EPISODES / WEEKLY COMMENTARY

This Time The Bubble Pops From The Outside In – Interview With Doug Noland & Dave Burgess

EPISODES / WEEKLY COMMENTARY
Weekly Commentary • Sep 18 2018
This Time The Bubble Pops From The Outside In – Interview With Doug Noland & Dave Burgess
David McAlvany Posted on September 18, 2018
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This Time The Bubble Pops From The Outside In – Interview With Doug Noland & Dave Burgess

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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

THIS TIME THE BUBBLE POPS FROM THE OUTSIDE IN –
INTERVIEW WITH DOUG NOLAND & DAVE BURGESS

September 19, 2018

“As adults, we think that we’re done with that, being adults – following the crowd, doing what our peers are doing. But you know what? When it comes to investing there is little difference between the adult mindset at it approaches the markets, and the adolescent mindset as it approaches peer pressure. It’s very rare to find someone who is willing to ask a different set of questions, who is willing to look at things from a different vantage point.”

– David McAlvany

Kevin:We just came off the weekend meeting, McAlvany Wealth Management Annual Client Conference. I was really honored, Dave, to be there. Doug Noland, Dave Burgess, a number of asset managers present what is going on in the markets and exactly how you are attacking that right now.

David:It’s always a good time for us to not only convey the ideas that are top in our minds and the pressing issues that we think would impact portfolios, but also to spend some one-on-one time. So annually, we have a host of clients come out and meet us here in Durango, and that’s in addition to our regular travels out and about. This is our effort to lay out a cornucopia of ideas and of course, food is always a part of our gatherings.

Kevin:One of the things, as you know, I love going and meeting the clients because oftentimes we’re just talking to them on the phone for year after year after year. But when they come here, or when we go to them – last year we had a number of conferences where we moved all around the nation – I’m just amazed at the community of people who were there. On Friday, I’m sitting there eating breakfast and I’m talking to a supervisor, retired from NASA, who was involved with the international space station, the safety and security of the international space station.

And then you have asset managers who were there. There was a helicopter pilot with 23,000 hours of helicopter piloting, a missionary, a pastor, managing family money. It was a fascinating mix, but what was interesting to me, I talked to several of them about how it can be lonely out there when you think independently. You need a community. And sometimes these meetings are exactly that.

David:Kevin, by Friday night when we were gathered for our final dinner, there was a group of these folks who came out to visit us and they were planning the next year’s event.

Kevin:I don’t think they had invited you yet to the next year’s event, right? These were people who didn’t know each other before this weekend.

David:It was going to be something like a vacation for diving in addition to the asset management brief. And so they were going back and forth between Bonaire and Kauai. We were going to be informed where we should show up. It was neat to see a group of people who, prior to this meeting, didn’t know each other but by the end of the meeting were looking at spending time together in a similar venue, and confirming with each other, “You’ll be back next year, won’t you?”

Kevin:I think it’s time to definitely thank the community that listens each week to the Commentary because what we saw here this last weekend was long-term readers of the Credit Bubble Bulletin. This is Doug Noland’s device to communicate to people what he is thinking. You have long-term readers of that, several decades, coming together with long-term listeners of the Weekly Commentary. They found immediately that they were community.

David:Right. When you share things in common and it’s a discovery, like, “Oh, wait, there is someone else that thinks these kinds of thoughts,” it is a fascinating thing to watch just from a sociological perspective, but I think also very rewarding. And of course that was just the add-on, the benefit, the bonus, the icing on the cake. The reason they were there was to have our minds on what was happening, what is happening, in the global economy, and what the implications are for an invested portfolio.

Kevin:Here’s the beauty of the program today. We’re going to have Doug Noland and Dave Burgess in, so for those who were not able to attend the meeting, I found the information just profound – some of the things. We’re all looking for new information. I was talking to you about this last night. We’re looking for new information. Tell me something new, and tell me why I care. We live in a day and age right now where there is a lot of new information but there is not a lot of consequence playing out in the marketplace. We’ve talked about this smoothing out of the volatility, but the information that was presented this weekend I was compelled by, listening to Doug Noland and Dave Burgess. I think this interview is definitely worth listening to.

*     *     *

David:Gentleman, this past week we met with a number of our Wealth Management clients from across the country. We do that once a year, where they come here and gather in Durango, and our traditional offerings using the maps, portfolio allocations – we’ve been running those since 2008 – along with Tactical Short clients who joined us this year, with that program in place over a year now, running that since 2017, and very opportunistic in our view given the current froth in the equity markets.

Also, clients with us this year from our DSA Growth Fund folded into McAlvany Wealth Management in 2016. Unfortunately, that manager isn’t here with us in the studio today, but I want to thank you for being here, and also thank you for the hard work that you do for our clients. I appreciate, as do our clients, your professionalism, and the total dedication that you have to your craft. You have to suffer through listening to the Commentary most weeks, so you know, we have experts from a variety of fields, including our own, on the program, or associated fields on the program, the Weekly Commentary. And I do like to hear from our in-house experts, as well. So my benefit, one of the benefits of being here is the routine contact that I have with both of you, but I would like for our listeners to have that same benefit, so I appreciate you being here.

