Tactical Short Strategy Conference Call – January 27, 2022
Disclaimer: Advisory services are offered by McAlvany Wealth Management, an investment adviser registered with the U.S. Securities and Exchange Commission. The comments made in this audio recording discuss economic and market trends and are not intended as advice for any particular investor. A short selling strategy involves a substantial degree of risk. Any decision to engage in a short selling strategy should be reviewed with your financial adviser. Past performance is no guarantee of future results.
Transcript from the call
Things Went Wild: Now What?
MWM Q4 2021 Tactical Short Conference Call
January 27, 2022
David McAlvany: Good afternoon, folks. Thanks for joining us. We appreciate your participation in our fourth quarter 2021 recap conference call.
As always, a special thank you to our valued account holders. We greatly value our client relationships. At the conclusion of our formal remarks, Doug and I will address the questions that have already come into queue. If there’s anything that you would like to add to that queue, we can do so. Go to our website, MWealthM.com, and look for the conversation bubble in the lower right-hand corner of your screen. You can type in a question and we’ll do our best to address it.
So again, we’ll start with formal remarks and then move to the Q&A. We do have a number of first-time listeners on today’s call, so we’ll begin with some general information.
For those of you who are unfamiliar with Tactical Short, more detailed information is available at the website, MWealthM.com/tacticalshort.
The objective of Tactical Short is to provide a professionally managed product that reduces the overall risk in a client’s total investment portfolio while providing downside protection in a global market backdrop with extraordinary uncertainty and extreme risk. The strategy is designed for separately managed accounts. It’s investor-friendly, with no lockups, with full transparency, flexibility, and reasonable fees. We have the flexibility to short stocks and ETFs. We also plan, on occasion, to buy liquid listed put options.
Shorting entails a unique set of risks, risk that has been on full display over recent quarters, and we are set apart both by our analytical framework, as well as by our uncompromising focus on identifying and managing risk.
We began the quarter with short exposure targeted at 70%. The short target was increased somewhat, and ended the quarter at 72%.
For those of you who can hear that “ recording started” over and over again, there is a glitch with our call bridge conference center. And so as new entrants come into the call today, unfortunately, that is happening. So I have a colleague who’s working on getting that resolved so that we’re not indefinitely hearing that. So my apologies for the technical glitch. I think you know by now the recording has started.
So again, I was saying, our Tactical Short strategy began the quarter with short exposure targeted at 70%. The short target was increased somewhat, and ended the quarter at 72%. That’s the highest level in the five-year history of the strategy. So due to the highly elevated risk environment for shorting, the S&P 500 ETF remained the only short position in the strategy. So we never recommend placing aggressive bets against the stock market, especially in today’s extraordinary environment. If you look at the volatility of this week, I think this adequately demonstrates the extreme sorts of volatility: The Dow starting the week down 1,000, finishing flat for the day. The S&P later in the week being up 3% and careening towards zero by the end of trading.
These kinds of moves are extraordinary, and are a strong indication of where we’re at in the market cycle. So we do highlight this particular message during every call, that remaining 100% short within a short offering, remaining 100% short all the time, and that is as most short products are structured, is risk indifference. It’s risk indifference. So the market rally over the past seven quarters has inflicted huge losses on the short side for those indifferent to risk. And we believe disciplined risk management is absolutely essential for long-term success. We structure Tactical Short to ensure the flexibility to navigate through even the most challenging market conditions.
So I’ll give you an update on performance. Tactical Short accounts after fees returned a negative 7.89% during the fourth quarter. The S%P returned a positive 11.02%. As for a longer timeframe, as for one-year performance, Tactical Short after fees returned a negative 17.79% versus the positive 28.68% for the S&P 500.
So over the past year, if you’re looking at our performance versus the performance of the S&P, we were at 62% of the S&P’s returns. We lost 62% of the S&P’s total. So even though we had a higher number than that, 72%, 73% exposure, that, again, just for that period of time, past your Tactical Short accounts [unclear] percent of the S&P’s positive return.
We regularly track Tactical Short performance versus three actively managed short fund competitors. First, the Grizzly Short fund, which returned negative 2.1% during Q4. For the past year, Grizzly returned negative 15.87%. Also, Ranger Equity Bear Fund returned 4.08% for the quarter and a negative 18.61% over the last four quarters. Federated Prudent Bear returned a negative 11.83% during Q4 and a negative 23.78% over the past year. While underperforming two of the three funds during the quarter, Tactical Short on average outperformed the competitors by 163 basis points for the full year.
Tactical Short has also significantly outperformed each of the bear funds since inception. So since April 7th, 2017, our inception, through the end of September, Tactical Short returned negative 42.18% versus the positive 120.3% return of the S&P 500. On average, the outperformance versus our three competitors was 2,543 basis points. Again, an emphasis on risk mitigation is what I think through that time frame has been very significant. The process, the disciplines, and Doug has executed extremely well through that period of time. There are, as well, the popular passive short index products that Tactical Short, again, outperformed. ProShares Short S&P 500 ETF lost 10.58% for the quarter and 24.21% over the past year. And then the Rydex Inverse S&P 500 fund lost 10.59% during the Q4 period and 24.19% for the four quarters.
Then there’s also the PIMCO Stock Fund, which returned a negative 10.88% and a negative 22.28% for the quarter and past year.
Doug, I’ll hand it over to you for comments, and then we’ll come back around to Q and A.
Doug Noland: I would like to begin by stating that David McAlvany is just a wonderful human being and a great professional to work with. So thanks for everything, David.
Good afternoon, everyone, and thank you for being with us today. I know these are trying times with busy schedules, and we appreciate that you would squeeze us in.
The quarterly string of extraordinary market environments continues, and I’m referring to Q4 and the unsettling start to 2022. Before I delve into this fascinating macro backdrop, I’ll begin with some comments on performance.
I’ve been in investment management now for over three decades, managing short exposure going back to 1990. This is the third major, arguably historic, bull market I’ve had to persevere through. I’ve witnessed some pretty extraordinary market environments and financial crises. The ’87 stock market crash. The early ’90s S&L and banking crises. The spectacular 1991 short squeeze. The ’94 bursting bond market bubble. The ’97 Asian tiger bubble collapses. The ’98 Russian LTCM meltdown. The 1999 tech melt-up. Y2K, the 2000 bursting tech bubble. The 2002 corporate debt crisis. The 2007 bursting subprime bubble. The 2008 mortgage finance bubble collapse. The trillion dollar QE1 experiment. The huge 2009 squeeze and market rally. Taper tantrums, the Greek and Italian bond collapses, $2 trillion of QE, and the wildly speculative market [unclear] in 2017.
I thought I’d seen just about everything. And then in September 2019 the Fed restarted QE in a non-crisis environment with the unemployment rate at multi-decade lows. From August 2019 lows to February 2020 highs, the S&P surged another 20%. Speculative excess that set the stage for the March 2020 crisis. It’s still a challenge for me to fully grasp $5 trillion of additional federal liquidity injections into market bubbles over the past couple years. The Fed’s original ’08 QE program was to provide liquidity to accommodate post-bubble speculative de-leveraging. The current QE program has been different in kind, in dimension, and in consequence. We’re over $5 trillion and still counting, and rather than accommodating a bursting bubble and associated de-leveraging, this liquidity onslaught fueled history’s greatest bubbles along with manias for the ages. Things ran absolutely wild.
Over the past seven quarters, the S&P 500 surged an incredible 90%, with the NASDAQ 100 up 112%. I’ve lived through some spectacular squeezes in my career, but nothing compares to the meme stock melt-up and brutal targeting of short positions. It might be too soon to say we’re completely out of the woods, but my confidence is growing that the worst is behind us. This has been really tough. At times, excruciating. We’ve suffered bigger losses than I imagined possible when we launched Tactical Short. But importantly, we’ve survived. During this rally, most investors on the short side threw in the towel. And who could blame them? Two of our competitors suffered single quarter losses of 30%. One of them actually lost 30% in a quarter, and then another 32% two quarters later. On average, our three competitors lost 58.4% over 21 months, with Tactical Short outperforming on average by over 2,000 basis points, or 20 percentage points.
