David: Good afternoon folks. This is David McAlvany. We will go ahead and get started with our Third Quarter 2017 Tactical Short Conference Call. We have a slew of questions that have been submitted and we look forward to getting to those here in a few minutes. There is also the opportunity, for those of you who did not submit questions ahead of time, if you would like to, you can do that online that we will be able to see in real time and we will address those as quickly as we can, of course, with deference to the questions that are still in front of us. We have several hundred people who will be joining us today and as you can, I am sure, guess, there are quite a few questions.
We are thrilled to be gathered today. Doug is going to join us here in a minute and share some of his thoughts reflecting on what the third quarter looked like and I’m very, very excited about that. I want to thank our clients for taking the time today, both those who have jointed the platform here in the last few months and since the beginning of the year. We also thank our friends and institutional partners for the opportunity to offer the Tactical Short, what we think is a better alternative in the short space.
This has been an absolutely fascinating period of time. The context is, for us, one of the most exciting that you can imagine, being in the asset management business. We have record highs in the stock market being set almost daily, whether it is the Dow Jones Industrial Transport Utilities Average, the Russell 2000, the NASDAQ, NASDAQ 100, and we are beginning to see the indicators that your analysts of old have looked as tried and true indicators of a market top, whether you are looking at the Q ratio or the Shiller PE, revenue-to-price, price-to-sales – these ratios that have never been hit before. Global stock market capitalization last week hit 87 trillion dollars. We tacked on an extra 2 trillion then. By the end of this week maybe it will be another 2 or 3 trillion, and global stock market capitalization, relative to global GDP, is also at an all-time high, never been here before, 111%.
It is, for us, what is an everything bubble. It is the consequence of a massive amount of accommodation by the world central banks, and we get to see not only what the consequences are of that money creation, but also what some of the unintended consequences might be as, as and when there is normalization, certainly talk of that, and Doug will address some of that, too, in terms of the impact to our portfolio and the way that he manages in light of a changing landscape.
Again, for us, whether it is looking at structural market dynamics, looking at liquidity, flows, looking at ratios which classically have been the bell-ringers, we still are of the opinion that we are in the process of putting in a major top. That is a difficult process to go through, but being value-oriented in our perspective, appreciating what cheap and expensive look like, there is good reason for us to be positioned the way we are, and we are grateful that you have taken an interest in our strategic approach to being short the market.
Again, Doug Noland is, for us, the man of the hour, not only a historical perspective – I think this is a very unique opportunity from a market standpoint, but also to bring 30 years’ experience to bear on that. So we are grateful for his skill set and what he brings to the table.
Doug, the whole team here is excited for how 2017 finishes, and what 2018 looks like, but perhaps as I hand the baton over to you, you can just give us a sense for where we have been in the third quarter, and where you think we are going from here.
Doug: Sure, David, thank you. And good afternoon everyone. Thank you for jumping on today’s call and a special welcome to our investors that have joined in.
Q3 was Tactical Short’s first full quarter of operation. Candidly, it has been a hostile environment for shorting but we feel we have done a decent job so far. We are doing what we said we would do, and we see confirmation for our decision to structure Tactical Short the way we did. For those just now learning about Tactical Short, it is a unique short strategy for individual managed accounts, and while losses have been relatively small and we have significantly out-performed competing short products, the bottom line is we have lost money, and I hate to lose money.
Going back to my youth on the basketball court, I have always been highly competitive and have not taken losing very well. Earlier in my career I remember getting frustrated with losses and a colleague saying, “Doug, losing money happens. It is just part of the business. You have to get used to it.” My response then was the same as it would be today. “The day I get used to losing investor money is the day I find another career.” I take investor losses personally. At the same time, we are very positive about what we are developing and how we are managing investor money in a very challenging environment.
Let’s start by addressing performance. Tactical Short accounts, in aggregate, lost 1.46% for the quarter, and that is with the S&P 500¸returning a positive 4.48%. So another way to look at – Tactical Short losses were 33% of the inverse of the S&P 500 return, significantly better than competing products. The Proshares Short S&P 500 ETF returned a negative 3.97%. Of the actively managed funds, the Grizzly Short Fund lost 4.28%, or 96% of the inverse of the S&P 500’s return. The Prudent Bear Fund for the quarter lost 4.85%, 108% of the inverse of the S&P 500.
Let me give a product update for the Tactical Short strategy. We have been fixated on creating a better mousetrap for managing short exposure. Ensuring a high degree of flexibility has been imperative. Many of the short products are always 100% short. That is risk-indifferent. Some only short stocks. That is risky and too constraining. We are keenly focused on risk and market dynamics and want to be more short when the risk/reward calculus for shorting is favorable. We want to be less short when the risk/reward is unfavorable.
So far, in 2017 the risk versus reward for shorting has proven unfavorable. ProShares ETF is down 13.4% year to date, Grizzly 15.1, Prudent Bear is down 12.7, Jim Chanos’ flagship short hedge fund is also said to be down double digits, and the Active Bear ETF is down almost 10% year-to-date also. The Tactical Short, since inception, which was April 7th, is down around 2%.
Exposure: Tactical Short ended the month of May with target short exposure at 11%. We finished June at 20%, then it was back down to 15% by mid July. I want to note also that new accounts were not taken to target immediately during the quarter, and this cautious approach somewhat mitigated losses for the newer account. We took exposure as high as 33% on August 18th, we ended September at 28%, and are currently at 23% short.
