McAlvany Wealth Management
Tactical Short 4th Quarter 2020 Recap
With David McAlvany and Doug Noland
Thursday January 21, 2021
Managing in a Mania
David McAlvany: Okay, we are going to go ahead and get started. This is David McAlvany and I’ll introduce our call today.
Good afternoon, everyone. Thank you for participating in our fourth quarter recap conference call. As always, a special thanks to you, our valued account holders. We greatly value our client relationships. I want to mention that if you have questions as we go through the information today, and were not able to submit something ahead of time, you can go to our website, mwealthm.com. There’s a chat function. I’ll be responding to those, just to acknowledge that your questions come through. Then we’ll add those to the tail end of our questions. Again, the chat function at mwealthm, and we have quite a few questions to go through today. Thank you for submitting those. We look forward to that. I’m going to keep my comments brief here at the front end, so we have plenty of time to get to those questions.
Doug has fantastic observations for you just in terms of market dynamics and where we go next. Before we get to the Q and A, I will open up our conversation today, pass the baton to Doug. Then we’ll come back around and both share the Q&A.
With a number of first-time listeners on today’s call, we’ll begin with some general information for those unfamiliar with Tactical Short, more detailed information is available at mwealthm.com/tacticalshort. The objective of Tactical Short is to provide a professionally managed product that reduces the overall risk in a client’s total investment portfolio while providing downside protection in a global market backdrop with extraordinary uncertainty. We would have said – well, I think we can say – extreme risk today.
This strategy is designed for separately managed accounts. It’s very investor friendly with full transparency, flexibility with reasonable fees, with no lockups. We have the flexibility to short stocks and ETFs. We also plan on occasion to buy liquid, listed put options.
Shorting entails a very unique set of risks. We are set apart both by our analytical framework and our uncompromising focus on identifying and managing risk that Doug will discuss in detail in today’s conversation.
Our Tactical Short Strategy began the fourth quarter with short exposure targeted at 66%. The short target held steady throughout the quarter, consistent with our view of an extraordinary market environment – I will say, extraordinarily unstable market environment – due to the highly elevated risk environment for shorting, the S&P 500 ETF was the only short position during the quarter. Again, Doug will dig into that as we go through our comments today. We never recommend placing aggressive bets against the stock market, especially in today’s manic environment of extreme uncertainty and acute market instability. And more than ever, a disciplined and professional approach to risk management is an imperative.
We highlight this message during every call that it’s our opinion that remaining a hundred percent short all the time, as most short products are, and that’s just by nature, that’s how they’re structured, that is risk indifference – which is why I mentioned the 66%. We are not fully short. We can be, but that is moderated and modulated through time. The fourth quarter was notable for inflicting heavy losses on the short side, for those who were indifferent to risk. We believe a disciplined risk management is absolutely essential for long-term success. We’ve structured Tactical Short to ensure the flexibility to navigate through even the most challenging and manic market conditions.
Let me give you an update on performance, Tactical Short accounts after fees returned a negative 8.07% during the fourth quarter, the S&P returned a positive 12.14%. For the quarter, Tactical Short accounts lost, again if you’re talking about the S&P’s positive gain, we were the inverse of that, 66% of the inverse of that. As for 2020 performance, Tactical Short after fees, was at negative 15.17, 15.17% versus the 18.39% positive return in the S&P. We regularly track Tactical Short performance versus our three actively managed short fund competitors.
I’ll mention those. First, the Grizzly Short Fund, which was negative 23% during the fourth quarter and for the year Grizzly returned negative 41.33%. Ranger Equity Bear Fund returned a negative 32.52% for the quarter and a negative 43.447% for the year. Federated Prudent Bear Fund returned a negative 10.98% during Q4 and negative 22.92 for the full year 2020. On average, Tactical Short outperformed our three competitors by 1,413 basis points during the quarter and for the full year, an average of 2,074 basis points over that full year period. Tactical Short has also significantly outperformed each of the bear funds since inception.
From April 7th, 2017, our inception, through the end of September, Tactical Short has returned a negative 30%, 30.34 versus the 71.2% return for the S&P 500 while on average outperforming our three competitors by just a skosh below 3000 basis points 2,918. There are as well, the popular passive short index products that we, again, significantly outperformed, the ProShares, short S&P 500 lost 11.57 for the quarter, 25% for the year. The Rydex Inverse S&P 500 lost 11.6 during Q4 and 24.9 for the year 2020. Then, also, PIMCO, their stock plus short fund lost 10% for the quarter and 21.14 for the year.
Doug I’ll hand the baton to you to dive into market comments. Then again, we’ll circle back around to questions. I’ll mention again, the spot online. If you want to go to our website to add any questions as we go, chat functionality’s in the bottom right-hand part of the page. Thank you very much.
Doug Noland: Thank you, David. Good afternoon and thanks for being part of today’s call. I have a favorite saying I’ve used over the years to begin team meetings. Every day is a new and exciting adventure. Following daily developments in this most extraordinary of environments is certainly exciting. These crazy markets, the policymaking, politics, and societal drama. I prefer to use words such as exciting and fascinating to describe things that these days probably more accurately would be labeled troubling or unnerving. For me personally, I always work to maintain a positive mindset, even when my analysis is pointing negatively. I wish I didn’t find the current fascinating environment so deeply troubling.
Let’s begin the analysis with an update of this unbelievable monetary environment. Federal Reserve credit has increased 3.1 trillion over the past only 45 weeks. That’s 88% growth annualized. Fed Credit was up 3.6 trillion over the past 70 weeks, or 95%. After beginning 2008 at 850 billion, Fed assets are on course to surpass 8 trillion around mid-year. M2 money supply has expanded about 3.7 trillion over the past 45 weeks to a record 19.2 trillion, a stunning 29% annualized growth rate since March. It’s worth noting as well, that institutional money funds, and they’re not included in M2, were up another 522 billion over the past 45 weeks or 27% annualized.
The 2020 fiscal year federal deficits spiked to an incredible 3.1 trillion, or 15% of GDP. For the first quarter of fiscal 2021, the deficit jumped 61% year over year to 573 billion and that’s just for the first quarter. The government borrowed 45 cents of every dollar spent during the quarter. There’s been nothing comparable since World War II. Let’s briefly delve into key data from the Fed’s quarterly Z1 report. US non-financial debt surged 5.74 trillion during the first three quarters of the year, an increase of 188% from comparable 2019 growth. For perspective, non-financial debt expanded on average 1.83 trillion annually over the previous decade. Now we do 5.74 trillion in three quarters and had not previously surpassed 3 trillion on an annual basis. Outstanding Treasury securities surged almost 3.9 trillion during 2020’s first three quarters, with year-over-year growth of an astounding 4.3 trillion, or 23% growth. After concluding 2007 at about 8 trillion, Treasury liabilities ended September at 25.8 trillion. Over the past five quarters, total debt securities, and that’s treasuries, agencies, corporates, munis, jumped almost 6.7 trillion to 52.6 trillion – growth more than double any previous comparable increase.
At 249% of GDP, total debt securities compares to a ratio of 200 back in 2007, 157% to the end of the ’90s and 126 to end the ’80s. Total securities and here this combines debt and equities [unclear] Q4 to record 110 trillion. At 518% of GDP, this compares to previous cycle peaks, 379% in ’07 and 359 during Q1 2000. With the value of securities inflating to record highs, household net worth reached an all-time high, 124 trillion. Household net worth ended Q3 at 584% of GDP. This greatly surpasses previous cycle peaks. Never in our nation’s history has there been such egregious monetary inflation. Money and credit have quite literally become unhinged, and at least some consequences have turned conspicuous. With market liquidity injections, the primary mechanism for Federal Reserve stimulus, there’s no mystery surrounding extraordinary asset inflation and bubble dynamics.
Following years of progressively expanding excess and bailouts, the US Stock Market has degenerated into a full-fledged mania. The NASDAQ 100 more than doubled in two years with a current price-to-earnings ratio of 39. The S&P 500 trades with a PE ratio north of 30, an all time high, according to Bloomberg. This is no 1999 style mania propelled by a single sector and a narrow group of stocks. The average stock value line arithmetic index has gained 130% from March lows, and the strongest broad-based market rally I can recall. The Small Cap Russell 2000 almost doubled from March lows with a Bloomberg PE designated as N/A, not applicable, meaning the index in aggregate is devoid of positive company earnings. Tesla surged 700% over the past year with a market capitalization reaching 800 billion.
David McAlvany: Doug, if I might interject, the move for Tesla to 800 billion, just relative to the car market as a whole, VW, just as one part of that market, is a hundred billion market cap company that produces 11 million vehicles a year. Toyota, and if you include the rest of the US, European, Japanese, South Korean automakers, you come in at a total capitalization of around 630 billion. You have Tesla at 800 billion, just for a relative comparison. All of those geographies, all of those producers are about, I don’t know, call it 43 million units a year, 43 million automobiles versus Tesla’s 500,000 cars, which is better than it has been in the past.
They’ve made money only on selling carbon credits. It’s just to your point of a full-fledged mania. You’re talking about the auto industry. They produce 86 times more vehicles, 86 times more vehicles, and yet have a smaller capitalization than Tesla … anyways.
