trying to pretend that it's not a knockoff of Tesla. They're not even pretending that it's anything other than an attempt to cash in on the fame of the Tesla situation and how much money has been made. They're saying they're going to do semi-trucks. They're building a facility in Arizona that they think is going to spit out 35,000 trucks a month that are going to be electric.

Fine. So that came out of the gates. It went from like $20 to $100 a share at its peak. It's now back in the 30s. Virgin Galactic, Sir Richard Branson's space company, Space Tourism, that also came public as a SPAC a couple of years ago. The Golden Nuggets online casino, There's an announcement from another SPAC That they're acquiring GoldenNugget.com So that'll be more online gaming

Utz, UTZ This is the company that makes your 9th favorite brand of potato chip And your 12th favorite type of pretzel Utz is Coming public via SPAC This year, deal was already announced So there's a lot of this going on Bill Ackman's launch Utz is coming public via SPAC this year. Deal was already announced.

So there's a lot of this going on. Bill Ackman's launch of the Pershing Square Tontine Holdings SPAC, as I said, is the largest ever. Investors bought 200 million shares at an offering price of $20 each. And on top of that, the Pershing Square hedge fund will probably kick in $1.5 billion or more of its own capital. So this will essentially be like a $5.5 billion or a $6 billion pile of cash that Bill Ackman wants to use to acquire a, quote, mature unicorn with. So I'm not sure. I looked up mature unicorn, but I ended up on an adult site. I think that's a category. So I'm not really sure what he means by that or what they mean by that. I think it's like a tech or software or media property or a fintech company that's private,

right? Like it's still like venture backed and private, but it's not like series A. It's not like he's going to do a venture investment. This will probably be a company that while private is already seasoned enough that it's earning money and it's more than a concept. It's an actual business. So I don't know how many of those there are in the five to $6 billion range offhand, but that's what that seems to be about. So then you say like, all right, well, he doesn't know what he's going to buy yet. So why would a retail investor want to sit in the stock and wait and wait and see? The way CNBC.com phrases it, and they put up like a guest column that was extremely bullish, but whatever. They say, in sum,

quote, in sum, for over two decades, large institutional investors have been paying a 2% annual management fee and 20% of all profits to invest alongside Bill Ackman. Even his fund's special purpose co-investment vehicles charge a 20% promote on profits. Here, meaning with this new SPAC, you can invest alongside him in one of his biggest investments ever and effectively pay no management fee and only a 6.21% incentive fee that is only earned after a 20% return to investors, end quote. So he kind of has like a high watermark that he has to hit before he can take the traditional incentive fee. And it's going to be a smaller incentive fee than usual. And I also read somewhere that he didn't do founder shares.

Founder shares are like one of the ways that the sponsors of these things can either own much more at a lower amount or take compensation in a much larger way that's less apparent to the retail investing public. And it looks like they didn't do that here. So look, I get it. I think if you're like really into celebrity hedge fund managers, if you're like a hedge fund guy groupie, why not? Sure. It's your money. It's also worth reiterating that Burger King Worldwide, which was the last SPAC that Ackman was involved in, actually worked out for shareholders. They made money. It came public into the SPAC structure on the London Stock Exchange, I think in 2012. And then within two years, it merged with Tim Hortons. So it became like Tim Hortons, Burger King Worldwide merged, and they became

something called Restaurant Brands. The ticker is QSR. And that's been a combination since 2014. And if you stayed, if you were a shareholder, it's pretty respectable. I think you did about 12% annualized. And that includes the current pandemic period, which has obviously been a shit show for anything fast food related. So you've done okay there. I would say that for every legitimate stock market success story that began life as a SPAC, there are probably 10 or 15 major disappointments or outright scams.