I thought it would be helpful to briefly discuss the factors that led us to build short exposure in August. The S&P 500 dropped 1.5% on August 17th, and that was the largest decline of the year. The VIX spiked on three separate occasions in August, with the popular trading strategy of shorting volatility at risk of a destabilizing unwind. Corporate credit spreads have begun to widen, with hints of risk aversion seeping into the marketplace. Market leadership was narrowing, and the broader market was under-performing. Market technicals were deteriorating. In short, we were seeing market topping action. North Korea’s provocations and President Trumps fire and fury threat had markets on edge and there was general mayhem in Washington, and the risk this posed to Trump’s market-friendly agenda was also not helping sentiment.
It appeared to us, probabilities for a risk-off market dynamic were rising. About that time, however, the Federal Reserve began shying away from previous talk of rate normalization, citing weak inflation trends as justification for a more cautious approach. The treasury bond market rallied, then tool yields to the lowest since last November as the U.S. dollar came under meaningful pressure. We stopped building short exposure after August 18th and then began reducing exposure a few weeks later.
I would now like to focus briefly on the key factors that drive the structure of portfolio composition. In short, we start by asking three over-arching questions. First, overall short exposure is a primary consideration, so how short do we want to be – what percentage of account assets? We expect, generally, to maintain between 50% and 100% short exposure, but are willing to go as low at zero.
Second, we are disciplined managers of portfolio beta. How much expected volatility are we willing to tolerate in our portfolio of short exposures? Let me add that our neutral position is that we prefer low beta to high beta.
And third, the composition of short exposure is critical. The question – what is the preferred composition in the context of the current market environment? We are not thinking out a year, or even six months from now. On the short side, exposure must be managed for relatively short time horizons. To ensure we are tactical and flexible, we prefer many tools in our tool kit. We are generally comfortable shorting market indices, usually through ETFs. We will short sectors, also through ETFs. We will short individual company stocks. And if presented with a favorable risk/reward we would also consider shorting other asset classes, including foreign markets, fixed income and currencies. We will also purchase listed put options on market indices, stocks and sectors.
Let’s discuss more specifically what drove positioning during the quarter. First of all, the backdrop beckoned for caution on the short side during the quarter. Importantly, financial conditions remained extraordinarily loose, monetary policy remained extremely accommodative, risk embracement was dominant in the marketplace, greed overwhelming fear. Corporate credit availability remained extraordinarily easy, credit spreads were quite narrow, CDS prices quite low, corporate debt issuance remains on record pace, and liquidity remained abundant.
Even at the periphery, junk bond issuance and returns were strong. Speculative dynamics were notably unfavorable for the short side. Hedge performance issues continued. The industry saw persistent outflows. There were, as well, notable fund closures. And all these factors ensured ongoing pressure to reverse short positions. Hedge funds dominate short trading, so their trading dynamics are important factors for us. Bear funds performed poorly, suffering outflows and shrinking assets.
I will say, while this might be encouraging for us on an intermediate basis, in the near term it creates added pressure to unwind short positions, exerting an upward price bias. In my eyes, the market backdrop is similar to periods in the 1990s. Raising short positions has been highly profitable, and thus, popular in the marketplace. Many favorite shorts are market performance meters – Tesla, Herbalife, and Micron come to mind. In general, it is a highly speculative market backdrop, illustrated by the 26% year-to-date gain in the NASDAQ 100, 40% for biotechs, and 35% for the semiconductors.
It has been an unfavorable environment for shorting individual company stocks, but we didn’t short any stocks during the quarter. We haven’t shorted any this year. High-risk backdrop for shorting risk must be managed diligently. This dictates keeping a tight leash on positions while trying to avoid shorts with a potential for outsized losses, especially in environments prone to short squeezes. In general out-performance and instability in a short stock universe, it is critical to avoid both the financial and the emotional headache. If the probability is high that a stock could go against me, I would then impose risk control to limit losses, and I would rather wait to play when the environment is more favorable.
In the current environment, a portfolio of fundamentally weak short stocks would leave me unclear on exposure beta. In an upsize squeeze environment, it is common for a group of short stocks to become highly correlated and out-perform the S&P by two, or even three times. That is a risk I haven’t been willing to take with investor money.
As a general rule, I prefer to increase short exposure when financial conditions are tight, or tightening. I will reduce short exposure when financial conditions are loose, or loosening. In high-risk environments for shorting where I’m playing for a change in market environment, I prefer using market proxies until I see a confirmation of my thesis, and that is how we have played it thus far.
I believe we are at peak monetary stimulus and that monetary conditions will be tightening. The Fed is in a rate increase cycle, and they will soon by paring back balance sheet holdings. I view global markets as extraordinarily vulnerable to any meaningful tightening of financial conditions. So I continue to believe that the probabilities are reasonably high for a market top in 2017, but I also appreciate that market-topping processes create an especially challenging backdrop on the short side.
I have strong conviction in my global bubble thesis and have been seeing overwhelming confirmation of this view. The current market backdrop reminds me a lot of 1999. There are important macro parallels to the late 1920s. Markets have become progressively detached from fundamentals. Speculation has turned intense, pervasive throughout the markets. Various risks are being disregarded, which is typical late in a prolonged speculative cycle. Managers who have reacted to heightened risk have seen performance lag, especially relative to the hot passive index products. The money has continued to flood into fully invested, risk-indifferent products. ETF year-to-date inflows have already surpassed 350 billion. Meanwhile, active managers are being forced to ignore risk just to survive.
I believe global bond markets remain grossly mispriced on a historic basis, distorted by low short rates and a huge ongoing QE from the ECB and Bank of Japan. Corporate credit is likely the biggest bubble in fixed income. We are witnessing a dangerous mania in bitcoin and the crypto-currencies. There is ongoing real estate and general price inflation fueled by extremely low rates and excessively loose financial conditions. The Fed waited too long to begin tightening, and the snail’s pace of rate increases has ensured only looser conditions and more dangerous bubbles.
