Tactical Short Strategy Conference Call – October 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

Prelude to a Market Accident
MWM Q3 2022 Tactical Short Conference Call
October 27, 2022

David McAlvany: All right, good afternoon. We appreciate your participation in our third quarter 2022 recap conference call. As always, a special thank you to our valued account holders. We greatly value our client relationships. We titled this call “Prelude to an Accident.” Now, I generally assume those on the call avail themselves of the weekly work that Doug puts into the Credit Bubble Bulletin. But just in case, just in case you don’t see it routinely, I encourage you to do so.

At the end of every week, Doug provides an invaluable perspective piece, following— He’s got his appraisal of currencies and commodities and market instability and indicators of mania and bursting bubble dynamics and inflation. It includes pertinent articles for each of those topics from the week, dealing with country specific developments, geopolitical flashpoints, and important public policy concerns. It’s packed. It’s packed.

And if you, like me, have ever wasted time online looking for a golden nugget of information in what seems like an endless pile of rubble, and sometimes rubbish, this is more than the golden nugget. This is the vein. This is high grade. This is running deep. I consider the CBB the weekly mother lode, so don’t waste any more time. Take advantage of his curated gold mine. I personally think Doug is the hardest working guy I know, and those efforts get distilled and offered to you weekly, so don’t take it for granted. It’s invaluable. 

Okay, there are some first time listeners on today’s call, so we’ll begin with some general information for those unfamiliar with Tactical Short. More detail detailed information is available at mwealthm.com/tacticalshort. 

For the remainder of the call, I’ll provide performance data, and Doug will cover the bulk of analysis, and then we’ll both engage with you in the Q&A at the end. If you did not submit a question ahead of time, you still may do so. You go to our website, mwealthm.com, bottom right hand corner, you’ll see a chat box. You can click on that and add your question. We’ll add it to the queue at the tail end of our comments. So again, M as in McAlvany, wealthm.com, and look for that little chat box in the bottom right hand corner.

The objective of Tactical Short is to provide a professionally managed product that reduces overall risk in a client’s total investment portfolio, while at the same time providing downside protection in a global market backdrop with extraordinary uncertainty and extreme risk. The strategy is designed for separately managed accounts.

This allows it to be very investor friendly, with full transparency, flexibility, reasonable fees, and no lock ups. We have the flexibility to short stocks and ETFs. We also plan, on occasion, to buy liquid listed put options. Shorting is a unique style of investing. It entails a unique set of risks, and we’re set apart both by our analytical framework, but also our uncompromising focus on identifying and managing risk.

Our Tactical Short strategy began this quarter with a short exposure targeted at 77%, and ended the quarter slightly higher at 78%, and that is the highest level in the history of the strategy. Due to the highly elevated risk environment for shorting, the S&P 500 ETF remained the only short position during the quarter. We definitely do not encourage aggressive market bets, including against the stock market, as we stress during each call.

Remaining 100% short all the time, as most short products are structured, is risk indifference. While aggressive shorting is indeed rewarding at times, the market over recent years has inflicted huge losses on the short side for those who have been indifferent to risk. So we believe a disciplined risk management is absolutely essential for long-term success. We structured Tactical Short to ensure the flexibility to navigate through even the most challenging market conditions.

Here’s your update for performance. Tactical Short accounts, after fees, returned 2.98% during the third quarter. The S&P 500 returned a negative 4.89. So we were plus 2.98 with the S&P down negative 4.89. As for one-year performance, Tactical Short, after fees, returned 10.08% versus a negative 15.5% return for the S&P 500. We regularly track Tactical Short performance versus three actively managed short competitors. First is the Grizzly Short Fund, which returned 3.12% during Q3, and over the past year, positive 29.37 for Grizzly. Ranger Equity Bear returned a negative 5.55 for the quarter and 17.74% over four quarters. Federated Prudent Bear returned 4.7% during Q3 and 11.57% for one year.

While we underperformed during the recent market’s decline, Tactical Short has significantly outperformed each of the bear funds since inception. From the April 7th, 2017 inception through the end of September, Tactical Short’s return has been a negative 31.31% versus the positive 67.67% for the S&P 500. On average, that’s an outperformance with those three competitors listed of the 2,749 basis points. 

There are also popular passive short index products, the ProShares Short S&P 500 ETF returned 4.73% for the quarter and 13.46 for the past year. And the Rydex Inverse S&P 500 Fund returned 4.75 during Q3 and 12.92 over four quarters. Last but not least, the PIMCO Stock Plus Short Fund, which returned 4.44 for the quarter and 11.04 over the past year. 

That’s what I have for performance. I’ll be joining you again for Q&A. Doug, it’s over to you.

Doug Noland: Thank you, David. Thank you for your kind words. And good afternoon, everyone, and thank you for being with us today. Let’s begin with performance. And to set up the discussion, I’ll underscore what was an extraordinarily unsettled market environment. From July 14th lows to August 16th highs, the S&P 500 rallied 16%, the NASDAQ 100 recovered 19%, while the Goldman Sachs most short index, by mid-August, had rallied 40%, quarter to date. It was a significant bear market rally.

We have specifically positioned short exposure in expectation of wild volatility, and really the certainty of erratic rallies. I have in previous calls discussed Tactical Short’s rebalancing strategy. As a refresher, counter to the long side, short exposure moves inversely to account value. This tends to be a little confusing. When the market rises, short positions get larger while losses reduce account value. When the market falls, short positions get smaller as account value benefits from profits on short exposure.

So if a manager on the short side strives to maintain short exposure at a targeted level, this requires rebalancing, and that’s adding to shorts during market declines and reducing shorts during rallies. Most short funds rebalance daily with the index short funds rebalancing exposure back to 100%. They do it automatically on a daily basis. Tactical Short approaches rebalancing more tactically. We specifically don’t rebalance daily, and allow short exposure to fluctuate within a band around our target. This significantly reduces trading, and we believe enhances long-term performance.

We lean heavily on our mosaic of market indicators to provide an edge for the timing of rebalancing trades, striving to be somewhat opportunistic in our rebalancing efforts. While I expect this approach over the longer term to benefit performance, it probably was a small negative during Q3. Anticipating market instability, this year I’ve widened the band around the target, meaning I’ve not been rebalancing exposure unless it diverges meaningfully away from the target level.

For example, there are occasions during steep market declines where actual short exposure temporarily dropped below 70%, and in market rallies, it rose above 85%. And you might recall that the market suffered a selloff into the end of Q2. This benefited Tactical Short’s second quarter performance. Because of the quarter-end market weakness and the wide band around the target, we began Q3 with short exposure below target, nearer to 70% versus this 77% target. This helped Tactical Short’s relative performance during the rally, and midway through the quarter, one of our competitors was down 22% quarter to date, with another losing over 15%.

But the market then reversed sharply lower with Tactical Short relative performance lagging during September. It’s worth noting that one of our competitors lost over 5% during the quarter. That, despite the S&P 500’s almost 5% negative return. This fund provided a poor market hedge during Q3. And that’s the nature of a portfolio of commonly shorted stocks.

During periods of market instability, they tend to turn highly volatile, with performance occasionally diverging from the S&P 500. Rebalancing a high beta portfolio during such extraordinary market volatility can create quite a drag on performance, while a failure to rebalance raises the risk of outsized losses. On average, Tactical Short outperformed the three fund competitors by 222 basis points during Q3.

Shifting to macro analysis, it was a most fascinating quarter. The period got going with news of June’s shocking 9.1% year-over-year consumer price inflation. Curiously, Treasurys disregarded surging inflation with yields trading down to 2.58% on August 1st. Markets interpreted Powell’s July 27th post-FOMC press conference as leaning dovish, confirming the market’s view of a Fed poised to quickly throw in the towel on hawkish policy at the first indication of trouble.

And importantly, China’s bubble deflation was gaining significant momentum as a movement to boycott mortgage payments for unfinished apartments stirred systemic worries. The spectacular Chinese developer bond collapse accelerated. Anticipating waning global inflationary pressures along with a less hawkish Fed, markets rallied forcefully, and that’s stocks, Treasurys, and corporate credit. Risk indicators pointed to a significant loosening of financial conditions.

For example, after beginning the quarter at 580 basis points, US high yield credit default swap prices were down to a four-month low of 421 basis points on August 12th. Investment grade corporate debt issuance continued to boom. Understandably, the Fed was uncomfortable with a loosening of market financial conditions that would counter its inflation fight. Powell delivered a short and to-the-point Jackson Hole message. The hawkish Federal Reserve’s singular priority was to aggressively rein in inflation. That ended the market rally. 

