Tactical Short 1Q Transcript – April 18, 2019

Tactical Short 1Q Transcript – April 18, 2019
MWM Posted on April 18, 2019

David:  Good afternoon ladies and gentleman, this is David McAlvany.  It is April 18th, fine Thursday here in Colorado.  We are looking forward to sharing some reflections with you as we look at the Q1 Conference Call for Tactical Short.  I want to give you the flow of the call.  I’ll have some introductory remarks and then Doug Noland will share, not only performance for the last quarter, but also some of the things that we anticipate coming into the next quarter.  So we will have some reflections on the markets.  

And then, as we always do, we will come to questions and answers.  We have a number of pages of questions already submitted, and thank you for sending those.  For those of you who would still like to submit a question, this is the step sequence for you to do so.  You can go to our main website, mwealth.wpengine.com.  If you go to the bottom righthand side of the page you will see a little chat box, a green circle and a chat box.  You can click on that, put in your name and email address, and then type in your question for us, and we will be glad to take those questions live.  I will intersperse those into the Q&A section.  Again, mwealth.wpengine.com, bottom righthand corner on the main page, chat box, click on that, and you will be ready to submit questions that way.  Look forward to entertaining questions there, as well. 

Truly fascinating times that we live in, and looking at the financial markets – wow, a lot to talk about.  We are interested in what the central bankers are afraid of, and we will get into this in detail today.  But I think one of the things that was tested between the 4th quarter of 2018 and the first quarter of 2019 is this notion of what, in fact, was in the minds of central bankers as they unanimously made a U-turn.  I think, frankly, they are afraid of testing the viability of a growth model which depends on credit expansion.  

And when we look at market valuations today we see them as extraordinarily high.  This is not a matter of opinion if you are looking at stock market capitalization to GDP, what some have called the Buffet indicator, we are in the classic nosebleed section.  This is as high as it gets.  From another perspective, the cyclically-adjusted price earnings multiple sitting around 31 is not the highest it has ever been, it is the second-highest it has ever been in U.S. financial history, and that has us somewhat concerned. 

So again, I just want to thank everybody for joining us today.  Special greetings to our account-holders.  Building long-term relationships is our motivation for working as hard as we do.  I will begin, as usual, with general information for those of you who are unfamiliar with Tactical Short, and if you need more detailed information it is available at mwealth.wpengine.com/tacticalshort.  The objective of Tactical Short is to provide a professionally managed product that reduces the overall risk for a client’s total investment portfolio, while providing downside protection in what appears to be a global market backdrop with extraordinary uncertainty, and we believe, extreme risk.  

The strategy is designed for separately managed accounts, and we have done this in order to facilitate something that is very investor friendly – full transparency, plenty of flexibility, reasonable fees, no lockups.  We will short securities, stocks, ETFs.  We will also, on occasion, buy liquid listed put options.  Shorting entails very unique risks, and this is where we set ourselves apart, both by the analytical framework we employ, and also our uncompromising focus on identifying and managing risk as the market zigs and zags, so we must, as well. 

We tactically adjust the short exposure, so we expect to generally target the short exposure between 50% and 100% short.  Our current short exposure is 57% of account equity.  Especially after the market’s recent rally, we see significant market downside risk.  At the same time, recent market trading dynamics confirm our view of an extraordinary environment, with ongoing elevated risk on the short side. 

We don’t recommend placing aggressive bets.  We do not – I repeat, do not – recommend placing aggressive bests against the stock market.  We do, however, continue to see the continuation of a highly unstable environment and mounting risks.  So myriad risks, some that came to the surface last year, particularly in December, demand a very disciplined approach to risk management.  

So let me repeat what we typically do at every call, that remaining 100% short all the time, as most short products are structured, is risk indifference.  And risk indifference is a problem, especially on the short side, especially in uncertain environments.  We structured tactical short differently, to ensure the flexibility to navigate through even the most challenging market conditions.  Being fully short was rewarded late last year but the cost of that risk-indifferent approach became very apparent in the 1st quarter of 2019, and I will just update you on performance, not only in Tactical Short, but on some of the competitive products that are, in our view, risk indifferent, and 100% short 100% of the time. 

Updating performance, Tactical Short accounts after fees during Q1 declined 7.99%.  The S&P returned a positive 13.65.  So Tactical Short lost 59% of the S&P 500’s return.  As for one-year performance, the Tactical Short, after fees, returned a negative 6.73% versus the 9.48 positive return for the S&P 500.  We regularly do track our performance versus the three actively managed short fund competitors.  First, the Grizzly Short Fund, which lost 17.88% during the 1st quarter.  For one-year performance, Grizzly returned a negative 16.32.  The Ranger Equity Bear Fund lost 18.8 during Q1, and 17.13 for the past year.  Federated Prudent Bear 1st quarter losses were 9.88, and if you count up the last four quarters, they lost 15.52%.  

So for Q1, and the past year, Tactical Short significantly out-performed all three bear funds.  For the quarter, Tactical Short, on average, out-performed the three competitors by 753 basis points.  Over the past four quarters, Tactical Short, on average, out-performed by 959 basis points.  Since its April 7, 2017 inception, through year-end, Tactical Short returned a negative 9.39% versus the 24.99% return of the S&P 500, on average, out-performing our three competitors in that timeframe by 1621 basis points. 

Doug, I would like for you to join us and share some of your thoughts on the markets. 

Doug:  Thanks, David.  Hello, everyone.  Thanks for being with us today, and yes, David, what a fascinating environment.  I will begin with the discussion of short exposure and portfolio composition and transition to our risk management focus that so differentiates our approach from the others, especially during the quarter.  And then I will dive into the macro.

We began 2019 at 66% short.  We were as high as 68% short on January 3rd.  Short exposure was then reduced throughout the quarter and into March at 60%.  I began this section of last year’s call with a mea culpa.  I regretted the missed opportunity for not having put options during the 4th quarter.  I stated at the time I would much rather apologize for missed opportunities than for outsized losses.  It was obviously a tough quarter and I hate to lose money, but our 2019 losses are less than half on some of the bear funds.  I’m just excited about the unfolding opportunities, but I also know this is not going to be easy, so it is the old “when the going gets tough, the tough get going.” 

We have a unique approach to managing short exposure.  We highlight that every quarter.  Q1 illustrates why we do things the way we do.  As David mentioned, we outperformed the three competing bear funds by 763 basis points on average during the quarter.  Two of the three funds lost more during Q1 than they made during Q4.  And two of the three funds have begun 2019 with losses exceeding 20%.  During Q4 market instability we maintained our disciplined approach to managing risk, this despite my belief that the global bubble was faltering, though what mattered most for positioning was our analysis that the risk of being short had remained highly elevated.  

I have been doing this long enough that when I see my bearish thesis coming to fruition I’m conditioned to expect a policy response.  Late in Q4 we viewed the dispersion of market probabilities, chiefly split between two divergent scenarios – a major market downside dislocation and potential crash scenario, or a policy response and likely rally.  Fulfilling our mandate, Tactical Short was positioned to provide a market hedge.  That is what we do.  