Underpinning the financial boom globally, securities markets are convinced that central bankers will not tolerate market weakness or recession, let alone another crisis. Global securities markets have become one historic “too-big-to-fail.” One might argue that we should have remained at zero short exposure throughout the quarter. Well, our objective is to provide a vehicle to help hedge market risk and I continue to believe downside risks are substantial.
Timing is always the biggest challenge when it comes to bubbles. While the risk of being short has been high, we also believe there are downsides in the current environment to having no short exposure. We are trying to provide a wise hedge, not a so-called reliable hedge, that would imply remaining fully short. Protecting capital is the priority when the market is going against us, but then to be able to respond to our mosaic of indicators and be more opportunistic when the market risk/reward for shorting improves.
I mentioned that we have yet to short individual company stocks. There is another important tool in our tool kit that has also remained untapped. We have yet to purchase a put option, although we came close to adding puts back in August. But the VIX low put options are seemingly cheap, but I don’t buy put options just because they are inexpensive. They are acquired when the probabilities for making profits are viewed as favorable. I want to buy options when I think they are going to work. I have been trading options now for over 25 years. They are tough instruments, and I’m pleased we have so far kept our powder dry, but at times they will be an important component of our exposure.
I want to ensure ample time to respond to questions, so I will try to wrap this segment up. To conclude, I am compelled to highlight the global nature of the current bubble. There are fragilities all around the globe – China, Japan, Europe, the emerging markets. They all face serious issues. Here in the U.S., prosperity is built on a foundation of policy-induced inflated securities and asset prices. Like 1999 and 2007, there is underlying fragility and it goes unrecognized.
In general, I view the global economy as being relatively strong, but it is fueled by record credit growth and ultra-loose monetary policy. My analytical framework sees markets leading economic activity. Fundamentals always appear robust at major market tops. What I don’t believe is appreciated today is the amount of speculative leverage that has accumulated in global markets over nine years, and how vulnerable economies are to faltering asset markets.
I also believe this explains why central banks have, after all these years, remained so hesitant to begin normalizing policy. This has only spurred the greatest, and I believe the most dangerous bubble in history. I have been managing short exposure going back to 1990, I persevered through several major cycles, but I can say I am more excited today than I have ever been about what I believe is the biggest opportunity of my career. David, back to you.
David: Thank you, Doug. We could have a long, long conversation about many of those points. You have covered, actually, a lot of ground, and we will hopefully get to unpack it a little bit more as we look at the questions that have been submitted. I am going to go ahead and begin with the questions that are in front of me now, and for those of you who want any clarification or magnification of a theme from what Doug was just speaking to, feel free to do that online through the tidiochat.com application. If you are on our website, if you are looking at the mwealth.wpengine.com/conference-call-2017 there at the bottom of your screen you will have the chat box which you can just open up and put additional questions in there.
We will go ahead and begin with the first one that we received, which is:
Perhaps you can draw a distinction between what you do, how you are different than an ETF, something that is short the market. What makes the Tactical Short different?
Doug: Sure. Yes, that’s a fundamental question. For one, we don’t want to be 100% short all the time. That is risk indifference, and to me, that is no way to do it. I am not a market timer, but I know there are certain environments where I want to have less short exposure, and certain environments where I want to have more. So being tactical is an advantage we have over these 100% short products.
Also, a lot of the ETF short products don’t even short stocks. They enter into third-party derivatives, and doing that, then they take on counter-party risk that we don’t want to take on. We go out and borrow securities, we sell them, and the cash from those short sales goes into a restricted account at the brokerage. Let’s say, for example, if the market had a major decline, then that cash would be transferred on a mark-to-market basis to our accounts. In the event of systemic crisis, I wouldn’t want to depend on third-party derivatives for my hedge of systemic risk. Those are a few ideas, David.
David: We are here in the United States, and the assets that we are shorting, primarily, are U.S. denominated. The question is:
What are the currency considerations for Canadians?
Doug: If a Canadian opened an account with us here in the U.S., then that account would be domiciled and we would hold dollar-denominated cash in the account, so there would be some short exposure. There are things we can do to help mitigate that. For example, we could, on the long investment side of what we do, instead of holding cash in the U.S. we could own Canadian-denominated fixed income assets, let’s say, through an ETF. But there is no denying the fact that for foreign investors coming and buying U.S. assets, or investing in our products, there are currency considerations that need to be taken into account.
David: I am just going to skip down to the bottom of my page because I think this is a reasonable segue. The question is:
Are we able to individually go to cash in our accounts?
And as the next question, maybe you can reflect back on the next question I just asked because there is some added flexibility, given the way that we have structured the relationship with clients through separately managed accounts. Are we able to individually go to cash?
Doug: David, we had a long discussion as far as how we wanted to structure this, and it was never a case of what is best for us as managers, it was always what is going to be the best product for investors, and we wanted to give investors a lot of flexibility. Unlike a hedge fund where they can put up gates and delay the return of your cash, we wanted to provide complete transparency. We wanted to provide liquidity and flexibility. Candidly, if I get a call from someone who says, “Doug, I’m really worried about the market. I don’t want to have any short exposure,” I’ll say, “Okay, we can do that.” We can unwind covered short positions for an individual account and get them out of their shorts if that is their preference. Again, that is one of the reasons we chose the separately managed account structure as opposed to, at this point, a fund, or certainly a hedge fund, where you don’t have that flexibility to manage the account favorably for the account holder.
David: Another question:
Why not just simply step aside completely and wait for a top?
And he elaborates:
It’s kind of painful staying short with this sort of runaway train heading higher day after day.