Dave Burgess, you have been with us for over a decade. It will be 15 years before we know it, and we’ve seen some amazing years. We’ve seen some amazingly difficult years, too, but I think maturity combines both of those. From your perspective, what are the most relevant factors an investor should be paying attention to, let’s say, with a one- to three-year timeframe in mind, not something that is going to happen tomorrow, but the big picture concerns that you see.

Dave:First of all, good to be here. Just want to say that. It’s fun to be with you both and discussing these things. It’s always a joy. One- to three-year timeframe – that’s a lot of time, and I see some things that are developing today in small proportions that I think are going to escalate over the next six months to a year. Definitely in three years I think we’re going to see big changes in the marketplace, and one of those places or areas that I think is instrumental to everything is the interest rate environment, the bond market.

If there is one thing I think we’re facing for the near-term and the near future it is interest rate risk and possibly leading to credit risk, given the delicate nature of our position and our debt, and the world debt for that matter. So if I were putting together a portfolio I would keep these types of things in mind and be sensitive to laddering in a portfolio, per se, if I’m exposed to bonds, and if I’m exposed to equities I would be more driven to be allocated toward those types of things that would survive better in, let’s say, a high rate of inflation or a high interest rate environment.

Dave:Looking at the utilities average, the Dow Jones Utility Average, it is one of those averages that represents a non-confirmation in the market today. You have had the industrials move higher, the S&P move higher, the NASDAQ move higher. The utilities reflect maybe that same sense of concern that you have, being a little bit more interest rate sensitive, if we are moving into an environment where rates are an issue. I won’t say the utilities investors are fixed income investors by proxy but there has been a lot of money that has moved toward stocks, and those are guys that pay a heftier dividend, and lo and behold they are the ones that are under-performing this year. So maybe you’re onto something there.

Doug, if anybody wants a thorough insight into your big picture views, obviously you have been writing the Credit Bubble Bulletinfor 20 plus years, and they might benefit from listening to the conference call you did in July. If they want to listen they can go to mwealthm.comand listen to that. But on the one hand, you’re a manager of risk and a disciplined analyst and a disciplined trader. But you might also describe your daily regimen and the task of shorting the markets as speculation. Tell me about that.

Doug:Sure. And thanks for having me on, David. It’s nice to be here. Yes, as a risk manager, especially on the short side, the risks are different on the short side than the long side. For example, if you buy stock at $10 and it goes to $5, on the long side your risk has been reduced, you lost half your money, but as long as you’re correct on the analysis you can wait it out. On the short side you can short a stock at $10 and it can go to $20, you lost half your money, but it can keep going. It can go to $30, to $40. I’ve seen stocks in my career go from $2 to $100. So going through those cycles, you come out of it with a keen appreciation for risk on the short side.

So I wake up every morning and the first thing I think about is risk. Where’s the risk? And my daily routine is, I get up and immediately follow to see what the international markets have been doing. That’s equity, that can be currencies, fixed income. Right now, in particular, the emerging markets is the first place I will look when I get up in the morning. I’m trying to get a sense for if the general market environment is risk-on, or could there perhaps be risk-off starting to get into the equation.

I start my day and my analytical framework starts from the macro perspective, so I’m looking at financial conditions and my general belief on the short side is when financial conditions are loose, or loosening, I need to be much less short. I need to control my beta, I need to control my short exposure. I need to be very careful with shorting individual company stocks, high-short interest stocks, etc. But if I see financial conditions start to tighten, then I want to be more opportunistic, so I spend a lot of time, and I have a mosaic of indicators to try to get some edge as far as a direction of financial conditions.

Right now it is a very interesting environment because we’re seeing a definite tightening of financial conditions globally. So there are a lot of indicators that I’m following very closely in global markets, especially the emerging markets. But at the same time you’re seeing financial conditions continue to remain loose here in the U.S. Junk bond spreads remain very low, risk premiums generally, the VIX index.

On the short side also, it’s critical to follow developments by the hedge fund industry developments because they kind of dominate the short side, short interest in individual stocks. Not that they’re bearish, but a lot of them run long/short strategies. So I have to get a sense for how the performance is. In the hedge fund industry I follow a lot of stocks that are popularly shorted, trying to get an indication if those stocks are out-performing. If so, I need to stay away from that asset class.

For example, there is what is called the Goldman Sachs Most-Shorted Index that I follow closely. It is up 22% year-to-date, out-performing almost all averages. Why? Because there has been a huge short squeeze. So that type of dynamic is critical for managing risk on the short side. I spend a lot of focus on that. It makes for long days, but I will also say, in this type of environment I make sure to get out, get exercise, spend some time with my son, and not let the difficult environment on the short side start to give me a negative perspective on life. I’ve been doing this for a long time and I have to manage it all very carefully.