At that same time it was essential to manage short exposure to mitigate the risk of outsized losses in the event of an abrupt rally induced by policy-making and what is often a painful short squeeze.  December was an especially challenging period analytically.  Risk-off de-risking, de-leveraging dynamics were gaining momentum, yet the Fed held firm with cautious rate and balance sheet policy normalization at its December 19th meeting.  At the time the Fed was called tone deaf, and much worse, and markets turned unstable.  

Things took a turn for the worse on January 3rd as markets began convulsing toward dislocation.  At the time there was clear potential for speculator de-leveraging, derivative-related selling, and a surge in ETF outflows, in particular, to spark synchronized illiquidity and disorderly trading across global markets.  Markets had begun moving rapidly toward central bankers’ worst fear, a seizing up of markets that would have deflated global bubbles and revealed acute economic fragility.  Chairman Powell, appearing the following day in a panel discussion with Bernanke and Yellen, unexpectedly pulled out prepared remarks and instigated a dramatic policy U-turn.  The Draghi ECB soon followed, as global central banks shifted to even more dovish postures.  Later, in the face of surging global risk markets, the Feds surpassed dovish expectations at its March 20th meeting.  

David:  Doug, if I could interject, I think this is a really important point to highlight, because what Powell revealed in that U-turn was really a financial market threshold, and I think we all need to learn a lesson from this.  As we saw the ten-year treasury get above 3%, about 3.3%, we found a very critical threshold and a highly leveraged environment in a financial backdrop that has grown on the basis of debt.  We know that the recalibration of any of that debt in light of a rising cost of capital, recalibration of the lion’s share of assets in the financial markets, was beginning to be dramatic.  And so his response, I think, is very telling.  Let’s not forget that moving forward.  We found the threshold.

Doug:  Yes, well said, David.  Excellent.  The timing of the January 4th inter-meeting dovish U-turn was only a couple of weeks after the FOMC meeting.  That was extraordinary.  We were positioned for the possibility of a policy shift.  And here I will highlight and important distinction between our approach and all the competing bear products.  When managing the amount and composition of our short exposure we start with comprehensive top-down macro-analysis of market risk versus reward.  And candidly, this is a lesson I learned the hard way back in the early 1990s working for a short biased hedge fund in San Francisco.  Our focus then was micro-analysis of individual companies with a top-down overlay.  Then I watched as the macro environment completely overpowered our micro-company research and analysis.  So ever since I have taken the approach that top-down analysis of policy-making, financial conditions, and speculative market dynamics is paramount for effective risk management.  I don’t see any other way.  Especially in today’s extraordinary backdrop, positioning decisions must start with macro-analysis.  And I doubt competing bear funds factored in the possibility of a policy-induced market rally into their portfolio management decisions.  Most don’t adjust exposures or portfolio composition because of macro risk.  When the risk of a policy response and rally is high I have learned – I know better than to be short popularly shorted stocks.  Short squeeze risk was highly elevated and the Goldman-Sachs most short index surged 18.8% during the quarter, certainly helping to explain dismal bear fund performance.  When policy and rally risks are high we don’t want to be short high-beta stocks in sectors.  To us, it doesn’t make sense.  For the quarter, the biotechs and semiconductors both surged more than 21%.

David:  And Doug, this is a point that I think bears repeating because one of the distinctions is we see opportunities to be short in certain sectors, at a certain juncture, in a deteriorating market environment.  Waiting for a policy response, wanting to see that reaction is a part of risk mitigation.  And it is easy.  You look at the semiconductors – declining sales, declining revenues, an impressive increase in price.  The disconnect is obvious, and to be short the semiconductors does make sense, except lo and behold, this is where you see the biggest short squeeze, and a lot of our competitors, not looking at the high beta, not looking at mitigating that risk – it boggles my mind, Doug, that there is not an appreciation for what a policy response can do, that you wouldn’t anticipate that, and yet that is what we saw here in the 1st quarter. 

Doug:  Yes, that’s right, Dave.  The Fed moving abruptly to bolster the markets often prompts the unwind of bearish speculative positions in securities and derivatives, as well as inciting what can turn into a disorderly unwind of myriad market hedges, and that is certainly including options and sophisticated derivatives.  This creates high risk for unpredictable and disorderly sector rotations.  Our positioning into the quarter was in anticipation of highly uncertain and potentially chaotic market conditions.  In hindsight, I wish I would have been more aggressive cutting back short exposure, but the bottom line is we managed something fundamental to our investment philosophy and process.   We avoided outsized losses.  It’s always key.

This has been an extraordinary period and I am compelled to again note we outperformed the three competitor funds, on average 959 basis points, or 9.59 percentage points over the past four quarters.  Our macro view has been that the market is in an historic topping process.  By their nature, major tops are periods of great uncertainty and volatility, and that is volatility and market perceptions, and policy-making and market performance.  We positioned both the quantity and composition of short exposure, specifically, in anticipation of market instability, both on the upside and the downside.  We continue to operate in a backdrop of major market structural anomalies, certainly including the proliferation of index ETFs and dynamically traded derivative strategies.  I will repeat a comment I made during January’s call.  This is a highly abnormal market environment, one that has shifted away from traditional analysis and active management to highly speculative passive trend-following strategies, algorithmic and high-frequency trading, and sophisticated derivative structures.  This is not the old marketplace. 

We certainly have not wanted to be 100% short during this process.  Indeed, we believe disciplined risk management, what I refer to as portfolio beta management, is absolutely fundamental to managing short exposure in such an environment.  Avoiding short squeezes and higher beta short exposure has been key to our outperformance for the quarter the past year and since inception.  

That is a good segue to the to-down macro analysis.  We subtitled today’s call, “What Are Central Banks Afraid Of?”  My thoughts return to the maestro, Alan Greenspan.  During the mortgage finance bubble period he repeatedly asserted that there was no national bubble because real estate markets are always a local phenomenon.  His analysis completely ignored the reality that the epicenter of the bubble was in finance, in new-age mortgage finance – the GSE’s, Wall Street firms, the big banks, the hedge funds, leverage speculation, sophisticated derivative structures, booming MBS and ABS markets and such, all comprising a highly levered speculative and distorted national financial bubble that was over-financing housing speculation across the country.  

It has been a full decade now since I began warning of the unfolding global government finance bubble.  What continues to transpire is so beyond what I previously thought possible.  Tightly interconnected global markets are now commanded by a massive pool of speculative finance, finance degraded by the perception that central bankers are there to fend off market instability, recessions,  and bear markets.  The upshot has been dysfunctional global markets incapable of effectively assessing risk.  The global bubble backdrop is comprised of synchronized ultra-low interest rate policies with a synchronized expansion of central bank credit, and unprecedented globalized expansion of sovereign debt, and the global proliferation of leveraged speculation and derivative strategies.  It has become one complex, highly integrated, and historic bubble.  Markets have never been so synchronized, so speculative, so distorted, worldwide. 

David:  Doug, that bears repeating.  When you look at how synchronized, at how worldwide this is, you can go back to periods where you had, say, the Tequila crisis, or the Asian contagion, and you had something that was regional in nature which certainly had global knock-on effects.  There were implications for everyone else as the dominos fell.  But in this case you are talking about levels of debt and distorted finance, mal-investment, which have taken root in every geography.  And so, I think what makes this context very different than periods of past crises is, it is ubiquitous.  You can’t look anywhere and say there is a safe haven.  Where are the safe havens in a world where so much is synchronized, so much is speculative, and so much is distorted worldwide?

