Transcript from the call

MAPS Third-Quarter Recap
Conference Call with David McAlvany and Doug Noland
October 22, 2020

David: Good afternoon, everyone. Thank you for participating in our 3^rd quarter recap conference call for Tactical Short. I want to say a special thank you to our valued account holders. We greatly appreciate our client relationships and are grateful you’ve joined us in this.

As we look forward to the world getting back to normal and, of course, we’re still dealing with a tremendous amount of change in our personal and professional lives here in 2020, we wish you well. And our thoughts are with you.

I also want to express my gratitude to Doug Noland, who for Tactical Short relentlessly pursues answers to the riddles of the marketplace each and every day. He is a true professional and his dedication to excellence, while exacting at times, raises the bar for everyone he works with. So Doug, we’re better simply by knowing you, and made much better through our keen interactions.

We’ll give you the flow of the conversation today, and I’ll start out with a few comments on performance and then hand things over to Doug. We’ll then circle back around together and handle the Q&A toward the end.

We have several dozen questions already submitted. Thank you for getting those to us in advance. We also have the opportunity, if you’d like to, to submit additional questions as we go through. If there’s something you’d like clarification on, expansion on, or a different topic altogether that you think is complementary to the discussion today, we’ll do our best to answer those. The best way to get those questions to us, go to our website, mwealthm.com, and you’ll see the chat function at lower right hand corner. I’ll put those questions in the lineup, and, of course, we’ll respond back to you that we have received those questions. And then again, we’ll handle those questions during the Q and A.

A short anecdote: I had somebody in the office the other day bring a challenge to me, and I’ll ask forbearance and forgiveness from any vegans in the audience. This is a problem I’m sure you’ll never face. But the problem presented to me was what to do with a bear shoulder. His son-in-law had shot a bear and wanted to know how to cook it. So everyone knows who’s been around the barbecue, that some meat is just tougher than others. And bear is indeed one of the toughest of meats. So I had the opportunity to do my best, or do my worst, as it were, and try to deal with this. So with an overnight brine and 13 hours of sous vide, the bear meat was indistinguishable from filet, at least according to my one of my sons, and he thought it was delicious. I have to tell you that the whole experience, I felt somewhat guilty. I don’t know if shame is quite the word, but preparing it four ways, Russian, Asian, barbecue and Moroccan bear, I kept on thinking, I don’t know that Doug would approve. And, of course, I’m sure between bears and ducks, those are two animals he probably won’t touch.

So let’s dive right in. Since we have a number of first time listeners on today’s call I want to start off with some general information for those of you who may not be familiar with Tactical Short. More detailed information is available at mwealthm.com/tacticalshort and there are details there.

But just to give you an overview here, the objective of Tactical Short is to provide a professionally managed product that reduces the overall risk in a client’s total investment portfolio, so in complement to assets that you may have elsewhere while providing downside protection in a global market backdrop that we see as extraordinary, both in terms of the types of uncertainty, extraordinary uncertainty, but also in terms of the risks. A very fascinating time to be managing money, and certainly on the short side.

This strategy, Tactical Short and non-correlated, is designed for separately managed accounts. It’s designed to be very investor friendly, with full transparency, with flexibility, with reasonable fees, and no lockups. We basically looked at everything else everyone was doing and said, “What would you prefer if you were in the client’s shoes?” And we designed what we thought was the best vehicle out there for that.

We have the flexibility to short stocks and ETFs. We will also on occasion buy liquid listed put options. Tactical Short – shorting of any kind, frankly – entails a unique set of risks. We’re set apart from some of these by our analytical framework and by our uncompromising focus on identifying and managing risk. And I’ll get into that with our performance numbers here in a minute.

Our Tactical Short strategy began the quarter with short exposure targeted at 66%. The short targeted held steady throughout the quarter and consistent with our view of a very extraordinary, unstable market environment. And due to the high-risk environment for shorting with a rising market, the S&P 500 ETF was the only short position during the quarter.

We don’t recommend placing aggressive bets against the stock market, especially in today’s environment of extreme uncertainty and acute market instability. More than ever, a disciplined and professional approach to risk management is imperative, and we highlight this point every quarter and this is critical for us. Remaining 100% short all the time, as most of your short-structured products are, that is categorically risk indifference.

For us, there’s no place for risk indifference on the short side. It’s been a killer. And we believe a disciplined approach, a disciplined risk management, is absolutely essential for long-term success. So we structured Tactical Short to ensure the flexibility to navigate through even the most challenging market conditions.

So updating performance, Tactic Short accounts after fees returned a negative 6.59% during the 3^rd quarter. The S&P, of course, this is what we’re shorting at this point, returned a positive 8.93%.

For the quarter Tactical Short accounts, that equates to about 74% of the inverse of the S&P 500’s return. As for one-year performance, Tactical Short after fees returned negative 12.18% versus a positive 15.14 return for the S&P 500.

I think it is sometimes helpful to know how we stack up against our competition. We regularly track our performance with three actively managed short fund competitors, and the fact that they’re actively managed is important to bear in mind.

First, the Grizzly Short Fund returned a negative 13.58% during Q3 and the Grizzly one-year return, negative 32.96%. For the Ranger Equity Bear Fund, you have a negative 7.42% during Q3 and a negative 31.62 over the past year.

The Federated Prudent Bear returned a negative 10.37 for the 3^rd quarter, and for the full year, for the past year, negative 19.15. So on average, Tactical Short outperformed our three competitors by 387 basis points during the quarter, 1573 basis points over the past year.

Tactical Short has also significantly outperformed each of the bear funds since inception from April 7^th, 2017 inception through the end of September, Tactical Short has returned negative 24.05 versus, if again, you’re looking at the S&P 500, positive 52.66% return for the S&P 500, and the average out-performance for three competitors, 2,429 basis points.

Doug, that covers our performance for the quarter, and we’ll circle back around to the Q&A, but I’ll mute my phone between now and then.

Doug: Thank you, David. Good afternoon and thanks everyone for being with us today. This continues to be just an incredibly fascinating, if not comforting, environment. I’ll repeat a comment from last quarter, from both analytical and investment management perspectives. It’s difficult to imagine a more challenging backdrop. I’m fond of saying that things get crazy at the end of cycles. Well, this has become nuts: the markets, finance more generally, policy-making and politics. Alarmingly, society has taken a troubling turn as well, and let’s just all hope and pray for a smooth and peaceful election a week from Tuesday.

It seems fitting to get the analysis started with an update on the monetary environment. Federal Reserve credit has increased 2.9 trillion over the past 32 weeks, and 3.32 trillion, or 88%, over the past 57 weeks. It makes the Fed’s 1 trillion 2008 crisis response appear rather anemic. M2 money supply has expanded about 3.2 trillion over the past 32 weeks to a record 18.7 trillion, a 33% annualized growth rate since March. Over the past year, M2 rose 3.56 trillion, or 24%.

It is worth noting, as well, that institutional money fund assets, and they’re not included in M2, were up 627 billion over the past year, or 28%.

The federal deficit for the fiscal year ended in September surged to an unprecedented 3.1 trillion, or 15% of GDP. The government borrowed 48 cents of every dollar spent this past year. There’s been nothing comparable since World War II.

Let’s briefly delve into some data from the Fed’s Quarterly Z1 report. Total non-financial debt increased 3.52 trillion during Q2, more than doubling Q1’s record expansion, and this pushed first half non-financial debt growth to an incredible $5 trillion. For perspective, non-financial debt expanded 2.44 trillion in 2019, and averaged 1.83 trillion annually over the past decade. So think of it this way. Debt growth for Q2, for the second quarter, was almost double the annual average over the past 10 years.

At 59.3 trillion, non-financial debt surged to a record 304% of GDP. For comparison, non-financial debt ended 2007 at 227% and 1999 at 184%.

Outstanding treasury securities, treasuries that have been issued, jumped 2.85 trillion during Q2 to a record 22.37 trillion. Treasuries were up 3.35 trillion for the first half and 4.56 trillion, or 26%, over the past year. After ending 2007 at about 6 trillion, outstanding treasury securities have increased 16.3 trillion, or 270%. Treasuries ended Q2 at 115% of GDP. This compares to 69% at the end of 2010, and 44% to conclude the 1990s.

Over the past year, total debt securities and that’s treasuries, agencies, corporates, munies, jumped 6 trillion, more than doubling 2007’s record 2.7 trillion increase. As a percentage of GDP, total debt securities surged 265%. For comparison, debt securities ended 2007 at 200% of GDP; the 1990s, 157%; the 1980s, 126%; and the 1970s at 74%.