Doug: Yes, it’s no fun, and I ask myself that question. What we are trying to do is provide a hedge. We have our exposure cut down, I mentioned, 23%. We are basically in indexes. We are not shorting any stocks. It is a low beta exposure. So we are managing risk carefully. We don’t have huge risk today. But if the market continues to go against us I will continue to cut exposure back. I am not a market timer, and I know from experience, if I decided we’re going to zero today, even in the face of geopolitical risk, even though the Fed is in the process of raising rates, even though global central bankers will soon be tightening policy, even though I see a lot of vulnerability in the fixed income markets and in stocks, I see classic signs of a top. If I went to zero, then when do I go back to adding short exposure?
So, psychologically, I want to continue to have short exposure. It will get lower if the market continues to go up, but I also want to be ready to respond and to add exposure if we see things develop. And things could develop soon, and they can develop quickly, so that’s the way we’re playing it.
David: Could you elaborate, Doug, on the range of target returns with the Tactical Short strategy, and the timeframe investors should plan for an investment to stay in this product? For instance, if the S&P drops 30% over the course of 20918, is the goal for the Tactical Short plan to see the inverse of that 30% positive returns? What is the best case and worst case scenarios, bracketing where you think you would be in light of that? But also, going back to the early part of that question, what is the timeframe investors should plan to stay in that product?
Doug: As far as the timeframe, we are hoping to have a product here that folks can stay without through the ups and downs of the cycle. We are hoping to generate strong returns in down part of the cycle and protect investors, but still provide them somewhat of a hedge in the up cycle. But on a customer, investor-by-investor basis, some may decide after they have captured strong returns they would prefer to unwind their short exposure, and we’re fine with that. We want flexibility.
As far as trying to guess what returns might be, if there is some major geopolitical event overnight and tomorrow the market is down huge, we’re not going to do very well tomorrow because we’re going to capture 23% of the S&P’s decline. In a different environment, let’s say, for example, if we are able to target sectors in stocks, I have had years in my career where we were maybe 60% in a year, and that is through excellent stock-picking, risk management. And I also think we can get some strong returns if we have puts in the right place at the right time. Is that easy to do? No. Do I plan on doing it? I’m going to give it my best shot.
So, I think we can do very well, but a lot depends how quickly the market declines, what the circumstances are, and that is just very hard to guess before the fact. I often say my job is not to predict, my job is to have a sound analytical framework and come in and be able to react, and react quickly. That’s how we plan on doing this. We want to prioritize protecting capital, and then become opportunistic when the environment when the environment is more favorable.
David: The next question is dealing with finding a flawed company rather than an index.
Is it fair to assume that indexes are the last to top? Would it be more favorable to short individual companies first, and then roll into indexes?
How would you respond to that?
Doug: That is, actually, a very good and interesting question. It is a dynamic that I have thought about a lot over the years. If I wanted to say right now that I’m going to make a bet, and my bet is that the market is going down, that we’re at a top, I would short fundamentally weak companies. I would do it. That would be my bet. But I’m not making a bet. One of the prominent bear hedge funds last year made that bet and lost 50% last year. Because if you’re wrong, you can really be wrong.
We started to see some of the fundamentally weaker companies under perform in August, and that was giving me some encouragement. Not that I wanted to short them, but that was an indication of a changing market environment. But sure enough, when the market rallied, those stocks came charging back. I think the numbers were, when the S&P rallied 5%, the small cap Russell 2000 rallied 12.
That’s what I call the upside beta issue, where if you have a portfolio of fundamentally weak stocks and you can be feeling pretty good about performance and all of a sudden the market reverses abruptly and you get a short squeeze and all these stocks become highly correlated, as I mentioned, you can lose two to three times the S&P return. That is almost expected, so I don’t want that dynamic today.
I’m not playing those stocks because I don’t want high beta. Especially in a topping process, you can get this where it looks like it’s topping, all of a sudden you break to new highs, and there is a flurry of buying and a melt-up, and those stocks kind of go nuts on the upside. So, I appreciate that that is something some people would want to do, but that is not what we think is a favorable risk/reward in this backdrop.
David: Next question is from someone who, I think, is interested in working with us, but is not currently.
In what way is this investment open to private investors?
I’ll just answer that, if I might. Separately managed account structure allows us to routinely take on clients. As Doug mentioned in his comments, regarding the July to August timeframe as accounts were coming in, he is judicious about when and how to get them to a target allocation, and we have the flexibility. So $100,000 minimum is what we need to open an account with the Tactical Short, and your visibility on that account is in real time through the broker that we have chosen to custody assets with.
The way we operate is not in a pooled environment where you don’t know what you own; you know exactly what you own. And you have, as Doug mentioned earlier, liquidity even for events that you don’t foresee on the front end. If you needed to raise capital immediately, the way we have structured this is not for it to be gated, or for there to be redemption dates.
We are here to serve you, and we do see a complement, and ongoing hedge strategy for a long equity portfolio through the up and down cycles, and we want our clients to see what we are doing, to be able to ask questions on that, to spend time with Doug on the phone, and get clarity on particular points where they maybe want to understand a little bit more what he is doing and why. So, again, individual investors, through separately managed account, have that kind of access.
Next question for you, Doug, is:
In what scenario do you see interest rates beginning to rise and the Fed unable to contain them?
Doug: Excellent question. I believe there are enormous amounts of leverage that have built up in fixed income, and I think it is throughout fixed income. I think it is in corporate debt, treasuries along the yield curve. You even hear talk of huge leverage in even T-bill contracts, etc. So right now the markets are convinced that the Fed will raise rates so timidly and, candidly, the market thinks the Fed is about done with rate increases, so they don’t worry about the potential for de-leveraging.
If the global economy continues to surprise on the upside, if we have some inflation pressure start to mount, I don’t think it would take much for all of a sudden the bond market sentiment to change to fear a de-risking, de-leveraging episode. We have the Fed will start winding down its balance sheet. The ECB is going to reduce its QE program soon, and will likely end its QE program in 2018. So we are seeing indications out there that QE is not going to be there to provide liquidity to the markets. The vulnerability is there, now it is just a matter of something to change sentiment and fixed income to worry about upside yield surprises.
