McAlvany Wealth Management
Tactical Short 1st Quarter 2021 Recap
With David McAlvany and Doug Noland
Thursday April 22, 2021
David: Good afternoon. This is David McAlvany, and we will go ahead and get started as folks are still coming in the door, so to say. Good afternoon, and welcome to first quarter recap conference call. It’s April 22nd, 2021. We’ll be looking at—
David: Good afternoon. We appreciate your participation in the recap conference call. As always a special thanks to our valued account holders. We greatly value our client relationships.
As they say, the days are long, but the years are short. Here we are well into 2021, and another quarter is behind us, to see the financial market anomalies, the public policy experiments, the social and political pressures as they continue to build here in the US and around the world. We’re indeed living history.
So to do that in partnership with you, our clients, is our privilege. I’m going to go ahead and get started with an overview of performance, and we’ll follow that up with Doug’s observations and conclusions on the financial market. I’ll weigh in a little bit on the geopolitical topics, and then we’ll end with our favorite segment, which is the Q&A. Some of those questions have been handed in already. And if per chance you are unable to send questions in in advance, I’ll do my best to monitor that online.
What you would do is go to mwealthm.com, our asset management website, M as in McAlvany, wealth, M as in management, mwealthm.com. Bottom right hand corner you’ll see a chat box. You can click on that and send us questions. So once we’ve finished any questions that are already in queue, we’d circle back around to those. I’ll try to acknowledge them as they come in.
Transcripts of the call will be available, along with a full length recording for future reference, if that’s helpful to you. With a number of first-time listeners on today’s call, we’ll begin with some general information for those unfamiliar with Tactical Short, and more detailed information is available at that same website, mwealthm.com. In this case, you would go /tacticalshort, mwealthm.com/tacticalshort.
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. This strategy is designed for separately managed accounts. With that structure, investors have full transparency, flexibility, reasonable fees, no lockups, it’s very investor friendly. We have the flexibility to short stocks and ETFs. We also plan on occasion to buy liquid listed put options. Shorting entails a unique set of risks. In past iterations of this call, we’ve explored some of that and would encourage you to go back to some of the previous quarters as Doug details some of the unique dynamics within a shorting strategy. And of course we had many of these illuminated during the quarter. We are set apart both by our analytical framework and by our uncompromising focus on identifying and managing risk.
Our Tactical Short strategy began the quarter with exposure targeted at 67%. 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, the S&P 500 ETF was 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, we found a disciplined and professional approach to risk management was imperative. We highlight this message during every call, but remaining a hundred percent short within a short portfolio all the time—and this is what most short products are structured to do—is, in our view, risk indifference. And we are in fact here to help mitigate risk across other assets that you have.
And so the quarter—the entire past year—was notable. It was notable for inflicting huge losses on the short side for those who were in fact indifferent to risk. And we’ll share our numbers versus those other competitive numbers in a moment. We believe that disciplined risk management is absolutely essential for long-term success, and we structured Tactical Short to ensure the flexibility to navigate through even the most challenging market conditions.
The environment has been a nightmare on the short side, but we’re going to get through this. So let me give you performance.
Updating performance for the quarter, Tactical Short accounts after fees returned a negative 4.55% during Q1. The S&P 500 returned a positive 6.17% for the quarter. Basically, if you’re comparing the two, Tactical Short accounts lost 74% of S&P’s return because, of course, we’re on the inverse of that. So, as for one-year performance, Tactical Short after fees returned a negative 28.07% versus the S&P’s positive return of 56.33%. Positive move by the S&P.
Over the past year, Tactical Short accounts lost roughly half of the S&P 500’s positive returns. We regularly track Tactical Short performance versus three actively managed short fund competitors. First is the Grizzly Short Fund, which returned a negative 9.13% during Q1. And for the past year, Grizzly was upside down, negative 57.62%. Yeah, worse than 100% of the S&P’s return. Ranger Equity Bear Fund returned a negative 16.45% for the quarter and a negative 63% over the past year—over the past four quarters. Federated Prudent Bear Fund was negative 6.67% during Q1 and negative 38.73% for the past year.
So, on average, the three competitors lost 174% of the S&P 500’s return for the quarter. Tactical Short on average outperformed the competitors by about 620—well, precisely 620—basis points during the quarter, and outperformed by about 2,519 basis points over the past year. And just a note, Tactical Short has also significantly outperformed each of the bear funds since inception, on average outperforming the three competitors by 3,015 basis points.
There are, as well, the popular passive short index products, the Tactical Short again outperformed the ProShares S&P 500 ETF, which lost 6.73% for the quarter, 39.41% for the year. The Rydex Inverse S&P 500 Fund lost 6.56% for the quarter and 39.21% for the year. And the PIMCO Stock Plus Short Fund, down 5.5% for the quarter and 33.73% for the entire year.
That is performance in a nutshell. Doug, I’ll hand the mic over to you and then slip back in, here and there, throughout our conversation today.
Doug: Great. Thanks David. Good afternoon, and thanks everyone for being with us today.
There’s just so much to comment on after such an extraordinary quarter. And I’m compelled to begin the analysis with an update on this unbelievable monetary environment. Federal Reserve credit has inflated almost $3.6 trillion over the past 58 weeks. It was up $3.9 trillion, more than doubling in just 83 weeks. After beginning 2008 at $850 billion, Fed assets are on course to … [recording unclear] $4.2 trillion or 27% over the past year to a record $19.1 trillion. Institutional money fund assets not included in it too. They were up another $700 billion. March’s $660 billion shortfall pushed the first half fiscal year federal deficit to $1.7 trillion.
Washington borrowed $0.70 of every dollar spent during March, and $0.50 of each dollar for the quarter. It’s a data point difficult to get my mind off of. Washington ran an 18-month fiscal deficit of $4.8 trillion. We’re almost 25% of GDP and is on track for back-to-back $3 trillion-plus annual deficits.
And I can’t do this historic monetary inflation justice without delving at least briefly into key data from the Fed Z.1 report, data that received little attention. US non-financial debt surged $6.8 trillion during 2020, almost triple 2019’s $2.5 trillion increase. For perspective, non-financial debt expanded on average $1.83 trillion annually over the previous decade. Treasury securities, they surged $4.6 trillion during 2020, or 23%. And after concluding 2007 at about $8 trillion, Treasury liabilities ended the year at $26.4 trillion. Total non-financial debt ended the year at $61.2 trillion, or a record 292% of GDP, having increased 83% since the end of ’07. Non-financial debt ended 2019 at 254% of GDP, up from 230% to finish 2007 in 189% in 1999. Over just the past six quarters, total debt securities—and that’s Treasurys, agencies, corporates, muni’s—jumped $8.2 trillion, or 18%, to $53.9 trillion. And history offers nothing comparable.
At 251% of GDP, total debt securities, that ratio, compares to 200% in ’07, 157% in the ’90s, 126% to end the ’80s and 74% to conclude the ’70s. Total securities—and that’s combining debt and equities—ended Q1 at a record $118 trillion. At 551% of GDP, this compares to cycle peaks of 379 in ’07 and 359% during Q1 2000. Total securities ended the ’80s at 194% and the ’70s at 117%. And with the value of securities inflating to new records, household net worth reached an all time high $130 trillion. Net worth ended Q1 at 606% of GDP, dwarfing previous cycle peaks 492% in ’07 and 446% in early 2000.
What we’re witnessing is nothing short of history’s greatest runaway global monetary inflation, and monetary disorder has taken root everywhere, most conspicuously throughout asset markets. Importantly, we witnessed during the quarter a wild speculative mania take hold in US markets. Amazingly, stock funds attracted inflows in excess of $500 billion over just the past five months. Think of this. Inflows in five months exceeded flows received over the previous 12 years. This is data from the Bank of America, which likened the stampede to a speculative melt up, in their words.
In addition to the tsunami of flows, investors in February had accumulated a record $814 billion of margin debt. That was up almost 50% from a year ago, the strongest growth since prior to the ’08 crisis. And from Z.1 data, broker-dealer loans expanded a record of $100 billion, or 84% annualized, during the fourth quarter, with 2020 gains of 40%.
I’ve seen a lot of crazy over my career that goes back a few decades. I lived through incredible short squeezes in the ’90s that I thought were surely a once-in-a-career anomaly. But Q1 was just— it was replete with really unimaginable market excess. The stock of video game retailer GameStop surged from $19 to $483, one of many targets in the phenomenal meme stock mania. And the larger the short interest, the greater the buzz in the stock chat universe.
After the Goldman Sachs Most Short Index, after its 38% Q4 return, how could things possibly get any worse on the short side? But they did. As a historic short squeeze captivated the entire marketplace, the Goldman short index returned almost 34% during Q1. Notable gains included GameStop’s 908%, AMC Entertainment’s 382%, and Express’s 342%.
