Doug Noland – The Global Bubble Has Been Pierced

Weekly Commentary • Dec 04 2018
Doug Noland – The Global Bubble Has Been Pierced
David McAlvany Posted on December 4, 2018


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

December 5, 2018

“To ignore risk has been to your advantage repeatedly, and every time the markets came bouncing back, financial conditions loosened again and it was off to the races, and basically, you were kind of stupid if you paid attention to risk. So, it’s not confusing to me today why the markets are ignoring risk because it has paid dividends repeatedly. I just think this time it’s a trap, and a lot of people are unprepared for what is unfolding.”

– Doug Noland

Kevin:Well, my 31stICA Christmas party with the McAlvany family. It’s been going on for 46 years, though, so actually, I’m still a newcomer.

David:Yes, 47 – we’re in our 47thyear and I think about the year that we are in, and the year that we are celebrating, so yes, the 38thyear for one employee, 36 for another, 32, two at 31. And this year we had a special honoring for four of our employees who are now at the 20-year mark. It’s a remarkable opportunity to work with remarkable people, and you feel so differently about going to work when you love the people that you work with and have a tremendous amount of respect for them. It really is something special.

Kevin:It is interesting because it is such a multi-generational company. My son was there at the party and he was talking to my wife, saying, “You know, this is one of the best ICA parties that I have ever been at.” Your son, who is 12, sat and talked to me, and I looked over at your wife and I said, “You know, this is strange for me because it was about that time that I came to the company.” You were about 12 years old when I came to the company. What a blessing. It really is amazing.

David:Today we’re going to visit with Doug Noland. Doug joined us here in the last few years after spending 25-30 years working in the hedge fund arena and mutual fund space managing short exposures, managing foreign currencies, managing all kinds of different portfolios.

Kevin:And we were reading his work while he was doing that. He was not connected to the company but we, here, loved to read the Credit Bubble Bulletin.

David:And before that, the Richebacher Letter, which he was helping to publish in the late 1990s. So Wednesday is an interesting day for us. Wednesday the markets are closed in honor to George H. W. Bush. My wife was playing tennis in Houston years ago – this is when she was still in high school – a man walks onto the court and challenges them to a match. So there is this vigorous volley that ensues, two against one, and he is kind, he is gentlemanly – this is George H. W. – and he is thanking them for the game.

Kevin:She got a chance to meet him.

David:Yes, they played some tennis. The Bush family office was just around the corner from the tennis courts and he would play there. I met him only once, years later, at the grand opening gala for the Hobby Center there in Houston. But that is why the markets are closed here on Wednesday. We have had a tremendous amount of volatility the last week or two and that is one of the reasons why I wanted to visit with Doug because he has some interesting insights.

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David:Doug Noland, you are joining us today to bring some insight to what has been some incredibly volatile weeks. Two weeks ago the market was in steep decline. Last Wednesday that began to change and we had the largest weekly rally in the S&P and the NASDAQ since 2011. You were noting that we had the 3.8% decline the previous week, the S&P then rallied 4.8%, last week the Dow surged 5.2%, the transports were up 4.4%, the banks rose 3.6% and the broader market somewhat underperformed.

Across the board we have this rally going on. The NASDAQ 100 surged 6.5% last week. Semi-conductors recovered 5.1%. And then some of your high-profile short stocks were off the charts, as you noted. Amazon surged 12.5%, NVIDIA 12.7, Netflix 10.6, and it goes on and on. What, last week, and even into the early part of this week, was fueling the market’s optimism?

Doug:Hi David, nice to be on with you today. I’m not even sure if it’s optimism. At important junctures in the market – and that’s where we think this is going, we think we’re transitioning from a huge bull market to a bear market – you get this wild volatility, a lot of indecision, a lot of speculative trading. I think we have seen recently at least a couple of bouts of significant shorting and hedging. We had the mid-term election and we had the big G20 meeting. You had a lot of traders positioning ahead of those.

And so we have seen some big short squeezes, and we have seen big unwinds of hedges. People get on the wrong side of trades and the market reverses on them and they are forced to almost panic to reverse either their shorts or get out of their hedges. We saw that going into Argentina in the day after. We saw it with the mid-terms also, a big rally in the mid-terms, a big up day the day after the mid-terms, and then selling commenced again. Bear market rallies are notorious for being ferocious and that’s the way it has looked so far. I don’t see a lot to be bullish about from either the mid-terms or Argentina.

I think the markets would like to believe, at least as far as U.S. and Chinese trade tensions go that some of that tension has been relieved, and maybe the risk of tough trade rhetoric and negative headlines has been reduced for a bit, but the jury is very much out on what was actually decided or agreed to in Argentina.

