Transcript from the call

MAPS 2nd-Quarter Recap
Conference Call with David McAlvany and Doug Noland
July 15, 2021

David McAlvany: Good afternoon. We appreciate your participation in our second quarter 2021 recap conference call. This is David McAlvany. As always, a special thank you for being here today, and a special thank you to our valued account holders. We greatly value our client relationships. We have a few more people trickling in for the call as we go, so let me address sort of first-timers with a number of you on the call today. I want to begin with some general information for those unfamiliar with Tactical Short, and of course, more detailed information is available at mwealthm.com/tacticalshort.

David: The objective, why we exist, what this product is about, the objective of Tactical Short is to provide a professionally managed product that reduces the overall risk in a client’s total investment portfolio, while providing downside protection in a global market backdrop with extraordinary uncertainty and extreme risk. The strategy is designed for separately managed accounts that allows for investor-friendly access, full transparency, flexibility, reasonable fees, no lockups, et cetera, et cetera. We have the flexibility when we are operating on the short side of the market to short stocks and ETFs, we also plan on occasion to buy liquid listed put options.

David: Shorting is a unique approach to the market, and it entails a unique set of risks, some of which were further illuminated during the quarter, and we’re set apart both by our analytical framework and our uncompromising focus on identifying and managing risk. For those of you who don’t have the privileges I do to work with Doug on a daily basis, this is where you see an extraordinary amount of heavy lifting and work done paying attention to every possible detail, and it’s both the quantity and quality of work which are appreciated, and we continue to learn from his dedication and professionalism.

David: Our short strategy, the Tactical Short strategy began the quarter with a short exposure targeted at 68%. The short target held relatively steady throughout the quarter, consistent with our view of an extraordinarily unstable market environment. Due to the highly elevated risk environment for shorting, we did choose to stick with the S&P 500 ETF, again, the only short position during the quarter. We never recommend placing aggressive bets against the stock market, especially in today’s manic environment in a quarter that experienced a historic short squeeze, which Doug will talk about further. There was a very disciplined and professional approach put towards risk management that has been and continues to be our imperative. So we highlight this message during every call, and I think this is one of the differentiators for us, compared to those who are doing something similar in the market to us, and we’ll look at our results, as well as theirs, and you can see the difference speaks for itself.

David: The message is this, if you’re 100% short all the time, as most short products are structured, we categorize that as risk indifference. So the entire past year was notable for inflicting huge losses on the short side, for those who are indifferent to risk, and we believe disciplined risk management is absolutely essential for long-term success. We structured Tactical Short to ensure the flexibility to navigate through even the most challenging market conditions. So let me update you on performance, and then I will pass it along with the baton to Doug, and then towards the tail end of our time together, we’ll go through the questions that you’ve submitted. Some great questions this time, we look forward to that interaction towards the tail end.

David: So updating performance, Tactical Short accounts after fees returned a negative 5.84% during the second quarter, the S&P returned to positive, 8.55. For the quarter Tactical Short accounts lost, if you’re looking at what we lost, 5.8 versus the 8.5, that’s about 68% of the S&P’s return, and that’s what our target was, 68% short. So we were on the money in terms of that calculation. As for one-year performance, Tactical Short after fees returned a negative 22.9, versus a positive 40.77, which is a loss of 56% of the S&P’s positive return. Again, the positive return for the S&P 500 over the past year at 40%, we’ve lost just a little over half of that amount, again, through managing risk in this environment.

David: We regularly track our performance versus three actively managed short competitors. These are funds that you can find online and research online. The Grizzly Short Fund returned a negative 7.28 for the quarter, and for the past year, down 44%, so actually more than the S&P’s return, in terms of the flip side or a mirror reflection. Ranger Equity returned a negative 9.22 for the quarter, and a negative 52.62% for the full four quarters or four year. Federated Prudent Bear returned a negative 5.71 during Q2, and negative 29.79 for the past year. On average, the three competitors lost 87% of the S&P 500’s return for the quarter.

David: Tactical Short, on average, outperformed the competitors by 156 basis points during the quarter, 1,900 basis points over the past year. Tactical Short has also significantly outperformed each of the bear funds since inception. So from our April 7th, 2017 inception, through the end of March, Tactical Short returned a negative 37%, versus the 97% positive return for the S&P, for an average outperformance versus our three competitors, just shy of 3,000 basis points, 2,874, to be precise.

David: There are as well, the popular passive Short Index products the Tactical Short also outperformed. The ProShares Short S&P 500 ETF lost 8% for the quarter, 31% for the year. And Rydex Inverse, the S&P 500 was 8.24%, and 31% over the four quarters. PIMCO has an interesting product, primarily derivatives-based, very interesting in its construction, not particularly reliable in my view in terms of a market really under stress and strain, will it even exist in that context, but it lost 7.93% for the quarter, 27.26% for the past year.

David: That is performance, and I’m going to hand it over to Doug.

Doug: Thanks, David. Hello everyone, and thank you for being on the call with us today. Another extraordinary quarter. Before I dive into the macro analysis, I’ll begin with some comments on performance and positioning. In a more normal environment, we would allot time for explaining adjustments to positioning, and how changes and overall short exposure and its composition impacted performance, but because of the environment, trades during the quarter were simply for rebalancing exposure to more closely aligned with the target. Inflection point, that was the theme for last quarter’s call. I believed there was a reasonable probability the market was putting in a major top, and I still see support for the topping process view. I thought it likely as well that I would be explaining during this call why Tactical Short performance had lagged, and the reasons why we didn’t shift our positioning, but the market didn’t top during the quarter, and Tactical Short performance did not lag.

Doug: I held the view that inflation was posing increasing risk to the bond market, and I saw a spike in bond yields as a potential catalyst for a risk-off period of de-risking and de-leveraging. Instead, market yields, they reversed sharply lower, surprising many of us and hammering those caught short, treasuries and longer dated bonds. Despite my view that the market was likely topping and my fundamental view of rising yields to the downside market catalyst, we did not adjust either the amount or composition of our short exposure. We stuck with our risk disciplines, expecting a continuation of the highly challenging market backdrop, and it’s worth noting that the broader market underperformed the S&P 500 Index, though from Q2 performance numbers, it’s apparent that our competitor funds were not able to capitalize on this dynamic. The quarter, it experienced wild rotations and heightened volatility, all consistent with the topping process, but at the same time, ensuring major ongoing challenges on the short side.

Doug: Importantly, one of history’s spectacular short squeezes ran unabated during the quarter. The Goldman Sachs Short Index jumped 14.1%, boosting one-year gains to an incredible 151%. Short stocks actually underperformed the market early in the quarter, before another powerful squeeze was unleashed. Between May 14th and June 28th, the Goldman Sachs Short Index surged 30%, caught by the squeeze high-profile hedge fund Melvin Capital into the first half down 46%.

Doug: As a disciplined manager of short exposure, for years, I’ve stated that my job, it’s not to predict, but to react, to adhere to a sound analytical framework and risk disciplines, by working diligently to recognize and respond to evolving fundamental and market dynamics. Shorting, it’s always demanded discipline and patience, but this cycle is without parallel. On a daily basis, really, it’s hourly, we closely follow a mosaic of indicators. I’m Monitoring for subtle changes in financial conditions and market dynamics that could point to shifts in the risk versus reward calculus for various short exposures. We definitely do not position based on my guess of market direction. We specifically avoid trying to time market tops. I’ve been doing this long enough to know that such guesswork is a problematic approach to managing short exposure.

Doug: So the bottom line, throughout the quarter, financial conditions remained exceptionally loose, risk-on continued to dominate. In particular, corporate credit conditions remained incredibly loose. Companies enjoyed the easiest access to basically unlimited cheap finance throughout the quarter. Jump-on yields dropped to record lows, both equity and bond funds were inundated with inflows during the period, and manic performance chasing behavior. Bullish sentiment reached extreme levels and remained highly elevated week after week. I’ve witnessed nothing like this in my 30 years in investment management.

Doug: We might monitor credit default swaps or CDS prices closely. Investment grade CDS prices dropped to multi-year lows during the quarter, while high-yield CDS sank to decade lows. Myriad credit spreads also dropped to multi-year lows, both here in the US and globally. Importantly, global markets and financial conditions remained highly correlated, corroborating the global bubble thesis. Bond mutual funds and exchange traded funds posted first half inflows of about 380 billion, with bond funds on pace to easily surpass both 2000’s 446 billion, and 2019’s record 459 billion.

Doug: And I’ll read verbatim from a Financial Times article from last week, in quotes here, “Investors are pouring into global equity funds with a fervor never seen before. About 580 billion has been added to the sector in the first half of 2021. And here’s the kicker: strategists with Bank of America estimate that if the pace of inflows continues the remainder of the year, equity funds will take in more money in 2021 than in the previous 20 years combined.” I’ll repeat, “More money into stock funds this year than the past 20 years combined.”

David: That is absolutely astounding. I mean, considering the last 20 years, Doug, it’s not like we haven’t seen strong inflows. It’s just unbelievable.