There has been scant attention by strategists and pundits to a key point. The Fed had, for years, ignored an increasingly speculative marketplace, and it was now coming home to roost. Markets had come to be dominated by speculation, the lever speculating community, but also institutions and the general public. In particular, options trading had mushroomed to become a major force throughout the markets. Hedging downside risk in the derivative markets is now ubiquitous, while trend following and performance chasing flows, they completely overwhelm traditional investing.

Market behavior had shifted, market structure had fundamentally changed, and speculative markets had, over the years, become only more convinced that any Fed hawkishness would dissolve at the first indication of market stress. We titled today’s call “Prelude to an Accident.” I believe the market’s rally and the resulting loosening of financial conditions had a profound effect on Fed thinking and communication strategy. 

I’m not alone with the view that the Fed will raise rates until something breaks. The rapid reemergence of market excess forced the Fed to get much tougher, and toughness risks breaking things. Not only would rates have to go higher, it became necessary for Fed officials to adopt a hawkish public persona. They now appreciate the imperative of avoiding any wavering, especially when it would be interpreted as the Fed surrendering to tottering markets. Markets were pricing in an early end to tightening and an inevitable reversal to looser monetary policy. This was pulling longer-term Treasury yields lower, and such negative real yields were working to sustain robust system credit growth.

Data from the Fed’s Q2 Z1 report underscore this analysis. Total non-financial debt expanded at a seasonally adjusted and annualized 4.3 trillion pace, with exceptionally strong first half credit growth second only to 2020’s onslaught. Household mortgage debt grew at an 8.8% pace, the strongest since 2006. And one had to go all the way back to 2001 for a period where consumer credit expanded faster than Q2’s 8.5% rate. And while there had been some corporate bond market tightening, lending businesses were absolutely booming. Bank loans expanded at a blistering 17.3% rate during Q2, with loans up 1.3 trillion, or 10.5%, over the past year. Only halfway through the year, 2022 loan growth had already exceeded 2005’s annual record.

So the Fed faced a major predicament. Expectations for persistently strong inflation were crystallizing throughout the economy, and booming credit growth was providing additional inflationary firepower. What’s more, rallying markets were further loosening conditions. Already flimsy Fed credibility was on the line. The Fed really had only one choice, and that was to play hardball. Officials united around a hawkish narrative, recognizing that any hint of a loss of nerve risked reversing nascent headway in its inflation battle.

In other words, the Fed had to decisively push back against the view that it would quickly reverse course to bolster floundering markets. Officials were compelled to strike directly at market confidence in the so-called Fed put. And the newfound ambiguity associated with the Fed’s liquidity backstop had a major impact on market pricing and trading dynamics, and that’s at home and abroad. This point needs to be underscored.

The return risk-on speculation and the resulting loosening of financial conditions forced the Fed to prioritize its inflation fight as it backed away from its decades-long market focus. This had major ramifications for market pricing and structure that had been distorted by years of loose money, Fed market interventions, and liquidity backstops.

What we witnessed in the second half of the quarter was the beginning of what we expect will prove a highly destabilizing market adjustment period. This adjustment process quickly gathered steam in the Treasury market. 10-year yields traded at 3.95% on September 27th, up 130 basis points from early August lows. After beginning August at 2.87%, two-year Treasury yield spiked 141 basis points to end the quarter at 4.28%.

The so-called risk-free Treasury market is the foundation of asset valuation throughout the markets and real economy, including being the anchor for corporate and international yields. As one would expect, the unleashing of downside price adjustment in Treasurys reverberated throughout US and global asset markets. US and global equities reversed sharply lower, giving back more than the rally. The MBS marketplace suffered through a difficult deleveraging. Benchmark MBS yields surged 129 basis points during Q3 to 5.68%, the high since 2008. US conventional 30-year mortgage rates rose to 7.17% last week, also the high since ’08.

In some respects, the mortgage marketplace is the epicenter of fixed income derivatives trading. The surge in Treasury yields spurred major hedging-related selling in the MBS marketplace, much of it sales of Treasurys and related instruments. Selling that led to higher yields, extended MBS duration, and only more intensive hedging-related selling.

There’s also significant leveraged speculation throughout the mortgage complex, so deleveraging also has been consequential. Market liquidity concerns returned, including for Treasurys. And while on the subject of liquidity, another very important dynamic was in play during the quarter. A hawkish Fed and surging market yields helped spur an upside dislocation in the dollar. This exacerbated emerging market currency and bond market weakness, intensifying de-risking/deleveraging, and hot money exodus.

To support their faltering currencies, EM banks liquidated Treasurys and other international reserve assets. This placed only greater pressure on Treasurys and global bond markets. My thesis has been that there are enormous amounts of global leveraged speculation, especially in higher yielding emerging market bonds. Key EM bond yields surge to multi-year highs during the quarter, while currencies came under intense pressure. Currencies in Hungary, South Africa, Russia, Turkey, Columbia, Poland, and South Korea all lost around 10%. 

Over the past decade, EM central banks accumulated sizable international reserve holdings. While these reserves have been vital in thwarting acute crisis, EM central banks have been burning through their reserves. China’s international reserves are down 220 billion so far this year, to a more than five-year low. And while China’s 3 trillion reserve hoard remains formidable, it is 1 trillion below its 2014 peak. China’s currency dropped 5.9% during Q3, trading to the weakest level since 2008.

David McAlvany: Doug, with the renminbi down more than 11%, right at 11% year to date versus the dollar, is the Chinese currency telling us something important here?

Doug Noland: I think it is, David, and that’s a good point. To me, the currency drop, it highlights what was really an ominous Q3 and an ominous 2022 so far for China. During the quarter, Beijing aggressively ratcheted up fiscal and monetary support for the economy. Various measures were implemented to bolster slumping housing markets. Importantly, however, the efficacy of Beijing stimulus has dissipated.

Even after the most onerous COVID zero lockdowns were lifted, China’s economy struggled to regain self-sustaining momentum. And importantly, consumer sentiment remained depressed despite Beijing’s efforts, and apartment buyer sentiment collapsed, perhaps beyond repair. 

The spectacular Chinese developer crash gained momentum. After beginning the year at 6.6%, Country Garden—and that’s China’s largest developer—saw its bond yields almost double during the quarter to trade above 50%. Many bonds, including Evergrande, traded with yields above 100%. Vanke, considered the only financially rock-solid top developer, saw its yield spike above 10% after beginning the year at 3%. 

Indicative of heightened systemic issues, China’s big-four bank credit default swap prices surged to multi-year highs. And after beginning the year at 40 basis points, China’s sovereign CDS ended the quarter at more than a five-year-high 110 basis points, and traded this week to 138 basis points. 

I won’t delve into the detail, but Chinese credit expanded almost 1 trillion during the quarter, and an astounding 4.7 trillion over the past year. I refer to perilous terminal phase excess: Systemic risk rises exponentially near the end of a cycle, fueled by a surge of credit of rapidly deteriorating quality. And I’ll say, China’s ongoing terminal phase is in a league of its own. China’s asset bubbles are deflating and its economy has weakened dramatically. Still, credit bubble excess runs unabated, only widening the gulf between credit and economic output. This is one historic accident in the making, and I’ll return to China in our geopolitical discussion.

On the subject of accidents, Japan—they may not quite be in China’s league, but it’s another major developing accident. With global inflation and bond yield spiking, most of your world central banks, understandably so, have adopted aggressive tightening measures. Not Japan. Not only has the Bank of Japan stuck with zero rates, it’s boosted bond purchases to maintain its 25 basis point ceiling on 10 year JGB yields. It’s off the rails, inflationist policy run completely amok. And the Japanese, they’ve been rewarded with 22% year to date currency devaluation to a level not seen since the dark bubble bursting days of 1990. Juggling a sinking currency and problematic yield control, Japanese policymakers, they’re at the cusp of a destabilizing crisis of confidence.

The euro is down about 12% year to date, trading during Q3 below parity to the dollar for the first time since 2002. The risk of a major accident in Europe has risen dramatically. The war in Ukraine has turned only more brutal and unpredictable. The Ukraine military successful counteroffensive was met by threats from Putin against Ukraine and the West, including the use of nuclear weapons. Putin has warned that he’s not bluffing, and US officials and governments around the world are taking Putin’s threats seriously. European bonds have been highly unstable after Italian yield spiked above 4% in June, and that’s despite zero rates and ongoing QE—the ECB’s so-called anti-fragmentation tool for purchasing periphery bonds in the event of a disorderly yield spike. Bond yields reverse sharply lower on the news, but then traded as high as 4.73% late in the quarter, and were as high as 4.89% just last Friday.

The ECB would prefer not to wield its anti-fragmentation tool. If they use it and it flops, they immediately face a very serious crisis of confidence. And what’s at stake, it’s nothing short of an existential threat to monetary integration in Europe and the survival of the euro currency. At the minimum, the unfolding periphery debt crisis risks financial, economics, social and political crises. 