The short side has been an unmitigated disaster. Assets at the actively managed bear mutual funds are now down more than 90% from peak levels. Few short-only hedge funds remain in business. The big squeeze also bludgeoned long/short strategies, most notably the $12 billion Melvin Capital that sank 49% during the quarter.
Excess was also on display in a booming IPO marketplace, about 300 SPACs—special purpose acquisition companies—launched on US exchanges, raising almost $100 billion. It was the strongest US IPO market since bubble peak Q1 2000.
But Excess was anything but limited to equities as ultra loose financial conditions fueled excess everywhere. Record global M&A activity saw $1.3 trillion of deals surpassing $140 billion. Junk bond issuance set a quarterly record. Bitcoin doubled, crypto inflows surged to $4.5 billion, and the value of cryptocurrencies inflated to $2 trillion. And NFT, non-fungible token, the digital image sold at auction for $69 million.
Importantly, mania dynamics also overwhelmed housing markets across the country as surging prices and a dearth of inventory incited panic buying. The National S&P CoreLogic Home Price Index inflated 11.2% year-over-year—the strongest price inflation in 15 years. Mortgage credit is growing at the fastest clip since 2007.
And I don’t want to admit a traditional metric for gauging the appropriateness of monetary policy. The US trade deficit widened in February to a record $71 billion. Bubbles at their core are mechanisms of wealth redistribution. Forbes’s annual world billionaires list included a record 2,755 billionaires, with last year’s list worth a combined $13.1 trillion, up 64% over the past year.
Monitoring for signs of peak excess, as we contemplate characteristics of an inflection point, they’re all there and they’re not subtle. This is, however, no ordinary cycle. I’ve shared a lot of numbers, incredible data, that’s rather mind numbing. So let’s shift to macro analysis as we attempt to fashion an analytical framework that helps us make some sense of all of this.
By the mid ’90s, I was convinced finance had fundamentally changed—out with the old bank loan-dominated financial system and in with a new age structure: a marketable securities-based system, underpinned by activist central banking. It was clear to me by the mid ’90s that this new finance was highly unstable, and policy interventions were only making it more so. I thought the bubble would burst in 2000, but then shifted to warning of a mortgage finance bubble in early 2002.
I again thought the bubble burst in 2008, but in 2009 reverse course, and then an unfolding global government finance bubble. Well, the world is now more than a decade into history’s greatest bubble. We’re today in a late-cycle manic bubble phase, where we naysayers have been discredited.
As an analyst, this is my third major bubble. I’m familiar with the routine. The analysis is completely dismissed. I’m Chicken Little with a big dunce cap stuck on my head.
Well, years of loose finance have made things too easy. The punchbowl was refreshed way too many times. Chronic monetary alcoholism. It became too rational to plow money into hot ETFs and trade meme stocks from home. Buy each dip. Buy every breakout. Aggressively purchase call options and right puts. It’s been way too easy for Wall Street, for the leveraged speculating community, for the derivative players and online retail traders.
Meanwhile, it’s been an absolute cakewalk for borrowers of all stripes. The Fed and global central bank community have everyone’s backs. Debt and deficits don’t matter. The beaming MMT—modern monetary theory—crowd is exclaiming, “Told you so.” Central bank money creation is out of control. Washington spending, out of control. Market speculation, also out of control. And it all passes for some wondrous bull market.
Some years back, I began referring to the Granddaddy of All Bubbles. The bubble had gone to the very foundation of global finance, central bank credit and government debt. Bubble excess poisoned the very heart of money and credit, perceived safe and liquid instruments. Excess had spread to every nook and cranny. This bubble is different in kind from previous bubbles fueled by corporate and mortgage credit. With money enjoying insatiable demand, it’s the ultimate bubble fuel. As we’ve witnessed, no matter how egregious the expansion of this money, we just can’t get enough of it.
Money’s insatiable demand has allowed central banks and governments to prolong bubble excess to unimaginable extremes. I thought the Bernanke Fed was reckless for its trillion-dollar QE and determination to coerce savers into risk markets, all in the name of post-crisis system reflation. I never imagined we would get to the point that, in 2019, the Fed would employ QE with markets near record highs and unemployment at multi-decade lows. I believe history will look back on that fateful decision as the beginning of this cycle’s final crazy speculative blow off.
The Fed’s balance sheet will soon surpass $8 trillion. A few years back, I posited a seemingly outlandish forecast that the Fed’s balance sheet would inflate to $10 trillion. I expected this to unfold when the Fed was forced to accommodate a major de-risking deleveraging episode, precisely what was beginning to unfold in March 2020. Instead, we’ve seen Fed holdings inflate about $4 trillion while the world is in the throes of history’s greatest bout of speculative leveraging. I’ll have to revise my forecast.
David: So Doug, just to play devil’s advocate, why can’t this just go on indefinitely, new age of market-based finance bolstered by unlimited government money?
Doug: Yes. And that’s the key question, David. First of all, we’re well aware of this. History informs us that paper money inevitably returns to its intrinsic value. And electronic money has some advantages. One being, we won’t be seeing wheelbarrows toting currency. But I do believe this cycle will end with a crisis of confidence in central bank credit, in sovereign debt and policymaking, and in finance more generally.
Financial debasement has accelerated markedly over the past year. In contemplating an inflection point, let’s break the analysis into four main categories: inflation, speculative bubbles, China, and social/geopolitical. We’ll address them one at a time.
I’ll get started with inflation. The Bloomberg Commodities Index is up almost 11% already this year to a near three-year high. Price gains have been broad-based—energy, copper, aluminum, iron ore, corn, soybean, sugar, cotton, hogs, cattle—lumber is up almost 50% year-to-date, to a record high, prices having tripled since October. The New York Fed’s National Manufacturing Index’s Prices Paid and Received components both jumped to highs since 2011, while the Philadelphia Fed’s Business Survey Prices Index surged to a 41-year high. The ISM services prices component rose in March, the high going back to 2009.
As for market expectations, a five-year Treasury breakeven inflation rate is up another 65 basis points already in 2021 to 2.62%, near the high going all the way back to 2005. And importantly, heightened inflationary pressures are very much a global phenomenon. Turkey, Brazil, Russia, and others have already tightened policies in response to surging price pressures. Meanwhile, Fed officials continue to aggressively promote inflation, dismissing inflationary risks while arguing pricing pressures will prove fleeting.
The history of monetary inflation is unambiguous. Once it begins in earnest, it becomes almost impossible to control the expansion of credit … boosts purchasing power throughout the system in the real economy, and, as we continue to witness, especially in the asset markets. Monetary inflation influences investment decisions, fueling resource misallocation, along with mal- and over-investment. And the longer the bubble inflates, the deeper the structural impairment.
Arguably, systemic structural maladjustment is the greatest risk associated with this most prolonged government finance bubble. Consumer price inflation is but one component of overall inflation risk. Yet consumer inflation does take on greater significance today because of mounting risks to bond markets. We believe the risk of a consumer inflation upside surprise is the highest in years, if not decades.
First, there’s unrelenting monetary and fiscal stimulus that has created enormous spending power. There are, as well, redistribution policies, direct payments, minimum wage increases—in various measures, shifting purchasing power to the working class in general. Even with today’s elevated unemployment, there remains upward pressure on compensation.
There are as well inflation risks associated with global climate change. We’re also seeing various forms of destabilizing monetary disorder, including shortages, hoarding, production bottlenecks, supply chain issues, along with broad-based pricing pressures. Housing markets—they’re demonstrating powerful inflationary dynamics that will feed through to other sectors. Friday’s University of Michigan Consumer Confidence Survey had one-year inflation expectations jumping to 3.7%, up 120 basis points in only four months to the highest reading since 2012.
Market inflation concerns have waned somewhat over the past couple of weeks as Treasury yields pull back. Yet the risk of an inflationary surprise rocking markets—it’s very real. Just last month, surging Treasury yields were pressuring vulnerable emerging markets. De-risking deleveraging dynamics were beginning to take hold. There was in March 2020 confirmation of the thesis that unprecedented leverage had accumulated throughout the fixed income universe, including Treasurys.
An inflation-induced spike in yields could easily turn disorderly, with deleveraging unleashing market illiquidity and dislocation. And last month’s yield surge—conventional thinking held there was no cause for worry, market yields were essentially capped. At some point, the Fed would purchase long-dated Treasurys as part of a yield-control strategy. And the Powell Fed countered inflation fears with an uber-dovish narrative, downplaying inflation risk while remaining steadfast with zero rates and 120 billion monthly QE. At this point, the Fed is clearly behind the curve. It is actively promoting higher inflation while it’s new doctrine insures the Fed will wait to respond to higher inflation until well after it has become entrenched. It will be too late.
