Tactical Short Strategy Conference Call – April 23, 2020
David: It is April 23rd and we are excited to be with you this afternoon. This is David McAlvany and Doug Noland will be joining me shortly. We are here for the 1st quarter recap conference call and a lot of ground to cover. So Good afternoon to everyone. Thanks for joining the quarterly call, and a very special thank you to our valued account holders. We greatly value our client relationships.
As a prelude, let me share the structure of our call today which will go something like this: I will open it up, a brief overview of Tactical Short including Q1 performance. Then Doug will cover the detailed analysis of how Tactical Short functioned in the most recent financial market environment. Next, we will both comment on our ongoing macro-analysis. And then we will wrap up with Q&A.
If you are online we will do our best to field live questions after we have addressed those that have already been submitted. You can go to our web page, mwealthm.com and there is a chat box there. The chat box is there for you to submit questions live, and again, we will address those after we finish up our formal comments.
As a reminder, we are in touch with clients multiple times a week through different venues and different resources I would encourage you to take advantage of. At weeklycommentary.com you have our audio commentary put out weekly. Every Friday we have a summary of hard asset portfolios in what we call Hard Asset Insights. Again, that is at mwealthm.com. And then every Saturday, as Doug has been doing for the better part of two decades, he puts up the Credit Bubble Bulletin.
So since we have a number of first-time listeners on the call today I want to begin with some general information for those of you who are unfamiliar with Tactical Short. If you are interested there is more detailed information available at that same website, mwealthm.com/tacticalshort. While you are there I would encourage you to explore the Hard Asset Portfolios described on the website, and in those portfolios are combined a sort of total return strategy, focused on a broad array of real things, from infrastructure to specialty real estate, natural resources, precious metals, what have you.
Doug adds his voice to that team, as well, routinely observing the risks, repercussions in the global economy that tie to those portfolios. On the team he is affectionately known as our secretary of defense. So we are glad to have him contribute, both on the Tactical Short side as well as with what we call our MAPS strategies.
To Tactical Short. The objective of Tactical Short is to provide a professionally managed product that reduces the overall risk in a client’s total investment portfolio. That is our objective. We want to provide downside protection in a global market backdrop with extraordinary uncertainty and extreme risk. The strategy is designed for separately managed accounts and it is very investor friendly. You have full transparence, there is flexibility, reasonable fees, no lockups. So should you need funds for any other reason, a phone call away, and very liquid. There is no gating or anything like that.
We have the flexibility to short stocks and exchange-traded funds. We will also, on occasion, buy liquid listed put options. Shorting entails a unique set of risks, and we will explore some of those today as we look at some of the mechanics because with the volatility in recent weeks, particularly mid March, it really demonstrated the importance of not only our analytical framework, but also how if this is not done well there can be real outsized risks. So yes, shorting entails unique risks, we are set apart by our analytical framework, and an uncompromising focus on identifying and managing risk.
Our Tactical Short strategy began the quarter with short exposure at 50%. That exposure was increased to 54% in late January in response to China’s Corona virus outbreak. The exposure ended February at 59% and was boosted to 62% by March 11th. Our target exposure was not increased further, and that was due to our expectations and Doug’s keen sense of awareness that aggressive monetary measures resulting from market instability can really hurt you on the short side.
So there are pandemic uncertainties, but certainly policy responses are virtually guaranteed, so that is a part of our risk management metrics. As always, we don’t recommend placing aggressive bets against the stock market even more so in today’s environment of uncertainty and acute market instability. A disciplined and professional approach to risk management is an imperative.
We highlight this key point every quarter, but remaining 100% short all the time, as most short products are structured, is what we would describe as risk-indifference, and we believe a very disciplined risk management is absolutely essential for long-term success on the short side. We have structured Tactical Short to ensure the flexibility to navigate through even the most challenging of conditions, the past year having been all of that. Doug will illustrate later how a 100% short portfolio introduces what we call the meat-grinder, an effect which, again, underscores the importance of a managed position.
Bear with me folks, I’m getting some feedback that the audio is a little spotty.
Doug: Good afternoon, everyone. Thanks for being with us today. I will start here with updating performance. Tactical Short accounts, after fees, gained 12.65% during Q1, as David mentioned. The S&P returned a negative 19.6. So for the quarter Tactical Short accounts gained 65% of the S&P 500’s negative return. As to one-year performance Tactical Short, after fees, returned 3.07 versus the -6.99 negative return for the S&P 500.
We also regularly track our performance versus three actively managed short competitors. First, the Grizzly Short Fund returned 25.81% during Q1. For the year, Grizzly returned 8.13. Ranger Equity Bear returned 29.1 during the quarter and 1.31 for the year. Prudent Bear returned 17.38 for Q1 and 4.25 for the past year.
While lagging during Q1 Tactical Short has significantly outperformed each of these Bear Funds since inception. That goes back to April 7th of 2017, since inception, through March, Tactical Short returned -6.93 versus the 16.26 return for the S&P 500, while on average outperforming our three competitors by 1533 basis points. It is also worth noting that on average our three competitors lost 28.55% in 2019 versus Tactical Short’s loss of 16.39. One of our competitors last year suffered a 36.28% loss. The way it works, the way the numbers are, if you lose a third of your money you have to make 50% just to get back to break even. So what an incredible environment.
First of all, I hope everyone has been staying healthy and safe. In January’s call, I recall saying, “Let’s hope this new Corona virus proves to be no big deal. Regrettably, it became so much of a bigger deal than any of us could have ever imagined. Those of us on today’s call are surely the fortunate ones.
Our objective for Tactical Short is to provide a reliable hedging vehicle with a lower risk profile compared to other short products, and Tactical Short will tend to significantly outperform competitors in a rising market environment, as it did in 2019. It can be expected to somewhat lag in periods of sizeable market declines, especially in the event of abrupt and precipitous market drops as we experienced in March. I don’t like it when Tactical Short underperforms as much as it did during the quarter, though a chunk of this underperformance has been reversed with a strong market rally to start off Q2.
It was a tough call, but I made the decision to maintain a risk management focus that cost us performance during the quarter. I will spend some time explaining the factors behind my mindset as it helps illuminate how we do things differently than others. To begin with, I don’t enjoy having to discuss why we didn’t make more money, but I’m prepared for it. I am in no way prepared for, what I would absolutely hate to have to do, is to explain surprising outsized losses. Minimizing potential losses has been and remains a top priority.
To explain my measured positioning during the quarter it is important to return to key 2019 developments, first of all, while we managed risk cautiously, Tactical Short accounts nonetheless suffered disappointing losses, losing about half of the S&P 500’s return for 2019. Last year was, as well, a period of extraordinary policy developments, and despite stocks at all-time highs, unemployment at 60-year lows, the Fed employed aggressive monetary stimulus measures, cutting rates, restarting QE. Moving early and aggressively, so-called insurance policy measures became the Fed’s prescribed policy approach.
So again, 2020, as manager of short exposure, committed to a lower risk approach, I confronted the challenge of managing accounts that had already suffered losses, with the Federal Reserve poised to respond forcefully to any incipient market instability. This played heavily in my risk versus reward calculus. Despite my view that we were nearing the end of history’s greatest bubble, our investment philosophy, risk disciplines, and macro-analysis were in alignment, dictating that short exposure be managed carefully.
It was going to be necessary to see things that were unfolding, both for confirmation of market weakness and to reduce Tactical Short account losses, before I was comfortable taking a more opportunistic approach with short exposure. And I knew this would not be a very satisfying strategy, and that is for account holders, for me, or for our business. But the priority was to provide a hedge against a market decline without risking outsized losses. Analyzing market and policy backdrops, there remained a high probability for bouts of speculative excess that I was compelled to guard against. Unique corona virus related uncertainties only added to the challenge. And recall that a highly speculative U.S. equity market completely dismissed China’s corona virus outbreak, trading to record highs on February 19th.
As it turned out, shorting high beta was the big winner in March, and for the quarter, a speculative bubble abruptly deflated and stocks of fundamentally challenged companies that had been detached from fundamentals, those that had operated in that space had big first quarters, though this was after sustaining major 2019 losses. And it is worth noting that many investors fled the high risk short strategies last year after being hit with painful losses, missing out on Q1 gains. We actually retained almost all Tactical Short accounts last year, a testament to the fortitude of account holders, and thank you for that.
While we don’t typically highlight these comparisons during quarterly calls, I regularly monitor Tactical Short performance versus a few lower risk short mutual funds. The ProShare Short S&P 500 is a popular ETF that is 100% short the S&P 500. This fund returned 15.31% during Q1, capturing 78% of the S&P’s negative return. Think of it this way. Tactical Short averaged around 60% short exposure during the quarter, capturing about 65% of the S&P’s decline.
The ProShare’s Fund, on average, had 67% more short exposure, and that is 100% short versus Tactical Short’s 60%, while capturing about 21% more return, their 15.3 versus Tactical Short’s 12.7. A typical reaction would be, why didn’t the ProShares return at least 100% of the S&Ps decline during the quarter? Was there some problem, or trading issue, that caused the fund to not perform as expected?
The fund actually performed as it is structured to do, and here is what is important to understand. This product rebalances every day. That means it adjust short exposure to ensure it starts each new trading session at 100% short. This aspect of managing short exposure – it tends to be confusing, so bear with me a bit on this — unlike on the long side, short exposure and account value move in opposite directions.
Let me give you an example. If short exposure is at 100% of account equity, let’s say, $100,000 account with a $100,000 short exposure, a 1% decline in the market index would see short exposure decline 1% to 99,000 while account equity would gain 1%, to $101,000. Rebalancing means adjusting short exposure to get back to that 100% bogie. In a market decline this means repeatedly increasing short exposure to stay 100% short to keep up with gains in account value.
So in a downward trending market this works to somewhat compound returns. In a simple example, think in terms of the market down 10% with an index short fund up 10% year-to-date. If the S&P 500 then falls 1%, or an index at 90% of its beginning year value, the S&P 500’s year-to-date loss would be 10.9%, that 10% plus 1% of the 90% index. Meanwhile, the index fund’s 1% gain would be on a bigger base because the base is now 110% of where it began the year, increasing year-to-date gains to 11.1%.
Things get trickier after an index suffers a major decline. Imagine a market index that begins the year at 100 and then falls 20%. In our simple example, the index would drop to 80, and our hypothetical bear index fund’s value, starting year at 100, jumps to 120 after profiting 20% from the market decline, and this simple example ignores compounding.
But now, let’s say the market reverses abruptly and rallies a quick 20%, and we saw it. So the market index would rise 20% off its 80 level, jumping to 96, a hypothetical bear index fund suffering a 20% decline from its 120 level loses $24, dropping down to 96. In this simple example the market index, as a 4% year-to-date decline, with a hypothetical bear index fund posting a 4% loss, as major volatility had the fund failing to benefit from the year-to-date market decline. Rydex (sp?) also has an inverse S&P 500 fund. It returned 15.43% during Q1, or 79% of the inverse of the S&P 500. As of last Friday’s close its fund was up 2.5% year-to-date compared to the S&P 500’s -10.5% return. That’s the way the numbers work with daily rebalancing.
So right here you see one of the disadvantages of these types of products is illuminated, especially in highly volatile market environments. They automatically rebalance daily no matter what the market does. This means when the market suffers huge daily drops the fund will add addition short exposure to ensure the fund is 100% short for the next trading day. Similarly, when the market is up big the fund will unwind short exposure back down to 100. I have always referred to this buy high, sell low dynamic as, and David mentioned this earlier, the meat grinder effect, creating a key performance challenge in managing short exposure in hyper-volatile environments. And Q1 was about as hyper as it gets.