Doug Noland: Yeah. Thanks David, for adding that color. That puts it in better perspective. The Goldman Sachs Short Index is up 260% from March lows in one of history’s great short squeezes. The GS Short Index is already up another 20% year to date. Short interest in the SPY, the S&P 500 ETF has dropped below 2%, a level rarely seen over the past decade. And this IPO madness. Companies raised 167 billion last year, trouncing the previous full-year record of 108 billion during the bubble blow-off year 1999, including secondary equity offerings. A record 435 billion was raised in the US last year, more than 50% ahead of 2014’s record and more than 240 SPACs, that’s special purpose acquisition companies, went public, raising an unprecedented 81 billion. There were 100 billion of convertible bonds sold, double 2019’s volume. The US in 2020 saw corporate debt issuance jump to 1.7 trillion, records for both investment grade and high yield sales.
Globally almost 5.4 trillion of new corporate debt was issued, 25% ahead of previous records back in 2019. Junk rated companies raised a record 547 billion, a third higher than 2019. The ETF industry, they saw assets surpass 8 trillion, with global ETF inflows reaching a record 763 billion. A 36% increase from record 2019 flows. Vanguard enjoyed inflows of 186 billion with assets surpassing 7 trillion. Average daily option trading volume reached 30 million contracts last year, up more than 50% from 2019 levels. Last Friday’s option volume hit a new record, with almost 50 million contracts traded. I’ll quote Reuters: “This year, some 416 million US equity option contracts have already traded over 10 sessions. That’s equal to the total options volume over the first four months of 2004.” End of quote. The majority of this record volume arises from the mania and call option buying. It’s worth noting the ratio of call versus put buying recently reached the highest since early year 2000.
According to Bloomberg, last Monday saw pet medicine maker, Zomedica’s trading volume at the top of the most active list reaching a billion shares. Zomedica and five other stocks trading below a dollar accounted for a full 20% of daily share volume. I’ll quote Bloomberg from last week: “Fact, shortly before 1:00 PM New York Time Thursday, there were six penny stocks posting daily gains of at least 9,900%. Off exchange venues where unlisted equities trade had seen about 38 billion shares change hands, up seven-fold from the average a year ago. More than 1 trillion shares changed hands in December over lightly regulated quotation systems.” End of quote. Then there’s the cryptocurrencies and Bitcoin. After starting 2020 at about 7,200 and dropping below 4,000 in March, launching a speculative moonshot that surpassed $40,000 earlier this month. I’m fond of seeing how things can get crazy at the end of cycles And with our view that central banks are prolonging the final phase of a grand super cycle, we shouldn’t be too surprised by anything at this point.
I thought I’d witnessed just about everything in my over three decades operating in unstable bubble markets, but the current mania has taken things to a whole new level. Traditionally, it was the Federal Reserve Doctrine to lean against the wind, to at least ensure monetary policy was not exacerbating excess. The Fed some years back proclaimed that it would not use rate policy to contain asset inflation and bubbles, choosing instead so-called macro-prudential measures. How is our central bank reacting these days to such conspicuous excess? Well it’s radio silence as they continue to pump 120 billion of new liquidity monthly. We’ve all grown numb to much of this by now, but think of this. Stocks are surging in what is clearly a momentous speculative bubble, and the Fed steadfastly sticks to its plan for injecting another almost 1.5 trillion into the markets this year.
If that’s not crazy, what is? We can today clearly observe unprecedented monetary inflation, money and credit growth, and we can identify resulting monetary disorder manifesting into acid inflation and highly speculative securities markets.
So let’s get to the theme of the call, Managing in a Mania.
This extraordinary backdrop beckons for a focused approach to risk management. Discussion of optimal timing and composition for short exposure has been a regular focal point of management discussions throughout my entire career. There’s complexity that is not self-evident. It seems intuitive that the higher a stock price, the better the short opportunity. The more the market goes up, the more attractive shorting becomes. If it were only that simple. Some of today’s most experienced and successful short analysts suffered huge losses being short Tesla, likely the largest losses of many careers. Tesla stock doubled during 2020’s first half, creating what appeared an even better short. The problem is, it doubled again, trading to 400 by August, and then more than doubled a third time to trade as high as $884 earlier this month.
It’s common to short stocks based on overvaluation. There was a solid argument that Tesla was overvalued even prior to its 800% gain. The point is that traditional short side analysis can prove highly problematic when financial conditions loosen. In a more normal monetary environment, it’s likely Tesla would have run out of cash. Many seasoned balance sheet and cash flow-focused analysts were betting on exactly that outcome, but not only has the company survived, it’s become one of the highest market cap stocks in the marketplace. Its founder has become one of the wealthiest individuals in the world.
How could the shorts have been so wrong? Well, financial conditions loosened dramatically, and short side analysts didn’t appropriately factor this into their microanalysis. Moreover, there’s a dynamic whereby a rising stock price alters trading dynamics. The more Tesla stock price rose, the more traders and institutions just had to own it – fear of missing out. And the more money that was made in the stock, the more traders and others were delighted to buy Tesla cars. It expanded into a full-fledged mania. I’m highlighting Tesla, yet similar dynamics propelled scores of stocks. The entire stock market has become one historic speculative mania.
We certainly don’t want to be caught short individual company stocks in a mania, and fortunately we weren’t. One of our competitor funds lost almost 33% during the fourth quarter, and a second drop 23% with 2020 losses exceeding 40%. They have been caught shorting stocks during a mania, and their investors have suffered. We didn’t expect this to evolve into a historic mania. There’s been a once-in-a-century pandemic, the intensity of March’s financial crisis, the steep economic downturn, along with alarming social and political instability. On its surface, it just didn’t appear an environment where the shorts needed to fear being steamrolled by a mania. This is where our analytical framework and disciplines shine through. We focus first and foremost on financial conditions. When financial conditions are loose, we maintain tight control on risk. From my experience, shorting stocks is a high-risk proposition when finance is loose or loosening. While we may not have anticipated this turning into a full-fledged mania, we appreciated that the probability for such an outcome was bolstered by the policy and monetary environment.
We recognized that market structure was conducive to speculative excess evolving into euphoria and manic behavior. Trend-following and performance-chasing dynamics have proliferated. Hedging programs were dominant in the markets earlier in the year. The unprecedented Fed and central bank crisis response spurred a huge short squeeze and unwind of hedges that propelled the rally. And uncertainties associated with the November election created another major hedging event, followed, post-election, by a second substantial unwind of hedges and squeeze that again powered markets higher. The fourth quarter rally was an unmitigated disaster for those short company stocks. Already impaired from the earlier liquidity-induced rally, the post-election short squeeze and speculative melt-up incited a panicked reversal of short positions.
The Goldman Sachs most Short Index surged 38% during Q4, pushing its 2020 gain to 51%. This historic short squeeze created a big problem for various hedge fund strategies, particularly long short and quant factor strategies. I believe the combination of a powerful short squeeze, the unwind of derivative hedges, and mayhem for a segment of the hedge fund industry was instrumental in fueling melt up dynamics and upside market dislocation. Meanwhile, euphoria was engulfing the bubbling retail trading universe – the so-called Robin Hood effect – certainly enveloping the Wall Street darling tech and stay-at-home stocks, but also call options and penny stocks. Making money in the markets has never [inaudible]. Our default position and high-risk market environments is to be short the S&P 500 Index. This offers the most attractive risk versus reward short exposure, allowing Tactical Short to be reliable as a market hedge, but with a well-defined risk profile.
After living through the brutal 1991 short squeeze, I’m aging myself there, and a very hostile environment for shorting throughout the ’90s, I emerged from that invaluable learning experience with strong views regarding risk control and the imperative of beta management and managing overall short exposure. In more layman’s terms, this means a disciplined risk management approach focusing on potential short position, upside volatility, more specifically the probability of outsized losses for various short exposures during squeezes and speculative market advances. Importantly, it is critical on the short side to objectively gauge market risk. Then, depending on this risk assessment, to manage short exposure portfolio beta accordingly. This assessment focuses foremost on financial conditions and that’s monetary policy, general monetary conditions, marketplace liquidity, corporate debt market conditions, and credit availability, speculative dynamics, and such. The higher the risk profile for short exposure, the stricter the adherence to disciplined beta management. When the risk backdrop is gauged as highly elevated, a strict discipline dictates hunkering down in the default short in the S&P 500 Index.
This default short position mitigates the risk of getting caught in squeezes in individual company and sector shorts, which has provided a huge performance advantage for tactical short versus our competitors. But there’s another key aspect of this default position, not as readily apparent. The fourth quarter illuminated another major risk for the short side during highly speculative environments: the risk of getting caught in violent rotations. I remember last year I fielded questions as to why Tactical Short would be short the S&P 500 when it was outperforming some other indices, notably the small caps and financials. In the marketplace, many strategies that incorporate short exposure, they naturally gravitate to the underperforming stocks and sectors, the perceived lower risk shorts. But in high-risk speculative environments, these underperforming sectors are transformed into landmines for the shorts. Market rotations into these stocks and sectors tend to spur panic reversals of short positions and derivatives fueling stock out-performance that then feeds into powerful self-reinforcing speculative excess.
That is the story of Q4. A lot of perceived low-risk shorts turned high beta. After underperforming much of the year, the Small Cap Russell 2000 exploded for a 31.4% three-month gain. While the mid caps returned 24.4. The KBW Bank Index returned to 35% during the quarter and the Philadelphia Oil Services Index surged 60%. The average stock Value Line Arithmetic Index returned 27% for the quarter. As noted previously, the Goldman Sachs Short Index, up 38%.