Again, I don’t think it is going to take much. I’m surprised that bond markets are as complacent as they are. But let’s keep in mind we have had a couple of trillion of QE this year, enormous amounts of QE considering what the markets are doing, what the global economy is doing. So that in itself, I think, explains the complacency in bond markets.
David: In an interconnected global world, it’s not just the Fed. When they create liquidity it has an impact to asset prices, but the Bank of Japan, the People’s Bank of China, the ECB, and the hundreds of billions of dollars that are coming to market each quarter. You’re right, it’s a broader picture which is causing the bubbling up of assets.
The next question is relating to the U.S. and world economies:
What do you see as the largest threat, or threats, to the U.S. and world economies?
Doug: Market vulnerability is near the top of the list, but as a longterm analyst of credit and bubbles, I look at China in awe. They will likely have 4 trillion of system credit growth this year which is significantly more than we had at the height of the mortgage finance bubble. Their credit growth is completely out of control there and they have tried all these timid methods to try to slow credit growth. Nothing has worked. At this stage of the cycle they will have no choice but to take more Draconian measures to slow credit growth, and we even have indications from President Xi’s speech from yesterday that they are going to target the real estate market, try to tighten up finance, and try to slow the speculation in Chinese real estate. That is a major accident in the making there.
Think of it this way. China has never even had a mortgage finance boom before. This is the first experiment with mortgage credit, and it is much worse than the mortgage bubble we had here. So I look at China as a big bubble that could burst at any time. Their banks are now major players globally. Their economy, obviously, is a major factor for the global economy, their imports and their exports.
But I also look at Europe. Europe is very vulnerable. They have inflated a huge bubble in European debt. Italian debt should be extremely vulnerable. We have the issues in Catalonia, Spain. The social, political risks in Europe have not disappeared, they have just been masked by this QE program. Japan is an accident in the making – incredible bubble, not only in their bond market, but in debt generally. Emerging markets, I think, are an accident in the making also.
David, I have been talking about this. I started warning about the global government finance bubble, believe it or not, back in, I think it was April of 2009, so I have watched this unfold for going on nine years and it is amazing to me, considering what has happened, that monetary policy would still be where it is today. These central bankers are so far behind the curve, they are going to have to start to normalize policy, and I just don’t see how markets will take that kindly.
And the more excess, the more of these blow-off tips we see in these various markets, the more inherent fragility that is created, and you always create a lot of fragility at the end of a cycle, and that is the way I see it now, be it bitcoin or global equities, fixed income, real estate. It is across the world and across asset classes, unfortunately.
David: There is an interesting interplay between the protective positioning in a Tactical Short product and someone wanting to own bullion, for instance. Maybe you can explain the differences between them. A lot of people would look at something like silver or platinum, the industrial metals, which have maybe a better growth profile than gold, but what are the vulnerabilities of those kinds of metals in the context of a market crash, where the Tactical Short may continue to perform well and the industrial metal is impaired.
Doug: I am a big fan of the metals, gold in particular. It is a big unknown what, say, a crash in China would do. I think it would be very favorable for bullion. I’m not as sure what that would mean for silver or some of the more industrial metals. What we are doing with Tactical Short is very different from that in that we are trying to provide a wise hedge against, not just a decline in the equity markets, but a decline in risk markets.
So, as much as I think the metals will be a very favorable store of value, that is a different type of a play from what we are trying to do being very tactical with short exposure. So I hope there is room in the portfolio for both, precious metals and Tactical Short. That is certainly the way I would want to play it.
David: How will your strategy handle a continuing stock market melt-up?
Doug: We will get shorter and shorter on our way to zero.
David: You will just reduce the exposure to zero.
Doug: Absolutely, yes. I hesitate to do that today. For example, I will reduce exposure this week if I don’t see some particular things happening. It is almost like I am on risk-control autopilot right now.
David: Really, the gist of it, and this next question deals with shifts in the mortgage-backed securities purchases, the Fed winding down its portfolio of mortgage-backed securities and treasuries, the question is:
The name, Tactical Short, implies that you are going to actively alter your portfolio if liquidity conditions change. Are you prepared for possible changes as we see the Fed unwind its balance sheet? What does that look like for you?
Doug: I come in every day monitoring for a change in financial conditions. We have started to see just a little bit of widening in mortgage-backed security, MBS, spreads. I would have expected more. I think the market right now is very complacent. I think the market believes if there is any tightening of financial conditions the Fed will immediate terminate selling treasuries or mortgaged-backed securities, and there might be some truth to that.
So it is going to be tricky analysis knowing that if I see something that is encouraging in the marketplace, for example, a tightening of financial conditions, a widening of spreads, etc., then I have to watch closely for the central bank response, and that is always key. Right now, the expectation is that this balance sheet reduction won’t go very far.
I remember back in 2011 with the so-called Federal Reserve exit strategy and I titled a Credit Bubble Bulletin back then, No Exit. I said there is no way the Fed is going to reduce its balance sheet as they plan. But I will tell you, back then with their balance sheet at 2.1 trillion I didn’t expect their balance sheet was going to double again at 4.5 trillion. But right now I don’t take the Fed’s winding down their balance sheet very seriously and I hope I am proven wrong. I hope they follow through with it, but I’m not looking at the Fed to tighten financial conditions too dramatically with their balance sheet.
David: Doug, let’s say that John B. Taylor is brought on to be the head of the Federal Reserve. His Taylor rule would imply that the Fed funds rate should be between 200 and 250 basis points higher than they currently are. What are the implications? What are the ramifications, the reverberations, throughout the asset markets to a jump by 200-250 basis points?