I doubt that many who sold their Bear Fund shares will invest again. As for Tactical Short, you have stuck with the strategy and now we’ll focus on recovering losses—filling in the hole, as they say. It’s a significant hole, but it’s manageable. Having gone through this before, I anticipate pressure to put up some big performance numbers and recover losses as quickly as possible. I understand.
I’m determined to post decent performance, but I’m in no hurry to significantly increase the risk profile of our short exposure. It continues to be a highly volatile, complex, and extraordinarily uncertain market backdrop. It remains a priority to manage Tactical Short as a lower risk short strategy. I will continue to manage the beta, or expected volatility, of our short exposure judiciously. And I so look forward to generating profits that will provide us a cushion for a more opportunistic mindset. For now, I’m determined to make headway and fill in our hole, though my first concern remains limiting the potential for outsized losses.
Let me start by explaining Tactical Short’s Q4 underperformance versus two competitors. First of all, small cap stocks significantly underperform the S&P 500 during the quarter. The small cap Russell 2000 gained 2.1% during Q4, a fraction of the S&P’s return. The Grizzly Short Fund typically shorts smaller companies, and they were able to outperform the other short funds during the quarter. The Goldman Sachs Most Short Index actually posted a significant decline during the quarter, dropping 13.4%. The Ranger Equity Bear Fund regularly shorts popular short targets, and the fund’s performance tends to negatively correlate with the Goldman short index.
For the quarter, the Ranger Equity Bear Fund outperformed the inverse of the S&P 500, capturing a fraction of the short stock underperformance. The broader market during the quarter underperformed the S&P 500. The average stock, the Value Line Arithmetic Index returned 5.63%. That was about half the S&P 500. Yet Tactical Short, again, outperformed the Prudent Bear Fund, this quarter by almost 400 basis points. And Tactical Short also outperformed the popular ProShares Short S&P 500 Fund and the Rydex Inverse S&P 500 fund by about 270 basis points during the quarter, and outperformed the Go Short Fund by almost 300 basis points.
I mentioned in the past couple calls how it is typical for breadth to narrow during topping processes. At the same time, topping notoriously comes with challenging volatility, sector rotations, and feverish speculation, especially with zero rates, ongoing QE, and all the COVID uncertainties. My risk management discipline dictates that we maintain strict risk controls; that we err on the side of caution.
Let’s transition to the most fascinating macro environment imaginable. I can report that key aspects of our macro thesis are materializing. I discussed during the last call how cracks had developed in China’s historic bubble. Over recent months, crisis dynamics have accelerated in China, which I’ll discuss. Meanwhile, inflation has become a pressing issue, and even the Fed now admits it’s a problem they need to address.
The Fed accelerated its taper and is preparing for a tightening cycle. Wall Street went from expecting no rate increases in 2022 to now seeing four—at least four. Moreover, the Fed is publicly contemplating reducing the size of its balance sheet, what’s referred to as quantitative tightening, or QT.
The prospect for persistent inflation, rising short-term rates, and dramatically less Fed liquidity has the bond market on edge. 10-year Treasury yields traded last week up to 1.9%, just slightly below that today—the high since December, 2019. Benchmark MBS yields are up a quick 55 basis points to start the year, indicative of stress within interest rate hedging markets. Prospects for tighter financial conditions have also begun puncturing speculative bubbles for meme and tech stocks to the cryptocurrencies.
The title of today’s call is “Things Went Wild: Now What?” For years, I’ve been a student of the Austrian school of economics. It plays prominently in my analytical framework, especially my focus on money and credit, bubble dynamics, and associated economic maladjustment. I believe in the precept that the pain and dislocation unleashed during the downside of the cycle is proportional to the excesses of the preceding boom.
Granted, this dynamic has been repeatedly subverted by ever-increasing amounts of policy-induced monetary inflation. As such, from my analytical perspective, I think in terms of a sustained multi-decade bubble period, and we’ve had to endure post-bubble hardship. There’s no doubt about that. In each instance, policymakers fail to address and rectify the underlying root cause of monetary disorder and resultant recurring boom and bust instability.
Instead, monetary stimulus has been the handy [unclear], dialed up in increasing doses as bubbles inflated ever larger and more unwieldy. In a monumental blunder, monetary inflation was viewed as the solution rather than the problem. I believe the world is now past a critical inflection point, commencing what will be a quite challenging and likely tumultuous transition to a secular post-bubble down cycle. Major bubbles culminate in wild excess. Think of the crazy subprime lending and derivative excesses in 2006 and ’07. The 1999 tech speculative melt-up. Or looking back further, late ’80s Japan, and the manic market environment leading up to the 1929 crash.
I am not, however, familiar with any bubble blow-off in history comparable to 2021. It’s worthy of a brief overview. Monetary inflation continued to run completely wild. Federal Reserve credit expanded $1.4 trillion over the past year to a record $8.74 trillion. The Fed’s balance sheet inflated an astonishing $5 trillion, or 135%, in the 120 weeks since QE restarted in September, 2019. The Federal Reserve has now inflated tenfold since the mortgage finance bubble collapse. M2 money supply inflated another $2½ trillion to a record $21.4 trillion with reckless two-year growth of $6.2 trillion, or 41% in two years. With these numbers, the myth of QE effects remaining well contained within Treasury and securities markets should finally be debunked.
In the seven pandemic quarters through Q3 2021, non-financial debt surged $9.2 trillion, combining with China’s expansion for history’s greatest credit inflation. The fiscal 2021 Federal Deficit reached $2.77 trillion, with a historic $5.9 trillion two-year shortfall, or 28% of GDP. Outstanding Treasurys into September at $24.3 trillion, up fourfold from year-end 2007. Treasurys surged $5.7 trillion in seven quarters, matching the total amount of accumulated federal debt through the year 2006.
In the stock market, there were new record highs in the S&P 500 70 times. Speculation ran absolutely wild. There was a short squeeze for the history books, meme stock mayhem. There was the SPAC craze, a record IPO boom, unparalleled retail market participation, zeal, and speculative excess. Global exchange traded funds, or ETFs, received a record $1.22 trillion of inflows last year, up 70% from booming 2020 flows. Reaching $10 trillion, and having doubled since 2017, ETFs are today’s poster child of destabilizing trend-following speculative flows.
According to Bloomberg, this Monday saw a record $478 billion worth of ETF trades, almost 20% ahead of the previous high from February 2020. Monday also saw 31.3 million put options traded, just short of Friday’s record, 32.3 million. Indicative of the speculative mania that enveloped the markets, derivative trading volumes continue on their moonshot.
A few data points. Last year saw nine of the 10 most active call option trading days ever. On average, a record of almost 39 million option contracts traded daily, almost a third higher than 2020. The daily average notional value of stock option trading reached $467 billion, exceeding the value of shares traded. Companies globally raised a record $12.1 trillion last year through a combination of bond and stock issuance and new loan borrowings.
Global mergers and acquisitions, M&A, surpassed $5 trillion for the first time, beating manic 2007’s record. US M&A volumes doubled from 2020 to reach $2½ trillion. Unprecedented asset inflation saw household assets reach a record $163 trillion. Household net worth, and that’s assets less liabilities, jumped to $145 trillion, more than double the previous cycle peak in 2007. Net worth at 624% of GDP compares to previous cycle peaks of 488% during ’07 and 445% in year 2000. More specifically, household holdings of financial assets reached a record 500% of GDP, up from the past two cycle peaks, 374% and 354%.
Yet manic excess was in no way limited to the securities markets and Wall Street deal making. The S&P CoreLogic National Home Price Index jumped 19.1% year over year, with the inventory of available homes sinking to record lows. After beginning the year at about 28,000, Bitcoin traded in November to almost 69,000. Scores of new cryptocurrencies joined the fray, while non-fungible tokens mobilized in a flurry of manic activity. And I could go on and on. These are merely some of the highlights from the most spectacular bout of [unclear] speculative excess the world has ever witnessed. Monetary disorder running completely amok. Now what? The simple answer: a really, really bad hangover.
Speaking of nasty hangovers, let’s discuss China. As a macro analyst of China, I continue to be in awe of China’s capacity to expand debt in numbers that are not easily fathomed. Aggregate financing, and that’s China’s metric of system credit, expanded almost $5 trillion last year following 2020’s unprecedented $6 trillion credit melee.