With Tactical Short I generally rebalance short exposure back to target on a weekly basis, yet market analysis and discretion are crucial in the decision process. Tactical Short was not rebalanced during the mid-march intense market drops, thus providing a relative performance advantage versus the automatic rebalancing that the funds do. That’s when the market rallied sharply near quarter end.
We also monitor the performance of PIMCO Stock Plus Short Fund. It returned 12.46% during Q1, slightly underperforming Tactical Short. Tactical Short significantly outperformed this fund in 2019. It is worth mentioning, the high beta doubled the inverse funds that could be really disadvantaged by wild volatility. As of this morning when I checked, and that is despite the S&P 500’s -11.8% return, the ProShares Ultra Short that doubled the inverse of the S&P 500 fund, which most would think would be up big, was down 1.9% year-to-date, suffering from the volatility.
As much as it would have been rewarding to have had more short exposure and some more volatile higher beta shorts, that comes with greater risk of performance issues. During the crisis period of 2008 the SEC announced a ban on shorting key financial institutions in. My financial stock portfolio rallied 10% in one session in extreme volatility I had not experienced in my almost 19 years of shorting at that time. Well, 2008 now seems rather placid compared to this year’s crazy market swings.
In 13 sessions starting on March 3rd, the S&P 500 collapsed 28%, but we have experienced some extreme upside volatility as well from March 23rd lows to the close on March 26th, the S&P 500 rallied 20%. The rest of the 2000 small caps had two 20+ rallies between March 23rd and 27th, and then from April 3rd to the 9th. The bank index had rallies of 25% and 28%. The Goldman-Sachs most short index posted two 30% rallies. Many of the higher volatility strategies have really suffered during this rally. Bear market rallies tend to be the most ferocious and such upside dislocations force difficult decisions on the short side. You cut back exposure on price spikes which can really negative impact performance, or do you let positions run against you and watch overall short exposure expand rapidly?
Importantly, the higher the portfolio beta the more consequential these trading decisions become and wrong guesses can be quite painful. Expectations for extreme uncertainty and market volatility have played a decisive role in my decision to run short exposure within very well defined parameters. As I said earlier, it is not very satisfying, but it means we get through this unprecedented period without big negative surprises.
I would have expected to have added more short exposure during the decline. But I held back because of my long held rule in adopting a cautious approach when the Fed commences crisis management measures. Recall that the Fed cut rates on March 3rd after an unscheduled emergency meeting, and I think this was only 10 sessions from the market setting all-time highs. The next week, the Fed boosted the potential size of repo operations by as much as 500 billion and then slashed rates to zero, announced a 700 billion QE operation on Sunday, March 15th. Boosting short exposure after acuity announcement is a risky proposition.
The Fed then began creating various funding facilities, starting with programs from 2008 that offered liquidity support to banks, the broker dealers, commercial paper, the money markets, and then introduced new facilities for state and local governments and Main Street. The Fed announced it would purchase investment grade corporate bonds and ETF shares, a huge move, and then quickly followed that up by broadening its mandate to include recently downgraded junk bonds, as well as ETFs that hold high-yield debt. This unprecedented crisis management response saw the Fed’s balance sheet expand a stunning 2.1 trillion in six weeks to surpass six trillion for the first time.
For a while now, I’ve been saying that the Fed’s balance sheet would inflate to 10 trillion during the next crisis. There was no doubt that unprecedented speculative leverage had accumulated over this protracted cycle and as we witnessed during marches dislocation, in a serious de-risking, de-leveraging episode, it’s basically only the Fed and central bank community with the capacity to accommodate speculative de-leveraging. What’s stunning is how quickly the Fed had to resort to unprecedented monetization efforts and the Fed asset growth now averages about 200 billion weekly, which would not surprise me.
The Fed will hit this 10 trillion bogie by year end. It’s incredible and it’s also frightening. To go along with unprecedented monetary stimulus Washington has unleashed unparalleled fiscal stimulus, with estimates for this year’s federal deficit approaching four trillion. I fear we’ve entered a precarious phase of unbridled monetary and fiscal stimulus that will be very, very difficult to rein in.
I want to address what I fear is a momentous misconception. The conventional view today holds that the U. S economy was healthy and robust prior to the outbreak. With some temporary pandemic period support the U.S. is going to rather quickly return to its previous enviable position, most believe. Here, my analysis takes strong exception with this popular view. U.S financial and economic systems have for years been dominated by bubble dynamics. It’s been part of this historic global credit and speculative bubble.
Unprecedented speculative leverage accumulated over this long cycle throughout securities and derivatives markets at home and abroad. Years of ultra-loose finance, also deep structural (inaudible) _00:27:15_ adjustment, more specifically, (inaudible) _00:27:20_. I would say (inaudible) _00:27:19_ thousands of (inaudible) _00:27:22_ and large enterprises (inaudible) _00:27:26_ in a backdrop (inaudible) _00:27:29_ and inflating asset prices. Years of the easiest money imaginable created an unsound system dependent upon rapid credit growth, rising financial leverage and asset inflation.
So long as the boom continued, the system appeared robust despite worsening latent fragilities. The system appeared sound and bulletproof as of February 19th. But in in March we witnessed how abruptly a risk-on backdrop can transform into to risk-off de-leveraging, illiquidity, dislocation and crisis. I believe Covid-19 is the catalyst for piercing history’s greatest global bubble.
When I refer to a bubble, I’m speaking of a self-reinforcing, but unsustainable inflation, generally fueled by credit and speculative excess, and typically underpinned by government intervention
and resulting market dysfunction. I’ve argued that unprecedented post mortgage finance bubble reflationary measures and notably extreme monetary stimulation and government debt growth unleashed what I have referred to as the global government finance bubble.
I’ve called this the granddaddy of all bubbles, believing there is no fledgling bubble ready to reflate the global system when the current bubble deflates. From a bubble perspective, we’ve reached the end of the line. There is no source of credit to massively expand beyond central bank credit and government debt. There’s no grander economic bubble to inflate when the bursting of China’s bubble takes down EM and myriad global bubbles in the process.
I am confident in the bursting bubble thesis. With global policy-makers now desperately expanding central bank liquidity, government borrowing and spending, along with the most egregious market interventions, all to try to hold bubble collapse at bay. This comes with great risk, with policymakers literally risking a crisis of confidence in central banking and financial markets, and for finance more generally.
So let’s delve deeper into a macro-analysis, first with a global focus and then circling back to the U.S. Today we see three critical international fault lines – Europe, the emerging markets, and China
that are key areas of fragility made acute by the pandemic.
I’ll hand it back to David as long as he’s got his technical glitches worked out to discuss Europe’s difficult situation. David, how’s it going there?
David: Let’s see. First, you mentioned Europe and we’ll dive in on that front. This is one of the three fault lines which is very structurally weak. We’re talking about structurally weak economies, we’re talking about fragile banking systems. We’re talking about social and political instability and as a result a vulnerable euro currency regime. In particular, Europe’s troubled periphery at the edges has been hit hard by Covid-19. You have Spain and you have Italy. They trail only the U.S. In terms of global infections and in terms of the death rates that they’ve put on record. Their statistics are about as bad as they get in the world.
European ministers met again today in an attempt to cobble together some type of agreement for an EU Covid stimulus package. Italy is at the heart of this. Italy came into this crisis with national debt-to-GDP approaching 140% and in a likely scenario where GDP contracts 10%
and debt surges at least 20% this year and growing rapidly again next year, it’s not long before Italy is facing an unmanageable 200% of GDP debt loads.
Conservative estimates have Portuguese government debt expanding to 146% of GDP this year, and Greece in the neighborhood of 219%.
Italy’s weak coalition government is arguing for the EU to issue system-wide Corona bonds, then employing these funds for grants to troubled nations, and that does not go over well with other member states. You’ve got Germany, the Netherlands and others which have been adamantly opposed to debt mutualization. The Conti (sp?) government is warning its EU officials that Italy cannot handle a surge in debt issuance and will not put its citizens through a Greek style austerity and debt restructuring.
So our view is that Germans and Italians sharing a common currency is unsustainable over the longer term. I’ve expected hardship that would accompany the piercing of the global bubble to again place European monetary integration and the EMU project at risk. You’ve got Italy’s deteriorating circumstances. That risks sparking public support for exiting the euro.
An important facet of March’s global dislocation was the spike in Italian bond yields, and this is something we cover in our portfolio manager meetings multiple times a week. But along with that, you had a dramatic widening of European periphery yields versus the safe haven German bunds. And I believe the global leverage speculating community is a major holder of Italian and periphery bonds, which only made sense. If you could get a little bit more in yield and you thought that the ECB had your back, why not? But this is insured vulnerability to the risk-off illiquidity dynamics which have been in play.
There’s the euro breaking lower. This is the currency, itself, breaking lower on heightened concerns for periphery debt and eurozone integration, which would only add fuel to the dollar’s upside dislocation. And with King Dollar already benefiting from the U.S.’ competitive advantage in terms of fiscal and monetary stimulus, an additional push higher for the dollar from a euro crisis would place only more pressure on your faltering emerging market currencies, including the RMB, the renminbi.
Doug, I think this is a good segue (sp?) back to you to discuss the emerging markets.
Doug: Yeah, let’s do it here. We believe EM booms have been a central facet of the global bubble. They’ve been thriving from a confluence of overheated domestic credit systems and booming Chinese demand and credit excess, along with unparalleled leveraged speculation and international flows. I remember when developing economies were called roach motels. International speculative flows would gravitate freely into EM booms, only to eventually be trapped by collapsing currencies, illiquidity, and capital controls come the arrival of the bust. After the most protracted of booms, I believe a historic bust has commenced.
Collapsing the EM currency and bond prices were a key aspect of March’s seizing up of global markets. Central bank policy measures, including the Fed’s expanded international swap arrangements, along with the global rally, they’ve somewhat stabilized developing markets.
Yet EM remains the global financial system’s weak link. EM has added unprecedented amounts of debt during this long cycle, too much of it dollar denominated. Widespread debt restructurings and defaults
EM now faces a very, very difficult road ahead. The hot money outflows have commenced, currencies have faltered and bond markets have turned unstable. Acute financial and economic fragilities have begun to surface. And I would say, importantly, EM central banks lack the flexibility to employ monetary stimulus to the extent enjoyed by the major central banks. Liquidity injections risk exacerbating outflows and currency crises, at the same time stoking inflationary pressures and bond yields. Sinking EM currencies and bond prices then incite panic, hot money outflows, dislocation and financial crisis. To make a bad situation worse, aggressive stimulus by the Fed bolsters U.S. Treasuries and securities markets, drawing international flows to King Dollar. The stronger dollar then further pressures EM currencies and stokes de-risking, de-leveraging dynamics.
I believe EM has entered what I expect will be a deep, multi-year down-cycle with far-reaching market, financial, economic, social
and geopolitical ramifications. Emerging market economies, certainly including China, played a powerful role as the global locomotive pulling the world out of the previous crisis period. They will now act as a major drag. I worry greatly about a potential collapse of China’s historic credit and economic bubbles.
And keep in mind that China’s banking system expanded more than five-fold from about 8 trillion to 42 trillion in dollar terms over this cycle and such excess virtually insures deep systemic structural mal-adjustment. It’s certainly fueled a historic apartment bubble. Housing and economic busts will leave one colossal hole in Chinese bank capital. There is no doubt about that. And I know complacency is rooted in confidence that Beijing has everything well under control and that they will simply recapitalize their banking system using central bank PBOC credit.