I understand people saying, well, things have changed and these have gotten better. Maybe a few of them. Because it comes back to a fundamental question regarding the target companies themselves. question regarding the target companies themselves. You ask yourself, if this is such a great business, why couldn't it just do a regular IPO or a direct listing on the exchange? Why does it have to sneak onto the stock market through the back door by being acquired by a pile of cash and then changing its ticker symbol upon approval of the shareholders of that other company. Is this how great companies come to market? So I've always been very skeptical about these and thank God, I've probably saved people a lot of aggravation, but a few of them

have done really well. So it's not as easy as just writing off the whole, I don't think they're an asset class, writing off the whole structure, which 10 years ago you easily could have just written off the whole structure. The proponents of SPACs would say, why should the target company agree to go public this way? Because the process of pricing a traditional IPO is months of wrangling back and forth between institutional investors and bankers. wrangling back and forth between institutional investors and bankers. And there are so many conflicts and so many different ways for things to get screwed up. And in an uncertain market, sometimes it's just too hard for people to agree with what the company is worth in that paradigm. So in this situation, you don't need a million people to agree. You just need the company doing the acquisition to agree, the SPAC. They would also say that the concept has come a

long way from its origins in the 80s and 90s when the SPAC structure was basically just a playground for frauds. Goldman Sachs underwrote one in 2016. The New York Stock Exchange welcomed its first new SPAC IPO since 2007, three years ago. So it seems like in the last couple of years, they've started to gain some respectability. But that's now. And we're in the midst of this moment of epic, what I call the word that I've been dying to roll out today, credulity. Let's talk about that word, credulity or credulity. Investors have become remarkably credulous. This is an important word right now. I think it's the word to describe the modern mindset of the investor class. Everything that you see happening right now

is a massive bet on the future with very little evidence. All of the valuations for the most popular stocks are predicated on just these miraculous feats of never-ending growth. And it's being seen as though these things are practically inevitable, as though every $50 billion market cap stock, it's just a few months before it's 100 billion. And then they can take their newfound size and build this new mini monopoly in whatever category they're in. And you understand why people feel this way, because they're looking at companies that have already done it, that they've been invested in. Amazon, Apple, Netflix. I'm not going to go down the whole list. So the credulity of the investor class, I think, is almost at an all-time high. Absent what I saw firsthand in the dot-com bubble,

this is as close as you get to that mentality. SPAC IPOs are just the latest manifestation of the zeitgeist. You say like, well, put your cash into this pot and give me 12 to 18 months to find a business to buy. You could trust me. Look at my track record. Look at my pedigree. Look how exciting the industry I'm targeting is. I'm going to get you a mature unicorn, Holmes. What are you worried about? Don't you want a mature unicorn with me running it? How could you lose? Look at me. So that's like the pitch and it's working. That's how you end up with a company like Nikola. Nikola is the first name of Nikola Tesla, who probably invented electricity or alternating current electricity or whatever. And Thomas Edison kind of stole it. And J.P.

or Pont Morgan kind of aided and abetted that theft for commercial purposes. J.P. Morgan was like the biggest backer of Edison financially when Edison was very similar to, I guess, what Elon Musk is now. But Nikola, his first name, is now the name of a new company that came onto the market via the SPAC structure. And Nikola now has a market capitalization of $14 billion. $14 billion. dollars 14 billion dollars they aren't producing anything yet so they claim that they'll have a hydrogen fuel cell semi-truck production line like they'll have this whole manufacturing facility up and running um it's like a million square feet in arizona they're i think they're like getting approval for it now like it doesn't even exist yet. And this thing is worth $14 billion. And I haven't really done the work on like, don't email me about hydrogen

fuel cells. I haven't even looked at like, do they have patents? It's not even the point, right? The point is that they don't have anything yet that they can sell. So I hope they plan on selling a lot more stock because otherwise it's a mystery where the money will come from to start making 30,000 trucks every month with hydrogen fuel cells at competitive enough prices that people are going to buy them. Maybe I was thinking they could just build the outer walls of the factory and use that to do a massive convertible bond deal and raise even more money. Convertible bonds are also red hot right now. Investors are extremely credulous and they're

ready to believe almost anything. And there's no reason for them to think that Nikola won't be able to keep raising money. Look what they've been able to do so far. Why couldn't they? And in many cases, companies like this, they raise money, they dilute shareholders, and you actually would expect the stock to go down and it goes up. Why does it go up? That happened with Tesla twice. Why does the stock price go up when they dilute existing shareholders? Because it's proof to the existing shareholders that the company has the ability to raise money and reach its endpoints and be able to build what it says it's going to build. So actually, not only does it not end up hurting shareholders, that dilution, it helps

them. Look, I told you they could raise more money. So we'll see how long that can go on. There are times when investors are highly inquisitive and circumspect about the funds and the companies that they choose to put their money into. Those times exist. This is not one of those times. These are the days of taking a leap of faith, a shot in the dark, taking a stab at it, a punter's chance, a roll of the dice.