David:Doug, your job is not an easy one. The market is up and down and this kind of volatility is a real challenge. We look at all bear markets and they begin as corrections. So here we are, not in bear market territory in big indexes, but certainly you have a number of stocks, almost 500 stocks out of the 2,000 that are listed on the New York Stock Exchange, which have declined from 20-90%, so there are some companies that have really taken it on the chin. If this is the Santa Claus rally it is not inconsistent with what we saw in the year 2000 and the year 2007 coming into significant market declines, what we do now characterize as some of the worst bear markets – had a nice little Santa Claus pop there at the end of the year, so I guess we can’t rule that out.

One of the things I think we take for granted is stability. Has there ever been a period where financial markets were stable? I think that is one of the questions I have for you. And are we at the point where 3-5% weekly swings – how do we understand stability, and financial stability, in this kind of volatile market environment?

Doug:That’s a great question. I’ve been in the markets going back to 1990, and for me, I haven’t seen a lot of stability. It has been serial booms and busts going back to the early 1990s. You could start with 1987, the boom and bust in 1987, and then follow the cycles all the way to where we are now, and if anything, I think these bull cycles have just gotten longer and more speculative, which creates a lot of inherent instability. The belief is that the markets are stable as long as they are going up and financial conditions remain loose, but the instability kind of lies in wait for financial conditions to tighten or speculative excess to turn to risk aversion, de-risking, deleveraging.

So it’s an interesting discussion right now that the Fed last week issued their first report on financial stability, and it is interesting just to look at the Fed providing their own definition for what they see as financial stability, and I’ll just reference it here. To the Fed, a stable financial system, when hit by adverse events or shocks, continues to meet the demands of households and businesses for financial services such as credit provisions, payment services, etc.

So the Fed believes they are dealing with a very stable financial system. It is important to them to have financial stability, but I would argue that there is a lot of inherent instability because what we believe is stability only continues as long as the markets boom, financial conditions remain really loose, and everyone remains optimistic. And that’s just not the way market cycles work.

David:I guess that gets to maybe a more philosophical question. We have a Fed, and maybe the J. Powell Fed is different than those that preceded it, but market cycles – you and I understand that there is boom and bust and that’s normal. So financial market stability – if they’re saying that somehow this can be a managed process and you can avoid having radical ups and downs, are we dealing with a totally different framework, and is that framework something that is even realistic?

Doug:I think this is a completely different framework than we have dealt with historically. I have argued over the years that we have had a huge, momentous change in contemporary finance to where we have market-driven credit, market-driven finance, as opposed to the old way it worked where bank credit kind of drove the credit and economic cycles, so these cycles, to me, are inherently unstable because when the markets are booming, finance it too loose, markets turns speculative, and it is self-reinforcing for these long, big up-cycles.

The markets believe that central banks can master the cycle and not allow the down-cycle. The markets believe that central bankers learned from the last crisis, but I believe this cycle has led to only a greater bubble and these bubbles inevitably burst, and that’s part of the framework here that we are dealing with, what really is a highly, highly unstable system that somehow poses as financial stability as long as things are going well.

David:So let’s roll the clock back to last week, Wednesday, a week ago from today. J. Powell and his team, looking at what variables they were, and maybe you have an idea of what they were looking at, because there was a shift in their verbiage. There was a shift in their views from their October statement. And the big difference was, “We’re a long way from neutral.” That was their message in October, and then their message last week was, “We’re just below neutral.” There’s a big difference, and I wonder what maybe they saw. Dig into the Fed comments for us.

Doug:I’ll start by saying, J. Powell, I think his comments were misinterpreted somewhat. He did not specifically say his view had changed from October to now. He wasn’t saying that we are now close to neutral. What he was saying was that we’re getting close to the range of neutral within the committee. But clearly, the Fed has turned more dovish. They are now saying – I think they would argue that the neutral rate has come down, and that’s fine.

Let’s think to where we were back in October. I believe it was October 3rdwhen Chairman Powell said that we are still a long way from neutral. Well at that point, if you think of it, we were almost three years into a Fed tightening cycle – a mild one, at that – but three years. You had credit conditions remaining very loose. The stock market was basically at an all-time high, and GDP forecasts were running at about 4% U.S. economic growth. So you could argue at that point that the Fed was going to have to continue to raise significantly to get to some point where their policies were restraining growth.

Well, the markets reversed between now and what we saw back in October, so all of a sudden financial conditions have tightened significantly, and that’s corporate credit. GDP expectations have down-shifted. We’re seeing weaknesses in some areas of the economy. So the environment has changed dramatically since early October in the markets, and I believe the markets dictate economic performance, so now the Fed has to back-track from where they were before.