Pandemic monetary stimulus pushed China’s already supercharged apartment bubble further into terminal phase excess. Beijing last year implemented some modest real estate finance tightening measures and the wheels soon started coming off. I’m reminded of Japan’s belated decision back in 1989 to rein in property lending excess, marking a critical juncture for both their asset markets and bubble economy. What started with credit stress erupting in major Chinese developer Evergrande with its $300 billion of liabilities has now engulfed an entire industry with debts in excess of $5 trillion.
I’ve set up a monitor screen on my Bloomberg that includes about 30 Chinese developer bonds. It’s one of the first screens I turn to when I rise each morning. Especially over recent weeks, the ferocity of the development [unclear] has been stunning.
David McAlvany: Doug, if I may interject, you’re talking about credit excess in China and the real estate development sector which has allowed the government to gin up GDP performance by directing credit into that space. And I want to comment briefly that as we move towards the Olympics we should bear in mind two things. Number one, the domestic political environment should come into focus pretty clearly after the Olympics. There’s no doubt that Xi will be elected for an unprecedented third term in October when the party convenes the 20th party congress, and that secures at least five years of increasingly muscular rule. So that’s the domestic political situation for China. But the second is, it’s worth keeping in mind that as the economy comes under pressure and Xi seeks to keep a very positive nationalistic tone in the press following the Olympics, we’re in a heightened risk environment as it pertains to Taiwan. It is no coincidence that Putin will spend a good bit of time with Xi at the Olympics.
And coming out of that, not unlike Sochi in 2014 and the Olympics there, we could see action on the part of the Chinese or on the part of the Russians, or both. So proactive coordination between Xi and Putin over Taiwan and Ukraine makes sense if you assume that the US does not have the capacity to manage two conflicts at once. Being overstretched, as I believe the US indeed would be, invites these two parties to maximize leverage together.
So the credit piece is very important. 2022 may be the most challenging year for geopolitical risk navigation we’ve seen in decades, maybe since the Cold War. So the credit dynamics do play curiously into Xi’s narrative creation between the end of the Olympics in October. That’s their political meeting. Is there a bolder set of actions conceivable after the Olympics or after the election, maybe post October? I wish I was a fly on the wall for Xi’s and Putin’s conversations. That’s February 4th. But yeah, sorry, I just wanted to interject. It’s all yours, Doug.
Doug Noland: Excellent points, David. Thank you. Let there be no doubt, this is an epic collapse with far-reaching ramifications that garners little attention in China, the US, or globally. The world remains confident that Beijing has everything under control. Developer bonds did muster a rally last week in response to rate cuts along with measures to loosen real estate finance, but there is no cure for bubbles outside of not allowing them to inflate. Beijing has its hands full.
China’s apartment sales have slowed markedly while prices have turned modestly lower. With demand waning and tens of millions of unoccupied units, apartment construction is poised to slow sharply, and China’s economy over recent months—it has downshifted, no doubt about it, though it remains buoyed by booming exports. But economic growth will be stymied by insecure Chinese households reining in spending. And if I’m correct on unfolding global market instability, China’s export-dominated economy is increasingly vulnerable to a synchronized pullback in global demand. In the short run, the Omicron variant presents significant risks.
Beijing’s draconian COVID zero-tolerance policy has protected its citizens, but at considerable and mounting cost. The average Chinese has been stung by a combination of COVID restrictions, troubling economic developments, and a flurry of heavy-handed governmental mandates. Now with Omicron threatening, a population with little natural immunity and unproven vaccinations faces the prospect of even more lockdowns and hardship. And from a global perspective, Omicron poses risks to already struggling supply chains.
I see a Chinese population having grown overconfident from prolonged bubble excess that is now in an increasingly confused state. Consumer sentiment and apartment buyer optimism and general confidence are largely beyond government control. There will be fits and starts, but I believe the bursting of China’s bubble foreshadows a deflating apartment bubble, waning economic prospects, and major issues throughout China’s financial sector. This is an ominous development for a fragile global economy and vulnerable financial structures. For the past decade, my analytical framework has focused on the interplay of two separate yet interdependent Chinese and US bubbles. That China’s bubble is faltering significantly elevates US bubble risk, and vice versa, which essentially places a world of bubbles in jeopardy.
Ominously, global markets have become highly correlated. We saw it again today. I titled last Friday’s CBB “US Market Structure in the Crosshairs.” I am increasingly concerned by developments. I have noted recent elevated correlations between the cryptocurrencies, technology stocks, and indicators of general financial conditions. This suggests heightened risk of a bout of risk-off selling that could portend illiquidity, panic, and collapsing speculative bubbles.
Some are already making comparisons to the bursting dot-com bubble. I recall that period vividly. At the late stage of the ’90s tech bubble, many recognized the extreme overvaluation of the leading technology stocks. The bulls, convinced of a new paradigm of unending industry growth, they were undeterred. Not appreciated was that inflated stock prices were but one facet of industry bubble excess. Speculation, speculative leverage, and extraordinarily loose financial conditions had fueled massive spending and malinvestment by flocks of internet technology communications and media companies. Financial excess had unleashed arms-race dynamics.
The current bubble has inflated so beyond the scope of late ’90s excess. Key indicators are now suggesting today’s bubble is in the process of being pierced. Stock prices have reversed sharply lower, indicative of a potentially momentous shift in speculative dynamics and the flow of speculative finance. If this proves to be the case, if de-risking and de-leveraging sparking major tightening of financial conditions, an expansive industry with scores of loss making, negative cash flow businesses is in for one rude awakening.
While the industry-wide spending boom at this point runs unabated, there is analytical rationale for the bursting of the US bubble to commence in the overheated technology sphere. This is the area of greatest excess and egregious market speculation, along with incredible arms race industry spending and overinvestment. I would argue that not only is the underlying finance fueling the boom highly unstable, but too much of this spending will prove uneconomic. In this regard, there are parallels to China’s bubble downfall that erupted with the overleveraged apartment developers.
While attention has been focused on collapsing cryptocurrencies in the tech shares, it’s worth noting last week’s ominous reversal in financial stocks. The bank index’s 10% drop, it actually surpassed the decline of the NASDAQ 100. Goldman Sachs fell almost 10%, JP Morgan, 8%, and Bank of America, 6%. Bank credit default swap prices also jumped higher, indicative of mounting systemic stress.
I monitor the financial sector closely, and interpret recent market behavior as suggestive of incipient market structure concerns. As I’m fond of repeating, as much as contemporary finance appears miraculous on the upside, it functions poorly in reverse. When credit and speculative leverage are expanding, market liquidity will appear abundant, financial conditions will remain loose, and asset price inflation and speculation will maintain self-reinforcing momentum. But fragility lies in wait, lurking patiently just below the surface.
With our limited time, I’m not able to delve deeply into the important subject matter of market structure, but I’ll draw attention to three key fragile structural fault lines, derivatives, exchange traded funds, and trend-following finance.
Portfolio insurance played an instrumental role in the 1987 stock market crash. Derivatives were also fundamental to market dislocations in 1994, 1998, and 2000. Hedging and leveraging strategies, and that’s through listed and over-the-counter derivative products, were integral to both the mortgage finance bubble and its collapse. Moreover, derivative markets and the ETF complex were central to March 2020’s near meltdown. I fear we’re heading towards another derivatives accident. All the necessary ingredients are present. But this time around, the Fed has less room to maneuver. In market dislocations all the way back to 1987, sinking bond yields provided key post-crisis stimulus. Importantly, for three decades, the Fed enjoyed great flexibility in employing increasingly aggressive stimulus measures.
Greenspan’s baby-step rate increases morphed into aggressive rate slashing, which evolved into Bernanke’s $1 trillion QE and Powell’s $5 trillion. And it was all made possible because of the accommodative bond market’s unwavering support. Underpinning the great bond bull market, inflation for the most part [unclear] the past 30 years, spending much of the past decade below 2%. The Fed in March 2020 opened the floodgates for unprecedented monetary stimulus, with both the Fed and bond market operating without fear of inflationary consequences.
Well, the world has changed. There is now a serious inflation problem. And while it may subside from the recent four-decade high 7% level, there is, at this point, every reason to believe inflation will prove persistent. The Powell Fed is under pressure from Congress and the American people. Inflation is causing pain and consternation. So the Federal Reserve will now think twice before bailing out the markets with trillions of additional monetary stimulus.