Doug: I am surprised the market is not more concerned. They took talk of Kevin Warsh as head of the Fed pretty calmly, and the latest talk is that Taylor may have moved to the top of the list and the markets don’t seem to be concerned at all. But I think either Taylor or Warsh would be unnerving to the bond market. I think both of those gentleman believe rates are too low, and importantly, neither one of them believe in QE. They don’t think that the Fed should be actively engaged in the marketplace, actively intervening, manipulating.
John Taylor is very much for rules, and I’m a rules-based – you have to have rules, you can’t give the central bank too much discretion because one mistake just leads to the next, and now the markets think the Fed has discretion to ensure that they are always highly liquid and that you don’t have a bear market or a liquidity crisis. We will see. Maybe it’s Powell, maybe it’s Yellen, and it’s steady as she goes, and Trump, candidly, chickens out on this.
But I think it is time to change direction in the Fed, it’s time to get them back to traditional central banking trends, time to get them out of the markets, time to get the markets weaned away from this promise of QE, promise of liquidity, and we have to get back to a healthier market environment that self-adjusts and self-corrects. We are so far away from that, and of course there is going to be a very difficult adjustment period, and that’s the way bubbles work. But we need to go in that direction, and hopefully we will get that process started with a new Fed head announced in the next few weeks.
David: Another question relating to how we make money in the Tactical Short strategy and the question starts this way:
I’ve seen the movie, The Big Short, but I still don’t understand how those individuals made their money. What is it that you are doing? How do you make money from the Tactical Short strategy? How does the investor make money in the Tactical Short strategy?
Doug: Excellent question. And nothing I do will ever be in a movie so I’ll start with that. In a way it’s simple. It’s not that common so people aren’t familiar with the logistics, so let me try to explain a little bit. Shorting a stock – basically, what we do through the brokerage is, we actually borrow securities. I’ll use an example. Let’s say we want to short IBM – we’re going to short 100 shares of IBM. We borrow 1000 shares of IBM from the broker. We then sell it into the marketplace – just a normal transaction. And then the proceeds from that short swell go into a restricted account.
Then, let’s say IBM goes down 10%. Let’s say we short it $100 and it goes down to $90. We buy it back at $90. We then have those shares and we return the shares to the brokerage. We then get to keep that $10 from where we sold it at $100 and bought it at $90, and that $10 is profit for out investors. So we are essentially making bets, we are putting on positions, to profit from the downside – it could be the market, an index, a stock.
Or as I mentioned earlier, we might by put options where we are going into the marketplace, buying liquid listed options from the exchange, that gives us the right – not the obligation, but the right – to sell a stock at a certain price. Let’s say if IBM is at $100, we might think IBM is going down. Let’s say we don’t want to short it because it is a risky short, so we are going to buy a put option which would give us the right to sell that stock at $90. Then if all of sudden IBM declines significantly, then we have an option that can be very valuable, because we might be able to sell that stock at above the price it is in the marketplace.
So we can make money shorting stocks, indexes, sectors. We can make money by put options. And again, we’re not doing over-the-counter derivatives, we’re not writing puts or calls on subprime traunches or anything that was done during the heyday of the mortgage finance bubble. Hopefully that clarifies it a little bit, David.
David: Yes. There are about three or four questions in here that deal with timing and how long can the Fed and Wall Street prop up the equities bubble? I guess where I would like to take this, because no one knows how long, but you were actively involved shorting the market in the 1999-2000 timeframe. You were actively involved in shorting the market in the 2007-2008 timeframe. And every moment of pain is like an eternity. Every moment of pleasure is just that – it’s a moment. And we tend to feel the eternal nature of pain when things are going the way that you expect them to.
Maybe you can walk us through a little bit of the market psychology, but also the investor psychology, in those days when fundamental factors are lining up in your favor but there is still a price movement away from you, not in your favor.
Doug: Right, and that’s not easy managing short exposure. These cycles can go on for a long time. It wears on folks. And I can tell you, in the conversations that I have, people on the short side, the so-called bears, are beaten up, financially and emotionally. The sector has been devastated. I’ve seen this all before, it’s part of the cycle.
At the end of 1998, after the Russian collapse and the LPCM collapse, the Fed came out with another bailout and the market started to rally, but I was convinced it was a bubble so I moved down to Dallas from New York, joined David Tice at the Prudent Bear Fund, because I thought this was going to be the opportunity of a lifetime. It was basically the only mutual fund that did shorting. Sure enough, the markets go parabolic in 1999, so we had to live through 1999.
I remember, even on our own chat board, people would make friendly bets as far as when we were going to close the fund down. I was saying, “You guys are crazy, this is the best opportunity I can imagine.” I know on CNBC, too, if you were bearish, or if you had issues with the boom in 1999, with all the new technologies and everything else, if you liked gold in 1999, you were considered a lunatic – very similar to today.
So, not easy to live through these long cycles. I always say that they put the dunce cap on you, and that’s okay, I’ve worn the dunce cap long enough to where I’m okay with that. I just stick to the analysis. There is no doubt in my mind this is a historical global bubble, and I have to play it cautiously and wait this out. I am very disciplined, I guess I’m patient to a fault. I just think this is a great opportunity, I’m excited about it, I’m glad we’re not getting killed. I’m glad we’re not emotionally beaten up because we’re looking for opportunities, ready to go.
No shortcuts in this, though. No shortcuts. Just come in every day, grind it out, have your risk disciplines, have your process, and get through this. But you also have to come in every day and say, “Okay, where are the opportunities? What could be unfolding here?” You just can’t really let up.
So the way it works, if I was talking to anyone who wants to do what I do, which I don’t recommend, you have to be extremely disciplined, unemotional, focused, and very focused on not getting emotionally involved in your positions in managing the exposure, because it wears you down to the point where you are not very effective if you do. I guess I’ve been doing this long enough to where it’s kind of old hat, unfortunately.