Doug: Yeah. It’s shocking, isn’t it, David? Yeah, the amount of liquidity sloshing around global markets, it’s unprecedented, and this provides a good segue to my update of this unbelievable monetary environment.

Doug: Federal Reserve credit has now inflated almost 3.9 trillion over the past 70 weeks, and was up 4.3 trillion, or 116%, in just 95 weeks. After beginning 2008 at 850 billion, Fed assets surpassed eight trillion during the quarter. As of the end of May, the most recent data, M2 had expanded 4.9 trillion or 32% over just the past 15 months to a record 20.4 trillion. Institutional money funds, which are not included in M2, they were up another 870 billion. Through the first two thirds of the fiscal year, our federal government ran a deficit of 2.1 trillion, with Washington borrowing 45 cents of every dollar spent. Our federal government ran a 20 month fiscal deficit of 5.2 trillion, or 25% of GDP, and is on track for back-to-back three trillion plus annual deficits. The 2021 deficit is projected at 13.4% of GDP, putting both 2021 and 2020 deficits at highs since World War II.

David: It’s worth repeating, we haven’t had this kind of spending since we were in a global conflict. I understand you could argue, “Well, okay, we’re coming out of the pandemic,” but I think we’re getting used to these deficits in terms of funding everything. Very fascinating, World War II.

Doug: Yes, David, it’s a shocking inflation of credit, and there’s no better data to illuminate historic US monetary inflation than the Fed’s own Z1 report. US non-financial debt surged almost 7.7 trillion over the past 15 months, and for perspective, non-financial debt expanded on average 1.8 trillion annually over the previous decade. Treasury securities jumped 4.9 trillion over five quarters. After concluding 2007 at about eight trillion, Treasury liabilities ended March at 26.8 trillion. Total non-financial debt concluded March at 62 trillion, or 281% of GDP, have increased more than 80% since the end of 2007. Non-financial debt ended 2007 at 230% GDP, and was at 189% in the ’90s. Over seven quarters total debt securities increased 8.8 trillion, or over 19%. at 247%, total debt securities to GDP rose significantly from Q4 2019’s 218%. This ratio ended 2009 at 223%, the ’90s at 158, in the ’80s at 124%.

Doug: Total securities, and this combines debt and equities, ended March at a record 125 trillion, with a stunning one-year growth of 33 trillion, or 36%. Total securities have now inflated 77 trillion, or 163%, since ’08. Total securities to GDP ended March at a record 565%, and compares to previous cycle peaks, 387% in Q3 ’07, and 360 in Q1 2000. And with the value of securities inflating to unprecedented levels, household net worth ended the first quarter at a record 137 trillion, net worth inflated 31 trillion over five quarters, or 30%. household net worth ended March at 621% of GDP. This was up from previous cycle peaks, 491% in ’07, and 445% in 2000.

Doug: It’s critical to appreciate runaway debt growth is a global phenomenon. For starters, combined Federal Reserve, European Central Bank, and Bank of Japan holdings surged nine trillion over the pandemic to 24 trillion. But perhaps the world’s most astounding monetary inflation continues to unfold in China. Aggregate financing, China’s measure of broad credit growth, surged an incredible 8.1 trillion, and that’s in US dollars, over just the past 18 months. The Chinese credit bubble is today deserving of special focus. For perspective, after ending 2004 below five trillion and surpassing 10 trillion for the first time in 2009, Chinese bank assets are poised to surpass 55 trillion this year, roughly three times GDP. And while the latest iteration of aggregate financing data goes back only to 2017, it has inflated more than 18 trillion, or 64%, in four and a half years, exceeding US mortgage finance bubble credit expansion. This historic bubble is literally spiraling out of control, a reality surely not lost on Beijing.

Doug: Over recent years, Chinese officials have made repeated attempts to rein in credit and speculative excess, but each time were forced by heightened bubble fragility to back off. Each pullback only further energized credit and speculative bubble dynamics. Their credit system went into precarious overdrive during the pandemic. Officials this year appeared to adopt a newfound determination to reign in stimulus, along with credit and speculative excess. It has been a centerpiece of my macro analysis that tightening measures in China would prove destabilizing for China’s maladjusted system, as well as for vulnerable global markets and economies. China State Council last week directed The People’s Bank of China to reduce bank reserve requirements, an important stimulus measure freeing up capacity for bank lending. This was a hasty and unexpected policy shift. Global equities rallied strongly Friday, apparently in response to China’s dovish pivot.

Doug: The bullish narrative is that Beijing is now moving to bolster waning growth momentum. From my analytical perspective, China’s policy shift provided important confirmation of the bubble thesis. We’ve been closely monitoring festering Chinese credit issues that clearly worsened throughout the quarter. The situation took a turn for the worse over recent weeks. For example, an index of Chinese high yield dollar bonds ended last week with yields up to 10.4%, rising about 70 basis points for the week. This index traded with a yield of 8% as recently as May 26th. The yield surge over the past six weeks has been the sharpest since the March 2020 crisis period. Troubled behemoth developer Evergrande with 350 billion of assets saw its 4-year bond yields trade above 25% last week. Other developer bond yields [inaudible 00:23:25] as well, as the marketplace increasingly questions the solvency of a number of China’s major developers.

Doug: But when it comes to heightened systemic risk, all eyes are now on the huge asset management companies, or AMCs. Four major financial institutions created in late 1999, as part of a strategy for recapitalizing China’s impaired banking sector. Troubled China Huarong has received the most media attention. After beginning Q2 at 150 basis points, Huarong credit default swaps surged above 1,400 indicating heightened default fears for this institution, with upwards of 300 billion of assets and liabilities. Huarong poses a major dilemma for Chinese leadership. Beijing would prefer to impose a market discipline, a discipline that has been conspicuously absent throughout China’s protracted bubble. Reports suggest Chinese leadership is fed up. It’s time for bond investors that mindlessly financed reckless behavior by Huarong and others, to suffer some pain.

Doug: Yet, Beijing faces a huge dilemma. Basically, China’s entire 12 trillion credit market trade’s based on the perception of implicit central government backing. A Beijing move to counter moral hazard, with even a modicum of market discipline, risk a more systemic crisis of confidence, and bubble collapse. China Huarong’s CDS jumped 137 basis points last week to a one-month high, and rose this week back above 1,200. Fellow AMC China Orient’s CDS increased with near record 250 basis points, and China Cinda, to 230 basis points, both about doubling since April.

Doug: Recent Chinese developments are reminiscent of the US mortgage finance bubble experience. Recall that the subprime crisis erupted in the summer of 2007, marking the beginning of the end for that bubble. Confidence began to wane in the perception that Washington had everything under control, manifesting first in riskier mortgage securities. However, it took about 15 months for trouble at the periphery to make its way to a systemic crisis of confidence afflicting the core. Importantly, between the subprime and layman collapses, there ensued an extraordinary period of monetary disorder and market instability. Post-subprime Fed stimulus measures played a critical role in extending the boom in core AAA rated mortgage securities, prolonging bubble excess. Crude prices surged to almost 150 a barrel, and a speculative US stock market ran to record highs, all unfolding after the bubble had been pierced at the periphery. Monetary stimulus employed to hold collapse at bay, only prolonged terminal phase excess, ensuring a more destabilizing bubble collapse.

Doug: I believe China’s bubble is today at serious risk of a destabilizing crisis of confidence. Faith that Beijing and their great meritocracy has everything under control has begun to wane, with clear signs of this phenomenon in the pricing of higher yielding bond instruments, China’s subprime periphery. Ominously, Chinese credit stress has erupted even in the face of incredible credit expansion and robust economic recovery, and I’m convinced this dynamic has been a key force driving the surge in safe-haven Treasury and global bond prices. This yield collapse and associated loosening of financial conditions, has sustained a perilous bout of speculation and other terminal phase excess.

Doug: Meanwhile, the bullish narrative has become ingrained that sinking Treasury yields confirm the Fed’s view of fleeting inflation. We saw this week that CPI rose 5.4% year-over-year in June, the strongest gain in 13 years. And for analysts that have issues with your-over-year base effects, consumer inflation, it’s up 3.3% in only five months. Producer prices were up a data series record of 7.3% year-over-year. Clearly, there are temporary factors driving some inflation in the price aggregates, but when we analyze the inflation backdrop, we see forces at work that point to a secular shift in inflation dynamics. We expect a protracted period of…

Doug: … Dynamics. We expect a protracted period of bottlenecks, shortages, hoarding and pricing pressures for many things. We see a secular power shift to labor over employers, and we see surging housing costs feeding through to various sectors. We also believe commodities have likely commenced a powerful secular bull market. There’s a long list of factors, domestic and global, we see, supporting a secular upswing in inflation dynamics. But I don’t mean to imply that the bond market is wrong on inflation. I instead believe that bond market focus shifted during the quarter away from inflation risk to the faltering Chinese bubble with negative ramifications for a myriad vulnerable bubbles across the globe.