As for the economy, China’s GDP contracted at a 9.8% pace during Q1, but despite this slowdown, China’s dangerous terminal phase of credit bubble excess runs unabated. Quarterly growth in China’s aggregate financing metric, and that’s their key measure of system credit expansion, jumped to a record 1.574 trillion, 1.5 trillion, just during the first quarter, and that was 29% above Q 1 2019 growth. I fear for what the unfolding downturn will reveal about Chinese finance.
I believe Covid-19 will prove the catalyst for piercing China’s historic bubble. Chinese consumer confidence was inflated by years of rising incomes and apartment prices. China now confronts its first housing down-cycle with an estimated 60 million unoccupied units. With expectations now deflated, it might be some time before consumer spending returns to pre-crisis levels.
And already struggling with huge overcapacity, China’s massive export sector faces the grim prospect of not only collapsing EM demand, but a global depression. In a recent CBB, I referred to China as the king of subprime. Not only did China develop into the manufacturer for the world, it was also the leading financier for scores of emerging market economies. They face the difficult choice of throwing good money after bad or cutting bait. This aspiring superpower will not easily pull back.
Beijing and the People’s Bank of China also face tough decisions with regard to fiscal and monetary stimulus. To hold collapse of their maladjusted system at bay will require massive U.S. style stimulus.
Such measures, however, risk a crisis of confidence and a highly destabilizing run on the Chinese currency. I believe it disorderly fall in the renminbi poses major global systemic risk.
I will wrap up this segment with a focus here at home. Let’s return to conventional thinking that the U. S economic boom was fundamentally sound versus my view that our market economy is an unsustainable bubble fueled by years of loose money, including last year’s aggressive monetary stimulus and fiscal deficit. This is no mere intellectual debate. I mean, these are two competing analytical frameworks,
and it matters tremendously which one proves closer to reality.
If the bubble analysis is accurate, expect the real economy to require massive ongoing stimulus, anticipate fragile financial markets, demanding, unending Federal Reserve stimulus.
Looking back at the previous crisis, continuing claims for unemployment nearly doubled to 4 million from the initial subprime eruption in June 2007 to the heart of the crisis in late 2008. The unemployment rate had jumped from 4.5 to 6.5% prior to the Fed unleashing a trillion dollars of cheating. I mean, it was a terrible hardship for millions of workers, yet scores of uneconomic businesses that proliferated during the loose money boom had to be shuttered.
Resources needed to be re-allocated, with the system requiring a period of major adjustment and restructuring.
Clearly, over the past month central bankers and government policy makers were not going to allow markets and economies to collapse. But our runaway financial free-for-all will come with steep costs. A decade of ultra-loose monetary policy ensured unprecedented proliferation of uneconomic enterprises, and that’s from sole proprietorships to small businesses, to major corporations. Many of these businesses are viable only with boom-time conditions.
There has similarly been a proliferation of businesses that depend on loose financial conditions and rising securities and real estate prices.
A dangerous view took hold that central bankers had conquered the business cycle. Whatever it takes, central Banking would resolve any problem. No longer did we need to fret bear markets or recessions,
not to speak of crises. Such perceptions became deeply embedded in financial asset prices and this epic loosening of financial conditions sowed the seeds what I expect to be the most challenging downturn since the Great Depression.
I didn’t believe it in the past, and I definitely don’t believe it today.
More central bank money and market intervention is not the solution.
Inflation is instead fundamental to the problem. What gives me confidence to claim the bubble has been pierced? First of all,
I believe, confidence in central banking has been badly shaken.
We’re now in the second major financial crisis in 12 years. It will not be so easy to dismiss this episode as the 100-year flood.
It’s been a global bubble dynamic, and confidence in policy-making is taking a decisive hit worldwide. I expect faith that Beijing has everything under control to be challenged. Markets will likely begin questioning the soundness of international financial structure.
Markets have over this cycle made assumptions with regard to market liquidity and continuity. We’ve recently seen some of the biggest market swings in decades, even generations. We saw the VIX index surge from 14 to 84 in about three weeks. Markets experienced systematic illiquidity across the board, including treasuries. Corporate Bond ETFs rapidly lost 20% of their value. This week we witnessed the four-month WTI crude contract sink 300% in one session to negative $40. We’ve witnessed things that couldn’t happen actually happen.
We now live in an age of alarming uncertainty. Myriad latent risks have sprung loose and I don’t believe they will be contained by central banks or global policymakers. This ensures a momentous change and market risk perceptions. At this point, I doubt any amount of monetary and fiscal stimulus will alter this reassessment of risks and changes in behavior. I have no doubt that trillions of central bank liquidity will spark major rallies and trillions of fiscal spending
will help stabilize economies.
On the market front, all this QE marketing intervention will exacerbate instability without improving the long-term prognosis. Indeed, as I’ve said earlier, the current trajectory, and if I’m right on the impetus for large ongoing monetary stimulus, it risks at dangerous crisis of confidence in central banking. I expect reduced risk tolerance which equates to a tightening of financial conditions irrespective of monetary policy.
I’ll throw out a few changes I expect to the global financial landscape.
There will be reduced risk-taking and less speculative leverage. I believe there will be far-reaching changes in the derivatives markets.
This massive complex has prospered on the specious assumption of liquid and continuous markets, a premise made viable only with confidence in the absolute power of simple banking.
Going forward, I anticipate market operators will be less willing to sell various forms of market protection, and the rising cost of such insurance will equate to less risk-taking generally throughout global markets, and that’s by investors, the leveraged speculating community organizations and financial institutions. There will be less MNA (sp?), less stock buy-backs, structured finance and financial engineering, more generally. As for the real economy, this spending free-for-all will delay crucial economic adjustment. Moreover, it will surely solidify the perception of inequality and injustice deepening the divide.
We’re an divided nation. Trust in our institutions
is increasingly fragile. Tighter conditions both in the markets and in bank lending will impinge recovery. For a while we will have more cautious households and business sectors. Beyond less overall spending, major shifts in consumption and investment patterns will reverberate throughout economic and financial systems.
In last week’s Credit Bubble Bulletin, I suggested that the U.S. stock market has become “a side show oddity.” I worry greatly about the consequences of the bursting of the U.S. Financial market bubble.
Perhaps my bigger fears revolve around social, political and geopolitical developments. As catalyst for the bursting of global bubbles, the pandemic has altered the world order. So many things are in the process of fundamental change, with most not yet in clear view.
The upside of bubbles, buoyed by an optimistic view of expanding the economic pie, is conducive to cooperation, assimilation and integration. The downside unleashes a demoralizing slide into antipathy, disintegration and confrontation. On the geopolitical front, we’ve already seen eruptions in the initial weeks of the pandemic, strongman leaders in Russia and Saudi Arabia and a bare-knuckled price war. There is back and forth enmity between the U.S. and China over the origin of the Corona virus. And in Europe, discord is stoking fears for the future of monetary integration.
I’m compelled to repeat that I’m an analyst and not a pessimist. We’ll get through this, but it won’t be easy. Hopefully, we’ll begin economic recovery soon. There is pent up demand and inventories to rebuild, to get our lives back to normal. My heart goes out especially to so many small businesses that will struggle to survive. I see no way around a protracted economic adjustment period. I believe we’re in the initial phase of what will prove a momentous adjustment to the securities and derivatives market, and that’s at home and abroad.
Unfortunately, it’s a troubling in view of the world in which we live today.
I am at the same time encouraged by prospects for Tactical Short and McAlvany Wealth Management. I believe we apply sound analytical prisms in viewing an unsettled world, while possessing unique experience, talents, and investment processes. As always, we will be hardworking, disciplined and determined.
David, back to you.
David: Thank you, Doug. We’ve covered as much ground as we can on Tactical Short in particular, and we have a few questions stacked up online. Those will follow about five pages worth of questions that you’ve already submitted, so we’ll try to get through these questions as quickly as possible. Thank you very much for the attention paid to our formal remarks. Again, if you have interest in Tactical Short as an addition to your total portfolio strategies, that information would be found at mwealthm.com/tacticalshort, and we are always available to do conference calls and answer any questions that you may have, so feel free to reach out to us.
The questions that were submitted – the first is relating to precious metals.
How much gold and silver should I invest in?
And Doug, I want to point back to one of your comments, which was relating to our analytical framework and how in this bubble analysis, if we’re right, then we are talking about unending Federal Reserve stimulus, and this is one of the reasons we have a preference for real things. And this is one of the reasons why gold and silver feature prominently, or we think that it should, in someone’s total net worth picture. So there are different ways to approach gold and silver, and on that basis, perhaps I could be prescriptive in different ways.
There are some who will look at gold and silver as a means of growth in this environment, and I think there are appropriate tools to use if growth is your primary objective. That may include option strategies, that may include mining shares and things of that nature. But I would suggest that first and foremost you start with gold and silver as a means of wealth protection, as something that has endured through every business cycle from the beginning of time and has retained value and preserved wealth.
So if you view it as an insurance policy, then I think you could look at sort of two different metrics. The classic European metric is something like 10% of net worth in an asset that is liquid but is outside the financial system. If you’re looking instead of at net worth, looking at that in terms of liquid assets, which tends to be a significantly smaller number, you could say up to 1/3 of liquid assets could be in a combination of gold and silver. Gold tends to be more reliable, less volatile. Silver tends to be more volatile, and also provides some additional growth opportunities.
So if that’s of interest, bear in mind that our family history with the metals predates the legalization of gold. We’ve been helping institutions and individuals own it in a portfolio, and we’ve been doing that since 1972, 2-1/2 to 3 years before it was legalized. And actually, we got to participate in helping get it legalized for January 1st 1975.
The second question, moving along is, is it best to ride this out? And what stocks should I be purchasing while they’re down?
I think if I were to add to that question, if it means do nothing in terms of an equity portfolio and hope for the best, then I would say no, it’s not best to ride this out. As Doug has suggested this is a protracted issue we’re dealing with, very structural in nature and actually goes well beyond Covid-19 where Covid-19 may have revealed weakness within the financial system. And so even with resolution of Covid-19 which will, of course, occur at some point, we’re very concerned that what has been baked into the cake still is there. And so, no, we would not sort of hope for the best in that regards and ride it out.
I do think that for those with an equity portfolio, Tactical Short makes a great addition a hedge, as something to reduce your downside volatility. And I would say this, too. When we look at our map strategies, this is our hard assets strategies, we’re talking about assets that are driven positively by the implications of monetary policy. On a short term basis, of course, we have deflationary trends that we have to be cognizant of, that is, a collapse in particular asset prices.
So those deflationary forces in play lead us to play that game very cautiously, and you’ll find in a current allocations a very high emphasis on cash. With existing accounts 40% is common. With new accounts, we could be as much as 80% in cash. So we’re cognizant of the deflationary impacts in the short term. In the long term, we see the inflationary implications of the current monetary policy and fiscal policy frameworks that are in place and will continue to be throttled. So we do think that real things make sense and that, in the end, is a better way to sort of ride it out if you must.
Doug, a question for you dealing with counter-party risk.
What counter party risk is involved in your short strategies?