David: So we have a confluence of mounting price pressures and the Fed’s new lax approach with inflation, which creates a major risk both to the Treasury market and bond markets in general. And today, along with that heightened vulnerability of the stock market, in the event that the Fed is forced to belatedly react to mounting inflationary pressures, especially after the pandemic response, you have markets that now have an ingrained belief. Markets perceive instability and liquidity challenges are going to be quickly resolved by open-ended QE; doing whatever it takes. And this perception has fomented excessive risk-taking because, well, why not? And of course leveraging on top of that risk taking.
So you’ve got steep asset price premiums virtually across the board, and it becomes an altogether different backdrop if inflationary pressures reduce the Fed’s propensity to quickly quit QE liquidity injections. Suddenly the marketplace would be forced to reassess the reliability of its liquidity backstop. Speculation and leverage would become, at that point, high-risk propositions forcing de-stabilizing market adjustments. So inflation is point number one in your argument, Doug, what’s the second? Will you take us into sort of the speculative bubbles?
Doug: Sure, David. Yeah, we don’t believe it’s possible to resolve debt problems with only more nonproductive debt, and we have major issues with inflationism generally. There is now this well-established dogma that troubled systems can be reflated out of over-indebtedness and economic stagnation. This is deeply flawed and dangerous fiction, especially in this new-age world of unfettered market-based finance, speculative leverage, and bubbles. To ensure the more aggressive defense reflationary policies late in this cycle, the greater the scope for intractable speculative bubbles.
Importantly, if central banks inject liquidity into a backdrop of speculative zeal and bubbles, with such powerful market inflationary biases, the outcome will be increasingly destabilizing speculation and perilous bubble dynamics, and never has this been on clearer display than over the past year. The Fed desperately injected a few trillion of liquidity into the markets to hold bubble clouds at bay, only to embolden speculation and inflate even greater bubbles.
Fed efforts to reflate the system out of trouble have greatly exacerbated excess and underlined fragilities. It’s worth repeating, the Fed commenced QE back in September 2019, months ahead of the pandemic. The Powell Fed responded to repo market instability, to late-cycle speculative bubble dynamics characterized by excessive risk-taking, leverage, and associated fragility. And that return of QE stoked speculation and leverage, and electrified [unclear] came home to roost, with March’s near market collapse.
The unprecedented monetary fiscal pandemic response has been instrumental in stoking bubbles and equities, corporate credit derivatives, cryptocurrencies, housing, art, NFTs, and the like—the so-called everything bubble. And recently we got a glimpse of how crazy things have become, with the collapse of Archegos Capital Management. This $10 billion so-called family office, a hedge fund structure without the regulations, was levered between five and 10 to one in concentrated holdings and volatile equities. Actually, it held third-party derivatives from the major prime brokers, and everything was going swimmingly until the scheme suddenly blew apart in a few short days, leaving the brokers, notably Credit Suisse and Nomura, with multi-billion-dollar losses.
I wrote in a recent CBB, “Get the women and children off the beach. We’re seeing some unsightly naked swimmers, and it’s still high tide.” We witnessed during Q1 markets erupt into full-fledged manias, and the Fed—they just keep pumping in added monetary fuel.
I’ve witnessed some spectacular bouts of manic speculative excess during my career. Now, thinking back, stocks, back in early 1987; Japanese equities in ’89; US bonds and derivatives, ’93; emerging markets, ’96; tech, internet stocks, in 1999; subprime mortgages, 2006. And there’s been extraordinary excess across markets over the past decade. But what we’ve been witnessing of late, it’s gone to a whole new level. One has to look all the way back to 1929 for comparable market-wide speculative excess.
The relatively short-term phenomenon by nature, yet speculative manias inflict tremendous structural damage. We’re in uncharted waters when it comes to government policies prolonging manic speculative excess. I do believe we’re nearing an inflection point. Retail investors are all in; institutions, all in; the leverage speculating community, all in; and it would be highly unusual for such manic market excess to be sustained for long. And speaking of historic excess, let’s shift to China. China’s bank assets have reached 50 trillion, up from 8 trillion in ’07, and a tenfold expansion since 2005.
I want to underscore a key point. China’s historic credit expansion and boom were made possible by Federal Reserve QE. The Fed’s balance sheet inflated tenfold since 2007, with the Fed’s inflationist doctrine spurring QE adoption and unchecked credit expansions globally. There’s a strong case that China’s financial and economic bubbles are the most momentous inflationary consequence emanating from the evolution of unfettered global finance.
Over the past 15 months, Chinese aggregate financing, and that’s the broad measure of credit growth, expanded an astonishing $6.9 trillion, and that’s in US dollars, or 17%. For perspective, this was 50% greater growth than the previous 15-month period in its own right. A period of exceptional credit expansion.
As an analyst of credit and bubbles, I’ve been in awe of China for over a decade. There have been cracks in Chinese credit that Beijing immediately sealed. Chinese officials have also made repeated attempts at reining in credit and speculative excess, only to be forced into retreat as fragilities emerged.
These days, markets assume that the great aging meritocracy has everything well under control. Markets are not oblivious to Chinese excess, but the bullish view holds that Beijing won’t dare do anything that might risk deflating bubbles. Well, global markets have grown much too complacent. In particular, markets disregard the acute fragilities that arise from a 15-month credit binge.
Beijing now appears determined to pull back on stimulus while sounding determined to rein in credit and speculative excess. But restraining excesses in a maladjusted system coming off such an extraordinary credit splurge is fraught with risk. Beijing has directed banks to restrain lending. It has commanded local governments to curb apartment speculation. It has cracked down on online lending platforms and other avenues of shadow banking. It has taken a much more aggressive regulatory stance with the big technology conglomerates. Across the board, Beijing is adopting a more coercive approach than in the past.
There’s one facet of Beijing’s newfound approach that is deserving of special attention. It has begun pushing back against the view of implicit central bank and central government guarantees for debts from state-owned enterprises and local government financing vehicles. From a credit bubble perspective, this is a momentous development with far reaching ramifications. The view that Beijing would not tolerate problematic defaults has been fundamental to the development of China’s entire credit bubble. Today there are literally tens of trillions of bank corporate and local government debt whose values are underpinned by the perception that Beijing would, when push comes to shove, move to thwart systemic stress and defaults.
Chinese officials, starting with President Xi, are now attempting to wean markets off this notion. Over the past year, several state-owned enterprises defaulted on debt obligations, something previously viewed as almost implausible. And just last week, default fears erupted for China Huarong Asset Management, one of four state-owned asset management companies created back in 1999 to manage bank non-performing assets.
Huarong is sizeable, with 260 billion of assets and over 200 billion of liabilities. This is one to watch. The company has 42 billion of bonds, of which about half are due over the next year. Huarong’s credit default swap prices began the month at 147 and closed a week ago, Friday, at 436 basis points. In last Thursday’s trading, the CDS spiked to 1,466. Some offshore Huarong bond yields approached a hundred percent, signaling market fear of imminent default.
Risk premiums also surged for other Chinese financial institutions, and rose generally throughout China’s corporate bond market. By Friday, Beijing Crisis Management Operations, they were in full swing. Huarong wired funds for a weekend bond payment. Chinese regulators declared the company’s operations in liquidity management. They declared then that they were functioning normally while requesting banks not withhold lending to the company.
Huarong’s CDS prices ended the week near a thousand basis points, have gone down to a still highly elevated 500 basis points. Chinese credit has been expanding at a blistering pace, and Beijing thus far has done little more than talk of tightening measures. Yet we’re already witnessing a major blow up. Beyond Chinese credit, contagion effects last week saw a widening of spreads throughout Asian corporate debt markets. Even China’s sovereign CDS traded to the high since October.
China’s aged credit boom is vulnerable to waning growth momentum. You can’t shock your system with parabolic credit growth and then expect things to just return to normal in China, the US, or elsewhere. That’s not the nature of credit bubbles. Arguably, ongoing wild credit inflation rests on the market premise that Beijing support underpins the entire system. As such, China now, their colossal credit apparatus, it will buckle without trust in Beijing’s implicit and explicit backing. The entire edifice has become too big to fail.
There’s troubled Huarong, along with the other vulnerable state-owned asset management companies. The solvency of China’s fragile multi-trillion, small banking sector last year became an issue, temporarily papered over by the massive pandemic stimulus. Solvency is also a concern for a few trillion dollars of local government financing vehicles and other local government liabilities.
In short, a tremendous amount is resting on Beijing’s shoulders. China is at a major inflection point, and I’m seeing developments consistent with how I would expect a credit crisis to commence in China. Focus is turning to implicit Beijing guarantees, marginal borrowers have begun to lose access to cheap borrowings. Importantly, debt at the periphery is beginning to lose its perceived moneyness. Board investors are showing some unease. Risk aversion and deleveraging have just begun to gain momentum. Financial conditions have begun to tighten at the fringe, even in the face of massive ongoing credit growth.