The UK provided a deafening warning to the world of underlying fragilities and how abruptly crisis dynamics can be unleashed. After trading at an early August low of 1.8%, 10-year gilt yields hit four and a half percent late in the period, a wake up call to global policymakers.

The new UK government’s tax and spending plan sparked a disorderly six session, 137 basis point yield spike. A highly levered and derivative-centric UK pension system was at the brink. The Bank of England intervened with a new emergency bond purchase program. Think in terms of the official return of the bond market vigilantes. A disorderly bond market dislocation forced the abandonment of Truss’s mini-budget and a few days later, of Prime Minister Liz Truss. This accident reverberated around the globe. 

With worldwide de-risking and deleveraging in force, the era of seemingly endless bond demand has run its course. Two dominant sources of bond demand, central banks and levered speculation, they’ve turned sellers instead of buyers. New cycle dynamics are at play. With the supply of bonds for sale now overwhelming demand, yields have been spiking, and expect more markets to revolt against fiscal profligacy. 

And while attention has been focused on the UK gilts market and Italian yields, there are vulnerable over-levered economies around the globe. It’s worth noting the poor Q3 Asian currency performance, with the highly levered South Korean economy suffering 9.3% won devaluation. As a region, Asia has all the necessary characteristics for a market accident and financial and economic crises. 

While the Fed has displayed determination to hold the line, I’m skeptical they’ll have the resolve to dismiss unfolding global crisis dynamics. And last week, there appeared to be a subtle change in tone from the likes of Fed presidents Bullard and Evans, Daly and Kashkari, seemingly to lay the groundwork for a Fed shift to a more measured tightening approach.

The Fed today walks a perilous tightrope. There are heightened concerns for global crisis dynamics and faltering marketplace liquidity. While inflation remains a major problem, the Fed surely wants to avoid unleashing a big market rally. In such a speculative market dominated by derivatives, hedging programs, and trend-following trading, it wouldn’t take much of a Fed pivot to spark disorderly speculation. 

But buoyant markets wouldn’t resolve our system’s deep structural maladjustment. Not even close. I know there’s a popular perception that the US is largely immune to global instability, but the harsh reality is that we have led the world in speculative excess. For years, we’ve feasted on ultra-loose finance. The resulting market structure is acutely vulnerable to risk aversion and deleveraging. Our bubble economy structure, it’s susceptible to tightening credit and liquidity conditions. No country has our faith that central bankers have everything under control. 

The problem today is that the Fed understands the gravity of our inflation problem. Our central bankers recognize that financial conditions must tighten. Credit growth must slow to ensure pricing pressures and inflationary psychology that they don’t spiral out of control. And this is a major issue for an entire financial structure that has for years been underpinned by the perception that the Fed will do whatever it takes to support the markets and grow the economy, that rate cuts and open-ended QE will be employed as necessary to thwart crisis dynamics.

But I do believe crisis dynamics have attained important momentum globally that will not be easily reversed. Moreover, in no way will the US be immune. Analytically, there are interrelated bubbles internationally that essentially create one monumental bubble. The singular bubble view, it’s based on interconnectedness and commonality, similar structure and policy and economic structures. There have been similar policy regimes. The entire world adopted Federal Reserve inflationist doctrine, low rates, QE, and market interventions and backstops that work to propel rapid debt growth everywhere. 

Market structures are often identical. In particular, derivatives, swaps markets, leverage, and speculation. The entire world readily adopted market-based Wall Street finance, and faith in whatever-it-takes central banking became deeply embedded in market perceptions and prices globally, stoking speculative excess everywhere. There is, today, unprecedented interconnectedness between global markets, trading systems, derivative platforms, swaps trading, and the leverage speculating community in particular, and international mutual fund complexes. Importantly, over a most protracted global boom, international finance essentially became one fungible, commonly shared pool of liquidity, dominated by trend following and levered speculative finance.

When I contemplate accidents, my fears turn to the global markets seizing up scenario, where dislocation in one market quickly reverberates around the globe. Market structure creates vulnerability for de-risking/deleveraging in one market to quickly transmit to other fragile markets—the proverbial dominoes—losses, illiquidity, and dislocation sparking fear and contagion across markets. I will reiterate analysis that is particularly pertinent. Contemporary finance retains strong tailwinds so long as financial conditions are loose and credit growth remains robust. Market-based finance functions wonderfully so long as interest rates are relatively low, credit spreads remain narrow, and the price for market protection stays relatively inexpensive.

Importantly, low Treasury yields in the past worked to bolster system resilience, even during recurring periods of widening credit spreads and rising credit default swap prices. The current environment is different. Treasury yields have been spiking, while spreads widen and market protection costs surge. This places tremendous pressure on market structure. The hedging of interest rate risk can overwhelm the marketplace—hedging-related selling of Treasurys, MBS, and corporate debt, but also selling associated with hedges for fixed income generally. There are too many sellers and not enough willing and able buyers.

David McAlvany: Sounds like a trifecta. One of those factors that you just mentioned is worrying, but not necessarily problematic. Two would be more worrying, but not necessarily dangerous. But with all three combined, not all that common, but when they’re there, you’re in trouble.

Doug Noland: That’s a very good way to think of it, David. Very important perspective there. I’ve seen similar situations a few times during my career. 1994 and ’98 come quickly to mind. With Treasury yields collapsing, 2008, that was a different dynamic. 2020 was noteworthy for intensity leveraging and Treasury market illiquidity, even in the face of collapsing Treasury yields. The GSEs provided market liquidity backstops back in ’94 and ’98 while Fed QE bailed out the markets in 2008 and 2020. 

Market structure is approaching a major test. A market accident, a synchronized global accident, in particular, would spark unprecedented de-risking/deleveraging, requiring a massive coordinated response from the global central bank community. Yet there are, today, serious impediments. Inflation has surged globally causing newfound reluctance by the world’s central bankers to open the monetary floodgates. Moreover, central bankers surely today recognize what a monumental mistake it was to have unleashed trillions of liquidity during the pandemic.

I stated previously my view that the Fed will resort to additional QE, but I suspect their market crisis response will be atypically slow and cautious. I also expect the major central banks to struggle individually to reach consensus on the appropriate course of policy, hindering a major concerted global response. Central banks increasingly face their own domestic issues, priorities and political constraints. Individually and collectively, central banks are entering a period where their coveted independence is in jeopardy. The swashbuckling days of self-assured central bankers were an anomaly of the previous cycle. And in our discussion of accidents, we must at least briefly address today’s distressing geopolitical backdrop. Allow me to rehash bubble analysis, especially pertinent to highly elevated new-cycle geopolitical risks. Boom periods engender perceptions of an expanding global pie. Cooperation, integration, and alliances are viewed as mutually beneficial. But late in the cycle, perceptions begin to shift. Many see the pie stagnant or shrinking. Zero-sum game thinking dominates. Insecurity, animosity, disintegration, fraught alliances, and conflict take hold.

Unfortunately, these days I often feel I’m witnessing my worst fears come to fruition. No longer can we dismiss the possibility of a nuclear accident, and that could be with one of Ukraine’s nuclear facilities or even tactical and strategic weapons. There’s all the recent talk of dirty bombs. And no longer can we dismiss the possibility of China moving militarily against Taiwan, perhaps kicked off with trade embargoes and blockades. There can be no denying the risk that war in Ukraine could easily spiral out of control. Putin has become a cornered animal, while his partner without limits is turning increasingly unpredictable.

I found Xi’s speech to open China’s Communist Party National Congress distressing, and there were elements that recall passages from Putin’s past diatribes. These powerful dictators share a dangerous obsession, hell-bent on forging a New World Order to counter US global power and influence. China faces the most extreme domestic financial and economic issues, yet Xi’s focus remains geopolitical. Everything points to Xi pushing the banks and state apparatus to the limits to achieve the growth necessary to underpin China’s global superpower status. Meanwhile, if Xi and his loyalists fail to quickly rein in unparalleled growth and nonproductive credit, China is facing the risk of a currency crisis, and even financial collapse. Concern that an accident in China could set off a cascading global domino of accidents seems— these days, it grows by the week.

Chinese markets were hammered on alarming developments out of China’s National Congress. Stocks dropping, bank and sovereign CDS prices surging higher, developer bond prices sinking further. Country Garden yields have spiked to 96%. At the minimum, we’ve entered a more dangerous phase of the unfolding Cold War, the new iron curtain. China will be moving aggressively toward self-sufficiency, certainly in the areas of semiconductors and high technology. There will be escalating tit-for-tat retaliatory trade measures. After the Fed’s recent restriction on some high-tech exports to China, Beijing will surely seek impactful retaliation. Shifting back to the US, I believe Q3 instability was also a prelude to accidents at home. I worry about our maladjusted economic structure and it’s vulnerability to a slowdown in credit growth.