Doug:  Absolutely, David.  And I will repeat a couple of my favorite little postulates:  Bubbles go to unimaginable extremes, then double, and things turn crazy at the end of cycles.  As we are witnessing, things turn really crazy during the late stage of a historic cycle, and at this point, all the craziness somehow passes for business as usual.  Deficits don’t matter and they never will.  The Federal deficit of 691 billion in only six months, running 15% above the year-ago level.  And Speaker Pelosi recently said she would meet with President Trump to discuss infrastructure, at least a 1 trillion dollar plan, but she would prefer 2 trillion, the newfound belief in the modern monetary theory – free lunch.

David:  This is fascinating, isn’t it, Doug, because if you go back in time, look at 2002.  The market had rolled over, we were in a recession, and we ramped up our deficit at that point to 158 billion dollars – massive sums of money circa 2002.  So when you comment about business as usual, when you talk about complacency, this is stunning to me.  We are not in a recession, and yet we are going to run between 1 and 1.2 trillion dollar deficits this year.  This is madness. 

Doug:  Absolutely, and David, I will add a point to that.  It’s not that we don’t learn from history.  We learn from history, but we learn from short-term history.  I was reminded how quickly things are forgotten last week when Bloomberg ran an article with the headline, “Evans sees lessons from 1998 rate cuts for Fed policy this year.”  The article writes, “For the Chicago Fed President, Charles Evans, the situation recalls the Asian financial crisis in 1998.  According to Evans in the reporting here, “The risk management approach taken by the Fed is not unusual.  It served us well in similar situations in the past.”  

I have trouble with historical revisionism.  First of all, the Asian crisis was in 1997.  The Fed aggressively reduced rates from 5.5 to 4.75 in the autumn of 1998 in response to the simultaneous Russia and Long-Term Capital Management collapses.  In Evans’ words, the Fed moved because of the fallout on domestic financial conditions, but the reality was that these implosions posed risk to vulnerable global financial systems.  Quoting Evans:  “How did this risk management strategy turn out?  In the end, the economy weathered the situation well, productive accelerated sharply, and by early 1999 growth was on firm footing.”  Evans leaves out the near doubling of NASDAQ in 1999, along with what I refer to as terminal phase bubble excess.  

The bottom line is the Fed aggressively loosened policy while the system was in the late stage of a significant bubble, and then failed to remove this accommodation until mid-November 1999.  Let’s not forget, the subsequent bursting of the so-called tech bubble led to, what was at the time, unprecedented monetary stimulus, including Dr. Bernanke’s speeches extolling the virtues of the government printing presses’ helicopter money.  These measures were instrumental in fueling the mortgage finance bubble that burst in 2008.  That collapse then led to a decade-long and ongoing global experiment in zero rates, open-ended money-printing, and yield curve manipulation.  

What are central banks afraid of?  Foremost, I believe that they are petrified that their great monetary experiment has been a failure.  Instead of reflating out of over-indebtedness and economic stagnation, they have further inflated speculative bubbles while rampant debt growth runs unabated.  Central banks are understandably frightened that they are now trapped into perpetual loose policies necessary to placate highly speculative global markets, while sustaining deeply structurally impaired economic systems.  And no matter how Evans and others spin success out the Fed’s previous risk management efforts, system stability has been poorly served repeatedly.  

For a long time now the Fed and global central banks have taken radical measures that have worked to sustain bubble dynamics.  We strongly argue that latent global financial and economic fragilities are today more acute than ever.  There has now been more than three decades of progressive central bank market intervention and manipulation.  Thinking back, what began with Greenspan’s 1987 post crash assurance of system liquidity evolved into early 1990s yield curve manipulation to recapitalize bank capital after the collapse of the late 1980s bubble.  

Then there was the 1995 Mexican bailout, followed by the 1998 rate cuts and bailout of Long-Term Capital Management.  The collapse of the tech bubble then provoked even more aggressive rate cuts and the promotion of mortgage credit excess, all in the name of system reflation.  The mortgage finance bubble collapse incited unprecedented moves to zero rates and a trillion dollars of Federal Reserve QE with synchronized aggressive policy stimulus around the world, including a 600 billion dollar Chinese stimulus program.  

The fed formulated an exit strategy in 2011 to normalize its bloated 2.2 trillion dollar balance sheet, only to then double assets over the next several years.  2012 European instability unleashed “whatever it takes” policies from the ECB and others.  When market instability briefly re-emerged in 2013 Chairman Bernanke stated the Fed would push back against a tightening of financial conditions.  This was yet another giant leap in activist policy-making.  

Markets took Bernanke’s comment as the Fed ensuring an ongoing bull market.  Powered by unprecedented synchronized central bank liquidity injections and market assurances, speculative bubbles went into overdrive.  When Beijing belatedly moved to rein in excess in late 2015 weakness in China’s currency and markets risked bursting Chinese and global bubbles, so the Fed quickly postponed policy normalization as the ECB and BOJ further extended QE programs.  

Global central banks at the time were adding about 200 billion monthly of additional liquidity into global markets, and after trading as low as 1810 in February 2016 the S&P 500 surged almost 60% over the next two years.  The loosest, non-crisis monetary policies imaginable were then combined with big U.S. tax cuts and fiscal stimulus.  When the Fed finally moved ahead with rate and balance sheet normalization, any negative liquidity impact from the Fed balance sheet contraction was more than offset by the ongoing rapid expansion of other balance sheets, notably the ECB’s and the Bank of Japan’s.  

Financial conditions only loosened further.  The new Fed Chairman was not oblivious to prolonged monetary stimulus compromising financial stability.  He had speeches that he addressed this issue in.  I was believe Powell was hoping for a subtle change in direction, preferring the Fed to begin letting the markets stand on their own.  The FOMC held its ground at the December 19th meeting, stating its intention to stay the course with cautious rate increases and balance sheet runoff despite market instability.  

Well, markets turned highly agitated.  Only a couple of weeks later on January 4th Powell made a fateful dovish U-turn.  Why the sudden change of heart?  Well, the previous day saw a disorderly flash crash in key currency markets.  Credit spreads widened significantly, the credit default swap market.  Prices were spiking higher.  In short, de-risking, de-leveraging dynamics were gaining momentum, with securities and derivatives markets in the process of dislocating.  Bubbles were faltering.  But in the end, the Fed came once again to markets’ defense, further cementing the view that central bankers have little tolerance for market instability and deflating bubbles.  

It has been called the “everything rally,” the latest acronym – FOMO – Fear Of Missing out.  As the S&P 500 enjoyed its best 1st quarter since 1998, the NASDAQ Composite returned 16.8%.  Corporate credit posted big returns in its investment grade, junk, emerging markets.  The Shanghai Composite jumped 24%.  China’s growth stock, ChiNext Index, surged 35.  The MSCI emerging market index returned almost 10%, European stocks almost 12, led by a 16% gain in Italian equities.  European periphery bonds rallied with Italian yields dropping 25 basis points.  