Total securities, and this is combining debt and equities, ended Q2 at a record 104 trillion. This was a record 532% of GDP. That compares to cycle peaks of 379% in 2007, and 359% during Q1 2000. And with the value of securities surging to record highs, household net worth reached an all-time 119 trillion. Household net worth ended Q2 at a record 610% of GDP. This compares to previous cycle peaks of 492% in 2007, and 446% in early 2000.

David: Doug, I know there are a lot of numbers here, but just this data underscores the interconnection between the Fed’s ballooning balance sheet, massive fiscal deficits and treasury issuance, record securities prices, inflated household net worth and what we perceive as wealth.

And considering the scope of both fiscal and monetary stimulus, and the surge in household perceived wealth, you have to look at the recovery from a slightly different perspective. But 532% of GDP versus previous cycle peaks significantly lower than that, and we know the cycle peaks, we know 2000, we know 2007, so it is worth bearing in mind how long this can go. We’re at the farthest reaches.

Doug: That’s right, David. Thank you. The bottom line is, financial conditions have been extraordinarily loose, with virtually every key monetary indicator now in uncharted territory. At 1.4 trillion, corporate debt issuance has already set a new annual record with a full quarter to go, and that’s record issuance for both investment grade and junk bonds. Meanwhile, Standard and Poor’s recently updated their forecasts for U.S. corporate default. S&P now expects U.S. defaults to double to 12.5% over the next nine months. On a global basis, S&P has so far this year downgraded 400 billion of debt to junk status, and an unprecedented 37% of S&P rated companies are now on downgrade watch.

The divergence between record stock prices and deep recession in the real economy garner some attention these days. Little focus is given to the extraordinary divergence between the booming corporate debt market and the deteriorating credit landscape. I’m reminded of the backdrop after the subprime mortgage blow-up in the spring of 2007 that proved the beginning of the end for the mortgage finance bubble.

Despite ongoing deterioration in mortgage credit, the vast majority of MBS and ABS, asset-backed securities, continued to trade at elevated prices completely detached from serious unfolding credit problems. Mortgage securities markets were supported by Fed rate cuts in the general perception that the Fed and Treasury would not allow a housing bust. During the mortgage finance bubble period, my analysis highlighted a powerful “moneyness of credit” dynamic and the delusion that Washington could ensure mortgage credit remained safe and liquid culminated most precariously in the 18 months leading up to the 208 crisis.

There’s no mystery behind today’s record prices and issuance of corporate debt. Not only has the Fed injected over 3 trillion of liquidity into the markets, in March it began directly back-stopping corporate credit with purchases of bonds and even ETFs that hold junk debt.

Exuberant investors responded to the Fed bailout, allowing 488 billion into ETFs during the first nine months of the year, 40% ahead of comparable 2019.

Back in 2007 I was convinced a major crisis was unavoidable. Trillions of mortgage credit were being significantly mispriced and the entire risk intermediation process had turned dysfunctional. Markets were dangerously distorted and adjustment was inevitable. Market adjustment would entail a downward revaluation, a major problem for a marketplace dominated by leveraged speculation and complex risk intermediation.

Allow me to repeat a most pertinent market reality. Financial leverage works miraculously so long as securities prices are inflating. But this miracle doesn’t work in reverse. Prices decline, de-risking de-leveraging takes hold, and bubbles burst. And as we saw unfold in late 2008, and temporarily this past March, de-risking de-leveraging foments illiquidity, market dislocation, and a dramatic tightening of financial conditions. The harsh reality is that a financial system and an economy that come to rely on rapidly expanding speculative credit face mounting risk of a sudden and destabilizing contraction of credit.

I have previously stated my thesis that the global bubble has been pierced, a view challenged by bubbling global securities markets. Let me attempt to clarify. I believe the clock is now ticking. Credit losses are mounting and painful market adjustment is unavoidable. The past six months’ credit tsunami and attendant surging securities values have thus far masked the scope of credit and economic impairment.

Moreover, the most recent Fed-induced speculative mania, having gathered strong momentum in U.S. markets, has raised the risk of a highly destabilizing market correction. We witnessed a near global market meltdown in March. Policies since that crisis have promoted only more egregious speculation and leverage.

And while pundits celebrate near-record stock prices, improving consumer confidence and economic recovery, for me, the more critical question is, how does this all end? I do believe we’re in the endgame. We’re witnessing record treasury debt growth and record corporate issuance at yields completely divorced from underlying credit risk. It truly has become moneyness of risk assets, late cycle blind faith in the safety and liquidity of financial assets generally.

It is a foregone conclusion. The Fed will do whatever it takes to shore up the markets and the real economy. I’m just convinced, and to me it’s become obvious over the past year, that whatever they’re doing is only making the situation worse, only exacerbating excesses along with underlying fragilities.

We titled today’s call Managing Short Exposure in Extreme Uncertainty. It’s difficult to envision a backdrop fraught with greater amounts of uncertainty.

Let’s start with Covid. We’re entering the winter months with daily infections already nearing 65,000. Does a spike in cases lead to restrictions and a population more resolved to hunker down at home? What will this mean for economic recovery, especially the tepid recoveries in restaurant, travel, and leisure businesses?

How about the tens of thousands of small businesses struggling to survive? When does a vaccine become widely available? Will it be trusted? What percentage of the population will be willing to be vaccinated? How efficacious do vaccinations prove to be? How long until the next shot is required?

My view holds we’re only at the early stage of recognizing the momentous economic, social, political and geopolitical ramifications from the pandemic.

What is the course of policymaking? Will there be a new administration in January, ushering in a momentous shift in ideology and policy focus? How large are prospective fiscal stimulus programs? What does the tax code look like in 12 months? Would a Biden administration use the stock market as a barometer of its success, or will the market going forward be more a symbol of systemic inequality?

One aspect of the environment is rather certain. Monetary policy will remain ultra-loose, zero rates and at least 100 billion monthly securities purchases. They seem baked in the cake. Yet uncertainties lurk. How might the Fed respond to fledgling market instability? Would the Federal Reserve be willing to expand Fed credit another 3 trillion in the event of market dislocation? How quickly will they react? And I do appreciate the Pavlovian response, “Doug, they will, of course, do whatever it takes.”

But how might a momentous political shift in Washington impact the Federal Reserve? The Fed has bestowed Washington a blank checkbook. Going forward, how might Republicans view enormous handouts to the troubled blue states that are being monetized by the Fed? It was inevitable, and pushed forward by the pandemic. The Federal Reserve interjected itself into the deepening divide of social and political acrimony and conflict.

From 2008 to the present, the Federal Reserve has faced no serious pushback to its QE experiment. This may be about to change. I can see the Republican Party emerging from a traumatic election with a much more suspicious eye toward the Federal Reserve money-printing and deficit monetization. How the Fed would respond to such a predicament may become yet another major uncertainty.

And when it comes to an extreme uncertainty, look no further than the markets. I have a favorite bubble maxim that is more pertinent than ever. Bubbles go to unimaginable extremes, and then double. It’s virtually impossible to time the bursting of a bubble, especially in this age of zero rates, open-ended central bank liquidity creation, along with myriad other support measures.

Yet bubbles do inevitably deflate, so the spectrum of reasonably high probability scenarios varies between ongoing, phenomenal speculative market melt-up, to a historic crash. Market uncertainty cannot be more extreme than that.

So how do we manage short exposure in such a backdrop? How do we balance our mandate of providing a hedge against extreme market downside risk versus our risk management focus? Admittedly, it’s quite a challenge. As I’ve commented in the past, our strategy can be simplified down to working to be a reliable hedge without getting killed. This means adhering to risk disciplines to start with, taking a cautious approach with short exposure. Most importantly, we’ve avoided the nightmare of being short individual company stocks. In high-risk environments for shorting, we will also avoid high beta sectors. We will try to stay clear of what others are shorting. This framework has helped to mitigate risk from what continues to be a historic short squeeze environment, the worst I’ve witnessed in over three decades.

Of our three competitors mentioned earlier, one of these funds lost 36% in 2019 and is down another 21% so far this year. A second fund lost 29% last year and 27% losses year-to-date. The third was down 20% in 2019 and another 16% so far in 2020.

It’s understandable that I continue to field this comment, “Doug, there must be better shorts than the S&P 500 index.” Let’s be clear. I’m never thrilled about being short the S&P, but I’ve been doing this long enough to recognize when the risk profile of shorting stocks and sectors is highly problematic. Others ignore this risk. We don’t.