But I think this whole concept of the neutral rate is problematic because I think they just used it to justify keeping rates low for almost a decade and now they are kind of stuck trying to use it during normalization or during volatile market periods, and it’s just not going to function very well because there is not a real neutral rate out there. It’s mythical.

David:This has been confusing to me because when I read Knut Wicksell, the Swedish economist – he talked about the neutral rate – it was like something that the market figured out and you knew more or less where it was because that’s where bonds traded. It didn’t have to do with assigning a particular number, if that makes sense. Anymore, is it based on market conditions? Is it purely economic data? Is it something that they choose conveniently to be able to place interest rates where they want and then they just have the language of neutral rates to give them some bearing above or below? What’s the bogie? Are we over or are we under?

Doug:The way I’ve looked at this, the old debate back with Wicksell was a different economic structure, a different financial structure, and to make this simplistic, it was banks lending to industry for capital investment. That was the driving force for credit growth and for economic expansion. Well, in the industrial sector there were profits, and there was return on investment, and basically, they would borrow to the point where their debt service cost matched the returns on their investment. So there was a self-adjusting process where the cost of borrowing would rise until it met the declining return on investment in the real economy. So you could try to decipher what the neutral rate was.

Well, this system today is totally different because, again, you have the market driving credit growth, you have markets driving interest rates, and there is no self-adjusting process because we have unlimited finance, and as we has seen, governments can borrow, corporations can borrow enormous amounts, and interest rates don’t rise because we just create more finance. So that’s the framework I see, where the neutral rate doesn’t work today as it would have in a much simpler economic and financial system.

David:You mentioned the Federal Reserve’s framework for monitoring financial stability, their Wednesday presentation. One of the items in there was funding risk. They talk about funding risk. They don’t appear all that concerned with funding risk. Where’s the catch?

Doug:Another great question. Unfortunately, I don’t believe the Fed learned probably the most important lessons from the mortgage finance bubble period. You have these market risk misperceptions and they can play a vital role in so-called funding risk. We don’t have to call it funding risk, let’s call it the risk of a run. That’s what it has been historically, and that’s what it was in 2008. Back during the mortgage finance bubble period I talked a lot about the moneyness of credit. It was this notion that if something was Triple A – that’s basically trillions of dollars in mortgage-related instruments back then – if it was Triple A it was perceived as safe and liquid, a store of value. It was perceived money-like, and that’s always dangerous because if something is perceived money-like you can issue enormous amounts of it which leads to distortions in the financial sector and the economy, etc.

What we have seen during this cycle, almost a decade long now, we saw central banks slash rates, massive QE liquidity injections, and I have referred to the moneyness of risk assets. They fostered perceptions in the marketplace that risk assets basically don’t have much risk anymore, that they are money-like. You can send your money into an index fund, you can buy investment-grade corporate credit. It doesn’t matter, it’s all liquid, the Fed will ensure we don’t lose money, so there is not a lot of risk.

Well, I’m sorry, crises almost always unfold in the money markets or where there is this misperception of risk. And that is the risk today in risk assets. Easy examples are equity in corporate credit ETFs, where trillions have flowed into these funds believing they can get out at any point and they can’t lose much money. And you could have a furious run on these types of funds if people get scared.

And there are a lot of funds that own illiquid assets, especially in corporate credit, and that’s where you could have a real problem. If you had a run on corporate ETFs and then the underlying funds out there try to liquidate corporate bonds, they can be very illiquid in good markets and can be completely illiquid in poorly trading markets. So yes, I think the Fed really under-estimates the risk of runs on these risk asset funds that have proliferated during this boom.

David:We had a central banker from the Bank of England on the program maybe a year or two ago – Charles Goodhart – and we were talking about debt and quantities of debt that central banks could take onto their balance sheet. This paper that we have been talking about from the Fed – the Fed sees that tariffs and debt, these are real-deal issues. That’s what they have said. One of those is an exogenous, or external, threat – the tariffs. They can’t control that. They can’t control the Twitter feed. They don’t know what’s going to happen with the Chiness or with NAFTA as it is being redrafted as we speak. These are things that exogenously they can’t control.

Then the endogenous risk – the debt issue. The reason I bring Charles Goodhart back into the conversation is because he said, “Look, we’ll just sterilize it.” This past period, the last ten years – you just mentioned the idea of monetizing debt, and QE programs. Is it possible they put debt out there as a strawman issue where they are not actually really concerned about it because they know they have a balance sheet that can expand, and as Goodhart said – I don’t even know what he meant by that – “We’ll just sterilize it.”