David: So let’s shift to the social and the geopolitical. There’s no escaping the reality that bubbles are mechanisms of wealth redistribution and destruction within societies and among nations. During the upside of the cycle, there’s a prevailing optimism and a perception that the pie is getting bigger. There’s cooperation and integration, and they’re viewed as quite rationally in one’s self-interest, but things shift late in the cycle, with the pie stagnant or even shrinking. What is viewed in one’s self-interest changes. Antagonism, disintegration, and conflict emerge as confrontation is viewed as necessary to secure one’s fair share of the shrinking pie.
We’ve witnessed society fray and social strife erupt across the US—the feeling that the system promotes inequality now permeates, and we see it in our fractured society, hopelessly dividing politics, both in Washington and in any city on the streets. Globally, we’ve witnessed an alarming deterioration in relations between the US and China, as well as deteriorating relations with our European allies.
Russia is pressing in on that European dis-unification, even as China further establishes itself as a regional hegemon. And the cooperation and integration that dominated the relationship specifically between the US and China, in the decade that followed the great financial crisis, that shifted to two hostile global competitors, and now geopolitical adversaries.
Markets have to this point ignored the momentous ramifications related to this bubble dynamic. It’s as if markets rejoice, competing global bubbles, confident that neither side would risk actions that might put them at a competitive disadvantage. Yet the economic landscape is changing. Both nations now want to be less reliant on the other, more self-sufficient in myriad technologies. So look at semiconductors, look at rare earth metals, healthcare supplies, look at the various supply chains. And this has been the story of the last three to six months.
China is taking a much more aggressive stance. We’ve witnessed this with their approach to Hong Kong, and increasingly with Taiwan, the hardline so-called wolf diplomacy is on display around the world. This week war planes are flying near Taiwan in record numbers. I expect China to become only more strident as their massive financial and economic bubbles succumb.
Economic disorder promotes two varieties of blame games, the external, toward other countries, and the internal, which regularly takes the form of xenophobia. And so it’s worth noting that China’s angry reaction last week to President Biden and Japanese Prime Minister Suga’s joint statement committing to, “working together to take on the challenges from China and on issues like the East China Sea and the South China Sea.”
And as a team, in our asset management team, we reflect on and we discuss this, that the US and Japan being the scapegoats, convenient scapegoats for Beijing to deflect blame from its gross mismanagement of China’s bubble.
So identifying inflection points in social and geopolitical risk is difficult. Perhaps it’s easier with hindsight, but China has clearly adopted an aggressive posture, and they’re projecting equality with the US on the global stage. And now after the Hong Kong crackdown, Beijing has turned its sight to Taiwan. The US-China confrontation over Taiwanese independence for us poses a when, not if, predicament.
Doug: Returning to the US stock market, myriad signs are consistent with a major top. Unprecedented public participation, sentiment measures at bullish extremes, hedge fund long exposures at multi-year highs. While S&P 500 futures short interest has sunk to 17-year lows.
About a hundred new ETFs have debuted already in 2021. ETF industry assets now surpass 6 trillion. There’s the new VanEck Social Sentiment ETF, symbol BUZZ, as well as Cathie Wood’s new ARK space exploration ETF, which quickly attained $650 million in assets.
And from Archegos reporting, we know family office assets have surged to almost $7 trillion.
Emblematic of today’s crazy speculative mania, online brokerage Robinhood had nine and a half million customers trade cryptocurrency on its platform during the first quarter, an almost six-fold increase from Q4.
Over the years, I’ve relied on a core versus periphery model of market instability as a key facet of my analytical framework. Instability and financial crises typically emerge at the periphery, at the fringe, where they’re structurally weakest—the most vulnerable to risk aversion and tightening financial conditions where they reside. For example, the bursting of the mortgage finance bubble began with instability in the riskiest subprime mortgages.
I believe this dynamic is already in play for the global bubble, with the emerging markets having experienced in Q1 an opening salvo of instability. Turkish yields surged 400 basis points and the Lira sank 15% on President Erdoğan’s firing of Turkey’s chief central banker. Contagion effects quickly spread to Brazil, South Africa, and others as de-risking deleveraging began to take hold.
But this process can unfold over months. Recall that it was 15 months from the initial June 2007 sub-prime eruption until the entire system was engulfed in crisis later in 2008. In reality, the core can initially benefit from instability at the periphery. For example, the subprime crisis and the Fed’s response sparked a major collapse in bond yields in ’07 and into ’08 that actually bolstered prime mortgages and extended the greater bubble. Analysts dismissed the relevance of subprime as stocks traded to record highs in October 2007.
We saw in the first quarter  significant global market instability. Treasury yields spiked higher, the emerging markets came under pressure with notable surges in key EM bond yields. Global currencies turned unstable. And here at home, there was a major market dislocation in the short stock universe, leading to losses and de-risking and various hedge fund strategies, including long/short and factor or factor quant.
There was, as well, the noteworthy dynamic of Treasury bonds not providing a reliable hedge against equities and the risk markets, throwing the appeal of risk parity and other leveraged strategies into question. And towards the end of March, there was the Archegos blow up.
None of these developments proved a catalyst for market correction. None even kept the market from surging higher, but I would argue all of these developments work in confluence to weaken market underpinnings, amplifying latent fragilities. I believe developments have raised the odds of a de-stabilizing eruption of risk aversion, especially in the case of Archegos, racing to get ahead of the regulators, prime brokers will now tighten risk parameters in securities, finance, and derivatives, as Credit Suisse announced this morning. Jobs were lost, bonuses disappeared, CEOs and risk managers have been awakened.
I’ve likened the Archegos blow-up to the collapse of Bear Stearns structured credit funds in June 2007 that marked a tightening of financial conditions at the periphery and the beginning of the end for the mortgage finance bubble—though, at the time, everyone was quick to dismiss subprime.
When contemplating an inflection point, first quarter development significantly increased the likelihood of a serious de-risking deleveraging episode. Inflation expectations and Treasury yields have surged higher. Another massive fiscal stimulus, manic excess, and equity SPACs, the cryptocurrencies, Beijing’s focus on imposing restraint spurring credit instability, and, on the geopolitical front, China’s heightened pressure on Taiwan, and 150,000 Russian troops positioning near Ukraine.
When I contemplate the possibility of a historic inflection point, my thoughts go to the market perception that central bankers have everything under control, that Beijing has China’s bubble well under control. It’s all a mirage. The situation is out of control. Great monetary inflations invariably turn unwieldy and uncontrollable. Trillions of money have incited an out-of-control mania.
We believe the inflation and speculative mania backdrops are in the process of limiting central bank flexibility. We could easily see the next serious de-risking deleveraging episode unfold in an environment of mounting inflationary pressures, especially after last year’s excesses. The scope of Fed QE necessary to thwart the next crisis dynamic will be even greater than last year.
Going back to 2008, the bond market has always relished QE while sinking yields played an instrumental role in resolving financial and economic fragilities. At this point, there’s little room for bond yield support. Instead there’s potential for bond markets to part ways with the Fed on QE. It would be a momentous development if QE comes to be viewed as exacerbating inflationary pressures. Imagine yields spiking higher on a Fed QE announcement. In such a scenario, the Fed would have to think twice before orchestrating another big liquidity operation, leaving bubble markets to adjust to a less reliable liquidity backstop.
I would like to leave you with this thought. Too much money playing a speculative bubble ruins the game. Today there’s way too much money sloshing about, and market pricing mechanisms are broken. The first quarter saw some wild instability, unprecedented inflows, and a historic mania. We saw a short squeeze for the ages, chaotic market rotations, cracks in the EM bubble, a spectacular hedge fund collapse, all while bubble markets inflated higher. So many facets of the quarter pointed to a major global cycle top. I believe we’re at, we’re approaching, an important inflection point, one I expect to be momentous. David, back to you.
David: The Q&A. And I had a couple of questions come in online. As I mentioned, mwealthm.com, bottom right hand corner, you’ll see the chat box if you want to enter those there. But we’ve got a full lineup as it is.
First question, Doug, to you. “How will tactical short investors fare if the S&P 500 melts up to 6,000 levels, given explicit or tacit support from OECD central banks?”
Doug: Well, an S&P 500 run to 6,000, that would present a further challenge for tactical short. There is no denying that.
In such a scenario, we would surely be reducing our short exposure. We would rebalance our short exposure to account for losses.
Now let me make an estimate here. If the market melted up 50% from here, I would expect tactical short losses to be less than half this amount, hopefully significantly less, but a lot depends on the nature and duration of the rally, how it would get to 6,000.
In a more normal environment, I would anticipate that we would significantly reduce short exposure in such a scenario, but the challenge remains that I see—we see the risk backdrop as extraordinarily high, for some of the reasons we touched upon. We’re seeing all the signs I would expect for a major top, and markets this manic, speculative, and leveraged, they just don’t typically give everyone a nice opportunity to get out at the top.
I also believe the more sophisticated market operators, they’re, at this point, they have one eye on the exits, and topping processes are, they’re really challenging the short side. And with my view that this is a major secular top, it’s only fitting that this environment has been, I guess, an absolute nightmare on the short side, but I expect when the market reverses lower, things will unfold quickly and perhaps dramatically.
