Tactical Strategy Transcript – October 18, 2018

Tactical Strategy Transcript – October 18, 2018
MWM Posted on October 22, 2018

David:  Hi folks, we will go ahead and get started.  This is David McAlvany and Doug will be here in a few minutes.  Welcome to the Tactical Short Third Quarter 2018 Conference Call.  It is an honor for us to work alongside you in your financial endeavors and provide a service that we hope is adding value by protecting against the downside and doing what we do best from an analytical perspective in complement to what else you may be doing in your investments. 

There will be transcripts available next week if you are interested in a re-read or looking back at it.  And then if you want to listen to the program again, the audio should be available next Monday, in a couple of days, and we will have that out for you.  If you want to listen to it again or if you would like to forward it to someone that you think should hear what you hear in the next little while from Doug, then again, next Monday or Tuesday feel free to post that and send it on to friends or colleagues.

The flow of the call will be something like this.  I have a few opening comments, then we will gain Doug’s perspective on the return of global contagion and then we will wrap up with the questions that you provided and our best efforts to answer those as we go through one by one.  I will be answering some of those questions where appropriate and we always give Doug the really respectable questions (laughs), the ones that are more challenging I always punt to Doug.

I will start with a few observations and just a reminder of what Paul Volcker said a number of years ago, which is that every ten years or so we have the worst crisis in 50 years.  If there is anything that we shouldn’t be surprised by in the financial markets, it is that we do have ebb and flow.  It is really not that difficult, and looking at the math of it, we have talked about the Tactical Short as being something that captures the other 40%.  60% of the time the market is going up, 40% of the time the market is going down.  

Downside volatility can set you back considerably, and so what we endeavor to do is complement what you are doing on the long side by muting the effects of the downside and off-setting some of those issues which require a tremendous amount of patience and longsuffering if you are not adequately hedged on the long side. 

From a valuation standpoint, just a few comments.  None of these are tradeable.  There are no actionable steps that can be taken when you are looking at valuations, but valuations do give you an indication of the environment that you are in, of the waters that you are swimming in, so to say.  And so, starting with the Buffet indicator, a gentleman who is famed for wondering what is happening when the tide goes out, and who is swimming with appropriate clothing or lack thereof.  

The Buffet indicator compares the scale of the financial markets.  This is drawn from the Fed’s quarterly Z1 balance sheet, and it compares that to GDP, the total scale of the economy.  The last number was at 144%.  That is, financial assets selling at a premium to the underlying economy.  It has only been higher once, at 161%.  That is the all-time high back in 2000.  So we are the second-highest reading in history.  Again, that is not an actionable item but it does certainly tell you where we are.  And then in terms of continuationable trend, you are in a latter not an earlier one.  So second highest reading in history.  

But it is interesting, back in February of this year, and we were only a few percentage points different at that point, Mr. Buffet said that it is still on the cheap side.  And for those of you who are familiar with some who taught their book you have to wonder if perhaps that is what was going on. 

So still on the cheap side, second-highest in history, makes us say, “Hmm.” The Q ratio is another valuation metric put together by Professor Tobin, Nobel Laureate.  It draws from the same Z1 report, a very helpful report.  And again, it is the second-highest valuation in history.  This is what the Q ratio is, the premium that you are paying over the replacement cost for the assets of a business.  So what would the basics of that business cost if you were just starting from zero when it opened as a business, and what would you have to spend to buy the assets to do it? 

Generally, you want to buy at discounts and sell at premiums.  That is a reasonable way of making money.  And in our case, maybe you even want to sell short at some point if you are selling at premiums which are suggesting that you are on the high side, because after all, markets are mean-reverting, never work off of an average, but are constantly moving one direction or the other.  The Q ratio tells us that we are in that nosebleed section. 

The Shiller PE, for those of you who follow the ten-year rolling average of the price earnings ratio, we started the month here in October at 32.6, precisely where we were in the September/October period of 1929 – 32.6, so a little bit of an echo from the past.  That’s puts us at the 97th percentile, only exceeded once, and that was in the year 2000.  Really, what it suggest is that over the next 10-12 years, a long-only portfolio is going to return somewhere in the neighborhood of 0 to negative returns on an annualized basis. 

The other thing I wanted to mention – those are your valuation metrics just as a backdrop – sentiment.  What is the sentiment in the marketplace?  Margin debt is worth considering.  It peaked at 669 billion in May.  Why margin debt is important to keep in mind is because we put capital to work in the markets – we do, as individual investors – and it is on the basis that we think we are going to see some reward for the risk that we take.  So we do that with our own money, with our own savings, and can start borrowing house money on the basis of what you consider to be a lay-up.  You are now expressing, not only a little bit of confidence, but a lot of confidence.  

So here we are in May at 669, we have ticked down a little bit since then to about 650, I believe, here more recently.  We are sitting at 3.3 times higher than the level when this bull market commenced.  Of course, this is a record, in nominal terms.  But if you want the historical perspective, because the currency has been inflated through time, and so what is a dollar today?  A billion here, a billion there, a trillion here, a trillion there – what does it mean?  Relative to GDP, relative to stock market capitalization we are also at a record.  So at 3.2% of GDP, margin debt far exceeds purchases in 2000 and 2007 which were more in the 2 to 2.25 range, maxing out at about a 2.5% level. 

Not measured in that margin debt number is the proliferation of leveraged products in the form of ETFs and ETNs which allow you to gain a multiple on an index or a particular asset class.  We’re talking two, three, four, five times leverage embedded in the product.  So we have the margin debt numbers, but it only tells part of the story in terms of leveraging the system. 

Doug is going to spend the majority of our time today exploring leverage in the system, and where we are beginning to see the fragility within the financial system reveal itself, and move, as we said in the last conference call, from periphery to core.  We could look at a host of surveys which tell us there the manufacturing sentiment is and consumer sentiment is, and they are all, shall we say, at perky levels.  

Doug, if you would, join in here, and I will hand the conference call over to you and then join back in for the Q&A. 

Doug:  Thanks, David.  Good afternoon, everyone, and thank you for taking the time to jump on today’s call.  As always, special thanks to our account holders.  We greatly value client relationships.  I will add here also that I really enjoy the opportunity to spend time with some of you last month at the annual MWM Investor Conference, and I am already looking forward to meeting more of you investors next year in Durango.  

I will begin, as usual, with some general information for those unfamiliar with Tactical Short.  More information is available at mwealth.wpengine.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 we believe, extreme risk.  

This strategy is designed for separately managed accounts, SMA.  We have made it investor friendly, with full transparency, flexibility, reasonable fees, and no lock-ups.  We will short securities, stocks, ETFs.  We will on occasion by liquid listed put options, and as always, shorting entails unique risks.  We are set apart both by our analytical framework and uncompromising focus on identifying and managing risk.  That is our bread and butter. 

We tactically adjust short exposure.  We expect to be generally between 50-100% short.  Our current exposure is 64%.  We believe current market downside risk is extremely high, yet we also recognize the elevated risk of being short.  We believe that risk versus reward calculus for shorting has improved markedly since our January call.  Often we are asked for our suggested tactical short allocation size.  Now, that is actually a question we can’t answer very specifically without a clear understanding of a client’s overall investment holdings, their financial objectives and risk tolerance. 

Tactical Short allocation decisions tend to be very client-specific.  In general, however, we believe a 5-20% allocation to Tactical Short is integral to a well-diversified investment portfolio.  We are no proponents for aggressive bearish bets against the stock market.  We do see a market environment with extreme risk that beckons for a disciplined approach to risk management.  

Since Tactical Short inception back in April of 2007 we have been navigating through a very hostile marketplace for shorting.  From inception to the end of Q3 the S&P 500 returned 27%.  During that period the NASDAQ 100 returned 43%.  We have been defensively positioned with our disciplined risk management approach helping to mitigate losses.  

We believe the global market environment is in the process of a very important transition, likely momentous change that I will discuss shortly.  We anticipate an opportunity to be more opportunistic in our portfolio of shorts composition in the not-too-distant future.  

Let me repeat what I stress in every call.  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, and especially in this type of market environment.  We structure Tactical Short to ensure the flexibility to navigate through even the most difficult market condition, and sure enough, they have been exceptionally challenging.  The third quarter was no exception, with most major indices surging to all-time highs. 