The S&P 500 short is our default short exposure in such high-risk environments, for good reason. When financial conditions are this loose, shorting individual company stocks is a high-risk proposition. And I really want to avoid shorting stocks when the short community is significantly impaired, when short managers have suffered large losses and operate with these big, bright bull’s-eyes on their backs. We have significantly outperformed our competitors because we have managed risk more adeptly. And the key to risk management in this type of environment is to stay away from company and sector shorts.

Why, you might ask, do others not adjust the risk management strategies? Well, they’re in a really tough spot. Believe me, I’ve been there. They become trapped by their strategies. Flexibility is lacking. Unwinding their individual company short positions and replacing this exposure with a short in the S&P 500 would not be an option for them.

Managers will instead be under intense pressure to improve stock selection, and a crucial element comes into play on the short side. Poor performance begets poor performance. As losses mount, risk management tends to surrender to intensifying pressure to recover losses and improve performance. It’s a bad cycle that we’re keen to avoid.

Problematic trading dynamics unfold. You tend to see a circumstance where mounting losses eventually dictate risk mitigation focused on the unwind of the largest losing positions. Often these shorts are replaced with short positions in perceived lower-risk stocks that have lagged the general market. But then you confront this dynamic and speculative market where dramatic rotations see the lagging stocks and sectors suddenly outperform, inflicting painful losses from short positions that were viewed as low-risk and out of the fray. Things can just really turn sour, and this over time takes an emotional toll.

Nonetheless, there is a reasonable question I need to address. “Doug why did you stay short the S&P 500 when it was out-performing the small and mid-caps? Why not short some of the sectors that have lagged the S&P 500?” In response I’ll draw attention to a recent market dynamic. In the 11 trading sessions between September 24^th and October 9^th the broader market significantly outperformed the S&P 500 in a classic speculative bubble rotation dynamic. Over this period, the S&P 500 gained 7.2% while the small caps were up 12.9, the midcaps 11.5, and the average stock, as represented by the Value Line Arithmetic Index, rose 10.2%. The banks jumped 13.5%. These types of price spikes are problematic for managing exposure on the short side, especially after having suffered through a period of painful losses. Rather quickly, surging stock prices, coupled with losses, can see a significant jump in overall short exposure.

In a hypothetical example, on an account 100% short, a quick 10% jump in stock prices leads to short exposure, rising 10% to 110, while losses see account value drop 10% to 90, with short exposure rising to 110/90, or 122%.

Most short managers don’t want to see their short exposure rise exponentially when the market is going against them, especially after already suffering major losses. So they’ll move to reduce short exposure by buying back shares to unwind, or to cover some of their shorts. This means purchasing stocks into market strength, often on price spikes, which can really hurt performance. Running high beta or high volatility short exposure can quickly turn problematic when price spikes and resulting deep losses for significant short-covering at unfavorable prices.

In short, it’s important to appreciate that less short exposure and lower beta positioning help mitigate the need to buy back stocks in environments where there’s a high probability of price spikes and speculative melt-up dynamics. This is fundamental to how we view managing short exposure, especially during a period of extreme uncertainty.

The S&P 500 has outperformed some of the broader indices this year, but not for a moment do I regret the decision to avoid higher beta stocks, sectors and indices. I also don’t regret another quarter of deferring put option purchases. As our out-performance versus competitors demonstrates, our risk management approach helped mitigate losses.

Yet it’s been an annual ritual of mine for the past three decades, at the end of the year, I’ll look back and I’ll have regrets for opportunities missed. While there still a couple of months to go, I expect to end 2020 especially thankful for our ongoing patience and disciplined risk management focus.

I deeply regret losing money, and with the benefit of hindsight, there are some things I would do differently. But I harbor no regrets in terms of the overall strategy. I’m nothing if not disciplined, and candidly, few in the industry would be willing to adhere so strictly to such a risk management focus. Over time, the pressure to modify strategies becomes too much to bear. I’ve lived it in the past. I’ll adjust the strategy when the market backdrop for shorting becomes less hostile.

Let’s take a deeper dive into the current market environment. While I was working in fixed income at the time, I vividly recall the 1987 speculative bubble that ended that October with black Monday. I lived through the abrupt market reversal and intense short squeeze in 1991. Speculation coming out of the Russia LTCM market bailout was spectacular, with NASDAQ almost doubling in 1999. The market’s rally to new highs in 2007 after the subprime crash was extraordinary, and 2009’s abrupt rally set the stage for bouts of wild speculative excess over the next decade.

But I’ve witnessed nothing comparable to the mania that was unleashed after the Fed and global Central Bank market bailout this past March. From my vantage point of 30 plus years of analysis, we’re witnessing the worst-case scenario. The Fed has lost control in that they no longer retain the capacity to stabilize the system. Their year-ago stimulus stoked speculative excess, and then their March emergency measures incited only more precarious speculation.

I believe speculative leverage that was already unprecedented, has increased meaningfully over recent months, especially in corporate credit. A record 170 billion has flooded into corporate bond funds with all these SPACs and loss-making IPOs. We’ve witnessed a major surge in online trading, with gains in the technology stocks reminiscent of the 1999 and early 2000 speculative blow-off, and importantly, there has been a proliferation of options and derivative trading that I believe has been a major factor in market melt-up dynamics.

Let there be no doubt, a derivatives trading frenzy, and it is both retail and institutional, has become a huge and pressing systemic issue. I believe derivative-related selling was instrumental in March’s market dislocation and near meltdown. And clearly, options and derivatives have been instrumental in what I view as a speculative blow-off, especially for the big NASDAQ stocks. Both on the upside and downside, the popularity of derivatives trading poses a clear and present danger to system stability.

Let’s look back to January and February. The VIX index traded as low as 14.5 on February 20^th, a remarkably depressed level considering escalating pandemic risks. I strongly argue the low cost of market insurance was a direct consequence of the Fed’s September adoption of a so-called insurance approach with stimulus measures.

Why not sell put options and other market derivative insurance with the Fed committed to moving early and aggressively to counter nascent market instability?

So rather than pare back portfolio risk profiles as pandemic risk began to escalate, many instead bought cheap derivative insurance. There had become little doubt, it was best to remain fully invested, manage risk not by adjusting portfolio composition, but with options and other derivatives.

As markets disregarded Covid risk through much of February, large amounts of derivative market insurance accumulated in the marketplace. Finally, the pandemic could no longer be ignored, risk markets reversed sharply lower, and those that had sold derivative insurance were forced to aggressively sell stocks, futures and ETFs to hedge rapidly expanding exposures. This selling is integral to what quickly escalated into a cascade of self-reinforcing liquidations.

And then over recent months we’ve witnessed unprecedented options trading. That’s by the Robinhood retail crowd, as well as by sophisticated hedge funds and institutions. There’s been a craze for buying out-of-the-money call options, as well as the adoption of trading strategies that use derivatives to duplicate more traditional long stock portfolios. In both cases, these derivative strategies lead to self-reinforcing buying and melt-up dynamics, as a rising market forces those that had sold call options and similar derivatives to aggressively buy the underlying stocks and ETFs to hedge escalating risks.

I have posited that the November 3rd election is the single largest event for risk hedging in market history. Moreover, this most-hedged event comes in the most speculative of market backdrops, which tracked history’s greatest expansion of central bank liquidity. The marketplace has had months to purchase put options and other derivative insurance ahead of the election.

Too much of the marketplace has acquired products and adopted strategies that are expected to offload risk in the event of a meaningful market drop. If we do see negative developments and a resulting market downturn, massive sell programs would kick in as sellers of market insurance move to hedge the risk.

Moreover, an extraordinarily speculative market is susceptible to any shift in risk tolerance. In short, the potential for a self-reinforcing cascade of selling and market dislocation is today even greater than March. If markets gap lower on disturbing election developments, there’s clear potential for derivative related selling and market dislocation. This would follow March’s meltdown and the subsequent derivatives-related melt up.

Importantly, the greater the Fed’s market interventions, the potentially more destabilizing this derivatives monster becomes. I believe we’re already witnessing heightened market distortions from this massive derivatives overhang. Stocks have rallied over recent weeks, at least partially fueled by the unwinding of hedges. As Joe Biden extended his lead in the polls, concerns have waned for the contested election scenario, with a long, drawn-out court battle and possible eruption of social unrest.

Meanwhile, the market has rallied in the face of a widening Biden lead and rising nods of a Democratic clean sweep, or more specifically, the Democrats taking control of the Senate. This has spawned the narrative that a democratically controlled Washington is actually good for the stock market. And while Wall Street today relishes the thought of ongoing massive fiscal stimulus, count me skeptical of the bullish clean sweep narrative.