David:But when you managed the Prudent Bear Mutual Funds, there was about 2½ billion dollars in assets that was interested in shorting the markets. That is what you were responsible for. Talk to me about the capital flows, the timing, the psychology, and why lots of money wants to short the market at the very bottom of a market, but very little wants to when a market is at a peak and actually ready to move lower.

Doug:Sure. I remember 1999, and assets leading, and assets under management very small at Prudent Bear. And then I remember after the crisis, assets growing to, as you said, over 2 billion dollars. We would see a lot of performance chasing flows – just the nature of the markets – especially contemporary markets where there is so much performance-chasing, trend following. Invariably, I would see the flows in at the wrong time. I would see, if the market was down a lot of times we were inundated with flows, and then when the market looks like it’s putting in a top that’s when we see large outflows. In many respects, it was somewhat of an indicator of market sentiment and probably not a bad trading indicator to follow our flows.

David:Dave, tell me the themes that you’re running with, the multiplier accumulator protector of those portfolios, what are the themes that are most important to you there? A couple of years back you started another variation of the portfolio that is designated with the letter S, and I think that takes a slightly different tack from the first three. What are the dominant themes that you think are important for those allocations?

Dave:Assuming that we are going to see some higher rates here, or higher inflation in one way, shape or form, not so much demand pull because I think still would bode well for, say, a healthy, functioning economy. We’re really geared toward something of a cost push dynamic if that were to occur. That is simply when either credit risk is moving higher, interest rates are moving higher on that basis, or you have commodity inflation going on where the price of oil is perhaps spiking, as it did back in 2008.

But all that is to say that the MAP, those three portfolios, are geared toward functioning, profiting, producing, in an environment with that cost-push and inflation. At least, that is the most optimal situation that the MAP portfolios would thrive on. It could do well in a more watered-down sense in a demand-pull type situation. We have often seen gold move up in an environment where there is demand-pull going on, which I think we saw a little bit of in 2017.

But to summarize the MAP, we’re really looking at taking advantage of inflation, in general, through commodities, through the metals, in specific. Cash now is paying $1.25 or $1.50. We have some allocations to that and I would fully expect cash to be moving up in terms of its payoff, I would say quite handsomely in the next handful of years, and with that 1.5% moving up to something more like 3%, 3.5% to 4%, maybe even higher.

The S portfolio kind of takes the MAP and, I wouldn’t say dilutes the idea of it all, but we’re moderating our convictions by being long the market in certain areas, whether it is stocks or bonds, but keeping a watchful eye on the markets when either of those markets or many that we might have exposure to starts to show some fundamental weakness where we need to hedge.

So what the S portfolio is trying to do is to maintain some ownership, some cash flow, collect on dividends, produce some exposure to the long side of the market, if I can use the financial vernacular. The only question is whether we are net short or net long when things start to heat up in the wrong direction. In other words, if we are headed into a recession, do we start to hedge those positions?

David:So you’re not opposed to a blue chip position in stocks, you’re just managing the downside, willing to put on a hedge as and when necessary.

Dave:Right. Let’s say you took Walmart, for example, which I think is yielding somewhere around 2.5%, somewhere in that vicinity. As long as I’m earning that 2.5%, and my hedging of that position costs me, let’s say, half as much, I’m still cash flow positive on the position, and I have the downside protection, as well.

David:While speaking of corporate America, Dave, tell me what you see there. Prices are up in the equity markets, so that is one theme, but I think many investors assume that because prices are up, all is well. Look under the hood a little bit, will you, and what do you see that might surprise the casual onlooker, or your buy and hold investor who gets a pat on the back every time he turns on the financial news network and, “Oh, well, the Dow is up another quarter to half a point?” That’s just normal for most investors these days to expect that to continue.

Dave:We’ve had a confluence of factors, I think, that have really benefitted the markets here as of late. I just can’t derive a lot of hope from it, simply because many of the things that we’re seeing are either temporary or artificial in nature. That’s one thing you really have to be cautious about if you’re looking at this thing and thinking it’s status quo, as if this is, again, maybe 1984 through about 1995, where things were steady, stable, and healthy.

The moves we have had in the market have been exaggerated this year. And if I could point out just a few things that have helped, we’ve had a lot of share buy-backs – a ton of share buy-backs. In fact, I think we’re running at a trillion this year in corporate America. That’s a record. That’s 50% up from last year.

David:Which was a pretty big year on its own.

Dave:Yes, huge. Buttressed up against that you have 310-315 billion so far in terms of spending which would not otherwise be in the economy if it weren’t for the storms that we have had. I think in just Harvey and Irma we had somewhere north of 250 billion dollars’ worth of spending hit the economy. So if you’re looking at various indicators, you’re going to see these spikes in and around what was November of last year, what it was this year in and around April. We didn’t have hurricanes in April but we had cold snaps through the Midwest, we had a couple of tornadoes, I believe, a volcanic eruption in Hawaii, we’ve had some fires. We’ve had a lot of things going on that, I think, cost us more than what the Weather Channel was telling us. At least, that’s where I go for the estimations. They do a fairly good job of it.