Doug: Yeah, good question. Counter-party risk has been a concern of mine throughout my career. I’ve never confronted an issue with that, managing it carefully. Unlike other short strategies, we don’t use over-the-counter, these third-party derivatives, so right there, we significantly mitigate counter-party risk. We chose interactive brokers for our accounts specifically with an eye on potential counter-party risk issues. They have a history of avoiding proprietary trading and carefully managing other risks. That’s notwithstanding the loss that they announced Tuesday evening related to customer accounts on the negative press crude oil contracts. But we think this was just a very unusual situation. We have confidence in and the risk management focus.
David: The next question is, again GLD, and I’ll take this one.
I’d also like your input as to the risks of using vehicles such as the GLD ETF as a way of investing in the gold market when physical gold is scarce, or trading at what most would consider too high of a premium to spot.
Let me give some perspective on that because we do have a business which trades in the physical medals. And I will say that there are real supply constraints when it comes to your small products, 1-ounce up to, say, 10-ounce size products, both gold and silver. When you start getting into the larger bars, which of course, GLD is dependent on, there’s really not an issue in terms of supply. We’ve seen plenty of supply available, and the means of procuring it has not been difficult at all. GLD has faced no issues to date. That’s something we will continue to review on an ongoing basis.
We will use GLD as a trading vehicle in the MAP strategies when we want something of a hedge for cash or we feel like the cash position is large enough that we want that as a part of our liquid position. But I would say that if you’re looking at building a metals portfolio, then I would I would choose something that is counter-party free, and you can look at, whether it’s physical metals that you hold in your possession or something like our vaulted program where we’ve seen a 1200% increase in demand within our vaulted program. It’s just vaulted.com.
Again, you are just removing the counter-party exposures and owning physical directly, either in the form of a kilo bars or in whatever form you choose to take delivery of it. So GLD, I do think a bottom line good vehicle. It’s proven both in the 2012-2014 period when there was intense liquidations and also during a major spike, an increase in demand. So on the acquisitive side, it’s proven to be an incredibly stable vehicle. That doesn’t mean that our homework ends, it means we continue to watch it for any aberrant behavior. But so far, both with mass liquidations 5, 6, 7, 8 years ago, and mass acquisitions, it’s performed very, very well.
Doug, the next question is on modern monetary theory.
Do you assume that MMT, or modern monetary theory, is bunkum, and will never be adopted by fiscal and monetary authorities?
Doug: Well, I do see MMT as bunkum, and I like that term, and it is essentially being adopted by the Fed in Washington today. I look at MMT generally as just the latest sophisticated incarnation of the same inflationism that repeatedly occurs throughout history. They always wrap it up a little differently, but at its core, it’s the same. I receive emails informing me that there are some thoughtful MMT proponents out there, and I’m sure that’s the case. I just have little to no confidence at this point in our government’s capacity for reasonable and rational debt and spending plans.
We’ve reached the helicopter money phase, and it’s a good time to recall that the history of inflationism is that once the money printing starts, it becomes almost impossible to rein in. It’s always, you read about just one more year of printing, we need just to get through the crisis, make it over the hump,
and we’ll get back to normal. Inflation history is full of good intentions run amok, and I think we’re watching it in real time now, unfortunately.
David: The next question is on an article out in the last couple of days where Bank of America-Merrill Lynch put a recent call out for gold to hit $3000 an ounce. The question is:
What is your opinion of B&A’s recent call of $3000 an ounce for gold?
There are tight supplies, and what I would say is that’s a constant case with gold in the sense that it is, by its nature, inelastic. You can have a radical increase in demand, and it’s not like you can run extra shifts and just produce more of it. There is a huge lag time between digging in the dirt, processing it, getting it refined, and moving to market. So, getting to $3000 an ounce, I think, may end up being a very conservative number because you have a rapidly expanding investor base aware of something that most investors are not generally sensitive to.
You remember, Keynes used to say that not one in a million investors or people know or understand inflation. And I think when you start – it was just a few weeks ago, 2.3 trillion here, and we’ve got various lending programs, 1/2 a trillion there, 1/2 a trillion here. I think it’s now on the minds of most Americans and most around the world that there is a lot of money printing going on. So you’ve got a rapidly expanding investor base. You don’t have a rapidly expanding supply. That makes for one very realistic scenario, which is an exponential expansion in the price.
Go ahead and play what we had this last week with the oil markets through your mind. We had an exponential collapse in price for oil because you had too much supply and nowhere to put it, so you end up with his oddity of trading negative. But it was an exponential collapse with too much supply. Is it reasonable to think you have an exponential rise in the price of gold with the opposite case being there, too little supply? And then again, you just run demographics and investor allocations. What they currently have allocated to gold is very, very slim indeed. So that’s my opinion on the $3000 for gold from B of A.
Doug, to you:
What is your opinion of using SPXU as my primary downside hedge?
Doug: SPXU — that is the Proshares Ultra short S&P 500, triple the inverse of the S&P ETF. I don’t like high beta, so I would hate this product. I pulled up the numbers. As of yesterday’s close, that’s with the S&P returning -12.8% year-to-date, that product was down 6.31%. So that shows you the risk of a high volatility-type short product in a volatile market.
David: Can I clarify that? Because if you’re saying it’s three times the inverse, a -12 for the S&P should be a positive 36 for the SPXU. And instead of a positive 36 it’s -6. Did I get that right?
Doug: Yeah, that’s the meat grinder. And think of it. I said earlier where we had a 20% rally, it was off a lower base. But if you’re short a 20% rally on a triple-the-inverse product, you’re gonna take a big hit, right? Any type of rally is going to really, really grind up performance. So I certainly don’t like it as a primary downside hedge. Basically, this is this is an instrument for aggressive, sophisticated traders, if that. Such products, as far as I’m concerned, should carry a warning label for retail investors unfamiliar with how leveraged ETFs function and the risks associated with market volatility. That’s one of the reasons I wanted to dive into the mechanics of this a bit today just to help educate people.
David: Next question is on oil tankers.
How long do we see these stocks benefiting from this oversupply of oil?
So the dynamic there, in case you wanted to know, is that we don’t have any place to put an excess supply of both Brent and WTI, West Texas Intermediate. So as the flow keeps on coming, it has to go somewhere. And oil tankers have been used as one of the gap fillers, a place to put oil. A couple million here, a couple million there, in terms of barrels of oil. And the stocks have benefited from the storage dynamic. I don’t think that that’s something that will go on, say, 3 to 6 months.
A lot of the way the oil tankers have structured their business is along two lines. One, they price availability on their boats according to a spot price or a current day price, if you will, a day rate. And the others according to a long term contracts. At these high levels, you’d love to see the VLCCs, the very large crude carriers – they would all love to now lock in long-term contracts at these elevated prices, right? So it’s a difference of interest.
Who wants what? They’ve benefited in the short run, but these are, if you’re looking at this from a long-term investment standpoint, inherently rotten businesses, just very tough to manage. So our view would be, probably have seen the best pricing on those as they’re already full, and I don’t think that you’re going to see producers inclined to paying even higher prices. Instead, you’re likely to see, like we’ve seen already this week with the Texas Railroad Commission, an addressing of the issue on the supply side.
Next question is:
Do we advise UK investors?
The answer is yes. That would be on both the MAPS portfolio strategies as well as Tactical Short where yes, we can. The one complicating factor may be, retirement accounts in the UK, but that’s something that we could certainly kick the tires on if necessary. But for a regular tactical short account, we can do that for an investor from the UK.
The next question is about – we’ve had quite a few on gold here – capturing upside in gold price using long dated options.
Go back to something I mentioned earlier, which is just, what is the reason you’re owning it? If it’s for insurance then I do think you want real money. And I should say, if you’re going to put real money into it, and it’s insurance, then the physical metal is a superior alternative. If you’re talking about growth, or speculative growth, then long-dated options may be appropriate. I think one of the things you have to keep in mind, particularly after this week, is that when you look at any derivative product, whether it’s in the futures market or options, you should expect from this point forward to see anomalous behavior, and that may not be to your advantage.
This tags onto, or borrows from, Doug’s comments earlier. We assume liquid and continuous markets, and if you’re using long-dated call options, you, too, are assuming liquid and continuous markets. Strange things can happen when you lose liquidity and the markets are no longer continuous. So be clear on the risk that you’re willing to take. Be clear if this is speculative growth, and I would say, well, then maybe play money is appropriate, but not real money. Real money, I would still focus on the physical asset, particularly this environment.
The next part of this question, Doug, because it’s actually in three parts, is shorting indexes versus shorting stocks.
Do you want to address that?
Doug: Sure. In a more normal environment a portfolio of diligently researched short positions offers some advantages over shorting an index, no doubt about that. Stock selection provides the opportunity for good research to generate so-called alpha will return out-performance versus the index. The problem is it’s been a long time since we’ve had any semblance of a normal marketplace. I generally don’t like the risk-reward calculus for shorting individual company stocks when financial conditions are quite loose.
Shorting individual stocks can be quite risky in a highly speculative environment and 2019 was a particularly painful year for shorting individual stocks, followed by a rewarding quarter. If you can get your timing right you’re in good shape. If you miss your timing, not as good. So in general, shorting stocks is a riskier proposition, but in certain environments it can be worth the risk, but this risk has to be managed carefully. I’ll just leave it at that.
David: Then the third part of this question is:
Is there a long equity position that we can take in this market?
I would just answer that with the word, selectively. Where we have managed risk on the long portfolio side is by position limits and being very deliberate about small allocations. So I would say very cautiously. What that has allowed us to do is outperform the general market. If the market was at its worst down 30% we might have been down 1/3 to 1/2 that in our position. So it’s not to say there’s not still downside in the market, even with the best research companies, which we do put a lot of emphasis on fundamental analysis and balance sheet analysis and liquidity analysis. So there is still downside pressure. The only way to mitigate that risk is by limiting your total exposure or creating a hedge within the portfolio. So the long the short of it is, selectively.
There is another part of this question which I’m not perfectly clear on, so I’ll do my best, but may ask for the person who asked this question maybe to just contact me directly and we can dialogue on it.
How is crude oil still relevant in the age of advanced nuclear power?
And then also discusses some things on derivatives and Wall Street and political capture, which I’m not perfectly clear on. To date I’d say crude oil is still very relevant. It was only before covert 19 that we reached 100 million barrels per day. We’re talking about levels that are at basically all-time highs. So if you’re talking about the global economy and what it demands or requires of the crude oil market, you could argue that it’s never been more important in terms of the global economy. That may change with time, but at this moment in time, it has not shifted materially.
Doug, I’m going to give you this next one. This is another one that comes in three parts. I’m gonna give you the second part of this and then come back to the first.
What are the ramifications to the bond market 30 to 90 days from now, whether it’s corporate, munies, mortgage-backed securities, given the Covid- 19 slowdown?
Doug: Great question. The complexity, I would say, of the question is 30 to 90 days from now. Clearly, there will be unprecedented debt downgrades and defaults over the coming months. There’s no doubt about that. That’s household debt, corporate debt, mortgages, munies, across the board. Forecasting the bond (inaudible) _01:15:52_ within 30-90 days, that’s very challenging. If the Fed continues its current course of liquidity injections and direct purchases of corporate debt, ETFs and such.
Corporate credit might be able to muddle through in the short term. A risk long liquidity driven backdrop, that’s possible over the next three months. But as sentiments shifts and risk-off, de-risking, de-leveraging re-emerges, the prognosis for corporate credit could rapidly deteriorate – a very difficult period of massive defaults for corporate munie, MBS, seems unavoidable to me. It’s just the timing. Again, it was 18 months from the eruption of subprime until the heart of the collapse back in 2008 . It takes a while for credit problems to materialize. So we’ll be following this monitoring this carefully.