A Democratic-controlled Washington would likely ensure upwards of a $3 trillion stimulus program, and that’s just to get started. Such massive new supply would risk a treasury market backlash, and we have already seen some back-up in long-term yields. And I do appreciate the bullish view that the Fed would simply step in to buy all the Treasuries necessary to ensure yields remain pegged at minimal rates.

I just don’t believe this would be the slam dunk for our central bank as expected. For one, confidence in the dollar has begun to wane. Significantly expanding QE risks unleashing dollar and market instability. Analyzing the potential course of policymaking, massive fiscal and current account deficits, and the potential for general U.S. instability, a crisis of confidence in the dollar cannot be ruled out.

Importantly, the Fed’s QE resolve has yet to be tested by either dollar or treasury market instability. A combination of both would surely have the Fed moving more gingerly on QE, and markets currently anticipate.

And as I mentioned earlier, I expect strong pushback from Republicans when it appears the Fed is monetizing the Democrat’s state and local government bailouts and liberal agenda. While the Republicans in such a scenario would have limited legislative recourse, the Fed does not want to be in the middle of such an acerbic partisan clash.

The Federal Reserve will be taking significant institutional risk, with the conservative media and a major segment of the populace adopting a critical view of the Fed’s nontraditional policy course.

Let’s wrap up this segment with a section I will call troubling spikes. What I see is a series of parabolic spikes supporting a super cycle endgame thesis. I mentioned earlier the spike in U.S. non-financial debt that expanded 3.5 trillion during the second quarter, adding Q2 U.S. debt growth to second quarter growth, and Chinese aggregate financing brings combined U.S./China credit expansion for the quarter to an astounding $5 trillion, an amount that until recently would have been an annual record. There’s nothing in history that compares.

And not only is this quantity of credit growth unparalleled, this credit is predominantly non-productive. Late cycle spikes and non-productive credit have traditionally been the kiss of death for system stability. I talk about a hypothetical chart of systemic risk showing a big parabolic rise, a spike that unfolds during the terminal phase, rapid expansion of credit of deteriorating quality.

This has been a defining characteristic of credit bubbles and subsequent crises over recent decades, including Japan, Mexico, Southeast Asia, Russia, Brazil, Argentina, U.S. mortgage credit and European periphery debt. What we’re witnessing now, a synchronized spike and terminal phase excess globally, is unique in history.

It’s worth noting, the spike in Chinese credit aggregate financing continued in September with another $500 billion jump. This pushed nine-month growth to a staggering 4.4 trillion. As an analyst, I look at China expanding credit 500 billion monthly over a nine-month period, and I’m in awe. In a year when their economy was essentially stagnant, aggregate financing expanded 13.5%, the strongest growth rate in years.

These are incredible numbers, a historic credit boom, and so few take notice. The view remains that Beijing has everything under control, but a $500 billion monthly credit boom, and largely non-productive credit at that, is evidence of finance running out of control. It’s a highly unstable situation that appears under control only so long as credit continues to expand rapidly. But unless Chinese policymakers have completely thrown in the towel of monetary stability, they will once again be forced to restrain financial excess.

History provides a clear warning. After a parabolic spike in non-productive credit, the reining in process never goes smoothly.

David: Doug, I’d say that history provides another clear warning, which is that if you have financial issues that present themselves or create domestic political and social concerns, things can very quickly move toward geopolitical problems. And so just to pivot from the credit dynamics and concerns that you have to the reality that not only do we have financial market uncertainty but geopolitical uncertainty as well.

I think Graham Allison highlighted this a few years ago. The tensions that he described in his book, Destined for War: Can America and China Escape Thucydides’s Trap? My oldest son is reading the historian Thucydides right now, and I think Graham’s book has helped me explain why books from the past can be so powerful in the present.

I do think destined is too strong a word. There’s nothing determined about our relationship with China in the negative, but if we borrow from the ancient world, we see how Sparta feared Athenian ascendancy, making the conflict during the Peloponnesian War far more likely. And that’s the idea that we, as number one in the world, see this rising economic giant and are unnerved by it.

We know that regional power and influence is increased by the Chinese. If you look at the nine-dash line, it demonstrates that clearly. You have the Spratlys, you have the Paracels, which have become an extension of Chinese military power with the express purpose of galvanizing economic power throughout Asia. And where we go from here is anyone’s guess.

But I think Allison asked the question whether rising economic powers in the future can upset the existing economic order and if that leads to an inevitability with conflict. That’s perhaps a question for those who specialize in international relations, but you do see the financing of the One Belt, One Road project, the Maritime Silk Road. You know that Chinese economic expansionism is matched with a grand vision, which does, to a degree, shift the balance of existing power. And so it’s just important to keep in mind the overlapping areas of uncertainty, and geopolitics is certainly one that enters into our weekly conversations.

And so the question I have is whether the credit conditions that you describe, Doug, in China are not actually part of this narrative. Today’s expansionism, territorially complemented by record credit growth, domestic social and economic issues that can arise if that credit expansion is disrupted, domestic credit markets turning to chaos there in China.

And then, of course, the blame game, other countries. Who’s responsible for undermining our trajectory? Look at the last year or two in terms of the dialog between us and China, it’s anything but friendly.

Allison asks whether the U.S. will be the aggressor. Again, we just come back to where, I think, as a firm we put this broadly into the category of geopolitical uncertainty. There are significant implications. We’re talking about world trade, financial flows, the value of the RMB, the value of the dollar, increased interest in gold.

Sorry to break in, but it just seems to me that this is in complement to your comments on credit. It’s important that we know that it’s not just about numbers, but it’s the implications from the numbers into personal lives, into political structures, and ultimately into geopolitical relations, which can be self-reinforcing, not necessarily for the good.

Doug: Absolutely, David. And thank you for that excellent insight. This parabolic rise in non-productive credit is not a characteristic limited to China and the U.S. It’s global – Europe, Asia, and the emerging markets more generally, and this credit fiasco is only possible because of the corresponding parabolic spikes in central bank credit, an additional 3 trillion from the Fed, 2 trillion from the ECB, 1.3 trillion from the Bank of Japan, and likely a trillion or two from others.

What are the prevailing consequences of this massive global liquidity injection? More powerful and synchronized asset bubble inflation, destabilizing manic market behavior, and I believe only greater accumulation of speculative leverage, with resulting acute systemic fragility.

Here in the U.S., markets are more convinced than ever that the Fed will do whatever it takes to continue bolstering markets. After last September’s insurance monetary stimulus and March’s incredible crisis response, markets do not doubt the power of the Fed’s tool kit, but there are notable holes in this point of view.

For one, there’s an overarching global bubble with much residing outside of the Fed’s control. There is major fragility in China and Europe and throughout the emerging markets.

Secondly, each Fed-orchestrated market bailout only ensures greater speculative excess and leverage, only creating a more problematic bubble dynamic. Distorted markets have turned hopelessly dysfunctional. They’re incapable of self-adjustment or disciplining even the most egregious excess.

Third, as I mentioned earlier, the Fed is now fully immersed in a far-reaching political and social battle with Fed monetization policies to now garner more attention and criticism. These days, the Federal Reserve and market nexus is viewed as a prevailing source of societal inequity and resulting strife.

Fourth, the Fed’s rapid $3 trillion policy frenzy was in response to a unique crisis backdrop, one characterized by a rapidly escalating pandemic, economic lockdown and market dislocation. The next crisis will unfold amid desperate circumstances, which could see the Fed taking a more measured approach with stimulus.

I worry about all these parabolics, the confluence of spikes in credit and central bank balance sheets and market prices, and in social and geopolitical insecurity. The spike in credit only exacerbates myriad inflationary effects that have been festering for years, including asset inflation, market distortions and deep economic maladjustment. All would turn more unwieldy with any waning of the credit boom.

The spike in central bank credit incited unsustainable speculative excess and a full-fledged market mania, elevated market prices and leverage worsened fragility, and now ensure only greater dislocation come the next bout of risk-off, de-risking and de-leveraging. The spike in market prices further expanded the gulf between inflated markets and deflating economic prospects.

This chasm, arguably the widest since 1929, creates vulnerability to market reassessment and adjustment.

Over recent months, the spike in central bank liquidity and government deficits fed directly into the market spike that has supported economic recovery. Faltering markets would see a hit to perceived wealth and confidence, while a tightening of financial conditions would choke a structurally frail economic structure.