Doug: The bond market disregarding inflation risk as it fixates on the bubble for agility is not without precedent. Recall the crude oil commodities went on their speculative moonshots in ’08, bolstered by a late cycle confluence of robust global demand and the Fed’s post subprime monetary stimulus measures. After peaking at 5.3% in June of ’07, 10-year you trigger yields were around 4.25% in mid June 2008. Yields trended lower through the summer, indeed in August ’08 at 3.8%. There was this extraordinary dynamic. Year-over-year CPI rose from 2% in August ’07 to a cycle peak 5.6 in July ’08, yet 10-year yield sank 100 basis points over this period. Last quarter, crude gained 25% while CPI surged above 5% to the highest since ’08. June’s ISM manufacturing prices index spiked to the highest point since 1979.

Doug: Meanwhile, labor tightness turned acute across the economy, house price inflation accelerated with the FHFA house price index registering a 15.7% year-over-year gain. In spite of mounting inflation risk, bond yields reversed sharp sharply lower. After ending Q1 at a 14 month high 1.74% 10-year treasury yields dropped 27 basis points to 1.47% and then traded as low as 1.25% last Thursday. It’s certainly tempting to dismiss current bond yields as market insanity, but there is method to the madness.

Doug: China is a historic credit accident in the making, during the US we have runaway manias and equities, corporate credit, ETFs, M&A, cryptocurrencies, NFTs, collectibles, real estate and the like. The treasury market in 2008 saw a bursting mortgage finance bubble as deflationary. Suspecting the Fed would respond with powerful monetary stimulus. Today, especially after witnessing a near 4 trillion Fed pandemic response, bonds have no doubt whatsoever that a faltering bubble in crisis dynamics will be immediately met by additional trillions of QE purchases, treasuries, MBS, corporate bonds and ETFs.

Doug: Several years before the pandemic, I posited a seemingly ridiculous thesis that the Fed’s balance sheet would reach 10 trillion come the next crisis. Unprecedented speculative leverage had accumulated across global markets and the eventual bursting would leave only the central bank community with the wherewithal to provide a liquidity backstop. The pandemic market crisis confirmed the analysis. The Fed and central banks acted about as expected, but something extremely troubling transpired that I did not anticipate. Rather than balance sheets employed for buyer of last resort post bubble stabilization, the scope and rapidity of liquidity injections only exacerbated historic bubbles. In short, central banks unleashed parabolic blow-off excess. A recent staff paper from the Fed included a most pertinent fact. Hedge fund grossed US treasury exposures doubled from 2018 to February 2020 to 2.4 trillion.

Doug: Data confirming an epic surge in speculative leverage heading into the pandemic and this data captured only a fraction of the leverage. It was gathered for reporting hedge funds, which excludes so-called family offices and other unregulated and offshore entities. I’m convinced this parabolic rise in speculative leverage only accelerated following the most extreme stimulus measures employed early in the pandemic. I believe speculative leverage has mounted across asset classes, treasuries, MBS, corporate credit, Muni bonds, cryptocurrencies and the like. We saw from the Archegos blow up a 10 to one and even greater leverage was employed even in stock market speculation and that derivatives are integral to levered strategies.

Doug: Following Friday’s PBOC cut in bank reserve requirements, Bloomberg ran an article highlighting a surge in overnight repo funding being used to lever Chinese sovereign bonds. I have suspected over recent years that huge speculative leverage has been accumulating in Chinese credit instruments, so-called carry trades, that borrow cheap to purchase higher yielding Chinese securities. After all, I mean, China has offered carry trade paradise, high yields, a stable currency underpinned by the PBOC and essentially pegged to the US dollar and implicit Beijing backing for the entire banking system and credit market.

Doug: I believe carry trade leverage in China’s credit market has likely reached the trillions and this historic speculative bubble is acutely vulnerable today. Scores of highly levered companies are indicating stressed finances while credit conditions have tightened markedly throughout the high yield marketplace. Meanwhile, there are heightened concerns for the Beijing backstop with particular worry in the off shore dollar denominated bond market. I believe a powerful de-risking, de-leveraging dynamic has commenced in Chinese credit, beginning with the high yield dollar bond market populated by the big developers, the AMCs and other fragile institutions.

Doug: If I’m right on this, this would be a monumental development for Chinese and global bubbles. I’ve argued that China evolved into the marginal source of global credit. Moreover, speculative leverage is the marginal source of liquidity for bubble markets across the globe. As such, the Chinese credit market evolved to become central to the overarching global bubble. I expect recent tumult in Chinese high yield debt to infect the Chinese credit market more broadly leading to a de-stabilizing tightening of credit conditions. That’s worth noting that Chinese banks expanded lending by 327 billion during June alone, with a record first half lending growth of almost 2 trillion.

Doug: And with Beijing’s prodding and further reserve rate cuts, Chinese banks can for a while take up the slack from an impaired bond market, but this incredible late cycle inflation in bank lending, guarantees enormous loan losses and resulting capital shortfalls for China’s banking system down the road. We saw important evidence last week of contagion jumping from Chinese credit to Asian markets. At Friday alone Japan’s Nikkei index had lost 4.7% for the week and was near 2021 lows. Hong Kong’s Hang Seng index was down more than 5% intraday and the China Financials index 4.1% both to lows for a year. The risk-off dynamic was beginning to gain traction in Europe and US markets with notable weakness in bank stocks, the VIX had started to spike, markets then rallied strongly on Friday’s Chinese policy pivot.

David: Doug, it comes to mind that a lot of people will argue whether it’s speculators, market participants, what have you, they’ll say, “Don’t fight the Fed. Don’t fight the central bank community. They have the tools that they need.” Do they really have the tools they need?

Doug: That’s the question, David. In many ways, today’s backdrop reminds me a lot of 2007, 2008. And it’s always obvious in hindsight, but I can tell you from my own experience that few at the time recognized the bubble. I was told repeatedly, “Doug, subprime doesn’t matter. It’s only 40 billion. Washington will never allow a housing bust. The Fed has everything under control.” The problem was there were trillions of suspect securities with prices divorced from underlying fundamentals and too many were held by leveraged speculators or part of speculative, derivative trading strategies. Faith in policy measures to sustain the boom had become way overblown.

Doug: I think back to Lehman’s predicament. They were highly levered in a portfolio of risky credits. The piercing of the bubble made their position untenable and it was somewhat confounding that market confidence was sustained for as long as it was. But that’s the nature of financial crises. A long creeping process can suddenly careen at lightning speed. I believe China’s historic credit bubble has likely been pierced and this dynamic has helped fuel the global yield collapse and I do vividly remember how trouble at the subprime periphery in ’07 spurred further terminal phase excess at the core comprised of top tier AAA rated securities, MBS, treasuries, corporate bonds. Compared to the mortgage finance bubble, the current terminal phase is off the charts, fueled by egregious monetary and fiscal stimulus, along with unprecedented leveraged speculation.

David: So we got the reserve rate cut that alleviated some pressure in the Chinese markets, how much time does that actually buy them?

Doug: Well, it’s difficult to gauge how much time a reserve cut buys the Chinese. I don’t believe they’ve yet thrown in the towel on efforts to reign in excess, so Beijing faces a real high wire act ahead. And there’s always this ebb and flow to faltering bubbles and actually it’s a thin line between panic and egregious late cycle manic excess. Treasury yields barely reacted to reports of much stronger than expected consumer and producer price inflation. The treasury market is signaling trouble on the horizon. I expect unfolding China de-risking de-leveraging to challenge over levered Asia along with the emerging markets that have been on the receiving end of enormous hot money and performance chasing flows. And while the finance and services based US economy is somewhat isolated from global economic factors, markets are not. It’s become one interconnected historic global bubble financed by speculative carry trade leverage derivatives and margin debt.

Doug: A key link from Chinese credit stress to US market vulnerability is through the leverage speculating community and global derivatives markets. Beyond Chinese fragility, I see vulnerability in the hedge fund and family office community. Booming equities and corporate credit have masked tough environments for a number of strategies. The historic short squeeze has impaired long short so-called market neutral strategies. The yield collapse caught a lot of macro and quant funds, short treasuries and investment grade corporate bonds. Yield curve trading strategies have similarly backfired. In general risk hedging strategies have been problematic with bubble markets turning increasingly dysfunctional. There’s been as well, some wild volatility in the cryptocurrencies and commodities that have hurt performance. Moreover, there is this post RK ghost tightening a prime brokerage securities finance. But so long as security prices are rising and speculative leverage inflating, these issues are not immediately problematic for booming markets. With 120 billion monthly Fed QE, it’s easy to dismiss liquidity concerns.