I believe the Fed will inevitably have no alternative than to resume its money printing operations. Fragile market structures are a crucial consequence of a most protracted bubble period. There’s too much speculative leverage, too much masking and shifting of risk through the derivative labyrinth, and way too gargantuan trend following speculative flows. This structure is viable only so long as the bubble is inflating, so long as credit leverage and speculative flows are expanding. In the event of serious de-risking and deleveraging, there is no source of sufficient liquidity to stem collapse outside of the Federal Reserve’s balance sheet. This is especially the case after two years of climactic monetary madness and manic excess.
Okay, I’m asserting the Fed will have no choice but to resort again to QE. However, today’s inflationary backdrop makes the timing and scope of Fed support unclear. I believe the unpredictability of the Fed’s response function to incipient crisis dynamics will become troubling for the markets, and particularly problematic for derivatives.
I expect derivatives to be an epicenter of market instability. Think in terms of the derivatives marketplaces offering market risk insurance. Writing flood insurance during a drought is about as close to free money as you’ll find. With zero rates and unlimited trillions of liquidity [unclear] central bank community have been able to control rainfall. Over this long cycle, low prices and readily available risk insurance have been instrumental in promoting risk taking. [Unclear] liquidity backstop coupled with booming derivatives markets have been fundamental to ongoing bubble access.
With the shift of inflation dynamics, the Fed is losing control of the weather. They can no longer just blindly print money and watch security prices stabilize or resume their upward trajectory. Additional monetary inflation will now be destabilizing as it risks exacerbating already robust price pressures and bond market instability. And if the Fed can no longer predictably dictate market weather conditions, writing market protection, flood insurance, will be a much riskier proposition going forward. Protection will be more expensive and less readily available. And as risk aversion takes hold, the now customary strategy of simply holding tight with stock and bond portfolios while acquiring cheap risk protection, well, that’ll be a thing of the past. Importantly, costly derivatives make it more likely that risk mitigation will require selling holdings. And keep in mind that market losses are not insurable in terms of traditional insurance offering protection against random and independent events. Actuaries have years of data that allow them to rather accurately predict accidents and insure losses—auto, homeowner, and life insurance policies, for example. Policies are priced accordingly, with reserves withheld to ensure the financial wherewithal to pay future loss claims.
Securities, market, and credit losses are neither random nor independent. They tend to arise occasionally in unpredictable and all-encompassing waves. The players in today’s colossal derivatives marketplace for risk protection price their products with the assumption that markets, they’ll remain liquid and stable, and they don’t hold reserves for future expected losses. And this becomes, at critical junctures, one huge predicament for markets. Dealers sell derivative contracts and then have computer algorithms dynamically hedge the risk depending on market direction.
What this means is that when the market declines, dealers will short-sell securities to protect against mounting losses. When markets accelerate to the downside, derivative-related selling can quickly overwhelm the marketplace, leading to illiquidity. As we learned in 1987 and repeatedly since, and certainly including March 2020, these structures are prone to sparking self-reinforcing market selloffs, dislocations, and panics. Recall that when market liquidations accelerated dangerously back in March 2020, it required multiple Fed announcements of massive liquidity support to thwart crash dynamics.
Market structure was fragile back in 2020, and there is every reason to believe latent fragilities have become only more acute over the past almost two years. Unprecedented flows inundated the securities markets, including over $1 trillion into the ETF complex. The flood of trend-following buying was matched by retail participation in online stock and option trading. Margin debt exploded, although this is but a small fraction of the speculative leverage that has accumulated from hedge funds and the global speculator community. This tsunami of speculative finance fueled by the loosest financial conditions ever, replete with record corporate debt sales, stock issues, IPOs, M&A, private equity, venture capital, and such.
The vast technology universe—and that’s the usual computer and communication technologies, joined by big data in the cloud, AI, quantum computing, blockchain, robotic automation, EV and autonomous vehicles, solar and green energy, internet of things, 5G, virtual reality, wearable tech, 3D printing, cybersecurity, drones, biomedical and telehealth, and on and on—it’s been such an extended period of overabundance of cheap money available for just about anything. The underlying economics of an enterprise have almost been inconsequential. The upshot has been a proliferation of tens of thousands of loss-making ventures whose very existence depends on easily accessible finance.
In Austrian economic terms, it’s a bubble economy structure that has been feasting on ever-larger amounts of cheap and indiscriminate money and credit. While the vast majority of analysts and economists remain quite bullish on US economic prospects, our financial and economic structures could not be more vulnerable. These structures are today sustained only by massive new cheap finance, the very same finance that now stokes inflation. Market and policymaking environments are currently fraught with complexity and high risk, and the very epicenter of market structural fragility lies with systemic misperceptions of safety and liquidity, with misplaced faith in the Fed’s capacity to ensure stability—the core underpinning of bubble dynamics throughout this long cycle. To wrap this up, I’ll take note of last week’s fascinating dynamic. The banks and Wall Street firms were hammered. The tech-based NASDAQ 100 fell 7.5%, boosting year-to-date losses to 11.5%. Bitcoin dropped almost 16%. Ethereum collapsed 28%. So-called safe-haven Treasury bonds had year-to-date losses already approaching 5%—this following last year’s 4.6% loss.
Meanwhile, the Bloomberg Commodities Index gained 1.8% and has posted early 2022 gains of 7%. Last week provided the clearest indications yet of the unfolding secular shift away from high-risk financial assets and into hard assets increasingly perceived as more reliable stores of wealth. Not only does this bode poorly for today’s historic mania and securities market bubble, the flow of finance into commodities and real things would also seem to ensure ongoing inflationary fuel for the real economy. While yields have been rising, today’s 1.8% 10-year Treasury yield still offers a deeply negative real yield. Bond markets, certainly including corporate credit, remain highly vulnerable.
And while I can see bond prices receiving some support from sinking stocks, the big test will come when the Fed is forced by market instability to restart QE, despite vigorous underlying inflationary pressures. This creates a challenge for the Powell Fed unlike anything since the days of Paul Volcker. Volcker, however, didn’t have to contend with today’s fragile financial structure dominated by erratic securities and derivatives markets, unparalleled leverage, and trillions of trend-following speculative finance. It’s a deeply troubling backdrop. From my vantage point, it’s time to hunker down and get prepared for difficult market and economic conditions ahead. David, back to you.
David McAlvany: Great. Well, we’ll go to the Q&A. And I have to say, I never thought I’d have nightmares in the future with a voice in the background saying, “Recording started.” Again, my apologies. Not exactly sure what button I clicked or didn’t click in the process of getting the call up and running today, so thank you for your patience. We’ve got the questions that have come in. As I mentioned earlier, we also have the app on our website, mwealthm.com, bottom right hand corner. You’ll see the little [unclear] conversation, whatever you call it. You can click on it and put your question in. We’ll do our best to answer those.
Doug, first one’s for you. “It seems that the markets are finally realizing that the party may be over. However, I’ve been thinking this for years, and yet the markets continue to climb. If the Fed is unable to do what they say, tightening, and markets correct down, will they have the courage to stay the course? Recent history says no. If they reverse course and prop up the markets again, how long is it possible for the party to continue? If this were to happen, would that change your investment strategy? Thank you.”
Doug Noland: Yeah, thank you for the question. The joke around our household is my family will ask me if I’m still warning about the end of the financial system as we know it. And of course, they all get a good chuckle out of it. I’ve been worried about these issues for years, and I’m more worried than ever. As I mentioned earlier, I believe the environment has shifted dramatically. Although markets have just begun the adjustment process, consumer price inflation has finally become a pressing issue. Furthermore, it’s a global issue, which further complicates Fed policy. Inflation is posing significant risk to the bond market, which also creates a huge challenge for monetary policy.
For the first time in decades, Fed officials could begin questioning whether they might actually need to raise rates to support Treasury and fixed income markets. Now wouldn’t that be a change? For years now, bonds have welcomed every QE purchase, the bigger the better. And a booming bond market supported speculative leverage, creating just the ideal low rate and liquidity-abundant backdrop for the stock market. It’s been a long time since the bond market had any concern for a secular upswing in inflation, and I think those concerns are starting.