I’m confident – I’m very confident – in the bubble analysis, and while timing is always quite challenging, I believe we’re late in the game. In my analytical framework, these unsustainable spikes are the beginning of the end. The clock is ticking and Covid cases are spiking again just as we’re headed into winter. Daily cases have spiked to a record 120,000 in Europe, and governments are in the process of re-imposing restrictions that will crimp recovery. While I don’t expect a return to full-fledged national lockdown conditions here in the U.S., a Covid spike comes with negative consequences.

There’s a general misconception in policy circles and the markets. The bullish view holds that the system was robust prior to the pandemic. With some temporary support from aggressive monetary and fiscal stimulus, the economy can get right back on its sound trajectory.

My analytical framework communicates something altogether different. The system wasn’t sound. A maladjusted bubble economy badly distorted from years of ultra-loose monetary policy and huge fiscal deficits. Asset prices were already inflated with powerful speculative bubble dynamics in force throughout the financial markets. In the real economy, loose financial conditions nurtured scores of uneconomic businesses and enterprises. The corporate sector was already overleveraged.

Importantly, this bubble economy structure has become an absolute credit glutton, and this credit addiction ensures massive fiscal deficits cannot be a temporary phenomenon. Our system is in the throes of a runaway inflation of non-productive credit, a predicament shared around the globe.

At this point, I don’t believe there’s any turning back. The stock market mania these days feeds off the notion of zero rates, QE and a fiscal spending bonanza. Yet there are monumental risks in the current policy course.

Let’s return to the virtues and the vulnerability of money, and of moneyness. Policymakers have failed to learn crucial lessons from history. We’re now in a period of unparalleled over-issuance, over-issuance of central bank credit, of treasuries, of money, of agency debt, of corporate credit, along with over-issuance of suspect equity securities and derivatives of all stripes. We are today risking no less than a crisis of confidence in finance and policymaking.

There was a point during the Fed’s initial crisis response back in March when aggressive Fed measures were actually failing to contain the market panic. It was very alarming. I had never witnessed this in my decades of following the markets. While quickly forgotten in the marketplace, I fear that episode was a harbinger of what we will face with the next crisis.

David, back to you.

David: Thanks, Doug. As I listen to your comments, it just underscores why the strategy is an important component in someone’s overall financial picture. As we mentioned earlier, it’s designed to reduce an overall risk in a total portfolio strategy. So where you may have accounts managed with different thematics on other platforms, our intention is to see that your downside is moderated. So in a global market backdrop, with the extraordinary uncertainties that Doug was describing and the risks that come with excess credit expansion, we feel that this is an excellent complement, and if it’s something that you have considered and want to engage us with, I grant you, coming into the election this is going to be very, very interesting to see what kind of volatility emerges through November 3rd.

But I would engage in conversation nevertheless, now, post-election, what have you, as we see some of these things unfold. So, we look forward to engaging with you in that way and discovering with you if it’s a good fit for your overall financial needs.

So we go to the Q&A, and there are some of these questions which I’ll handle, and Doug can handle the others. As I mentioned earlier, if you want to go to the mwealthm website, there in the bottom right-hand corner is the chat box, and I’ve got a couple of questions that have come in from that, and I’ll put those to the end of the long list we already have.

I’m going to take the first one, which is:

With millions in cash, what are we to do in anticipation of negative interest rates, and with the idea that digital coins in Britain, Europe, and the U.S. are coming?

I’m going to interpret that last piece as central bank digital currency, as opposed to what we know as the more current cryptocurrency offerings because there has been a suggestion here in the last 3 to 6 months from each of those places, the UK, the European Union, and most recently here in the United States, that we have the equivalent of Fed coin, or whatever it may be, the digital currency managed by the central bank.

I think that looking at the risk implicit to a cash position, specifically, negative interest rates, you have to balance out a cash position with other hard assets, with metals, that is, gold and silver, the kind of offering that we have with Vaulted at vaulted.com, that kind of a cash equivalent or bank savings account alternative, just to re-denominate some of your liquidity position.

The fact that there’s more and more discussion about a digital currency issued by central banks, what that portends is that negative interest rates are coming, and what is best described is really the context in which central bankers double down their efforts. There’s no admission of wrongdoing to this point, nor will there be. There will be no mea culpa from the central banks. There may be an assertion that they should have done more, and that’s why they need to do more, and that’s why – and then you fill in the blanks with what the next policy prescriptions are.

But negative rates are something that allow the central banks to extract value from cash deposits. Again, I think that if they’re talking about a digital currency in that sense suggests that hard assets are something to consider. If you can find income attached to those hard assets, even better. Those are ways of addressing the consequences more opportunistically of that kind of a policy direction.

The next question, Doug, deals with the bond market:

Are 30-year bonds over after being the best trade since 1981?

Doug: Well, 30-year yields traded today at 1.65%, so that’s a far cry from the double-digit yields from the early eighties. Could yields go lower? Perhaps in a crisis environment with massive Fed QE purchases. That’s certainly possible, but I see the risk versus reward calculus for long-term treasuries today as unusually unattractive.

I certainly wouldn’t want to bet on consumer inflation staying low over the next few decades. To buy long-term bonds today with the expectation for yields to go lower, for one, that would be showing a lot of faith in the Federal Reserve. There is massive, unending supply coming. I would not be surprised by several years of deficits running at least 10% of GDP.

And it’s not clear to me who will be buying these trillions of new long-term treasury bonds. The Fed, of course, they’ll take a chunk of it, we know that. The Chinese in the past were major buyers, but they could turn sellers going forward. The foreign central bank community has also been consistent buyers, but I would expect their interest to wane as well. I guess the hedge funds can continue to buy treasury bonds on leverage, but there were indications last September and again in March that speculative leverage has already become a major source of vulnerability for the treasury market.

So I would tend to believe the great bond bull market is coming to a conclusion. But then again, when I see Italian yields go to 0.6%, Greek yields to 0.8%, French yields a negative 35 basis points, I guess it’s a reminder that in this strange time, almost anything is possible.

David: Doug, I think one of the things that presents itself as a part of this tension is on the one hand, you’ve got policy prescriptions which might define the course of interest rates lower if you’re talking about what central banks want. But sometimes what we want in life is not what we get.

So the difference between the policy prescription and a market-imposed discipline, the response within the market place, regardless of what the policy announcement or prescription may be, prices ultimately are not determined by the central banks. Now, we’ve grown accustomed in recent years to thinking that that is the case, but there dozens of examples over the last 20 or 30 years, where it was the case on Monday and on Tuesday – or pick the day in sequence, it was no longer the case.

The policy makers did have influence, but not control. And people believed they had control and all of a sudden were shocked to find that, no, the market is still alive, and will price assets according to their risk profile, whether that’s a credit profile or what have you. So there’s a lot in that question about bond market being over. Who determines the course going forward? And who has the control? I think that’s a part of part of the discussion.

The next question:

I’m not sure this is the correct time to ask, but I’m terribly curious about the possibility of the U.S. Treasury returning to the gold standard. Apologies if it’s off topic. Sincere and total appreciation for you.

In brief, I’d say no because the gold standard represents constraints which are not consistent with the textbook knowledge that has been disseminated for decades and decades and decades. I think individuals can do it for themselves, but if you look at the policymakers and the focus of the U.S. treasury, the idea of going back to a gold standard is the idea of really saying we’re going to live within our means.

There is a natural conclusion, a logical conclusion, which is drawn from having a limited supply of money. If you have a limited supply of money, you can’t spend more than what you have. Can you imagine politicians having to deal with an actual budget, and there being a high penalty to running a budget deficit? These are the kinds of constraints that the Treasury Department does not want, and the politicians would not vote for.

And I think the likelihood again of returning to a gold standard is very low, certainly relating to what I mentioned earlier, this theoretical bias against it, because Keynes has dominated the textbooks for decades. What people know about economics, what people know about the definition of money, the use of money, etc., has a deep philosophical basis, whether people recognize it or not, an ideological basis in John Maynard Keynes’s ideas. And to break free of that, you’re talking about a long process.

I’ve thought that perhaps on the other side of the crisis, there might be more openness to it, and it’s difficult to say because on the other side of a significant crisis, we don’t know who’s in leadership. We don’t know who is voting, but we do know at present the current folks in D.C. would never allow it. So you’re talking about significant changes in other places within the structure of power before that conversation would even be welcome.

Doug, next question is for you:

What do you see as the best hedge against a falling market for an individual investor who is not high net worth but wants to protect his assets?

Doug: Excellent question. Unfortunately, whether one is a small investor or a major institution, finding a so-called best hedge has become quite a challenge. And some of the traditional adages, such as long-term treasuries, will almost certainly be less effective as hedges than they were in the past, and they could completely fail as hedges. We could have treasuries get hammered as stocks get hammered.