I will update performance.  Tactical Short accounts, after fees, lost 4.67% during Q3.  The S&P 500 returned a positive 7.71% during the period.  As for one-year performance, through September 30th the Tactical Short was down 8.66%, and is versus the 17.90 positive return for the S&P 500.  We regularly track our performance versus three actively managed short fund competitors.  First, the Grizzly Short Fund lost 3.55% during Q3, and over the past one-year period was down 17.83%.  The Ranger Equity Bear Fund was down 5.64% for the quarter, a comparable one-year loss of 12.49%.  The Federated Prudent Bear Fund lost 7.59% for the quarter, and was down 18.44% for one year.  Over the past year, Tactical Short outdid these three funds by an average of 700 basis points.  

The benchmark performance versus the inverse of the S&P 500, over the past year Tactical Short’s 8.66% decline was about 48% versus the S&P 500’s return.  This has been really tough, and candidly, had we known at the time that the S&P was going to rise another 27% we would have further delayed the launching of our short products.  It just really frustrates me to lose money, and the 4-2/3 percentage point loss for the quarter was especially hard to swallow.  It was an exceptionally challenging quarter, and not just because stocks were strong.  

I will attempt to explain why it was such a challenge from an investment process standpoint.  I won’t bore listeners with long explanations and minute detail.  Over my investment career, the thrust of my investment philosophy for managing short exposure can be boiled down to the old, “You got to know when to hold ‘em, when to fold ‘em, when to walk away, and when to run.”  I use a mosaic of indicators in investment analysis, along with risk and trading disciplines to manage the size and composition of short exposure. 

We started the year at 22% short and took exposure down to 16% in January.  We were at 24% short for the February 5th downdraft.  Short exposure was ended February at 38%, March at 52%, and then closed out the second quarter at 62%.  Exposure was taken to as high as 64% in mid-August, and cut to 56% by late August.  Exposure ended September at 59% and it was increased to 52% the first week of October.  Short exposure was near the highest we have had in Tactical Short for last week’s sell-off.  

It was a very difficult call on exposure during Q3.  The market was going against us and we were losing money.  Meanwhile, my analytical framework was indicating a significant tightening of financial conditions globally.  In contrast to the beginning of the year, analysis of the backdrop made me hesitant to cut exposure too significantly.  You’ve got to know when to hold ‘em, and when to fold ‘em.”  

My top-down analysis of the market backdrop argued for not folding, to maintain moderate short exposure.  Market risk was high and rising.  Tactical Short accounts have a mandate to provide protection against a market drop, but to do so with a keen focus on risk management.  My analytical framework has been pointing to elevated and mounting market risk.  Importantly, global markets succumb to risk-off dynamics, with a resulting dramatic tightening of financial conditions.  The emerging markets have experienced contagion and unfolding crisis dynamics.  It erupted in Argentina.  Interest rates there were hiked to 60% to halt currency collapse.  Rates were then hiked 24% to support the Turkish lira.  

China is indicating acute financial and economic fragility.  Since the last crisis, China’s financial and economic exposure to the emerging markets has expanded significantly.  There is also a domestic credit slow-down, rising risk aversion in equities and credit.  It has been a virtual equities market collapse.  China also has an out-of-control mortgage and apartment bubble that is vulnerable to destabilizing busts.  

Globally, yields are rising almost across the board.  Local currency bond yields have surged, in some cases by hundreds of basis points.  Dollar-denominated debt, a key source of international finance for companies and countries alike, has seen surging yields and sharply reduced issuance.  

In Europe, we are again seeing indications of growing instability.  Most notably, instability has returned to heavily indebted Italy.  The new anti-establishment and anti-Brussels government is pushing to increase government and deficits.  We have seen a sharp market reaction with surging yields, up 150 basis points, almost 3.6%.  

We are witnessing global re-risking and de-leveraging dynamics that have gained momentum.  This has major ramifications for global market liquidity.  When risk embracement dominates, expanding speculative leverage creates self-reinforcing liquidity throughout securities markets.  Risk aversion, on the other hand, leads to de-leveraging and a destruction of liquidity.  

CBB readers will be familiar with my phrase, “Periphery to core crisis dynamics.”  This year we have seen de-risking, de-leveraging, and faltering liquidity at the global periphery, specifically, within the emerging markets.  This is contagion.  Risk aversion and waning liquidity in one market, leading to fear for the next vulnerable domino to fall.  At first, market perceptions change at the margin.  Bullish analysts contend so-called idiosyncratic country issues are responsible, only for fears to turn more systemic over time.  

We have seen contagion effects globally over recent months, but we have also witnessed something that may seem counter-intuitive – the dynamic where instability at the periphery has fueled financial flows to the core, specifically, to U.S. markets.  International and hot money flows have stoked already highly speculative U.S. markets, fueling a speculative blow-off right into the face of weakening fundamental prospects.  That was the great challenge during Q3 – how to position in a deteriorating global bubble environment, with escalating risk for U.S. markets in the face of what was essentially a speculative melt-up in U.S. stocks. 

Let’s shift to portfolio composition.  The high-risk environment for shorting has beckoned for disciplined risk management.  We have managed overall short exposure carefully, recently about 60% short.  A very disciplined approach has been taken with portfolio beta, or the expected volatility of our exposure.  That is crucial.  We have been focused on avoiding short squeezes and minimizing risks associated with expected volatility and violent rotations.  My experience and study of history inform me that things tend to turn crazy at the end of long cycles.  I clearly recall 1999, but I also recognized that ultra-low rates and QE make this cycle unique in history. 

I believe we are putting in a major long-term top in U.S. equities.  Topping processes can be frustrating, exhausting, and costly to play on the short side.  There is added uncertainty and confusion in an already speculative market backdrop, greed interrupted by abrupt bouts of fear.  The topping process sees, indecision and volatility, wild sector rotations, performance chasing, and crowded trades.  There is a prevalence for short squeezes.  

First, if you have short positions they tend to increase because of the dimming of fundamental prospects.  There is also increased hedging activity, but the longs still generally dictate the markets with the shorts having low tolerance for losses.  Using another gambling analogy, the longs are sitting confidently at the table with big piles of chips, snickering at the lowly shorts with their little stack across the table.  

There is market inertia.  The nervous bears begin to draw better cards, but for a while the longs have the wherewithal to bet aggressively and bluff.  Analyzing current market trading dynamics, it would appear the hedge funds have been on the wrong side of many trades.  For too long, too much liquidity has chased too many crowded trades, creating treacherous trading dynamics.  Many popular short positions have out-performed the market, while the favorite longs have often under-performed and traded erratically.  It has made it easy to lose money and under-perform the indices which fuels more outflows from active managers, and inflows into passive index products.  

As an industry, hedge funds have been badly lagging the indices this year, creating intense performance pressure.  This dynamic helps explain choppy markets and strange internals.  Those that integrate risk analysis in their investment process have under-performed and lost assets.  I want to stress that this is a highly unusual market environment and we have been positioned anticipating chaotic market dynamics.  We prefer to remain out of the fray.  

It is when the markets rally strongly in the face of deteriorating fundamentals that my job turns especially un-fun.  Our over-arching objective has been to minimize outsized losses.  We have done a decent job managing risk through an extremely difficult period.  We have survived a major speculative melt-up in the market topping process, and can now move forward without huge losses to recover.  

Let me segue from portfolio composition, which has been largely dictated by top-down analysis, to some additional macro-analysis.  As many of you are familiar, my thesis holds that we are in the throes of history’s greatest global bubble.  Moreover, the global bubble was pierced at the periphery earlier this year.  Global financial conditions continue to tighten meaningfully.  That Italy has been drawn into the global instability is a significant development.  I have referred to Italy as the periphery of the core because of the scope of its weak banking system and financial impact on the greater Eurozone, de-leveraging in Italy has far-reaching consequences. 

As I have mentioned, Q3 saw further tightening of global financial conditions, risk aversion, and waning market liquidity.  We believe risk-off has attained important momentum in global markets, although we expect the usual ebb and flow of confidence in market trading action.  I believe de-risking/de-leveraging dynamics have become self-reinforcing.  Moreover, U.S. market instability, to begin the fourth quarter, indicates that crisis dynamics afflicting the periphery are nearing the core.