David: The next question is, “What is the current technical analysis view that informs the S&P 500 outlook?” And I would say that, just like the last question asks about the potential for a move 50% higher, that looking at the technicals, you could just as easily make a case for a move by 50% lower.
Let me go through a couple of things real quick. Again, from just a technical standpoint, sentiment numbers are redlining. We had the investors’ intelligence numbers out again this week. This is the third week in a row of a greater than 40 point differential, where bulls are at 63.7% bears are at 16.7%. Again, the difference between those two numbers, if it’s greater than 40, is very significant. It’s been greater than 40 for three weeks. These extremes are common at, and only at, a top.
As for the S&P 500, you still have daily and weekly buy signals, but the index appears to be in the process of rolling over. We need some confirmation to the downside. And so, I think a couple of things to keep in mind: one is relating to seasonalities. We head into the seasonally weak part of the year. You have the classic adage: sell in May and go away, which is based on the disproportional benefit of being long the market from November through April, and then getting out of the market from May through October. Most of your positive returns come in that November through April timeframe. Your negative returns come from the May to October. So seasonality is likely to be a factor.
We don’t have a sell signal for the S&P 500, and I would say yet, but we do have sell signals in the Russell, IWM, and in the QQQs or NASDAQ. So we do have sell signals there, looking at broader market weakness already, which is indicated to us by the Russell in particular. A sell signal in the S&P 500 in that context could signify a top, not unlike what we had in the year 2000 or year 2007.
So, bringing it all together, when you look at sentiment, which is supportive of that thesis, the innumerable examples of speculative mania that Doug brought in, and the sell signals that we already have in the IWM and QQQ. Don’t hold your breath, but if we get a daily and weekly sell signal in the S&P, and our guess would be that would be a mid—could be as soon as a mid—May event, you could be looking at the S&P losing 50%. That’s a reasonable probability.
The next question, on to you, Doug, is, “Are other US equity indexes, which derive a lower proportion of their value from the FANG-type stocks, are those more suitable candidates for the tactical short?”
Doug: Yeah. Good question. After surviving a brutal short squeeze environment during the ’90s, I adopted a risk management philosophy and discipline. It was necessary to more effectively manage short exposure. The focus has been to manage overall short exposure through specific buckets of exposure—those buckets being individual company’s shorts, and one sector is indices, options, and the S&P 500.
And I’ve varied the relative sizes of these exposures based on my gauge of financial conditions, market dynamics, performance, and the risk versus reward. The key to my management philosophy is managing overall short exposure beta, or volatility versus the market, and adjusting this beta depending on the environment.
The S&P 500, it’s my default short exposure. When the other buckets of short exposure have unattractive risk versus reward profiles, this default position provides— I’ll call it beta clarity, when beta or volatility risk from the other exposure buckets is highly unclear.
Today I doubt anyone is thrilled about being short at the S&P 500. I’m not, but I’m disciplined and believe in our risk management philosophy and process. Throughout much of my career, for various reasons, I had to remain short stocks, even when I knew the risk/reward calculus was poor.
For tactical short, it was crucial to have the flexibility to avoid getting caught in squeezes and along with outperformance of individual stocks and sectors. Our positioning in our default S&P short has been fundamental to our 2,500 basis point—that’s 25 percentage points—outperformance versus our actively managed short competitors over the past year.
Is there a better index? There are a lot of them when the environment changes. Absolutely. But at this point, the broader market, at least year to date, has outperformed the S&P 500. The average stock value line, arithmetic index, is up almost 19% year to date; mid-caps, 18; the small caps, 14 or so.
And it’s also worth pointing out that most FANG stocks are underperforming so far in 2021. Apple is about flat. Netflix is down 6%. Amazon’s up a few. I think Facebook’s up about 10. Tesla’s gained less than five. Google is the big exception. It’s gained upwards of 30%.
But I really want to start broadening short exposure. And we were actually very close to beginning the process, just a couple, two, three weeks back, but I’m going to see some tightening of financial conditions and more favorable market dynamics to move away from our default short position. And I believe we’re getting close to that happening, but we’re just not there yet.
David: So added onto that question a bit, Doug, “A market correction is coming, but when? Could you describe the types of market shorts, timing involved, risks, et cetera?”
Doug: Sure. Over the years, when I’ve explained my process for carefully managing and adjusting both overall short exposure and its composition based on financial conditions and market dynamics, I’ve on occasion been accused of being a market timer. And my response would be, I’m not a market timer, and I don’t know how to time the market. Markets are going to do what markets are going to do. I believe a correction is coming. I expect a long and brutal bear market is in the cards, but I don’t know the timing.
As I’m fond of saying, my job is not to predict, but to be ready to react. I just need to work really hard, remain intensely focused, and have a sound analytical framework and investment philosophy. And all of those provide the tools for being prepared to react to changes in the environment. As for types of shorts, we anticipate shorting that we can— The indexes, sectors, some individual company shorts, and we hope for some opportune timing on put option purchases. We expect listed put options at times to be an important component of our overall short exposure.
It’s hard to believe that we’re in Tactical Short’s fifth year, and we’ve yet to buy a put. I feel good about not losing money on puts, but I really hope to use them to our advantage when the environment begins to change. I’m in no hurry to short individual company stocks, but I am a bit antsy to broaden short exposure with other indices and some sector shorts. But for right now, I’m content to avoid short squeezes, along with these wild sector rotations that continue to cause a lot of grief on the short side.
David: The next question is, physical gold as a hedge versus fiat currencies. “The USA has confiscated gold in the past. With all the current advertising promoting precious metals as a hedge, what is the possibility of the current executive action writing administration to enact confiscation again?”
So just a little look into the past on that, to frame the answer, you might recall that confiscation occurred in 1933 as the Federal Reserve was just learning to walk. I mean, they were 20 years old, but still, from 1913 to 1933, they’d really not been given control of the money supply. And so the argument was a liquidity argument. It was an argument for arbitrarily having the ability to increase the money supply and supply more market liquidity.
Domestic devaluation was a tool in the context of a debt-laden financial system, which had just collapsed, again ’33 is just a few years after 1929 in the massive run-up bubble, and then ultimately the bursting of that bubble. So this quasi fiat money, disconnected from gold, was used as a means of stimulating the economy.
Now I’m not convinced it worked. I think World War II and the demand engine that was cranking for that effort was more powerful than the printing press, but, suffice it to say, all the devaluation tools, if you fast forward to the present, they already exist. We’re post the gold standard. I mean, heck, we’re post-Bretton Woods and well beyond gold serving any monetary function. So the real question is why? Why would there be a confiscation today? If it’s not to control the money supply as it was back in ’33, maybe it’s just an expression of control, that’s possible.
I think what I would say is, make sure some of your metals are in a different geography. Or make sure some of the metals that you own are in a retirement structure, because quite frankly, far more likely that you see control come by the tax code than a literal confiscation. Look at the current context and what’s happening all around us. The Biden administration has already announced a confiscation of corporate assets.
That might take you aback, but think about it. Tax rate proposals to go from 21-28%, that’s an increase in taxes. What if I said the same thing about gold and said, well, the government’s going to keep 75% of any gains that you have sitting in gold. Wouldn’t you consider that to be a confiscation of the reward of being a gold owner? It’s no different than corporate assets being taxed or corporate income being taxed at a higher level. That’s where the control will always be felt. And a part of that is because the compliance requirements fall to you. All they’re doing is lifting the goalposts, making it a little bit harder for you.
So the long and the short of it is, I think there’s a three-pronged strategy. One, own a diversity of metals from gold to silver, to the platinum group metals, to— Like the dog, perhaps in your neighborhood, burry a bone in every back yard. In other words, diversify, geographically. And three, utilize the tax code and the existing retirement structures to protect from a shift in capital gains, should that ever occur. And in my view, that is what is far more likely to happen, than an outright confiscation. So, have metals positioned in an IRA.
Our sister company was the first to put physical metals into IRAs back in the mid ’80s. Incidentally, my dad was one of the three guys involved in gold’s relegalization, January 1st, 1975. Neither here nor there. But I think some of the history gives us an insight into whether the confiscation issue is highly probable or what it might look like in today’s generation, which, I would say, has far more to do with taxation than confiscation.
Next question for you Doug, is, “Do equities’ prices depend more on interest rates, inflation rates, the value of the dollar, or liquidity in the credit markets?”
Doug: Another good question. I guess I would say, some of all of the above, but I do have a strong, analytical bias. The liquidity in the credit market, and I would say financial conditions more generally, are really the driver for market performance. And that’s why I spend a tremendous amount of time monitoring a mosaic of indicators of credit and financial conditions. We’re trying to discern subtle changes in market liquidity, risk embracement versus risk aversion, any policy adjustment that could impact the environment and our positioning. We want to know, is the market leaning risk on or risk off? Are there leveraged speculators? Why consider the marginal source of marketplace liquidity? Are they increasing or decreasing leverage? Are players looking to hedge risk?