I would start by saying that for many of us, using some savings to pay down debt makes a lot of sense today. My own view is that it’s prudent to reduce exposure to equities and risk assets across the board. Despite low deposit rates, I still view it as a great time to build cash balances, build reserves.

We certainly like gold and precious metals as long-term stores of value in this age of reckless financial excess, at least for me, and I think David is similar, I’ll let him speak for himself. But at least for me, the precious metals remain the best hedge against central bankers and spendthrift governments.

I don’t recommend nonprofessionals do any shorting, so I won’t recommend any short positions as hedges.

David: Follow-up to that question from the same person:

Where do you see stocks heading in the short term?

Doug: Well, I believe equities are quite vulnerable, but I have enough battle scars to remind me to shy away from short-term market predictions. As I discussed earlier, there is great uncertainty heading into November 3rd, and the fact that there’s been so much hedging going into this election season, it only adds to a degree of uncertainty over short-term market moves. These markets could do anything short-term.

Currently, the odds seem to point to a reasonable probability of a Democratic clean sweep, and while stock market strategists look favorably on the likelihood of all the stimulus, I think there’s a chance that such an outcome proves problematic for the dollar and the treasury market. So I could see stocks rallying initially on a decisive election for the Democrats. But I would expect a jump in yields would be a cause for concern for equities.

Let’s say Biden wins, but the Republicans hold the Senate. This could be viewed positively for treasuries, and lower yields might support post-election equities in a bounce and continued rally. Markets could see a short-term boost from the unwind of hedges. We don’t know. That’s an unknown.

So our plan is to come in every day with our intense focus and be ready to respond, and we really don’t sit around and try to predict short-term market moves.

David: The next question is about how to protect cash, stocks and other assets against a move to digital money. I think I had started on that one to begin with, so maybe I’ll add a couple of things there. It’s always struck me as an important choice to keep your options open, and of those listed assets, cash, stocks, other, I agree with Doug in terms of building reserves. How you did denominate those reserves is a secondary question, a follow-up question.

So yes, pay down debt, build savings. As you’re building savings, figuring out if that’s greenbacks or ounces, I also agree with Doug, I have a little bit of gold flowing through my veins, so, comfortable with that as a reserve asset personally. Cash is really the primary risk if you’re talking about digital money, and I just think it’s way too early to categorically write it off. At this point, you’ve got discussions among central bankers about what they would do with a digital currency. That could be two years away or 20 years away. It’s too early to say, well, then I just hate cash because it holds that potential risk. Keep it in that category, a potential risk.

And even then, if you see the experimentations already done in the Scandinavian countries with negative rates or even in Switzerland, you have to weigh what the actual costs are to getting out of cash. What is the actual risk there? A depositor with Credit Suisse in Zurich might get dinged a half a percent per year or three quarters of a percent per year. That’s real, it shouldn’t be ignored, but it’s also not catastrophic. And so I think that’s what you’d have to look at. I would be fairly levelheaded in that way. I wouldn’t write off cash as a category at this point.

Next question, Doug, is very brief:

Puts, calls, strike prices?

Doug: Okay, I’m not sure of the question, but I’ll assume it’s related to Tactical Short strategy with options. I’ll start with that. In general, options provide some advantages. Purchasing put options provides downside market exposure, but with limited losses. That’s appealing to me as a manager of short exposure.

We plan on incorporating put options into our short exposure, but these are tough instruments that often work better in theory than they do in reality, so we have always planned on trading options carefully, to look to use them opportunistically. And we actually have not been using them. I’ve traded options since the mid 1990s. I prefer to use them when financial conditions begin to tighten. Since March, also, option prices have remained elevated, which on the margin reduces their attractiveness on a risk-reward basis.

But let me also add, if the question was actually seeking a recommendation on a particular option trade like shorting, I recommend nonprofessionals avoid trading these instruments.

David: Is there any indication that the Fed and/or investment banker managers are active in support of ETF funds and thereby defeating short positions?

Doug: Good question. Well, the Fed has resorted to conspicuous massive direct support of the markets. We all know that, it’s obvious. And we also know the ETF complex has become so dominant in the markets that it will now garner keen attention during crisis periods, any period of market stress, and we certainly saw that in March.

The Fed has responded by adding equities and buying ETFs into their instruments that they’ll purchase in a crisis environment. The problem is, every time they intervene in the markets they just embolden speculation and incite even greater flows into ETFs and other perceived safe instruments. It’s been a wall of liquidity into the ETFs since March. The bubble just inflates. It gets bigger and bigger. And this is why I focus some of my comments on all of these spikes, all of these extreme developments we’ve witnessed over recent months. I believe all these extremes set the stage for what I’ll call a momentous market reassessment and adjustment from “they have everything under control,” to, “oh no, this is out of control, let’s get out.” From everyone loves equities and corporate bonds for the long-term to a potential run and panic. That’s unfortunately the nature of markets.

David: Doug, this next one deal with short portfolio:

Curious about how dollar devaluation influences short portfolio management?

Doug: Good question. It’s more complex than one might think. Generally I view a weaker dollar as supportive of equities, supportive of global risk-on, so weakness would factor into our overall assessment of risk versus reward, that calculus for short exposure.

When we discuss dollar evaluation, we think of a backdrop of loose monetary policy and credit excess, an environment where risk control must take precedence on the short side. But the current environment is beginning to look different. I believe we’re seeing indications of what’s called a regime change.

Dollar weakness is now a key indicator, at least of mine, of general confidence in U.S. policies, and that’s financial stability and U.S. prospects, more generally. So we’re monitoring the dollar in currency markets closely. It’s only one of a mosaic of indicators. But if I see more dollar weakness in concert with other signs of fledgling instability, then I will view this as improving the risk reward for shorting. I would look to add short exposure, potentially adjusting the composition of short exposure and becoming more opportunistic, and somewhat less risk averse with overall short exposure.

David: Next question:

I just read a report that talks about the elimination of cash in large denominations in the U.S. Could you address this issue?

There is, of course, the book written several years ago by Ken Rogoff, The Curse of Cash. The argument was made by Mr. Rogoff that, whether it’s drug money or any other form of illicit use of cash, that the cash was dangerous and we needed to eliminate it. He is an academic, but he wrote this particular book in very layman terms, making an appeal that we need to eliminate the dangers and make the world a safer place.

We’ve already seen experimentation sponsored by the USAID in India, where they did eliminate large denomination currency and tried what they considered “financial inclusion” to bring people into the banking system.

Now, with Covid, it’s interesting. The latest argument is not so much that we have to be worried about drug money and money laundering, now it’s dirty. We know it’s dirty because if you put Covid-19 on bills, it stays there, I forget what the research said, 24-27 days. Science proves it. I thought it was fascinating as I read through that, that actually the only way it stayed that long is by over exposing the bills, basically dumping Covid-19 on them, not with a minor exposure, but it would be like soaking each bill to the degree that you could. I thought that was interesting.

But they are basically saying that now science proves that cash is dangerous because Covid stays on it a long period of time. Again, the devil is in the details. You’ll find more Covid cells on any surface if you just put them there in the billions versus the tens or hundreds.

The issue is still driving toward what we talked about on our weekly commentary for years, which is that financial repression is a policy course which is very useful to policy-makers. It allows for a corralling of investors and the limiting of options, and an extracting of value. That’s basically it. It’s another form of taxation, and another form of determining who wins and who loses as they clean up a significant financial mess. So cash in the mattress has always represented an opt-out. As gold represents an opt-out, so does cash. So if you can eliminate the most popular of those opt-out mechanisms, then you move toward being able to implement that policy choice which is known as financial repression.

Will it get implemented? I don’t know. We watch, and we look at things as they’re announced, whether it’s reading Foreign Affairs magazine. Actually, they did a trial balloon with Rogoff’s book about a year before he published it, The Curse of Cash. It showed up in Foreign Affairs magazine as a feature article. So we’ll continue to watch and see what policies they want to implement, but it would seem that they’re trying to find reasons, if that is much of an answer.

The next question is:

What are the potential implications of upcoming election results?

Doug mentioned a couple of those highlights, and I’ll mention just the categories that we think through. The implications of an election result, again, blue wave, red wave, some sort of a split outcome, we would look at monetary policy implications, we would look at fiscal policy implications, we would look at social policy implications, of course investment implications following on all of those broader categories.

Is there an implication for the cost of goods and services? Is there a greater likelihood of what I was just talking about, financial repression? These are all things that we could begin to lay out, depending on who wins. The biggest of those categories, I would argue, are almost identical.