Back in February I noted parallels between the blow-up of short vault products and the June 2007 collapse of two Bear Stearns structured credit funds, marking the beginning of the end of subprime and the mortgage finance bubbles.  Back then it took 15 months, including new record highs in U.S. stocks, before the onset of full-fledged crisis.  Contagion effects from this past February’s instability spurred risk aversion at the periphery, fragile emerging markets, acutely vulnerable after rampant hot money and speculative blow-off dynamics.  Fragility worsened by waning global QE.  What started in Argentina led to contagion effects for EM more generally.  I have called the EM crisis the second phase of the bursting global bubble.  

Allow me to back up this analysis with just a few data points.  Let’s start with EM currencies.  Following QT’s 30% drop in IMF bailout the Argentine peso fell another 30% during Q3.  Argentina’s ten-year dollar yield surged almost 200 basis points.  We saw the Turkish lira sink to 24%, their yield surging above 21%.  Other EM Currencies under pressure during the quarter – the Indian rupee down 5.6%, the Russian ruble down more than 4, Brazil down more than 4, Indonesia about 4, South Africa down 3.  Yields spiked throughout emerging markets – 400 basis points in Turkey, 200 in Brazil, 100 basis points in Indonesia and Hungary.  Issues in the emerging markets have led to significant downward revisions to global growth prospects.  

In China we see a country facing very serious issues.  The Shanghai Composite is down 25% year-to-date.  The CSI 500, 36%, and the gross stock China X index,  31%.  Chinese stocks were hit again hard today.  Credit growth has slowed with a contraction of shadow banking credit, yet household mortgage borrowing has continued to expand % annually.  

China’s currency was down 3.6% during the quarter, and now has a year-to-date loss of 6.25% versus the dollar.  China’s international reserve holdings were down 23 billion in September, indicating heightened risk of a return of destabilizing capital flight.  Keep in mind, the Chinese international reserves peaked at about 4 trillion in mid-2014.  China’s system worries and capital flight saw these reserves drop to almost 3 trillion in early 2017.  Now after a weak recovery, reserves are shrinking again.  

To counter its faltering bubble, Chinese officials are loosening conditions again with, I believe, significant risk to their vulnerable currency.  China’s maladjusted economy now faces a series of major risks, including slowing domestic demand, risk of a collapse of their historic apartment bubble, major EM downturn, massive over-capacity, an unfolding trade war with the U.S., and I could go on and on.  

Markets have perceived that Beijing has everything under control.  This faith is beginning to crack.  I believe we are now commencing the third phase of an unfolding global crisis dynamic, with de-risking, de-leveraging contagion having made its way to the core. 

Let’s focus a bit on the core, and that is, U.S. securities markets, and the economy, in particular.  Ironically, instability at the periphery fueled looser financial conditions in the U.S.  From a market standpoint, this pushed speculative markets into melt-up dynamics.  For example, the NASDAQ 100 returned 20% through the first of October – biotechs 27%, double-digit gains, semi-conductors, health care, industrials, small caps, and so on. 

From an economic standpoint, loose finance and booming markets pushed the U.S. into over-heating – 4% GDP growth, the lowest unemployment rate since 1969, the strongest consumer and business confidence in years, booming M&A (sp?), leveraged lending, and stock buy-backs, inflating residential and commercial real estate prices and bubble, major sector bubbles in technology, biotech, alternative energies, and elsewhere. 

This loosening of finance came at a critical juncture.  The U.S. economy was already bolstered by powerful monetary and fiscal stimulus.  The federal deficit for the just-ended fiscal year jumped 17% to 779 billion, and it poised to surpass 1 trillion this year, or about 5% of GDP.  The profligate backdrop has complicated Fed policy-making, basically negating the Fed’s gradualist approach to normalization.  The FOMC increasingly recognized that rates would likely need to rise more significantly than both they and the markets had previously expected.  

Increasingly hawkish comments, even by the most dovish Fed officials, were downplayed by the markets, expecting global developments to conclude Fed tightening measures.  Well, this complacency was broken on October 3rd with Chairman Powell’s comment, “We may go past neutral, but we’re a long way from neutral at this point.”  

Ten-year treasury yields traded as high as 3.26% the following week, and that is a week ago Monday, accompanied by large outflows from U.S. corporate bond funds.  Both investment-grade and high-yield spreads widened meaningfully last week.  Benchmark MBS yields traded above 4% the first time since 2011.  I believe significant leverage has accumulated in U.S. fixed income over this long cycle of ultra-low rates, especially throughout corporate credit, leverage that is now at heightened risk.  There is also the issue of massive flows into fixed-income ETFs, now vulnerable to losses and destabilizing outflows.  

I want to return to Chairman Powell’s comment, and his approach, generally, and explain why this is so critical to the analysis.  For years now, markets have operated with confidence that the Fed, and really, global central bankers, would swiftly respond to incipient market instability with additional easing measures.  This goes all the way back to Greenspan, but was made explicit with Bernanke’s comment, “The Fed will push back against a tightening of financial conditions,” back in 2013. 

Faith in the Federal Reserve put, the Fed’s market liquidity backstop, became only stronger with Chair Yellen, viewed as averse to any action that might risk market instability.  Now, Chairman Powell is discussing stronger tightening measures in the face of heightened global risks and market vulnerabilities.  This was reiterated yesterday with the release of the Fed minutes.  For good reason, the markets are now questioning not only now much U.S. rates might be pushed higher, but also how quickly the Powell Fed will come to the market’s defense in the event of instability.  I believe this is an important factor in unfolding marketplace risk aversion. 

Let me state this clearly.  I believe the Fed and global central bankers will inevitably see little alternative than to resort to lower rates and additional QE measures.  When global markets confront a major de-leveraging period, only central bank balance sheets will have the capacity for buyers of last resort operations.  I have even conjectured the Fed’s balance sheet might approach 10 trillion during the next QE period, but that is based on my view of enormous speculative leverage that has accumulated since the crisis.  

There is a but here, and a quite important caveat, at that.  I doubt central bankers are in any rush to restart the electronic printing press.  The current mindset is to proceed with normalization, to try to let markets stand on their own, attempt to engender the return of at least a modicum of market discipline.  The dilemma for markets is not knowing how bad things have to get before central banks will be willing to step in.  

Keep in mind that the central bank backstop is not a pressing issue when the markets are rising, and risk-on speculation is thriving, but it becomes a critically important issue with de-risking/de-leveraging dynamics gain momentum and illiquidity becomes a market concern.  I believe we have reached the point where risk-off contagion has begun to affect the core.  I believe that is what the markets began signaling last week, that the global dynamics and tighter financial conditions are placing restraints on growth.  

Historic bubbles are faltering in China and the emerging markets.  At the same time U.S. rates and market yields are rising, the first actual tightening of financial conditions in years.  There is, as well, the unfolding trade war with China and a number of geopolitical hotspots.  I believe the core is much more vulnerable to a tightening of financial conditions than is commonly perceived.  

My view is one of U.S. bubble economy increasingly susceptible to both financial and economic fragilities.  Loose financial conditions have been inflating securities and asset prices, with record household perceived wealth driving confidence and spending.  Easy credit availability has bolstered corporate debt issuance and stock buybacks, inflating equities prices.  Massive fiscal deficits have inflated corporate profits and household spending.  Corporate earnings and the U.S. economy, more generally, have major exposure to the faltering global backdrop.  I will also add, the unprecedented expansion of perceived risk-free treasury debt that worked to stabilize the U.S. system for the past decade has likely lost much of its capacity to stabilize over the next downturn.  

Especially after this week’s rally, many are comparing the recent stock market downdraft to February’s fleeting sell-off.  I would counter that today’s backdrop is in stark contrast to the robust financial conditions prevailing globally back in February.  The current global liquidity backdrop these days is acutely fragile.  Rather than the risk embracement environment from early in the year, risk aversion is today more dominant.  

On a global basis, speculative dynamics are dominated by de-risking and de-leveraging.  Liquidity is being destroyed instead of created, and it is anything but clear in my mind how this unfolding tightening of financial conditions would be reversed.  

It is not only the speculative backdrop that has experienced momentous change.  The Fed has liquidated about 250 billion of its holdings since February.  Both the ECB and BOJ have significantly reduced monthly QE liquidity injections.  ECB QE operations conclude at the end of the year.  Markets have grown complacent that reduced QE doesn’t matter, that a contracting Fed balance sheet doesn’t matter.  