David: The first part of this person’s question:
Given the pandemic and the decrease in oil demand, isn’t it harder for the Fed and U. S. Government to conceal their inflationary monetary policy?
I think this is absolutely fascinating to see that we’ve gone from talking about, we’ve just generally accepted now a 2% inflation target, and there’s some discussion about raising that to 3% or 4% in terms of the inflation target. At the same time the framework is being put in place to take rates, not only to zero as we’ve seen in some European countries, but the IMF was arguing last summer, theoretically, it makes sense to take them deeply negative – 5, 6, 7, 8.
I say that because in terms of monetary policy, the boldness is absolutely astounding. There is no shame in running an inflationary monetary policy, right now even more so given the decrease in oil demand, given the decrease in aggregate demand. This is where the neo¬¬-Keynesians are literally showing up as knights on white horses. They believe themselves to be, and they are pretending to be, and they’re printing more to prop up aggregate demand. It’s not only on the fiscal side where they’re spending to prop up aggregate demand, but they’re printing to prop up aggregate demand. And if this continues with Covid-19 for very much longer, you do have the monetary machinery in motion.
At the same time, you’ve got a global economy which is just not moving, which does point in the direction of stagflation. That’s a reality that is in the making if we don’t get people back to work and the economies of various countries moving again. You blend a slowing global economy with money-printing, and that’s what you get is stagflation. So the long and the short of it is there is no shame, there’s nothing to hide. They’re quite proud of the fact that inflationary monetary policy is in play. It’s out in the open.
Next question, Doug, for you.
What will be the impact on insurance companies that hold these fixed income instruments – corporates, munies, mortgage-backed securities – as the lion’s share of their reserves?
Doug: Yesterday the CEO of Chubb (sp?) was quoted as saying, “Covid-19 will be the largest event in insurance history.” I think, clearly, the insurance industry faces unprecedented pressures, and that’s both on its liabilities, its book of insurance exposures. as well as its assets. The industry is holding all types of debt instruments. But there are major unknowns at this point, including the scope of government bailouts and support. I’ll assume the insurance industry will need support here.
I also know from my previous experience that insurance accounting creates challenges in accurately gauging underlying fundamentals. It’s tough accounting, and you can look through financial statements and you really don’t have a sense for the risk profile of their assets or liabilities. So this story will unfold over months and quarters.
David: Next question is simply this.
How to profit in an expected forthcoming hyperinflation?
I think if you look back at previous hyperinflations what you find is not only that real things had real value, but that simple things had high value. And you might think, well, how simple can it be? Water is simple and basic and necessary and a real thing. Chickens are simple and basic and real things and anecdotal stories going back to the Hungarian and German hyperinflations of the 20th century suggest that something as simple as a chicken or a small bag of flour is more valuable than a Steinway grand piano. There is a very harsh reality to hyperinflation, and that’s where real things, vital things, simple things, I think not only maintain value but have a higher value in that context.
So if we assume that that is to be the case, let me just tell you one story because we knew of a bond fund manager years ago. His name was Klaus Buscher (sp?). Klaus and his family had made it through the hyperinflation with a basement full of vodka. You don’t necessarily think about liquid assets in those terms (laughs), but in fact, not only was it liquid, but it was very basic and of very high value. And I suppose on a very bad day might also represent some form of self-medication.
Doug, I’ll hand this next one over to you.
Doug, can you postulate a maximum dollar amount like 10 or 25 or 50 trillion dollars on the Federal Reserve balance sheet, the tipping point beyond which the financial world would lose faith in the Federal Reserve? I’ve never seen an amount proposed in any financial medium.
Doug: It’s a great question. It’s a key issue. And I’ve never seen an amount proposed in any financial medium either because no one, as far as I know, has really contemplated this. I know just over a month ago when I would talk about a 10 trillion dollar bogie that sounded like whackoism. This 10 trillion dollar bogies that I’ve been discussing is somewhat arbitrary, but it would be a doubling of the previous high level. And if the Fed rapidly doubles its balance sheet and markets nonetheless suffer a bout of illiquidity and dislocation, this could be some kind of tipping point.
We saw heightened market concerns last month when the adoption of extreme measures didn’t at first reverse the panic. The Fed eventually got the market reaction and wanted, but it took astonishing measures and I think damage was done to confidence over the past month, and I think more damage comes as we watch this balance sheet inflate every week. The tipping point, we’ll just have to follow with it closely.
David: The next one for you, too, Doug.
If a Federal Reserve maximum could be analyzed and justified, then couldn’t we back into the amount of monetary and fiscal policy that may be applied to offset the Covid-19 economic downturn to project either a U-shaped or L-shaped stock market recovery?
Doug: My reaction would be that’s an interesting thought, hypothetical because we’re in the age of whatever it takes and that balance sheet is only going to grow. I also think today’s unprecedented uncertainties make it about impossible to project the unfolding downturn, and then the nature of the recovery. We don’t know to what extent the economy opens up this spring and summer, and there is today great uncertainty as to what we will be facing this autumn and winter with Covid.
Will there be needs for additional shutdowns? Would these shutdowns be isolated, or for the entire economy. I would argue the global economy is even more clouded. And as we sit today, for me, kind of this downward sloping W seems reasonable, an economy moving in these fits and starts, a highly unstable financial environment wavering between risk-on, risk-off. And we also have the November election ahead with potentially major market economic ramifications. So it’s difficult for me to look out too far into the future, unfortunately.
David: The next question.
Can we assume that the financial world will have faith in the Federal Reserve, US GDP, at least the extent to which the financial world has
faith in the Bank of Japan and Japanese GDP, implying that the Federal Reserve can add much more to its balance sheet to support monetary and fiscal policies?
I would say that this goes back to the question that you answered two questions ago, Doug, in terms of a number and a tipping point, because we’re really talking about is a confidence game, and that may well be the case that you can continue to press the envelope and not get to a specific point where psychology breaks. Is there a point where psychology breaks? That has been the case in the past, and I guess the reason why that earlier question is a difficult one – is it 10, or 25, or 50 trillion dollars as a tipping point – is because we don’t know the other factors influencing psychology at the time. And so it could be a much lower number or a much higher number. I hear the hedge fund community looking at this kind of a question and saying, “Faith. We’ve got it. Let’s trade it. And just buy whatever the Federal Reserve or the banks of the world are buying and you’re protected.”
But also, what comes to mind is something that Ray Dalio said last year about owning gold. He said, “If you don’t own gold, you don’t know history, and you don’t know economics.” So there is this strange world where on an interim basis, faith, yes, it’s gonna be maintained. But I think as an investor you have to say, “All right, well, that’s that is a social reality constructed by maybe some combination of chewing gum and baling wire.” But if you’re going to have faith, you had better be operating with caveats and hedges. And that’s where I think things like Tactical Short, owning gold, back to Dalio’s quote, you can play the game and assume that faith will continue to be maintained, but you had better darn well do it with some caveats and with sufficient hedges.
The next question for you, Doug.
What are the differences between Tactical Short, long volatility and anti-fragile strategies?
Doug: Tactical Short is a much lower risk strategy than many of the long-ball strategies. I believe the long ball strategies are more just short-term focused and at Tactical Short we’re trying to manage a strategy that can navigate through the ups and the downs of the cycle with a longer¬ focus. I’m actually not familiar with anti-fragile strategies, so I cannot comment on those.
David: It sounds that sounds like something out of a black swan book or something where there’s a proprietary strategy.
One of the things I’d add to that, Doug, is that you’re looking at the race and not this particular lap, and you mentioned short-term focus on the long ball strategies. There are any number of strategies that in a week and in a month may post some impressive gains, but when you step back and look at performance for a year, two years, five years, 20 years, whatever the case may be, all of a sudden it begins to look very different.
When you were mentioning the relative performance metrics, that we are farther ahead in the race on managing a short position than virtually any of our other competitors, that’s because we are keeping the full scope of the project in mind, helping clients preserve value through the cycles not just, hypothetically, this next Tuesday. So it is a strategy for a longer period of time.
Next question for you, Doug, too.
Best areas to apply my cash to increase wealth and be safe at the same time.
Doug: In this environment it is extremely difficult to try to make money and to be safe at the same time. That’s not an easy proposition. David, I’m with you as far as long-term wealth preservation strategies, and the precious metals, and the MAP strategies. We like to think we have excellent opportunities, extraordinary opportunities with Tactical Short here in this environment, trying to manage our risk very carefully. But there are a lot of strategies out there that will struggle in this environment, there’s no doubt about it.
David: Doug, it seems to me, too, that there is a focus on how your money grows in terms of capital gains versus relative purchasing power. And this is where I think if you looked at the deflationist camp, the idea is to own as much as you can in terms of U.S. treasuries and cash, and the world gets cheaper and you get to buy more of it with the dollars that you have. The inflationist might argue against that and say yes, but what will your dollar ultimately buy you? You may have a million dollars preserved, but does it does it buy you a cup of coffee? Let’s ask the Argentinians, let’s ask the Venezuelans, and see how that works out.
I do think striking a balance between those two uncertain outcomes and maintaining liquidity but redefining liquidity not just in terms of cash but also in terms of what has been a more reliable form of cash again referencing gold, strike a balance and know that there’s going to be opportunities where your growth comes not from buying at X and watching it go to 3X, but watching an asset that’s worth X sell at a fraction of X, and then just recovering to its normal value over time. That kind of wealth creation requires little counterintuitive thinking, and lot of patience, but I think would serve the person who asked that question well.
My investable funds are spread between my wife’s and my deferred accounts and taxable accounts. Does that present a problem for capitalizing on this opportunity?
We actually have Tactical Short in two different formats, one that is appropriate for retirement accounts, what we call our non-correlated, and then Tactical Short for your ordinary taxable accounts as well. So
either way it can be a compliment.
Doug, the next one for you.
Am I at risk of losing more than I invest with this method, Tactical Short?
Doug: Well, for Tactical Short, you’re not risking more than you invest. We maintain a disciplined risk management process. We’re focused on avoiding outsized losses. Since the inception we saw the market go dramatically against us. In many cases 2019 is almost like a worst case scenario for a store strategy and we navigated through it. As I keep harping on, I don’t want any surprises, so there’s not going to be losses like that.
David: Next question. (laughs) Frankly, I’m surprised there are so many questions on gold, but I guess that means there is, like we have seen with our Vaulted program, a 1200% increase in demand in that program, a general interest in it.
What percentage of my assets should be in gold and silver before I move into this method, Tactical short?
I think I would ask a question to clarify. What are you hedging? Because I think one of the magical aspects of Tactical Short is that matching that against an equity portfolio can be very handy. And particularly for institutions or accounts of a million or more, we can customize that approach, where, if there is an outsized stop position, whether it’s a legacy position held inter-generationally, or as executive compensation, or what have you, or even thinking of pension funds and insurance companies, where there may be a long position in equities which is going to be retained for a long period of time, it has the ability to customize the approach.
This is one of the advantages of the separately managed accounts is, at the right scale we can customize it and match it up to an equity exposure. That is where I think Tactical Short has as a keen advantage. There is a general concept of gold operating as a hedge, and it does. But if you were to sort of test that out, there could be days or weeks or months where correlation between gold and an equity portfolio, that correlation breaks down, and it does not represent a reliable hedge.
So philosophically and generally speaking, gold is a decent hedge in a market environment like that. But recall that during periods of deflation, gold is a liquid asset, which often is liquidated to create liquidity necessary to keep other speculative bets in play. So ala 2008 and 2009, gold dropped 30% while the equity markets dropped 40% to 60%. It really did not help you as a hedge, and Tactical Short would have done a much better job in that instance.