There are just too many negative cash flow uneconomic enterprises that proliferated during the long period of loose finance. So far, booming bank and non-bank lending has supported this economic structure, but I believe a difficult adjustment is unavoidable. This will unfold over time. I worry about inflated US housing markets. In some ways, excesses surpassed the bubble period that culminated with the 2008 crisis. In particular, high-end markets in California and throughout the country are more vulnerable today than ever. With mortgage rates at 7% and even higher for the larger mortgages, I expect affordability issues will force significant downside price adjustment. I fear we will see some crazy speculative excesses come home to roost. My sense is that the housing bust has commenced, though this process also takes some time. 

Market derivative-related accidents don’t take much time. I really worry about the proliferation of derivative trading, and that’s for hedging purposes and certainly speculation. I recall the Black Monday 1987 stock market crash and how so-called portfolio insurance played a meaningful role in the avalanche of sell orders that crashed the market. I later watched as derivatives were instrumental in market crises in 1994, ’95, ’97, ’98, 2000, 2008, 2011, and 2020. And with each central bank market bailout, the monstrous derivatives bubble inflated to even more dangerous extremes. Everything is in place for one historic financial accident, and we witnessed just a few weeks back in the UK how the interplay of speculative leverage and derivatives can quickly spark panic de-risking/deleveraging, illiquidity, and collapse.

This shockwave immediately reverberated globally, including to our bond market. While Bank of England rescue operations and a new prime minister have calmed markets, fragilities were exposed. Memories from March 2020 remain fresh. A serious de-risking/deleveraging episode required repeated announcements of ever-larger QE programs to reverse market collapse. I believe the scope of excess and speculative leverage and derivatives now exceeds 2020, and I don’t expect the Fed will again be so footloose with trillions of QE. These days, so much market risk—and that’s across global markets—has been offloaded to the derivatives complex. And the sellers of market protection use sophisticated trading programs, buying and selling instruments in the marketplace to have positions in place that will provide the necessary cash flow to pay on the derivatives they wrote. In particular, when derivative dealers write market protection, the strategy dictates that they turn aggressive sellers into a declining market. This creates a clear and present danger of cascading sell orders and market accidents. 

Again last week, we saw extraordinary volatility, in this case, a 4.6% rally in the S&P 500 into option expiration. While smaller than recent three and a half trillion dollar quarterly expirations, October’s expiration was said to amount to 2 trillion of notional contract value. The size of contemporary derivatives markets is unfathomable. Derivatives are clearly a major factor in wild instability that has engulfed global markets, and that’s equities, sovereign debt, currencies, fixed income, and commodities. We have been witnessing a degree of market disorder that in the past was prelude to accidents. 

Today’s predicament has been building for a long time. Central banks have repeatedly rescued faltering markets, ensuring they inflated only more precariously. The world has now entered a new cycle of inflation, financial and economic fragility, deflating bubbles, fragmentation, and acute geopolitical instability. The answer to this distressing confluence of issues will not be found in more central bank monetary inflation.

Most unfortunately, crises of confidence and an onerous adjustment period are unavoidable. I’ll end with the same words that concluded my Q2 formal presentation. I sincerely hope my analysis proves way too pessimistic. David, back to you.

David McAlvany: Thank you, Doug. And again, just a special thanks for our account holders. We consider it a privilege to be working with you. If you’ve listened to these quarterly calls and have been intrigued by the service, I would encourage you to inquire. I would encourage you to take action. We are in the context of a bear market. We’re now in the short term in the context of a counter trend rally. My view is that we’ve been through the first phase of a significant decline and have at least two more phases ahead of us in terms of a compression in value in the equities markets. So for existing account holders, we’ve had a number ask, should we be adding to our existing short position with Tactical Short? And I would say, proportional to the market hedge that you need or desire, yes. And as we’re in the context of a counter trend rally, this is an excellent time to get that started.

But as we look ahead, for those of you who, again, may have considered this service and have not taken action, call. Talk to me, talk to Doug, and we’ll begin the process. A management agreement is the first thing that we need, followed by the account opening with interactive brokers. You’ll find our minimums to be very approachable, $100,000, and our fees to be incredibly reasonable for the work that goes into this service, 1%. There are no performance fees as we noted earlier. There are no lock ups. You have complete transparency through interactive brokers, the custodian of the accounts, and we invite that conversation. I would just encourage you to do that sooner than later. It’s an excellent time in the marketplace to be putting those details together, taking care of logistics and being in place for phase two and phase three of a significant market decline. 

Doug, I’m going to start with the first question to you, which is, “How serious do you see the problem where liquidity is evaporating for US Treasurys? It seems Janet Yellen indicated that this is being watched and is of concern. I suppose this is especially true after the gilt meltdown in Britain. Of course, I suppose the Fed can always be a buyer of last resort.”

Doug Noland: Yeah. These liquidity issues, they’re quite serious. It’s very serious. And I focused on liquidity in my presentation because I believe it will be a major ongoing challenge in this unfolding new cycle. 

I mentioned that two key sources of buying, central banks and the levered speculators, they’ve turned sellers. And this is a sea change for markets that, for a while now, essentially operated under the assumption of unlimited demand for Treasurys. The Fed and central banks, they would predictably slash rates to zero, or even negative, and they would purchase trillions of bonds to ensure abundant liquidity. And this had profound effects on market behavior and structure. Importantly, it incentivized leveraged speculation. It also reduced the cost of market protection, and the inexpensive cost of market insurance promoted speculative access. And I think it’s important to recognize that this backdrop essentially created unlimited demand, unlimited buying of Treasury and fixed income securities.

And I’m not familiar with anything comparable in history. I know there’s nothing comparable in history. And this unlimited demand dynamic completely distorted pricing dynamics. Basically, the supply of new debt instruments no longer impacted market yields. Governments, they would borrow like crazy, the private sector would borrow like crazy, yet the price of credit was held artificially low. And this dynamic, the cost of finance completely divorced from the forces of supply and demand, this was key to the massive credit growth that fueled financial asset and economic bubbles. But as I keep repeating, this is a new cycle. We’re in a new cycle where consumer price inflation is a serious problem. Central bankers can no longer keep rates at zero and print trillions without worrying about inflation spiraling out of control. They now worry about their credibility, their independence. And this new backdrop, it has profoundly impacted both the risk and reward of leveraged speculation.

So we’re now in a new cycle where demand for bonds is anything but unlimited. As the UK situation witnessed just a couple weeks back, if governments want to run larger fiscal deficits, they’ll know now, they’re going to have to pay up now. Markets, they could protest, and as gilt yield spiked higher, this sparked major pension funding leveraging, markets quickly turned illiquid and required central bank support. 

I believe the UK situation, it provides a model of new cycle liquidity risks that will unfold globally, certainly including here, here at home. Market illiquidity, it will be a major risk at least until a lot of this leverage has been wrung out of the system. And as I said earlier, the UK crisis, it’s a wake up call. It surely alarmed Yellen, the administration, and Fed officials. So thank you for the excellent question.

David McAlvany: Doug, in your comments you mentioned new cycle dynamics at play dealing with the supply of bonds now overwhelming demand, and it really is a fascinating contrast. For instance, with precious metals, you’ve got demand overwhelming supply, and we’ll get to that in a minute, as opposed to the opposite in the world of sovereign debt where supply is now overwhelming demand. Probably not an accident that those two things are happening simultaneously. 

The next question I’ll take. It says, “I’ve been very reassured by your explanation of the strong dollar being responsible for the drop in the price of gold in the US. Can you explain exactly what method or metric is used in pegging the value of the dollar?” 

I’m assuming that the first comment is connected to the second part, the query. 

So I would describe the dollar-gold movement as a trading dynamic. On the one hand you’ve got a trading dynamic. On the other hand you’ve got a clear look through to currency stability. I’ll get to that in a minute. But this trading dynamic can be consistent for long periods of time, but is not axiomatic. This year, year to date, the dollar’s traded higher, gold has traded lower. So it looks like this clear and clean inverse relationship, and it has held constant thus far, but it’s not always that way. So a counterexample would be in the late ’70s when the dollar put in lows, started moving higher, and as the dollar recovered and was moving higher, gold moved higher as well. In fact, more than doubling in price in the context of an appreciating US dollar. So a strong dollar does not automatically force gold lower, but what you typically will find is that gold traders can take a strong dollar as a cue and either sell gold on a sort of knee jerk basis, a reaction to it, sell gold or sell it short, pressuring the price.