Doug:Yes, I would just say that’s a sign of the times. There are a number of problems with monetization. We can look at financial history but I would say one of the big, big problems with monetization is that it works, or more actually, it appears to work for a while. But it has always been, and I think this time, a big trap. We’ve seen it throughout history. It used to be called inflationism. And once you go down this road it becomes very difficult to get off of it because you can monetize debt, you can add liquidity to the system, but your system becomes only more dependent upon ongoing inflation, these rising price levels in the economy and the asset markets. They get elevated, and this economy, this structure, becomes increasingly distorted, and the system becomes acutely vulnerable to any slowing of credit growth. Now we’re starting to see signs of this globally, certainly in China.

So then if you have this credit slowdown, that risks bursting asset and speculative bubbles while exposing a large number of uneconomic enterprises that flourish during inflationary periods. Again, this is part of economic cycles that go way back. But the key part of the analysis, I think, is prolonging the inflation – and that is credit inflation – prolonging the boom only extends what I call the terminal phase of bubble exits. So you have greater financial and economic maladjustment and fragility. Your bubble just gets bigger and bigger and bigger.

And that’s where we are today, it’s been growing for a decade. And if central banks want to come in and continue to monetize, okay, well, when does this stop? And what do they expect down the road as far as market perceptions as far as the soundness of all this credit that is created? Japan has that problem now. They can’t turn off the spigot, they just keep monetizing government deficits and where it stops nobody knows.

But at the end of the day, that credit is not good credit. The central bank balance sheet is impaired. The Japanese government sheet is heavily impaired. And it gets back to the issue we spoke about earlier of financial stability, or, more accurately, inherent instability of all this monetary inflation.

David:I think this last week is really instructive, and I hope our listeners will really clue into this. One of the reasons I asked you to join us for a couple of minutes today is because, on the one hand, Wednesday last week up through the early part of this week, the stock market was just on a tear, going straight through the roof. And yet the credit markets continued to send a different signal than the equity markets. Equities are ebullient. Credit still seems concerned, which is consistent with what led into the Fed suggesting that maybe we’re at a different place. We won’t see hikes in 2019 and maybe we’re closer to neutral. That’s the consensus view. What are the credit markets telling us, and was there a misread last week in the equity markets by equity traders?

Doug:Right. And these two markets play very different games, especially at the end of a cycle. We saw very similar dynamics back in 2007 where the mortgage finance bubble was actually pierced in the summer of 2007 with the blow-ups in subprime. And that started to lead to a tightening, obviously, of mortgage credit, but also some tightening of corporate credit and the credit markets turn risk-averse, increasingly risk-averse.

But at the same time that led to a collapse in treasure yields and this perception in the stock market that the speculative cycle could continue to run, because if the stock market is not focused on fundamentals it has become a very speculative game and you can get really wild moves at the end of the cycle. You can make a lot of money at the end of these cycles. And that’s the focus of stocks and when you see market yields go down you think you’re going to get another bite of the apple in equities.

That’s the way the stock market has traded recently where the credit market is seeing the cycles turn, and even last week with a big rally in equities, there was no rally in corporate credit. Corporate credit remained nervous. But equities, okay, we’ll get the Santa Clause rally, we can make a quick 10%. And you get this divergence between these two markets, and that divergence is problematic and over time I would put my faith in the analysis of the credit markets because they have more of a long-term focus, than I would the real short-term focus of the speculative stock market. We’ve seen it all before, but that doesn’t make it easy to play as an investment manager, but not that confusing when you see markets act like this late cycle.

David:Earlier you were talking about ETFs and both equity and corporate debt inside the ETF structure. What are the volumes telling us in those ETF flows?

Doug:The flows into corporate credit remained more resilient than I would have expected this year, but they have turned, and we are now seeing outflows. We’re seeing outflows from the junk bonds. We’re also seeing outflows from the investment-grade funds. That is a real change in the marketplace. What we don’t see – we don’t have transparency to see what the hedge funds are doing. I am assuming that they are unwinding leverage in the corporate credit market where I believe there is significant leverage. We have seen spreads widen. We have seen the cost of insuring the credit default swap market. We have seen the cost of that insurance rise. So we are seeing a lot of signals that the cycle has turned in corporate credit. I think the big outflows will come as we get further along in the cycle, but we are seeing cracks today.

David:Run through a hypothetical scenario where your segment of investment-grade paper, Triple B, comes under pressure from the rating agencies. You have 2.5 trillion dollars in this Triple B category out of 9 trillion that is in the corporate credit sector. What happens should it be downgraded?

Doug:That’s a very pertinent question. It’s almost not even hypothetical at this point. For our listeners, the first thing to remember is, credit is self-reinforcing. That’s the nature of credit. So there is some inherent instability in credit. That’s why you have these booms in credit. Everything looks fine as long as financial conditions remain loose. And in corporate credit, as long as funds continue to flow into credit ETFs, and hedge funds continue to want to leverage, then credit availability is very loose, and even the poor credit, even the really risky junk borrowers, can easily borrow money, refinance debt, do whatever they want. So the markets overlook a lot of things when financial conditions are loose.