I monitor a broad range of credit default swap prices closely for subtle changes in risk perceptions, and as a marginal source of corporate finance, we follow the junk bond market closely. I’ll add that, I believe in this environment it is critical as well to closely monitor global credit and financial conditions. For example, I’m watching China very closely right now. From my analytical perspective, it’s become one highly synchronized global bubble at this point. Markets— it’s really— it’s stocks, bonds, risk assets, generally, they’re all highly correlated around the globe and it wouldn’t surprise me if an international development ends up piercing our bubble. So it’s imperative that we monitor for changes in global credit, liquidity risk-taking and policymaking. So, it’s a comprehensive look at the markets.
David: The next question is, “Do you look for a blow-off top before we hit a major bear market down the road?”
Doug: Thanks for the question. I sure hope I’m right on this one. I think we’re in the throes of a historic blow-off top. I hope that’s not in front of us. I think we’re in the middle of it. If I look at the massive inflows, the huge retail trading volumes, extreme bullish sentiment, conspicuous, speculative excess, these things that we’ve been discussing over the last hour or so, it all points to blow-off excesses. And as I mentioned earlier, excess is beyond anything I’ve witnessed previously. Does it get only crazier? It might, but I do believe we’re in the topping process for a multi-decade cycle here. And thanks for the question.
David: The next question is, “Does the speculative mania in cryptocurrencies and NFTs, non-fungible tokens, represent leverage? If so, can the leverage unwind and cause problems in the broader markets?”
I mean, on the one hand, it’s not leverage, but I think any bubble that reaches those manic proportions, when they burst, it can be felt throughout the financial system. Because typically institutions are interconnected, and you’ve got cross-asset bets at those institutions, which have everyone in the institutions beginning to think very, very differently. So, as Doug mentioned earlier with Archegos, it represents a real moment of honesty, a moment of truth within your prime brokerages and within your financial institutions to say, are we really protected?
Archegos was not about cryptocurrencies, but it was a reminder that a single client can create chaos across, in this case, a half dozen firms. And what we’re seeing right now is that cryptocurrencies are being broadly adopted— popularized across the Fidelity platforms and other more traditional investing venues, which introduces the risk within that asset class into those institutions. And so, I think that’s something to be mindful of.
Now, I will say, as futures have been developed for cryptocurrencies, there you do have leverage. So the CME has options and futures for bitcoin and ether. So they’re not generally available. I mean, there’s several thousand cryptocurrencies, but it’s just a couple of the larger ones there are options and futures for. You have to stop and think about that. Pause and reflect on the old use of those derivative products as a means of hedging production and spreading out risk. And now, futures, it’s primarily about speculation, leveraged speculation, not hedging.
So I think in retrospect, when the chapter on cryptocurrencies is written, you’ll find folks reflecting on the irony of so much value being placed on things like ether. Ether is one of the two that you can get futures and options contracts on. Ether is a noun, which is defined as the clear sky, the upper regions of air beyond the clouds. That’s what people are pretty excited about. Even more ironic is the second definition of ether, which is a pleasant smelling colorless, volatile liquid that is highly flammable.
So, I think you’re right to assume that an unwind is consequential, and, at a minimum, it changes the degree to which speculators are leaning into a trade. And it certainly changes the institution’s willingness to allow it, to accommodate it, even to fund it. So what we’ve called the tightening of financial conditions can cause an unwind. As you see an unwind in one asset, it can reverberate into, and cause an unwind in, other assets. It’s like financial geography where problems in one place simply cross the border and impact another asset class altogether. So, I think the space is definitely worth watching.
And to the question that you asked a moment ago, or answered a moment ago, Doug, about there being a blow-off top, I’d say, sometimes when you look at bubbles, it’s disproportionate, it’s not equally excessive in every category of investment, but you look at Dogecoin up 18,000% in one year, that might be exhibit A or B, C, D, E, or F, in terms of an illustration of a blow off top, 18,000% in one year might be.
Next question for you. “How does the debt, especially sovereign debt, get resolved? There’s a limit to the national debt.”
Doug: Yeah, we’re an uncharted territory with debt levels, as well as central bank monetization. So I’ll be humble here. There’s an extraordinary degree of uncertainty as to how this cycle plays out. I’ll assume central banks, they continue to try to inflate out of debt bubbles, and that this only gives nations more rope to hang themselves with debt. In the end, I don’t see how this massive debt, where we don’t have a lot of default, I don’t see how it can be avoided. But between today’s market euphoria and an eventual default crisis, I would see market upheaval and a crisis of confidence.
This gets to the heart of the problem I see in today’s backdrop. Central banks create trillions of liquidity, which gives markets confidence to buy and lever government debt at extremely low yield. This only encourages countries to keep piling on more and more and more debt. At some point, I expect more discerning markets to begin imposing discipline on profligate borrowers, certainly including national governments.
And I know this sounds a little crazy in these days of financial exuberance, but there’s been a complete breakdown on the market pricing mechanism. At some point, markets should begin fearing an endless supply of increasingly suspect debt in an environment of eventually waning central bank support. I thought it was interesting that yesterday Mohamed El-Erian, formerly of PIMCO, and he commented on Bloomberg, got warning that the Fed was quickly missing its window of opportunity to begin its taper program, expecting market reaction could be somewhere between the 2013 taper tantrum and the 2008 Lehman moment. Of course, El-Erian’s warnings fall on deaf ears. But he’s a keen observer of markets whose insights should not be dismissed. I think this is a dangerous time for global markets.
David: Thanks, and so, a follow on for that, Doug is, “Is it possible that the bond market could stop the Fed’s money printing within the year—the bond market vigilantes showing up, so to say?”
Doug: Sure, I certainly don’t dismiss that. Thinking back to March 2020, it’s important to recall that it was only a couple of weeks from stocks at all-time highs to a crisis and an emergency Fed meeting. Moreover, market liquidation accelerated even after the Fed’s initial liquidity measures. It was becoming clear back then that markets were demanding unprecedented stimulus, and, in the end, they got it. The problem is, the next bout of serious de-risking deleveraging, it’s going to require only greater stimulants, and, in a backdrop, we expect, of heightened inflationary risk. So this will put the bond market in a tough spot.
And as I mentioned earlier, I expect markets to begin disciplining these profligate borrowers. And I wouldn’t be surprised to see the bond market— to see bond market instability, having the Fed thinking twice before launching another massive QE program. But could this unfold within a year? I think it could. Is this, in this global backdrop— I could see a fall-through bubble at the global periphery creating some safe haven demand for Treasurys also.
So there’s a lot of moving parts to the analysis, and I’ll add, a lot could depend on the dollar. We haven’t spoken enough about the dollar today. The dollar, because of fundamental abuse, it’s vulnerable. And while the dollar does benefit from emerging market instability, we have to believe our currency is unsound after decades of abusive policymaking. So the scenario of a disorderly drop and the dollar sparking bond market instability is— it’s anything but far-fetched. And that’s the scenario that would have the Fed in a quandary with more QE. Thank you for your question.
David: Doug, it makes me think, and this is a good segue into the next question, but it makes me think: the markets have behaved like so many children on a playground with doting parents. If something goes wrong, the markets scream, the parents come running, everything’s put right. And so there’s moments of high drama, but there’s nothing really catastrophic.
The next question I think is interesting, because it looks at a different style of bear market. One that an entire generation of investors has no experience with, but is not that far removed from us historically. So the question is, “Is the tactical short designed more for short-term bear markets, like 2000 to 2003, 2007 to 2009, or more for long-term bear markets like 1966 to 1982? So far, you’ve been reluctant to boost short exposure because of the risk of short squeezes. And I totally understand why. That said, if you were to have a short-term correction of 50%, I feel like it’s likely that the market could easily fall 20 or 30% before you would boost short exposure. With short exposure of around 60%, a lot of that initial downside move would be captured, but not all. Perhaps it’s just the price you pay for a safer short product.”
So the bottom line, Doug, for the question is, is it designed, is Tactical Short designed, to capitalize on short-term bear markets or long-term bear markets? And if tactical short was designed for, in essence, is it the once-in-a-lifetime or the long, one-off move like 1929, or the long-term grinding out bear market where actually a part of the negative return comes from inflation? There’s that dollar thematic back in view.
Doug: I love the question. Comprehensive question, but I would say that we’re striving for a longer-term hedging product that can provide downside market protection, but at the same time survive major market rallies and volatility. We don’t want to be like these other short products that get completely slaughtered right before payday.
Managing short exposure, especially from our investment philosophy, it demands a short-term focus. We can’t sit and say, “Okay. We’re going to position for where we think the markets are going to be in a couple of years.” That’s not advisable. We’re today surely not positioned for a once-in-a-lifetime bear market. We’re conservatively positioned for withstanding a blow-off, upside blow-off. We’ve got to survive to be able to profit from what I believe is an approaching major bear market.