Doug: I’m reminded of City Group’s Chuck Prince and his infamous still dancing comment from the summer of 2007. Things get crazy at the end of cycles. And with our view that we’re in the waning months of a historic multi-decade bubble period, we shouldn’t be surprised by any degree of manic excess. Clearly pandemic related stimulus extended the lives of myriad bubbles. The Fed recently admitted to talking about, talking about tapering. The central bank is making yet another catastrophic mistake by sticking with massive QE in the face of egregious excess. It’s reckless monetary management. And I’m reminded of the old, “What are they afraid of,” Rick Santelli rant. To me it’s rather clear. They witnessed firsthand how precariously over levered and speculative markets had become by March 2020. They know it’s a bubble and are left hoping that if they delay tightening measures, things can somehow resolve themselves over time.

Doug: The late Dr. Richebacher had epiphany in sight. Simple, controversial and brilliant. He would say, “The only cure for a bubble is to not let it inflate.” No one wants to admit this is true. Wall Street clearly loves bubbles, the bigger, the better. Politicians celebrate them, while central bankers prefer to ignore the entire issue. They refuse early intervention and they absolutely won’t touch bubbles once they inflated big and vulnerable. They want to believe the myth that macro prudential policies offer effective management.

Doug: Most unfortunately, tremendous amounts of damage can be inflicted during terminal phase excess and that’s precisely where we are today. Global bubbles have inflated tremendously over recent years, especially over the past year. Wildly inflated bubbles are now acutely vulnerable to any tightening of financial conditions, albeit by Beijing, the Fed or otherwise. I believe a global tightening of financial conditions has likely commenced in China with waning market confidence and highly levered companies and related speculative de-leveraging. I believe last week’s volatility is a sign of things to come. This bubble has been the proverbial cat with nine lives, but each resuscitation results only in more dangerous speculative bubbles and systemic maladjustment. There’s just no getting around this bubble reality. I really fear the consequences from this latest round of monetary madness.

Doug: And the amazing thing is, at this point, everyone’s completely numb. Numb the excesses, numb to the risk. I spoke about how this period reminds me about ’07, ’08. I am troubled as well by the parallels to 1929. These days, I think of Benjamin Strong’s infamous coup de whiskey in 1927. Fed stimulus that unleashed a final precarious speculative market blow off, to conclude a historic economic and market cycle. I also think of 1999 bubble mania craziness. But today’s speculative excess and market dysfunction are really in a league of their own.

Doug: To conclude our bubble thesis update, I see the current environment in terms of a speculative blow-off in a historic bubble in financial assets and the normal mechanisms that would temper excess are nowhere to be found. The old bond market vigilantes, tighter monetary policy and general investor risk aversion. From my analytical framework, we continue to witness the absolute worst case scenario and I fear financial economic, social, political and geopolitical consequences. From the tactical short perspective, this has been such a long and difficult period, but I do believe we’re close to seeing a more favorable environment. David, back to you.

David: Thank you, Doug. We’ll dive into the Q and A and the first one I’ll take. The question is, what does looming inflation pertain for equities and for the tactical short?

David: The easiest answer is that a financial system as leveraged as ours is very brittle and it doesn’t take a lot of external pressure or internal pressure for that matter to cause damage. Let me run through a couple of scenarios there. The first scenario is that an increase in inflation numbers pressures the central bank community to tighten financial conditions. You could see that by raising rates, you can see that by scaling back or eliminating asset purchases, which in turn reprices equities downward. And so, any increase in rates, either by central bank edict, or if you’re looking at sort of normal market pressures, that cast a negative shadow over equities.

David: Couple of things to keep in mind, you’ve got your discounted cashflow models. Those get re-figured for a higher hurdle rate, which ends up shifting valuations higher, raises the question of whether or not a sustained move in terms of price is even possible. So in that circumstance where, again, rates go higher and people rejigger their DCF models, you’ve got the opportunity for organic selling to ensue. Often that’s the case. And of course, what I’m assuming in this first scenario is that there’s sort of a sensible reappraisal of values and prices and thus sort of a reallocation within portfolios.

David: There is a different reality, which takes us to scenario two. So the second scenario is real returns, when you start factoring in inflation, real returns look different in a period of rising inflation, obviously. Risk appraisal changes under that changed set of return assumptions. And so you have folks who are creating asset allocation models, they begin to make their shifts, the assumption shifts, and so you have de-risking. I think that’s sort of a safe bet.

David: Let me go through a third scenario and that’s this. The third scenario is one where inflation accelerates to the point of breaking down confidence in the currency. We’re talking about not just low levels of inflation, but higher levels of inflation, even leading towards something of an extinction event. Von Mises described it, as my colleague Morgan Lewis reminded me of the other day, as a crack-up boom. The crack-up boom inflation results, we know just sort of the nuts and bolts of it, but inflation results from an expansion of the money supply. And this is certainly the Austrian view of inflation as well.

David: Inflation results from an expansion of the money supplies, so the theory goes, hyperinflation as a result of radical increases in money supply. So, you can see, in this scenario of a crack-up boom, you can see the value of assets accelerate to the upside, being repriced to reflect lower purchasing power. That’s possible. If your money is rapidly losing purchasing power, demand for that money declines and in its place demand for anything, for anything not paper, increases. It could be a bottle of wine. It could be an acre of land. It could be a sack of potatoes.

David: And to quote from Human Action, you probably don’t want to tackle 890 pages of Von Mises, but I would suggest a careful reading of page 426 through 428 and on 427 Mises says, this phenomenon was in the great European inflation of the twenties, called a flight into real goods, a flight into real goods. I think it suggests that hard assets are a critical puzzle piece and it should be a part of an investor’s portfolio allocations going forward. This is a potential as we talk about this third scenario and a crack-up boom, this is a potential negative for tactical short. But, and I want to get your opinion on this too, Doug, but what makes this last scenario less likely to be an upside catalyst for equities is the present, at least in my view, in the present tense, is that you’ve got leveraged speculators running the market.

David: And if you’ve got a shift in rates, really a shift in anything, and we go back to what Doug mentioned earlier, the RK goes blow up in the last 12 months. It forces de-grossing of positions, regardless of an inclination to own, quote, anything but dollars. This is counterparties stepping in and saying, “You will sell, we’re going to cover our butts. You’re liquidating your positions.” So, a forced issue of selling and of course selling begets selling. So the quantities of leveraging the system today, alter the mechanics of buying and selling. And I think leave the equities markets vulnerable to sell offs, including what we’ve seen the algorithmic opportunistic jumping in on shorts, riding the momentum down just as they are so keen on riding it up. So, when you factor in the derivatives entwined hedging strategies with, again, some of the changes in mechanics within the markets, I think you’re talking about an exaggerated selling at the worst time.

David: So that last scenario to my mind is unlikely. I come back to one word that to me, stands out, brittle. Brittle is the word that comes to mind. It appears to hold a structure. When you’re looking at something that’s brittle, it seems to be sound, but any odd thing can become a problem for the structure that’s brittle. I can’t help but think of the Challenger shuttle, the engineering was brilliant. No question. The math was near perfect, but one small condition, a cold morning, cold conditions made an O-ring brittle and the rest is history. Doug, what are your thoughts on the same topic?

Doug: Sure, David, and I’ll begin with at this point, it’s no longer necessary. It doesn’t seem necessary to use the word looming when we discuss inflation. David, kind of supporting your stew comments, I would say inflation poses a major risk to a highly levered US bond market and credit system, along with a very speculative stock market. Not to mention highly inflated real estate markets of the country. A spike in market yields, it would crush levered trades with this de-risking deleveraging dynamic, leading to illiquidity market dislocation and panic. We saw that dynamic start to unfold in March 2020, and also we can expect hedge fund blowups and things. So far the Fed is content to keep repeating to itself that inflation will prove transitory and the markets love it when the Fed stays on the easy money script.

Doug: And it wasn’t that many months ago where the narrative was that the Fed would employ yield curve control measures to cap market yields in the event of an unexpected bout of market inflation angst. So we’re in this extraordinary, I would say unprecedented backdrop, where there is a major jump in inflation to above 5% year-on-year, you have the bond markets determined to disregard inflation with 10-year treasury yield at 1.3%. Who would have thought that?

Doug: So, today the bond markets should be disciplining the inflating Fed and spent thrift Washington politicians, but because of QE, there’s no impetus for the markets to administer this upon, because the Federal Reserve, it’s always there with QE to make the bond market whole in the event of trouble. And this is really epic market dysfunction and I actually believe bond yields remaining this low in the face of a lot of reckless behavior only ensures bigger problems down the road. And that’s including higher inflation, but also market structure maladjustment, and eventually unwieldy supplies of treasuries and credit instruments and added general inflation is [inaudible 00:57:35] the benefit equities by inflating corporate earnings and cash flows.

Doug: And there is some of that, but what we’re witnessing is monetary inflation feeding mania as a market bubbles. And that’s a major dilemma that central banks can’t inflate away with their balance sheets. The more they inflate, the greater the scope of bubble excess and the inflation in this backdrop, it’s highly destabilizing and-

Doug: … backdrop. It’s highly destabilizing, and from my perspective, I would argue, catastrophic. I believe this is shaping up as by far the biggest short opportunity of my career, but it’s sure a challenge and taking forever to materialize. Once we get through this manic environment, I see the inflationary backdrop providing ample opportunities for tactical short. I appreciate the question.