As I touched on earlier, I believe the speculative melee since the start of the pandemic makes it very difficult for the party to continue. Such manic behavior, it’s just not sustainable. Extreme bullish sentiment, as well as these financial flows. That’s why speculative blow-off so often marks the end of cycles. As I mentioned earlier, the Fed will have no choice but to respond to bursting bubbles with additional QE. Once again they’ll operate as the buyer of last resort. But I expect this support to arrive later than usual, likely after a significant fall in stock and risk market prices. And that the Fed doesn’t immediately rush to defend the stock market with whatever it takes, that’s going to have a major impact on confidence and the market’s willingness to embrace risk taking.
As I discussed, I believe it’ll have a huge impact on derivatives pricing and availability. The Fed will be hesitant, at least at first, to open the floodgates to the type of massive liquidity injections that will be necessary to restore market confidence. I don’t expect Fed policy will be capable of once again resuscitating the great bull market, but their efforts will surely stoke volatility in some powerful bear market rallies. We’ll have to be on our toes, closely monitoring policymaking, the markets, the liquidity backdrop, speculative dynamics, credit growth, the economy, and myriad global issues. It surely won’t be easy, but I’m confident we’re up to the challenge. And we’ll adjust strategy as necessary. I’ve been doing this long enough to know you’ve got to be willing to adjust and you’ve got to be ready to adjust. You have to have the right analytical framework to recognize you have to adjust. So thank you very much for the question.
David McAlvany: Doug, the next question is, “How long does the average market downturn last? I assume this is a short-term strategy?”
I thank you for this most pertinent question. How long might the bear market last? More recent bear markets have been relatively short in duration compared to more traditional bear markets, abbreviated of course by aggressive monetary stimulus. But I believe repeatedly short-circuiting the market adjustment process over recent decades will come back to haunt us during the approaching down cycle. I’m expecting a particularly grueling multi-year bear market compared to the relatively short-lived bears that markets have grown accustomed to.
I would imagine there’ll be significant rallies. There’ll be a lot of talk of new bull markets. “The worst is behind us,” we’ll hear a lot of that. But I think it could be years. I wouldn’t be surprised if it’s decades for some of these indexes to climb back to all-time highs. It took the NASDAQ 100 16 years to return to its March 2000 peaks—a similar dynamic for the S&P 500 and other major industries. That wouldn’t surprise me in the least. We actually see Tactical Short as more of a longer-term allocation. Thank you for your question.
David McAlvany: I would add to that. If you go back to the bull market of 1949 to 1968, we didn’t have a real strong bull market until 1982, so we kind of peak at ’68 and then take a 14-year hiatus. Of course there’s lots of volatility in between. You even had sort of the recessionary ’75, ’76 period in between. So an up stroke in the early ’70s, then another down stroke midway through. But if you look at that 14-year period, a part of what was grinding on real returns was the increase in inflation over time. So ’68, inflation wasn’t a very big deal, but by the time you get to the late ’70s, regardless of the nominal price of volatility in the equity indexes, inflation started eating your lunch year after year after year.
So to look at a bear market that does extend, I think one of the things we have to keep in mind is the impact of inflation on a real return. And yes, there is, in nominal pricing, upside and volatility. And I think it’s not difficult to imagine six, eight, 10, 14 years in the period of ’68 to ’82 where stocks aren’t helping you. Just not helping you.
David McAlvany: The next question, “Most pressing is how to protect what I’ll need to continue to grow and possibly subsist on.”
Doug Noland: So this is an interesting observation, what the investor is suggesting. I think the balance here is between taking some risk, with growth in the equation—growth being one thing that the investor’s noted here, while also being mindful of risk in the marketplace.
So what we do, how we operate, is not necessarily how everyone does. Adding to positions or reducing the size of a position according to market conditions is a place where we do engage as practitioners for an investor’s benefit. So I think we do blend the two things that this particular person has mentioned: protection, as well as growth. I think we do blend the protect and grow expectations in a reasonable allocation to asset classes that have a solid economic justification and provide a combination of growth and income for a valuable total return approach.
Doug, I appreciate your kind words earlier in the presentation. I think the team dynamic and the coupling of fundamental research with the technical overlay—the team is a good one. I wish—for any of our investors, whether it’s on the Tactical Short side or on our commodity-based–or hard-asset, really–approach to asset management—I wish you could know what happened every week. I just will say this: if you’ve ever been overwhelmed by the market’s complexity, partnering with a team like ours I think is a great option. But yeah, I think protection has to be in the equation. And growth, yes, that is a part of the equation too, particularly with some sensitivity to increasing inflation. You could say, “Well why not just sit in cash?” Beware, inflation’s not your friend, and there’s a risk aspect even to cash these days.
The next question is, “What is your position on investing in cryptocurrency? Yes it’s volatile, but its return on investment over the past three to four years is eight times the S&P 500.” Doug I’m going to make a comment or two here and then, if you have anything you want to add to investing in cryptocurrency, feel free.
Let me say this: The use cases have not provided the upside gains. It’s the Ponzi-style pile in with the first in making a killing that I think is ultimately going to be sort of the side story. Or, if you want to look at the postmortem of cryptocurrencies, as it’s told, first in made a killing, the last in got killed. So yes, the rate of return is intriguing. The return on investment is attractive if you’re not late to the party. But it’s more like a party than an investment. I think that’s something that is worth keeping in mind. It’s a speculation, that’s what it is. I don’t see it as an investment. Why do I say that? I would start with a question. What is it you’re buying? What is it you’re buying?
Even the best use cases, the demonstrations of a disruption to a particular industry or business model. XRP, which you might know as Ripple, it’s basically an improved Western Union. It could be a replacement for SWIFT. It may in fact leapfrog the SWIFT system. All you can do is talk about their solutions. All you can do is talk about their solutions. Adoption and disruption are still only theoretical after, in the case of bitcoin, 14 years of existence, which brings me back to this issue of the use cases being very intriguing to talk about, but so far that’s not how you’ve made money. You’ve made money on that Ponzi-style pilot.
So if it were an investment, you would know who is managing the development. Who’s controlling the rollout of these potential use cases? You might even set expectations for delivery of them. Yet what we find is a routine rehash and regurgitation of what it might be, as if it already was. So it’s a wave of the future. Use cases will be developed, but I think ultimately you’re talking about use cases being developed not by the private sector but by the public sector.
I view there being a nasty transition ahead for the cryptocurrency crowd where the technology, which stood to serve a number of unique use cases, ends up being co-opted. The technology ends up being co-opted as a great replacement for paper fiat currencies with a digital fiat. I have to be honest, this is where my view is perhaps—maybe it’s too dystopian, but I see it as one of the more dystopian developments in the last 100 years. You’ve got China, who wants a central bank-distributed currency—digital currency, rather, central bank digital currency. You’ve got Russia, who is on their way towards developing their own central bank digital currency and having large public discussions about making all other cryptocurrencies illegal, as we’ve already seen some moves in China and India. You’ve got the US and the UK; they will develop their own central bank digital currencies.
And the implications of that are not good for the consumers’ experience. What it really looks like is central bank digital currency is being a new way of [unclear] fiscal and monetary policies. And the fiscal and monetary policies that I see being a complement to digital currencies are not great. They’re not great. Again, I think it’s the means by which you implement financial repression more directly. It’s the means by which you implement inflation more directly, quicker. And the temptation for central bank communities to say, “Look, we can manage in real time, as opposed to waiting for monthly reports.”
So, again, I— Don’t get me wrong, there’s value in blockchain. You’ve got an example of that with the Estonian government. It’s codified all of its government documents using the technology in order to reduce future governmental corruption. Great. That’s fantastic. It’s a valuable use case, but it’s completely disconnected from the value of bitcoin. There was no way to monetize it. It just happens to be something that is actually a usable aspect of blockchain.
So that’s my concern. If you’re looking at a rate of return on a cryptocurrency, what you’re really talking about is a speculation on more people coming in and buying into the story. But I’m still looking for steak more than sizzle, and I’m still looking for the use cases coming live, instead of just the monetization of what I see as really something of a Ponzi scheme. Probably long-winded. My apologies. Doug do you want to say anything on that or should we let it rest?