It is worth noting also that Greek ten-year yields are down over 100 basis points so far this year to near all-time lows.  The quarter also saw the Bloomberg Commodities Index increase 7.4% led by a 40% surge in crude oil.  And let’s not forget, the collapse in safe haven sovereign yields, the melt-up in prices.  There are elements of this rally similar to late 2007, but in important respects it recalls 1999.  Back in 1999 speculative markets became convinced the Fed would not move to tighten financial conditions due to lingering global fragilities and the approaching Y2K issue.  1998 rate cuts were in response to global crisis fears, yet in reality the Fed was pouring fuel on bubbles that had been gaining momentum throughout the 1990s, speculative bubbles, along with a bubble economy. 

Yet current bubble dynamics absolutely dwarfed those from 1999.  That bubble was largely confined to the U.S. technology sector in the markets and the real economy.  Today’s bubble dynamics envelope global markets in the U.S., China, emerging markets, Europe, as well as the entire unbalanced global economy.  There are securities markets bubbles across asset classes, equities, corporate credit, sovereign debt, and structured finance.  The global levered speculating community is gargantuan compared to 1999.  The 5 trillion plus ETF industry didn’t even exist back then.  The derivatives industry had a fraction of today’s global scope, and importantly, Chinese finance and China’s economy that today pose great systemic risk, were irrelevant back in 1999.  

I believe central banks are deeply worried about the soundness of internal finance and global economic structure.  They worry that their tools may be incapable of everting the next crisis.  They will, of course, never admit as much.  This continues to be a monumental confidence game, especially of late.  Central bankers point to the risk of inflation running below target, a strong-man argument if there ever was one.  The evolution to globalized market-based finance has profoundly altered the nature of inflation.  Under-shooting CPI should no longer be a paramount issue, especially with the proliferation of new technologies, the digitization of so much output, the move to service-based economies, and of course, globalization.  

There is today a virtual endless supply of goods and services that exerts downward pressure on aggregate consumer prices.  Importantly, consumer price indices are no longer a reliable indicator of price stability, general monetary stability, or the appropriateness of central bank policies.  I mentioned similarities to 1999.  There are ominous parallels to 1929, as well.  Concerns for downside consumer and commodity price pressures had in the late 1920s contributed to the Fed’s accommodation of increasingly speculative financial markets, and as late cycle economic prospects began to dim, the Federal Reserve feared the consequences of piercing the stock market bubble.  When that bubble finally suffered its fate, the cataclysm set off the Great Depression.  

Ben Bernanke was considered the nation’s foremost authority on the Great Depression when he was appointed Fed Governor in 2002 following the bursting of the tech bubble.  Dr. Bernanke believed the Great Depression was chiefly the consequence of the Fed failing to print enough money and reflate the system after the crash.  He was determined to ensure the Fed never repeated this mistake.  

But was the Great Depression primarily the result of post crash policy mistakes, or instead was it the consequence of unsound money and credit and egregious Roaring 20s excess?  We are convinced of the latter.  The Fed thought the bubble burst in 2001, and then again in 2008.  The problem with monetary stimulus and reflation is that once commenced it is difficult, if not impossible, to rein in.  We believe a decade of radical monetary measures will end terribly.  

I also believe we’re in the end game here, and it’s not a surprise that central bankers are increasingly desperate to avoid the cycle’s downside.  Central banks are once again afraid of bursting historic bubbles, and their response to late cycle fragilities and faltering booms only delays inevitable adjustments and corrections by worsening structural impairment.  We’re in a very dangerous period of globalized speculation and economic maladjustment.  Central bankers are no longer in control.

David:  Doug, on that point, they’re not in control, but publicly they certainly project a very different image.  You would believe that they are in control, and the general consensus is that they are in control.  But again, as you’ve pointed to, this is a bit of a confidence game and what you see is really the game face that they are wearing.  What we talked about earlier is the fact that they showed their hand.  There in December and January, that transition, like we said earlier, we found the threshold.  We know what is truly on their minds, regardless of what is on their faces.

Doug:   That’s right, David, and central bankers are left to stoke excess, in fear of their decade-long monetary experiment blowing apart.  China’s long experiment in state-directed economic and monetary management is similarly vulnerable.  Their policy response is, as well.  It only further inflates their historic bubbles and intensifies financial and economic fragilities.  The general view in the marketplace is one of incredible complacency.  The Fed’s next move is to start cutting rates, they surely won’t tighten ahead of next year’s election, and Beijing has concluded de-leveraging and is now intent on stimulating stronger economic growth.  China’s aggregate financing, their credit growth, without including government sector, expanded 1.22 trillion during the first quarter, surely history’s greatest ever credit expansion.  The U.S. and China should soon ink a trade deal and a pickup in the U.S. and China will underpin global growth recovery, or so bullish thinking goes.  

What could go wrong?  Well, why did the NASDAQ bubble burst in Q1 2000?  Why did stocks peak in the summer of 1929?  A few short months ahead of catastrophe, it is worth recalling that stocks surged to record highs right into the 1929 crash, the 1998 crisis, the 2000 tech bust, and again in Q4 2007.  Central bankers are once again afraid of addressing excess.  But as we have witnessed repeatedly in the past, bubbles do eventually burst on their own accord, and when left to their own devices, their highly disruptive collapses come after years of cumulative distortion and structural impairment.  

I didn’t begin posting the Credit Bubble Bulletin until 1999, but I was convinced in 1998 the Fed was committing a major policy error.  U.S. markets had turned highly speculative, and why today the Fed and global central bankers were afraid of global fragilities.  Yet markets and economies do turn progressively fragile after years of excess.  That’s just the way it works.  Unfortunately, central bankers have not learned from their past mistakes of fixating on fragility while accommodating dangerous booms.  Slashing rates and orchestrating a bail of LTCM only pushed the 1990s bubble to terminal excess.  

I worry about what central bankers have unleashed with a recent ultra-dovishness in the face of historic late stage global bubble terminal excess.  The Fed and global central bankers have committed a similar mistake here in 2019, except on a much grander scale.  Today’s bubble is at a whole different level.  It’s global across the risk markets, as well as throughout virtually all sovereign debt.  Global economic imbalances are much more extreme.  China’s bubble, surely history’s greatest, is at acute risk.  

Moreover, the global bubble has gone to the very foundation of global finance, and this is not appreciated.  It has gone to the heart of global finance, central bank credit, and government debt.  Worst of all, the world is convinced central bankers have things well under control.  Recalling pre-1998 crisis exuberance, markets were highly confident back then the West would never allow Russia to sink into financial crisis. 

I will conclude this segment by highlighting a Bloomberg editorial earlier this week with the former head of the Federal Reserve of Minneapolis, Narayana Kocherlakota.  The headline:  “The Fed needs to fight the next recession now.  It’s tools are limited so the central bank must compensate by being aggressive.”  

David:  I don’t know if any of you listening find that to be odd or out of place, but Doug, I can’t recall any historical precedent where the Fed has wanted to act in advance.  This, to me, is again confirmation that they have showed their hand (laughs).  I just can’t believe that actually got printed.

Doug:  Right, it’s extraordinary.  And David, I don’t think history will be kind.  Central bankers are afraid of global bubbles bursting and the revelation of epic policy failure, so they become only more determined than ever to act early and aggressively, from the bubble perspective, and this is most unfortunate.  This continues to follow the worst case scenario.  The global bubble today is sustained by two crucial factors – faith in the all-powerful central bank community, and confidence that Chinese officials can continue to orchestrate steady economic growth while maintaining financial stability.  It is a very different world when this confidence begins to wane. 