We have this interesting dynamic in the markets where we have had an incredible boom in Triple B-rated corporate debt, and that is basically the riskiest tranche of investment-grade debt. And why have you had a boom there? It’s because there has been all of this money just flooding into investment-grade mutual funds, ETFs in particular, and those funds have gone out and had to buy corporate credit. And they like to get a higher yield so they have been aggressively lending to the riskier investment-grade credit. And everything works great as long as the credit continues to flow, finance continues to flow, the global economy continues to grow, the U.S. economy expands, etc.

Well, I’m sorry, that dynamic has changed. I believe the global bubble is pierced, financial conditions have tightened dramatically globally. We have seen the emerging markets, we’ve seen 20% stock market decline in China, etc., a real tightening of corporate finance globally that will usher in weaker global growth. And now U.S. corporate credit has finally been hit by this contagion which impacted the periphery months ago. Now credit conditions have tightened in the U.S., so all of a sudden credit is not as easily available. It has tightened up.

The economy now will slow, and a lot of these risky credits, these Triple Bs, will now be at risk of being downgraded to junk. And if they are downgraded from junk, that means the investment-grade funds that own them, can’t own them anymore, they have to sell them. It’s not clear who is going to buy them, so that leads us to believe credit conditions will tighten even more dramatically, with an impact on the economy and what we will see is the downside of the credit cycle and we are seeing a significant widening in credit spreads at General Electric. That means the market is getting nervous about General Electric, one of the big issuers of Triple B credit.

The worry is that General Electric could be a junk issuer before too long. That means the market for their debt will be difficult, at best, and then the markets will worry about if GE can continue to borrow money, and if they can’t, what is the prognosis for that company going forward? What is the prognosis for other high-risk borrowers now that may lose access to borrowing much as subprime lost access back in 2007. That is kind of a long-winded answer as far as what we are seeing start to unfold in corporate credit right now.

David:You started by saying that credit is self-reinforcing and in the midst of that explanation you were also describing the structure of those financial products, which doesn’t accommodate large amounts of liquidations. Mutual funds and ETFs are not structured to be as liquid as they are perceived. You can’t turn around and sell billions and billions and billions of dollars of ETFs and mutual funds without there being a self-reinforcing negative price dynamic, which again puts a lot of those companies under pressure, and certainly puts the segment for investors in a point of real pain.

My next question deals with what kind of circumstances do you think would be there for a downgrade, or do we have them already?

Doug:Touching upon your last comment, David, back during the mortgage finance bubble period I referred to the alchemy of finance, this Wall Street alchemy of transforming endless risky mortgage loans into perceived safe and liquid Triple A-rated mortgaged paper. Well, that works during the boom, but then the misperceptions there come back to haunt the system when all of a sudden the holders of those perceived money-like instruments all of a sudden realize they are holding a lot of risk that they don’t want to hold and they start to try to dump them. And that’s that run scenario that we referred to earlier.

At the beginning of every year for my Credit Bubble Bulletin I have the issues for that year and my Issues 2018, I titled it “Market Structure” because I have a real problem with this alchemy of finance where we have transformed all of these risky risk assets, corporate debt, equities, into perceived safe and liquid, ETF shares in particular. That’s a real problem. You don’t want to have a big gulf between perceptions of safety and the reality of a lot of risk – liquidity risk, price risk, etc. The downgrades come as soon as system finance, as soon as credit starts to tighten, then the risk that your borrowers lose access to financing changes the cycle.

And you always have this contagion where one country, or one company, loses access to finance and gets in trouble, and then the markets not only lose some there, they want to look ahead and get out of the way of the next vulnerable country, market, or company, and that leads to contagion. And what we have been seeing is, again, the contagion starts at the periphery of the global bubble in the emerging markets. Now it’s made it to the core here in U.S. corporate credit, and that’s why I think people should take this very seriously because the dynamics that we are used to over the past decade of loose credit are changing now, so that changes the prognosis for the economy, and certainly for a lot of the riskier borrowers in the marketplace.

David:That leads me to the next question which deals with the ECB. The European Central Bank is stopping the CSPP, the Corporate Sector Purchase Program, and they put, I don’t know, 150-170 billion dollars into corporate paper. Losing access – we’re talking about European companies which have been subsidized by the European Central Bank. Pricing is distorted, yields are cheaper, and the ECB is saying, “We, the artificial buyer in the market, are stepping back.” Is that enough to create that sort of contagion effect and impact into the U.S. corporate credit markets because of the ECB stopping the CSPP program?