Now, one of the things we do know about those deflationary bouts of liquidation pressure is that there is a reappraisal, whether it’s counter-party risk or other factors which cause investors to say, “Hey, wait a minute. Maybe I do need to own gold. Maybe I don’t want to keep those other speculative bets in play. So again, referencing back to 2008 and 2009, we finished 2008 with a positive gain. Gold had recovered all its losses that is had accrued in the October-November timeframe. December was a very big month for it.
So that’s where I would start. What are you hedging? Are you hedging an equity portfolio? What mandates have you given to your metals positions? I think that’s another important clarification. Because, like with Vaulted, I would say that mandate is a liquidity mandate. It’s a cash equivalence, and it’s meant to run in a parallel track with savings account or banking account, just denominated in ounces instead of dollars. If you’re trying to construct a defensive portfolio with physical metals, you would do well to get some adviser advice in a proper portfolio construction from one of the advisers from our sister company, ICA.
So I guess that’s where I would begin. What are you hedging? And an equity portfolio, I think, is very well hedged and certainly at scale. The Tactical Short is something that offers immense value for its customization potential.
Doug, the next one.
I’d like to know what kind of option strategies Doug will use. Thanks.
Doug: I’ve traded options throughout my career, and it may be just a coincidence, but I had this really nice brown hair like the day before I started trading options. They’re tough instruments that often work better in theory than they do in reality. That said, I definitely plan on occasion to purchase put options and that could be options on individual stocks, sectors or the general market. I regret not having bought them prior to March, but we will have other opportunities.
With options and risk, generally, I tend to err on the side of caution in highly uncertain environments, especially if our accounts have suffered losses, and will only buy listed put options. I don’t write options in this strategy. I generally don’t prefer short dated options, so I tend to go out 4-6 months and purchase moderately out of the money puts. These option positions will be monitored carefully – they have to be – and traded in a disciplined manner. We will only allocate a small amount of account value to options at first. Once we have gains, we might bump up exposure somewhat. When I have options on during what wild market environments they demand my full attention again. These are challenging instruments.
David: Doug, I’m trying to remember if I’ve ever even seen a picture of you with nice brown hair.
Doug: I’ll get one for you. You won’t even recognize me.
David: (Laughs) This is from somebody who came on with us from inception. Doug, you had mentioned that we’ve been watching the market rise rapidly in 2017, 2018, and 2019 ends up being a very challenging year if you’re short the market, as the stock market is moving to all-time highs. So this is a sincere question asked from somebody that joined us right from the beginning. It says:
I opened the short fund three years ago with $101,000. My account shows $86,000 as of April 21st, a net loss of $15,000 over three years. Realistically, what would be the expectation to regain to break even?
We experienced a stock decline greater than the Great Depression in just a few weeks and yet the short fund has greatly underperformed through the whole three years. The only position we’ve had on account is the S and P, with a few minor exceptions. (I’m sorry, I must have misread that, I apologize.) I’m not sure why. Why not short some other positions? I would like to remain in the fund.
Doug: Well, it’s good that he wants to remain in the fund. Hopefully, I’ve answered some of those questions in my earlier presentation. Keep in mind that the S&P 500 has returned -1.8% return over the past year. Over the past three years it has returned a positive 27.5%. That’s as of today. I pulled up the Rydex (sp?) Inverse, the S&P 500 fund, during that same period. It’s down over 25%. So it’s been a really, really tough period. Over the past three years many short strategies were obliterated. Highly speculative stock market was at all-time highs only two months ago. And I’m anticipating a deep multi-year bear market. The bear market has barely commenced. My priority remains not getting clobbered in a chaotic market-topping process.
I’ll use a bullfight analogy. The bull has been pierced by the sword, and the bull is in the process of succumbing. But in the meantime he’s going to go berserk and inflict as much damage as he can. I’ve lived through similar things in the past, never to this extent, but this wild volatility is consistent with the topping process of a historic up cycle.
As I explained earlier, this market environment has been unprecedented. My focus has been risk control. I’ve remained very disciplined. In hindsight I do wish I would have added exposure (inaudible) _01:43:09_ right before the three-month collapse. Of course I do. Many of the most successful hedge fund managers in the business, though, have been hammered in this downturn. So this has not been easy. It always looks these in hindsight, but it hasn’t been easy.
Do I regret my risk control focus over the past three years? No, I do not. We plan on building a team and we’ll have some focus on individual company analysis, and I would also like to provide the opportunity for investors to choose between a low risk or a more moderate risk strategy. Right now I’m running a low risk strategy in an exceptionally uncertain high risk environment. I don’t want our accounts to have days when they would lose 5% in an abrupt rally, and that’s the way this market environment works. It’s easy to lose 5% percent in a day.
I don’t like to lose 5% a day, and I’m specifically trying to avoid actively trading these accounts because I’m not convinced that a trading focus would be that rewarding. So I’m running a strategy that I believe has a high probability of success over the longer term, and this is important., with a low probability of outsized losses. You can’t have it both ways. I’m not sitting here saying, “How quickly can I get back to break even for the initial accounts?” I’m thinking, “How do I take good risk award to get to the place we need to be to be more opportunistic and then to really start to compound gains in what I think is going to be a long term bear market.” There were specific market dynamics that I have been waiting patiently for to signal some significant changes in portfolio composition. I’m a patient guy, but Covid-19 changed all of that. Again, this is an unprecedented backdrop with wild animal markets.
So if I get through this without any accidents, and in an environment like this, trust me, there will be a lot of accidents out in the markets. We’re already hearing of some of them and I’ll add that I knew it was going to be a difficult transition from very cautious positioning to be able to catch the initial market decline. That is a challenge because I do not try to pick market tops. Why? Because they can go on for a long time, as this did. But we’ve had the initial market break. Now we’re seeing the typical market rebound. For me, things get much more interesting when the next downturn begins to unfold. So I would just say, “Come on, just hang tough. Things were going our way, we just have to get through this this crazy period right now.”
David: Confirmation of the thesis. Absolutely, you are right about the break? There is one comment in there, “We experienced a stock decline greater than the Great Depression.” Keep in mind, it went faster to the downside, in that sense it was greater. But we’re only talking about the initial break, both now and going back to 29. It still took an additional 12-18 months to play out in the 1929 period. We didn’t get to the negative 89% on the Dow overnight. We had the break, we had the rebound, and then we had the slower deterioration of psychology, and the breaking down of expectations, the realization that this was going to be a long slog. And as it turned out, we did not get back to the old highs of 1929 until 1953. There was a lot of volatility by the time we got to 1937, but there was an extended timeframe in there before the first break.
This kind of ties into the next question, which is:
Will the coming crash or depression resemble the crash of 1929? Will war be the mechanism to bring us out of the crash? How does the middle class survive and come out ahead on the other side?
I’m just gonna take that first part and say this. There’s a lot that is similar to the 1929 period in terms of the build-up of excess in credit in the system, probably more so now than there was then. If you’re talking about debt-to-GDP figures, both domestically and internationally, we have never been to these extremes before and it makes 1929 actually look very calm by comparison. You had a lot of leverage, specifically in stocks, as a percentage of stock market capitalization in 1929. Now, we have not only that kind of leverage as a percentage of GDP, we’re talking about margin borrowing, which just 12 months ago was at all-time highs, both in terms of stock market capitalization and in terms of GDP.
But beyond the leverage implicit to the stock market, what Doug has done for years in the Credit Bubble Bulletin is highlight how much leverage has pervaded every nook and cranny of the financial system itself. And the problems have stretched from not just, as we have in the last round, mortgage-backed and asset-backed securities, but now, into the very heart of money and credit. We have government finance which is at jeopardy. So to expect this particular episode to be anything less than 1929, I think would be to ignore the fundamental facts that we have stacked up against us.
How it gets played out, what measures will be used, we’re already seeing MMT is as a popular curative. I liked what Doug said earlier about this being more like a W in response to the question about if this will be a U-shape or an L-shape. Well, clearly not in our conversation or in the questioner’s mind was the idea of a V-shaped recovery. But the W implies that we’ve got some strong moves to the upside and some stronger moves to the downside. But this is going to take quite a bit of time.
The second part of the question is:
Will war be the mechanism to bring us out of the crash?
I think this is where we will spend a good bit of time in future quarterly calls looking at the deterioration of both political and geopolitical relations. The world is changing on many fronts. As the petrodollar comes into question the old relationships set in motion to stabilize the U.S. currency are being pressured and changed. There are a number of things that are fundamentally changing in terms of geopolitics, and we might have had reason to maintain tight relationships, and it seems that our foreign policy today is not prioritizing the old relationships.
This goes back maybe 25-30 years, the first conversations that I had with my dad, maybe even 40 years. We started young in our family. The idea that when you get into a crisis environment, it’s first financial, second economic, and these air like dominos that fall – financial, economic, political, and geopolitical. What it implies is that we are still in the context of going through political upheaval, and as we see populist catharsis on the global scene, that’s indicative of, again, political issues. But the question, I think, points in the proper direction, which is, at the end of the day, when politicians cannot solve the problems, they just blame someone else. And this is the beginning of war as the end of the cycle.
So I do think that’s very realistic. And maybe that’s three years from now or 10 years from now and not six months from now. That’s tough to tell.
The last part of the question”
How does the middle class survive and come out ahead on the other side?
I would go back to, uh, Doug, your last comments. As difficult as these things are to contemplate, I think it’s worth remembering that Americans do well, and I think people in general do well, coming up with solutions to big problems when they have to. If they don’t have to then sometimes they just enjoy the benefits of wealth and wealth creation. But if those things get pressured, you do find that people become much more creative and solutions come out of the woodworks.
The only two words that come to mind in terms of the middle class surviving and thriving is adaptability and resilience and figuring out how to implement those words in particular circumstances, remaining adaptable and adapting a mindset of resilience, if not a lifestyle of resilience, I think is pretty critical. That question was from Bernie. I don’t know if it was from Vermont. If so, wow. Glad to know that you’re a fan of the show (laughs).
Next questions is for you, Doug.
Can we expect a rebound from here, or are we headed for lower lows, 40% or more from the top is what occurred over the 1-3 year period from 2000 to 2003. Also, what’s the best way to profit from this longer period of decline? ETFs like SH have really not performed well at all in terms of percentage gains.
Doug: We’ve seen quite a rally from the March lows. Could we rally more from here? Absolutely. I’m a probability guy so I think the highest probability is that we’ve seen much of the rally and that over the coming weeks we will start heading lower again. Unfortunately, I think the market’s going to go down a lot more than the typical 40% or so. I think it goes down a lot more than that. Likely, this will unfold over a period of years.
The best way to profit from a longer term decline? Not easy, right? Not easy. I don’t think the ETFs will work that great. We’re biased, of course. We think you need to find a kind of a risk focused, active manager on the short side, with a lot of experience. There aren’t a lot of us around out there, so it’s not going to be easy to find different vehicles that you could just buy and expect to make a lot of money over the cycle here.
David: Asset preservation, I think, needs to be first and foremost the motivator more than outsized profits. That’s, I think, got to be a key.
Doug, this next one.
I’ve seen a lot of skepticism on China. The Chinese government is on both sides of their local banks. The government lends them money and tells them they should lend, too. They can do this for a long time, like the U. S. Fed can create U.S. dollars. Of course, China’s need for hard currencies would remain. China seems to be ahead of the curve in dealing with Covid-19 with measures which may not be possible in the Democratic set-up.