But 300 billion plus – when that weighs in against the share buy-backs you had, that forced earnings-per-share, which is what everybody seems to want to focus on – we call it bubble vision from time to time, I’m sorry CNBC and those nice folks – but 26% is what it worked out to be, the year-over-year growth in earnings-per-share. So for those of you at home, if I can give a better picture of this, they have reduced the shares outstanding exponentially. They’re doing a great job of it. We can talk about how that is financed and everything later, but they’ve reduced the shares outstanding.

When you have revenue growth, profits then go up. There is a little bit of leverage involved, so there is a nice bump you get there. But if your earnings don’t change but your share balance goes down, your earnings-per-share will go up, with no change in aggregate earnings whatsoever. But we got the change in aggregate earnings based on the storms. We had a bump up. And that was weighed against the lower share balance, and so we got a 26% rise in earnings-per-share, but the aggregate earnings only went up 7.1% year-over-year.

The actual money earned was only 7.1% better, and of course, I think that was distorted by the 300 billion plus. So when you are seeing these prices move up, you have to be very careful. You have to understand if it is something that can last, or is it something that I’m looking at that is going to be short-lived?

David:Right. So let’s talk about IBM, 22 consecutive quarters of decline in revenues. We finally got one quarter where the revenues are up a little bit. That’s good news. Now, should I assume that that means that they are turning, and are now going to play catch-up to the rest of the tech sector which has colored our imaginations with everything that is potentially perfect in the world?

Dave:Of course, IBM has been hurting for a long time. It’s possible they could be turning around, but I think you want to give that a quarter or two to give it the proper air (laughs) to breathe.

David:So the other factors would be debt, share reduction, and what has kept them positively positioned in the mind of the investor.

Dave:Yes, forward recognition of their revenues, I think, has been a big thing at IBM for a while. They have a defined benefit program, as well, and I think they haven’t been contributing to that using the market returns as the basis for being…

David:Adequately covered?

Dave:Yes. The obligation has been met if the market goes up 6% on their assumption. But they’ve been using debt to acquire other firms. I could go on. I haven’t looked at them lately so a lot of things aren’t fresh on the mind, but they’ve been pulling just about every string, I think, in an accounting sense, to make their numbers go higher. And if there is one big thing that they have done, you are leveraging the company to buy additional firms, and of course the mergers and acquisitions at IBM have very active, but in the bigger sense in the last two to three years they have joined the rest of the crowd, a very large and growing crowd of people. They’re using leverage to buy back their shares.

David:I guess if you reduce your outstanding shares by 20-25%, which they have, and you increase your debt from 20-25 billion to north of 65 billion, Doug, this is one of the endemic issues that we have, whether it is corporate America or governments here, or other places in the world, debt has given us a certain perception that all is well – “We’ve been able to take money that wasn’t ours and spend it like it was ours.” On the front end that feels good. Ultimately, your concerns about credit, and being at the end of a credit cycle, more to the point it is that everyone has been doing it and no one thinks there is a problem with it. Does that, in itself, tell us where we are in the cycle?

Doug:Yes, David, I guess in seven months it is going to be ten years that I started warning about the emerging global government finance bubble. Some years ago I called it the granddaddy of all bubbles. Why did I call it that? Because we basically unleashed our bubble to the whole world. That’s central bank credit, it’s sovereign debt, zero interest rates, and basically it’s been a monetary free-for-all. It’s been in the emerging markets, it’s certainly been in China, it’s been in the U.S. And we’re at the stage of the cycle where the view is, deficits don’t matter, debt doesn’t matter, speculation doesn’t matter.

And it’s been going on for so long that it is easy to dismiss risk. And that’s where we are today, it’s that manic phase where all the money has gravitated toward those that have been the most aggressive, and that’s the most aggressive in the markets, in business, in management. Those that have been cautious have been pushed to the side. Central banks have created an environment where anyone that paid attention to risk and tried to manage risk was at a disadvantage, especially in fund management.

So you’ve seen index products out-perform actively managed products. So then you’ve seen huge flows into passive investments. The ETF industry that wasn’t around that long ago is 5 trillion dollars now. So this has gone so far beyond what we have seen in the past, and as someone that analyzes money and credit and the market macro-factors, this bubble has gone beyond anything anyone even imagined possible not that long ago.

David:Doug, I was chatting with a friend of mine who manages a mutual fund in the Midwest. It’s about a 1.6 to 1.8 billion-dollar fund, and he’s a good manager. A new CEO has entered the firm and sends out the memo – “No one should be allocating to cash.” He basically said, “That’s for someone else to determine. In an asset allocation model overall, let someone else decide what should be in cash. If your mandate is to be long equities, then you are going to be long equities.” And he made it very clear that anyone allocating to cash with the risk of underperforming the market index would be penalized or let go.