Doug Noland: You did a great job David. I would just throw a short comment out there that I look at cryptocurrencies as the ultimate vehicle for speculation. There’s not a fundamental anchor there, so that’s not going to hold down valuation at all. You can just let your imagination run wild. If you throw five trillion into the system, your imagination can really, really run wild. But what worked so successfully on the upside, I think that’s the weakness on the downside, that you don’t have the fundamental anchor there. So we’ll just see how that unfolds.
David McAlvany: Thanks. The next question is, “What’ll happen with gold and silver in the ‘reset?’”
Yeah. The diplomatic answer is, it’ll either become more valuable or it’ll become less valuable. I think it’s not entirely clear what a reset will ultimately entail. I’ve read Klaus Schwab’s ideas. I know that to agree what the World Economic Forum crowd has discussed, we can try to imagine that in application. Anyone can read it. But without knowing a set of future events, how a market responds, the gold and silver market in this case, it’s difficult to say with confidence. We can put that in the “what is it?” category. What is the reset? How will it ultimately look?
There’s a second category, category B. We’re talking about, in general terms, a restructuring of ownership of assets. A change in our understanding of private property. Essentially a rewriting of a social construct—or contract, rather. Yeah. I think how a disparate global audience responds to those types of things unfolding—that, too, is unclear. So it makes it a challenge to predict the direction of the precious metals tied to the reset in both of those categories. One, we don’t exactly know how it’ll take shape. And, two, you’re talking about a lot of people with a lot of different priorities. So that’s the second category of how people respond to it.
What I can say is that when freedom is eliminated—and I think this is really critical—when freedom is eliminated, the means of freedom become more valuable, regardless of a market price. That’s worth thinking about. Not an investor looking for gains, but as a free agent valuing agency and free choice, what will happen to gold and silver in reset? Price is one thing. Now you’re talking about the value of agency as being something that may be distinct from price, but of real value still.
What I think I can also say with high levels of confidence is that an expanded fiscal and monetary footprint by a global elite, by an expanded state leviathan—and you can reflect that, hypothetically, in things like the universal basic income— Because again, if you look at Klaus Schwab’s ideas of the Fourth Industrial Revolution, you are talking about a lot of people not working because they’ve been replaced by robots and AI and whatnot. So the implementation of the universal basic income is how you keep the peace. It’s one of the ways that you make sure everyone’s happy. The happiness quotient is still in play. Again, to the degree that you have an expanded fiscal and monetary footprint because of the implications of the policies implemented, universal basic income being just one that we can talk about, I think that motivates investors to migrate towards gold and silver. I could be wrong. But if behaviors and beliefs continue to shift towards that type of an outcome, I think prices—yeah, I think prices can go up.
Yeah. As I mentioned earlier, I think gold and silver being an enabler of freedom— Too often people think of it as just an asset class. I do think that it is that, but it’s also— In a long history, it’s played the role of currency. I think I’ve mentioned this on previous calls, but I would go back to Greenspan’s paper on gold and economic freedom for a view of how valuable the asset is, regardless of its current pricing dynamics. So, again, what’ll happen with gold and silver in a reset? I think we’ll discover just how valuable it is, regardless of market price.
I’ve got a couple more questions that I think are geared towards me. Doug I’m going to throw one to you and then come back to those. Why don’t you take a stab at this, “How to apply practicality with good risk control?” How do you operate in the markets today practically with good risk control?
Doug Noland: Sure. Risk control, David, obviously, is a subject near and dear to our hearts. I’m not sure if the question is directed more at a Tactical Short account holder or the management of the strategy, so I’ll start by saying that Tactical Short, our objective is to be an allocation within an overall investment portfolio. David mentioned that to start out the call. We think in terms of a five- to upwards of 20-percent allocation. And that’s depending on the composition of an investor’s overall portfolio and their individual risk profile, so it can vary depending on the individual. And, as David mentioned earlier, no big bearish bets. That’s not what this is all about.
As for managing Tactical Short risk, our objective is to provide a lower risk product than these other products. We don’t want to be 100% short all the time. We want to be able to adjust based on the environment. We want to be around for the long term. We don’t want any big— We don’t want any accidents. To accomplish all of this, we are very disciplined with managing the expected volatility or beta of our short exposure. I guess that’s the bedrock of risk discipline. We prefer low volatility short exposure to high volatility. In high-risk environments, we stay clear of shorting individual company stocks and always want to avoid the risk of getting caught in these brutal short squeezes that are a regular occurrence in the marketplace. We want to have liquid and well-diversified short exposure, especially in volatile high-risk backdrops.
We rebalance our short exposure, meaning that when the market is going against us we reduce short exposure so as to not see our short exposure move far away from our targeted level. We want to have more short exposure when the risk-reward calculus is favorable for shorting, and less when it’s unfavorable. That’s just kind of a philosophy we have to help manage risk. We want to become more risk averse when we’re losing money. That’s natural. When we’re losing money, we’re not going to take more risk, we’re not going to make bigger bets, we’re not going to double down. None of that. I think our top-down macro analysis provides us an edge, should provide us an edge going forward. I hope that helps. Thank you for your question.
David McAlvany: That’s great. The next one is, “Do you see—” I’ll address this one. “Do you see any evidence of the SDR replacing the dollar in 2022? I’m watching a lot of videos online, and many speculate that a digital dollar will be coming onboard in the form of an SDR.”
Yeah. I’d say no, there’s no real consideration of the SDR replacing the dollar—the SDR being a currency basket. There is, however, a major global push towards those central bank digital currencies. That is different than a basket construct taking out the dollar’s role as the world’s reserve currency. I don’t think the Federal Reserve or the US government has any intention of diminishing our role on purpose. On purpose. Central bank digital currencies are—they’re a little bit like a model change. It’s got new features. Like I’m thinking of a car. New features, improved experience. Well, I don’t know. Maybe a Ford Taurus from 2003 changing to something more like a Ford Taurus but in Tesla clothing. It’s got the benefits. I think that’s what you’d see advertised, is the benefits of a new dollar as you shift towards the digital currency.
I think what you have to do, as an individual investor, is think beyond the advertising to see what the drawbacks and compromises might be. Again, I mean you think of the old car. The old car is a basic. In some sense it might be more reliable. You can probably open up the hood and fix it yourself, but clearly it’s less sexy. The new model has some things going for it in terms of appeal. It also has some other things that the old model doesn’t have. The new model may have a remote kill switch. It works until your social credit score declines and then you lose mobility. Think about that as the implications, potentially dystopian implications, of the digital currency are being expanded.
Yes there’s opportunities. It’s more efficient, in terms of economic management. But now remember that you’re a part of what’s being managed. Digital currency expands the opportunities for the state to nudge you, to direct your choices with a combination of stick and carrot. And the experience is in real time. As I mentioned earlier, it empowers real time monetary policy implementation, real time feedback on the results, no more monthly reporting. Every breath from the economy is measured. Again, that sounds intriguing until you realize that every breath can also be limited, yours included, from an economic standpoint.
So it’s— we are moving towards the digital dollar. The Federal Reserve just put out a questionnaire. If you haven’t read it, I encourage you to look it up and read it, and look through the implications of some of the questions. I think it was 22 different questions. As they consider the launch of their digital currency, what are the problems they’re solving? How do they intend to implement it? You do get some insight from looking at the Fed’s 22 questions and public inquiry on the topic. I think that’s all I’d say. But no real indication of an SDR replacing the dollar in 2022.
Doug, the next question’s for you. “How long can central bank intervention, QE, continue without serious consequences? Given how much money has been printed, money printed, and debt created since George W. Bush’s stimulus plans back in the day.” Then there’s sort of a sub-question here. “Are we at risk of a hyperinflationary event?”
Doug Noland: Yeah, thank you for the question. I would start by saying I don’t believe the consequences could be any more serious than they are today. History’s greatest bubbles and manias, I would argue acute financial instability. And in the real economy I don’t believe structural maladjustment could be anymore serious. Admittedly, none of this outwardly appears to be that serious today because security prices remain highly inflated. Perceived household net worth and wealth remains at historic extremes. Unemployment is quite low. Inflation, while elevated—and this doesn’t get enough attention—while inflation’s a problem, it’s not yet viewed as a serious consequence because bond yields remain so very low. That keeps mortgage and corporate credit costs low and inexpensive and readily available. So today it doesn’t look as serious as it is.