David: How about epic market disfunction exhibit A? I think you’ve already gone through a couple of them, but I’ll add my exhibit A. High yield, or what we know as junk bonds, having a yield below the rate of inflation. And so inflation is an issue and it does seem like the bond market is simply ignoring it. Next question for you. When will the credit bubble burst? It just seems to go on getting bigger and bigger. Will it last for months more, years more, decades more?

Doug: There’s the question. It just keeps getting bigger and bigger, no doubt about that. Over the years, I’ve been fond of saying that bubbles go to unimaginable extremes and then double. Well, this one has quadrupled, but I think we’re in the end game. Could it last another year or two? It could. I’ll be shocked if things hold together for another decade of monitoring insanity. Things, they just turn too reckless. All the money printing, the speculation. Mania is the leverage.

Doug: I mentioned before. I see this as a final blow off of a multi-decade cycle akin to ’27, ’29. I believe there’s an important test coming in China in the coming weeks or stretching into the fall. Through so many trillions of monetary inflation at a maladjusted system, albeit China or the US, and you’re playing with fire. I speak of monitoring disorder and wild pricing stability, and in such environments, latent instability, it festers below the surface within both markets and economic structure. We’re already seeing in stability and Chinese credit, and they haven’t even really begun to tighten. At some point, the fed is going to have to return to some semblance of monetary sanity, but I don’t expect this adjustment to proceed smoothly. Systems, they’ve become too unstable and maladjusted. I really think bubbles in US, China, and elsewhere are on borrowed time. The pandemic, it was a gift for these aged and vulnerable bubbles, but it will come at a steep cost.

David: What is the future of the banking industry when deposits are being shunned, lending is constrained? If loan defaults were to become problematic, defaults amounting to 10% of a bank’s portfolio, it’d wipe out much of the bank’s capital because of the nature of fractional reserves. There’s the question looking for comment. Before you do, Doug, I just remember your [inaudible 01:01:26] comment. 10:1 leverage was significant in terms of an unwind, and yet 10:1t balance sheet leverage for your average commercial bank is considered conservative in terms of positioning. So back to the question. What happens to commercial banks in this instance?

Doug: QE, it’s distorted everything. And it’s created trillions of bank deposits, literally trillions of bank deposits, while booming corporate credit markets create a drag on bank lending. There’s a lot of focus on bank lending. Well, it’s suffers because corporations are out borrowing commercial paper, selling junk bonds, and all these other things.

Doug: With my view of credit market vulnerability, at some point in the future, banks will have to provide the key source of system credit growth. I don’t see any way around it. The banks will be forced to lend when credit markets seize up and bond issuance tanks. We could be in the early stage of this dynamic unfolding in China. And when it comes to surge in bank defaults, Beijing, they’ll have no alternative than to recapitalize the banking system. And down the road, I would not be surprised to see many US banks, perhaps the entire system, in need of a major recapitalization. Doesn’t make a lot of sense to me that the federal buy corporate debt and ETFs when markets turn to liquid, but then not recapitalize the banking system when insolvencies start to mount. So I would suggest that the future of banking is likely a more state directed system, and it will be closely tied to federal reserve and Washington policy making. I don’t think that’s a positive prospect.

David: The next question is, I’ve been reading the Credit Bubble Bulletin for many years, and it seems we’re always on the cusp of a major economic calamity, but it never happens. So why can’t central banks just keep printing money infinitum? Japan has been doing it for decades and the day of reckoning never happens.

Doug: First of all, thank you for reading. I appreciate especially the long-term readers. We’re at the stage of the cycle where bubble analysis, it’s been discredited. I’m a crazy, crazy guy again, and I’m wearing the dunce cap again. This is a late cycle phenomenon. It’s not new to me by any stretch. I don’t think the Fed’s balance sheet would be above $8 trillion today unless the fed has repeatedly recognized the system was at the cusp of calamity. This goes back to the Fed’s 2011 stimulus so-called exit strategy. But in instead of unwinding crisis period asset purchases, the Fed instead doubled their balance sheet to $4 trillion by 2014. The Fed has now doubled its balance sheet again to $8 trillion, and it’ll reach at least $9 trillion next year. And as to the next crisis, surely Fed assets at $15 trillion and counting, and the entire system will suffer from only greater disfunction and fragility.

Doug: I would argue… I don’t want to argue. It seems factual. The Fed’s money printing has gone parabolic, and the trillions of liquidity created has stoked historic speculative manias of bubbles. It’s clearly been policy desperation. There is no historical precedent for massive monetary inflation leading to positive outcomes. Japan experienced a historic bubble in the ’80s, and they’re still suffering the consequences decades later. Does Japan have excessive government debt and speculative excess in their asset markets? Yes, they do. But they have not, for 30 years, run massive trade and current account deficits. They’re a nation of savers. The Japanese government basically owes a huge debt to its domestic savers, which is problematic, but it’s a much better and a much different dynamic than here in the US. I don’t believe they have anywhere close to the amount of leverage speculation in their credit market as the US or China, and I don’t see the type of economic maladjustment in Japan that I see here and in China. On a social basis, it is a much more cohesive society. They’re not nearly as vulnerable to strife and conflict as we face here at home.

Doug: So I’m not a big fan of the argument that if Japan can do it, we can do it even bigger. And why can’t central banks continue this forever? First of all, money printing is not going to resolve any of the serious financial, economic, social, and political issues plaguing the US and other nations. There is ample history, old and recent, to prove this point. It seems rather clear to me that monitoring inflation is only making things worse. In fact, it is risking a crisis of confidence in the markets with money and credit and with policymaking.

Doug: At this point, we’re on a direct course to calamity. So far, the bond market, dollar, they’re all good with this monetary inflation. I don’t think this will always be the case. And we’re at the point where the system won’t be able to function well with a spike in market yields. And you can’t just keep creating trillions of new treasury securities and financial claims without, at some point, expecting serious devaluation and a de-stabilizing run against the suspect instruments and borrowers. The laws of economics and markets, they have not been repealed.

Doug: I have, in previous calls, highlighted a possible scenario. Come the next crisis, acute market stress will force the Fed to announce trillions more QE. And this could unfold with consumer price inflation already elevated. The bond market might well look at the backdrop and finally say no mas. And the world might reasonably conclude, we don’t like your bonds or your currency. Party over. And thank you for your question.

David: That was a great answer. Doug, just for the record, it’s not a dunce cap, it’s a ducks cap. It’s a ducks cap, and you wear it well.

Doug: I’m proud of both of you.

David: So is the S&P 500 the most suitable US equity index for tactical short? What about other indices which have a lower concentration of FANG stocks?

Doug: Okay. As I’ve explained in the past, I’ve used the S&P 500 as the default short exposure in high-risk environments for years, going back to my days as a mutual fund manager. For Q2, David highlighted this, tactical short loss 68% of the S&P’s return. Right in line with our 68% short exposure throughout the quarter. As a manager of short exposure in such an extraordinary environment with such uncertainties, I see a lot of value in knowing the so-called beta of the positioning. Said differently, it’s critical to have a clear idea of the losses that could be suffered in the event of various market scenarios. I don’t want surprises. Hopefully as investors, you find value in knowing your manager is going to execute the strategy as discussed, and he’s focused on not doing things that could lead to negative surprises.

Doug: I will be venturing out into other short exposures. And at that point, gaging beta under different possible market outcomes will become a more challenging endeavor. This is part of the business. But in an environment experiencing so many extremes, I’ve erred on the side of sticking tightly with the default exposure, and I just don’t have regrets on that. I appreciate the question. Thank you.

David: Next question. Is the US dollar the cleanest shirt in the laundry bag of currencies, with each central bank competing with each other to competitively devalue the currency? I’ll answer this. Yeah. Next question. No.

David: Okay, part of what holds the dollar up as a distinct currency with distinct advantages is the depth of dollar capital markets. Of course, there is a flip side to that. You could argue that a broad base of dollar and dollar asset holders does not have to maintain those positions forever, as you suggested a minute ago when you were discussing the answer to the question on Japan. And if motivated, they can return them. So at some point, we could be swimming in a deluge of returnable dollar assets.

David: But the crisis oriented argument in favor of the dollar and why the dollar is the cleanest dirty shirt is that when liquidity is needed, the most reliable place to get it is by the dollar markets. That’s the running assumption. So what we have is swap lines open to other countries. I think right now, we’ve got up to 14 major central banks with swap lines open to the Fed. And then downstream from there, of course, through those 14 central banks, downstream, you’ve got the commercial banks. If they need liquidity, pressure is alleviated. In US dollar terms, that can be done very quickly. So both liquidity to the institutional level, the regional level, and this system is imperative to have in place in an interconnected global economy. Global banking system, money moves faster than ever, and having a liquidity backstop prevents crisis if it’s based purely on the evaporation of liquidity from one locale. So the global monetary system is still dollar based. And so we sit in this privileged position from a demand standpoint.