David, back to you. 

David:  Doug, thanks for your thoughts.  We’re going to dive right into Q&A and I’ve had a couple of questions pop up online again.  If you’re intending to ask a question in that venue, feel free to go to mwealth.wpengine.com.  Bottom righthand corner you will see a green chat box.  Click on that and you can submit the question.  We’ll get those in cue. 

The first question, Doug, is: 

You often discuss about the terminal phase of the market, the one we’re in at this moment.  In your opinion, what could be the early warnings that the market has turned?

Doug:  Good question.  Yes, the terminal phase of bubble excess is a key concept in my analytical bubble framework and it certainly includes speculative asset bubbles, but there is an economic component also in bubbles dynamics – terminal phase excess.  A lot of damage can be inflicted upon economic structure late in the cycle – resource misallocation, mal-investment, and let’s focus on the markets.  I believe history will look back and see plenty of signals that were ignored.  

Last year we saw the short ball blow up in February.  We then saw problems in the global periphery and the emerging markets, especially with crisis dynamics erupting in Turkey and Argentina.  We saw a major drop in Chinese equities toward the end of the year, in particular.  It evolved into a global bout of risk-off, de-risking, de-leveraging, that erupted in core U.S. security markets in December.  As I mentioned earlier, I believe we were much closer to a major global market dislocation than most will admit, and that is in equities corporate credit derivatives.  

So looking at the big picture, I think we have been forewarned.  But when markets have these big rallies, surely fueled by short covering and unwind of hedges, speculative dynamics take on a life of their own.  And let’s face it, what investment manager today can afford to miss out?  FOMO again.  So everyone is forced in and the resulting rally becomes self-fulfilling.  Sentiment turns bullish, rallying markets create their own liquidity, financial conditions loosen, and it is that old George Soros’ reflexivity – perceptions create their own reality for a while so what I’m honoring today to try to anticipate the rally ending, first of all I would like to see some tightening of financial conditions.  

I’m watching corporate credit very closely.  That’s key.  Credit spreads have narrowed significantly from early January.  Risk premiums have declined to the lows going back to October.  I want to see that reverse.  That is across fixed income.  There continue to be huge inflows in the fixed income funds, especially some of the investment-grade high-yield muni mortgage ETFs.  Global debt issuance so far in 2019 is running ahead of last year’s record pace.  I want to see that slow down.  And in such a backdrop I can assume that the hedge funds and the derivative players are adding leverage, which tends to be self-reinforcing.  So I need to see some tightening of liquidity, less risk embracement, and some risk aversion to begin seeping into the marketplace.  

China fragility could be a catalyst, as well as potential catalysts in EM and Europe.  I don’t think it would take big losses in some of the major bond ETFs and resulting fund outflows to quickly see liquidity change.  That is within equities and fixed income markets these days.  They are liquidity challenged.  When prices are rising it has the effect of making markets appear liquid.  It is not until selling materializes that liquidity concerns return.  So it’s a fragile environment and I just come in every day and follow these indicators the best I can. 

David:  So I’m at the point of liquidity evaporating.  The next question: 

Why has the Fed not come in, why our central bank has never issued money to buy stocks during a previous panic sell-off, the actually step in and just buy an index, or what have you?

Doug:  Right.  I think a lot of bulls in the market assume it’s only a matter of time.  But central banks have been around for a few centuries, going back to the 1600s, with Sweden’s Riksbank and the Bank of England.  It was not until very recently it was thought that it was appropriate to buy anything but short-term government bills, and even in a crisis environment, the role of the central bank has been to provide lender of last resort functions, and that is just necessary to avert systemic liquidity crisis, not just to keep the stock market up.  

David:  Part of that is because the nature of banking, both commercial and central banking, ties to collateral, and so when you start talking about quality of collateral, when you step into equities (laughs) you’re in a totally different sphere.  It’s no longer the quality of fixed income, it’s the quality of something that can be truly ephemeral in nature.  It can go to zero very quickly.  

Doug:  That’s right, yes, and going back 150 years to Walter Baggett, it was the central bank’s role to avert panic, lend freely at a high interest rate, not for ten years at zero rates and everything else they have done.  Buying stocks has traditionally been viewed also beyond the mandate of central banks, and so is purchasing corporate debt and mortgage-backed securities.  Central bank principles have long opposed central banks actively involved in resource allocation, allocation of credit.  That has just always been seen as posing a risk to central bank independence and a front to well-functioning markets.  

I think we are seeing, it would open up central bankers to political and market pressures, and it distracts from their over-arching objective, and that is price and economic stability.  We have witnessed traditional concerns come to fruition and central banks respond during their response over the last crisis.  The expectation is the Fed will be ready to expand its hold on its treasuries, agencies, during the next downturn.  It doesn’t even need a crisis backdrop, so most just think they will expand their mandate to stocks, but I don’t think the Fed wants to go down that path.  We have seen the ECB and BOJ go down that path.  I don’t think the results are that encouraging.  

But basically, I will just say that the genie is out of the bottle, and once central bankers cross that Rubicon and abandon traditional central bank principles, it is, as we have seen, very difficult for them to go back.  There is a strong consensus that consumer price inflation is a problem, but what constituency is against inflation of stock and bond markets?  So that is kind of a problem here.  It just seems reasonable for central banks to offer a helping hand with the markets, the economy, the entire nation.  Why not?  Today, there is no central banker that can articulate why we should go back to principles that held central banking in such high regard for centuries.   

David:  Kind of a subset to that last question on buying stocks, assuming that they will now be buying, what would be a realistic exit strategy for their holdings?  We have algorithmic trading, huge market volatility, you have ceilings on stock performance due to the large sellers over time.  How do they exit?

Doug:  It won’t be easy.  There was an article posted yesterday, I think it was on zero hedge, which said the Bank of Japan is now a top ten shareholder in 50% of all Japanese companies.  So once you go down that path, I don’t see the Bank of Japan ever selling those positions.  Who is going to be on the other side of that trade?  And as soon as the market sees that they are starting to sell, then everyone will want to get ahead of that.  So my assumption as far as realistic exit strategy, I will assume if the Fed does take that plunge and buys stocks, it won’t be sellers for years to come.  While it may reverse markets for a spell, that would be an act of desperation, and I think recognized as such.

David:  I am going to include a question from online.  This is from Warren.  Thank you, sir.

Is money gradually moving out of equities into more fixed income markets since January 2009?  If so, is that a signal of investor mood?

Doug:  Yes, for every buyer there is a seller.  And the data gets confusing because it makes it look like a household sector is a big seller, but I think part of the dynamic that is going on is we have had enormous corporate stock buy-backs.  And in a lot of cases these buy-backs basically accommodate selling by company management and employees, and those sales get kind of put in with the general public and it looks like the public is bearish equities when it is not the case at all that these fortunate employees that have these huge stock option plans and have become wealthy are cashing in. 

David:  So let me get that straight.  We have had close to a trillion dollars in liquidations here in the last few years.  At the same time we have had 3 trillion dollars in buy-backs.  What you are saying is that the household sector liquidations of equities have been somewhat inflated, because a lot of that trillion dollars in liquidations is coming from insider selling, so you have a combination of insider selling at the same time corporations are buying back their shares with treasury capital?