Importantly, it becomes impossible during a mania to accurately gauge the beta of a portfolio of individual company shorts. That’s the reality. A default position in the S&P 500 avoided the misery of getting caught in these types of rotations that have a propensity to extend into speculative blow-off. If one’s mandate is to remain short only individual company stocks, without regard to the market environment, a lot of time and frustration is spent trying to figure out how best to be positioned. This invariably leads to a lot of overtrading, too often zigging when you should be zagging. Poor performance begetting poor performance.
Our risk management and default short exposure discipline sidesteps this predicament, avoiding the expensive proposition of trading in and out of stocks and sectors, getting caught in rotations and short squeezes, and being forced into risk control that dictates buying back stocks during price spikes.
It was just an exceptionally tough quarter and year. I hate to lose money, so this has been very frustrating. This period just very frustrating. We did outperform our three competitors on average by over 1,400 basis points and that’s 14 percentage points during the quarter, and over 2,000 basis points for the year. Tactical Short also outperformed these three index short products on average by 300 basis points for the quarter, 854 basis points for the year. This is huge outperformance, to which we credit our analytical framework, risk disciplines, investment process, and philosophy.
As I’ve said in the past, running a short portfolio of volatile company stocks is playing Russian roulette, and in an over liquefied and manic environment you’re playing with multiple bullets in the chamber. A number of shorts took bullets in 2020.
I want to stress this critical point. This doesn’t occur in normal environments. Markets wouldn’t behave in such an erratic manner if underpinnings were sound. We’re witnessing a consequence of acute monetary disorder, disorder that arose from the extreme policy responses to financial and economic fragility.
Why do things turn crazy at the end of cycles? Because years of mounting excess culminate in destabilizing speculation, even in the face of late cycle economic maladjustment and vulnerability. Policymakers respond to heightened risk of bursting bubbles with only more forceful measures, aggressive monitoring inflation that eventually pushes speculation into a melt-up, mania dynamic.
I’ve had a long fascination with past bubbles and monetary fiascos. Perhaps some of you share this. Earlier in my career, I exhaustively studied the late ’20s period. Often I was left confounded. How could markets have kept rising in spite of a clearly deteriorating fundamental environment? How could participants have so blindly disregarded such troubling unfolding developments?
I do not recall the book, but sometime back I came across contemporaneous accounts of 1929 and its aftermath. Wall Street traders were interviewed and a key question was posed. How could you have ignored all the issues, the debt overload, the surge in broker call loans, the obvious speculation, excesses, and mounting fragilities? Many of the responses shared a similar perspective. An explanation that left an indelible mark on my thinking. These market operators basically said, “You can only worry about things for so long.” Yet they had fretted about these issues for years, especially in 1927. But eventually, the late-cycle environment had forced them into abandoning their concerns and blindly embracing the mania.
I think a lot about this dynamic these days. Future historians will surely look back at this period and ponder how on earth so much was ignored. What were people thinking? They will surely question how faith was maintained in the course of unconventional central banking, why euphoric markets maintained such confidence that more central bank money would resolve deepening maladjustment and how central bankers could turn a blind eye to reckless debt growth, speculative asset bubbles, and mounting structural impairment.
I want to address what I see as one of this bubble period’s most dangerous fallacies: that central banks control market liquidity, and financial conditions more generally. It’s my view that speculative leverage evolved into the prevailing marginal source of marketplace liquidity. So long as speculative leverage is expanding, markets remain highly liquid, and this is a self-reinforcing bubble dynamic. But we saw again in March that this dynamic does not function in reverse, how rapidly illiquidity and dislocation take hold during sudden bouts of de-risking and de-leveraging. I saw in March powerful confirmation of my thesis that global speculative leverage has expanded momentously since the ’08 crisis.
The Fed responded to 2008 de-leveraging with an unparalleled $1 trillion of new liquidity. Last March, de-leveraging actually accelerated even as the Fed announced QE in excess of 1 trillion, forcing a panicked Fed to dramatically expand the scope of emergency liquidity operations. Because of the fragility associated with unparalleled global leverage speculation, the Fed and fellow central banks were forced to move quickly and extremely aggressively.
They were successful in reversing de-leveraging, but at the cost of promoting even more egregious speculative excess and leveraging. The bottom line: an already historic bubble has inflated tremendously since March. While it today appears, whatever it takes, central banking has market liquidity well under control, this is a bubble illusion. The next series bout of de-risking and de-leveraging will again incite illiquidity and dislocation likely on par with March. I would argue that each of these massive Fed market bailouts provokes only more precarious speculative leverage, a broadening scope of bubble excess, and even deeper maladjustment. It’s a bad cycle of ever-bigger bubbles and bailouts. Come the next series post pandemic risk off episode, will the Fed be willing and able to re-liquefy the markets with perhaps another few trillion of Fed money. Markets at this point take for granted that whatever it takes ensures the Fed will readily resolve any and all problems.
I believe there are serious shortcomings in the market’s complacent and optimistic view. Huge risks are being ignored. For one, the Fed in 2020 inserted itself right into intense partisan political rancor. The Federal Reserve became a major force in credit and wealth allocation – dangerous domain for central bankers and central bank independence. Our central bank was rightfully recognized as a major propagator of wealth inequality, inflating the stock market for the benefit of the wealthy and a fortunate segment of the population.
Meanwhile, the Fed was also actively promoting monstrous fiscal stimulus and deficits. Going forward, the Fed will be viewed by many as supporting the Democrats’ liberal agenda. The Biden administration is already proposing a $1.9 trillion stimulus package, while stating that a second round of spending legislation addressing infrastructure, tax changes, and such will be coming around mid-year. There was already notable Republican pushback at Yellen’s Tuesday confirmation hearing.
I see the Republican Party emerging from disarray with the return to its roots of fiscal conservatism. Expect the Fed’s $120 billion monthly money printing operation to come under heightened scrutiny. This will especially be the case if inflationary pressures continue to mount. We view inflation risk as being the highest in years. The 10-year treasury break-even inflation rate has jumped to 2.17%, the high since October 2017 – or 2018, excuse me. Commodity prices continue to rally. Food prices are surging. Services and manufacturing surveys point to heightened pricing pressures. Home prices are inflating at the strongest double-digit rates since the housing bubble period. The world is awash in liquidity. The dollar has weakened. Our central bank, overseeing the world’s reserve currency, is trapped in reckless monetary inflation. This backdrop has afforded nations around the world the flexibility to recklessly inflate their money and credit. Global money and credit are today unhinged like never before.
It’s no longer hypothetical. Global central bank money is solidly on a trajectory that ensures intractable global monetary disorder. A critical juncture for global inflationary dynamics has been reached. There does remain a very real possibility of bursting global bubbles with sinking securities markets and a contraction of speculative leverage, galvanizing deflationary pressures. We see reasonably high odds of a particularly problematic scenario: the global central bank community, by synchronized de-risking and de-leveraging, to move early and aggressively to again flood the system with liquidity.
For the first time, central banks would be inundating the system with liquidity despite increasingly entrenched inflationary pressures. General price inflation could finally catch fire. We take exception with bullish faith in the Fed maintaining full flexibility, infinite capacity to rescue the system from whatever crisis that might unfold. We view the Fed today as facing diminishing capacity and potentially significant constraints. Surging bond yields, and a disorderly decline in the dollar, would force the Fed into taking a more measured approach with QE. Meanwhile, political pressures are brewing. Our nation faces massive intractable fiscal deficits.
Unless the Republicans get their act together, the blue wave will grow only more formidable. The MMT crowd, modern monetary theory inflationism, is emboldened and eager to push the envelope. It has now left the markets to impose some fiscal discipline upon profligate Washington. The bond market today largely disregards the unending massive supply of treasuries in the pipeline, if you hold that the Fed won’t allow treasury yields to rise much before boosting purchases. The problem is that a bout of de-risking and de-leveraging will require a huge increase in purchases just to absorb the liquidation of treasuries and other securities. In an environment of heightened inflationary pressures, we see a problematic scenario whereby markets would start to panic that the Fed has lost control. This is not far-fetched analysis.
Recall that markets were initially panicked by the Fed response to the March crisis. It required the most extreme measures in the history of the Federal Reserve System to hold financial collapse at bay, but reckless monetary inflation has only inflated a more colossal bubble, creating the potential for an even more chaotic market backdrop come the next serious de-leveraging episode. The new Biden administration took office yesterday. Manic markets have been fixated on additional stimulus, easily dismissing the wealth redistribution policy mandate the Democrat clean sweep entails. Monday’s Bloomberg headline read: Biden’s Wall Street Watchdogs Signal New Era of Tough Oversight.
The president’s pick to head the SEC, Gary Gensler is a sharp, experienced, and proven tough regulator. Robin Hood retail trading derivatives and SPACs and such are now in regulation crosshairs. Corporate tax rates will be going up, and a $15 national minimum wage a distinct possibility. There will be more regulations, but with trillions of stimulus in the pipeline, Wall Street isn’t today concerned with corporate profits.
But inflated bubble period earnings are unsustainable and vulnerable. Quoting Treasury Secretary Yellen: “Right now with interest rates at historic lows, the smartest thing we can do is act big.” End of quote. But another 3 trillion plus annual deficit is not smart. In the past, it would have been recognized as foolhardy, if not negligent. It’s playing with fire. We believe Washington has pushed things too far – much, much too far. The most extreme debt growth and the most extreme Federal Reserve debt monetization.