I see a scenario where global financial market fragilities, coupled with counterparty concerns, the kind of counterparty concerns that we saw in the 2008 and 2009 timeframe, drive investor traffic into US dollars and into gold. I can in my mind imagine a scenario where, again, we’ve got greater global stress that benefits the US dollar, but also, again, those counterparty concerns drive a significant traffic into the gold market as well, and the price higher. 

So I mentioned, so outside of the trading dynamics where traders are reacting to market inputs and triggering short term trading trends elsewhere, there is that reality of currency appreciation or depreciation. When it’s significant it becomes more obvious, and you’ve got real assets that reflect that kind of mathematical translation, different quantity of currency units now required in exchange. And I think that’s what we saw so far this year with yen/gold and Turkish lira/gold, where if you look at the performance of gold in those currencies, it’s very healthy, double digit, positive gains.

And I don’t know the statistics off the top of my head, I can’t speak to Japanese demand dynamics for metals here in 2022. But with the currency in free-fall all year due to their yield control, curve control dynamic, that those policies, that curve control policies, gold has reflected the weakness. And so a Japanese investor has maintained purchasing power. At the beginning of the year, the per-ounce price for gold was roughly 200,000 yen, and now it’s 251,000 yen. So in the neighborhood of 24, 25% gains in yen terms. So again, on the one hand you’ve got the trading dynamics, on the other hand you’ve got that clear look-through to currency stability or instability.

Doug, the next question is US based. This is the orientation from a US perspective and in the US context, “Does Modern Monetary Theory provide an extension to traditional economic cycles or is the current political administration doing everything they can to prevent a recession—or the optics of a recession, since, technically, we’re in one?”

Doug Noland: Sure. I’ll start by stating that the combination of MMT thinking and ballooning central bank balance sheets, I mean that was one perilous combination. History will not be kind. My baseline is that we can always count on politicians to spend as much as they can get away with. And for years now, they’ve obviously gotten away with murder when it comes to reckless deficit spending. But now with yield spiking, we’re hearing a lot less about MMT. And while we’re early in the process, I think the bond market is going to put a lot of pressure on spendthrift Washington, finally, belatedly.

It’s hard to believe it’s been 30 years since Bill Clinton’s strategist James Carville quipped that if he’s reincarnated he wants to come back not as a baseball player but as the bond market because the bond market can intimidate everybody. So in the unfolding new cycle, I expect the bond market to return to its traditional intimidating ways. There will surely be fiscal spending programs to try to counter economic downturns, but I suspect we’re going to have a skeptical bond market watching over the purse strings in Washington now. I suspect the free spending days are likely behind us, and I’m hoping MMT has been at least somewhat discredited. I don’t think the proponents will be out hawking too strongly with inflation remaining elevated, but only time will tell. And thank you for your question.

David McAlvany: Next question, “I’m 37 years old, and in one of the recent McAlvany podcasts it was mentioned the US hasn’t seen true real inflation in 40 years. If that’s true, what type of realistic inflation can we expect to see over the next 40-ish years?”

Well, to be specific, we have seen inflation, but for most of the last four decades we have not seen a decline in living standards as a result. And I have a theory on that. We have had inflationist monetary policies, and to look at incomes adjusted for inflation, you can see a truly discouraging trend, compliments of the monetary and fiscal policy makers. And we will continue to see a degree of inflation baked into the cake as comparable fiscal policy steps are taken, and sort of backfill if there is any gaps created from monetary policy conservatism, if you can imagine such a thing.

I think politicians, as Doug pointed out, you can expect them to spend as much as they’re allowed to, even if they don’t have it to spend in the form of deficit spending. So if you look back at the last 40 years, the offset to those inflationary pressures, I would argue, has come through post-Cold War labor arbitrage, which redirected manufacturing overseas to take advantage of cheap labor. We increased our imports relative to exports, and with cheap transportation to get that stuff over to us, and much cheaper prices possible given the collapse in labor costs associated with those finished goods, the consumer benefits. And the consumer was able to navigate a moderately improved living standard in spite of stagnant real wages or declining real wages. So I think we’re now in the process of removing that inflationary offset, again from cheap imported goods, taking advantage of cheap wages, and we’ll see consistently elevated levels of inflation well above the Fed’s target of 2%.

So the next 40 years, it’s a long time to speculate about. I think we could argue, at least for now, that a deterioration in global trade and an increase in on-shoring of production will complement the policy decisions. Again, we’re talking monetary policy, fiscal policy decisions, and just reinforce an upward inflationary bias for years, if not decades, to come. What does that look like exactly? 6, 8, 10% years I think will be interspersed with 2 and 4 and 6% years. So if the average inflation rate over the past 30 years has been officially counted at roughly 2.25%, I wouldn’t be surprised by a multi-decade average of 4, 4.5% per year. In answer to your question.

Doug, there’s a question that came in online, I’d be interested if you want to take a stab at this one. “If the Fed, after its expected rate increase, holds at that rate for a prolonged period of time, do you see any dynamics which would allow energy to continue to be in a counter-trend compared to the broader market as it has performed currently? If so, what kind of a time horizon would you guess before it followed suit?”

Doug Noland: So David, it’s mainly focused on energy prices, is that the gist of the question?

David McAlvany: Yeah, exactly. So we keep interest rates high for prolonged period of time, and does energy somehow diverge from the rest of the market if the market is in fact pressured by those higher rates?

Doug Noland: Sure. Yeah, and I know, David, I know you have views on this too. My view is it absolutely could. There are a lot of factors here that, going forward, that will determine energy relative price performance outside of the fed funds rate. The dollar for example, if we see a significant dollar reversal, that is a very positive influence on energy prices, precious metals, commodity prices. Generally, there’s serious geopolitical risks that could have a major impact on energy prices. Global demand is uncertain. We’ll have to follow European, Asian, global growth dynamics, certainly Chinese growth dynamics. But there are a lot of factors out there that we think over the long-term could support energy prices. And I’ll leave it up to you to speak intelligently on this subject.

David McAlvany: No, I think point one, you’re exactly right. The US dollar reversal is very supportive to that sort of differentiating factor, and I think we’ve also seen the will of OPEC and OPEC+ expressed. $90 plus is a target they’d like to maintain. And like any governmental organization, if you look behind the screens of OPEC and the energy conglomerate that it represents, you get governments that say, “We have to be able to pay our bills.” These are our resource-rich countries, but also poor in terms of revenue streams from other sources. So Biden most recently has said, “Yep, we’re interested in refilling the SPR at 70.” So you’ve got one party that wants 70 and lower, you’ve got another party that needs 90 and higher, and the folks that need 90 and higher are the folks that control the tab. So this is the kind of dynamic where you say, “Okay, in spite of broad market pressures, you may still see higher oil prices.” And that something supportive of the energy space within the equities markets. So I think it could very well diverge.

Next question, “Curious for other opinions on the paper market prices of gold and silver versus physical. Out of stock, huge premium with premiums with gold and silver. When and how do you think paper markets will capitulate?” 

This is fun. We track the COT reports weekly because knowing how players are positioned in the paper market is important. We want to know where pressure’s building, and when sentiment is at extremes, and who is coming and going from the marketplace. And these are indicators that when we take them with our real time anecdotal exposure to the physical markets, because bear in mind our sister company is in its 50th year as a precious metals brokerage and consultation firm. So lots of anecdote in terms of the physical metals trade there. I think combining those gives us a better sense for present and future pricing dynamics.

There’s a misconception in the tail end of that question, in the capitulation of the paper markets. There’s a popular belief that we get to some sort of a threshold event, and then all of a sudden we begin to see a skyrocketing of price. Paper markets don’t ever have to capitulate, and this is a small point, but a very important one. All trades can be settled in cash. All product pressure can be alleviated at a moment’s notice from the head of the exchange. Full stop. So waiting for there to be this awkward moment where you run out of gold or silver and then all of a sudden the price spikes. The nature of the future’s market is they do not have to be settled in kind. They can arbitrarily, at the whim of the head of the exchange, be settled in cash. Product pressure alleviated instantly. So I think it’s just worth noting.

Individual players. Now this is comes back to the COT reports. You do have individual players, however, that capitulate. Which is why the COTs are fun to watch. I mean it’s a little bit like watching a high stakes Vegas poker hand. I don’t do this often, but when I have, you kind of see the mature player. Occasionally you’ll see someone who’s kind of the patsy, and sometimes it’s even worth looking and saying, “All right, I’m measuring the pile of chips here, and I know who has the power to bully a hand to the point of folding.” And there is a degree of that in the COT reports as well. Today we have commercials that are growing bullish, and we’ve got speculators that are growing bearish. It’s a pretty positive trend because commercials have the bigger pile of chips. So how they play is a much stronger determinant of price movement.