Doug:Right, exactly. And I’m going to sound arrogant here, and I don’t like to, I have been humbled in the markets for so many years I can’t believe I could sound arrogant, but this whole notion of central banks reflating whatever it takes to reflate trillions of dollars of liquidity just thrown into the marketplace like this, is foolhardy. The reason it is so dangerous, and we’ve seen it in Europe, all of a sudden when the ECB is going to monetize, when they are going to add the list of liquidity, they’re going to buy corporates, they are going to buy government debt, they are going to buy Italian debt.

Well the speculators in the marketplace – what do you want to own? Why not own Italian debt because they are going to give you a higher yield? You can make more money during the upside of a cycle. Why not buy debt of European banks. Why not buy just European debt, generally? So everything looks great again, credit self-reinforcing, speculative bubbles are self-reinforcing. Well, when things change, as we have seen with the global bubble being pierced and the entire financial condition, where does the market fear? Oh, the marginal borrower, Italy, European banks, European corporates.

So that’s where you see the big reversal of speculative flows and you see all the problems unfold and the problems in Italy today are worse than they were before because they have had years of more deficit spending and lack of structural adjustment. European banks are just as fragile or more than before, the issues were not resolved, and the question is, what is the link between Europe and U.S. corporates? Well, for one, you have hedge funds, for example, that have been big players in higher-yielding European debt. They now have losses. They are unwinding positions in Europe. They have to be more risk-averse so they need to take risk off in the U.S. markets also.

Again, this is part of contagion. So now the hedge funds are re-risking, de-leveraging in U.S. corporate credit. Credit conditions are tightening. So global dynamics started in, let’s say, the emerging markets, made it to Europe and then moved from Europe into the U.S., just part of this global bubble dynamic that I have been writing about for years and everybody has ignored it for years because it hasn’t mattered. But now it matters because global financial conditions are tight.

David:All right, so the world is complex. We have lots of things going on. Obviously, the credit markets underscore the expansion of assets and we’ve been talking about that. In recent weeks I have been working through a couple of books on Richard Cantillon and John Law, and one of the things that the author noted is that the South Sea Company was a market leader and Cantillon, who was a banker at that time, said, “The sine qua non, the most essential aspect for maintaining a rising market, was an expansion in credit.” Lo and behold, the ending of that bubble period was when credit began to contract, and all of a sudden the South Sea stock couldn’t be maintained at those levels.

We have a confluence of negative returns today across asset classes. Deutsche Bank did a study where 90% of 70 different asset classes they were looking at were negative in turns of their rate of return through mid-November. This is a lot of red that we’re talking about, and I don’t feel like the attitude in the market as shifted at all. There doesn’t seem to be a lot of concern. In fact, if we want to transition from that to looking at what happened over the weekend, the working dinner in Buenos Aires, we get a lot of enthusiasm coming out of that. The equity markets in Europe and in Asia are giddy with Xi and Trump accomplishing – what did they accomplish? They got a 90-day postponement of the fireworks, they’re going to work on things, so nothing bad is going to happen immediately.

But the market liked it. I just don’t see the market having any real sensitivity to declines which have already occurred, and to what you are talking about in terms of a shrinking of available credit, if credit conditions are tightening, and we know from history that it is credit expansion which drives an increase in asset prices, why is there not more concern in the marketplace today?

Doug:There should be. The way this is unfolding so far, for me, it provides a lot of confirmation in the thesis that I argued starting back in 2009. I started warning about the unfolding global government finance bubble, and this bubble could be fueled by a historic expansion of central bank credit and government debt. That is basically the heart of global money and credit. I never imagined it would get to this point, but we have seen tens of trillions of dollars of central bank credit and in sovereign debt growth. So it has been global, it has been across countries, regions. It has been across asset markets, risk assets, perceived safe assets, government debt.

So what we are seeing in the marketplace now and why I am saying the global bubble has been pierced, is that we are seeing weakness almost across the board, across asset classes, something very unusual in markets. I think it is very problematic because for a lot of reasons there has been a proliferation of strategies. Risk parity is one that people talk about where these are leveraged strategies where you can have corporate bonds, you can have equities, of course, commodities.

And you can hedge them with a big chunk of, let’s say, treasury debt. For years now we have seen any potential nervousness in the market, you get a big rally in treasury debt and that offsets any weakness you see in any other asset classes. Well now, we have seen dynamics where losses across asset classes, and that is going to force a lot of these leveraged players to de-risk and de-leverage these strategies. So it’s an important part of the market dynamic. At the same time we have highly speculative markets, as we have talked about. There is a big belief that markets will rally. Why would the markets believe that? Why would markets discount what we are talking about, David? Because that has paid dividends for almost a decade. To ignore risk has been to your advantage repeatedly.