We’ve structured the product to be, as David talked to you at the beginning, tactical and flexible. We want to be able to navigate whatever market environment we’re confronted with. It’s been a great challenge, but we refuse to be like the other bear products that are risk-indifferent. Always fully short, no matter what. Always short stocks, no matter what. Their strategies, they’re easier to execute, but their management shortcomings, risk management in particular, have been exposed. I’d be really disappointed if the market was down 30% and we hadn’t significantly adjusted exposure. If there’s a sudden market shock, that could happen, but usually there are initial signs of stress that we can react to. At least that’s the way things have generally played out throughout my career.
Typically, bear markets, they would unfold over months, and at times years, with the biggest percentage declines usually coming at the end of the bear market. On the short side, you can build some really solid performance by compounding returns over the course of the bear market. Also, I want to be clear. I prefer a lower beta strategy on the short side to high beta. When I’m working to recover losses, I manage risk especially diligently. I’m willing to take more risk with profits. Others, they’re willing to roll the dice when trying to dig out of performance holes. I’m not, we’re not. I’ll add that my management challenge is reduced when the Fed faces some restraint and when markets are no longer responding so dramatically to central bank policy measures. Those are excellent questions. Thank you for your questions and for your support.
David: The next question is simply precious metals versus cryptocurrency. I think the easiest answer is, they’re not the same. We’ve got bitcoin, which has been around since about 2008, and that’s the oldest of the cryptocurrencies. I hope this doesn’t offend, but I think an analogy might be helpful. If you’re thinking about precious metals versus cryptocurrencies, you might think about a goose down jacket versus a bikini. We’re talking about textiles, but each offer a very different sort of coverage and a very different sort of environmental protection. Obviously, one is thought of as sexier, but I can promise you, if the weather is ever nasty and cold, only one has its proven merits.
I think the great contrast between those two, gold and cryptocurrencies, is between speculation and something that, more basic and boring, has been treated as money for 5,000 years. It’s been a secure and reliable store of value. I think one of the ironies just by using that analogy of the— or the word picture, rather, of the goose down jacket versus the bikini, believe it or not, if you’re looking at a pile of gold versus a bit of computer code, it’s actually gold that raises the eyebrows and catches your attention.
Now, I realize this may have been a totally inappropriate word picture, but some people say that cryptocurrency is far superior in the 21st century to gold. I think what they’re forgetting is that they have not been environmentally tested. They have not been put through various ringers. What are all the ringers that you might expect from something that needs to be considered reliable, tested, a store of value, a store of wealth through time? How does it behave when the rules change? How do you operate if the system is not particularly reliable? What does it look like if you have markets that are correcting and institutions which are no longer interested in trading a particular asset?
The nice thing about gold is that it’s very, very basic. In fact, it’s elemental, and so the 21st-century approach neglects the thousands of years of history which give us human experience. The human experience in each of the stories of what gold does in the context of crisis, I think it’s very difficult to duplicate that or to somehow pretend that cryptocurrencies are exactly the same. We may be talking about textiles, but we’re talking about, again, a very different kind of coverage and environmental protection.
The next question is thoughts on bitcoin as a hedge against the existing global macro environment. Then a secondary question from this person is, “What is your opinion of MTA or Metalla Royalty and Streaming?” Probably, judging by the last response, I would describe bitcoin, amongst other cryptocurrencies, as a speculation, not as a hedge. As for the global macro environment, it’s a big term. Global macro environment can include a deep dive on geopolitical considerations, economic considerations, public policy considerations, financial market dynamics. So to figure out if bitcoin is a hedge against any of those things or all of the potential negative ramifications that flow through from geopolitics, economics, public policy, it’s just not clear to me what problems bitcoin solves in any of those spheres.
I understand that it’s considered to be private and portable. Certainly there’s no argument in terms of its portability. I do even question the notion of its privacy. I question the privacy aspects because even look at last week’s Treasury Department targeting of Russian IP addresses connected to cryptocurrency assets. Again, this is a very concerted effort to say, “These are people trading in cryptocurrencies, and we are going after them.” I don’t think there’s anything truly private on the web. Portability perhaps on a thumb drive. Great. The merits that it is supposed to have, I’m not sure it actually carries.
Metalla, the second part of the question: okay, the company owns a number of streaming contracts or royalty contracts with existing gold miners. In the future, perhaps it’s interesting as an investment. I would not find it particularly compelling. I do not find it particularly compelling. It has zero earnings today. It has a fairly large market cap, $400 million for a company that doesn’t make any money. I guess if you look at what we’re learning from the tech space, you don’t have to make money to be a big deal.
In my mind, if you’re talking about a gold company, a gold investment or something that’s relating to gold and silver royalty or streams of income from existing miners, I would like to see a company that’s actually making money. I like royalty companies in general. I like the streaming companies in general. But I prefer that they have earnings, that, yeah, dividend policies means something.
Metalla has a dividend policy. It’s a healthy dividend policy. They just have never paid one because they’ve never made any money. Someday maybe they’ll pay a dividend, but I’m curious how a streaming company is unable to make money with gold between 1,500 and $2,000 an ounce. That’s interesting to me. My preferences are elsewhere in that space. Within our other asset management strategies, the hard asset strategies, we own a number of companies that fit that bill. Again, earnings, as evidenced by payable dividends, that’s a little bit more interesting to me.
The next question. I think I’ll take this one too. It deals with SLV. “I understand SLV has changed their rules or commitments in light of last month’s artificial run-up in silver. Can you explain their changes and the implication of same, if any?”
That’s a good question. ETFs create baskets, and they do this on a daily basis. ETFs create baskets which hold the underlying asset and serve as the supply for when demand increases. As demand increases for a particular investment, you create more baskets and it holds the assets inside. When demand for physical silver increased a month or so ago, the concern was that there would be insufficient physical silver in order to create the newly created baskets. You have to have the actual asset to go inside. If you can’t get the actual asset, then you’re just going to have to stop creating the baskets that hold it.
They announced that under certain market conditions they would not create more baskets. Ergo, the number of SLV units would temporarily be stagnant. If demand remains and supply of SLV units is stagnant, then the price increases, in which case you have a divergence where the SLV unit is trading at a premium to the underlying product. I hope that’s clear.
In the case of diverging from the silver price, you have a premium on the underlying product. In essence, what SLV was doing, they were saying, “We need to disclose the potential for a price divergence considering the possibility of being unable to create enough units to meet current demand.” That’s it.
The takeaway is that for a new buyer of SLV, in that case, if and when that happens and they’re not creating new units, you’re paying above the spot price for silver, and may not recover that premium, because you paid a premium and it can go away. As fast as it’s there, it can be gone.
For the existing holder, the premium price is a benefit to your position. Frankly, if the premium is large enough, it may give you an opportunity for arbitrage. We did this a few years ago with the Central Fund of Canada product, CEF. It’s a combination of gold and silver. We looked at the silver value, just the silver value in the product, and this was before Sprott butchered that product, by the way. It traded with a premium because it was structured as a closed-end fund, which gave it similar characteristics to the SLV in limited supply as they were disclosing. Similar scenario in that there would be a set amount of supply.
Demand increased for these CEF units. It traded at a premium. We captured, I think, a 9% gain in silver ounces when we moved, ironically, from CEF to SLV. Bottom line is, what SLV did was unnecessary disclosure. There was nothing to be concerned about. If anything, it’s a pre-announcement of the existing SLV holder standing to benefit from the supply and demand dimensions with within a tight space, within the silver space. Hope I didn’t bore you to tears.
A question for you, Doug. “When will the investing public come to the undeniable conclusion that the Fed put is ineffective at supporting the stock market? Like other central banks around the world, will the Fed, in an act of desperation, start to purchase equity ETFs?”
Doug: Good question. The proliferation of ETF products, it’s been such a key aspect of the mania and it’s integral to the speculative bubble till we’ve gotten to the point, if you want to make money, just buy an ETF. If you want to make a lot of money, well, there’s ETFs for that as well.
Now, I spoke earlier about the critical role perceived money and money-like instruments are playing in today’s bubble. Since the post-2008 crisis reflation, I’ve referred to the moneyness of risk assets and the intervention the Fed and QE in particular created the perception that these risk assets, and certainly include ETF shares, were safe and liquid stores of value. Sure enough, ETFs have for the most part enjoyed insatiable demand over the past decade.
We saw, and it was brief, but what happens when certain ETFs lose their perceived moneyness in March 2020. There were popular investment grade corporate bond ETFs that quickly lost 20% of their value. ETFs that invest in less-than-liquid assets, they’re an accident in the making. That experience, it should have been a learning moment for the public, but the Fed bailed out the system so quickly that another lesson was learned. It was reinforced that the Fed really does have everything under control and will protect the moneyness of ETF shares, and, as I said before, risk-taking was emboldened.