There is plenty of competition on Wall Street these days for a fund management position, this guy has been there 20-plus years and I don’t think he’s ready to retire. But I thought it was interesting, a new CEO comes in and, like you said, allocations are going to the highest returns. We’re talking about the mandate at this company of going full throttle. Nine years into a growth phase. Equities haven’t been in this kind of a stretch of growth ever, over 4,360 odd days of growth, almost uninterrupted. And the mandate is to go full throttle.

You and I have talked and you have suggested that what you see, you manage a short exposure that benefits as the markets go down. Well, the market is still going up. Why do you see this as the greatest opportunity that you have seen in your entire career?

Doug:I thought the greatest opportunity was going to be in 1999. I was convinced that there was a bubble in the 1990s, the proliferation of the leverage strategies, the hedge funds, the GSEs, mortgage-backed securities, Wall Street finance. There was a new financial infrastructure that I knew was unstable, and I was confident that the bubble would burst. When I started writing the Credit Bubble Bulletinback in 1999 I actually thought the bubble would only be in the title for a year or so. And that bubble did burst. It was an excellent opportunity.

But then in 2002 I started warning of the mortgage finance bubble that was starting to inflate. And then as that unfolded I said, “Wow, I can’t believe this kind of opportunity is presenting itself,” with what was going on in housing, Fannie and Freddie, and subprime and all of that. It was reckless. And it did create a very good opportunity, but then we had another reflation after the bubble burst, and this one goes to the heart of money and credit, central bank credit, sovereign debt. It’s global, it’s across all asset classes. We’re ten years past the anniversary of the crisis and we still have interest rates at just below 2%. We’re going to run trillion dollar deficits and we still have zero rates globally, negative rates, we still have QE globally.

So this has gone so far beyond anything I have seen in the past, and people have really bought into it. The way this works, we know from reading history, things get crazy at the end of cycles, and we’re seeing crazy. But it’s strange in that it actually becomes irrational not to be involved in the bubble. And that’s what we’re seeing in the mutual fund complex. You can’t hold cash because if you hold cash you’re going to underperform the ETFs, the indexes. You’re going to lose assets, you’re going to lose revenues. So everyone has to buy in. And this is so far beyond 1999 and 2006-2007. That’s why I’m excited about the unfolding opportunity.

David:It’s an unfolding opportunity if you’re on the right side of that trade. If you’re not, if you haven’t created any sort of a hedge, then actually there is a lot at risk. If we’re talking about the corporate issues of 1999 and it being somewhat isolated to the tech sector, that’s where we saw 80-90% declines. That’s where the most pain was felt, in a fairly small space. There were reverberations more broadly, but the real crisis was there in the tech sector.

2007 rolls around and it’s more broadly based. Now you’re talking about mortgage finance. How many people in America paid cash for their home – lock, stock and barrel? It’s a bigger issue and it’s more diversified because it is now into a lot more households. Relatively speaking, there are only a few people who own tech stocks. There are a lot more people who have mortgages.

Then you have government finance. Now you’re talking about the basis of everything that we do. So this issue of momentum and not being able to get off the train – Dave, investors are benefitting from momentum. That is what is driving the markets today. It’s the winning strategy. When have you seen this before?

Dave:Twice, in my lifetime at least. I wasn’t alive in 1929 – my grandfather was, I wasn’t (laughs). But just to back up for just a second, if I may. If we’re talking about the bubble blowing, it occurs to me that yes, we had the impetus in 1995 to 2000 – it was the tech sector that everybody got excited about. And this, of course, I think was just an excuse to perhaps behave badly financially. And I think the policy background at that time was very accommodative to allow that to happen, right? And then we had the housing sector after that that blew up.

Today, I think what we’re trying to say here is that the bubble blowing today is the financial sector, itself. It’s stocks, it’s everything – everything in terms of the wealth generation. That’s the focus. The traded securities – everything is really getting pumped up. We’re looking for ways to prop up the market as best as possible. So I think it is everything we see economically. Aside from that, it may be ancillary, or it is indirectly connected to that phenomenon. But it’s the financial market, itself, if I could describe it as such. Really, the focus has been turned to juicing that which makes us wealthy.

David:So you’ve witnessed them twice. One of them was on your watch here with McAlvany Wealth Management. One of them you were managing mutual funds – I don’t know in 1999 if you were with Nuveen or Claymore Securities, I don’t remember. But the momentum shift – what happened in 1999? Everybody wants to know, “What’s the trigger? What’s going to be that event which clues us in because I want to be the investor who gets out just before then, and if I can anticipate it then I’ll make it out on time?” What did you see in 1999? How well did those folks do trying to get out at the 11thhour, 59thminute?

Dave:I think what the driver was back then is the same today. I just think it is more pronounced today than it was back then. Back then we needed maybe an excuse. I supposed we’re using Trump as an excuse, right? The markets really took off because of him so we thought all of his policies to be bullish, so we have speculated on that premise, just as we did with tech and the housing boom.

But the real specter underneath the market, per se, I still think, is the access to leverage. The access to credit is still available, it is still there. It is still profitable to borrow somewhere across the curve and invest somewhere in the long end, whether that is in bonds – typically, today, we’re taking a lot of that short drive leverage and we’re investing in stocks.