Doug:  Think of the big technology companies, and I’m not even talking about management, I’m talking about regular employees that basically have all made tremendous amounts of money and they are selling tens, or perhaps hundreds of billions of dollars of stock to capture these gains.

David:  Oh, the world we live in.  This is another from the online portal:

Can you discuss how political pressure may force central banks into policies that might trigger a shortfall into equities or bonds, such as helicopter money?

Doug:  The way I look at it is, we will get to a point where if the markets start to question if central bankers have it under control and we don’t know when that point is, even in January when Powell did a U-turn, and let’s say the markets would not have responded favorably, this thing could have spiraled downward. But I think we get to some point where the markets recognize, “Oh, my God, they don’t have it under control.”  

I have always believed that point will come when there is some recognition to the degree of leveraged speculation globally – carry trades, derivatives, and such – I think the amount of leverage speculation globally is so far beyond what we saw back in 2008 that I think if we get into a real significant de-risking, de-leveraging episode, the central banks can respond with even a QE program and it doesn’t even make and impact on global liquidity, that, I think, is when the markets start to question if central banks really have this under control.  And the pressure will clearly be political.  We see that today.  There is going to be enormous pressure on these central bankers to come in early, and come in aggressively with whatever measures to keep the markets up.

David:  Just as evidence of that, let me go back in time a little bit.  September 29, 2011, if you’re listening, I want you to guess who said this.  “The Fed’s reckless policies of low interest and flooding the market with dollars needs to be stopped.”  Who do you think said that?  That was our president.  Of course, that was before he was in the White House and before he owned the bubble.  Remember in 2015, and even halfway through 2016 before he was elected, he called the stock market a big, fat, ugly bubble.  Only he is that talented in terms of being a wordsmith.  But it was a big, fat, ugly bubble, and the Fed’s policies were reckless, even as early as 2011.  It has only become worse, but of course your policy changes, and your preferences change, when you take office.  Now it is a competition for who can spend what.  Doug, you alluded to Modern Monetary Theory in your comments.  That is maybe the fringe left’s or the far left’s version of how do we hand out the free lunch?  How do we buy votes using the Treasury to do so, the Treasury distribution mechanism, and ultimately, the Fed to fund it with printed dollars?  But this is the fascinating environment we are in where politics will become very critical, and I think it is very important for everyone listening – there is some much of this which depends on confidence.  There will be significant players within the equities markets that just say to themselves, “It’s not worth playing.”  This has become – it is disproportionate the risks inherent, and the rewards that are now possible.  And by the way, I might actually be a target because guess what happens when politics changes?  So do the chosen winners and losers. 

Let me go back to the next question, Doug.

How did Tactical Short do after the Plunge Protection Team intervened?

Doug:  It was tough quarter, but we made it through it.  I mentioned before we lost 59% of the S&P 500’s return, which is a favorable outcome when compared to other bear products.  Two of our closest competitors, for example, lost more than 130% of the S&P 500 return.  We lost less than half of that.  I think that is a reasonable strategy.  That is what we set out to do, not to have outside losses, so as miserable as it was in the quarter, certainly it could have been worse.  

David:  This goes back to a question that we have been talking about in terms of there being confidence upon which so many of these variables hang.  The question is:

Will central bank intervention, manipulation, prevent a true crash from coming?  Is it possible for a government, or multiple governments in collusion, to prevent what you see as the inevitable?

Doug:  As I stated earlier, I believe central bank policy-making is only creating larger and more dangerous bubbles on a global basis.  It’s kind of interesting, years ago when I spent a lot of time in the library reading the old objectivist, Ayn Rand publication, one of the writers said, “As our colleague, Alan Greenspan, explained to us, the Great Depression was caused by the Fed continually putting coins in the fuse box.”  I think that is the dynamic, they keep putting coins in the fuse box and unfortunately, this thing is going to blow at some point.  They can delay a major dislocation but I don’t think they can avert it indefinitely.  The way I see it, and we have a lot of history behind this, sooner or later there will be a crisis of confidence in the markets in credit and policy-making and I expect a crisis of confidence in global, financial and economic structure. 

To follow up on the comment we had, or the answer before, one of the things that could easily happen, and this is not a wild imagination here, is that all of a sudden the bond market looks at central bank policy and another round of big QE and says, “Wait a minute, I don’t think this is in my best interest here at whatever low yield that treasury, bund, JGB yield is at that time.  And you could have the bond market basically protest central bankers, and that would change the whole game right there. 

David:  I’ll take this question as it relates a little bit to the gold market:

Is there a coincidence between the Bank of International Settlements’ treatment of gold, change of that treatment here recently, and record purchases of gold be central banks in 2018?  

I think this is tied.  The treatment of gold is now more favorable as a reserve asset than it has been in previous decades, and you are seeing the accumulation of gold by central banks, particularly your emerging market central banks.  This is something that was positively advised by Ken Rogoff starting probably three years ago, and it has become more popular.  I think it is ironic that you have the idea that people should not own it, but central banks, yes, you should.  

To me, there is something that this anticipates.  Not only are we seeing less interest in U.S. treasuries by the central bank community, but the fact that is happening simultaneously with an increase in demand for gold by central banks – last year was a record going back 50 years, I believe.  From one year to the next it was about a 74% increase in central bank buying.  I think what it suggests is that they are aware that changes within the structure of the monetary system, or non-system, that we have had post Bretton Woods, are about to change, for what it’s worth.  So, reasonable observation, reasonable point made there on the BIS. 

Next question, Doug, to you: 

Why is Japan’s experience of the last 30 years not a possible model for the U.S. to emulate in managing perpetual easing?

Doug:  Right.  That is certainly a common view that I think is misguided, that we, Europe and China can all follow in Japan’s footsteps.  I look at Japan and I see a unique country, and I admit, I’m biased.  I worked at Toyota’s U.S. headquarters as a treasury analyst way back some 30 years ago.  We own Japanese manufactured cars.  I have a Toyota Tacoma pickup in the garage.  

The Japanese have an intense focus on quality manufacturing and are a value-added juggernaut unlike any other country in the world as far as I’m concerned.  They run trade current account surpluses for the vast part of 40 years.  For the past 20 years I think their current account surpluses have averaged about 3% of GDP.  They have accumulated international reserve holdings of 1.3 trillion.  We basically have none in this country.  The Japanese have an impressive work ethic and a level of social cohesiveness that sits on a par in the world.  So I don’t think they are a good gauge of how this will play out for other countries.  

I also say that the Japanese government and the Bank of Japan have made a mess out of things.  The Bank of Japan balance sheet now surpasses 5 trillion, and they have doubled it in four years.  Japan’s government-to-debt GDP has surpassed 240%, up from 172% at the end of 2008.  So nobody, I don’t think, wants to follow those trajectories.  But at the same time the Japanese household sector – they are big savers, big savings rate.  So Japan has a situation where the government owes money to its own citizens, and clearly, its central bank.  As unsustainable as this is over the long-term, I believe it is less problematic than the situation here in the U.S. where we are accumulating massive, massive liabilities to overseas creditors.  