That’s the end of the comment/question. Do you have any answers?
Doug: Yes, I’ll give it a shot. I’ll start with the question, is China a developed or developing economy? If it’s developing, then there’s going to be an issue here in the downturn of trusting policy-making, of trusting the banks, of trusting Chinese finance, of trusting Chinese economic structure. I’ve called China not only the King of Subprime, I’ve called them the King of EM because I think they’re going to face
some serious issues as far as the soundness of their financial system. I think that’s just started.
Right now the perception remains that Beijing has this all under control and that that meritocracy will do whatever it takes to keep the boom going. I think that’s going to be challenged. They have responded with draconian measures in Wuhan and Hubei. I think if they have a second wave, which I don’t know why they wouldn’t, it may be more challenging because it will be more dispersed throughout their nation, as we’re dealing with here. So they’re not out of the woods. And as I’ve already mentioned, I worry about the currency and what a run on their currency could mean, not only to Chinese finance, but global finance more generally.
David: Let me ask you a question on that, Doug. Just my own personal interest. If you’re looking at interest rates or exchange rates, is there is there a threshold at which you say, yes, it has begun, the pressure is being revealed, and you can’t You can’t keep the message hidden. Which would you prefer to look at? One of those, or both of them, or even something else? Interest rates, exchange rates or another particular tell?
Doug: Yes, it’s this tipping point issue from a previous question. We’re going to have to watch a lot of indicators. To what extent has high-yielding Chinese credit been leveraged? Are their 3.4 trillion dollars’ worth of international reserves really liquid? How quickly
do those reserves decline if you have a lot of capital outflows? So I’m watching Chinese credit carefully. We’ve got an enormous number of defaults coming in in Chinese credit, so we’ll watch for signs of crisis of confidence, not only in the currency but in Chinese credit instruments, and certainly the banking industry.
Lots of different indicators to follow because for one, there’s not a lot of currency, and two, we know that Beijing, the so called national team, will plug every hole in the dike for as long as it can, so the tipping point comes and things might unravel quickly. So it might look great, and then all of a sudden instability takes hold.
David: I think it’s also worth mentioning just because there is there is the possibility, the last part of that question that was submitted, China seems to be ahead of the curve in dealing with Covid-19. We have to make certain assumptions about the numbers that are being provided. Very rarely does anything come out of China that doesn’t have a political posturing with it or to it. It serves a purpose. And so there is an implicit message in the numbers that have been provided. They may or may not be accurate, but you could ask or through the same sort of angle or critique, look at their economic growth figures.
For years, people who are doing good economic work in China would say that their 6-7% growth rates, which, of course was pre Covid, were absolutely balderdash. They haven’t had those growth rates in a long time, probably more in the 2-3% range. So what you see in the numbers is not necessarily the reality. It is true that you can do different things in in a less democratic society. But I wouldn’t say, “Let’s do what they’ve done because it’s worked so well.” Just as you pointed out, Doug, that credit expansion to over $42 trillion in this last cycle, there are plenty of implications from that, some of which may have already been sort of swept under the rug through similar things that we’ve done here in United States. Recall Maiden Lane, special purpose vehicles. How do you create bad banks? Well, you shuffle the bad stuff off so that you can continue on as if things are normal.
The next question to you Doug.
Buying U.S. equity ETFs seems to be next on the Fed’s playbook. I know that you prefer to avoid shorting stock market darlings without mentioning specific trades. Where do you see opportunities to benefit from the weak economic environment despite the OECD central banks profligate liquidity?
Doug: I’ll be candid here. The analysis today is a bit of a mess because of the Fed, because of the different bailout programs, because of the market volatility. I think there are going to be opportunities throughout the markets because I think it’s going to be a systemic crisis unfolding. I think there will be a limited number of companies that will benefit and those stocks already traded unbelievable valuation. So we’re gonna have to wait to see how this plays out over the next few weeks to have a better sense, I think, for at least the near term opportunities.
David: This one is:
Do you see solid, unqualified, long term buys for retail investors?
(laughs) It’s a tough market environment to, with that qualification in there – unqualified long term buy for the retail investor. I don’t think you can, on an unqualified basis. There are market permutations which have yet to reveal themselves and you have to remain flexible in your thinking and in your allocations, and in the processes and in the risk disciplines that you employ as things happen, which have either rarely happened in history or never happened before. So I would say it’s not the time to be hopeful on a long term basis and go long to see what happens over the next 10-20 years. The long term buy on an unqualified basis – it can’t be done that way. You have to have risk controls in place. You have to have a process in place. You have to be willing to change if the market reveals through price action that you’re wrong.
Doug, I will give you the next one.
Does a collapse in oil prices affect the corporate bond market, and is the Fed stepping into problems attempting to buy bond ETFs and corporate paper?
Doug: Yes, think it’s a big impact, and as time unfolds it will certainly reverberate outside of the corporate bond market. You’re going to see municipal debt impacted, etc. We’ve already seen some major damage in energy related debt, especially high yield. That market was hammered, it faced illiquidity dislocation that was reversed, and we have had a heck of a short squeeze in that space since the Fed announced it would be buying some fallen angels and some high-yield ETFs. If oil prices don’t recover over the coming months, the impact will be that it’s going to be a major issue for debt downgrades, rating downgrades. The impact (inaudible) _02:04:43_ investment grade corporates, and that means more impact in corporate credit derivatives.
The fed’s move into corporate bond purchases and ETFs, from my vantage point, is regrettable. This will further distort market pricing, which I believe only creates greater volatility and instability. Furthermore, and I think this is an important point that doesn’t get enough attention. The Fed is now clearly in the credit allocation business. They know better than that and this is a move, which I mentioned earlier, that puts the Fed’s credibility at risk. And you don’t want to do anything to put Fed credibility at risk because if you lose that credibility you cause tremendous damage.
David: A couple of questions that have come in online. There is one relating to the euro, and I think we dealt with that in our comments on Europe and pressure that is faced there with implications for the currency. Another deals with the Middle East. It says:
Could you discuss how the potential risk of a Middle East, i.e., Iran
escalation is integrated into your risk profile?
That’s the first part of it, and then:
How much is quantitative modeling versus active management and judgment in our methodology?
Doug: I’ll hit the last one. We focus a lot on, I call it the mosaic of indicators. It’s kind of an intensive studying of financial conditions, speculative market dynamics. We’re numbers people, data people, but we don’t we don’t use quantitative models. We use a lot of discretion in how we position. That’s kind of key to what we do. We always want to take what the market gives. We don’t want to fight the market. So that is some thoughts on that.
David, did you want to address the Middle East maybe? You’re more articulate on that than I am.
David: I think what we continue to do is reassess all the potential risk variables. If you took the general categories of financial market risk, that certainly fits into your mosaic of indicators, and bleeds over in terms of the numbers and the data into economic analysis. And then comes public policy decisions and a very intense discussion about the implications from public policy choices.
And then also, another category of our thinking and processing relates to geopolitical relationships and international relations. So what is the potential risk in the Middle East of escalation with Iran? That’s something that we are constantly aware of. We’re not going to trade a headline the way an algorithm might, and either overemphasize or not emphasize it enough. Events get factored into the conversation, the conversation gets factored into, ultimately, how we’re positioning, whether it’s on the long side or the short side. I don’t know if that adequately answers it. If not, I’m happy to get online with you privately afterward.
The next question is:
The appreciation of gold seems so obvious at this point – inevitable. What can make it go lower, longer term or short term?
Doug, I’m gonna put this out there, and you put this to critique. What we watched happened this last week with crude was a function of a commodities contract, a contract that relates to commodity that has to ultimately be physically delivered. And there are obligations implicit to that contract, which to some degree are separate. There are complicating factors, or additional factors, to just simple supply and demand.
And when you have a legal contract and obligations, this is where all of a sudden we saw the unprecedented -40 on the WTI contract this last week. Is it possible that gold could trade to $1000, $500 dollars or negative $1000 on the basis of contract gyrations which may have little to do with the real world supply and demand dynamics? I think
Anything is possible and I think one of the things that I would say is when we think about the price of an asset, we have to appreciate whether or not it has any vulnerability in terms of its association with a contract.
And to the degree that contracts exist on that asset class, whether it’s soybeans or eggshells, and certainly gold, there may be a different set of rules beyond supply and demand that influence the price. Now what is that “price?” Is it even relevant? I think, as we found out this week, it’s not particularly relevant. One of the data points that Lila, who is on our wealth management team, brought up is when you look at the volume of trades that were transacted between zero and -40, it is really virtually no volume at all, in terms of the grand scheme of things, less than $200 million worth volume traded total at those levels, and yet we have the impression that that was the price of oil. Not really.
Again, you have to appreciate the constraints of Cushing, Oklahoma, the delivery process, the mandate that it be there, there being no place for it to go, etc. And then you realize that what’s attached to the contract is what is being priced, not necessarily the commodity, if that makes sense.
Doug, your thoughts on downside for gold short term.
Doug: I had this same thought from the previous question. We look at things, risk versus reward. We can look a reward on the short side and see potential reward, it’s phenomenal. We can look at the upside in gold and see that the potential reward is phenomenal because of the environment. I have no doubt about that. The risk part of the analysis is quite a challenge because of the unprecedented environment. We have unprecedented monetary policy. Whatever it takes central bank (inaudible) _02:12:31_ two trillion in six weeks from the Fed.
We have unprecedented market structure. We saw that come to life Monday with the May crude contract, WTI contract. And we saw it also in them in the downdraft in March. We saw gold come under pressure in March. Why? Because the hedge funds are reeling and there is a big de-risking, de-leveraging. and they’re selling everything, and if they start to dump gold the buyers back away temporarily and the price can go down a lot quickly. It came back quickly, which is not a big surprise, but could we have a significant downward move in gold because of hedge fund liquidations, because of strange derivative issues and things, de-risking, de-leveraging? Absolutely. Does that change the long term potential award? No, I don’t think it does, but we have to navigate in an environment where, basically, when I look at positioning, my basic assumption is the equity market can move quickly, 25% up or down.
So I have to factor that into positioning. I probably have to change that now that 30% because that’s the environment we’re in and we could easily get 20% or 30% moves in two or three days. And could we see a 20% or 30% moving gold? I doubt we would see that type of move, but we could see a big down move probably, short term, temporary.
David: Next question is from John. He is talking about Powell, and recognition of the downside consequences of MMT in the Fed’s policies. And he’s asking:
Is everyone supposed to be, including Jerome Powell, blind or incompetent? Has he been confronted with the reality of what he what he is effectively setting in motion?
Let me start, Doug, and maybe you can modify the opinion. A friend of ours, Richard Duncan, lives in Asia’s as an economics analyst and I think one of the things that he would say is what they see is grave enough for them to do anything. And if you’ve looked into the financial market abyss, it’s not that this is incompetence or stupidity, it’s that at this point in the cycle, there’s not very many other options other than extend and pretend. The extend part is necessitated by the dire consequences of doing nothing. And the pretend is there to help people maintain a sense of calm, and not panic.
In many conversations I’ve had with Richard Duncan, it’s basically been we can’t afford not to throw the kitchen sink at this. It may not be rational, that may not be a healthy solution, but do you know what the consequences are if we don’t? And I quite frankly disagree with Richard Duncan on that because what we’re really saying is we can’t handle fear of the unknown. We don’t want any sort of reckoning because it could be worse than we expected. Maybe really, really bad, the kind of thing that ends in war. But as we talked about earlier today, I think, actually, that is moving towards a certain inevitability.