There’s other categories. You’ve got the quiet accumulators in recent quarters, which have been in the literal “Other” category as it’s listed in the COTs. This is your family offices, pension funds, insurance companies, and whatnot. And they don’t trade in and out as much as they do build positions on the basis of a larger- and longer-term investment thesis. So when they begin to accumulate, it’s worth taking note of because it’s not a “buy today, sell tomorrow,” it’s a “buy today and hold a bit longer.” So yeah, there’s some dynamics there that are interesting. 

Today, silver contracts in the commercial category suggest a buying opportunity on par with the three best we’ve seen in the past two decades. So very, very compelling. Gold futures are not quite as compelling yet, but could match the ’99, 2015, and 2018 levels by year-end if these trends continue on. Again, looking at the commercial net holdings. 

So, now to premiums as a part of that question: Premiums on product indicate a strong retail demand, but they are telling you about a particular kind of retail demand as well. So are precious metals a trade, or are they investments? Are they a part of accumulated wealth, or are they merely a short-term opportunity? And how you answer those questions defines the products that you prefer. So short-termers are your ETF folks or those with a strong liquidity preference. That can also be a reason to hold ETFs. On the other hand, building a pillar of wealth in the form of physical ounces, that’s a longer-term objective than buying today to sell tomorrow.

So just to illustrate the contrast, looking at the ETF holdings, you get silver ETFs which have dumped close to 12.5% of their holdings from April to the present. So you’ve got an investor base, a “retail demand” exiting the space, 12.5% of holdings from April to the present have left. That’s in stark contrast with premiums on bullion coins and bars, which have increased due high demand and limited supply. And we’re talking, in some instances, premiums of 30 to 50% over the spot price. And I would just remind you, here’s at least one argument for owning physical metals because there’s arbitrage opportunities as a result. I illustrated this for our clients who visited us here in Durango a few weeks ago, talking about silver eagles and bags of junk silver. Let’s say you’ve got those old bags, a $1,000 face value of dimes or quarters or 50-cent pieces.

If you’ve got 10,000 ounces worth of old bags, you should, as I did, convert those to large bars and capture the premium in new ounces. In that illustration, we’re talking about 3,000 free silver ounces. On Eagles it would be closer to a 50% gain in ounces. That’s worth a call to folks at our sister company. But again, do you see the difference? Do you see the difference between a liquidation dynamic because of short term trends? 

And that’s actually pretty consistent when you look at the COT reports, the kind of players who are exiting the futures market in both silver and gold tend to be shorter-term in nature, kind of hot money, flow type people, hedge funds and short-term traders. Gold ETFs, just like your silver ETFs, saw— A little bit different. They saw an increase in ounces by over 10% in the first quarter. So, accumulation, accumulation. And a lot of those ounces that were bought in the first quarter of this year have been sold back into the market. And yet we still have gold premiums on a lot of physical metals probably twice what they typically are, not impacted at all by the liquidations from the ETFs.

The ETF fade in interest, in both cases, gold and silver, appears to me to be investors, whether it’s buying the Fed pivot argument or assuming that inflation’s going to be tamed, or the bull dynamics and equities market are going to be reignited on whatever basis. And so you exit the metals position thereby. 

Great question. There’s just different dynamics depending on the kind of buying you’re talking about. And some of those premiums should be taken advantage of. 

Anyways, next question is with currency volatility. This one’s for you, Doug. “What effect does currency volatility have on the leveraged speculative community?”

Doug Noland: Okay, David. This is such an important— and it’s a complex issue. To be highly levered, a speculator has to remain comfortable that they understand that they can gauge the risk versus reward calculus of their positions. In simple terms, what are the rewards if I’m right? How much could I lose if things go wrong?

As I’ve been discussing, central banks created this extraordinary backdrop where markets came to believe that central banks were willing and able to control marketplace liquidity, that things wouldn’t go wrong. And so long as global markets enjoyed the liquidity abundance, there was limited risk of big losses associated with abrupt moves and market discontinuity, certainly including in the currency markets.

This backdrop, it incentivized leverage, especially in higher-yielding instruments. And these are these so-called carry trades, and they proliferated globally. This is where leveraged speculators, they could borrow at zero or even at negative rates in the US, Europe, or Japan, and purchase much higher-yielding emerging market bonds, say, in Brazil or Hungary, Turkey. There’s a list of them.

This was a huge moneymaker for the leveraged speculating community. But the environment, it’s changed. Inflation forced central bankers to tighten policies. And for the most part, they’ve ended QE. The market liquidity backdrop, it’s shifted dramatically.

Losses have forced the leveraged players to pare back on carry-trade leverage, which unleashed currency instability and market illiquidity that is forcing only more destabilizing, de-risking, and de-leveraging. It’s kind of a snowball effect.

And this has turned currency markets wildly unstable. And importantly, individual central banks, they can’t ensure currency stability, especially in this environment. So this makes it too risky to remain highly levered.

Volatility also increases the cost of market protection in the derivatives marketplace. And the derivatives complex operates under the assumptions of liquid and continuous markets. And currency volatility and resulting speculative de-leveraging significantly increases the risk of market illiquidity and discontinuity. And this has resulted in much higher costs for market protection.

And these factors, they’re having a profound impact on the amount of speculation and leverage throughout global markets. And anytime you get de-risking/de-leveraging, then you have liquidity issues, and we’re certainly starting to see those. Thank you for the question.

David McAlvany: So in the end, what it changes with that volatility is that risk-reward calculus. You just don’t have as much that can be done with the generous rewards on offer.

Doug Noland: Exactly.

David McAlvany: The next question. Various economic experts and geopolitical sources are strongly indicating that when Saudi Arabia joins the BRICS system, they’re going to repudiate the petrodollar agreement, at which point the petrodollar system will come crashing down.

The dollar will then immediately plunge into collapse. Coupled to this abysmal collapse is the operational Sandman agreement, which by compact allows the non-G7 nations of the world to formally repudiate the dollar for all economic transaction purposes. This nuclear-level devastation is not easily accepted, but there’s significant logic behind it. Does MWM have any thoughts about this subject or preemptive preparations along these lines?”

A big question. Let me give you the perspective on the dollar first. Obviously, the petrodollar has been key to US dollar stability and the maintenance of our position post-Bretton Woods of dominance in the world.

Trade dollar recycling has become equally important. It’s not just petrodollar recycling into the supporting of our Treasury market. But we’ve also seen what I mentioned earlier about labor arbitrage giving us the opportunity to import cheaper goods but then run significant trade deficits.

So on our side, it’s a trade deficit. On the other side of the pond, it’s a trade surplus. And those surpluses have, for years, been recycled into US dollar paper and US dollar assets.

So there is more to the story than just the petrodollar because that was one of the benefits to US dollar stability. Trade dollar recycling is also in the mix, too, so I wouldn’t want to leave that out.

I think the bottom line for the US dollar maintaining its current position and not being subject to this kind of immediate plunge or collapse is there is no alternative to the dollar. What other currency is more universally useful for trade, for currency pegs? For instance, 65 countries have chosen the dollar as a peg. 11 actually use the dollar as their currency.

And, of course, all these things can change if you’ve got the dollar that trades lower by 50% or 75%. But until then, you really don’t have any other better choices. The euro, if you go back to 1999 and 2000, there was a timeframe when I was aggressively buying euro-denominated German bonds. And there was a compelling case to be made for the euro replacing the dollar. And you could see that gaining traction in terms of reserve assets. The percentage of reserve assets with central banks, dollar assets, was diminishing. Euro assets were increasing. These were things that you could say, oh, okay, this is a trend. We see a replacement. Not anymore. Not anymore.

I used to argue with my dad about this as it related to the Chinese and the Chinese currency. And he would argue this is a new expression of capitalism. They’re probably doing a better job of opening markets and entertaining a libertarian free market environment than anyone in the world.

I said I don’t think so. We disagreed on, not the long-term success variables of the Chinese as a people, but really the direction of their currency. Can they replace the US dollar? They don’t have the depth. And to this point, we still have the largest military. Of course, those things can change, right? But for now, we get to enforce our position in terms of dominance.

I think something to illustrate just the importance of the US dollar comes from the activities of the last two weeks. The Swiss have been dealing with issues, I think, that relate somewhat to Credit Suisse and a major concern in terms of viability with that company, with that commercial bank.

But we’ve seen the swap lines open between the US and the Swiss National Bank. That’s opened up last week. And then they were in for another $11 billion this week. We’ve also seen swaps to the ECB. We’ve also seen US dollar swaps to Japan.

If you’re looking at the role that we play, we are this marginal source of liquidity. When liquidity is needed, where do they go? It’s the US dollar market. It’s the US Fed.

So I just would want to reposition this question a little bit to say, it’s not one decision that would be made by a group like Saudi that would unseat the US dollar. To be unseated, there still has to be someone else to take the throne. And it’s not clear who that is at this point.