I would stress that so long as risk speculation and leverage are being embraced in global markets, there will be ample liquidity despite waning central bank monetary stimulus.  Importantly, however, this illusion of liquidity abundance will disappear quickly in the event of a serious risk-off bout of de-risking and de-leveraging, and I believe we are moving closer to just such an unfortunate outcome right now.

David, back to you. 

David:  Doug, I think one of the key elements there that you just mentioned is the illusion of liquidity, and whether it is in the products that have been popularized over the last decade, and since the global financial crisis of 2008 and 2009 with the proliferation of exchange-traded funds, to the implementation of Dodd-Frank in the interim.  One of our Commentary guests, Richard Bookstaber, who managed risk for Solomon Brothers, helped draft and get the early stages of Dodd-Frank implemented.  And the last thing he mentioned to me as we chatted about this is that he felt responsible for creating the next significant market downturn because Dodd-Frank fixed many things, but it also disincentivized market-makers.  

We have yet to be in a serious downturn where the new market-maker dynamic and backdrop is there.  Market-makers are not inventorying the kinds of product that they were, to the degree that they were, prior to the last global financial crisis.  So there have been some structural issues that feed into, and I think, add to what you are talking about in terms of the delusion of liquidity.  Everyone is happy to buy and hold, but in the event of a liquidation, again, product choice and market structure may reveal itself in a fairly dynamic way. 

We have some charts that we will post with the transcript, so for those of you particularly curious, and in love with pretty pictures – some of them pretty, some of them not so pretty – we will look at the big four central bank balance sheets, total outstanding nonfinancial debt, rest of world holdings of U.S. financial assets, so it will be about a dozen charts for you to review next week if you dig into the transcripts.  

But for now, we will transition to the Q&A. I will start with the first question, which is really one that goes back to Doug’s early explanation of what we do, and how we do it, and I think it is a helpful distinction.  The question is:

How is the Tactical Short different from other hedge funds?  Spitznagel runs the Universal Black Swan Fund.  How is it different?

This is where Douglas was talking about our fee structure early on.  We have intended to be a leader, not a lagger, in that respect.  We see the hedge fund structure of funds as being something that is going away.  And that is good for investors.  It means that as investment advisors, as partners with you, we take the long-term view to working with you in partnership to mitigate risk over a longer period of time.  

The hedge fund structure that is mentioned – the question here is about a particular hedge fund.  It is very opaque, the structure, itself.  Don’t know what is being invested in – typically lock-ups, which Doug mentioned earlier.  We have none.  Most hedge funds have significant lock-ups where you don’t have access to your funds except with brief windows throughout the year.  Again, these are significantly different.  

Having an account with us, you have the ability to log on online and see what you have, any day, which feeds great dialogue.  We feel like transparency and the moderation of fees to a 1% flat fee, no performance, sets up apart in the industry and aligns us with your long-term financial interests.  So, are we looking for the home run?  No.  We’re looking to be a strategic partner to reduce risk and volatility, and allow for long-term compounding to be of greater benefit to you.  

Doug, the same question is:  

What trigger points will change the portfolio as it is today from SPY shorts, S&P 500 shorts, to a different, or broader, basket?  

Doug:  This is a good question, a seemingly rather straightforward question.  There are some complexities that I am going to try to explain here.  The market traded at record highs about two weeks ago, and generally, if I had my druthers, I would prefer not being short a market at all-time highs.  So my risk discipline forces me to have one eye on exits.  I think the market has put in a high, but if I’m wrong, if the market breaks decisively to new highs, I would be cutting back exposure to mitigate losses, I would likely be reducing exposure into a market with many stocks and sectors spiking higher, especially those with large short positions.  So, in this type of risk backdrop I prefer the major indices to individual stocks and sectors, just from managing risk.  

If I were to short stocks in the current environment I would keep a very right leash on all positions.  In other words, my risk management discipline would impose tight stop losses.  I would not accept large losses on individual positions, and in a market at near record highs, as well as unstable and volatile market backdrops, tight stop losses would create a situation where the probabilities of losses on individual positions would be too high.  Even if you are right on fundamentals, these market whip-saws can lead to stop-loss traders and poor performance, which I am trying to avoid.  

Another point – the hedge funds dominate the short stock universe right now and hedge funds are struggling, and vulnerable to outflows.  So in a risk-off dynamic, and I have lived through these before, the hedge funds may be forced to unwind both long and short positions.  This can lead to really strange, unpredictable market dynamics.  This is a marketplace with a very high risk of short squeezes.  We saw a major short squeeze during the second quarter, and to a lesser extent during the third quarter.  

So I want to avoid being caught in short squeezes, where stocks can abruptly spike higher.  I just want to stay out of the fray until these market dynamics change, and candidly, I think they are changing.  So I’m looking across the poker table right now and the bulls have big piles of chips, so I’m adjusting my bets and my game.  But the environment is changing and we would anticipate being able to broaden out, branch out, in our short exposure in the not-too-distant future.

David:  The next question is about commodity trading advisors, again, back to the first question about hedge funds, which can go from a max short position to a max long position.  The question is:

Is the portfolio designed to have tactical longs?

The short answer to that is no.  Maybe at some point.  Our mandate in this particular product, the Tactical Short, is on the short side, with the flexibility of not being short at all.  At certain points we can be 100% in short-term treasuries, or we can adjust to being 100% the market.  So I guess the addition of tactical longs would be, really, on a demand basis, and probably in a separate product.  So this is a clearly defined mandate for us on the short side.  And Doug, if you want to add to that?

Doug:  The question is addressing technical analysis also that the CTAs use, and important levels in the market.  So, I’m not a technical analyst, although I certainly use technical analysis as an overlay for my fundamental analysis, especially for risk-control purposes.  Today was an interesting day in the markets.  We’re right at the 200-day line on the S&P, which is a critical level.  Last week the S&P 500 traded to an inter-day low of 2710 – that was last Thursday – so that would be a level that the market will be following closely. 

And if you look at the charts, this 2700 level looks very significant and probably 2600 even more significant.  So there are a number of key levels that we are watching out there.  It is not just for the S&P, but also for the NASDAQ 100 and some of the other major indices.  

David:  The next question is: 

The market is trying to drive interest rates higher.  This is creating a rock-and-a-hard-place problem.  An adage says that markets are stronger than governments, but governments have guns, and central banks don’t, so higher interest rates present an existential threat to an over-spending government which has become addicted to zero interest rates.  Governments simply cannot tolerate, on the other hand, higher interest rates unless they introduce exponential inflation created by printing enough money for governments to pay the higher interest rates.  

So the question is, what is going to happen here?  What scenarios are most likely in this currency end game?  When will the wheels fall off?  That question is kind of a crystal ball question, and since we don’t have one, we can’t answer it precisely (laughs), but we have often discussed the migration of financial market crisis with that sphere, just within the financial markets, to the sphere of economics, and then ultimately, that roiling politics, where you end up with a political crisis following the economic crisis.  

And if that can’t be resolved quickly, if the political crisis flames can’t be put out there, then it can spread to a geopolitical crisis and the unstaging, similar to Jim Rickards’ pattern of currency war, to trade war, to shooting war.  I think what we have, clearly, is two phases in motion.  We have the currency war which has been in effect for years now, and we have the trade war which is also afoot.  

So, as Doug reflected in his comments, the core, at this point, has benefit as capital flows have moved from the periphery.  And I think that can shift quickly in the context of deficit surprises here in the United States – capital control implementation in various jurisdictions.  So we would argue, to some degree, the wheels are coming off.  

Doug, do you want to add to that?

Doug:  I like this question, and this question would make a very good book.  A couple of thoughts came to mind.  I think it was back in 1992 that James Carville from the Clinton campaign quipped that if he was reincarnated he would want to come back as the bond market because a bond market can intimidate everybody.  It used to be bond markets were very effective at disciplining governments, companies, and even central banks, but that was a different age.  That was before shadow banking, QE, contemporary central banking, and this new era of unlimited finance.  

The perception these days is that central banks are stronger than markets, that no amount of debt issuance or government deficits will impact market yields, not with central banks ready to expand their balance sheets, print money and monetize debt.  So from my vantage point, we have had a complete breakdown of functioning markets and market discipline.  This is a key dynamic – key to the whole bubble.  