But at this point, I don’t think it will take much for market and financial fragilities to be revealed. And when markets buckle, I expect greater recognition of the seriousness of our financial and economic predicaments, and the serious policy mistakes that have been committed. Even when markets falter I believe we have a serious inflation problem. I would assume that the bond market will discipline the Fed before they get too carried away in a hyperinflation scenario. But in this regard the bond market has let us down repeatedly.
I worry very much about the dollar. The dollar’s greatest asset, though, remains: It has very unsound competitors. For the hyperinflation scenario, we would need a dollar collapse. It’s a possibility, but it’s a world of weak currencies. But thank you for your question.
David McAlvany: I’ve got two separate questions from two separate people. I’m going to try to combine them as best I can. It starts with, “To what are precious metals most closely correlated? Interest rates, the price of the dollar, inflation figures, et cetera?” Then the second part is about metals manipulation. “Do you believe that precious metals are manipulated on COMEX? You heard about the almost preposterous short position of 800 million ounces that Bank of America has been leasing from JPMorgan according to the CFTC reports and Ted Butler. Would you care to comment on this?”
So I’m going to try to run through both of those as quick as I can. 90% of the time I think your closest correlation is the dollar. There are months and even years where that correlation breaks down, but in the very short term and in the very long term they are more correlated. You’ve got a negative correlation with rates, so the lower a real rate goes, the better for precious metals. The higher a real rate goes, the more precious metals struggle. And if you want to explore that, the Summers-Barsky thesis, which you can google and read, is, I think, a very useful resource. That was by Larry Summers, I don’t know, some 30 years ago.
We’re in our 50th year of serving precious metals investors, the company that my parents started in 1972. Yes, there are periodic interventions and manipulations in price, not only to precious metals, but I think it’s noteworthy to say yes, in terms of stocks and bonds. Look at the Fed balance sheet. You’re at $9 trillion. You have a first-rate example of price manipulation in the bond market. That was trillion with a T. We know that, but other than the periodic games that get played for the benefit of your monthly or your quarterly or your annual P&L, and that’s where you see some of the games played in the short run, with the metals. These are your big banks and Wall Street firms, again, just sort of gaming for performance.
Other than those, the idea of a major systemic metals manipulation, I’m going to be a little bit more critical of. I think that speaks to the—bear with me here, but I think it speaks to the exaggerated expectations of precious metals market participants, where the preferred explanation of being wrong on a market move is to deflect and blame the big guys rather than eat humble pie and lose your readership. In the case of Mr. Butler, it’s a newsletter readership.
So yes, there’s a creative reading of the COT reports, which can become a way of constructing evidence in support of systemic manipulation, but I think if you check the math, if you check the math of gold and silver from 1971 to the present, you find that you’ve got a 38X move in silver from the lows in 1971 to what we’ve had is the $50 highs more recently, and a 58X move, a 58 times move in gold, from $35 up to $2058. And those kinds of moves are nothing to blush at, and really, they don’t appear in the long run to have been constrained. What is unconstrained is the imagination of a metal speculator. And I think it’s like any speculator who envisions not a 38 times move or a 58 times move, but a bazillion and eight times move. And so I think gold and silver have actually performed quite well.
And yes, you can make the case for the short-term manipulations, but no, I don’t think the short term or the systemic manipulation is “what’s holding gold and silver back.” I think they’ve performed quite well, if you look at all the variables in play. So let me misquote Julius Caesar, I’m going to draw some truth from his words, but it’s clearly a misquote: The fault, dear Brutus, is not in our stars, but in ourselves. It may be easier to blame fate, it may be easier to blame the bankers, it may be easier to blame anyone else, when perhaps we should consider the inflated speculative expectations that we had coming in, and own the fact, own the fact that we may be the problem in the mathematical equation. There’s some manipulation, but not like what is suggested. I’ll leave it at that.
Doug, “Under what conditions, Fed funds rate, 10-year bond interest rates, GDP numbers, will the Fed abandon its balance sheet runoff or raising the Fed funds rate?”
Yes, another excellent question, and I’ll try to expand somewhat on the analysis I shared earlier. I don’t believe the Fed will move forward with tightening measures once de-risking/deleveraging becomes a serious issue for market liquidity. So in this regard, more fundamental indicators, such as the Fed funds rate, 10-year Treasury yields, GDP, and such tend not to be my primary focus. It’ll be instead— I call it a mosaic of indicators. They’re my market liquidity indicators, and that’s Treasury, MBS liquidity, corporate credit spreads, credit default swap prices, repo market instability, derivatives pricing, ETF flows, that sort of thing. That kind of gives you an idea of the liquidity dynamics within the marketplace.
At least in the past, the Fed responded quickly to market liquidity issues, and in the current risk-off market backdrop, I don’t think it’s going to take much for the hedge funds and the levered players to move more aggressively to reduce risk, which unleashes self-reinforcing market weakness, waning liquidity, and only more risk aversion. I believe this process has commenced, although the Fed is in a difficult spot where it’s forced to take a hard line against inflation. So I don’t see this hard line as being sustainable, but I think they’re going to be forced to stick to it longer than they ever would have in the past, and the markets will become increasingly concerned. You’re starting to hear the question, How far below the market is the Fed put?, et cetera, so I think the markets are getting a little nervous about this dynamic. Thank you.
David McAlvany: The next question is, “Where do you think gold and silver will be at the end of 2022 or at the end of 2023?” I’ll take that, but Doug, could you sum that up in a word or two?
Doug Noland: Yeah, whatever you say, David. That’ll work for me, thank you.
David McAlvany: I think higher, and I’ve been wrong enough times and have dogmatically stated an opinion enough times to recognize that the future—it’s not something that we know. We can’t pretend to know with any certainty. But I do think, like Doug, that financial market excess has built frailties into the financial market. And now from a valuation perspective I’m talking about stocks as having a major role in the next move higher for gold. So from a valuation perspective, we should expect to see mean reversion in financial assets, from overpriced to underpriced. And we know from the pattern behaviors of investors that when stress increases, when uncertainty increases, when portfolio losses increase, gold is a favorite safe haven asset.
So is that 2022? Sure looks like it. Would that continue into 2023? Pretty good shot at it. But combine that with, as Doug was just describing, the limits of central bank and governmental interventions, with inflation running the hottest it’s run in 30, 40 years, and I think we’re safe to say gold and silver will be higher at the end of 2022 and 2023. If bear market dynamics emerge in earnest this year, you’ve got the inflationary dynamics, which may well explode as the Fed and federal government both—the Fed from the monetary policy side, the federal government from the fiscal policy side—intervene, right? That’s an interesting set of variables that weren’t around in 2022. 2% inflation versus seven, it’s a different backdrop. With a new stress being present, that inflationary pressure is something that the bond market hasn’t seen in a long, long time. It takes away the appeal for Treasurys as the other safe haven, and I think that, too, could be a huge factor for the metals.
Doug, the next one’s for you. How severe are contagion risks of the collapse of the Chinese real estate bond market to the US market? And if the risks are severe, why are we not hearing more discussion on the impact of this and that this could have here, domestically?
Doug Noland: Great. And I’ll address that question. I want to come back, and my silliness conveyed that I don’t have a view on gold and silver. So I just wanted to throw out the thought, and I do not articulate this nearly as well as you do and let’s say Jim Grant, but I look at the precious metals, the value will be inverse to confidence in global central banking. And it goes beyond that. Confidence in global central banking directly plays into confidence in this global—we’ll call it a financial system, which is really just this huge global ledger of electronic debit and credit entries. So my view has always been that I expect the precious metals to really shine when there’s increasing worry about, do central banks have this all under control?
But anyway, back to this question of severe contagion risks in China. As I mentioned earlier, the world remains very confident that Beijing has everything under control, so that’s why we don’t hear a lot about it. For me, it’s a little— it’s the old déjà vu all over again. It took about 15 months from the subprime eruption in the spring of ’07 before the crisis had gravitated to the financial system’s core for a systemic crisis in late ’08. The subprime collapse marked the beginning of the end of the great mortgage finance bubble, and I was amazed at the time what markets were willing to believe and what markets were happy to ignore.