That's what's going on right now. a punter's chance, a roll of the dice. That's what's going on right now. The stock market environment that we've been in hasn't punished anyone for having acted this way in quite some time. When was the last time somebody got hurt for this? All they get is rewarded. In fact, if you look at a list

of factor performance year to date, you find that the taking of excess risk has reaped instant gratification for the people who have done so, whether they were doing so inadvertently because they don't know what they're doing or systematically because they were waiting toward a momentum factor or a factor of taking more risk than the overall market, a high beta strategy. So growth stocks as a group are up 14% year to date. Growth investing is a bet on a company's future being amazing. Growth stocks are for optimists. Value stocks

as a group are down 14% year to date. Value investing is a bet that a company's future will not be quite as terrible as its current share price seems to be discounting. Value stocks are for realists or for cynics who are investing at gunpoint because the ultra low interest rates give them no other alternative. But going beyond growth and value, do you know which factor has the best return of all this year? I'll tell you, IPOs. New companies have the best returns in the entire market out of every factor as a group. Better than the quality factor, better than the profitability factor, the insider buying factor, the size factor, the sentiment factor, all of the different quantitative ways that you can slice and dice

stocks in the public markets. Of all of those ways, IPOs has been the leading factor strategy. Initial public offering stocks as a group are up an astonishing 36% in 2020. Look at the Renaissance IPO ETF, if you want to say. That's just one more demonstration of the credulity of the cloud. You know the names. You may even be investing or trading in some of them as we speak. Zoom, Uber, Slack, Datadog, Moderna, CrowdStrike, Neo, Pinterest, Peloton, all kinds of Chinese tech ADRs. Some of these things are up hundreds of percentage points this year. This year, it's July. The dictionary defines credulity as having or showing too great a readiness to believe things. One year into the Great Depression, the winter of

1930, President Calvin Coolidge said, quote, when people are bewildered, they tend to become credulous. I would say the contrast between the stock market versus the economy this year is one of the most bewildering moments in American history. So I understand it. You see other people doing something. It continues to work. It's working better than everything else. Why wouldn't you be credulous? It's profitable to be credulous right now. Being skeptical is a cost. Bertrand Russell said that, quote, man is a credulous animal and must believe something. In the absence of good grounds for belief, he will be satisfied with bad ones. End quote. There are no good grounds to believe in.

And a lot of the things investors and traders are now wagering on, there's just no good reason if you have any sort of frame of reference for how things have ended up through history. You would already know that things won't work out for most of these companies that are in these top 50, top 100 momentum stock lists. So people don't have those good grounds. So to Bertrand Russell's point, they're taking the bad ones. Well, it's working today. Well, how do you know, right? So some of the investments people are making now will become painful for a slightly less bad reason. Some of these things will become painful because it'll turn out that yes, they're great companies, but the prices people paid were too high and the expectations were already too elevated relative to what the companies can realistically deliver. It happens.

Even to, quote, great companies. It's a great company. Yeah, okay. Microsoft's a great company. We know. That's why everyone agrees. That's why it sells at 35 times last year's earnings, 11 times sales, $1.6 trillion in market cap. We know it's a great company. Nobody disagrees. Okay, now what, right? So that's a form of pain, but it occurs at a glacial pace.

So you'll see these, quote, great companies continue to deliver growth and earnings, but the share price will stop going up. Why? Because everyone's already on one side of the boat. Everyone already agrees. So it'll be very hard to impress anyone new. And so that process plays out over years and decades. But some of these investments will be acutely painful because they'll disappear altogether. They'll be catastrophic. Starting valuation will be the least of their problems. It'll turn out that they were outright lies or they were well-intentioned, but there was

a lot of self-deception going on with the people who were gambling on them, the quote unquote investors. So of course this will be the case. There's too much money out there. And investors right now are just being too credulous to ask any tough questions. And when you see them funding piles of cash, you know, you know that's what's going on. My colleague Ben Carlson did a book, I think it came out last year, called Don't Fall For It. And it's moments like these where fraud flourishes. That's the term Ben uses. How does fraud flourish? Ben points out that there are necessary conditions to bring an environment like this one about.