We’re witnessing an unprecedented late cycle runaway expansion of risky, nonproductive debt, too much of it held by leverage speculators. Market backlash is inevitable and overdue. We just don’t see market forces remaining inoperative indefinitely. Supply and demand will matter again. The quantity and quality of system credit will prove momentously important. We see a multitude of bubble piercing catalyst possible, starting with a spike in treasury yield and a disorderly drop in the dollar. We believe market optimism regarding post pandemic recovery is too optimistic. The pandemic will leave deep scars, including problematic credit impairment across households, small business corporations, and state and local governments. Debt problems have thus far been held in check by massive stimulus, repayment moratoriums, and the loosest financial conditions imaginable. There’s no free lunch. Credit problems propagate and fester. The system is only a tightening of financial conditions away from serious credit issues.
We have focused much of our attention on this call so far to domestic issues. There are myriad potential global catalysts that could spell trouble for our markets. Right now, optimism on China’s debt-induced recovery is strong. Beijing’s efforts to get their bubble under control have been repeatedly postponed, more recently due to the US Trade War and then the pandemic. Chinese officials have cautiously begun the process of slowing credit growth and removing some stimulus. We believe this process will reveal financial vulnerabilities in their highly speculative asset markets and corporate credit, and in the soundness of China’s bloated banking system.
Over liquefied and highly speculative markets have masked deep structural impairment throughout the emerging markets. We expect fragilities will be exposed with any risk-off tightening of global finance. European bond markets are a historic bubble fueled by the ECB and global central bank liquidity. In short, a global system so overburdened with debt, speculative leverage, and unparalleled imbalances is an accident in the making. And it could be something completely unexpected that pierces vulnerable bubbles. We certainly don’t see heightened US social and political instability as supportive of healthy securities markets.
We’re excited. We’re excited by 2021 prospects for Tactical Short and the hard asset MAPS strategies as well. David, back to you.
David McAlvany: We’ll dive into the Q&A. Thank you, Doug. Let’s get started with Burt’s question. “Thoughts on how the US government’s level of current debt and forecasted growth in debt to fund deficits will impact the dollar. Clarifying question: since almost all countries seem to be running deficits, is the size of the US government deficit by itself the issue, or is the key issue, the US government deficit relative to the deficit of other countries, meaning as bad as the US looks, it could still be considered the safe haven relative to other alternatives?”
Doug Noland: Excellent question. Thank you for that. Well, currencies, they’re a relative game in that a currency is valued versus another currency, and the dollar’s greatest asset these days is that it competes against structurally weak competitors. That may underpin the dollar, but certainly not global financial and economic stability. When analyzing the euro, for example, one sees much of Europe as a basket case. Although from my perspective, many of these countries have been making progress towards some of their structural shortcomings over the past decade. Most, at this point, I do not consider bubble economies such as I do the US. But their economies still face significant structural maladjustment while the ECB has been inflating only somewhat less than the Fed. Looking at Japan, while the Bank of Japan hasn’t been monetizing debt to the extent of the Fed or ECB, the Japanese government has accumulated a staggering debt load.
Doug Noland: However, the yen is supported by some favorable fundamental dynamics. Japan remains a manufacturing powerhouse while running sizeable trade deficits, and has over a trillion dollars of international reserves. We have essentially nothing. It enjoys enormous domestic savings, which has meant that most government debt growth has been financed through domestic savings. The government sector borrows from the household sector. A much different dynamic than we have here in the US. So the dollar suffers from serious structural weaknesses, massive expansion of non-productive debt, unparalleled central bank monetization, intractable trade, current account deficits. Ponder this: China’s pandemic recovery was driven by surging manufacturing and exports. Here in the US massive fiscal and monetary stimulus has led almost immediately to expanding trade deficits. I believe the November US trade deficit was an all-time record. So my concerns for the dollar, they’re structural in nature, I believe the US public economy suffers deep maladjustment.
It has evolved to be services, finance dominated, which creates vulnerability to any tightening of financial conditions, any credit slowdown. Now we’re trapped in this dynamic of massive fiscal monetary stimulus and resulting current account deficits. We continue to flood the world with dollar balances. Keep in mind, over the past decade, much of these balances were accumulated by foreign central banks. Although demand from the big holders of debt, such as China, Japan, and others, it’s waned. I believe the slack has been taken up by the global leverage speculating community. My view is that levered hedge funds and derivative players have become major holders of treasuries and fixed income securities. This was instrumental to March’s market dislocation. I believe, we believe, the dollar is vulnerable because of both fundamental structural issues. I’m unaware of any historical precedents for a country persistently running large current account deficits without eventually confronting a serious currency problem.
In a global crisis environment, I clearly, especially if the emerging markets get in dislocation, the dollar might enjoy a safe haven demand, but I fear a crisis of confidence in the dollar is long overdue. We can’t continue to massively inflate nonproductive debt and have the Fed monetize much of it and the hedge funds lever it without setting the stage for a bout of market revulsion. I’m skeptical that this can continue. We’re today pushing the extremes too hard. Bit of a long answer, but a great question. Thank you.
David McAlvany: Doug, I’m re minded of Jacques Rueff’s book, The Monetary Sin of the West. In it, he describes the deficit without tears, where it appears that we can run these deficits and there is no consequence. But you look at the heart of his argument, and the heart of his argument was why the French, specifically Charles de Gaulle was encouraged and ultimately took action on pulling gold from Fort Knox. This is late ’60s, early ’70s. In theory, you can pretend that the deficits don’t matter and in practice, they do. There’s a lag between when you care and when it hurts. That’s really what Rueff was getting at. The next question – thank you, Burt, for that. The next question is from Charles. “In an economic and market environment now controlled by the Democrats with Biden and Bernie Sanders already saying trillions in spending programs are coming. The Fed has claimed to project spending six plus trillion dollars over the next few years on stocks and bonds. How is this an environment that a short strategy can succeed? The only viable short I see is shorting the dollar.”
Doug Noland: Yeah. Fair enough. Good question. Well, the Fed is currently targeting 120 billion monthly purchases. It’s enormous, but that’s treasuries and agency MBS. They’ve actually purchased few corporate bonds, and have yet to take the plunge into equities. This year they will likely finance, call it a third of the federal deficit. Let’s remember that the Fed restarted QE back in September 2019, not only did this not preclude the March financial crisis, arguably it made it worse. As I highlighted earlier, the mania has gone to dangerous extremes, and manias typically are not long lived. Could stocks go higher? Of course, but everything points to this being an accident waiting to happen. I remember 1999 and how everyone was so bullish to begin year 2000, and then the bubble burst and NASDAQ lost 78% of its value in 20 months. There was a brutal 2002 corporate debt crisis. Most don’t recall, but back then there were worries that Ford wasn’t going to make it.
Back in early 2000, underlying fundamentals, actually, at least on the surface, appeared pretty good. But there was a huge issue that was perceived by few back then, and that was the underlying finance fueling the boom was unsound. As an analyst of money credit and finance more generally, finance in 1999 – it was pristine compared to what we have today. I understand that it might appear today hopeless on the short side, but I persevered through a few of these cycles. Excess has always come home to roost. Manias sow the seeds of their own destruction, and printing money and issuing more debt will not resolve deep structural maladjustment. Time is always the great challenge, but I’m confident that the backdrop is in the process of creating the best short opportunities of my career.
David McAlvany: Thank you, Charles. Next one is from James. “Now that the Democrats have total control over national government and they have great influence over media, big tech, and many large businesses. How do you perceive they’ll manage the national and global financial markets?”
Frankly, I think this is the scenario of more of the same, where you have monetary accommodation, you have fiscal accommodation, and there has in the last three or four years been a lot of that, but the narrative has been somewhat critical of the White House. The media has set a negative tone in some sense. Now you’re likely to have glowing commentary on anything that’s done, fiscal measures, even monetary measures with what Doug pointed out is sort of the one sticking spot. You might find the GOP finds some fiscal religion and fiscal conservatism. To me, that’s a long, sad story of political convenience and hypocrisy on the part of the GOP.
They didn’t care about it. They haven’t cared about it. Given the opportunity to spend $2 when they only have one, they’re first in line to do it as well. Now they have a story and it’s a story of differentiation. Cast that into the equation as sort of obstruction. Other than that, you’ve got green lights for fiscal craziness. MMT also, as Doug mentioned earlier, MMT is coming online. The fear of deficits is receding.
Again, management in this sense is about continuing a narrative of growth and progress. How that will sit with the financial markets, assuming changes to the tax code or with pressures raised on segments within the financial community. This is where it gets a little trickier because the private equity who’s going to come under pressure. You get carried interest that comes to mind as an area that will be under pressure. Gensler at the SEC has something to prove, mismanaging the credit default swaps of the last financial crisis and having some egg on face from that. I think he’s going to want to manage hard, and really get into Wall Street and quote unquote, make a difference.
We referenced the Treasury departments going big. Yeah, that’s what’s echoing through the halls of the Treasury as of this week. That really is a focus on the economy. The question dealt with the financial markets. I think this is a fair place to maybe make a distinction that actions taken may have short-term positive impacts on the economy. That doesn’t necessarily guarantee follow-through into the financial markets. I mean, in summary, management of the national and global economies, yes, it’s reliant on huge deficits, massive debt monetization. That’s why I would say it’s more of the same at the macro level. The financial markets may continue to benefit from that, but there’s this issue of politics and political agenda, redistribution, and taxes. All of these are uncertainties. We don’t know what those particulars will be, but it means there could be a distinction between an economy which makes some progress and the financial markets already very overextended, which began to experience some pressure.