We had almost a crisis back in 2011 with the Fed’s exit strategy talk. We had almost a crisis in 2012 with the big unwind, potential unwind, in Europe. We had the 2015/2016 scare in China in the emerging markets. And every time the markets came bouncing back, financial conditions loosened again and it was off to the races, and basically, you were kind of stupid if you paid attention to risk. So it’s not confusing to me today why the markets are ignoring risk because it has

Paid dividends repeatedly. I just think this time it’s a trap and a lot of people are unprepared for what is unfolding.

David:In the midst of the market gyrations, we also have geopolitical issues swirling. We have Russia, Ukraine, the Iranian ballistic missile tests which this last week were in violation of U.N. Security Code Regulation 2231. You have domestic political issues there in France with fuel protests turning violent. If you want to hop on a train in downtown Paris I don’t think you’re going to get anywhere. To me, it is all summed up with a single word – cusp. That may not be the first word that comes to your mind, but so many things are on the cusp, with surprise being a growing probability. When you’re on the cusp of something, whether it is a joke, or a particular insight, or whatever it is, you have people assuming that they are one way, and then all of a sudden, in an instant, it’s revealed that it is quite different.

Markets like surprise as long as it’s positive. They don’t like surprise if it’s negative. I just wonder what is being left out of view. Here we talk about geopolitical issues and these other issues. It’s almost as if nothing is as important as getting support from the central bank community. That’s really the only thing that seems to register with investors today.

Doug:Right, and this has been a very long speculative cycle, so the money has gravitated to the more aggressive managers, and even in business, it has gravitated to the more aggressive business managers. Geopolitical is one very important risk that, if you ignored it you were better off throughout this whole cycle. We have watched these geopolitical tension escalate, and a lot of us look at this and say, “Oh my God, what is unfolding, and where is this going to end up?”

But in the marketplace, if you ignored all of those things you made more money.

So again, the markets have ignored it, but all of a sudden you have this dynamic where these risks could start to compound while in the markets you have fragility start to compound so all of a sudden if the markets start to falter and all of a sudden the perception in the marketplace is, “Uh-oh, maybe the central banks don’t have this all under control. Maybe they can’t just do more QE and make everything good, so maybe we have to focus on geopolitical, we have to focus on various risks.”

Then you have a very, very different game, and that is how market perceptions can change so quickly late in the cycle, because all of a sudden the markets go from ignoring these risks to all of a sudden saying, “Oh my God, these are big risks.” And again, they think, “Uh-oh, I thought I was holding something really safe. Now I realize, uh-oh, it’s really risky.” And that emotional swing can play itself out in the market with a lot of instability. And candidly, that’s how panics ensue. And I’m certainly hoping we are not going in that direction, but we’ve seen all the excesses during this really extreme up-cycle that would lead me to fear that kind of outcome is not a low probability event.

David:The last year or year-and-a-half as you and I have compared notes multiple times each week, you have been pretty clear that the U.S. economy has been improving, and that your primary concern is within the structure of the financial markets. In the financial markets you see lots of excess and tremendous over-leverage, whether it is in the corporate sector or certainly promoted by governments.

On the domestic front here in the U.S. I have to wonder, though, on the economy we have pending home sales which are down. This is the 10thmonth of annual decreases, according to the National Association of Realtors. You have October new home sales which tumbled 8.9% – 4% positive was expected, so a little bit of a reversal there. Auto sales peaked over a year ago. At what point do you think slowing global growth becomes a U.S. economic growth concern?

Doug:I’ve been in the camp for a while now, that the U.S. economy was in a boom, and I got a number of emails questioning me on this, and I never said it was sound. Actually, I believe the U.S. economic structure is very unsound. It has been in this late cycle boom fueled by loose financing, gloomy financial markets, asset inflation, and unfortunately, a tremendous amount of malinvestment. So I’ve seen no good news in the economy as far as the prognosis for the future.

So what are we seeing now? We are seeing the inevitable beginning of the end of the up-cycle because financial conditions have tightened. Housing, for example – there is an affordability issue. Home prices have inflated a lot which didn’t matter as long as the monthly payment was going down because mortgage rates were so low. Well, mortgage rates have gone up, prices are high, monthly payments are much more expensive. There is an affordability issue. I also think there is likely in housing an issue with a significant slowdown in foreign buying, and let’s call out the Chinese. They were buying, in certain markets, a lot of properties, and I think that has slowed. So not only is there an affordability issue and less foreign demand, you are also seeing a tightening of mortgage credit. I think subprime borrowers now have a much more difficult time getting a reasonably affordable monthly payment than they did six months ago.