We’ve just started a new fiscal year that could have trillion-dollar deficits, and the assumption is, basically, that inflation will never be an issue again, so there is little risk in owning government bonds, prices won’t be impacted, even by massive increase in supply.  The perception is that if there is any shortage of private demand, central banks will step up and buy them.  

So for me, this is all part of the central bank-induced mania for financial assets, and I believe this will end in a crisis of confidence in central banking, and financial assets more generally.  My thesis holds that this is the end game for history’s greatest bubble, a bubble that has gone to the very foundation of finance, and that is what is not appreciated.  This bubble has gone to the very foundation of finance, and that is central bank credit and sovereign debt, and I fear a crisis of confidence likely commences with a major global speculative de-leveraging and resulting illiquidity.  

At some point markets will question whether central banks really have things under control, and I believe faith in central bankers will be shaken.  Trust in debt will be shaken.  I don’t know the likely timing of such a development, but I suspect it is not years into the future.  As I have explained, and as you mentioned, David, we think that global crisis dynamics have commenced.  

David:  Doug, I can’t help but think back to my days of studying philosophy in undergrad, and what we had in the 2008-2009 global financial crisis was in many respects an appeal to authority.  It is a fallacy, but nevertheless, a fairly effective one in terms of changing market dynamic and sentiment in the short run.  But the issue is, when you appeal to authority, and basically, elevate the Ph.D.’s in the financial and economic community and say, “These guys are going to fix it – these gals are going to fix it,” that’s all well and good, but on the next go-round, if they haven’t actually fixed it, now you have a different level of crisis of confidence.  

That is, I think, a part of what you are getting at in terms of this being the granddaddy of them all in terms of bubbles, because tied to it, decision-makers, those who have played a salvific role in this whole process of speculation and then deterioration after that, 2008 and 2009. 

From an existing investor, a current investor in your fund, trying to continue to learn more about how the hedges work, how do you use corporate bonds in deciding corporate financial viability?

This is for you, Doug.

Doug:  That’s a good question.  Corporate credit is an important indicator of risk perceptions, and that could be risk perceptions for individual companies, as well as for the overall market.  So I follow corporate credit spreads, the difference between corporate yields and treasury yields – I follow that.  I follow credit default swap prices closely as an important indicator of financial conditions and more specifically, as a key indicator of risk aversion.  I follow investment grade and junk bond spreads, as well as senior and subordinated financial institution debt, because they are often very good early indicators of changing market risk perceptions.  So yes, corporate credit is a key area to follow for my analysis. 

David:  Next question:

What are volatility strategies for the remainder of 2018?  

Best strategies for someone who is trying to engage the market.  I’m adding to the question, here, but the last two weeks, intra-day volatility has been phenomenal.  

Doug:  Right.  I’m not sure about volatility strategies, but I expect the fourth quarter to be a period of extreme risk for U.S. and global markets.  I believe we are now moving quickly toward risk-off de-leveraging and global markets, which in my analytical framework means risks are rising for the onset of a very serious financial crisis.  

So with this in mind, for most folks this is a time to manage risk very carefully.  Don’t go out and put on highly volatile positions, that’s for sure.  It is a time to hunker down.  I think you cut back on long exposure, and for a lot of people there is long exposure that they do not want to liquidate, and that is where, hopefully, we can come in and help offset that with the Tactical Short strategy and some downside protection.

David:  You mentioned third quarter numbers, redemptions in the quarter, inflows, holdings, assets or management, Tactile Short, non-correlated.  Any comments on what you have seen in terms of our investors’ enthusiasm for being a part of the product, or saying, “Wait a minute.  Wait, wait, wait?”

Doug:  We had no redemptions during the quarter.  We had no accounts closed.  We opened some new accounts.  If I had to throw out, obviously, with the market going to all-time highs people we taking their time to open up a Tactical Short account.  But I think new inflows were maybe $400,000 or so.  Assets under management, Tactical Short, I think for the strategy we are up around 6 million, I believe. 

David:  Next question:

I am 89.  I have been aligned with precious metals since reading Franz Pick.  As part of this kind of recession gold will probably take a hit, according to Harry Dent, as it did in 2008. 

Note, I’ll have a comment on that here in a second.  The question goes one:

What about getting into lesser gold stocks and cash, with cash available, at that point?  Of course, not buying on margin.

First, I will give you a comment on gold.  In the fall of 2008 gold did sell off initially, in the fall of 2008.  It was a 90-day set-back.  By the time we finished the year, it was actually up for the year, roughly 6%.  It was a short sell-off and a fast recovery, so those year-end numbers were very positive in spite of the short-term volatility.  What we saw happen as a dynamic, as the realization of counter-party risk and of systemic contagion entered people’s minds, the initial sell-off was reversed, and people came right back into the metal.  

In fact, because of those two things, they weren’t sure if their money sitting across the street at brokerage firm XYZ or bank ABC was actually going to be there.  Had it been rehypothecated?  Was it there?  Was it going to be locked up?  And so owning gold made even more sense, and we saw a radical shift by hedge funds, sophisticated investors, family offices, doing something that they hadn’t done in years or decades, which was allocate to gold.  And that was, really, in that late 2008, all through 2009 timeframe. 

So fast-forward to 2018, everyone is acutely aware of counter-party and contagion issues.  That is no longer that thing that lingers in the back of your mind – hyper-paranoid.  It is now a known variable and has to be considered, and is being considered by everyone in the financial industry.  So my concerns are not really with short-term volatility, but with product availability, which I think is going to be extremely limited when everyone wants to own the product.  So part two of the question is:

Relating to gold stocks, waiting to buy them, if the gold sells off, the gold shares sell off, etc., should you wait to buy them then?

I think miners are cheap now, they should be own now.  I think you average into a position, and averaging into a position you may be paying less for those shares, you may be paying more.  I think here you are underscoring the value of cash – it remains of value, giving you a tremendous amount of optionality.  It keeps your options open.  

Last comment – the deflationist crowd.  Debt would be included in that.  They have been dead wrong on gold for nearly 20 years, so I’m not particularly concerned about any critique coming from those quarters.  I totally agree with the comment on not buying on margin.  If a little it good, that does not mean a lot is better.  As they say on Wall Street, pigs get fed and hogs get slaughtered.  You can avoid margin, if you would, in this market environment.

The next question, Doug, for you:

How is any further upward pressure on the benchmark ten-year T-note – those interest rates?  

If you would, comment on that.  Do you think there is going to be move toward that as 3% looks like a good deal?  In fact, now, 3% in treasuries is a number that is above your dividend yield for the S&P 500, and arguably, more attractive.  So how is further upward pressure on the benchmark going to be impacting capital flows?

Doug:  Sure.  After a decade of such low yields there is going to be some demand for investors to say, “Well, I can lock in 3.25% for ten years.”  That’s reasonable.  And there will also be demand from people during a global crisis.  If there are deflationary pressures, rate cuts, more QE, there can be demand.  But I am also reminded of the old Doritos commercial.  I think it is, “Crunch all you want, we’ll make more.”

David:  (laughs)

Doug:  There is massive supply in the pipeline and that’s if everything goes well.  If we get into a scenario where risk assets in the economy get into some trouble, and let’s say treasury yields don’t come down, or even rise, you could have massive costs of bailouts for GSEs, and other financial institutions, and then you have sinking tax receipts.  So who knows how big these deficits could explode to?  

I think that is one of the dynamics that could unfold going forward, and this gets back to the gold question.  What happens if stocks go down and treasury yields and treasury bond prices don’t go up to offset part of that.  All of a sudden gold is a nice, safe haven, but also, there are a lot of stock and bond portfolios out there that believe that they are diversified and well-protected through all weather situations.  But I just think that fixed income could be a real problem if we get into a de-leveraging period.  

David:  This, I think, also goes back to that idea I mentioned earlier about there being a deficit surprise.  We have been dependent on the kindness of neighbors and we are not gaining in popularity on the global scene under the current administration.  In the Middle East, obviously, we have issues of a different flavor this week with Saudi Arabia.  

But the kindness of neighbors has helped fund our deficits, and our deficit is going to be larger this year than it was last year.  And to the degree that they begin to pull back, whether it is the Chinese, the Japanese, or our friends in the Middle East, we will have a funding issue.  And now you are talking about a different deal altogether.  

The next question:

What are some strategies that will be taken in the Tactical Short that are asymmetrical positions?