Doug and I may differ on the details here, but in terms of monetary policy, will we see an elimination of monetary policy largesse one way or the other? Will we see a curtailment of fiscal policy largesse one way or the other? Now you’re talking about who spends on what, but not the quantities involved. I think you’re still talking about significant quantities in both of those categories.

Maybe the one difference is in the area of social policies where you do have a clear difference between one side versus the other. And obviously the Democrats tend to sponsor a larger role for the state in all things and so in that sense there are implications. This is not a complete punting on the question, but it seems to me there’s not a big difference in terms of actual policies implemented between Republicans and Democrats.

Doug, feel free to take that and agree, disagree, or add to it, or take away from it. Give me a better answer.

Doug: We’ll chat Monday, right? That’s our big session on the election, so it’ll be fun.

David: Yes. Well, how does the short strategy work in a market that continues to go up?

Doug: A continuously rising market makes life tough on the short side. That’s reality, but I’ve operated in upward trending markets that still provided attractive short opportunities. I’ve also operated in strong markets where I didn’t see huge downside market risk.

What makes this environment extraordinarily challenging, what makes it unique, is this combination of extreme speculation and extreme downside risk. The potential rewards from shorting are the most attractive of my career, but risks remain quite high so we have to be disciplined with risk, be ready to shift to a more opportunistic stance.

At this point of the cycle it’s a daily focus to stay on top of developments, to stay on top of market dynamics in the course of policymaking. In short, it’s just a daily challenge, a daily grind. That’s the way it goes. We like challenges around here, and we’re pretty excited about what’s unfolding here with opportunities.

David: Next question reads:

What am I, or we, missing? When will mid and long end of the bond market begin to react against the central bank’s massive stimulus programs and the out-of-control federal budgets?

Doug: Yes, isn’t that the truth? The 10-year treasury yield is today up to 0.86%. That’s the high since June, so we’re seeing a yield reversal. We’re seeing higher yields. That’s not a flop, it’s a start. The Fed’s been buying $100 billion of securities a month, and markets today assume they’ll buy as many as necessary to keep rates low.

I think also, the leverage in long-term bonds continues to grow, and with all the supply in the pipeline, this is a market just really vulnerable to a surprising jump in yields.

As I mentioned earlier, corporate bond yields have remained low in the face of mounting credit risks. I see the corporate bond market as especially susceptible to disruption, to de-risking and de-leveraging. These are key aspects of a historic bubble that I keep rambling on about. This bubble has gone on longer and to a greater excess than I thought possible, but I believe this only assures more trouble in marketing, economic adjustment, but it’s coming.

David:

Is there any chance that companies will start to issue new stock? Years of share buybacks have created a virtual shortage of shares, which drives this market higher. Is it possible for companies to issue new shares at the same time as they’re buying them back? Would this be done to rewrite the shareholder bill of rights, making NYSE a list of quasi private equity firms rather than publicly traded companies?

David: I would say a couple of things. There is, depending on the sector in question, lots of new shares issued on a routine basis, particularly if you look at your Silicon Valley types. Your tech companies are notorious for issuing shares as a form of compensation so that you don’t see the compensation line item increase, a diminished impact on the P&L. So that’s a way that they play the game, low expenses, issuing new shares.

I think, at this point, if they can continue to play the earnings per share game, they will. What I mean by that is when you shrink the share count, even with diminished earnings, you can pretty up the pig, so to say. You can make the results look better by shrinking the number of shares that are compared to those quarterly earnings. So that’s a game that I would expect to be played on an ongoing basis.

I think just looking at the pattern of boardroom behavior, there tends to be a lot of money spent on buybacks at high prices, and issuance of shares at low prices, as often … and I don’t know why that pattern is the case. That’s the classic by high, sell low, which is not favorable for an individual investor, and it’s really not a good idea for a corporate treasury to do the same, but that’s typically what does happen.

I think that’s all I would say on the issuance of shares, either continued issuance or trends in buybacks. Obviously, the question points to one of the elephants in the room, which is, companies have improved their numbers considerably by shrinking shares outstanding. And that’s paid into executive remuneration. That’s factored in there. And I would expect them to do that for a long as they can. I think one of the things to keep in mind is that we are beginning to see a change in conditions, and they may not be able to do that any longer. So I would I would watch for continuation of the conditions shifting that don’t allow for them to use their liquidity in those ways.

Doug, the next one deals with two particular short products:

Is a substantial position in SH or GRZZX a viable choice?

Doug: I don’t recommend nonprofessionals do shorting, and I’m leery of most short products available in the marketplace right now. There is not an inversely correlated product I would be comfortable recommending today, unfortunately. If I could offer a bit of advice, if you feel compelled to purchase a so-called bear fund, do your research and choose a less volatile product, a fund with a lower beta. That would be my recommendation today.

David: I might just point out that that’s what we are here for, and what Tactical Short and the noncorrelated are specifically for, retirement accounts, is able to do for someone without the responsibility being on the investor to make the corrections and the allocation shifts in terms of percentage exposure to the market.

That’s what you do, Doug. I know you’re not going to necessarily say, “Hey, that’s what we’re doing. That’s what we do.” So as you’re considering those other products, I will unashamedly say you should look at ours, as well.

The first part of this question:

Doug, is the crash imminent?

And the second part is:

What would some early warning signs be of a crash?

Doug: Let me put it this way. I see all the signs that lead me to believe a crash scenario is a possibility, and I don’t view it as a low probability. There are a number of potential catalysts. I touched on a few that have me quite concerned. As I mentioned earlier, all these spikes increase the odds of an accident.

Warning signs – we were on the cusp of a crash scenario in March, and in that strange case, there were few warning signs outside of all the excesses in the markets over the preceding months. What warning signs would I expect in the current environment? I think a spike in treasury yields would be problematic for the markets. If you a saw spike in treasury yields with a widening, with widening risk premiums for corporate credit, widening credit spreads, I think that would be a serious issue today with all the leverage.

With the current structure of markets, any significant de-risking, de-leveraging dynamic has potential to snowball into market dislocation and panic. De-leveraging in the corporate debt market would be a key indicator of major systemic stress. I would expect such a dynamic to show itself in the credit default swap, the CDS marketplace, along with waning liquidity and cancelled debt deals and things like that.

I would expect a spike in bank CDS, big outflows from the ETF universe would be a warning sign. Waning confidence in the derivatives market would be a very important sign. For example, trouble in the repo and overnight funding markets, currency market instability, especially for currencies popular for carry trades and leverage speculation.

Importantly, and I touched on this, if we see markets questioning the power of the Fed, the system, I think, then faces a critical test. We started to see this in March, and the Fed quickly responded with overwhelming QE and other stimulus.

What happens when they come with overwhelming firepower but markets don’t react? Those are those some of the things we’re looking to.

David: Next question:

With a period of debt revulsion and default, interest rates should smartly rise. Would this not strengthen the dollar as the world’s reserve currency?

Doug: Yes, great question. Let me start by saying, as the world’s reserve currency we’ve been running massive current account deficits now for going on three decades. The Fed just expanded its balance sheet by 3 trillion.

We just ended the fiscal year with a 3.1 trillion federal deficit. So we’re doing about everything possible to damage our status as the guardian over the world’s reserve currency.

As part of my macro analysis, I lean on this periphery and core framework where instability generally arises in the periphery first, and then moves toward the core. Typically, in a crisis environment, the emerging markets are at the periphery. They would initially show the most vulnerability, and as risk aversion takes hold at the periphery, and we’ve seen this, finance actually tends to flow toward the core, which has worked in the past to boost the U.S. dollar to boost U.S. securities prices.

But what happens when the excesses at the core create fragility at the core, and that’s where I think we are today. There is fragility in the emerging markets, Europe and China, but there are reasons to suspect that there are acute latent fragilities here in the U.S., and the markets have been positioned for the dollar to act like a safe haven in an unstable world.

I think this this type of speculative positioning only increases the likelihood for a destabilizing break lower in the dollar. For a long time now, we have flooded the world with dollar balances and securities. A reckoning, I fear, is long overdue.

David: The next question is about being long gold and precious metals miner as a hedge.

Is a long gold in miners a better hedge considering how difficult it’s been to short anything since March 2009?

Better is the key word there. I don’t know if it’s an exact hedge at all in the sense that miners have their own risk profile, in particular. I would say there’s a complementary strategy. It’s one that we do offer in house, what we call our MAPS strategies, four different management styles, the M, the A, the P and the S. And it does include, to a degree, some exposure to gold and miners, along with other things of structure, especially real estate and global natural resources. But to describe any of those, or even just two of those, as the equivalent of a short position, I don’t think you can, but I think they are complementary to a short strategy. I would say that if there’s anything that represents sort of a systemic hedge, it might be long gold. And anything else on that list would have its own unique issues to consider in terms of risk versus reward. Gold does, too, but as a systemic hedge, I think gold still stands out.