And one of those conditions is when greed is abundant. So Ben cites Charles Kindleberger's outline of the five phases of a bubble. We'll go through this really quickly. Phase one, which I think is the pandemic. Phase one is called displacement. An event or innovation occurs that sharply changes expectations. This phase is typically grounded in reality and good intentions. This phase is typically grounded in reality and good intentions. Okay. So we certainly have that. The sharp change to expectations occurred this March and April as three years worth of online and digital adoption were pulled forward into a span of six weeks.

We did three years worth of new e-commerce adoption in six weeks. E-commerce's share of total retail doubled from 12% to 25% pretty much overnight. And I think stock prices have done a pretty good job adjusting to that scenario. The instantaneous mass adoption of things like video conferencing and streaming content and online games and virtual medicine and virtual real estate tours, and thousands of things. We don't even have time to list right now. Thousands of things. It stoked this sensation in investment fervor for the companies on the NASDAQ that are enabling it. Almost everything that once was primarily analog is now going permanently digital. And you may have

thought you had 20 years to watch these transformations play out and complete themselves in the industry you work in. And all of a sudden, this pandemic hits, and now it's looking more like you have six months to get ready, or you're out of business. You're done. You're out, right? Oh, you don't have app-based ordering? Bye, right? So that's phase one. Phase two is expansion. This is the stage where that narrative, like the narrative I just laid out, takes hold

and people begin bidding up asset prices. Well, mission accomplished. We are definitely there now, okay? And then phase three, which I think there's room to debate. Are we there yet or not? Or how deep in are we? Phase three is euphoria. So quote, by this point, all bets are off. Everyone assumes that they can get rich easily and very quickly. Risk is taken with abandon and nobody worries about the hangover in the morning. Euphoria makes people think the good times will last forever or at the very least, End quote.

You know what comes after that? Phases four and five are crisis and contagion, respectively. We'll get to those another time. Something tells me it won't be long before investors in things like SPACs and electric cars and cloud computing and software as a service will be arriving at those final phases at some point very soon. And they will have been led there by their own credulity. So that's my word of the day.

All right. Coming up, my discussion of Tesla with Larry McDonald and its potential inclusion into the S&P 500. So we taped this right before the company reported its latest earnings quarter, which in fact was the foretold fourth consecutive profitable quarter in a row. So now the clock is running on the index committee to make a decision. And Tesla has reversed. It's negative after reporting those earnings, but still up substantially over the last few months. So

let's listen to what Larry thinks this means. It's a great interview. I think you're going to love it. Stick around. All right. So Larry, you guys did this really interesting thing about inclusion games and the fact that Tesla looks like it's about to report an earnings quarter that's going to put a lot of pressure on the S&P 500 to make a decision. You have left Tesla out of the index all this time. It's almost a $300 billion market cap. And now with another profitable quarter, they can't any longer. So what's your take on that? There's a number of criteria in terms of Tesla's going to meet the most important one, and that is the four quarters of profitability. They're definitely going to have a profit. So I think Tesla's gaming the system. It's very clear that it's a big game, and it's a brilliant game by Musk.

But I think that there's so much attention, and videos like this are very important, and there's so much collateral potential damage to the indices. There's trillions of dollars of indices that track the S&P. So all of these indices are going to be impacted. So they may just wait it out for another quarter and put off the decision until next quarter. They don't have to make the inclusion now, but there'll be lots of pressure on all sides. Let's get into some of the numbers here that we're talking about. One of your analysts, Robert Van Battenberg, he's saying there's approximately $3.9 trillion

of pure index capital following the S&P 500. These are mostly index funds, including the ETFs and mutual funds that mimic the index. Tesla's market cap is $278 billion, but Musk owns 18.5% of the stock. So if you just look at free float market cap, it's $220 billion. And then he has the base on the S&P's market value at 27.8 trillion. So based on that, he's saying Tesla should have a 0.8% weight in the S&P. And that would imply $30 billion of buying power from index buyers. And then he's saying every $100 on Tesla's stock price imply $30 billion of buying power from index buyers. And then he's saying every $100 on Tesla's stock price means $3 billion in additional buying power from index trackers.