David: I’m going to go back to 1990. This is when you began in the hedge fund world and then migrated to David Tice and mutual fund world. You mentioned 108% of the return, 108% of the inverse, was Prudent Bear’s performance in the last quarter. What we set out to do was create a product that was superior by being managed, by getting out of the way when the market went up, and we’re doing what we said we would do. And the performance is there. Yes, there is a loss, you addressed that already, but it’s a fraction of a loss relative to everything else that is a competitive product.
Another question here is:
Could you address those historically reliable signals that presage a downturn in the equity markets?
Doug: Yes, I’m looking for a tightening of financial conditions, widening of credit spreads. I want to see tightening of corporate credit conditions? I want to see some risk aversion. Usually those things unfold from exuberance in credit markets, in the equity markets. Greed takes over, speculation takes over. You get a lot of leverage built up, and that inevitably leads to, at some point, a reversal. 1999 – why did technology stocks peak in March, the first quarter of 2000? It is very difficult to know, fundamentally, why they peaked, but I do believe the reversal came after the speculative melt-up. I think derivatives led to a lot of the upside final blow-off top in the Internet technology stocks.
I think often the leverage that builds up in the derivatives market is a key dynamic latent cycle, as far as fueling the final speculative melt-up. But also, when markets reverse, then those derivatives quickly reverse and people that were buying calls one day will be selling their calls and buying puts the next. So I’ve seen a lot of typical late-cycle dynamics in corporate credit, in sovereign debt, emerging markets, in equities. We’re seeing bitcoin. And what you see is this surge of liquidity that comes in with all this speculation, it is just not sustainable, and at some point it starts to reverse.
That is kind of where we are now. I think we’re close to that, we come in every day looking for those indications, but I want to see some tightening of finance, I want to see the hedge funds start to de-risk, de-leverage. And importantly, a lot of times these types of indicators are discerned first at the periphery. That could be junk debt, the emerging markets, etc., so certainly, looking in those spots. I like to watch bank CDS closely. They are a good indicator of systemic risk. As I say, it is a mosaic of indicators, market dynamics, financial conditions, and certainly, policy is an important focus right now also.
David: Another question is:
Are you short China? If so, what vehicles would you use to short China?
Doug: I’m not short China today, although as an interest point today, the popular MSCI China ETF rose to all-time highs, I believe, today. That is certainly a focus there. I will mention, also, these ETFs, this is a sign of the times. Who needs to do analysis, just speculate on the direction of markets, and everyone piles into these ETFs. But the proliferation of ETFs has also created a nice platform for us to be able to short different markets, different sectors. About whatever you want to short there is an ETF that provides you that opportunity. And that is how we would likely short China when we decide the risk/reward is favorable through the ETFs. But also we could target some specific sectors or some other specific markets that we think are highly correlated, or would likely be highly correlated with a Chinese downturn.
David: One more question:
When investments are not short, where is the money parked?
Doug: Excellent question, and I realize now that my logistics of shorting were not very complete. Shorting takes no cash. Think of it that way. Or I will say, you don’t use cash to short. You need to have assets as collateral within short positions, but if you opened up a new account at Interactive Brokers for us for Tactical Short and funded it, the funds that come in immediately go into cash and it says in cash because we don’t have to use it to short stocks, so the short exposure is away from the assets. It’s away from our cash. So we are going sit in, basically, almost 100% cash unless we buy put options. So we are always highly liquid, and if investors want that cash back we quickly can unwind our short positions and then they have their cash in their account, unencumbered by any collateral requirements for their short exposure.
David: Another question:
Is the popularity of bitcoin and the crypto-currencies, do you have a sense for these being similar to a new era innovations which we had so popular in 1998-1999 as we moved toward the tech bubble reaching its pinnacle? It was a brave new world, lots of fresh ideas and amazing new concepts, none of which had to be money-making, per se. Is that what we have? Granted, the block chain is its own value proposition, but as a currency speculation, what do you see there that has rings of the past? What are your thoughts on these kind of alternative currencies, the cryptos in general, bitcoin in particular?
Doug: Yes, to me it brings back memories. In 1999 it was insanity with these Internet stocks. Some of them went from a few dollars to even hundreds of dollars. Some people made a lot of money. Most people ended up losing a lot of money because most of those stocks disappeared, at least lost 90%. Very few of them were survivors. The crypto-currencies, to me, are very similar, a similar dynamic where you have this very lax monetary backdrop and all of a sudden bitcoin is making a lot of money and everybody wants to jump on board, either to create a new crypto-currency or to jump on board and buy one. You even have hedge funds now setting up funds to invest in crypto-currency.
So to me, it has all of the signs of a mania. And sure, block chain, it’s real, and some of these currencies will be around. I think most of them go to zero. The others have said it’s too many. For me, yes, for me it’s too many. I’m certainly not big into speculating in them and I wouldn’t own them as an investment. But for me, a sign of the times.
David: This idea with Trump being in office – we have tax reform, we have business and regulatory reform, we have a number of things which may be positive for the economy. How do you compare and contrast that – maybe it’s just a potential “that” – with the realities of leverage in the marketplace which are being taken to extremes? The margins debt numbers that we have are the highest on record relative to stock market capitalization, relative to current GDP, or just in nominal terms. That is just one form of leverage, buying stocks on margin. How do you compare and contrast fragility in the financial system with things that may actually be fundamentally helpful in this four-year stretch with Trump?
Doug: The first question I ask is, is finance sound today? If finance was sound, a lot of these positive developments would be significant. We have seen in the past, for example, tax cuts only fueled the bubble war. I’m a little leery of how favorable the agenda will prove to be for the markets.