David: I’d say we’re more than the cleanest dirty shirt because not all shirts are created equal. We’re like the stained, and arguably ruined, dress shirt amongst a bunch of smelly undershirts. Throw away the dress shirt and your attire steps well below business casual. What we do is try to hide the stains as best we can.

David: This point of competitive devaluation is an important one. And I think it’s lost on most people who, frankly, don’t get to travel much or follow the foreign exchange markets. The best measure of watching this competitive devaluation is watching the price of gold in a half dozen or a dozen currencies. When the price of gold is rising in all of those currencies, everyone is losing. But again, without this external barometer, hardly anyone notices. And again, a lot of folks don’t really even compare one currency to another. But when currencies relative to each other are declining, it’s even hard to know how much you’re losing. So yeah, this issue of competitive currency devaluation is a real one. We’re, as I say, the cleanest dirty shirt, but still maybe a nicer version of that.

David: The next question is also about the dollar and gold. Can the US dollar and gold appreciate or depreciate at the same time for prolonged periods? And the answer is yes. Many people view the dollar as always inverse to gold. So you wake up in the morning and the dollar index is up X%, and you can gasp and say, “Okay, well, gold’s got to be down.” And generally speaking, that may be true, but it’s not always the case. The dollar and gold can move in the same direction. Prolonged periods, if you’re talking about months to years, there’s certainly precedent for that. 1978 to 1980, both were moving higher at the same time. 1974 to ’76, both were moving lower at the same time.

David: I think in the period ahead, what we have is, again, an opportunity for… You could see them both move higher, not because the dollar has merits, but you look at risk-off dynamics where you’ve got some investors scrambling for dollar liquidity, and at the same time, people seeking gold as a safe haven. And all of a sudden, you lose that knee-jerk CME commodity trader type of relationship where, again, just knee-jerk, dollar up, gold down, or vice versa. That takes on a very different dynamic when you’re talking about risk-off dynamics. Again, dollar liquidity, putting a floor under the dollar, and safe-haven demand for gold driving that price higher, potentially at the same time. So you can see the move in the same direction at the same time. And those timeframes, I think, should help. ’78 to ’80, ’74 to ’76. I could probably come up with some others, but it’s at least a start.

David: What is the classic definition of a hard asset? This is the next question. Hopefully it’s not as hard to understand as an idea like crypto.

David: Classic definition of hard asset. It’s a real thing. It’s a tangible asset. It’s a resource with fundamental value. So examples, farm land, gold, a tractor, an oil pipeline, a cell tower. They’re real things. I’ll mention our other product offering includes this very thing, ownership of hard assets focused on four categories. Infrastructure, real things, global natural resources, a hard asset. Precious metals miners focusing on the oldest of what has been both a monetary and hard asset, especially real estate. Again, in the classic sense of a hard asset.

David: We like hard assets because they’re not as complicated as cryptos. They’re not as complicated as other assets, which are, in this environment, valued very irrationally. And when I say irrationally, I think of Tesla, for instance, being valued more than the nearest nine competitors who produce I don’t know how many multiples more vehicles. It’s astounding. But for us, the valuation of those insane assets, we would prefer to keep it simple. And hard assets with fundamental value, preferably with cashflow returned in the form of dividends, these are the things that make sense.

David: Now, if you wanted to keep it very simple and come back to, what is the classic definition of a hard asset? Well, the simplest hard asset to own, and what the asset that served as the basis of value in past monetary regimes, is gold. Is gold.

David: I’m going to take one more of these and then pass the baton to you, Doug. Would you recommend a highly rated bank CD ladder or a highly rated insurance fixed annuity ladder for short-term three year period for a little bit higher interest rate?

David: First of all, I would say in this environment, if you have to stretch at all for a higher rate of interest, the answer is no, don’t do it. This is the classic picking up pennies in front of a steamroller. You’re not being compensated enough for the various risks in play. So, no thank you. The fixed annuity is an easy no. A laddered bank CD, I think I would rather eliminate the bank counterparty risk and that periodic illiquidity, and have those dollars in T-bills directly with the Fed rather than in a laddered CD portfolio. And you can create a similar structure if you want with various maturities and not be bound.

David: If I wanted to balance out inflation… Maintain liquidity. This is really a question about what to do with liquidity. If I wanted to balance out the inflation risk of a T-bill position, I would probably do something like this. 60% T-bills, 40% gold, in a program like Vaulted, designed to be an alternative to bank deposits, but instead, held in ounces with Royal Canadian Mint. Accessible, liquid, deliverable, allocated kilo bars. It’s cheap, it’s easy, it’s transparent. And again, what you’re trying to do is basically balance out, with this liquid position, what risk you may have from inflation. Now all of a sudden, we’ve got the Feds whining about I can’t get above 2%. Now everyone’s surprised.

David: Remember, it’s the expectations of the professional economic class that were surprised by this week’s CPI and PPI prints. They expected a lower number, 0.6. It came out at 0.1 for PPI. I think it was 0.5 or 0.6 for CPI, and it came in at 0.9 on your month over month changes. These are professional economists, PhDs who know how to do the math, and they were not off by a small margin. Their estimates of inflation were significantly off. So the idea of moving to cash, I think it’s very relevant to keep this barbell approach in mind. If I’m talking about a cash position, like the timeframe here in the question that’s asked, three years, again, some sort of a balance between a liquid gold position and the liquid treasury bill position. Maybe it’s lopsided at 60/40 or more of an equal balance between 50/50. That’s how I would manage liquidity right now.

David: For you, Doug. What kind of precipitating events do you think might pop the economic bubble?

Doug: This is somewhat semantics, but I would start with a broader credit bubble, which is fueling speculative asset bubbles where both feed into this boom time economic structure created, in economic terms, a bubble economy. So in my analytical framework, I see the markets driving the economy, as opposed to the traditional view that the economy drives the market. So in market and economic analysis, I focus first on financial conditions and speculative dynamics. We saw again in March 2020, if the markets unravel rather swiftly when de-risk and de-leveraging dynamics take hold.

Doug: I’ve argued that contemporary market-based finance seemingly functions wonderfully only when it’s expanding. It doesn’t work in reverse. The collapse of speculative leverage played an instrumental role in the 2008 crisis, and speculative leverage has ballooned significantly since. I mentioned earlier that hedge fund levered treasury holdings doubled in the period 2018 to February 2020, indicative of this parabolic increase in speculative leverage that surely only accelerated after the Fed’s pandemic response.

Doug: At this point, any number of things could spur when markets, we call it a risk-off. De-leveraging in the marketplace now would be quite problematic. It could be a spike in bond yields. That would be highly destabilizing, especially because of the extreme amount of leverage that it’s accumulated in treasuries and fixed income markets, generally. A spike in yields and associated liquidity would be quite problematic to the derivatives complex. A rapid widening of risk premiums for corporate credit would be destabilizing, again because of the leverage.

Doug: I’ve also explained why I believe worsening in credit stress in China has potential to incite a de-risking de-leveraging dynamic that would reverberate around the globe. Global markets, I’ve mentioned this before, they’ve just become tightly interconnected. So development in China or elsewhere could prove a catalyst to risk aversion in problematic de-leveraging in our highly levered markets.

Doug: Right now, with the system so inflated from the effects of extreme fiscal monetary stimulus and what I call this resulting monetary disorder, there’s vulnerability to any number of potential catalysts originating at home and abroad. At some point, the Fed will need to hold back on stimulus and even begin to raise rates. This will not go smoothly, and the Fed fully recognizes this. So they’re moving in slow motion, which only extends the life of the terminal phase here. And at some point, I expect market confidence and Fed policy and the efficacy of monetary stimulus to wane. And any loss of confidence in the power of the Fed to sustain the boom, that would have dire consequences on market and economic bubbles. So thank you for the question.

David: The next question is, how is it legal that silver and gold are held at such low levels or such low values? I personally don’t think they are held at a low level. Let me just go back through at least recent episodes. You have the 800% move in silver over a 10 year period from 2000 to 2011. And at that time, I remember the conversation about JP Morgan manipulation and it wasn’t really moving. Price suppression. I think 800% is the evidence that you need to say no. In fact, it was moving and it was moving at a pretty decent clip.

David: I think markets do what they’re supposed to do. Sometimes it’s not when we want them to. So my experience has been, in working with individual investors, that when time expectations are not met, sometimes there’s an explanation gap. Why isn’t this happening? What’s going on? And it’s not uncommon to find the answer is with someone else.

David: So I tend to see this more frequently with an options trader or an equity speculator than I do with a physical metals investor. Time is less of a concern with someone’s sitting on a tangible asset. But if you’re a trader or a speculator, you’re chasing a particular goal, then not having the time expectation met, you can search out and say, something’s going wrong here. Why isn’t this happening?