I think, for us, options do provide asymmetry.  I think the question is when and how we engage that.  Doug, you may want to add to this, but I think we prefer to buy options – put options – in connection with a catalyzing event, and not merely because they are cheap.  Because what are they?  They are a trend bet with a fuse attached to them, so you have a limited timeframe to be right on that trend bet.  

People are very fond of seeing their names in bright lights as being the people who call the top in the market, or the bottom in the market – to the day.  Frankly, anyone who tries that, if you look at what they have published, they have called tops and bottoms for probably a six-month period and then just happened to be coincidentally right.  They called the top five times, 20 times, 30 times, and one of those times they were right.  

We don’t want to call the top.  We don’t want to call the bottom.  We want to operate on the basis of reasonable probability.  And this is where Doug’s execution is superb, we want to focus on certain disciplines and financial indicators for confirmation.  So we like those asymmetrical bets as they begin to be revealed, not before the market plays its hand.  We like these bets in an established downtrend versus trying to use them with a presumption of knowing the future – when that trigger point is going to be, when that sell-off, to the day, to the minute, to the hour, is going to be?  

What we know. and what we don’t know, is very important, and we operate with a high degree of humility.  We have to.  If you don’t, the markets will teach it to you in a hurry.  Nobody knows the future, and sometimes making those asymmetrical bets early is with presumption of knowing more than you actually do.  

If you want to add to that, or I’ll go to the next question, Doug.

Doug:  That was good, David, thank you.

David:  Doug, does it make more sense to be short the general market via ETF, or short certain stocks?  And that could even be via options.  I am going to tie this into a question that has come online here in the last couple of minutes, which is:

You have the high-flyers like Amazon and Netflix.  If the bubble is bursting, why not pile in on those?

Doug:  If the market continues to go down right now, we will look back and say, “Wow, it would have been great to have been short the high-flyers.”  I have to look at this and say, “Okay, we’re still in this market topping process, so I’m not drawn toward high volatility.  I want to get through this period and then move forward without having significant losses to make up.  My instincts tell me right now that, yes, I would like higher beta, but my risk discipline says that I have to play this smart, get through this, I have to anticipate wild volatility, short squeezes.  

Actually, if I was in front of my Bloomberg screen right now I would check – I’m not sure how much Amazon was up Tuesday, but Amazon can have a day where it is up 100 points.  I think that is not unlikely.  When it is up that much that day, am I going to impose risk control, or am I going to say, “Okay, I think it’s going to go right back down?”  I don’t really want to be put in that position of being forced to cover a highly volatile stock on a spike right now, so I’m avoiding that.  

David:  Next question is:

Will the tariff wars affect the metals markets up or down?

I’ll take that one.  Yes, I think it will affect the metals, in my opinion, on the upside.  Here is why.  It is likely to encourage continued central bank diversification away from U.S. treasury market and toward gold.  That has been the case throughout 2018.  One of the primary buyers in the marketplace, investors have still been absent with the exception of Western Europe and Asia, but central bank buying has been huge.  And so, slow diminishment of treasury purchases, increase in gold demand, I think in the context of tariff wars you see that trend continue.  

I think it is also likely to influence consumer prices over time.  So this is the real key thing with gold.  Inflation is not the thing that drives the gold price, so you wouldn’t want to look for a correlation between the inflation rate and the gold price.  But it is an inflation mindset, or fear of inflation, that sets something very different in motion for gold.  So, whatever the catalyst is – if it is trade, if it is increase in earned income, if it is a reduction in dollar holdings to facilitate oil purchases – whatever it may be, it is ultimately the mindset of inflation which drives the gold price markers, and I think you would be likely to see that along with central bank buying in the context of continued or increased tariff and trade wars.

Doug, the next question kind of echoes the one:

Would you recommend using out of the money puts on FAANG stocks?

I think you have addressed that already, but feel free a frame on it.

Doug:  Sure.  The costs, or the implied volatility for such options on volatile stocks like the FAANGs, are really expensive, right?  The market is not stupid.  And that doesn’t mean you can’t make money with such options, but in a lot of ways it is just a market call.  You are going to bet a decent amount of money that those stocks are going to get hit in a weak market environment.  That is a risky bet in volatile markets.  And I will say, generally, with options they work better in theory than they do in real life.  

I say that because this is a very sophisticated market.  I cringe when I see all the advertisements of retail investors to play options because a lot of the sellers of options are sophisticated players that are out there trying to make money.  That is why we see a lot of big market rallies the week of expiration.  We saw a rally Tuesday – a lot of put value destroyed Tuesday in that rally a few days in front of expiration.  So they are just tricky and challenging so I don’t recommend people play those, myself. 

David:  The next question is in our Frequently Asked Questions, and feel free to visit the website which has a number of those things at mwealth.wpengine.com and go to the Tactical Short section.  

What is the minimum account size?

For an individual investor it is 100k, and for an institution, pension fund, what have you, a million is the minimum.  

Next question:

I am writing covered calls.  Are there other option strategies to protect against further downside catastrophes to my portfolio as a retired gent?

I am going to echo a little bit of what you said, Doug, and I think what I mentioned earlier, as well, puts are intriguing at a certain stage, and Doug can put into work for us – this is one of the amazing things that he has in terms of the historical play-by-play, the phases and the unique behavior exhibited in a variety of asset classes in the context of a decline.  

So the challenge with puts is what you just mentioned, Doug, short-term manipulation of trend.  You mentioned the rally Tuesday, and I don’t want to be hyperbolic, but it is almost always right there in front of expiration, where that value is robbed from you.  So we see that as a part of what we are going to do moving forward.  It is a part of the price of admission, so to say, the option strategies.  It is just really a question, for the Tactical Short, of seeing more of an established downtrend first. 

The next question, Doug, is:

In election years, you usually have November as an up month in the markets.  Will it be this way in 2018?  Why, or why not?

Doug:  In general, I tend to look at the current environment as being unique, so I don’t put a lot of stock into some of these historical trends that people point to.  And I know it is always dangerous to say this time is different, but I do believe we are in uncharted waters, here, after ten years of extremely low rates and trillions of QE and such.  So right now, in this wild marketplace, November seems a little way away from me, to be honest.  

We have the midterms coming.  Who knows how that plays out?  That could easily impact the markets.  But there are a number of domestic and international developments that are unfolding now and could have a huge impact on the market during November and going forward.  So, could it be up?  Sure.  Would that change the thesis much?  No, no it wouldn’t.

David:  Next question:

Any opportunities for smaller investments, or as an augmentation to metals and a cash portfolio, hedging against traditional modern portfolio theory, the long stocks and bonds typical allocation?

Just a moment of reflection, modern portfolio theory is going to hurt a lot of people in the next down cycle, particularly if inflation enters into the equation just as correlations across asset classes tend to increase.  In a period of rising interest rates and inflation bonds aren’t going to offer you much of a safe haven as an offset to losses that you might see in your equity portfolio.  Maybe short-term instruments and high credit quality still have a place.  

But I would say, for smaller investors, you are pretty well positioned with healthy cash, the metals position as an offset to your currency exposure.  Miners?  They play a role.  They are kind of like non-expiring call options on the gold price.  I think what we are doing with the Tactical Short offers a healthy gain potential in downside, both when we see pressures in the equities and fixed income space, again, as a way of offsetting longs that you might hold elsewhere. 

Doug, next question:

What major asset classes seem most attractive to you now for the longer-term investor?

Doug:  This is a really difficult environment to answer that question because I have a real issue with financial assets generally (laughs).  I’m concerned about stocks, very concerned about fixed income.  For me, personally, with you, David, I like gold and precious metals.  I want to be diversified with some cash.  I am okay with some good real estate.  Just a diversified portfolio to get through the storm with minimal exposure to risk assets, generally. 

David:  The next question:

If you could not short anything, where would you put your money for the short-term?

Doug:  I assume that this questioner is referring to Tactical Short accounts, like, perhaps if there is a government-imposed ban on shorting.  I’m not sure if that is the direction this is going, but I will answer it that way.  I am often hit with that question.  I doubt we would see a ban on shorting.  I don’t think it would be practical because shorting is so integral to derivatives and hedging strategies and such, and a ban would be so highly destabilizing.  

But if we couldn’t short we would focus on listed options for downside market exposure, and we always have our cash.  If this question is actually referring to what an individual out there would do, we have already addressed that — just be risk-averse.  And also what we haven’t mentioned, I think for a lot of folks, it doesn’t hurt if you have some spare cash, if you sell some risk assets, to pay down some debt.  You can’t go wrong there.  