In Japan, they accomplished something quite enviable that really goes largely unappreciated.  They experience a historic bubble and their painful aftermath, yet they retained a strong currency that still enjoys strong confidence globally, and I believe their strong currency is a major factor behind the resilience of the Japanese situation in their economy and their financial system.  I fear the U.S. will not enjoy these types of benefits of a strong currency if comes the bursting of the bubble.  The U.S. is the opposite of Japan with persistent trade current account deficits, and I think those come back to pressure the dollar.  

And if the world loses confidence in the U.S., in our debt, in our markets, in our political process, in our economy, we will face a very different problem than what Japan has faced.  We owe the world an incredible amount of money and we just don’t have the export base to make good on these claims.  At the same time I appreciate that as long as U.S. markets and the dollar stay strong there is little attention to this hypothetical ratio of the debt to economic wealth-producing capacity, what we can really produce for wealth in this country, but I believe this does matter in a post bubble backdrop where confidence in financial assets becomes an issue.  

That’s a long-winded answer, but I just believe the Japanese experiment seemingly worked, but it has worked in a most unprecedented backdrop of global monetary inflation and credit growth, and what I label synchronized currency devaluation and this, I don’t think, can just keep going on decade after decade.  So look at it this way.  The Japanese experiment has run concurrently with the global experiment and at the end of the day I believe both experiments fail and they likely fail simultaneously and spectacularly.  

I think those that extrapolate the Japanese experiment to the U.S. and others don’t appreciate Japan’s unique situation.  It might appears sustainable today but throughout history massive debt forever, and issue it forever, and issuance will eventually catch up and lead to a crisis of confidence in these obligations, and that would be a first in human history if it doesn’t.  And I don’t believe it is possible that we continue to issue all these financial claims without a come-uppance.  

David:  Thanks for that.  The next question deals with both long and short positions: 

Do you have more long positions or short?

I am going to start by answering that and saying that our other product offerings in what we call the MAPS strategies are really our long portfolio strategies, and Tactical Short is unique on the short side as being focused specifically for short positions, as we described earlier, with that modulating exposure to the short side, where typically, 50-100% short.  Could be zero, could be 100%, but this particular product offering from McAlvany Wealth Management is short only.  If you all are interested, we will have a 2nd quarter call, of course, as we have had for Tactical Short, but with very positive feedback on the Tactical Short Conference Call, we will be initiating that for our MAPS strategies, as well.  So stay tuned there as we head toward the end of Q2 for something equivalent on our long positions. 

Doug, the next question then:

How do you expect the debt, both public and private, to get resolved in the next recession, 243 trillion and counting?

Doug:  Yes, that is such a huge number, isn’t it?  In my earlier comments I said that from a bubble perspective, this is following a worst case scenario and I mean that.  I also mentioned the terminal phase of bubble excess and how a tremendous amount of damage is wrought into the system in a relatively short period of time.  I just discussed the Japanese situation, and think of it this way.  Japan enjoyed spectacular economic development for decades after World War II, and then basically destroyed their credit system in about four reckless years in the late 1980s.  That is an episode that still haunts Japan some 30 years later.  

Late in the cycle there is this dynamic where system risk expands exponentially and I struggle with why others won’t allow themselves to appreciate this.  Think in terms of the rapid compounding in credit growth where you have this debt of rapidly deteriorating quality and this derangement of finance ensures a horrible allocation of financial and real resources.  We have seen this in the past, with over time, increasingly deep structural impairment to the underlying economy.  

We are seeing this terminal phase dynamic now play out on an unprecedented global basis and I will say, on an unprecedented central bank induced protracted basis.  So we have never really seen a terminal phase like this, global, that is stretched over this many years.  So I, again, think this ends very badly, and it will be a market dynamic that unfolds before I think it will be economic.  It will be some seasoning up of the markets that leads to the economic downturn.  But yes, it is a very troubling, ongoing, rapid growth globally of debt. 

I will finish with this, also, Dave.  Not only is it a rapid growth of debt, a lot of it is nonproductive debt which is, again, part of this late cycle, big problem dynamic. 

David:  I will just add that from a policy response standpoint, from how does government manage this kind of a problem, we already know, and it is the twin approach through understating inflation and then running inflation, and financial repression.  If you can depress interest rates, on the one hand, and control the outflow on debt obligations, and at the same time begin to inflate away the burden of debt, of course, who gets crucified in this?  It’s the saver.  It’s those living on a fixed income.  You have the worst of both worlds where you can have a rising cost of goods and services and a diminishment in purchasing power with a limited amount of capital.  

You said earlier that we will look back and central bankers won’t be remembered well for this.  There are hundreds of billions of dollars each year in an environment where you have 11 trillion dollars with a zero rate of return – with a negative rate of return, globally.  This translates into 100-200 billion dollars a year in foregone income, income that would have gone to savers.  We already have a policy response to 243 trillion dollars in global debt – 243 trillion.  It is that there will be chosen winners and chosen losers, and in this case the chosen losers are the folks who are least suspecting.  They are the least likely to be aware of what is happening to them.  I talked a little bit about this in this last week’s audio Weekly Commentary, that the one-two punch is inflation on the one hand, repression on the other.  

Doug, the next question to you is:

What is your plan for adding to the short position when it starts to work, or covering on rallies?

Doug:  Right.  This all gets back to our investment process, our disciplines.  If we are losing money and financial conditions remain very loose, our risk management discipline will dictate that we continue to reduce short exposure.  In a way, it is autopilot.  If we are losing money, financial conditions are loose, then the positions get smaller.  As a general rule, I do not attempt to predict market tops or ends to rallies.  On the short side that is not a wise thing to do.  As tempting as it often is, I try to avoid it.  The key is to keep a tight rein on risk and not let losses mount.  

One of our competitor funds – I looked at the number – they are down 22% year-to-date.  Another is down 20%.  Those are the types of outsized losses that accumulate if strict risk disciplines are not adhered to, so our objective is to not suffer losses like that.  When financial conditions begin to tighten, the opposite side, where there is change in the market backdrop, we will begin to rebuild short exposure.  The amount and composition of short exposure always depends on how we see things developing.  

With the market basically at all-time highs we may look to add put option exposure.  In certain environments, puts will be an important part of our strategy.  To this point, however, we have kept our powder dry.  A lot of money can, and is, being lost in put options during this long market-topping process.  And when the market environment turns more favorable for shorting we will look to short sectors where we see a favorable risk versus reward for shorting.  In the right environment, shorting stocks can also provide an attractive risk versus reward, but as I stated earlier, the risk of shorting individual company stocks has remained highly elevated, so I have been in no hurry to short them. 

David:  One of your favorite phrases, going back through time, is that markets go to unimaginable heights, and then double.  Right now, if you look at the technical picture of the S&P 500, you have a classic rising wedge, out of which you either have an explosive move higher, or a collapse lower.  From a technical perspective, it is undetermined which way it goes.  So although we can build a fundamental case for being more short  now than, say, three months ago, and could be at 60, or 70, or 80% short the market, it is that risk mitigation aspect, the risk management aspect, Doug, that you are so keen on that says, “Yes, and you now what?  We could break out technically to the upside, just as easily as we could the downside.  We don’t have adequate confirmation at this juncture. 

Another question for you, Doug:

In December’s plunge, you did not add to a short position materially, or cover to lock in the gains.  In the 20% rally since then you have lightened up a few percent, but have done so at a time when valuations are getting more stretched, which might advocate for adding to the short.  In short, there doesn’t seem to be a coherent, dynamic strategy.