I’ll take this next one, too. It’s, I think, kind of a personal question:

Is it best to keep silver investments rather than purchasing a house?

I would put that question in a personal category, not knowing the needs and the priorities of the particular person. I think that the next 24 months for the silver market do represent a compelling opportunity for appreciation, and if I had the opportunity to look at the silver/house exchange rate in two years, I would probably do that.

But of course, there are other considerations when you’re thinking of a house. It’s not just finance in play. But if you could boil it down to one asset class versus the other, I think you probably have better appreciation potential in the silver market than you do in real estate. Some of those factors are relating to interest rates, the direction of interest rates and, ultimately, who can afford housing. What happens to the price of a house, real estate?

Sometimes people forget that real estate and the bond market often trend together. The cost of capital is important for the value of both of those assets. So if we should see, as that earlier question was asking, debt revulsion, default, interest rates rising smartly, on the one hand, you have an axiomatic move lower in real estate, and with the metals only a move lower if you’re talking about a positive, not just rise in interest rates, but a rise in real rates.

Doug, this next one for you:

I recently read an interesting article by leading technical analyst, asserting that, number one, stock markets lead the economy and not the other way around. And number two, market sentiment outweighs all other factors in deciding the level of the stock market. Would you subscribe to that philosophy?

Doug: Thank you for your questions. I definitely subscribe to the framework where I see the markets lead the economy more than vice versa. And this has become even more the case in recent times. The markets respond first to a loosening of financial conditions, and then strong markets promote credit growth and wealth effects that feed into the real economy.

And these days, the Fed directly uses the markets as its primary source of system stimulus. Now, it hasn’t always been this way. The traditional dynamic was for the Fed to adjust bank funding costs to encourage bank lending, and that would feed over time into the real economy. So there is no doubt in my mind that markets lead, which creates a lot of economic uncertainty when the markets turn unstable.

As for market sentiment outweighing other factors, I would say that is somewhat the case. My first question would be, what is driving sentiment? Is it faith in the Fed, recent market performance, general confidence in policymaking? Especially in a bubble backdrop, market sentiment means about everything.

But there is a confluence of factors that support entrenched bullish sentiment. That’s key to a bubble. Today, whatever-it-takes central banking is fundamental to market optimism, speculative dynamics and these massive flows into the markets, unrelenting flows. Bullish sentiment is underpinned by the view that policymakers, and that’s monetary, fiscal, will do everything necessary to support the markets and real economy. And there is this self-fulfilling prophecy where these booming markets then support economic growth.

And it’s self-reinforcing, and it works – until it doesn’t. At some point the finance becomes hopelessly unstable, dysfunctional, and the real economy becomes dangerously maladjusted. That’s how you get to this point of a looming crisis of confidence, and I touched on this earlier. At some point, there’s this holy crap moment where the basic premises of the whole bull market are questioned.

David: The next one is:

Is there a way to benefit from the bearish outlook on commercial real estate by shorting a CMBS, that is, commercial mortgage-backed securities index? Perhaps that segment is less likely to receive liquidity injections from the U. S. Fed.

Doug: Interesting question. Carl Icahn, the big hedge fund manager, last year bet against commercial mortgage-backed securities and that turned into a home run for him, for his fund, with Covid. He did this through the credit default swap market. Think of it as buying really cheap flood insurance during a drought, but you buy it right before an unexpected deluge and wipeout of a flood. It was a very attractive risk/reward trade in the derivatives market, with some luck thrown in.

Tactical Short will not be trading the CDS markets or buying over the counter derivatives. There are CMBS ETFs that could be shorted. I know iShares has one, and it came under significant pressure along with everything else in March, but then rallied right back to near all-time highs and returned almost 7% year-to-date. Fixed income shorts, generally, provide their own challenges. If you short a security that provides a dividend, you have to pay that dividend. So these ETFs that offer attractive yields, there is a significant carrying cost involved in your short. You basically have to pay that yield.

As I mentioned earlier, I approach these types of short positions very cautiously when financial conditions are so loose. We’re in our default short exposure position right now, but hopefully we’ll be able to begin broadening this out in the not-too-distant future.

David: The next question is about the best way to hedge silver and gold positions for the short-term, say, over one to three months, not using futures market instruments.

That’s a tricky question because if you want to hedge anything in the gold and silver space, you can even look at an inverse ETF. Look at the structure of those inverse funds and you’ll find that you’re right back dealing with derivatives. You’re dealing with the futures market again. It’s just one level removed. You don’t have an account with a purveyor of futures market instruments, but you are still using them. It’s just one layer deeper. So you’re buying and selling like a stock, but you’re still connected to the futures market in that way.

I would say if there’s something that you expect as an imminent impact to any market, selling down to the level where you sleep at night is probably the best thing to do. Cash gives you the option of redeployment later on, and takes away some of the complication. You’re hoping that in the context of stress and pressure on a particular asset, in this case gold or silver, that the tool you use to short is a reliable tool. And that may or may not be the case depending on how healthy the market is, on how well it’s functioning in that moment of stress. So again, I would say, sell down to a level that you’re comfortable, as an alternative to going short. Just eliminate some of what you have as an asset class risk.

David: Doug, a question from the online portal:

Is the euro currency a problem?

I think at the end of the day, and I’ve said this before, I don’t think the Italians and the Germans share a common currency forever. The euro has been strong, especially recently, it’s been strong in the face of an impaired banking system, a weak economy, all the issues in Europe. Why has it been strong? Because of the weak dollar.

So I think the euro, unfortunately, was a flawed concept. You have all of these individual countries sharing a common currency with significantly different cultures, different fiscal policies, etc. I don’t think it works, and unfortunately, I think the stress that we saw back in 2011 and 2012 was an important part of the global bubble in that the ECB started aggressive QE, and it just led to all the other central banks being able to do QE. It was an important factor of getting us to the point where we are today of de-synchronized global bubbles. So I’m not a big fan of the euro currency, unfortunately.

David: A friend of ours has often, referring to the French and the Germans, referred to it as a Frankenstein currency (laughs) and I think that’s about right.

David: The next question deals with financials:

Why are financials strong?

Doug: Financial stocks? Okay, I’ll assume it’s stocks. Well, the banks have been very weak. They’ve rallied. What has been stronger lately, very strong, would be the brokerage stocks, the broker dealers. Why have they been strong? They’re trading income has been off the charts. They’re benefiting from record corporate debt issuance, huge deal flow. Their capital markets businesses are absolutely booming, and the assumption now is that the Fed will ensure that that boom continues.

The bank stocks, on the other hand, I think they’re signaling, and when I say bank stocks, I’m not talking about just U.S. banks, European banks are back to below March lows. Asian banks have been weak. Banks in Japan have been weak. U.S. banks have dramatically underperformed this year. I think they’re signaling this approaching major credit problem, and they’re going to have to continue to lend in a new environment of very elevated credit risk. So I guess it’s a little bit of a bifurcated market for the financials right now.

David: Doug, that wraps up our questions for the call and I just want to conclude with where we started, gratitude for our account holders. We value you very much. And if you ever have questions, feel free to get on the phone with us. We look forward to those conversations.

As we march through the remainder of the fourth quarter, this is one for the history books, and again, it’s a privilege for us to be partnered with you at a very critical time in financial market history, both chronicling what is happening and also making real-time decisions in light of the changing dynamics.

Grateful for your time today, and if you are sort of kicking the tires with Tactical Short, or our other Wealth Management products, we hope to provide the resources that you need to make a decision in short order. We do think that there are opportunities here in the marketplace, and significant opportunities as we come into the end of the year. So we look forward to engaging you with answering any questions you may have and getting the process started. Thanks so much for your time today.

Doug: Thanks, everyone, and good luck out there.

• Don’t be risk indifferent – unwise to maintain 100% short exposure all the time
• Don’t disregard the macro backdrop
• Don’t ignore the market
• Don’t disregard portfolio beta
• Don’t pretend long/short strategy mitigates risk
• Don’t only short stocks
• Don’t maintain concentrated short positions
• Don’t only short a market index
• Don’t have illiquid positions
• Don’t rely on potentially problematic third-party derivatives
• Don’t invest short collateral in potentially risky and illiquid instruments
• Don’t be a “one-trick pony” – (i.e. company research, index or quantitative focus)