David: I think gold will pass $5,000 an ounce, and I think silver will get past $150 an ounce, perhaps even $250. Those may sound like large numbers, but I would not put a timeframe to that. Market pressures emerge when assets are overbought. Market pressures emerge when assets are oversold. And that’s typically when you see an advantage played. If you want to see a hand in the market pushing. A little money goes a long way. If you’re talking about tipping the scales and either bullying price or boosting prices, it happens at the market extremes, typically there’s the technical vulnerability. And so again, I would see short term opportunism as an explanation more than I would something nefarious-

David: More than I would something nefarious or less than legal. Now, you have to look and say, “Look, there have been games played. They’re spoofing. There’s cheating within the commodities markets.” And we know that’s happened because in the last two or three years, there’ve been a series of lawsuits and fines for some of your big commodity trading houses. And so, that’s a reality. I guess what comes to mind is that with those kinds of games played, there’s a structure, there’s a setup where you want to be on the winning side and you don’t care who’s on the losing side.

David: And so, a trade desk may do that. But I don’t know that it’s any different than like what we saw John Paulson do in the period of mortgage-backed securities stuff. He packaged a piece of garbage to bet against and he won big because he convinced someone else with weekends to take the other side of the trade. And it’s maybe a different version of market opportunism and manipulation but you do see that happen from time to time. But I would say I’m not frustrated with where gold and silver are at.

David: Yeah. I think they will go. As I said earlier, markets do what they’re supposed to do. Not necessarily when we want them to. So, patients and for the tangible asset holder, probably familiar with this already. It is a virtue. I think a question to compliment this one. I want to steer this back to you, Doug, back to tactical short, because this comes into against her, this notion of manipulation or control. If moral hazard has all been evaporated and markets are managed for upside results, what prevents that from being a permanent situation like a Truman show for the equities markets?

Doug: Yeah. I really enjoyed that movie, David. Yeah. Key point. I believe we’ve been witnessing the consequences, epic market disfunction. It’s a breakdown in the market pricing mechanism. One example would be the short squeeze I noted earlier. Stocks but also with treasuries. I believe shorting generally helps to contain exits. But now, over liquid five markets are largely under strength. Who wants to get in front of it? Fuel bubbles and result in economic maladjustment.

Doug: Also important to appreciate that bubbles need ever increasing amounts of credit in speculative firepower. And at some point, both turn increasingly destabilizing. I think that’s where we are right now. I’ll add that, don’t expect capitalism to function properly, a financial market pricing mechanisms are dysfunctional. Bubbles or mechanisms of wealth destruction and redistribution both are problematic for social, political and geopolitical stability. So, we’re seeing the impact in all of those already.

David: The Truman show, of course, there was just a minor glitch, right? That starts to bring in the question of is my perception real? Am I seeing things as they actually are? Maybe it’s not a perfect world managed so well by the central banks or the movie studio as it was in the Truman show. If you haven’t seen the movie it’s worth looking at. What are your thoughts on the feds talk… I’ll take this one. What are your thoughts on the feds talk about migrating from petrodollar to a dollar backed by central bank digital currency?

David: Great question. I think this is the wave of the future. It’s happening globally. A bank of international settlement survey shows 86% of central banks researching the potential for their own digital currency. 60% are currently experimenting with the technology and 14% are deploying pilot projects as we speak. China was one of the first out of the gates and the U.S. response to that was, “We don’t need to be first, we just want to get it right. We want to make sure that the ones that get it right.”

David: So, central bank digital currency is you’ll have to put me in the category of not too excited about them. I understand there’s some efficiencies gained. And from a monetary policy standpoint, transmission of policies becomes easier. So, from a technocratic standpoint, you could say, “Well, this is an improvement.” Perhaps it is a positive from that vantage point. Central bank digital currency is offer a range of new management tools for the monetary system and for the economy.

David: And I think they’re so compelling that central planners will not be able to refuse them. The immediate appeal is that an improvement to monetary policy transmission. But to me, this is a second iteration of Fiat currency and the temptations that come with Fiat. The temptation towards Fiat currency is an old temptation. It’s as old as north fables. It’s as old as Greek stories even before them of what you might recognize in literature is the ring of power. It’s a tool that is to be used for good but which is ultimately corruptible and in the end leads to tragedy.

David: And if you look at the history of Fiat currencies, it is that exact argumentation we’re smarter, we’re better, we can do it more effectively, we just need the tools and then lo and behold, give it a certain number of years. And we find ourselves in a tragic situation. This goes back to 3000 years ago and the first experiments with paper money in China. So, Fiat money is in a sense child’s play compared to the central bank digital currencies. With a digital alternative, you have the ability to incentivize money flows. You have the ability to channel liquidity towards economic winners away from losers. However, you define those.

David: And it really becomes a perfect tool in a Neo Keynesian interventionist dream. And again, I say I’m not real keen on this, mainly because that particular vision of ingenuity and improvement doesn’t crank my engine. I got to remember that one man’s utopia is another man’s dystopia. And I’m probably in that latter category. So, the incorporation of central bank digital currencies, I don’t think it eliminates the benefits. It’s not a move away from the petrodollar as implied by the question. It doesn’t move us away from the petrodollar. It doesn’t move us away from trade dollar recycling.

David: It would simply improve the management tools for domestic money system, greater transparency, combination of big data, monetary gatekeeping, those things open up new levels. The argument would be an opened up new levels of stability. Imagine if our economists had real-time reporting, we didn’t have to wait for the numbers to be tabulated. We could look at money supply growth. We could look at all of these things literally in real time, how are we doing in this very second? The temptation is, of course, if you have that information, how can you then micromanage, right?

David: And the importance of the manager becomes even greater. The U.S. is going to play in this game. If for no other reason, than we don’t want to lose a seat at the table in the international monetary system, we will do what we can to stay at the head of the table as host. I’m sure. But in my view, it’s not a healthy development. And again, this is maybe archaic to prioritize autonomy, to elevate value, to see the value of individual choice versus that which is coerced or corralled or prodded as is possible with a digital currency alternative.

David: I am a skeptic probably leaning on the history lessons of power and corruption and that which with absolute power. And so, a part of what we talked about a little bit today is the dangers of inflation, digital currencies make… Obviously you don’t have to take the time to print. And so, there’s no limitations in terms of paper and ink but there’s another aspect which is equally dangerous in my view, as a saver, as an investor. Digital currencies make financial repression as a compliment to inflation and even easier policy choice.

David: It’s much more simple to implement financial repression with a digital currency. And so, is this coming? Yes. Of course. Because you look at the way we’ve continued to move towards greater levels of control and interventionism. And this is a natural extension of the state being involved in the economy. So, I translate this. Savers and investors are becoming easier targets. And those are my thoughts on the transition, which we will be participating in from a simple greenback dollar to a digital alternative.

David: I follow on question from the same person. How do you expect gold and silver prices to react to a scenario where central bank digital currencies replace central bank Fiat currencies? Well, we’re already in a bull market and metals. I think constraining human choice and corralling investor capital will drive a bull market and metals absolutely crazy. And it’s these sorts of dynamics that lead to very binary outcomes. What you could consider a generational repricing. Like I said earlier, the market does what it’s supposed to do. Not always when you want it to.

David: I think the move towards digital currencies, you’re talking about a moonshot event in the metals markets as people scramble towards what they view as one of the last places to have some say over their own financial destiny. Haven’t read the strategy yet. And will, this is the next question. Haven’t read the strategy yet and will but a broader question is if equities tank and we jump into a deflationary period, won’t gold sink in that environment?

David: I would love someone with more academic insight to do some critical work on Roy Jastram’s book, The Golden Constant. But as I read it, it creates a really interesting narrative for gold in the context of a deflationary cycle. So, the question, won’t gold sink in that environment? That is possible. In a deflationary depression. Everyone loses the person who loses the least wins. That’s I think fair to say. But I would say, this is really well illustrated in Jastram’s book, The Golden Constant, where he documents the increase in purchasing power of nearly 250% in the context of the 1930s. Everyone lost. You lost the least.

David: And in fact, in the context of increasing your purchasing power, you might have increased your financial footprint so to say, 250%. Let me see if I can illustrate this. Assume all assets sell off, assume gold sells off 50%. not predicting this. This is just follow the numbers. Gold sells about 50%. The equity markets sell off 90%. We started at a one-to-one relationship before the sell-off. So, a hundred dollars invested in each. One-to-one relationship before the sell off becomes a five-to-one relationship after the sell off, which in essence is a 500% increase in purchasing power and a radical increase in the ownership of underlying assets if you then translate what you have retained in gold in the other assets.

David: The argument amongst deflationists is if that’s the case, then why not sit in cash and see a 10-to-one benefit instead of a five-to-one benefit? Well, frankly, my issue with that… And I understand the math is elegant there and quite appealing but it requires me placing my money with the federal reserve for management. And to be a hundred percent cash coming into some sort of a crisis, given their version of price stability through the years, I’m not sure that’s a perfect bet. I’m not sure that’s who I want managing my money.