David:  Great point.  That’s a pressure that you don’t necessarily want to be under in those market circumstances.  Doug:

Is the risk-off environment conducive to also shorting single equities, like Tesla?

(laughs) We’re changing the name, but it’s a good question.

Doug:  Do I have other choices on that? (laughs) Generally, risk-off shorting stocks, can be fruitful.  Keep in mind, though, that some of the biggest stock market rallies are bear market rallies.  In the past I have used a bullfight analogy.  When the bull is first pierced by the sword you can confidently predict that it is going to go down, but it is also safe to assume that bull is going to go nuts and try to inflict as much damage as possible.  

David:  (laughs)

Doug:  That’s part of my framework, right?  We have hedge funds, ETFs and derivatives.  We’re expecting a lot of volatility, and if you have high beta, or a portfolio of individual company stocks, that adds a new dimension to managing volatility.  And I will also add, the challenge with a portfolio of individual company stocks is, you can build that portfolio, you can construct that portfolio believing that you are well-diversified in those individual companies by sector, size of company, etc.  

But a lot of times in these squeeze environments in these bear market rallies, all of a sudden they are highly correlated.  I call it the upside beta problem where you are running a beta portfolio, let’s say you’re negative 1.2, so if the market goes down 1%, you make 1.2%.  Well, that beta, in a spiking squeeze environment can turn to negative 3.  I have seen it, that’s not uncommon.  So all of a sudden you have a really high beta portfolio because all of a sudden it’s one trade.  It’s almost like one stock.  

In that situation, then, it’s like you have a gun to your head, saying, “Okay, are you going to cut back your risk and protect yourself, or are you going to assume the market is going to go back down?”  So, I’m trying to avoid those dynamics of the high beta, the highly correlated portfolio, the short squeezes, etc.  

David:  The next question:

What are the implications of oil starting to be priced in other currencies?

That’s great.  That’s a big picture question, for sure, because you go back to the 1970s and we were said at the time to be able to run deficits without tears.  That concept is seeing no consequence to budget, and particularly, trade deficits.  It ties to the privilege that we still retain from being the world’s reserve currency – that’s the dollar.  When the dollar was in terminal decline in the 1970s, it took some fast-talking diplomacy in the Middle East getting oil priced in dollars to extend that dollar tenure.  And so oil priced in dollars has for decades been one of the lynchpins for dollar stability.  

Should we ever lose the oil market to other currencies, one of the consequences would be the float of dollar liquidity which is currently required to keep the global energy market functional.  That would like shrink.  And I think the other thing it would do is, it would create more supply of dollars homeward bound in that world of decreased demand.  So the classic too much money chasing too few goods, that would be an environment where you could expect to see something of an inflationary surprise.  It could be serious.  

So I suspect that from a geopolitical standpoint, if you began to see very many, not only serious announcements, but executions on those plans, you would have bombs and planes flying before it got implemented.  Something very interesting to note, the different between the 1960s, 1970s, 1980s, and today, the State Department used to do a lot of things overseas.  Today it is the Treasury Department.  

I suspect the Treasury Department would attempt to destabilize any regime that moved in the direction, which again, if you think about this, this is one of the reasons why there is a growing global audience for the metals, gold in particular, because people want to be removed from the U.S. Treasury Department tentacles which do have real impact in global financial markets.  If we want to put pressure on Iran, we can do that instantly.  And again, it is through the financial markets.  So gaining some independence from there is a part of the equation.  Hopefully, that answers the question. 

The next one is relating to 457s.  These are plans where money is locked in for people in various mutual funds, don’t have many options.  

For those with money in 457s, what should you do?

This is, in many respects, in the spirit of what Doug and I have created the Tactical Short, because we recognize, for a variety of reasons, whether it is structural limitations, or tax priorities, tax planning, estate planning, etc., you may want to maintain a long exposure, or again, because of the structure of the plan you may not have any other choice.  That’s why the Tactical Short exists, to help create that parallel universe where whatever volatility that you see negatively impacting a part of your assets, you have the positive offset on our side for your benefit.  

I would say, create whatever hedge you can outside.  If you are talking not the $100,000 minimum that we have, but a smaller amount, that might be in metals.  It is a $5000 allocation to offset what you have in the 457 plan, or whatever it is.  You could also look at inside the 457s.  What is your closest option to cash or short-term fixed income instruments?  The reality is, we’re not against owning equities, it is just that we don’t want to see individuals take the full brunt of a market sell-off, which is why from a pragmatic standpoint, 40% of the time we are an absolutely essential ride-along in terms of the services provided. 

Doug, do you have recommendations of funds that could get people close to mirroring the Tactical Short? (laughs) What are your thoughts on that?

Doug:  Okay, of course I’m very familiar with the other short mutual funds that function as a market hedges, but I don’t really have a recommendation.  We like to think we have structured a better product, but we also know that for some investors these funds may be a reasonable choice to help manage risk.  Just be aware that most short products are 100% short.  Some are even more than that, some of the ETFs.  

So that forces the market timing decision up on the investor.  They are not going to adjust their exposure based on changing market dynamics, risk/reward, etc., like we do.  So it makes it more of a challenge, some of the other products.  We are working toward a product that would mirror the Tactical Short but in a mutual fund structure, so hopefully we will have something at some point.

David:  Yes, stay tuned for that.  Doug, here is where the rubber meets the road:

What happens to your portfolio, or the asset allocation, if your strategy is wrong?

Doug:  I could be wrong? (laughs)

David:  (laughs)

Doug:  I’ve been doing this for so long I often say that I’ve had the dunce cap put on my head so many times, it fits pretty well.  Risk management is key to our investment process.  If our strategy is working, we do more of it.  If it is not working, if we are losing money, we do less of it.  So in that regard, we keep it rather simple in a way.  We have our views, but it is important for us to see confirmation of our views in the marketplace.  We don’t want to just go out there and fight the market.  Life is too short for that.  We also know timing can be very key.  On the short side, being early is essentially be wrong, so risk control is very important in this business.  

And we also know that we could be right on our macro views and still contend with aggressive policy responses.  I have seen that throughout my career, too.  So we know that we could be right on our fundamental analysis but the market may be driven by different factors, so we have to consider all of those different factors.  Again, that is all part of us trying to gauge risk/reward and establish our short exposure and composition accordingly.

David:  I think that goes back to what you said earlier in response to whatever fund you would recommend that go along with Tactical Short.  This is what makes us different – risk control, and looking for those confirmations.  When you are contending with policy measures are you willing to shrink your exposure?  And we have that flexibility.  The mandates of those other funds that we compared ourselves to earlier on when you were going through your formal notes, don’t have the flexibility.  So we can be at 0% short or 100% short, and that is of great value.

I’ll answer this one:

Thoughts on using whole life insurance as a part of a protection strategy against downside.

One, I think there is some value there in terms of stock market decline.  Two, I don’t know that it helps you at all in terms of systemic risk.  There is the bigger issue of, what is the institution you are working with, and what is their viability in various contexts?  Three, I think the structure of the product is that you do lose quite a bit of flexibility, so being unable to adjust if you need to or want to is an issue.  

And I think the last issue is, and this is more of just a long-term critique of insurance products, which is, how do you deal with inflation over time?  Because you are giving out, in present-value dollars, to an insurance company, and they are delivering to you a set obligation in future-value dollars.  And believe it or not, inflation matters, even 2% a year inflation target at present, matters over time.  

So 20 years from now when you are going to collect, or 10 years from now, or 30 years from now, what you thought was a sizeable insurance amount really isn’t that much in terms of purchasing power at term.  So those are other considerations.  I think systemic risk is probably the big one that you can’t really wrap your arms around, but those are thoughts and considerations on whole life as a hedge.  

Doug, the next question: 

I am interested in learning your views of liquidity and how current credit conditions have an impact in the overall markets.

Doug:  That’s a very timely question —a difficult question.  Liquidity can be such a nebulous concept and what we perceive as liquidity abundance can turn into marketplace illiquidity in just such a brief amount of time.  I believe liquidity in contemporary markets means something very different than what it has meant traditionally.  I focus on the leverage speculating community, as I call them, and that is mainly the hedge funds, big global banks, securities firms and such.  They are the marginal source of liquidity for global markets.  