So if there is anything to be said about the trigger at this point in time, I think what Doug is saying about the desperation of it all, having to be invested, having to play the game, having to keep this thing moving is very, very important for the players involved because the alternative is dire. To turn these markets south is going to be devastating. I think Larry Summers was talking about that over in Europe during the summit there. That was maybe about three to four weeks ago, or more.

But if there is a trigger here, I think it’s that access to credit. If there is anything that starts to block that off or prohibit it I think there are some things that are active in the markets today that are starting to move in that direction. We could see some fireworks here in the next six months to two years.

Doug:Yes, those are excellent comments. We’re in that mode of anniversaries right now – a decade since the crisis. We’re also at about a 20-year anniversary from the 1998 crisis. It is long forgotten. But I remember in the summer of 1998, U.S. markets were exceptionally strong, record highs. And I was sitting back saying, “I can’t believe the market is ignoring what is happening internationally, what is happening in the emerging markets, the risk of a serious de-leveraging and dislocation in Russia.”

Well, the markets reversed and a few weeks later a lot of people were introduced for the first time to Long Term Capital Management, and to find out all the leverage that they had – the egregious leverage. And it is forgotten that that almost brought the system down. So I would say look at what is happening now internationally, and the emerging markets – it could be Argentina, Turkey, Brazil, even India, South Africa. It’s a long list. And we’re told that it is idiosyncratic, but it’s not. It’s systemic.

I think this is the beginning of a tightening of global financial conditions, and I think people are too complacent. And the reason they are complacent is, we’ve seen brief episodes of instability over recent years, especially late 2015, early 2016, in the emerging markets in China. It didn’t even impact the U.S. and they just bounced right back. Well, that was a different environment back then. We had large amounts of monthly QE injecting liquidity into the markets. This is the first EM instability we have had in some time where we don’t have that big, positive QE backdrop.

So I think now contagion is starting to impact the emerging markets and I don’t think it would take that much of a leap to make it to the U.S. now. Here the perception is we’re benefitting from the flows meeting the emerging markets. Well, I think we could find out that if we have a global de-risking, de-leveraging, that the tightening of financial conditions that is happening globally starts impacting U.S. markets. I think that could be the surprise that could perhaps be a catalyst.

David:Doug, say you’re talking to someone – let’s pick a range, between the ages of 40 and 70 – so you have a mix of people. Some of them are saving, some of them are working, and like beavers, investing as much as they can, thinking about the future, managing allocations for, or in anticipation of, retirement. What questions should they be asking themselves right now?

Doug:I think they need to look back and see how the market instability or the crisis in 2008 affected them. And it’s not just their investment portfolio, it could be their businesses, it could be the value of their homes, their property. Try to look and get some sense how exposed they are if this is, in fact, a bubble. I know most people don’t believe it is, but I think it is time to start asking that question to make sure that we don’t have too much risk in our incomes and in our investment portfolio and our businesses. It all becomes one individual play if we are in a systemic crisis. So it is a good time to re-evaluate risk.

David:Dave, there are a lot of managers out there. You have been with McAlvany Wealth Management for some time. Maybe you can tell me what you think our value proposition is. If you said, “Ten-year vision, where I would love to see portfolios settle into, we think there is going to be a series of events and ramifications and there is opportunity in that” – where are you aiming to settle the portfolios, and is there anything that guides your management style toward that objective with a longer term, assuming we get beyond a financial crisis, what are you aiming for?

Dave:I think the important aspect to pay attention to here is, again, if we are faced with higher rates, and I’m not really sure how high they go from here. I think if it is a crisis we could be seeing double-digit interest rates on the ten-year treasury develop at some point in time. Between here and the next four years it is very possible. So I think everything you do, if we keep seeing the fundamental developments that move along that track, and we get that confirmation, I will be positioning – we will be positioning – clients’ portfolios to handle the higher interest rates, the higher costs that come along with that, the lower economic activity that ensues.

So the focus, perhaps, on discretionary-type businesses, whether that is food – you mentioned utilities before, of course there is that risk with their association with the bond market. Ultimately, we would like utilities, but that might be further down the pike. But in the near-term, again, it is positioning yourself to take advantage of higher interest rates, being prepared for the higher costs. In an environment where economic activity is shrinking, people still eat, they still take a warm shower, they still put gas in their car to get to work, etc., so we’ll be focusing on the things that benefit from the base needs of society.

David:You’re really talking quality. You’re talking about a conservative positioning – just getting that bought right.

Dave:Yes, and in the near-term, those things are expensive, and that’s why the hedges are important at this moment in time.

David:When you say double-digit interest rates here in the U.S., it is difficult to imagine. You would have to go back, really, not that far, just one generation. My parents’ first mortgage was financed at over 17%, so it’s not unheard of. This week, think of this. I guess it was a week-and-a-half ago, Argentina raises rates by 15% in one fell swoop. So now they are not at 45%, they’re at 60%.