So the cycle has turned. We’re seeing it in autos, too, a tightening of auto finance. And now, just recently, we’re seeing a more broad-based tightening of corporate credit which will have important ramifications, and if the markets decline all of a sudden, you are going to see the reversal of this huge growth in household net worth that we have seen over recent years. All of a sudden if households feel they are poor, as stock prices go down, as potentially home prices go down, they will pull back on spending and that’s going to be the downside of the economic cycle and it’s not going to be pleasant.

I fear the big surprise – here we have literally thousands of enterprises out there that have been growing aggressively. They don’t make profits, they’re negative cash flow companies, but they have been enjoying easy access to finance. You see the commercials all the time on television of all these strange businesses, and I think when finance tightens we will see a lot of these companies have to fold up shop like we saw back in 2001-2002. Again, that is what will make this a very difficult economic down-cycle.

And also, another comment on bubbles, there is a dynamic when the excesses are conspicuous like we saw in the tech bubble, then that bubble is generally not as dangerous because the excesses are isolated to one sector. What we have seen during this cycle, it hasn’t been as conspicuous because the excesses have been spread across asset classes, across business sectors, and unfortunately, I think there is a lot of vulnerability out there that will become more apparent now that finance is not as easy.

David:And that is something that I’ve thought about. We did have the kind of conspicuous excess in bitcoin, and ethereum, and ripple, and some of the crypto-currencies. That was eye-popping. As you said, it’s so limited in terms of being a sector that even with its demise or decline here in 2018 it’s not as if it’s taken the economy down with it. What you’re arguing is that this is more of a pervasive bubble. I wonder if we’re not feeling some of that come unwound.

Tell me if I’ve got a misread on this. The Wall Street Journalhighlighted this last week that 80% of borrowers who refinanced in the third quarter chose the cash out option, withdrawing 14.6 billion dollars in equity from their homes. That’s the highest share of cash out refinances since 2007. Am I reading too much into that to say that, actually, the man on the street is looking for liquidity, maybe not to take a vacation but maybe because he needsliquidity? Correct me if I’m wrong. Am I reading too much into that?

Doug:No, I don’t think you’re reading too much into it at all, and to me it’s just another indication that we are very late cycle. We’ve had an echo housing bubble, and if you look at some of the markets, the ones that come to mind – San Francisco, Seattle, Portland, and there are some markets on the East Coast, as well, where prices have exceeded previous bubble peaks. So nationally, we have had significant price inflation so there is equity to withdraw from people’s inflated home values.

And we’re at the end of the cycle. Not only do some consumers get stretched who need to tap that old housing ATM, but you also have more discretionary type spending when people get really optimistic – buy that boat, that trailer, that second home, etc. So to me, it’s just one more indication of where we are late in the cycle.

Also, David, I wanted to touch just a little bit more on the economic structure. If you just think about technology, and the huge boom we have seen in technology, a lot of the growth in technology has been selling technology products to other upstarts, selling technology to the booming emerging markets, to China. So you could see a situation where the downturn for technology is much more severe today than it was during the previous downturn after the 2000 burst of the technology bubble.

So we’re starting to see some nervousness in technology stocks, but I think there are a lot of tentacles there with this boom in technology, alternative energy, and a lot of the growth industries have been supporting businesses that are uneconomic, economies that are now faltering. So we could see a significant surprise in weakening demand with major impact on the U.S. economy.

David:You see that with the semiconductors. If you look at NVIDIA, massive increase in accounts receivable, and from the beginning of October to here recently, down 67%. That’s a pretty significant move – 179 billion in market cap to 81 billion in seven weeks. That suggests that there are segments within technology that, when they get hit, seeing an 80-90% decline, they may face extinction events, but 80-90% is not out of the question.

So I am going to ask you – this is a shameless plug, an absolute shameless plug, so those of you who don’t like shameless plugs, you can tune out now. Tactical Short is your best iteration for what you have been practicing for 25+ years. Why Tactical Short? Why now?

Doug:We believe there are extreme risks in the marketplace. We think the time to de-risk is upon us here. We are providing a product that we hope can be part of people’s portfolios so they can better manage their risk, provide some downside protection, reduce the volatility of their overall portfolio. Basically, we are short the market, but we try to do it tactically. We try to manage the risk more carefully than a lot of these other products available in the marketplace. And we just think it’s time for people to sit down and think about how they want to manage their exposure to not only risk markets but their finances generally, and to get hunkered down for what we think is a rather momentous change in the market cycle here.

David:Well, we appreciate you sharing your thoughts with us, and certainly looking at the corporate credit markets and the divergence between that and what the equities have been saying over the last week or so, it is a very helpful insight. Glad you’re on the team. We feel stronger together and grateful for your time today. We should probably let you get back to trading the market.

Doug:Thanks, David, I love being part of your organization and whatever we can do together I really enjoy. Thanks for having me on today.

David:Thanks a lot. I appreciate your time.

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