And of course, that could work on the way down too. So based on those numbers, I do feel that they have to decide something. They don't have to implement it in July. Implementation of index inclusion could come between now and the end of the year. Do I have that right? Yeah, I think that makes more sense. So how much of the run-up in Tesla's stock price do you think has happened as a result of people trying to front run the S&P 500 inclusion? I first want to say the reform broker blog that you wrote in 2014

opened my eyes to sell a lot of this and you called it the endless bid and it was incredible foresight foreshadowing. Oh, you know, the relentless bid. Yeah. The relentless bid. And it was like, at first I didn't know what you meant in, I'll never forget. It was like, you remember there's some things in life around your understanding of certain things. And it was like, there's a bunch of things that happened through a year and through your career. And that was to me, the aha moment, like the light bulb, like that's really wasn't aware of the power of the passive indices in 2000. Like this was like 2004, 13, 14, I think you wrote it. And so this whole passive game, since you wrote that blog, $2 trillion has come into passive asset management.

And now the stakes are getting bigger and bigger and bigger. And the games are getting bigger and bigger and bigger, right? Because the inclusion process is so much bigger than it was before because 0.08% of an index this big with all of the passive money coming in and all the passive money that will come in in the future. So the University of Pennsylvania did a study that which we wrote about on our blog, the beartrapsupport.com. And all the studies that have done the academics, God bless them, you know, they're, they try really hard to try to put the stuff in studies but all a lot of the studies were done uh well before and also the new york fed did

a study uh all the studies on inclusion gains were done way before the the passive explosion and but what they did find especially in new york fed was that um both companies and stock price appreciation in terms of earnings, a lot of it comes in the 12 to 24 months ahead of the inclusion. So this is not just Elon Musk. Companies, CFOs, these guys want to get rich. They have incredible lifestyles, and they want to really get into that S&P and be part of this bigger and bigger and bigger passive game. So they will typically pump up those earnings. And so what you typically see is a large move up in earnings, a large move up in stock price performance, heading into inclusion, and then a pretty substantial fall off over the following 12 months. So in essence, the index is

left holding the bag. And that's what- Are you saying stocks upon being included tend not to do as well as they had leading up to the inclusion? Yes, that's what the New York, the Fed and the University of Pennsylvania studies imply. And not just in share price, but in earnings growth too.

Yes, in earnings growth, especially exactly because the companies are really doing everything they can to get in there in that, in those. And then there's a little bit of relief, right? So once you're in, you know, there, there may be like a 12 month period of like, okay, we're in, this is a game changer for us because of all of the passive flows. And there's, there's a little bit of a relaxed process. So this is clearly a

brilliant game that Musk is playing. Is there any way to say that maybe this time is very different? Because most of the time when you're talking about a company being included in the S&P, it's probably a $5 or $8 billion market cap. This is $300 billion. It's a company that's been publicly traded for 10 years, one of the most liquid stocks on the NASDAQ. And it's certainly not an unknown company that people are first going to discover. And it's a very polarizing company that people have very strong opinions about in both directions. This isn't your typical inclusion stock, right? Exactly.

This is the granddaddy, the mother, the mother load of them all. It's never been anything like this. And remember, this company, if you look at the high yield bond market and you just look at the investment grade market. So here's a really cool way to look at it in terms of I like to look at the bear trap support. One of the things we'd like to do is look at cross-asset flows. And we have a Bloomberg chat with hundreds of mutual funds, pension funds, institutions around the world. And we look at how different asset classes and how different audiences are viewing a company. And for example, if you have a $300 billion market cap right now in the S&P. The yield on your bonds is anywhere between 20 basis points, maybe 40 basis

points for a company like a Pfizer. That's a little bit more than 300 billion. But in that neighborhood, you're really talking about 45 to 50 basis points up to maybe 1%. In the case of Netflix, you have a 2% yield on their five-year bond, two and a half, three. So, but Tesla- But a $300 billion market cap, you're in the top 15 stocks already. Exactly. So you're talking about, these are literally blue chip, blue chips. These are JP Morgan, Pfizer, Alphabet.