So again, we lose perspective and think, “Well, you know, come on, we’ve got the ECB sitting on rates at sub-zero levels, and Doug, as you mention, the Fed sitting at 2%, and we’re continuing to run these big deficits. They’ve got it under control.” Well, everybody thinks they’ve got it under control until something emerges that they can’t wrap their arms around.

Dave:Yes, the Argentine stock market, itself, hasn’t really change very much, hasn’t broken into a bear market pattern during all of this. But I’ll tell you, if that central bank key rate stays at 60% for any length of time, you’re going to see some big changes.

David:Doug, if somebody wants you – they say to themselves, “Look, I’ve read the Credit Bubble Bulletin, I know his experience at Prudent Bear, and before that in the hedge fund world,” if they want you to manage a short exposure, either opportunistically, because they think the market is going to sell off, or as a hedge against legacy assets, in your mind, who is the ideal client, and what do they need to do?

Doug:The ideal client – this is someone who is sensitive to risk, questions if markets are as safe as advertised by Wall Street. This is someone that probably has an investment portfolio that they would like to at least partially hedge. They want to do it smart. They don’t want to go out and make any big bets on a bear market. But they want to reduce the volatility of their investment portfolio. They want to achieve some downside protection. That’s what we’re trying to do with Tactical Short, being tactical, managing risks very carefully.

And what do you do? You give us a call. We can chat with you and give you more information about our investment process, our philosophy, how we manage short exposure, how we can differentiate our ability to hedge market risk compared to other products.

David:Now, you speak of other products. There are funds out there, both ETFs and mutual funds that you can buy today that offer short exposure. My question for you is, why has this year’s performance for you been so much better than virtually any of them?

Doug:Yes, it’s been an exceptionally difficult year on the short side, and some of the numbers by the funds – it’s been rough, and I feel for them. I know a lot of them. They’re good people, they work hard. But I think our process is better, we manage risk better. How have we out-performed? First of all, we haven’t been caught in short squeezes, we haven’t been in some of these stocks that are up 50-60%, we haven’t shorted sectors that have out-performed. The higher beta sectors that many thought would underperform this year have performed exceptionally well.

I think a lot of funds have burned a lot of money buying puts, which is a popular strategy – “We’ll just buy puts, we know the market is going to break down.” Well, we haven’t bought any puts yet in Tactical Short. We haven’t quite seen the indicators that we are waiting to see. We think we’re getting close. We have managed risk diligently in a difficult market environment.

David:Again, it’s counter-intuitive, but things seem to look rotten at a market low, and people are ready to give up and walk away, again, when a market is just on its keister. And things look great at market tops, and you have data to confirm it, you have trend lines on a chart to confirm it. You have all these things. What does it take, Doug, for an investor to begin to shift from existing momentum toward an alternative allocation? If that’s what you’re playing – momentum, momentum, momentum, and you have benefitted from it, what do you have to do to shift your mindset to say, “Maybe just a slight allocation shift makes sense?”

Doug:To begin with, I think you need some independent thinking. You can’t just follow the crowd because a crowd always crowds in the same trade at the end of a cycle, and we’re seeing that today. I think someone needs to back up and say, “Okay, we’re running trillion-dollar deficits at this phase of the cycle. As we have been saying, interest rates are still only 2%. Globally, does this look sound? China, they’re banking system going from 7 trillion to 40 trillion during the cycle – is that reasonable?

I think you need to step back and say, “Okay, is there a chance that this is another bubble?” We’ve seen a series of bubbles going back decades. You can go back to 1987. So I think they have to ask themselves, “What’s different about this that makes me believe I don’t need to protect myself at this stage of the cycle?” It’s not easy because it’s not easy watching your neighbor make money in some high beta ETF, and you’re not making money. But it’s time to think independently and try to get away from the crowd.

David:When I think about my kids, one of the things that I want to teach them is to not be afraid of failure. Everybody makes mistakes. Sometimes people don’t do things, or they follow the crowd, because they are afraid to step out, because what if they’re wrong? I would love for my kids to know that sometimes you are wrong. And sometimes it’s okay to be wrong. What may be more valuable in the equation is the process of ultimately getting it right, which may be duplicable.

And if you have to bump along a little bit along the way, and it’s not a perfect record to get there, it’s okay. I want them to be willing to take a little bit of risk, step aside from the crowd, and not just do what everyone else in their age group is doing – just ask a few questions. It’s funny, because as adults we think that we’re done with that, being adults, following the crowd and doing what our peers are doing.

But you know what? When it comes to investing there is really little difference between the adult mindset as it approaches the markets, and the adolescent mindset as it approaches peer pressure. We can’t do it. It’s very rare to find someone who is willing to buck the trend, who is willing to ask a different set of questions, who is willing to look at things from a different vantage point.