Next question is from Jonathan. “Would like to hear ideas about how to structure your 401(k) due to limited options available in most 401(k) plans as a part of someone’s complete portfolio. I recently was given an option to open a personal choice retirement account at a brokerage, which allows for a much wider range of investment options, but not physical metals. I also have precious metals, metals IRAs, and physical holdings.
Doug I’ll take this one and then toss the next one back to you. I like the personal choice retirement account. It does give you a broader set of options, and looking at all of your accounts, not just that one, but all of your accounts. You need a balanced approach between equities. We favor hard assets in that category. Our MAPS strategies are focused on those, but balanced between equities and cash and gold.
It sounds to me from the question, Jonathan, that you are already balancing those positions. If you did not have the personal choice option, I would use the 401(k) as a part of my cash allocation. Again, stepping back and looking at all of your resources and how they work in tandem, if you’re not given very many good options, then, in that category, just reduce your risk as much as possible. Keep the total portfolio in mind. Think big picture. Since your options are limited, reduce risk. Focus on putting your other accounts to work to gain diversification that you want, whether that’s across metals or equities, as you’ve done. But that’s how I would use the 401(k). Again, I like the fact that you may be able to customize it more with individual equity positions. That’s to your advantage.
This is from Pranad. “Please outline your strategy for capturing some of the expected downsides in the S&P 500 in the next three to five years. We understand your risk management stance and also that the U.S. Fed may pull a leaf out of the Bank of Japan’s playbook for buying equity ETFs, such as the S&P 500. My two cents is that the Fed will simply set up a special-purpose vehicle, like they did last March, to do that.”
Doug Noland: Thank you for your question. As you know, we’ve been positioned in our default short in the S&P 500 Index, but we have the flexibility. We can short stocks. We can short sectors. We can buy liquid listed put options. Actually, I don’t find it that fruitful to try to guess how this is going to play out at this point. As I like to say, my job is not to predict, but to react, to have a sound analytical framework, to follow developments intensively, and to work really hard to have an edge in reacting to developments. We have yet to buy a put option. When David and I developed this strategy, we anticipated put options being a meaningful facet of this strategy. We’ve been disciplined and patient to this point. We may miss opportunities, but I’m hoping we’ll have some well-timed and well-placed put option exposure when the bear market begins to materialize.
The puts, they may be on the general market, but they could also at some point be sectors, and even individual company stocks. We expect to short company stocks at some point, but I will likely short sectors first. We have a range of tools to use. The key will be to have the short exposure in the right places, and, hopefully, demonstrating a little market savvy. I’ll add that throughout my career, I’ve shorted and purchased put options on financial stocks. I expect this to be a fruitful area of focus at some point. I look forward to developing strategies to profit from faltering bubbles in China, in the emerging markets. The mania in tech stocks is creating opportunities. But as always, timing will be the challenge. But there is no shortage of candidates out there. That’s for sure. And as for the Fed purchasing equity ETFs, I expect the Fed to really want to avoid such a course. The deeper they fall under political pressure, the more unlikely they will be to further branch into unconventional measures. They’re already viewed as beholden to Wall Street and the wealthy.
Besides, when the next crisis strikes, they’re going to have their hands full, more than full, for sure, buying treasuries, agency securities, corporate debt, and, likely, state and local debt. Could they come in and provide temporary liquidity for equity ETFs, for example? Sure, sure. But I doubt they desire to follow the Bank of Japan on this. I could be proven wrong, but that’s how I see it today.
David McAlvany: The next question, “Are we in the late stage of a U.S. business cycle? Or, did we start a new business cycle from April 2020 and have a ways to go before the cycle ends?” There’s a sub question here. “Are any subcategory of REITs likely to narrow their discounts to the broader market performance, so categories in the REIT space where the baby was thrown out with the bath water?”
I would say that what began in April 2020 was a liquidity-induced market rally in the context of a deteriorating or topping out trend. In that sense, the deteriorating and topping out trend would reference both the financial markets and the economy. As and when that topping process is finished, I think we’re talking about multi-year declines within the financial system. It’s difficult to see how the economy wouldn’t come under pressure at some point in that scenario. If you go back to April, we were already in the late stages of a larger, longer-term business cycle. If you want to take it back to 2009, that’d be fine as a starting point.
I think we will see a recovery in business activity coming out of the COVID and policy-induced economic slowdown. But I would not equate that recovery activity with a new business cycle. Particularly, I think this is helpful if you hold the view of cycles which includes secular or long-term trends and cyclical or shorter term trends within them. I guess you could argue if economic numbers return to pre-COVID levels, you might think of that as a cyclical short-term recovery. But we’re stretching the capacities of our economy to maintain and extend that trend without even more added leverage in the system. I say that because creditism is the system that we have today, not purely capitalism. Creditism is the operative system. Growth, economic growth, is predicated off of credit expansion, which has its whole host of issues, but that’s what we’re addicted to.
The limits in this case, I think, are balance sheet limits. You might argue that debt can increase and that assets can increase right alongside them. So it’s not really a big deal if we see debt increase and assets as a balance sheet issue, marching up, being inflated right alongside them. This is where, again, I think Doug addresses this Credit Bubble Bulletin routinely, any tightening of financial conditions and you end up with the consequence of that being a shrinkage in asset values. The debt, which has been pushed to higher and higher levels, that remains. Asset values fluctuate. The burden of debt remains. So the unhealthy ingredient in this, and core to our thesis, is credit, cycles beyond stretched.
Now, what are they doing creatively to keep the game going and the trends in place? They’re playing with the lower bound of interest rates in order to keep those trends in place. So zero rates. In a lot of instances, negative rates, $17 trillion in negative rates globally. Now we’re beginning to see, again, the popularization of long-term debt, 50- and hundred-year paper. Disney, Coca-Cola, Mexico, and Indonesia have put out 50-year paper. We’ve suggested even this week, Yellen has said the 50-year paper might come to a market near you. All this to say, this is not a new business cycle. We’re at the end of a fairly stretched and exhausted one. I’d say we’re late in the ninth inning. So unless there is a surprise demographic boom or a radical economic recalibration from some sort of a shift in technology, which we have yet to see, again, late in the ninth inning.
On the REITs, real estate discounts, we’ve seen them mostly in the commercial areas, whether you’re talking about retail or office space, and those discounts are deserved. You’d have to look very carefully for the baby thrown out with the bath water. I think that most of those discounts are reasonable. Certainly, there are people who want to go back to the office. The work at home is a new thing, and it’s generally accepted, but there are a lot of people that want to get back to the office. So even some of the discounts that apply in those commercial areas are likely to narrow. I think it’s too early to look there, because you’re still dealing with significant migrations in play. Corporations moving from one state to another. Individuals who are getting out of New York City and Chicago and Los Angeles and San Francisco. So in that sense, I don’t think we fully know where the discounts remain versus closed.
Our REIT focus in the hard asset strategy has a specialty aspect to it. It was not badly influenced by the events of 2020. But again, we’re talking about select exposures, storage data, areas that have not been discounted. If you’re looking for the value play or buying on the cheap, my guess is that you’re either going to pay for the places that didn’t suffer, and reasonably should not have. Or, in the case of trying to close the discount gap, you might end up, as they say, catching the proverbial falling knife.
The next question, “In your view, what asset classes are likely to produce 5 to 7% nominal U.S. dollar denominated returns each year for the next five years? Are there any asset classes that could produce 5% real U.S. dollar returns? Please don’t call Bitcoin an asset class.” That was in the question. It’s not my sub commentary. I’m glad we got Bitcoin out of the way on that one. People in that space are migrating their expectations to 5 to 7% daily or weekly returns. I’m glad we’re talking about normal return expectations over the course of the year.
In answer to the question, if I can get there, 5 to 7% nominal, on a total return basis, combined dividend and a small boost from capital gains, the answer is yes. Although commodities have had a healthy 2020, I think a number of large cap commodity producers who are in the game with 2 to 5% dividends already, it just means that filling the gap to get to that 5 to 7% nominal, it’s achievable with modest growth.
I mean, we, on the MAPS side, on the natural resource side, and in our hard asset strategies, we have a natural resource focus. We have a precious metals component. I mentioned the specialty real estate and infrastructure. There’s no doubt if you’re looking at where to pick up a little bit of growth on top of income, infrastructure is another focus for us. We can see that the focus, in terms of fiscal policy, will make that a reasonable place to be for the next few years and meet those kinds of return expectations, I would guess, in real terms or in nominal terms.
Doug mentioned the Russell Index not listing a price/earnings ratio. There are too many companies with no earnings. I think this is where you’re looking at significant downside. Even if we saw a sell off as we witnessed in March, where would you want to be in that kind of a sell off? This is where I think real things that already have generous dividend policies, again, in terms of a total return equation, have gotten you two-thirds, three-quarters to what your return expectations are. That I think is a healthy way to mitigate some market risk, but also get to those return expectations.
Just one more question here on value investing I’ll take, Doug, and then I’ll turn it back over to you. “Is value investing past its sell-by date? Proponents of value investing, Ben Graham and Warren Buffett, did well when the investing world was not as flat as it is today. Today a retail investor can screen for a low price-to-book value, or any other common metric, as quickly as a fund manager. Value investors seem out of date for 12 years now.”