To be honest, I’m not well-versed in the particular agreement, Sandman, which was suggested. I know that there was some talk about that last year. I suppose a trigger in October where this was going to happen, and it didn’t happen. I don’t know if that means that that’s just an idea that’s speculative in nature.

Maybe it’s in line with Jim Rickard’s idea of an Ice-9 scenario to describe a global liquidity freeze. But I think it’s also key to keep in mind, these are fictional names given to possible scenarios, not unreasonable to consider by any means. But there’s a difference between a possible scenario and a name that Jim gives it or someone else gives it and some sort of a formal agreement.

Anyways, I think both Doug and I would agree that the dollar has significant pressures ahead, but there’s very few currencies that don’t face those same pressures. So you’re still grading on a relative basis. It’s difficult still to see who emerges other than the US dollar as the world’s reserve currency.

Long-winded answer. My apologies. I just have one more question for me, and I think the rest are yours, Doug. So I’ll get this out of the way. And that way, I can just be quiet the rest of the time.

“Why is gold and silver going down with the markets?” I’ve answered this before with the Japanese, Chinese, Indian, European, British, if we want to capture an entire continent, South America. Basically, most of the world has had an experience in 2022 of gold being up, not down.

Priced in dollars, it’s down. And this is a year where we’ve seen the dollar appreciate more than any other in 20 years. Just bear that in mind. The global audience for gold sees positive 2022 performance. And so it’s just from this anomalous dollar move higher that we’ve got a negative print on gold. I wouldn’t let that discourage you.

Doug, “what was your rate of return during the last two months?” That’s the next question.

Doug Noland: Rate of return during the last two months? I thank our beloved Robert Draper for retrieving this data point for us. Tactical Short returned 6.99% for the two-month period, and that’s August 26th to October 26th.

And I’ll add, I jumped on Bloomberg and quickly found the returns from our competitor funds and the major bear index funds. And I’m pleased to report that Tactical Short outperformed the other funds for this period, both the actively managed and the index short fund. 6.99%.

David McAlvany: Great. “Stock market. Will it eventually fall?” That’s the next question.

Doug Noland: Will it eventually? I was assuming the question is how far I think the stock market might fall. So I’ll answer it that way because, obviously, we’ve already seen it start to fall.

I know this sounds extreme, but I expect the stock market to drop as much— It could be 70, 80% from all-time highs. This has been a historic speculative bubble. And there’ll be harsh consequences.

And I believe in the Austrian School of Economics, the premise that downside risks are proportional to the excesses of the preceding booms. So this is going to be, unfortunately, a very onerous adjustment period.

The market, from where we are today, would have to drop almost 40% just to trade to March 2020 lows. And I expect markets to fall significantly below those 2020 low levels. I don’t think it’s farfetched to see the S&P500 again trading at 1,000.

I expect this to be a most prolonged bear market. And how you can look at this, I assume corporate earnings will easily drop more than half, while market multiples will also drop as much as half. And that’s how you can get these enormous price adjustments.

And some of the high-flying stocks, including companies in the S&P500 index, they could lose 90% of their value. Many companies will disappear. It’s been a while since we’ve experienced a long and wrenching bear market. Price collapses can be brutal. Hopefully, this analysis is too bearish. Thank you for the question.

David McAlvany: It’s easy to dismiss those as significant numbers too large to fathom. And yet you can see massive volatility in individual companies, whether it’s Amazon, or— We’ve already had a number of companies like Facebook and Netflix which have traded off 60%.

For them to continue under general market pressures, maybe through no fault of their own, maybe because they do have poor earnings going forward, coming into the fourth quarter or first quarter of next year, the adjustments can continue. And that’s certainly what Charles Dow would’ve suggested.

First phase of a bull market is just correcting the excesses of enthusiasm. People thought that they could literally go to infinity. Right? And then all of a sudden there’s a sober moment where, well, I guess they can’t go to infinity. And that’s your first round of corrections.

Then you deal, if there is a slowing in the business cycle, with poor earnings and the correction that takes into account those earnings. And that is not even getting you to the kinds of dynamics which would take you to panic selling. That’s when psychology is broken.

We haven’t seen any panic selling. Not this year. This is a fascinating thing. Healthy correction. No panic selling. That’s the phase three, final bombing out of psychology.

“Will QT continue and wreck an equity portfolio, repricing in—“ Let me see if I’m reading this correctly. Yeah. “Will QT continue and wreck an equity portfolio? Will there be a repricing in 2023 after this valuation reset from 2022?”

Doug Noland: I expect the Fed in the not-too-distant future, they’ll have to curtail its balance sheet runoff. Maybe they’ll stop it altogether at some point. The so-called QT, quantitative tightening.

Liquidity stress in the markets, I expect it to become too much to bear. It wouldn’t surprise me if markets rally on such an announcement. But I don’t think QE is actually the biggest story here.

Markets have commenced a destabilizing period of de-risking/deleveraging. I keep talking about this. Rising yields and losses, they’re forcing the unwind of speculative leverage. We’re talking many trillions of dollars of speculative leverage globally. We don’t know the size. It could be tens of trillions. And this is the hedge funds, pension funds, institutions, Wall Street firms, along with individual investors. People are unwinding leverage.

I mentioned earlier how foreign central banks are selling reserves to help stabilize their currencies. So there are forces that are having major impacts on marketplace liquidity beyond just QT. I’d fear that 2022 is just the start of a process. This will unfold over years. And this is why I keep talking about this new cycle that’s unfolding.

There will, of course, be rallies along the way, but I don’t expect markets to mount the rapid recoveries we’ve seen in the past. I don’t see the Fed and global central bankers— They’re not in a position to open the monetary floodgates and reflate the markets this time around.

If I had to guess, I would expect another tough period for the markets in 2023. But I don’t think that far ahead. I just try to come in every day and do the best I can. The whole team, we all do the best we can to monitor developments and analyze the environment. 2023 is coming around quickly, but my focus right now is getting through 2022. Thank you for the question.

David McAlvany: The last question, Doug. I wasn’t sure if this was tongue-in-cheek. I’m going to let you just take it as you like. “How long should I stay short?”

Doug Noland: It reminds me; I used to always say long is wrong, but anyway. Okay. As I just mentioned, I expect a protracted bear market. As is the case with any good short, anytime you have a good short, the challenge is to try to stay short, so to fully capture the downside.

It’s common to trade around short positions, attempting to be opportunistic, and trying to take advantage of volatility; sell high, buy low. But this can prove quite a challenge in unstable markets. And not only are they unstable, they move abruptly, and they move to the downside really quickly. And I expect highly unstable markets to continue.

And as you mentioned, David, at the onset, we don’t encourage folks to place big downside market bets. At Tactical Short, we’re striving to provide a reliable, sound market hedge.

I expect to be short for a while, but we’ll also keep an open mind and respond to developments. Again, we come in each day, closely monitor the markets. We closely monitor policy, that’s so important, the economy, and global developments. There are just a lot of moving parts these days. For now, my bias is to remain focused on staying short. Thank you for the question.

David McAlvany: Well, Doug, as we wrap up, I just want to remind folks that if you’re interested in knowing what next steps are, getting a hold of the management agreement, you’re looking under the hood and seeing how we do what we do, what we promise to do for you.

And if we find agreement on that, then we get an account open and fund, and then Doug gets to work. So I wouldn’t delay if that’s a consideration for you. Have a conversation with someone here in our office.

And again, we can help facilitate that and take some of the ease of a normal account opening process. We can make that easy for you.

Thank you for joining us today. Doug, thanks for your thoughts and reflections as I started the commentary today or our discussion. Avail yourself of Doug’s curated newsfeed. It’s on a daily basis. This was a habit for me for 20 years. It’s how I got to know Doug is looking at his curated newsfeed. It saved me so much time every day.

And then, of course, you’ve got the end-of-week Credit Bubble Bulletin report. So if you want to stay up with what’s going on, I really do think that you’ve got a great ally and support in Doug Noland. Hopefully, the rest of our team can provide you with the services you need.

Thank you for joining us. Have a wonderful day. Doug, the final word.

Doug Noland: Yeah. Thanks so much, David. You’re a good man. Thanks, everyone, and good luck out there. We’ll talk to you next call, if not sooner.

FREQUENTLY ASKED QUESTIONS: 

What is the purpose of the Tactical Short Strategy?
The McAlvany Wealth Management (MWM) Tactical Short is designed to generate positive returns from downside volatility within the equities market.  The strategy is not intended to necessarily hedge an equity portfolio dollar for dollar, but will instead strive to opportunistically capture gains as particular stocks and/or sectors decline in value. The objective of our short offering is to provide a mechanism for reducing a client’s overall investment portfolio risk profile while providing downside protection during periods of market instability.