Tough question.  I’ll hand that one to you. 

Doug:  (laughs) It’s a very good question and I appreciate the opportunity to answer it.  Short exposure was at 68% on January 3rd.  Today it is at 57%.  Keep in mind also, the way it works on the short side – and this gets complicated but I’m going to dive into it a little bit – when the market rallies, our short positions become larger.  Prices go up, our short positions get larger while our account value declines because we are losing money.  We have losses.  

So our short exposure – let’s say if we were not actively managing our short exposure, the short exposure wouldn’t have been at 68% on January 3rd, it would have gone to 72, to 74, to 76.  As the market went against us, our positions got bigger, our equity got smaller.  Not only did we reduce to 57%, we did this rebalancing.  So we ended up covering a lot of stock, a lot of short exposure between 68 and 57 – one, to reduce the overall exposure, and two, to rebalance that short exposure so it didn’t get larger as the market went up.  I know that’s complicated, but suffice it to say that we imposed our risk control. 

As David highlighted earlier, we expect to generally target exposure between 50 and 100% short.  We did not get anywhere close to 100% in December because we were anticipating some type of a policy response, and today we are really not that far from our lower bound, and we could go below 50, but generally, we’re going to be between 50 and 100.  It is a fair criticism, the question why short exposure was not increased more significantly in December – a fair criticism, as I highlighted earlier, and as I have tried to explain to investors.  

I provide investors a weekly client update and every week, very Monday, I try to update them on my thinking, the exposure, and hopefully I was clear on this in December.  I was hesitant to increase exposure significantly ahead of the December 19th FOMC meeting because there was a high probability they were going to do the U-turn on December 19th.  They threw me a curve ball and they waited an additional two weeks, but I made the conscious decision to manage risk cautiously, anticipating some policy response.  

And in hindsight, this was the right call.  Could it have been executed better?  Sure.  In hindsight, I could have been much more exposed in December, cut back aggressively on January 4th.  Why not?  But things are always a lot easier in hindsight, right?  So we got through a very difficult period.  I always strive to be better, but again, I will compare myself to our competitors.  We were not out in front of our skis like other were.  And as I have explained, I am not going to add short exposure when we’re losing money.  

This is addressing the question, why do we continue to cut back now, why aren’t we adding because the market is up so much?  Well, that’s not the risk discipline.  I don’t add when we’re losing money, when the market has strong momentum, when financial conditions are loose – it’s just fundamental to our investment philosophy and process.  We look to increase short exposure when the environment is favorable for shorting, and reduce it when it is unfavorable.  

There was a mention of valuation.  Valuation is a factor when we are gauging risk versus potential reward, but valuation is not part of the framework for the decision of when to add short exposure.  So if you don’t see a coherent dynamic strategy, I’ve done a very poor job of explaining our discipline process and philosophy, but thank you very much for that question.  

David:  From Penny:

Do you think China has already divested itself of a majority of its U.S. treasuries by various other means than directly selling them?

Doug:  Thanks for the question, Penny, and I will look forward to our quarterly chat here in the next few weeks.  China’s treasury holdings and strategy is somewhat of a mystery.  We see that Russia dumped its treasury holdings, but China has not done that yet, supposedly.  China has over 3 trillion dollars of international holdings, about a third of that in treasuries, so if they dumped treasuries they would have to replace them with other securities and they could consider them less liquid and less secure than the treasuries. 

And there is also a situation where they might believe these holdings give them some power over the U.S., if not in trade negotiations, then maybe at some point in the future.  Most likely, they understand that their treasury holdings are so large that if they became sellers it would be disruptive to the markets, to the value of their own holdings, and to global bond yields, more specifically.  So there are clear incentives for China, at least for now, to hold their treasury positions. 

David:  It was interesting, a conversation with a Commentary guest a few years back who pointed out that the way the Chinese have bought treasuries through the years, you were talking about something as more of a political tool than a financial sector allocation.  So owning or selling them, it does come back to politics probably more than, do we want to own treasuries?  I think maybe Russia did want to own another asset class, but the Chinese have always bought on a political basis, not really for financial reasons.  

The next question:

Do you think there is, essentially, no foreign demand for U.S. treasuries at this point?

Doug:  It appears foreign demand for treasuries has waned, and that can be for geopolitical reasons.  Some countries, and we have mentioned Russia, have reduced holdings.  Throughout the boom emerging market central banks were recycling some of their strong inflows into treasuries.  That’s the way it works.  Money flows into EM, they recycle them back into treasuries, and the game continues.  But now EM inflows have really slowed, and some countries such as Turkey, have seen their reserves depleted, so there has been less demand, and some of these central banks have been selling treasuries just to finance outflows from their economies.  

And I would imagine there are foreign investors, public and private, that look at the direction of Washington policy-making and feel less compelled to own our long-term securities.  So I would not necessarily say, no demand, but clearly, reduced command, and also I will say the potential for more aggressive foreign liquidations into the future.

David:  The next question, I think, ties to maybe Trump’s history of using bankruptcy as a tool.  The question is:

Do you think Trump is engineering a U.S. treasury default?

Doug:  My own view would be that the President is fixated now, and will be for a while, on one thing, and that is re-election.  He would look for fiscal monetary stimulus to boost the economy and his election prospects.  I did read at some point that he made a reference at some meeting that said he will be dead when U.S. debt reaches the point of its blow-up, so I don’t think he is oblivious to the risk of huge Federal debt growth, but I will just assume he believes it is a long-term issue and he is going to use fiscal stimulus to the advantage of his election campaign.  

David:  The next question is kind of a currency question, but it ties back to disruption within the treasury market:

Will the U.S. have a new, or even just a devalued currency, as a part of the process of unwinding our debts?

Doug:  Right.  I have real, deep, long-term worries for the long-term prospects for our currency.  But currency values are relative, so the dollar does have the advantage of competing against a group of fundamentally weak currencies.  I do fear a crisis of confidence in the dollar.  That could be part of a difficult future crisis.  In my view, the U.S. has been in this grand experiment in finance and policy-making and economic structure, and I believe the prospects for the dollar depend mightily on how these experiments play out.  I am not optimistic about the experiment, I’ll put it that way. 

David:  Well, this is about all of our questions, and I want to just say thank you, again, to our listeners and our readers, both of the McAlvany Weekly Commentary and the Credit Bubble Bulletin.  We hope that these are helpful resources for you on a weekly basis to have our minds on what is happening in the markets, and what may impact the future, not only of the funds that you have entrusted us to manage, but also things that might impact your family in other regards, whether it is social or political, or what have you.  

We are honored by our partnership with you, and look to continue in the future to offer services that are of great value to you.  We are always available, so with additional questions from this time together, or as they emerge in the coming weeks and months, please reach out, both for one-on-one consultation with either me or with Doug, or just a simple question by email.  We are eager to respond.  Again, long-term relationship is something that we value greatly, so again, just a little shout-out to our existing clients.  

Thank you for joining us in this very fascinating timeframe.  It is an honor to work with you and we think that the months and years ahead will be very, very rewarding.  

Thank you for your time today, and we look forward to the Q2 call.  Until then, or until we hear from you, have a wonderful afternoon and evening. 

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