Exactly. And so if you look at the yield on their bonds in that group that you just described, Tesla is coming in at four to four and a half percent on their five year paper. And these companies are 40 basis points to one percent. So you're talking about almost a four percent differential to where the bonds are trading relative to the equity. So the equity is in this $300 billion neighborhood, right? So it's a really high-end neighborhood, but their bonds are, the bonds are trading like they're in a little bit poorer neighborhood. So the bond market's just not buying this inclusion game. And the bond market's basically saying, okay, you guys had bid the stock up to this much, $300 billion, but the yield on this bond relative to other

$300 billion companies is 2% to 4% more. And that's a real warning sign. Is it a warning sign or is it possible that that yield goes down upon inclusion because creditors feel better about Tesla as a risk once it's, I mean, I know it's just being in an index. It's not really like a coronation, but isn't it possible that the bond market comes more into sync with other issuers of debt rather than the stock price having to go the other way? It is a big stamp of approval. So for sure. But I think, I think bond investors typically are not really relying on S&P. They're doing their own work.

You know what I mean? They're real credit people. So what's the current yield on Tesla debt? Well, they have a callable bond. It used to be a high-yield bond. It's right now 4.4%. So Johnson & Johnson's 52 basis points. Now, that's a bigger company. It's $390 billion.

But let's go down to like MasterCard, $300 billion, 50, 60 basis points. Now that's a bigger company. It's 390 billion. But let's go down to like MasterCard, 300 billion, 50, 60 basis points. Home Depot's at 280 billion, 43 basis points. Intel at 254 billion is up at 64 basis points. And Tesla is 4.4% for their 2025 paper. So it just, it just something. I still think it's a huge accomplishment, though, that Tesla, which has yet to have a profitable fiscal year, is able to sell bonds

to the public at four foreign change percent. I still think that's, that's pretty remarkable. I don't think that there's, I don't think there's any parallel to that in history. Now, I think a lot of people would say, well, look at the Fed. I think a lot of people would say, well, in the case of Tesla, actually, the bond market has been wrong and the stock market has been right, which I know is a very controversial statement, but people would say that. Tesla's going to report Wednesday, the 22nd. I don't want you to make any earnings predictions, but I think we all agree he has every reason to report a blowout quarter. And maybe some of the enthusiasm in the stock over the last few weeks is because everyone gets why. In addition to S&P inclusion, there is also the potential for a very big stock bonus or stock-based compensation.

Could you explain a little bit about what you were saying there? This is fascinating. So Musk, I'm just going to read from my notes because I want to make sure I get it right legally. Based on 2018 performance award going forward, Tesla has achieved its third milestone needed to unlock the first 12 tranches of stock awards to Musk, which they're about to achieve. The first tranche unlocks once Tesla has a market cap of $100 billion for six months. So, he did that. And then it allows Musk to buy 1.7 million shares at $350. Remember, this is a stock that's trading around $1,500. So he can basically buy the stock at $350, which means he locks in a $1.8 billion P&L profit to himself. That's breathtaking. It's incredible. Absolutely.

When does he owe the taxes on that? Immediately or not until he sells? Absolutely. When does he owe the taxes on that? Immediately or not until he sells? Yeah, I think he has to hold the shares for five years. So that means it'll be a very high net worth on paper. But still, in this day and age, you could take that equity-based net worth and you can borrow probably an equivalent amount. They're doing it in million-dollar wealth management accounts at every brokerage firm on the street. So it's almost as though you have the money when you can pledge that it's collateral, right?

Exactly. But on the earnings, so we look back and we went back to last year. In the second quarter, they lost $400 million in the second quarter of last year. No big deal. But what's interesting is, Josh, and you'll like this, this year they sold almost the exact same number of cars. But they sold them at lower prices. So this is fascinating. So they sold almost the exact same number of cars,

but at lower prices, you know, with global recession. They operated two car facilities instead of one, which drives up fixed costs. So there's a lot of things pointing to a miss here, but it just shows you if they do make the numbers based on those pretty reliable stats. I've got a number of really important analysts that I've known for years that have gave me those numbers.