So when they expand borrowing, when they increase leveraging, new liquidity is created.  That is new purchasing power for securities.  This purchasing power inflates security prices which ensures more self-reinforcing liquidity.  And if this goes on long enough you have speculative bubbles that are formed.  And markets appear highly liquid.  They always appear highly liquid during the bubble.  

But this doesn’t function well in reverse.  When security prices decline losses for de-risking and de-leveraging, and that is the destruction of liquidity.  Waning liquidity then leads to market risk aversion and further de-leveraging and quickly a very problematic illiquidity problem can arise.  My view is that there is unprecedented speculative leverage globally after a decade of this ultra-loose money and central bank stimulus and all the market backstops.  And now we see rising rates and much reduced QE, so the global liquidity backdrop today, I believe, is extremely vulnerable. 

David:  This question relates to gold.  I’m going to hit this, and then flip a question to you on percentage allocations to Tactical Short – what you recommend.  This question is:

Please comment on the gold confiscation under FDR.  If the government can make it illegal to own gold like they did in 1933, why should we think this time is any different?

I would say two things.  One, it accomplished something in 1993 which the Fed was arguing they needed.  They needed to control the money supply.  So they created a two-tier monetary system which maintained a legitimate dollar in the world picture because we were still settling our debts in gold, but domestically, it allowed for devaluation, and again, that increased the money supply for them to stimulate the economy, etc.  

So my question is, what would be accomplished now?  You already have control of the money supply.  Then versus now, gold was ubiquitous then – very low market ownership today, single digits, certainly, if you’re looking at the population.  So I just have some questions, maybe, about what they would benefit from it.  The backdrop is different.  Today we live in an entirely fiat system, and it has been a system in transition from 1922 to 1944 when we took the helm at Bretton Woods, 1972 when we got off the gold standard, altogether suspended convertibility under Nixon.  And in that process the nature of money changed from being anchored to being unhinged.  

So again, I think that it is difficult to answer the question, “What are they accomplishing?” in taking the few ounces of gold that are out there.  And by the way, gold was still traded outside the United States through all that period of time, so every U.S. person could have had gold someplace else and liquidated as ounces.  It wasn’t as if you were locked up for a lifetime if you were amongst the 60-70% of Americans who did not hand in their gold when it was confiscated.  Take it across the border and spend it.  So, those are some thoughts on the 1933 confiscation. 

Doug, transitioning to your question:

Looking at Tactical Short, what percentage should a private investor, barely accredited, they are at a million dollars.  What makes sense to have in Tactical Short?

Doug:  I kind of addressed this in my opening comments.  We generally say 5-20% makes sense.  That’s a big range.  It depends on a lot of factors that are client-specific.  It depends on their exposure to risk assets – stocks, bonds.  It could also relate to their exposure, let’s say, if they have large real estate exposure that could be impacted by systemic risk.  So we really need to sit down and talk with potential investors, get a feel for their greater investment portfolio, the risk tolerances, etc., before we can give a good answer to a good question, actually.

David:  Question:

What will take the place of subprime loans in the next market downturn?  CEOs, CLOs, ETFs, some other instruments, some other state?

Doug:  Another good question.  Thinking back, during the mortgage finance bubble period I would write a lot about what I called the moneyness of credit, all this Wall Street alchemy, this process of transforming risky mortgages loans into perceived safe and liquid money-like instruments, and that was the CLOs and all those kinds of things.  Over the years I have discussed how money is dangerous because it enjoys almost insatiable demand, because we always want more money.  So there is always demand for Triple A securities because it is perceived safe and liquid.  

For this cycle, I have focused on what I call the moneyness of risk assets, which takes this whole concept from fixed income into equities and other things.  We have transformed risky securities into perceived safe and liquid assets.  So from this perspective, I worry most about the ETF complex, and that is both stocks and corporate bonds, especially the funds that have grown over the cycle, and they are full of illiquid securities, and that could be small cap stocks, junk bonds, etc. 

At the same time we have had this resurgence of CLOs, leveraged lending and structured finance, so we will still have issues in structured finance to contend with, too.  And I really worry about potential problems created in the derivative markets during this cycle, so I think there is a lot longer list of candidates than we had back in 2007, and we had a decent list back then to replace subprime, most of them much larger in scope than we saw during the last bubble, unfortunately.  

David:  This is not a question on the list, but I’m going to ask it:

Speaking of derivatives – there is a huge number of derivatives which are traded over the counter.  These are no exchange-traded, they don’t have a price, but they do implicate real financial values, real insurance bets and risk that is supposedly being offset.  What does it look like to move into a period where you have acute financial stress, and derivatives are a big problem, but you have a huge chunk of them, which you don’t the value of because they don’t trade on a daily basis.  How do you approach that as a risk, and is the mitigation of that risk simply by changing the mark-to-market rules, or mark-to-make-believe rules and accommodating, buying more time and getting past a period of real intensity?

Doug:  I put this near the top of the list of lessons not learned from the past crisis.  I have had an issue with derivatives for a long time and the whole marketplace, basically, revolves around this assumption of liquid and continuous markets.  Let’s say there is a contract that is sold, a derivative that is sold.  Let’s say someone is buying market protection.  Whoever sells that, then, they are going to manage that risk so if the market starts to go down, they are going to go out and short something to make sure that they have a position that generates the cash flows to pay on this derivative protection that they sold.  

And that all works fine as long as you assume that the markets are liquid and continuous, that you are not going to have these big gaps in market prices and illiquidity where you are not able to put on that hedge on the derivative you sold.  So I just think, especially in what is unfolding right now, where I am very concerned about and illiquidity and perhaps even a seizing up of global markets, what this means to derivatives.  

Again, as you mentioned, how do you value derivatives if you get into a marketplace where you have illiquidity?  And for these derivatives to perform as expected, they need to sell something or to buy something.  So this is part of this unfolding financial liquidity problem that unfortunately I think we will be dealing with in the not-too-distant future.  

David:  This is another question for you:

Formerly, QE, quantitative easing, was involved in the buying of debt instruments.  Can you discuss the possibility of future U.S. equity purchases via any such form?  As you know, other central banks have engaged in this already.  If you could, address the likely efficacy of any such equity buying over the short or mid-terms?

Doug:  Another good question.  I expect that the next crisis environment is going to be a much more hostile period politically than we have seen in the past, so that could change dynamics.  The Federal Reserve as an institution will be under attack.  I’m not saying that it won’t purchase equities directly, but their activities will be under heavy scrutiny and that is all types of purchases backstopped, bailouts, all of that.  I am assuming they will have little alternative than to purchase government debt, likely in massive quantities.  Certainly, they will purchase treasuries.  I expect they will purchase mortgage-backed securities again.  

And I wouldn’t be surprised if they have to purchase GSE debt.  They are going to have plenty of things to purchase, so I believe the equities, for them, might be crossing a line that they would rather not cross.  At least they wouldn’t make the purchases until well into a major crisis, and at that point I would expect such purchases to provide only temporary market support, but probably not change the character of the crisis.  Central banks will really have their hands full.  Again, were talking about derivatives, we’re talking about all types of asset classes that there could be major liquidity issues.

David:  So in terms of their own self-interest, the government, that is, it would be down on the list, not at the top of the list, of things to purchase. 

Doug:  Yes, I think they will be more worried about debt markets than they will be stocks, I assume.

David:  Well, we have gone a long stretch, and borrowed a considerable amount of time from our clients and listeners.  We are grateful for the time that you have given us.  There are a few more questions here relating, specifically, to Australia and Canada, a few more relating to gold stocks and things of that nature.  I am going to be reaching out to each of the listeners, as will Doug, over the next couple of weeks, to have a conversation with you.  If there are specific questions that were not asked, or that have come up in the context of our conversation, feel free to pepper us with those as we are in touch with you.  You can always send an email over the weekend if it is on your mind now and you think you might forget.  But look for a call from somebody in our firm.  We want your feedback on the conference call and also just to see where your interests and ours may run in a parallel track, with the Tactical Short complementing some risk mitigation and some downside opportunism, if you will, through Tactical Short. 

Doug, thanks for sharing your thoughts today.  And for those who are listening, thanks for joining us.  As always, it is an honor and a privilege to serve you in the financial markets.  

Doug:  Thanks, everyone.  Good luck out there.

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