The Tactical Short is described as non-correlated instead of consistently negatively correlated.  Can you explain?
A constant negative correlation would imply always being positioned fully short, thereby reflecting the direct inverse returns of the asset mirrored.  Such approaches are indifferent to risk.  It is fundamental to our strategy to be selective and willing to wait for more favorable market conditions and compelling opportunities.  Our focus on risk versus reward metrics dictates that there will be periods when we will be minimally short.  Our decision-making process is driven by intensive analysis of a mosaic of indicators, from both “top down” and “bottom up” perspectives.  Depending on our analysis of the backdrop, we will have the flexibility to position either opportunistically or defensively – to expand short exposures in favorable backdrops or significantly reduce exposure to mitigate losses during highly unfavorable environments for shorting.  Positioning the strategy as “non-correlated” is consistent with the objective of avoiding the type of heavy losses suffered by negatively correlated funds during bullish periods.

Is this a fund with pooled assets, or will investors have separately managed accounts (SMA)?
We have chosen to structure the Tactical Short offering in separately managed accounts to allow for advantageous investor transparency, liquidity and, on occasion, some tailoring to better suit the needs of an institutional or individual investment mandate.

What kind of accounts can be opened?
While the Tactical Short offering was developed with the discerning institutional investor in mind, it may be appropriate for individual, trusts or corporate accounts.

Can I transfer a retirement account?
That’s not possible.  The nature of shorting requires that securities be borrowed prior to consummating a short sale.  Regulations mandate a margin account for such strategies, and margin accounts are prohibited for qualified plans (IRA’s and other retirement vehicles).

Is positioning a portfolio to benefit from declines and volatility the only investment style MWM offers?
Definitely not.  While MWM specializes in alternative asset investment management, we do offer traditional portfolio management along with our natural resource and long/short strategies. Tactical Short is a unique offering intended to compliment other risk asset allocations held with MWM or elsewhere.

What do you see as an appropriate percentage allocation to something like the Tactical Short from an overall portfolio mix perspective?
An allocation to our non-correlated Tactical Short adds value by reducing overall investment portfolio downside risk. We would suggest exposure to the Tactical Short in the range of between 5 and 20% of risk assets to help reduce overall portfolio volatility, enhance liquidity and provide meaningful downside protection.  For example: $2,000,000 in total equities and risk asset exposure would typically benefit from a $100,000 to $400,000 Tactical Short allocation.  With an allocation above 20%, we would assume that an investor has chosen our product to place a directional bet on a declining market.

Are there Minimum account sizes?
Institutional investors would generally have a minimum account size of $1,000,000 while, where appropriate, qualified individual investors would be considered with minimum account sizes at inception as low as $100,000.

What are management fees for Tactical Short?
1.0% per year paid quarterly in advance (25 bps per quarter).

If I am utilizing margin in the Tactical Short, will my account be charged for margin borrowing expenses? Are there other expenses I should be aware of?
While the portfolio manager seeks to minimize such costs, there are typically expenses associated with borrowing securities.  Borrowing costs are generally small, with the exception of hard-to-borrow securities. Traditionally, borrowing costs were offset by the return on an account’s cash collateral.

Why would I choose a MWM Tactical non-correlated account instead of a short ETF or options strategy?
We believe our strategy is superior to competing “bear” products and instruments.  Being fully short all the time simply doesn’t work.  Options strategies are risky and tough to execute successfully.  In our eyes, risk management is paramount.  The key to success on the short-side is having the flexibility to navigate through various market environments.  To do so successfully demands a disciplined investment process coupled with a sound analytical framework.  Importantly, there’s no substitute for experienced active-management on the short-side.  In our view, our new offering incorporates the most seasoned portfolio manager with the most compelling analytical perspective, investment process and philosophy available in the marketplace.

Does MWM custody assets? If not, who is the custodian?
We do not custody assets.  Our preference is to retain the services of a preeminent third-party custodian, an arrangement that facilitates online access to account holdings and myriad amenities common to a brokerage account.  Tactical Short client assets are held at Interactive Brokers.

Can I send additional funds to my account in the future?
Sure.  Additional funds can be added in any quantity.  Because Tactical Short accounts can be rebalanced daily, there should be minimal delay in adjusting positions sizes to incorporate flows into (or out of) your account.

Will this offering be closed at some point to new money?
We do not at this time anticipate capacity issues that would cause us to close the Tactical Short to new investors or restrict inflows.

Do I need to reserve a place?
That’s not necessary.  We would, however, highly recommend funding an account and then to allow us to determine the appropriate time to allocate assets. This is much preferred to beginning the process in the middle of unstable market conditions.

Are assets always invested on the short side?
No, there will likely be periods when we choose not to hold short exposure.  Our analytical framework and proprietary indicators assist us in gauging both when conditions are more favorable for shorting along with the most attractive composition of short exposures (i.e. stocks, sectors, the market, etc.) from a risk versus reward perspective. When conditions are expected to be unfavorable, the Tactical Short is content to watch from the sidelines (sitting in cash and avoiding short exposures).  Such a tactical pivot from being opportunistically short to defensively positioned creates the flexibility necessary to capture gains and then safeguard them from major market advances.

If Tactical Short operates with hedge fund-like versatility, why not charge the standard “2/20” (2% management fee and 20% of profits)?For one, we do not share the typical hedge fund mindset.  By keeping fees to a minimum, we endeavor to develop long-term partner relationships with our investors as we together navigate through the vagaries of market cycles. We did not develop our new product with the intention of getting rich from the next market downturn or financial crisis.  We were motivated by what we saw as a glaring lack of quality flexible short-side products – the type of strategy that savvy investors could live with comfortably during these uncertain and unsettling times.

When you are not short how are funds allocated?
It’s a little confusing.  Unlike long investing, cash is not used up in the process of borrowing and selling securities short.  Whether fully short or not short at all, account assets remain mostly in Treasuries and/or cash-equivalents.  Some of the cash holdings are used as collateral against short positions, but this cash remains in the account.  So even in periods of market stress, Tactical Short assets should remain safe and highly liquid.

How liquid are the funds in my account?
Funds are generally available same day. One of the benefits of a separately managed account is that requests for same-day liquidity can be accommodated.  Short positions will also be highly liquid.  In the event an account is liquidated, it will be possible to unwind (“cover”) short positions upon request and return cash collateral on a standard T+3 settlement basis.  No “gates” here.

Can I add money to an account in the future?
Yes.  There is a minimum to open an account but should you desire to increase your allocation to the tactical non-correlated theme you may do so at any time.

If future gains boost the size of my account, would you recommend allowing my short allocation to increase over time or instead employing a total portfolio re-balancing approach?
Having access to liquidity at market bottoms can be highly advantageous to value-conscious investors.   We’re going into our new venture with the assumption that Tactical Short’s ability to create liquidity in down markets creates an enticing long term value proposition for astute investors.  While tactical decision-making will be a primary management focus of our short offering, we fully expect our long-term investors to engage in cyclical allocation decisions consistent with their individual goals and circumstances.  As partners, we’re committed to doing our very best in offering valuable insight as well as attractive investment alternatives to best serve our investors as they strive to generate and preserve wealth.

Don’ts
  • Don’t be risk indifferent – unwise to maintain 100% short exposure all the time
  • Don’t disregard the macro backdrop
  • Don’t ignore the market
  • Don’t disregard portfolio beta
  • Don’t pretend long/short strategy mitigates risk
  • Don’t only short stocks
  • Don’t maintain concentrated short positions
  • Don’t only short a market index
  • Don’t have illiquid positions
  • Don’t rely on potentially problematic third-party derivatives
  • Don’t invest short collateral in potentially risky and illiquid instruments
  • Don’t be a “one-trick pony” – (i.e. company research, index or quantitative focus)

Do’s

  • Daily intensive, disciplined risk-management focus
  • Wisely adjust exposures based on market risk vs. reward backdrop
  • Be flexible and opportunistic with individual short positions and overall exposure
  • Incorporate experienced top-down macro research and analysis
  • Search for opportunities rather than fight the market
  • Intensive beta management: 
    • Protect against short squeezes and “upside beta” issues 
    • Guard against high market correlations
  • Have as many tools in the toolbox as possible: 
    • Short stocks, sectors, indices, various asset-classes, global perspective,
    • Liquid put options
  •  Incorporate a technical analysis overlay with risk management focus
  • Protect against potential systemic risks: 
    • Avoid third-party derivatives 
    • Liquid put options
    • Vigilant cash and liquidity management
  • Incorporate the best of micro, macro and technical analysis

    For more information or to inquire about opening an account for the Tactical Short Strategy, please contact us: [email protected]