I would say value still has a place. What you’ve seen over the last 10 or 12 years is more of a focus on growth and momentum plays that have captured most of the capital flows. A part of that is a self-reinforcing dynamic as exchange-traded products have tapped into index investing, which is primarily capitalization weighted. So the companies that are winning continue to win as more money comes into the market. It’s already predetermined that it’s going to the largest cap names. And again, there’s momentum, and growth begets more momentum and growth and interest.
So while you can screen for cheapness, it’s not where the money is going, if that makes sense. I don’t think it’s changed the reality that price is what you pay and value is what you get. That momentum trend and prices getting to, we mentioned Tesla earlier, now we’re talking what, 1,500 years worth of earnings? It may be more than that. I haven’t looked at the PE of Tesla in the last several days. You’re overpaying and the overpayment is going to be the post-mortem commentary on a lot of those momentum and growth trades. In the moment, you don’t appear to be overpaying as long as the gains are accruing and you’re happy with the results. So value investing has in recent years looked like the loser. I would suggest that that’s more of a judgment in this particular time slice.
It may be that way for a time, but value investors are used to waiting. They’re used to waiting for positions to be out of favor, not see capital flows, and then return to favor, gain in popularity, and then see capital returning to that space. How long do you have to wait? That’s an unknown factor.
Again, I think the juggernaut has been the cap-weighted index investing, which has overpowered many normal market behaviors and made value-oriented analysis seem less valuable. But I think, just as an example for 2020, energy was a 2020 value play. You might say, “Well, gosh, they closed any value gap pretty hard and fast.” Keep in mind the history of how energy has played into an index like the S&P 500. The energy complex is less than 3% of total market capitalization.
At the other extreme, when I think it got down to as low as maybe 2.3 or 2.4% as a percentage of the S&P 500, it’s been as high as 25% of that index. So value is there. I think it does make sense. It does require patience. It’s not necessarily as rewarding as playing the games that have worked very well but also are very speculative.
I think one last thing on value is that value can emerge pretty quickly. Doug, you mentioned the violent rotations in the fourth quarter, third and fourth quarter of this year from one sector to another. I think that’s a reminder that value can emerge pretty quickly as one sector is left for dead or investors move on to the next pretty little shiny thing. Any other comments, Doug, on value or the death of value?
Doug Noland: No, David, I thought you answered it very well.
David McAlvany: The next one for you, “if you were running both…” Well, these are big shoes to fill. “Doug, if you were running both the U.S. Treasury and the Fed, how would you kick the cans of sovereign debt and other contractual pension payments, sub-sovereign debt, down the pike so they don’t explode in your face while you’re in charge? Your successor will grapple with the consequences.”
Doug Noland: Yeah, my personality, I would not be a good can kicker. But the history of monetary inflation, the history informs us that once commenced, they become very difficult to stop. Today is unprecedented monetary inflation, and that’s the Federal Reserve money growth and Federal debt, in particular. It’s not going to be reined in without major dislocations. You could see the strategy. The Fed is hoping zero rates and massive balance sheet growth will help the system inflate out of these debt and pension liability issues. Just increase the price level and everything will be okay. The problem is, their inflationary measures have a profound impact on further inflating asset bubbles while only a minor effect on raising the general price level.
So it’s this dynamic, we’ve been watching it for a while. The more they inflate, the greater the problem. They moved to kick the can down the road, and asset bubbles and structural maladjustment, they only worsened. So they’re trapped. It’s rather obvious they’re trapped. I guess, it appears they’ll just keep buying treasuries and monetizing debt until the market [inaudible]. As I mentioned earlier, we expect the Treasury and currency markets to, at some point, impose some discipline. I sympathize with Powell. Greenspan, Bernanke and Yellen, they were all too successful at kicking the can. Now, this proverbial can has become a very big and heavy load. I’ll just end it at that.
David McAlvany: So, Doug, what’s your best guess for U.S. sovereign indebtedness by January 2022 or January 2023? Under what circumstances could U.S. sovereign indebtedness become a key election metric or is it too much to expect in the U.S.?
Doug Noland: Sure. Yeah, I’d rather try to predict debt levels than the markets, I guess. I expect this year’s fiscal deficit to approach 3 trillion. Wouldn’t surprise me if it goes above 3 trillion, which would put outstanding treasuries near 26 trillion. If I’m forced to make a guess for the next year, I’ll throw out two to two and a half trillion. Still going to be enormous. I’m assuming the stimulus packages won’t be as big. But all bets are off when this financial bubble bursts. That’s something that no one factors into today’s discussion. We can borrow as much as we want. Well, what happens when the financial bubble bursts? At that point, I wouldn’t be surprised to see $5 trillion deficits. It sounds like a crazy number, but we could see enormous bank and financial sector bailouts, recapitalizations and the like, kind of the post 2008 scenario, plus massive spending to keep the economy going. A rise in market yield would only add to debt service costs. That’s part of the nightmare scenario.
So I believe the debt level becomes a key issue as soon as markets falter, as soon as de-leveraging incites a tightening of financial conditions. Right now, we remain in this dream world period, where everyone believes we can just have massive stimulus and deficits without negative consequences. Well, when market discipline commences, Washington will be forced to rein in spending and then the allocation of Federal expenditures immediately becomes a heated political issue. The whole game changes. I think that’s only a matter of time.
David McAlvany: Next question is by Robert. “How would digital currency affect the metals markets?”
I’m going to look at that from two different vantage points, Robert. Number one, we’ve got the central banks of the world who are discussing more and more of the launch of their own digital currencies, which brings us back to Ken Rogoff’s comment that what the private sector innovates, governments ultimately take over. I’m paraphrasing, but there’s a move by central banks to say, “Hey, maybe this is not such a bad idea.” In fact, with an all-digital currency, financial repression becomes a lot easier. Financial repression is that academic description for keeping rates low or negative and being able to pick your pocket in that creative and somewhat obscure way. So that may be a different direction than you were thinking.
If you’re thinking Bitcoin or Ethereum, or what have you. To me, if it’s the central bank version, which is, I think, the version that ultimately wins out, because no monetary authority wants to give up monopoly. That I think is a reality that has yet to sink into the minds of the digital security currency champions. Again, more of the private market digital currency champions. When the digital currency is run by a central bank and if it is ever to replace paper currency, and really you’re talking about the digital currency, it allows the money machine to run quieter. If you think about the history of money and printing and inflation, digital ones and zeros, very easy to create on an instantaneous basis. I do think, in reference to the metals market, if you have broad adoption of digital by a central bank, again, particularly by central banks, you still need a reference point for stability. You still need a reference point for reliability.
So while you have the functionality of 21st century technologies, gold as a reserve asset in the backdrop, I think it’s still critical. The taxing authority and the threat of coercion, I mean, again, you still have to have things that serve as the reason for legitimacy and trust. Digital still needs a basis for belief, like all currencies have through time. Might that affect, if you went to an all digital currency, the stipulation on who can own the metals? That’s a possibility. When we changed the monetary system in 1933, that was an issue. We ended up with a two-tier monetary system, where we settled our debts internationally in gold and the domestic currency system was inflated, and U.S. persons following 1933 and the Trading With The Enemy Act were not allowed to own gold. That’s an outside possibility. I don’t see that at this point.
But the negative effect on metals, I don’t see it as a negative effect. I still think central bank demand for gold and the legitimacy of gold, it’s a part of the story. It’s a part of the narrative. Why would they be changing from one currency to the next? If you are, there has to be some bona fides, things that you look at and say, “Wow, it’s easier to use. It seems pretty stable.” That’s where I think, yeah, that’s how I would respond.
So from the same gentlemen, “Would we still be able to cash in our physical gold and silver if it was a hundred percent digital currency?” Again, we’re dealing with an unknown future and variables that are difficult to… I mean, this is all hypothetical. But if by cash in, quote unquote, you mean liquidate, then yes, I think you can cash in your gold and silver. If by cash in you mean turn in for physical cash, no, not in a digital currency environment, not in a purely cashless society, if you’re talking about a hundred percent digital.
I’m not concerned about a lack of liquidity, if that’s what you have in mind. Maybe it’s liquidity in another form, liquidity in the form of a bank deposit, liquidity in the form of another asset that has value. Bear in mind, value exchanges occur regularly without physical currency changing hands. So having gold and silver, I think the last thing I’d say is this. In a world where you’re going to a hundred percent digital currency, if we were to go there, I would want to own gold and silver more than ever. That may, in fact, provide for an exchange of value outside of a digital system that is otherwise closed.
So a financial system that sets values… I mean, think of Argentina and official exchange rates and official inflation rates. You have an operative black market where currency changes hands at a more realistic rate. And it is outside of the official banking system. All I’m saying is that if we move to a one hundred percent digital currency, I’d be really glad to own gold and silver, even if they didn’t give me cash in exchange for it.
The next question is an asset allocation question. Doug, I love how I get to take the easy ones and pass the hard ones to you. The question by Thomas is your opinion for an all around encompassing portfolio to fit these surreal times.
Well, what comes to mind is an all-weather approach. I’m thinking not just about financial assets here, but about total net worth. If you looked at total net worth and said, this is all back of the napkin, of course, but 25% real estate, 25% cash, 25% equities, 25% precious metals. Let’s assume that you owned a business and the mix would reduce each of those categories by five. Again, if you own your own business, in which case you spread it across the equivalent equally of those five categories. That makes sense to me. In terms of allocating a total net worth in really weird times, to the degree that you’ve got much more than that in equities, this is one of the reasons why tactical short exists, to operate as a hedge for market exposure.