To answer your question, I’ll assume the public doesn’t come to that conclusion until they’ve suffered huge losses and Fed efforts to reflate the markets have been unsuccessful. It’s all a setup for one major— I’ll call it catastrophic crisis of confidence, a crash, but we can assume the Fed will try to come to the market’s rescue.
These rescue efforts will likely drag the process into a long and especially grueling bear market. I assume that the Fed does at some point buy stock ETFs. They said after the problem with the fixed income ETFs that they would buy some ETFs that even included junk bonds. But they’ll also be buying huge quantities of Treasurys, mortgage-backed securities, corporate bonds, munis, and derivatives. In general, I expect the next big round of Fed QE, it will prove very alarming to the markets. Thank you for the question.
David: Next is kind of combined comment, compliment, and question. “In a market without Fed intervention, I can’t think of a better time to be short the epic stock bubble, but I’m hesitant due to the never-ending Fed intervention. If you can convince me that there’s a scenario that the Fed is ultimately destined to fail, I would be very happy to have your firm manage a meaningful percentage of our investment assets going forward. I’m incredibly impressed with Doug Noland’s incredibly insightful analysis of the increasingly unstable and deeply maladjusted credit markets around the world. The world owes Doug a debt of gratitude for being one of the very few analysts to warn the investing community of the gravest risks the world faces when the epic bubbles inevitably pop, with consequences unimaginable. Thanks.”
I’m going to say a word or two, Doug, and then perhaps you want to add something to it. I think being short makes sense as a hedge, and has become compelling as a speculative directional bet as well, for all the reasons that Doug has explored today. If you’re talking about timing, even some of the technical reasons we provided in the Q&A.
As far as the Fed’s interventions are concerned, I would keep this in mind. Our alternative strategies also make sense. Some people would say, “If you don’t know where you’re going, any road will get you there.” Which is one of the reasons why we refer to our accounts as the MAP strategies. It’s an acronym which differentiates the kinds of strategies that we have, but I think we do know where we’re going, largely. We’ve put together portfolios that are risk-managed, cash-heavy, hard asset-focused, diverse holdings of real assets across the categories of global natural resources, infrastructure, specialty real estate, and precious metals mining companies.
In essence, we don’t have to fight the Fed. The hard asset strategies already recognize that monetary and fiscal policy largesse are in fact consequential, and we’re positioned accordingly. On the short side, when the weight of financial market instability collapses in on itself, we are positioned for that as well. Doug, do you want to add any comment to that?
Doug: Yeah. I would just add I’m deeply appreciative of those kind comments and we would be honored to manage a part of your wealth in Tactical Short and/or the MAP strategy. Thank you.
David: A question here on annuities, “Your thoughts on short-term, high-quality, fixed annuities in place of CDs.”
This is easy. I don’t like them. Fixed annuities are only an interesting vehicle at the end of an interest rate cycle, so at the opposite end of the interest rate cycle. I don’t like them because you’re locked up. You have low visibility on the underlying invested assets. You’re dependent on questionable counterparty risk, and most insurance, not all companies, but most insurance companies churn you and nickel and dime you to death. To me, it’s only worth it if you are willing to pass on the long-term risk to the insurance company of a guaranteed fixed rate north of 10%, which you’re not going to find that in this interest rate environment, because then at least you have that one thing, a high rate of interest fixed for a long period of time. At least you’ve got that going for you. Sorry. Not a particular fan, unless you’re in a different part of the interest rate cycle.
Doug, we have two questions from online, which one we’ve covered a little bit. Jeff asks, “So which way does the system in markets break? Outbreak of broad-based sustained inflation or deflationary collapse with massive debt as asset values trend lower?”
Doug: Yeah. If I had to guess right now, I would say we could have surprising upside consumer inflation with really painful losses in the asset markets—asset market deflation. You could see an unwinding of speculative leverage causing dislocation and panic in the asset markets. Meanwhile, ongoing QE and global excess could support continued rising inflation for consumer goods. I don’t think it’s— For years now, it’s been the inflation/deflation debate, and I’ve always argued, it’s not that simple. It’s not that simple, and especially after the melt-up we’ve seen in central bank credit corresponding with melt-ups in asset markets. I think that makes me certainly lean towards this scenario of deflation in asset markets, inflation in consumer prices.
David: To add to that, Doug, a couple of years back, on our Weekly Commentary, the podcast, I interviewed Charles Calomiris, who had written the book Fragile by Design: The Political Origins of Banking Crises and Scarce Credit. Essentially, when you think of bubbles, busts, and the consequences of those busts, there are a series of political choices. The winners and losers—it’s no accident. There is a sorting process as to who wins and who loses, both in the context of the bubble phase, but also in the bust phase. I think it’s fair to say that if you’re talking about which way does the system break. I agree with you in terms of the consumer price inflation. When you’re talking about a deflationary collapse or a shrinkage in the value of particular assets, now you’re talking about, who’s on the right list? Are you chosen as a winner or loser?
It’s a fascinating commentary. I would encourage you, if you’re curious, to look at the book. I think we interviewed with Charles back in January of 2019, if I’m not mistaken. Again, you see that actually the construction of the credit markets and the inherent frailty was by design. A part of that designation is who the credit is intended to flow through to, and in the midst of cleaning up the mess, again, who gets a bright light of salvation shined on them and who gets to go the way of the Dodo bird. You can have a deflationary collapse where— Not all assets are created equal, some do quite well, some don’t, and there is some political favoritism that’s showed in the midst of that. Kind of an interesting or different take on the question. Fragile by Design, Charles Calomiris. One more question, Doug. Why can’t the Fed up the amount of U.S. Treasurys purchased and thereby preempt the market from pushing yields higher due to sustained inflation?
Doug: Well, the markets would question if this additional QE is only going to worsen the inflation backdrop, right? You can’t just continue to print money forever. I would also argue, when the central bank creates liquidity, this liquidity is directed wherever there is an inflationary bias. We’ve seen that overwhelmingly in the asset markets over recent couple of decades, really. Well, now we’re seeing this liquidity going into commodities. It’s increasing wages. This flow from the central bank balance sheet, that liquidity into the economy is shifting now. I think that shift is going to increasingly make the bond markets nervous.
I touched on this earlier. We could get to the point where the bond market wants the Fed to rein in QE to support the bond market and support the perceptions that inflation is under control, and that changes everything. I don’t think just buying Treasurys indefinitely can solve the bond market’s issues. We’re already seeing these deficits, $3 trillion deficits is basically we’re going to have massive deficits, massive supply as far as the eye can see. There needs to be some discipline in the marketplace.
David: To some degree, hasn’t that already happened, Doug? I mean, if you look at the last six to 12 months of behavior in the U.S. Treasury market, we see the 10-year Treasury march from 60 to 70 to 80 to 90, to 120 to 175 basis points. It’s off of those peaks today, not by a whole lot. Yet, this is not with permission from the Fed. This is in spite of $120 billion in monthly purchases of mortgage-backed securities and Treasurys. In fact, you are seeing something of a discipline being brought and the bond market showing up and saying, “Yeah. Well, regardless of what’s said in terms of this notion of transitory inflation, we don’t buy it and it’s time to start repricing.” Isn’t it fair to say that we’ve already seen the market preempt as opposed to the Fed preempt in the interest rate market?
Doug: Yeah. Fair enough, but I mean, yields have started to rise, but we haven’t seen any discipline imposed on borrowers yet. I think the next significant market yield rise, that will be a different story. That one will be more destabilizing, especially if we start to see the rising yields in corporate debt, especially junk bonds, even investment-grade. We haven’t seen rising yields lead to any slowdown in debt issuance whatsoever. That’s what I mean by discipline. We need corporations to back away from borrowing because of the bond market. We need Washington to say, “Wait a minute, can we continue to run these deficits with these yields moving higher?” We’ve got a little ways to go on that front.
David: Well, we want to circle back around to where we began. We’re at the end of our conversation today and the Q&A. We appreciate your participation in the call. We hope this is helpful for you in understanding what’s going on in the financial markets. There’s a lot of detail. I would encourage you to either get the transcript, which will be out within the next four or five days, or if you want the full-length audio recording, that’ll be available in even less time, to just review, because I know we’ve covered a lot of details and there’s a tremendous amount of complexity.
Our hope is that we’re able to bring some insights that allow you to make wise decisions for your family, for your own personal wellbeing and wealth, and that whatever challenging market environments we have in the future, that you’re well considered in all the ways in which you can navigate that. Mitigating risk, taking advantage opportunistically here and there. We’re grateful for the time you spent with us today. We’re grateful again for our valued account holders. We look forward to you joining us again next quarter as we look at the second quarter of Tactical Short. Thanks so much for your time today.
Doug: Thanks so much everyone, and good luck to you out there.