Dave, we were talking about the Credit Bubble Bulletinand Doug’s having written that for over 20 years. Almost every Friday for the last ten years you’ve been writing your Market Wrap-Up. That is a one-pager, a great short summary, short and sweet – “Here’s what we see, and these are the things that would be impacting – the multiplier, the accumulator, the protector.” Is that a good use of time for somebody wrapping up the week and trying to get some perspective?

Dave:At the end of the day it might be more helpful to me than to anybody else. I have oftentimes been told that I need to dumb it down a little bit and put it in the common vernacular, so to speak. So, it’s probably more beneficial to me because I get to summarize, quantify, qualify, about everything that has happened during the week and I think that helps me gain a better perspective via the information on what is happening, so I have a little bit of clarity every week.

David:I don’t want you to dumb it down. I hope you don’t.

Dave:I’ve been trying to a little bit, but it’s hard.

David:But for both of you, what you do in the Credit Bubble Bulletin and the Friday Wrap-Up, you show great respect to your readership by expecting them to step into the shoes you know they can wear, which is to engage intellectually at a level that they have the full capacity to. That’s not to say that it’s easy, but I think you show a much greater respect by letting them come into a language that they may not be comfortable with, or familiar with, and gain a knowledge base and then become comfortable with it. I think that is incredibly respectful.

So, parting shots – Dave, Doug, anything you want to wrap up today with?

Dave:Right off the bat, I was looking at the last question we had here on the docket, what to make of the current environment – the general attitude is positive, we’re calling for higher stock prices. The media, I think, is looking for a continuation of this bull market. I think, right at this moment, we have some things that we have never seen before, whether it is 15, 20, 25 some-odd years, we have higher interest rates that I don’t think the Fed really planned on, both at the short end of the curve and somewhat at the long.

David:You’re suggesting they’re chasing the market, they’re not setting the market.

Dave:Yes, I think the market is setting the rates here, and I think that is what is going on worldwide. I don’t remember a time when, in the news we had north of, let’s say, one or two countries at any one particular point in time that have had a crisis ongoing. And I think right now I can count maybe six. Just to rattle off a few, we have Argentina, Turkey, Greece is in their third bailout. We could add China, perhaps, to the mix. Some people would blame that on the tariff situation but they have been having some problems that pre-existed before the tariff talks started. Venezuela, Brazil – we have probably six or seven countries, and a few more that are on the brink.

So I think you have to be very careful with the prevailing thematic, I really do. I think that if those types of things out there were allowed to proliferate in any way, shape or form – and I think you and I talked about this earlier. Back in the 1990s, if the Fed thought it was – well, whether they thought about it ahead of time or not, but when they had a chance to react to these crises like Argentina that has had a few over my tenure, we were there to rescue them very quickly. We were there to draw them out and flood their markets with liquidity, bring their rates down, restore their economy to health.

I don’t know that that is happening today and I think there is a reason for that, and I think it coincides with this, perhaps, uncontrollable market-setting mechanism that is going on in the bond market that the Fed is following. I think policy has, for the most part, lost its effectiveness, at least at this level in the marketplace it probably has. And I think that is why we are taking a step back from these crises and saying, “Wait a minute. We really have to think about helping these folks, because can we afford it? Can we afford to print the money? Or maybe, can we afford the consequences of printing the money?”

Which I think, again, is what you are seeing manifest itself in the bond market, which is through higher rates. And that is putting a little bit of pressure on our economy and I don’t think they want to further that. So I think these problems might become chronic, perhaps contagious. Argentina may not deal with us directly, but they deal with other nations – China, in particular. So we may see some back door effects here, coming round Robin, and I think you ought to be prepared for that.

Doug:David, this is my third cycle of the market going against me like this on the short side. I’ve been on the short side going back to 1990. I still refer to the 1990s as my lost decade. I just had a thought here, there are probably listeners out there that maybe this is the first cycle they have gone through like this where everything that they thought they believed, the market tells them they’re wrong, and how frustrating it can be, and how negative it can be. And we question ourselves. It’s like we get this dunce cap put on our head, and it can be really, really difficult to deal with.

But I think back to the 1990s and it was an invaluable experience. I just want the listeners to know – keep your chins up. You’re going to look back at this and you’re going to say, “Wow, I’m so happy that I lived through this and learned these lessons that will benefit me for the rest of my life.” And also try to compartmentalize our negativity about what we see in the world from our personal lives. I’ve been able to do that and it has made a huge difference. So don’t let this stuff that we’re seeing – there is a lot of nonsense. Don’t let that affect our attitudes toward life, our family, and everything else, because this will pass, and life will be good.

David:Well, when asset managers care about something more than money, I think that’s a very valuable attribute to have. A pleasure having you both in the studio today. Thanks for sharing your insights with the clients that traveled in for the seminar this last week. That was great. For those of you who are interested in the team and what we do, feel free to email us questions that you may have, follow up with us at mwealthm.com, and you will find Dave and Doug to be highly accessible. The product offerings are unique in the world of money and finance, maybe because we look at the world in a slightly different way.

Thanks, you guys, for joining us and shedding some light on the markets today.

Doug:Thank you.

Dave:Thank you.

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