Another question, I’m going to send this one to… I’m going to give you one and then I’ll take one again, Doug. “I’m an investor in the product. The performance of the product has not been exactly stellar since it started. What can be done to turn that around short of waiting for the market to crash, if anything?”
Doug Noland: Thank you for your question. I wish performance would have been better. I’m thankful it was not much worse. As we’ve discussed, tactical short has significantly outperformed all the other short products we compare ourselves against. And that’s both actively managed and passive. We’ve outperformed the short-only hedge fund universe. I’m a big believer in the strategy. I’m certainly not waiting for the market to crash. The current crash scenario would not be optimal for us. I’m waiting patiently for financial conditions in the market environment to change. We’re being disciplined as we wait for the risk versus reward for shorting to improve. We’ve got to see that. We’ve been in our default short exposure position for the reasons I explained earlier, and it’s been the right call. So no regrets there at all.
Do I wish I would have cut back exposure during the rally? Yes. Am I happy we didn’t increase exposure, especially individual company stocks, during the crisis period? Absolutely. So the bottom line is, this has been an absolute nightmare on the short side, and we’re going to get through this in much better shape than others. Tactical short outperformed its closest competitors last year by over 20 percentage points.
Doug Noland: This degree of relative out performance would be showered with praise in the fund management industry. I’m certainly not looking for any praise that’s for sure, but I just concentrate on staying focused, working hard and doing my best every day. And I’m sorry if I have not lived up to your expectations, but thank you for the question.
David McAlvany: The next question, “How long can this irrational exuberance last since the economy, Wall Street, and the Fed are in uncharted territory? What destinations do you see the US moving towards? Could a change to a digital dollar create a devaluation of the dollar that might be needed?”
And let me just jump in, I, it’s more… When I think of irrational exuberance, I think more of it’s a celebration and elevation of insanity rather than just irrational exuberance. And with that in mind, you’ve got Keynes, who was right. The markets can remain irrational longer than you can remain solvent. Probably a sentiment expressed in one of his short-term trades. He did make a little bit of money in commodities here and there. I think at this point anything is possible, thinking of devaluation. In the past, desperate governments have either defaulted, inflated, or nationalized.
Those are the three main routes that they’ve gone. In this case, they’ve already introduced repression, which I mentioned earlier, the 10-cent word for low to negative rates. That’s one form of pocket picking. Inflation is already on its way. So we’ve got two out of, if you want to think of them as three or four strategies, two of them are already in motion. A new currency, digital, or otherwise, still seems ways off, but would not come as a surprise. There’s little bit more to the question. Let me see if I can summarize it for you.
It revolves around the idea of a new great depression and the bursting of a stock bubble. And again, I think anything is possible. You’ve got desperate times, and desperate measures can certainly be taken. We’ve seen a ratchet with each of the last financial crises. If you go back to ’99 and 2000, if you go back to the global financial crisis, if you go back to March of last year, and all the little indications or instances of pressure in the markets between, each time the Fed has had to get involved, and the Treasury has had to get involved, whether it’s direct liquidity into the markets or swap lines just to foreign central banks, it’s on a larger and larger scale.
I think that’s one of the reasons why gold as an asset makes a ton of sense to me. It’s a global asset. It is a money good asset acceptable in any geographic context. And yeah, it’s the irrational exuberance piece being an uncharted territory. It speaks for itself. But I think so too, due to the insurance measures which are necessary, tactical short, precious metals, cash, these are all ways that you can reduce downside exposure on the other side of irrational exuberance, or as I like to say, the elevation of insanity.
Doug, “What effects will a slower rollout of COVID-19 vaccines and subsequent vaccinations of the American people have on the bond and stock markets, as well as precious metals, as it appears the new administration wants to continue stimulus to the tune of 1.9 trillion. This would seem to be a further catalyst for Fed money printing, rising interest rates, consumer inflation, and commodities price increase. Oil, copper, gasoline, food, as well as rising physical gold and silver prices. What portfolio percentage allocation to different sectors and precious metals would you recommend for the average investor? In which sectors would you focus on using a tactical short strategy?” That’s about 10 questions for you.
Doug Noland: Sure. Let me start David, and maybe I’ll push it back to you for… You’re always so good with the allocation type discussions. As far as the slower rollout of COVID-19 vaccines and things. Well, I think the new administration was planning on a massive stimulus plan whether the rollout was going smoothly or not. And I don’t think the Fed had been contemplating beginning a taper anytime soon. So I don’t see their plans as having been changed, either. But there’s little doubt that the market saw the surge in new cases along with the slow rollout as ensuring more stimulus. And that’s what we’ve seen since March. Any bad news is good news. It just means more stimulus. It’s consistent with this bullish narrative of fiscal monetary stimulus forever.
So I’m surprised the bond market to this point has not been more rattled. But then again, they’re prolonging the pandemic in the US and globally, it comes with major negative consequences. The bond market… I think the bond market looks at the crazy stock market mania and sees nothing but trouble ahead, so that underpins the bond market, that keeps yields low for now in the face of supply coming. But we definitely see the backdrop as supporting hard assets. I’ll let you David chime in on that some more. Thank you.
David McAlvany: Yeah. I mean, I think a part of our thesis on our long strategies instead of our short strategies, that is the hard asset strategies, assume that we are going to continue to see the Fed accommodate and the Treasury accommodate, and the consumer inflation and commodity prices, we’ll see a boost. And we’ve begun to see that.
Three years ago it was less clear. Now it is becoming even more clear. Oil, copper, gasoline, food ag, your commodities for 2020, your top-performing asset class if you’re not including cryptocurrencies. Silver about 45% for the year. These are all very, not only healthy moves, but I think strong signals and those signals I think would be worth noting. What we’ve tried to do is divide up our exposures between four different areas. And two of them are highly cyclical, and we don’t have as much of a marriage, if you will, to those two. That’s global natural resources and precious metals mining stocks, because they’re so cyclical.
So we like them, but we do not, never will, love them. The other two, specialty real estate and infrastructure, we both like and love. Not love blindly, but we do like them as longer-term plays and more balanced assets in a portfolio. They are all in the category of real assets and those real assets, I think play well.
For us, that’s divided up roughly equivalent or equal between those four areas. We have certain styles that favor the cyclical, and certain styles that favor more of the stable income. And that’s really a question of the investor that we’re talking with and their particular needs. Portfolio percentage allocations, my caution is that with precious metals in particular, and I’m thinking of the miners, these are things that have radical swings because the price of commodities ebbs and flows so dramatically. And so does company performance. So what we do is in an effort to manage that risk. And if you’re an individual investor doing that yourself, I think you have to be even more diligent with the cyclical elements within your portfolio.
Next question is, coming deflation and asset prices, how can we protect our wealth from deflation if we already have a significant position in physical gold? So I’ll comment on this. There are growing signs of inflation. If we said that debt deflation was going to be the predominant theme, I still think you would want something of a barbell approach between cash and gold balancing out. With that, I think you have a huge priority on liquidity. So if you wanted to say, “What’s the overall theme, if you’re concerned about debt deflation?” Maintain liquidity. So minimize debt. That increases your staying power. Tactical short, of course, is a healthy hedge on market volatility.
If you’re sitting on a large resource and are expecting significant debt deflation, then that balance between cash liquidity and gold liquidity is pretty key. It balances out some of your risks. And I think it leaves you with the key priority, which is liquidity.
So let’s look at the other side of that. I’m going to ask a question for you, Doug. Let’s take the other side of the coin instead of debt deflation. What are your thoughts on the recent 10-year yield spike? It’s not exactly a question about inflation, but maybe you can expand on your thoughts on the recent 10-year yield spike.
Doug Noland: Sure. It’s not surprising, although I would have expected more of a jump after Georgia’s Senate races went to the Democrats. And then we have the Biden administration proposing $1.9 trillion package and Yellen explaining how going big is smart. And as you just said, David, we’re seeing myriad indicators pointed to strengthening inflationary pressures. So the fundamentals have aligned for a surprising surge in market yields. They’ve aligned. But as I mentioned earlier, the market is basically betting the Fed has adopted yield control. If they’ll just step up purchases, if yields rise, if the rising yields, if it begins to be a problem. There’s also this dynamic, and we’ve witnessed this going back to the mortgage finance bubble period, 2007 in particular, where the bond market, it’s really good at sniffing out trouble that the stock market is happy to ignore.
The bond market can look at today’s stock mania and feel pretty confident that this is going to end badly. And for the bond market, badly means the Fed will be at zero rates for longer and more QE bond purchases. So I understand why bond yields haven’t risen more, but it would appear the backdrop is ripe for a surprise in yield spike. And I wouldn’t be surprised if it turns out to be a really painful bond bear market.
David McAlvany: The next question is thoughts on passive flows.
Doug Noland: Okay. Yeah. I appreciate that question. I like these questions here. These massive passive flows don’t get the attention they deserve. And they’re a key facet of the bubble. To begin with, this is not investing. You can’t just send money into an index and try to convince yourself that you’re making a reasoned investment decision. There’s no analysis of value, no contemplation of risk. So it’s just speculation. And these speculative flows have become massive and they have fundamentally changed market structure. It’s forced so-called active managers to become closet indexers. If you fall too far behind the index, you’ll lose your assets to passive index products.