This is really implying some very creative accounting to reach the holy grail of this profit number that the company needs for this big bonus. And you're not using the word creative as a compliment. Well, as a former Lehman trader, and I remember I'm so grateful to you, my book came out. We have a book that's a New York Times bestseller about Lehman. But I tell my wife once a month, if we sell a million books, we'll break even on our Lehman stock. But my favorite part of the book was when we had four CFOs in four years. You know, and I think one time in one of your blogs,

you called it musical chairs, musical CFOs. And it's like this same dynamic has been playing out in Tesla. It's like they've had multiple chief accounting officers. They need to get a certain result coming into this holy grail S&P inclusion. And lo and behold, it's very interesting that they've gone through nearly the same number of chief financial officers as Lehman did in the 12 to 18 months before Lehman went under. I almost feel as though the index committee has to acknowledge the sheer size of Tesla within the US stock market. But what if they didn't? What would that say about what the S&P 500 is?

Could you truly call it passive investing if they ignored a $300 billion company and it had no market cap waiting in the largest 500 stock index whatsoever? Like what would that say about passive investing if they ignored it? So if they pass on the entry? Yeah, let's say. Well, it definitely would say that kind of what we're getting into in this interview is, and it's kind of, I like discovering this with you together on the interview, but it's like we're reaching a point where the passive game is so big and this turn of events where you know normally a company would come into the S&P at maybe 75 to 100 billion maybe 50 billion you

know to here to come in at that level it's almost like if they don't put it in it's saying that this is the company that broke the passive back. Like it's almost like too big a number to swallow. And to your point, they- Right. It becomes more actively managed than anyone thought it was if they were to say no in a situation like this. Yeah. I see what you mean. Yeah. Exactly. Exactly. That's taking away the, now I see, yeah, you're taking away the passive element of the automation of the not optional, but I think every company in the world is following the way this story is developed.

And I think the big takeaway is we have plenty of time to worry about profits so long as we build a rabid fan base for both our product and our stock. Not that that's easy to do, but it's an alternative to having to show a positive profit in the early stages of a company. And we know that from other situations, but Tesla seems to exemplify it. All right, Larry, where do you want people to find your stuff? I get the Bear Traps Report emailed to me every week. I love it. Is that, is beartrapsreport.com the best place to check you out? Yes. Yeah. It's thebeartrapsreport.com. And I'm really proud of this, Josh. We have now tripled the business over the last three years. It's essentially, you know, you were

part of the democratization of information. So when I was a retail broker years ago in the nineties, of information. So when I was a retail broker years ago in the 90s, I wanted, you know, I always felt like, you know, in 1994, I was working on Cape Cod as a retail, on the retail side, and I always felt like, you know, I was getting information second, third hand. And so now what we've done is we have an institutional chat with 500 institutional investors. And they're, what I like about them is there's different skill sets. There's two or three people that are really strong on equity volatility. There's two or three high-yield managers, a number of really good foreign exchange people, and euro-dollars rates and the like. And so what we do is we recap that chat, kind of the most compelling takes that are coming out of the institutional chat, and send it to high-net- worth people, financial advisors like yourself. So, you know, I want, I want the Josh Browns of the world, the financial advisors to have,

you know, really that front row seat into that institutional platform. And, you know, and that's what, that's what we're trying to do. Well, I think you do a really great job. I love reading your stuff. One of the reasons I like it so much is because you have, you're actually have an opinion. You're not just saying, here's some data, choose your own adventure, which there's nothing wrong with that either. But I think you do a really good job at saying, look, this is what we think. And here's all the data that backs it up and why this is our opinion. And I think people really like that. So I appreciate you coming on. Everyone will check you out at the Bear Traps Report. Follow my friend Larry McDonald. He's also on Twitter. Are you at ConvertBond?

At ConvertBond, yes. All right. We'll hit you there too. Hey, let us know what you think about Tesla, the S&P 500 index committee, and this stock being the straw that broke the active passive debates back. the active passive debates back. We'd love to see what you guys think. Go ahead and subscribe to the channel if you haven't already. Give us a like. We will be back with you very soon. Thanks for listening. Check us out at thecompoundnews.com for daily investing and market insights. You can watch all of our videos at youtube.com slash the compound RWM. Talk to you next week.