So no, they’re not incompetent by any stretch, and I think Powell, in particular, is not incompetent. And he’s not blind. But I’m not sure that he has very many options that don’t have more obvious consequences.
How would you modify that, Doug?
Doug: Not much to modify. I would just add that when Powell came in, I think he was determined to start letting the markets function on their own, try to back away gently from the Fed backstop. That blew upon him quickly, and he was seen as incompetent, could not communicate. And really, what he was trying to do is say, “Come on, markets, you have to be able to handle this on your own.” The markets were not able to handle it on their own. Again, they had to start QE last year because the repo market started to unwind.
I feel for Powell because this is a problem that I’ve been warning about. This is the worst case scenario to unfold since Bernanke came onto the stage in 2002 talking about helicopter money, and you’re saying, “No. No.” Because if you go down that road, you’re not gonna be able to turn around and reverse course because every time the Fed intervenes, every time they’ve done QE, they’ve just enticed more leveraged speculation, and that leverage grows much larger than the capacity of the central bank’s balance sheet to deal with it. And that’s what we’re seeing right now. So I completely disagree with thoughts that this makes any sense at all. This is just out of desperation, unfortunately, and I hope it doesn’t end badly, as I suspect it will.
David: Well, Doug we will wrap here. And if further questions have been stirred in the midst of either our formal remarks or in the questions that we have attempted to answer we would love to talk to you. We are very committed to our work, we love our work, and would love to involve you in that process. If there’s something either in the MAP strategies or in Tactical Short and the non correlated which resonates with you and you want to kick the tires further, of course, you can do that at mwealthm.com/tactical short and start a dialogue with us.
If there are questions that we just missed, and for one reason or another, didn’t address it all, then please send me an email or let’s put something on the calendar this next week for us to be able to address those as best we can. I will remind you that Doug’s Credit Bubble Bulletin is an invaluable resource, done weekly for several decades now. Our hard asset insights on a Friday is a great summation of what we see in the space in that particular niche on the long side of the market. And the weekly commentary is kind of a mishmash of covering economics and politics, public policy, international relations. You name it, it’s in there.
We want to provide you with the best possible resources and information to be able to make wise decisions. If that is exclusive of our work, we want you to be well prepared for a very challenging market environment. If it includes our work on the asset management side, it would be a privilege to work with you, and we look forward to striking up that conversation. So engage us on the terms that are best for you, whether that’s informational and educational, or actually the active management of resources. It’s been a privilege to have your time today and thank you very much for spending it with us.
Doug: Thanks, everyone, and good luck out there.
FREQUENTLY ASKED QUESTIONS:
What is the purpose of the Tactical Short Strategy?
The McAlvany Wealth Management (MWM) Tactical Short is designed to generate positive returns from downside volatility within the equities market. The strategy is not intended to necessarily hedge an equity portfolio dollar for dollar, but will instead strive to opportunistically capture gains as particular stocks and/or sectors decline in value. The objective of our short offering is to provide a mechanism for reducing a client’s overall investment portfolio risk profile while providing downside protection during periods of market instability.
The Tactical Short is described as non-correlated instead of consistently negatively correlated. Can you explain?
A constant negative correlation would imply always being positioned fully short, thereby reflecting the direct inverse returns of the asset mirrored. Such approaches are indifferent to risk. It is fundamental to our strategy to be selective and willing to wait for more favorable market conditions and compelling opportunities. Our focus on risk versus reward metrics dictates that there will be periods when we will be minimally short. Our decision-making process is driven by intensive analysis of a mosaic of indicators, from both “top down” and “bottom up” perspectives. Depending on our analysis of the backdrop, we will have the flexibility to position either opportunistically or defensively – to expand short exposures in favorable backdrops or significantly reduce exposure to mitigate losses during highly unfavorable environments for shorting. Positioning the strategy as “non-correlated” is consistent with the objective of avoiding the type of heavy losses suffered by negatively correlated funds during bullish periods.
Is this a fund with pooled assets, or will investors have separately managed accounts (SMA)?
We have chosen to structure the Tactical Short offering in separately managed accounts to allow for advantageous investor transparency, liquidity and, on occasion, some tailoring to better suit the needs of an institutional or individual investment mandate.
What kind of accounts can be opened?
While the Tactical Short offering was developed with the discerning institutional investor in mind, it may be appropriate for individual, trusts or corporate accounts.
Can I transfer a retirement account?
That’s not possible. The nature of shorting requires that securities be borrowed prior to consummating a short sale. Regulations mandate a margin account for such strategies, and margin accounts are prohibited for qualified plans (IRA’s and other retirement vehicles).
Is positioning a portfolio to benefit from declines and volatility the only investment style MWM offers?
Definitely not. While MWM specializes in alternative asset investment management, we do offer traditional portfolio management along with our natural resource and long/short strategies. Tactical Short is a unique offering intended to compliment other risk asset allocations held with MWM or elsewhere.
What do you see as an appropriate percentage allocation to something like the Tactical Short from an overall portfolio mix perspective?
An allocation to our non-correlated Tactical Short adds value by reducing overall investment portfolio downside risk. We would suggest exposure to the Tactical Short in the range of between 5 and 20% of risk assets to help reduce overall portfolio volatility, enhance liquidity and provide meaningful downside protection. For example: $2,000,000 in total equities and risk asset exposure would typically benefit from a $100,000 to $400,000 Tactical Short allocation. With an allocation above 20%, we would assume that an investor has chosen our product to place a directional bet on a declining market.
Are there Minimum account sizes?
Institutional investors would generally have a minimum account size of $1,000,000 while, where appropriate, qualified individual investors would be considered with minimum account sizes at inception as low as $100,000.
What are management fees for Tactical Short?
1.0% per year paid quarterly in advance (25 bps per quarter).
If I am utilizing margin in the Tactical Short, will my account be charged for margin borrowing expenses? Are there other expenses I should be aware of?
While the portfolio manager seeks to minimize such costs, there are typically expenses associated with borrowing securities. Borrowing costs are generally small, with the exception of hard-to-borrow securities. Traditionally, borrowing costs were offset by the return on an account’s cash collateral.
Why would I choose a MWM Tactical non-correlated account instead of a short ETF or options strategy?
We believe our strategy is superior to competing “bear” products and instruments. Being fully short all the time simply doesn’t work. Options strategies are risky and tough to execute successfully. In our eyes, risk management is paramount. The key to success on the short-side is having the flexibility to navigate through various market environments. To do so successfully demands a disciplined investment process coupled with a sound analytical framework. Importantly, there’s no substitute for experienced active-management on the short-side. In our view, our new offering incorporates the most seasoned portfolio manager with the most compelling analytical perspective, investment process and philosophy available in the marketplace.
Does MWM custody assets? If not, who is the custodian?
We do not custody assets. Our preference is to retain the services of a preeminent third-party custodian, an arrangement that facilitates online access to account holdings and myriad amenities common to a brokerage account. Tactical Short client assets are held at Interactive Brokers.
Can I send additional funds to my account in the future?
Sure. Additional funds can be added in any quantity. Because Tactical Short accounts can be rebalanced daily, there should be minimal delay in adjusting positions sizes to incorporate flows into (or out of) your account.
Will this offering be closed at some point to new money?
We do not at this time anticipate capacity issues that would cause us to close the Tactical Short to new investors or restrict inflows.
Do I need to reserve a place?
That’s not necessary. We would, however, highly recommend funding an account and then to allow us to determine the appropriate time to allocate assets. This is much preferred to beginning the process in the middle of unstable market conditions.
Are assets always invested on the short side?
No, there will likely be periods when we choose not to hold short exposure. Our analytical framework and proprietary indicators assist us in gauging both when conditions are more favorable for shorting along with the most attractive composition of short exposures (i.e. stocks, sectors, the market, etc.) from a risk versus reward perspective. When conditions are expected to be unfavorable, the Tactical Short is content to watch from the sidelines (sitting in cash and avoiding short exposures). Such a tactical pivot from being opportunistically short to defensively positioned creates the flexibility necessary to capture gains and then safeguard them from major market advances.
If Tactical Short operates with hedge fund-like versatility, why not charge the standard “2/20” (2% management fee and 20% of profits)?For one, we do not share the typical hedge fund mindset. By keeping fees to a minimum, we endeavor to develop long-term partner relationships with our investors as we together navigate through the vagaries of market cycles. We did not develop our new product with the intention of getting rich from the next market downturn or financial crisis. We were motivated by what we saw as a glaring lack of quality flexible short-side products – the type of strategy that savvy investors could live with comfortably during these uncertain and unsettling times.
When you are not short how are funds allocated?
It’s a little confusing. Unlike long investing, cash is not used up in the process of borrowing and selling securities short. Whether fully short or not short at all, account assets remain mostly in Treasuries and/or cash-equivalents. Some of the cash holdings are used as collateral against short positions, but this cash remains in the account. So even in periods of market stress, Tactical Short assets should remain safe and highly liquid.
How liquid are the funds in my account?
Funds are generally available same day. One of the benefits of a separately managed account is that requests for same-day liquidity can be accommodated. Short positions will also be highly liquid. In the event an account is liquidated, it will be possible to unwind (“cover”) short positions upon request and return cash collateral on a standard T+3 settlement basis. No “gates” here.
Can I add money to an account in the future?
Yes. There is a minimum to open an account but should you desire to increase your allocation to the tactical non-correlated theme you may do so at any time.
If future gains boost the size of my account, would you recommend allowing my short allocation to increase over time or instead employing a total portfolio re-balancing approach?
Having access to liquidity at market bottoms can be highly advantageous to value-conscious investors. We’re going into our new venture with the assumption that Tactical Short’s ability to create liquidity in down markets creates an enticing long term value proposition for astute investors. While tactical decision-making will be a primary management focus of our short offering, we fully expect our long-term investors to engage in cyclical allocation decisions consistent with their individual goals and circumstances. As partners, we’re committed to doing our very best in offering valuable insight as well as attractive investment alternatives to best serve our investors as they strive to generate and preserve wealth.
- Don’t be risk indifferent – unwise to maintain 100% short exposure all the time
- Don’t disregard the macro backdrop
- Don’t ignore the market
- Don’t disregard portfolio beta
- Don’t pretend long/short strategy mitigates risk
- Don’t only short stocks
- Don’t maintain concentrated short positions
- Don’t only short a market index
- Don’t have illiquid positions
- Don’t rely on potentially problematic third-party derivatives
- Don’t invest short collateral in potentially risky and illiquid instruments
- Don’t be a “one-trick pony” – (i.e. company research, index or quantitative focus)
- Daily intensive, disciplined risk-management focus
- Wisely adjust exposures based on market risk vs. reward backdrop
- Be flexible and opportunistic with individual short positions and overall exposure
- Incorporate experienced top-down macro research and analysis
- Search for opportunities rather than fight the market
- Intensive beta management:
- Protect against short squeezes and “upside beta” issues
- Guard against high market correlations
- Have as many tools in the toolbox as possible:
- Short stocks, sectors, indices, various asset-classes, global perspective,
- Liquid put options
Incorporate a technical analysis overlay with risk management focus
Protect against potential systemic risks:
- Avoid third-party derivatives
- Liquid put options
- Vigilant cash and liquidity management
Incorporate the best of micro, macro and technical analysis
For more information or to inquire about opening an account for the Tactical Short Strategy, please contact us: [email protected]