And this is not just an equities phenomenon. There has been massive growth of passive fixed-income products. And over this bubble cycle, I’ve referred to this concept, the moneyness of risk assets. This evolution from the moneyness of credit during the mortgage finance bubble period, and with the Fed’s blessing and these liquidity backstops, ETF shares have enjoyed the attribute of moneyness. This perception of a safe and liquid store value. And this dynamic has attracted literally trillions of flows. In some cases transforming risky illiquid securities into perceived safe and liquid ETF shares.
And we saw in March what happens when holders suddenly panic and their ETF shares are not viewed as safe and liquid. Huge declines were suffered across the ETF universe, notably in high yield corporate debt, small cap equities, and various products that hold less than liquid security. So I look at these types of passive flow phenomena, and they’ve changed market structure and they’ve significantly increased systemic risk. And I would argue also it’s an important factor behind the Fed’s massive March crisis response. And from that, the resulting worsening of bubble excess. So these passive flows, hugely important.
David McAlvany: And so what about options? You’re talking about change in market structure. What are your thoughts on the options market now, or at times being larger than the stock market?
Yeah. And it’s a great question to follow up after the passive question because the options market is another major, major influence on this period. I’ve traded options over my career, and I have the gray hair to prove it. These are challenging instruments that work candidly much better in theory than in reality. They’re tough. You got to know what you’re doing. You got to be on top of them. To see the public embrace options trading is alarming, but consistent with late cycle manic, speculative excess, and I can say confidently, it’s going to end badly. But in the meantime, I believe it has created major additional unappreciated leverage throughout the markets. You know, the crowd rushes to purchase call options. You know, let’s just say Tesla, for example, it’s a darling option play, and all the call buying fuels and rising stock price which attracts only greater speculation.
And when the stock rises further, the sellers, the writers of these call options, they’ve got to go into the marketplace and buy the underlying shares of Tesla to hedge their rapidly increase in exposure to option losses, but they buy stock on margin, creating new liquidity for the marketplace. And I believe, the massive option marketplace, I threw out some numbers on trading volume earlier, and derivatives more generally. They’ve contributed significantly to marketplace liquidity and likely system money and credit growth more generally. And like passive flows, the proliferation of options trading has become a major facet of the mania, and key to speculative blow off dynamics, unfortunately.
David McAlvany: So you described the writer of the option having to step out and buy the underlying stock to hedge their exposure to the person who bought the call option. And they purchase that stock on margin. I guess it’s no surprise then that margin levels have reached all time highs. Over $720 billion, never seen it before as a percentage of stock market capitalization, I think it’s the highest perhaps of all time. And certainly in nominal terms by a wide “margin” gets to pass them up.
Okay. Next question is, “Gold still anticipated to go much higher in spite of the current surges and pullbacks we’re experiencing?”
I’ll just keep this very straightforward. Yes. I think it is anticipated to go much higher. I would think that outside of super hyperinflationary speculation, you are talking about a maximum of about two times its inflation adjusted price.
So take your 26 to $2,800, the inflation adjusted price for gold times two, and that’s about your max. I would say 5,400. The next question is the inflation outlook. And I would say that, real world versus official stats are the key contrast. Real world, we’ll get used to double digit annual. I don’t think we’ll see super or hyper. At least that’s not baked into the cake at this point, perhaps that changes, but it’s not baked into the cake.
And official stats move above 5%. We’ve seen the change in inflation outlook at the Fed this year from 2% to taking an average. That was a significant policy change by the Fed in 2020. They’ll now accept an average of 2%, which means that they’ll take far higher numbers as long as they can average it out at two. And then, of course, we’ve seen Fed president Evans and others say, yeah, we’re pretty comfortable targeting, yeah.
Something closer to three or more. So they’ve basically moved the goalposts and I think bought themselves some credibility in doing so. When we get to higher inflation numbers, it’s not going to look like they’re out of control because they told you we wanted to get there anyways. But your official stats move about 5%, you real world double-digit annual that that I think is reasonable.
And in that context, I go back to the previous question. Your gold figure hangs out at about two times the inflation-adjusted price. That’s where it maxed at $875 back in the early ’80s. Inflation adjusted price was 400. It got there – doubled in a six-week period. And when it corrected back, ended up hanging out at it’s inflation-adjusted price, something far more sustainable for the next 20 years.
I could see that kind of a trading dynamic where you get concerns, the price shoots the moon, and then it ultimately falls back into a trading range between 2500 and 3,000 for a very boring 20-year period. Obviously it’s about the future and we don’t have a crystal ball, but Doug, for you: “I followed Doug Noland’s credit bubble bulletin for 16 years. I consider it a brilliant long-term insight here at the peak of all things financial, I’m wondering about some themes he wrote about in the past. Where are the pressure points to watch? At what point does credit rating for the US become a factor?”
Doug Noland: Thank you for reading and the kind words. We’re in the phase of the cycle where the dunce cap has been on long enough for it to cause a bit of a headache here. So I appreciate your comments, your positive comment.
I mentioned the moneyness of credit, the moneyness of risk assets. There’s also the old financial sphere and economics sphere framework that I need to come back to because, boosted by decades of central bank support, the financial sphere has inflated to completely dominate. And this has, it’s part of this historic divergence between inflating asset prices and deflating economic prospects.
Basically, from my analytical perspective, things have followed, unfortunately, the absolute worst-case scenario. And that’s especially over the past nine months. It’s inflationism run completely amok, with policymakers risking a crisis of confidence in money, in credit, central banking and finance, and our institutions more generally.
And over the years – this goes way back. A bubble financed by junk bonds, while conspicuously unsound, that would not pose a major systemic risk to stability. After a while, the buyers and holders of this debt would say, “Hey, enough, no more of the junk.” And the boom would come to an end before it came to a deep structural maladjustment. I’ve argued over the years that a bubble fueled by money, it’s very different and much more dangerous. The previous bubble period was financed largely by perceived safe and liquid AAA-rated mortgage bonds and debt instruments, and money essentially enjoys insatiable demand. So the mortgage finance bubble inflated for years, and that ensured excess and maladjustment that would come back to haunt the entire financial system and economy when confidence inevitably faltered.
I began warning of the unfolding government finance bubble, and that’s a global government finance bubble, back in 2009. I was worried at the time that this massive expansion of central bank money and perceived safe sovereign debt had the potential to go to even greater excess. I warned early on that Bernanke’s use of risk assets as the key for system inflation unleashed a nefarious moneyness-of-risk-asset dynamic. And today, the greatest bubble in history inflates on this fuel of money and perceived money-like instruments. Tens upon tens of trillions.
The insatiable demand of all these financial assets sows the seeds for a systemic crisis of confidence. The problem with the perception of moneyness is that resulting over-issuance insures monetary disorder. And in an eventual crisis of confidence and market revulsion to these instruments. And as for the US AAA rating, I’ll assume this will be similar to when the mortgage finance bubble collapsed and everyone blamed the credit agencies for their top ratings of all the mortgage paper. Well, no one of sound mind can actually believe the US is today a AAA credit. And, thank you very much for the question.
David McAlvany: Last question. “Do you believe in the virtual assurance that the US Treasury and central banks worldwide will continue to engage in the various policies, modern monetary theory, universal basic income, et cetera? If so, how has that not deflationary?” And the second part of the question is, “If so, how does that not lead to continued asset inflation for the seeable future, thus further continuing the beating taking by short positions?”
Doug Noland: Sure. As I discussed earlier, I think the Fed in Washington, they’ve gone too far this time. They’ve just gone too far, way too far. And they’ve pushed an already out-of-control bubble to precarious extremes. And this has exacerbated the… There’s gaping hole between the inflating securities markets and prices and deflating economic prospects and this late cycle terminal phase. That’s the term I use. Terminal phase excess, it’s the most obvious and precarious manifestation of this. And it’s the nature of bubbles that they do eventually burst. And the longer they inflate, the greater the inevitable hardship, and that’s financial and economic, and we can certainly today throw in social, political, and geopolitical.
Doug Noland: I’m highly confident in the analysis. And unfortunately I do believe this is going to end badly. But as far as profiting from this on the short side, the issue is timing. The opportunities are extraordinary, but I expect this will continue to be challenging, but I love the challenge. I know David loves the challenge. We love the challenge. So we just come in as I said before, focus and work hard every day.
David McAlvany: It takes a unique constitution to love this kind of challenge. And so, yeah, it’s nice working shoulder to shoulder with you, Doug. That question, do you believe in the virtual assurance of the US Treasury and central banks worldwide. I believe that they will deliver all that they have promised and more. And I also believe that there’s a consequence to that, and it shows up in the way treasuries are priced. It shows up in the way the dollar is treated and priced in the foreign currency markets. And so, yes. MMT, UBI, we’ll have a whole other extended list of promises and programs in this new administration, from this new administration. And they’ll do their very best. They will deliver all that they can. Our question is what are the implications?
What are the consequences? In a world of cause and effect, does it matter? And we believe wholeheartedly it does. So thank you for joining us. Thank you for all the questions, more questions I think, than we’ve ever had in any of our calls, but that means that yes, you’re engaged and you’re curious, and there’s a lot at stake here. We recognize that. The global financial markets have put on quite the firework show in 2020. And we look forward to walking a very challenging, but we also believe very rewarding, road in 2021 with Tactical Short and the MAPS programs. And look forward to more questions from you in the next quarterly call. Appreciate your time. Appreciate you joining us in this venture. Any parting words, Doug?
Doug Noland: Yeah. Thanks so much everyone for your interest, and good luck out there.
David McAlvany: That concludes our first quarter call. Thank you. Bye bye.