Some of the fundamental things I look at – I like to look at the total security market’s value to GDP. It is far the highest ever – higher than 1999, higher than 2007. I like to look at household net worth to GDP. Again, much higher today than 2007 or 1999. I don’t think this economy functions very well now if we don’t have that constant perceived increase in financial wealth. The economy is being driven by the markets. As long as the markets are creating, literally, a couple of trillion dollars a quarter of perceived wealth, people are going to go out and spend, corporations will invest, etc. It is very much a bubble economy, so I don’t expect it to function well when markets inevitably retreat.
At that same time, we need changes. I am all for trying to stimulate, resuscitate our manufacturing sector. I think we desperately need to get back to get back to manufacturing. We have run perpetual trade deficits, current account deficits, at least going back to 1993 which is crazy. We flood the world with dollars. We create new credit to drive our consumption/services-based economy. I think, at the end of the day, it is unhealthy.
So I certainly support this push – the infrastructure, the manufacturing base. I am very fearful that we have massive deficits as far as the eye can see. The bond markets are not going to like this when they inevitably respond to the backdrop. So I’m glad we are starting the restructuring in some regards, but I’m fearful the markets are going to interrupt this economic boom.
David: This question is probably more for me:
For non-short investments, is it possible to make short-term liquid investments in metals?
The short-term liquid is what I want to focus in on. Specifically for that, our sister company has launched a product in parallel with the Royal Canadian Mint, which allows for very quick access to funds, very fast settlement, and the product is designed to basically be a cash equivalent, denominated in gold ounces, kilo bars from the Royal Canadian Mint. So that is a possibility. That is an option.
There is a question here, also. We talked about currencies earlier, specifically, the Canadian currency, and this question is:
Are you short the Australian currency? What currencies would you short? What would be the context in which a currency would be attractive to you as a short opportunity?
Doug: I’m not short any currencies today and I put it in that high-risk category of an asset class we have been following closely, but I’m not interested in playing today. I would like to be short a currency when they have large current account deficits, a speculative credit system, potential for abrupt reversal of flows. And there are certainly a number of those types of currencies today in the emerging markets. That would be my first target. A lot of it is the vulnerability of hot money inflows fueling credit bubbles. But again, I’m not short them today, and I would definitely need to see some change in dynamic right now. There is so much inflows from the ETF universe into the emerging market currencies that I am sitting back watching at this point.
David: This will be our last question:
Where are asset prices headed?
And the context of this question is, we have government intervention at a level that we have never seen before that has bolstered stock market prices, it has bolstered bond market prices. You mentioned, drawing from a comment you made earlier, you saw the Fed balance sheet at 2.1, couldn’t imagine it at 4.5 trillion. Who is to say that asset prices don’t triple or quadruple from here as we see the central banks of the world, in essence, go all in, as the Bank of Japan has done? Again, is it a lack of imagination on our part to assume that they couldn’t take a balance sheet at 4.5 trillion and make it 15 trillion, or 20 trillion?
- A) Is that a possibility? Where do asset prices go with government intervention. B) What prevents that from happening? Is there a market mechanism that somehow acts as a check? Because it seems like the bond vigilantes are all but dead and gone.
Doug: Yes, all but dead and gone. Isn’t that the truth? The thesis here is that this bubble, which I have called the granddaddy of all bubbles, has gone to the heart of money and credit, it has gone to central bank credit, it has gone to government debt, and it has done so globally. Having followed these bubbles now for three decades, when one bubble bursts, it’s always reflating the next bigger bubble. When this bubble bursts, I don’t know how they inflate another bubble if you have a crisis of confidence in government debt and central bank credit. You can’t increase this type of nonproductive credit forever without the markets finally saying, “Wait, I don’t really trust that there is going to be real value behind these kinds of electronic IOU’s in the future.”
I do think global central bank balance sheets get a lot bigger at some point. Right now, though, I sense that they are nervous of these assets prices and they do want to start normalizing. With the change in central bank leadership here at the Fed, we may no longer have a QE backstop bid where the markets can say, “Okay, no matter what, the Fed will come in and add liquidity along with their central bank partners globally.” If that is taken away you have a different ballgame in the markets.
And I will also say, and I’ve said, I wouldn’t be surprised if the Fed balance sheet goes to 10 trillion. But that is in a crisis environment, in a de-risking, de-leveraging environment. It’s kind of like the first trillion of QE back in 2008-2009 where it didn’t help the markets at all. All it did was, basically, accommodate hedge fund and bank de-leveraging. It basically shifted assets from the speculators onto the Fed balance sheet.
So I think, because of the amount of leverage that is built up over the last nine years, and the Fed could increase the balance sheet to 10 trillion just accommodating de-leveraging without new liquidity to fuel a new bull market. So anything could happen. Things get crazy at the end of a cycle and they are crazy today, and they will continue to go crazy for a number of additional years. That’s not generally the way markets work. This is generally the way it ends, not the way it gets warmed up for the ending. But we will keep an open mind and come in every day and analyze the best we can.
David: I want to thank all of you who joined us today for the Third Quarter 2017 Conference Call for McAlvany Wealth Management Tactical Short, and Doug, thanks for sharing your thoughts and comments. For those of you who asked questions, we appreciate you submitting them, and if there is anything that you would like for us to follow up on, we look forward to being in touch in the next few days and weeks. Let us know how we can serve you, and we look forward to bringing you and update at the end of the year. And please give us some feedback as to whether or not this format is helpful to you and what we can do to improve that communication, making it more effective for you. We appreciate that.
We are going to go ahead and wrap the call for the day, and we look forward to the fourth quarter when we will get on the horn again with you. Thanks so much.
Doug: Thanks everyone. Take care. Bye-bye.