And I remember the mantra, “Washington will never allow a housing bust.” If I had a dollar for every time I heard that, “The Fed had everything under control,” like Beijing does. And thinking back, the initial problems in subprime actually led to greater speculative flows and leveraged [unclear] into the perceived safest MBS and mortgage related securities, actually stoking segments of the bubble right at the end. But tighter lending conditions and sinking housing prices eventually opened the floodgates for credit losses, and those impaired trillions of dollars of securities.
It took some time, but it reached a point where solvency issues for some of the major financial institutions could not be ignored, and then rather quickly panic ensued. According to official data, apartment prices in China have declined only slightly so far. And for the most part, global markets remain confident in Beijing’s backstop and the stability of China’s banking system, and that’s key. There haven’t been worries about China’s banking system. At some point I expect waning confidence in Beijing’s capacity to ensure stability. This would be a critical juncture for a Chinese banking system vulnerable to a crisis of confidence, and I believe global concerns for the stability of China’s banking system would have major ramifications for global markets. We’re just not there yet. We’re not there yet. Heading that direction. We’re not there yet. But risks are clearly mounting, and considering the incredible $55 trillion size of China’s banking system, risks are certainly severe. Thank you.
David McAlvany: Okay. The next question comes from Pete. “What is the impact of an increase in interest rates for the insurance company industry? Does that ultimately impair their ability to meet major payouts?”
Doug Noland: Yeah, I’ve analyzed the financial system, financial institutions for a long time. I’ve never been strong in the insurance company area. That’s a tough— tough accounting, and I’ll put it that way.
Our entire financial system is today vulnerable to a spike in bond yields. I probably worry most about the big banks and their capital markets exposures. I do, though, have concerns about the insurance industry and the impairment these surges in bond yields would create. It’s been a while since I’ve taken a deep dive into industry exposures. I hate that accounting, to be candid.
But there’s clearly major risk there, to rate risk but also to credit risk. The chase for yield ensured the insurance industry boosted its exposures to higher yield and corporate credit, commercial and residential mortgages, and, importantly, structured finance. If things unfold as I fear, this industry and others will find themselves running through mine fields of risks, and we’re going to have to be very focused as this starts to unfold, as far as what players in that industry are sound, the more stable players, and which ones have reached too much for risk during this cycle. And that’s going to be important analysis going forward. Thank you.
David McAlvany: Yeah, I think just to add to that, you can throw pension funds into the same mix as the insurance industry, as having significant allocations to bonds within their portfolio to try to match the outflows and inflows. And so they’ve got the cash flow piece covered, as best they can, with a portfolio structure that does have higher rates from back in the day, and zero rates factored in today. You’re talking about capital losses on the portfolio, on a mark-to-market basis. Fortunately, that’s not something that an insurance company has to do in real time. I think your biggest risk is probably with the type of company that you could choose. A mutual company, maybe you see their annual dividends shrink as a way of sort of cushioning a hit to the balance sheet. And that’s going to be a little bit different than a non-mutual insurance company, where I think maybe you’ve got a little bit more risk implied from a big interest rate increase.
So it’s a real thing, a huge bond portfolio in a rising interest rate environment, there’s no joy in Mudville, as they say. You do have that partial benefit of not having to mark the portfolio to market every day, which they probably lean into.
The next question, Doug, “Do you believe China would implement deep negative interest rates once the renminbi is fully digital, and what effect might such a move have on the broader world economy in China’s pursuit of their global initiatives?”
Doug Noland: I think it’s safe to assume Beijing will be forced into myriad forms of aggressive stimulus. They’re going to have to throw the kitchen sink at this thing. But I’m not sure they today would look elsewhere and see evidence of the great benefits of negative rates, so I don’t think that’s going to be their primary tool, by any stretch. And it’s not clear to me what role digital renminbi will have. If China’s credit system does succumb to a crisis of confidence, it’s difficult for me to believe the world will see the renminbi as a secure store of value, and that’s digital or otherwise.
I recall fears back in the ’80s that Japanese manufacturing was going to take over the world. The situation today is obviously very different, but I do expect China’s global ambitions will confront—we’ll call them the harsh realities of having to deal with a number of collapsing bubbles in the myriad associated domestic issues. I harbor fears, and David touched on this a bit himself, that Beijing responds to instability with a more aggressive approach to Taiwan, the South China Sea, and its global influence more generally. Analysis of China, and that’s from the financial perspective, economic policy making, and geopolitical. It’s certainly— It’s complex and very dynamic. We’ll be quite focused on monitoring developments and expecting major impacts on global markets and economies. I don’t think you can overstate what is starting to unfold in China, in the US, and globally.
David McAlvany: Yeah. Doug, what comes to mind immediately is supply chain issues being exaggerated, even a bigger deal. What does the world look like without Taiwan semiconductors? Or instead of a supply chain bottleneck, we start looking at it as a supply chain choke hold, where the Chinese have basically been able to determine who can manufacture products A through Z, based on their access to what was just, again, a normal, ordinary in the course of doing business access to semiconductors. China’s going to be very interesting to watch, and our interests are primarily financial, but you can’t not pay attention to the political and the geopolitical issues there.
Two more questions, Doug, that have come in from our listeners. One is, it’s kind of a— Steven says, “I made a mistake going short six years ago, still have them, and of course have lost…” he says 75% of value, so I guess that would be one of those sort of static, what we described earlier, Doug, some of the competition is a hundred percent short all the time. “Do you have any advice when I should sell those investments during a market turndown?”
Doug Noland: Tough question. And David, take note for the next call, when you invite questions, ask for easy ones, but yeah, there’s no easy answer here. I know from my experience, when the markets really start to unravel, people generally take their profits early on the short side, expecting a short bear cycle, expecting rallies, so you have a choice. You can try to navigate around these rallies, because a lot of times they can be ferocious, right? Especially in high beta areas, you can have rallies of 50% easily. And it’s hard to have staying power in those rallies, so it’s just a very difficult question. It depends on the product, how the product’s managed, the volatility of the product, an individual’s risk tolerance. But generally, I think what I want to do is to have lower volatility, short exposure, that I can stick with throughout this bear market.
David McAlvany: Yeah, and that’s what you’ve continued to provide, Doug. Yeah, I’m so grateful that I’ve got access to these questions, Doug, and the easy one I get to take, the hard one, I get to throw to you.
Rick asks, “Any dips in gold and silver prices over the next few years, should those be considered as good buying opportunities to add more?”
I continue to look at gold and silver as a store of wealth, and as a representation of enduring wealth. And if you’re able to take advantage of lower prices, by all means do. I don’t think the gold and silver have reached their final destinations. I think we will see continued outperformance for those metals in the years ahead.
But again, I still look at the metals as something a little bit more complex than, Is the price down, should I add? Yes, that’s an opportunity. Not just because the price will go up, but because you have something that represents a store of value which may be of great value to you and your family, your friends, your community. I think we do have some challenging years ahead of us in the financial markets, and having a resource like the metals, I think it will prove its merits to you and everyone you know. So yeah, I would take advantage of any lower prices.
Well, listen, we’ll wrap the call with this. Thank you for joining us. We’re grateful to our account holders. We appreciate the partnership through the years and months, however long you’ve been with us on the Tactical Short, and we look at the next several years as no different than the last. We’re going to work as hard as we can to understand the markets, manage risk, and take advantage of the opportunities that present themselves for this product. And look forward to doing that towards your benefit, and in service of your financial needs and desires.
So thank you for joining us, we’ll be available if you have not opened an account with us in this regard and are kind of kicking the tires at this point on Tactical Short. I would do that sooner than later. Set something up, either a conversation with me or with Doug, and we can explore how this represents a hedge for your other assets. Certainly that is one approach, and if you see this as being particularly opportunistic, you probably get the gist of our comments today as this being a significant market top, and there being indications of that. From a fundamental standpoint, certainly, from a technical standpoint, we discuss this every week. We now have a daily and a weekly confirmation of the market’s having sell signals. We may, at the end of this month, have a monthly confirmation as a sell signal on the downside as well. Things are stacking up in your favor to have Tactical Short in the mix for your portfolio mix. So engage with us, we look forward to your questions, and thank you again for joining us for Tactical Short and the fourth quarter review.
Doug Noland: Thanks very much everyone, and good luck out there.