David: So, gold, yes. Vulnerable, like any other asset in the context of deflation. Do you have a liquid asset? That’s very critical. And can you turn around and translate that into other assets improving your financial position? Handsomely, that was proven out in the context of a series of deflations. Actually, Jastram goes through five or six different periods of deflation. The 1930s was one of the best to illustrate the increase in purchasing power sitting in gold even with a nominal loss.

David: So, for what it’s worth. Even in the context of deflation, that’s a loss I’d be happy to take. Doug, the question for you here, there doesn’t seem to be any tactical in the tactical short strategy anymore with all the liquidity being injected into the system over the last year and a half, which has driven market indexes all time highs? The short percentage… And he’s talking about in our portfolio hasn’t changed much. Why didn’t you just sharp percentage lower as the record amount of fed liquidity injections were being made, which have kept driving stock prices higher? Thanks.

Doug: Yeah. I’ve tried to explain my thoughts on this on a quarterly. This business is always easy in hindsight. Did I expect the fed would continue with the 120 billion monthly QE and zero rates with you over your consumer inflation surging to 5.4%? I did not. Did I expect [inaudible 01:42:11] to drop at 1.25% in such an environment, I didn’t. Did I expect a once in a century of pandemic to spur a once in a lifetime speculative mania? Again, this is not the way I would have sketched it out.

Doug: As David explained earlier, the objective of tactical short is always we’re trying to provide a professionally managed product that reduces the overall risk in a client’s total investment portfolio, all providing downside protection in a global market environment that we think is of extreme risk. So, tactical short is a hedging vehicle to help offset overall risk in a client’s portfolio. As I’ve explained previously, I’ve hesitated to reduce short exposure because of the extraordinary backdrop.

Doug: It’s one replete with a great uncertainty and associated risks. And what’s a short manager significantly reduces exposure? There’s then this great pressure to quickly get the exposure backup as soon as possible as soon as the market starts showing some weakness. So, you find yourself in a situation where your boost in exposure during market pullback and then reducing on market rallies. And this dynamic is detrimental to performance, especially involved to markets. And I’ve specifically wanted to avoid that predicament.

Doug: I’ve entered each new quarter with the expectation that the environment could change and have been ready to adjust the overall level and composition of shorter exposure. There have been potential catalysts that they did not play out. There has not been an impetus to adjust our exposure tactically. What I do? It’s not easy. And the nature of the process will be questioned. The nature of the beast out when the market goes up, it’ll be why I didn’t cut back more short exposure. When the market goes down, it’ll be why I didn’t increase exposure more, right?

Doug: That’s nature of the challenging profession in which I operate. The bottom line is tactical short has avoided getting caught in a historic company, stock short squeeze. One of our competitor funds lost 67% over the past five quarters. That’s one huge hole to try to dig out of. We’ve outperformed the other shore strategies. And I hate to lose money. And I’m sorry for the losses. I really am. And I’ve got to be as frustrated or more than anyone. But I appreciate your question. Thank you.

David: Well, one of the beauties of teamwork is that on tough questions, I just get to pass them to you, Doug.

Doug: Yeah. Thanks David.

David: Yeah. The current bull cycle has been the longest in history. How much longer can this cycle last especially in light of central bank and central government intervention?

Doug: Okay. Well, that’s certainly the $64 trillion question, isn’t it? Policy makers have pulled out all the stops to hold bubble collapse at bay. As David’s discussed at length, it seems obvious to me that they’ve only ensured a much greater crisis when the bubble bursts. This cycle is on borrowed time. I could last another year or two. It could. But I believe there’s a reasonably high likelihood global bubble short faltering over the coming months. I’ve already mentioned China’s procurious situation. And I believe the treasury market is signaling approaching instability.

Doug: When I look at market structure, the now massive ETF complex, derivatives, the unprecedented speculative leverage and really this unparalleled public participation that we haven’t really talked about much. I fear that when this bubble begins to deflate, things could unravel rather quickly. And I’ll add that, I don’t believe in free lunches. There will be huge costs to pay and all this reckless. And for all the reckless fiscal and monetary stimulus, a sinking dollar, persistent inflation and surging bond yields are all distinct possibilities.

Doug: I would expect to see things turn sour on multiple fronts. And it’s been a long time since we’ve experienced a grueling and protracted bear market even in ’08. Well, deep, the worst of the market route on full lid over a relatively short period of time. When this historic cycle finally succumbs, we’ll see that all this monetary inflation, it’s lost its capacity to bolster confidence in speculative access and we’ll see a crisis and policy-making in general.

Doug: I actually believe we’re already witnessing the initial phase of this loss of confidence, QE and deficit spending. They’ve become silver agregious that an increasing segment of the population is questioning this approach. I mean, I listened to multiple questions on this with pals, testimony in Washington this week. People are experiencing inflation in their daily lives. I think we’ll look back at the current period and see that end of cycle warnings were flashing. And thank you for your question.

David: Doug, going back to the financial times piece that you quoted from earlier, 580 billion coming into the markets a year to date with Bank of America suggesting that that run rate takes us to more money coming into global equities in one year than in the last 20 years combined. If we think of those dynamics, do you think current bull cycle, it’s important to just back away and say, “How does the market work? What are the mechanics?”

David: Prices go higher when new money comes in. And so, the bid, it continues to get pushed up and up and up. And the minute someone isn’t pushing the price up, this is to your point in terms of speculative bubbles requiring greater quantities of capital to keep them going, what do you do for an Encore? What do you do after you’ve squeezed 20 years worth of inflows into a single year? It impresses on me the idea that you might have your last buyer in here shortly. Then, the reverse question gets asked in terms of market dynamics, where is the bid?

David: If I wanted to sell, what was someone giving me for it? And the market can search out the bid on the downside as well. And if there is a buyer’s strike and only sellers, this is of course in the nature of a bear market. But I’m just amazed. And then I stopped you in the middle of your comments earlier that these are really big numbers and we need to not forget. We need to not forget this is the kind of thing that you would expect in a run for the roses, the final push to the end in terms of a bull market cycle.

David: Next question, with our perfect storm setting, what do you think are the last three things that will happen before everything falls off the cliff that can’t be overcome by central bank and governments and forces in power? I don’t know if I have three things that come to mind but I do remember seeing [inaudible 01:50:15] describing the Turkey’s best day as his last. And only in retrospect can you recognize that the market’s enthusiasm was excessive and unsustainable. And just before the financial market on unwinds, what you see is perfection.

David: I mean, from the standpoint of the bowl, accruing benefits and making money, what did we say? U.S. household net worth, 137 trillion? That looks like the Turkey’s best day to me to corroborate that price to sales figures sitting 25% higher than the levels they were in 2000. The Buffett ratio, Warren likes to compare stock market capitalization to GDP highest level it’s ever been. Cyclically, adjusted price earnings, the 10 year rolling average of price earnings multiple also known as the Shiller PE 37.

David: I mean, we could go to 50 in a heartbeat if prices stay where they are and earnings trail off at all. So, three things, I don’t know exactly how to approach the question from that standpoint. I don’t know. But there are plenty of indicators that were there now. The problem with a bubble is once it’s blown, the bursting is disorderly, which you’ve talked about Doug. Central banks and governments are in that context.

David: They’re powerless to prevent the damage that follows. And the unwind is because of leverage particularly. It’s a little bit like a tsunami, just nothing you can do. You’ve got to get out of the way. And yeah. That’s where I, yeah, come back to that picture of the Turkey. What has to happen before things fall apart, things need to look better than they’ve ever looked before. And that’s basically what you’ve illustrated with dozens of statistics today, Doug.

Doug: Yeah. David, I’ll just throw in also three things that come to mind to me that would really signal trouble is unfolding. If we had a spike in yields, even in the face of an announcement or the fed doing aggressive QE, it disorderly declined in the dollar showing that the fed can’t control the dollar market and then social and political instability, which is outside of the fed control. So, those three things come to mind for me.

David: Great. Last question relates to Schwab and in the use of IRA strategies. We do have solutions on the tech short program but we have them in the IB platform, not the Schwab platform. But there’s details like that we can certainly discuss over the phone in terms of trying to figure out some way of creating a hedging strategy. When I end where we began with gratitude, we do our work for you and we’re grateful for the partnership. We’re grateful for the trust and confidence that you put in our team. And yeah. We would not be here without you.

David: And so, thank you for joining us as investors. And if you’re interested in what we look to and Doug commented on early earlier as what he sees as the greatest shorting opportunity of his career. If that’s something you want to pursue further, we should do it soon. We should get on the phone. We should talk about it and look at the logistics of getting something in motion. A long time in waiting is not an eternity. It is in the moment.

David: And then all of a sudden, you’re in the rear-view mirror wondering this thing has transitioned so quickly, what happened? So, I wouldn’t wait. I would be very intentional about getting something in motion on Tech Short, if there’s this of interest to you. As they say, luck favors the prepared. So, again, thank you for joining us. Doug, any last comments?

Doug: Oh, thanks everyone. And good luck out there.

David: Thank you. We’ll wrap up our call.

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